Income Volatility of Indonesian Banks after the Asian Financial Crisis

Abstract

The factors that determine Indonesian bank risk (especially income volatility) are considered from a longer run perspective. The paper considers Indonesian banking through three distinct developmental phases, (i) the period leading up to and including the Asian Financial Crisis (AFC), (ii) the post AFC reform and reconstruction period and (iii) the post reform period. It is found that higher franchise value (as measured by retail activity) is consistently related to lower bank risk across all three phases of Indonesian banking. Evidence is found of a U-shaped relationship between bank risk and loan growth. In particular, low to medium levels of loan growth are associated with lower bank risk, while high levels of bank risk are associated with increased bank risk, consistent with (Kwan and Eisenbeis, 1997). The combination of regulatory laxity prior to the AFC and regulatory forbearance in the reconstruction period has meant that this paper finds no evidence that bank capital has acted in its traditional (Diamond and Dybvig, 1983) role of reducing bank risk. In the post-AFC reconstruction period there is some limited evidence of decreasing returns to size in terms of risk reduction. Finally, this paper finds no evidence to support the arguments in favour of bank’s increasing portfolio diversification via increased non interest income. Instead, the post reconstruction evidence finds that those banks more focussed upon providing traditional banking products (intermediation) are less risky than those banks with higher levels of non interest income, consistent with current body of empirical evidence (see for example, (Goddard, McKillop and Wilson, 2009), (Berger, Hasan and Zhou, 2010)).