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Early warnings of changes in bank soundness during normal and crisis economic conditions: A supervisory approach for Indonesian banks

Sadguna, I Gde Made (2000) Early warnings of changes in bank soundness during normal and crisis economic conditions: A supervisory approach for Indonesian banks. Professional Doctorate thesis, Murdoch University.

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During the recent Southeast Asian financial crisis, numerous banks failed quickly and unexpectedly. The devastating impacts of the crisis necessitate an effective bank monitoring system to prevent similar failures from repeating itself in the future. In particular, maintaining the stability of the financial system requires - among other things - effective early warning systems that allow for assessing bank soundness overtime more accurately.

This study uses a unique data set provided by Bank Indonesia to examine the changing financial soundness of Indonesian banks during the normal and crisis periods. Bank Indonesia's non-public CAMEL rating data allow the use of a continuous bank soundness measure rather than ordinal or dichotomous measures used in previous discriminant analyses or logit and probit studies. These data and financial report data of 52 commercial banks over 18-quarter periods are used to construct panel data sets. Panel data analysis procedures are used to estimate models predicting bank soundness during normal and crisis economic conditions.

The results indicate that during stable economic periods, all of the CAMEL components provide insights into the financial soundness of Indonesian banks. However, during Indonesia's crisis period, only one of the traditional CAMEL components - earnings - objectively discriminates among the supervisory ratings. The results also suggest that the role of unobserved variables representing individual bank characteristics (bank effects) and time variant factors (time effects) are important in determining bank soundness. Individual bank effects are important during both normal and crisis economic conditions. While they are not significant during stable periods, the time effects are particularly important during the crisis. This implies that bank soundness and risk profile varies across banks and across different economic conditions. In addition, theoretical analysis and the subsequent practical examinations suggest that panel data analysis technique incorporating bank and time effects results in early warning models that are superior to models resulting from classical ordinary least squares techniques.

Hence, this study accomplishes three important goals. First, it provides early warning models applicable for normal and crisis economic conditions. Second, the study recognizes the fact that banks are heterogeneous; suggesting that "one measure fit to all" approach in banking supervision must be implemented with care. Third, the study provides evidence that business environment, especially changes in economic conditions, shapes the soundness of a bank.

In addition, the study highlights the key role bank supervision plays as a "safe guard" of the financial system. Finally, the study also underscores the invaluable practical benefits gained from using empirical approach to support the well functioning supervisory system.

Item Type: Thesis (Professional Doctorate)
Murdoch Affiliation(s): Division of Business, Information Technology and Law
Notes: Note to the author: If you would like to make your thesis openly available on Murdoch University Library's Research Repository, please contact: Thank you.
Supervisor(s): Gasbarro, Domenico
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