Business and Economics Cycle, Financial Market Fluctuation, and Bank Profitability: Empirical Evidence from Indonesia

Abstract

This study examines how economic cycles, business cycles, and financial market fluctuations affect bank profitability. The topic is relevant and important in the context of macro prudential policy and systemic risk in the banking sector in Indonesia. Evaluating how economics cycle, business cycle and financial market fluctuation influence the profitability of bank is important as such indicators could be used as early warning indicators in anticipating the banking instability that could lead to a more severe financial crisis.The sample of this study comprises of banks operating in Indonesia, which includes seven groups of banks: (1) commercial banks; (2) state-owned banks, (3) foreign exchange commercial banks; (4) non-foreign exchange commercial banks; (5) regional development banks; (6) joint venture banks; and (7) foreign banks. The data utilized in this study is panel data covering 13 consecutive years observation period (2000-2012), with a total of 91 firm-year observations.The factors examined in this study are based on the model of macro prudential indicators proposed by IMF (2001). The model states that there are three main groups of macroprudential indicators: (1) macro economics indicators; (2) aggregated micro prudential indicators; and (3) market-based indicators. The dependent variables in this study can be classified into two groups: (1) the components of profitability (net-interest income; non-interest income; operating costs; and profit before tax), and (2) the level of profitability (ROE and ROA). The study utilized the Generalized Method of Moment (GMM) regression which economically considered more superior in terms of efficiency and consistency than the traditional OLS regression models.The findings reveal that bank profitability is positively associated with the economic cycle factors such as GDP, but negatively affected by the exchange rate of USD/IDR. Among business cycle indicators, the result indicates that the net interest margin (NIM) has a positive and significant effect on bank profitability, while asset quality indicators, efficiency (BOPO) and credit risk (NPL) showed a negative effect on bank profitability. The findings on financial market fluctuations factors indicate that the stock market capitalization, capital market volatility index, as well as the proportion of foreign debt relative to GDP showed a negative effect on the profitability of banks.The implication of this paper is that policies aimed at controlling those factors found significantly induced bank profitability should be given priority in fostering financial intermediation. Since the indicators of macroeconomic cycles (GDP and exchange rate of USD/IDR), the bank business cycle indicators (asset quality, NPL, BOPO, and NIM), and fluctuations in the financial markets (stock market capitalization, capital market index volatility, as well as the proportion of foreign debt) matter for bank profits, the government and Central Bank should put more attention on the various factors as indicators that can be used as the early warning system to anticipate the occurrence of banking instability and to prevent a systemic financial crisis.