Financial System Stability and Deepening in Indonesia: challenges - - PowerPoint PPT Presentation

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*The views and opinions expressed herein are those of the author, and do not necessarily reflect the views of the World Bank and its affiliated organizations, or those of the Executive Directors of The World Bank or the governments they represent

Financial System Stability and Deepening in Indonesia: challenges amid regulatory capital reform under Basel III

Djauhari Sitorus - World Bank*

The Asian Banker Indonesia International Banking Convention Jakarta, February 2012

What do we mean by Financial System Stability and Financial Deepening? There is no single definition of financial system stability nor financial deepening. Financial system stability is a condition represented by a strong financial system capable of withstanding economic shocks, one that is able to ensure intermediary function, settlement of payments and diversification of risk. Financial deepening, sometimes is known as financial development, refers to the increased provision of financial services with a wider choice of services in the economy or an increase in the size of the financial system and in its role and pervasiveness in the economy.

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Financial Stability in Indonesia depends on financial soundness of the banking sector

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Banks (Comm & Sharia) 80% Pension Funds 3% Insurer 5% Finance Companies 6% Mutual Funds 4% Rural Institutions 2% Pawnshop 0% Venture Capitals 0%

2000

Banks (Comm & Sharia) 80% Pension Funds 3% Insurer 5% Finance Companies 6% Mutual Funds 4% Rural Institutions 2% Pawnshop 0% Venture Capitals 0%

2010

• Highly concentrated -

banking sector dominates, recording stronger asset growth compared to that of the non-bank financial institutions.

• The top three state-owned

commercial banks account for

• ne third of all banking sector

assets and deposits.

Source: BI, Bapepam LK, WB estimates

The economic cost of a failure to maintain financial soundness of banks is high

 The 1997/1998 banking crisis was costly. It wiped off 50% Indonesia’s GDP.  Fiscal costs of the 1997-1998 crisis were the highest recorded.  Since then, serious reforms and efforts have been taken to restoring and maintaining financial system stability.

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10 20 30 40 50 60 Swe de n 91 Co lo mb ia 82 Hung a ry 91 Cze c h 89 Philippine s 83 Ma la ysia 97 Me xic o 94 Ve ne zue la 94 K

• re a 97

T ha ila nd 97 I ndo ne sia 97 % o f GDP

Source: Honohan and Klingebiel, 2000.

Sustained efforts for maintaining financial system stability have been paying off…

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• Banking sector NPL ratio

largely unaffected by 2008 crisis and continues to improve.

• In 2011 NPL ratio

maintained low level of 2.7% (vs 2007 6%).

• CAR consistently strong

and 17.2% 2011, high level of Tier 1 capital.

• ROA, ROE and NIM had

increased to 3.1%, 18.8% and 5.9% in 10/11 respectively compared to 2.9%, 19.2%, 5.7% 12/10.

• High level loan provision

consistently over 100% minimum level required. As of 10/11, the ratio increased to 194% from 131% in 12/10.

18.58 73.46 89.44 3.36 3.08 5.84 0.00 1.00 2.00 3.00 4.00 5.00 6.00 7.00 0.00 15.00 30.00 45.00 60.00 75.00 90.00 105.00 120.00

CAR (L HS) L DR (L HS) BOPO (L HS) NPL (RHS) ROA (RHS) NIM (RHS) Source: Bank Indonesia

Banks Intermediary function has improved, with significant lending share to SMEs.

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Ag ric ulture , 5 mining , 3.7 ma nufa c turi ng , 15.5 e le c tric ity, 2.3 c o nstruc tio n, 3.5 tra de , 18.2 tra nspo rt, 4.3 b usine ss se rvic e s, 10.4 so c ia l se rvic e s, 2.6 Othe r, 34.6

L

• a ns b y se c to r

2011 (% to ta l ne w

• Maintained low operating efficiency

measured by the ratio of operating expenses to operating incomes - increased slightly from 85.9% in 10/2010 to 86.4% by 10/2011.

• The deposit and lending rates stable at

6.5% and 12% over 2011.

• Domestic credit to private sector slight

increase 28.8% (v 25% 2006).

• Loan to deposit ratio increasing 81%

2011 (75.2% 2010, following regulation on minimum LDR 75%).

• Loans increased 20% with SME lending

increasingly prominent - outstanding SME lending increased to 53% (52.4% 2010, 50% 2008).

• Majority bank lending for working capital

(48%) but over past five years shifting to investment loans (21%) and consumption (31%), the latter also capturing MSME lending.

10 20 30 40 50 60 2007 2008 2009 2010 2011

Pe rc e nta g e Ne w le nding

Wo rking c a pita l lo a ns I nve stme nt lo a ns Co nsumptio n

Stress Testing and Vulnerability: Lessons from FSAP

 From October 2009 until March 2010, a joint IMF-WB team conducted the Financial Sector Assessment Program (FSAP) for Indonesia. As part of the FSAP, a bank stress testing was conducted.  The stress test involved scenario analysis and sensitivity analysis. The scenario analysis was used to infer banks’ vulnerability to credit risk, while the sensitivity analysis focused on banks’ vulnerability to a range of market risk shocks. Both top down and bottom up methodologies were used.  Key findings:  Credit risk is the main source of risk facing the Indonesian banks.  Indonesian bank are relatively resilient to market shock. They are most sensitivity to interest rate shock on their banking book but can withstand other type of market risk.  Banks have limited exposure to interest rate on their trading book.

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Stress Testing and Vulnerability: Lessons from FSAP

 Key findings (continued):  Smaller sized banks are most vulnerable to liquidity risk whilst the largest banks are vulnerable to concentration risk.  Contagion risks through the interbank market are not significant due to small size of the interbank exposures.  There is a wide diversity of stress testing capacities among the participating banks (12 banks). Most were able to undertake meaningful sensitivity analysis. They were able to also assess their exposures to concentration risk arising from the failure of their largest borrowers.  However, a few banks were able to fully evaluate the adverse macro-economic scenario that was chose for the FSAP. In particular, there were significant shortcomings in the methodologies used by many of these banks to assess credit risk regardless whether these were models based on/or incorporated expert judgment.

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However, financial deepening appears to be a challenge…

 Bank’s size to GDP is low compared to Thailand 97%, Malaysia 129%, Philippine 54%.

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44 43 42 41 39 38 35 35 36 36 5 10 15 20 25 30 35 40 45 50 2002 2003 2004 2005 2006 2007 2008 2009 2010 No v-11

%

Ba nk De po sits/ GDP

Insurance Multifinance Pension Fund Mutual Fund

Source: Infobank, BapepamLK

119.9 139.4 174.9 228.8 243.6 315.6 356.7 100.7 119.6 152.9 202.2 211.5 273.5 313.6 41.4 48.1 55.6 77.8 90.3 103.2 60.9 0.0 50.0 100.0 150.0 200.0 250.0 300.0 350.0 400.0

2004 2005 2006 2007 2008 2009 Se p-10

IDR T rillion

T

• ta l Asse ts

T

• ta l Inve stme nt

T

• ta l Pre mium

500 1000 1500 2000 2500 3000 3500 5 10 15 20 25 30 35 40 45 50 Jun-05 Oc t-05 F e b -06 Jun-06 Oc t-06 F e b -07 Jun-07 Oc t-07 F e b -08 Jun-08 Oc t-08 F e b -09 Jun-09 Oc t-09 F e b -10 Jun-10 Oc t-10

IDR T r illion

NAV E q uity (L HS) I HSG (RHS) 52.3 62.12 71.82 68.56 84.13 3.94 5.34 6.82 6.86 9.08 5.85 7.5 9.29 11.13 14.85 2005 2006 2007 2008 2009

T

• tal Inve stme nts

(IDR T r illion)

E PF

• De fine d Be ne fit

E PF

• De fine d Co ntrib utio n

F IPF

NBFIs are growing strongly but still small.. (1)

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96.5 108.9 127.3 168.5 174.4 102.5 92.8 107.7 137.2 142.5 49.2 55 76.8 109.9 101.9

20 40 60 80 100 120 140 160 180 200 2005 2006 2007 2008 2009

IDR T rillion

T

• ta l Asse t

T

• ta l F

ina nc ing T

• ta l Bo rro wing

NBFIs are growing strongly but still small… (2)

 Stock market capitalization trending up, hovering around 48% GDP.  Low compared to region- Thailand 74%, Malaysia 139%, Vietnam 35%.

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20.42 14.33 14.78 35.80 18.68 14.21 14.16 22.50 29.91 28.77 37.40 50.24 21.73 35.97 50.55 47.63 7.58 11.75 8.64 12.76 8.83 5.79 6.36 6.13 10.87 14.58 13.35 26.54 21.49 17.37 18.31 16.47 249 246 247 247 239 246 245 242 241 243 242 246 240 241 245 247

232 234 236 238 240 242 244 246 248 250 0.00 10.00 20.00 30.00 40.00 50.00 60.00 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

T ime s %

Sto c k Ca pita liza tio n/ GDP Va lue T ra de d Ca pita liza tio n/ GDP T urno ve r Ra tio (RHS)

NBFIs are growing strongly but still small… (3)

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1.4 1.1 1.1 2.2 2.7 2.3 2.0 2.1 1.5 1.6 1.8 1.7 2.3 3.8 21.0 19.1 17.6 14.4 12.5 12.0 10.6 10.2 10.0 9.2

5 10 15 20 25 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

%

Co rpo ra te Bo nd Ca pita liza tio n/ GDP Go ve rnme nt Bo nd Ca pita liza tio n/ GDP

 Bond market capitalization is small though growing: Approx. 13.4% of GDP (2011) compared to 12% (2010).  One of the lowest in the EAP region: Thailand 65% GDP.

Access to financial services is limited for a significant portion of population…

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20 40 60 80 100

Share of the population with formal financial access

%

Source: World Bank 2010

The regulatory capital reform for banks: from Basel II to Basel III

BASEL II

BASEL III

In essence Basel III is an evolution rather than a revolution. Basel III was developed from the existing Basel II framework, and the most significant differences for banks are the introduction of liquidity leverage ratios, and enhanced minimum capital requirements.

MINIUM CAPITAL REQUIRMENT SUPERVISORY REVIEW PROCES DISCLOSURE AND MARKET DISCIPLINE ENHANCED MINIMUM CAPITAL AND LIQUIDITY REQUIRMENTS ENHANCED SUPERVISORY REVIEW PROCES FOR FIRM WIDE RISK MANAGEMENT AND CAPITAL PLANNING ENHANCED DISCLOSURE AND MARKET DISCIPLINE SOURCE: PWC, Moody’s Analytics, WB

2.00 3.50 4.00 4.50 4.50 4.50 4.50 4.50 2.00 1.00 1.50 1.50 1.50 1.50 1.50 1.50 4.00 3.50 2.50 2.00 2.00 2.00 2.00 2.00 0.63 1.25 1.88 2.50

Current 2013 2014 2015 2016 2017 2018 2019 Common Tier 1 Capital Other Tier 1 Capital Tier 2 Capital Capital Conservation Buffer Counteryclical Buffer

8-10.5% 8-10.5% 8-10.5% 8.63-11.13% 9.25-11.75% 9.88-12.38% 10.5-13%

0-2.50 0-2.50 0-2.50 0-2.50 0-2.50 0-2.50 0-2.50

8%

Minimum Total Ratio

* Ratios DO NOT include potential capital surcharges for SIFIs or Pillar 2 charges.

* Ratios DO NOT include potential capital surcharges for SIFIs or Pillar 2 charges.

Enhancing preparedness- how to stand firm

Basel III: Minimum Pillar 1 Capital Ratios*

2011 2012 2013 2014 2015 2016 2017 2018 2019 Leverage Ratio - 3% level Migration to Pillar 1 Leverage Ratio - Disclosure Introduce Disclosure Guidelines Minimum Common Equity Capital Ratio Levels 3.50% 4.00% 4.50% 4.50% 4.50% 4.50% 4.50% Capital Conservation Buffer Level 0.63% 1.25% 1.88% 2.50% Minimum common equity plus capital conservation buffer 3.50% 4.00% 4.50% 5.13% 5.75% 6.38% 7.00% Minimum Tier 1 Capital 4.50% 5.50% 6.00% 6.00% 6.00% 6.00% 6.00% Minimum Total Capital 8.00% 8.00% 8.00% 8.00% 8.00% 8.00% 8.00% 8.00% 8.00% Minimum Total Capital plus conservation buffer 8.00% 8.00% 8.00% 8.63% 9.13% 9.88% 10.50% Countercyclical Capital Buffer 0% - 2.5% 0% - 2.5% 0% - 2.5% 0% - 2.5% 0% - 2.5% 0% - 2.5% 0% - 2.5% 0% - 2.5% 0% - 2.5% Total Capital including 2 Buffers 8% - 10.5% 8% - 10.5% 8% - 10.5% 8% - 10.5% 8% - 10.5% 8.625% - 11.125% 9.125% - 11.625% 9.875% - 12.375% 10.5% - 12.5% Non-qualifying instruments Phase-in of deductions from CET1 (including amounts exceeding the limit for DTAs, MSRs and financials) 20% 40% 60% 80% 100% 100% Liquidity coverage ratio Introduce minimum standard Net stable funding ratio Introduce minimum standard Liquidity Observation period Observation period Supervisory monitoring Parallel run Definition of Capital Phased out from 2013-2022 - 10% of 2013 value per year

Phase-in Arrangements of Basel III

Potential impact on emerging markets*

• The focus so far has been on the potential impact on developed

economies.

• Less attention is paid on the potential impact on emerging markets,

perhaps because of the belief that they will not be severely affected by the reforms since most emerging market banks already have high level and quality of capital.

• However, this is a static accounting view. Taking on a more dynamic

view reveals that the global regulatory reforms could potentially have an adverse impact on emerging markets through 2 channels:  Direct channel – impact on availability and cost of credit in emerging markets.  Indirect channel – impact on capital flows to emerging markets and

• n the growth in developed economies.

Adopted from Andrés Portilla (Institute of International Finance) presentation at the World Bank’s FPD Forum , April 2011.

Potential impact on emerging markets

Direct channel

• Characteristics of emerging markets’ financial systems.

 Financial intermediation is mostly done by banks.  Relatively underdeveloped capital markets.

• Hence, any reforms that limits the ability of banks to provide credit to the

economy will hamper growth. The new capital and liquidity standards could potentially limit the volume and tenor of bank lending:  The stricter capital rules will force banks to decrease lending in order to meet the capital requirements.  The new liquidity rules will make it less attractive to lend long-term.

• In the long run, the reforms may also have implications on efforts by emerging

markets to increase penetration of financial services in their economies.

• Finally, the reforms may also be a bane to emerging markets’ efforts to develop

their capital markets.  Since the Basel rules are designed specifically to increase the amount of capital to support banks’ capital market activities, this could hinder the growth of capital markets in emerging markets where banks are the main players.

Potential impact on emerging markets

Indirect channel

• Structurally, most emerging economies have to rely on foreign capital,

i.e. they have more consumption than savings.

• However, the reforms may limit the amount of funds from international

lenders that goes to emerging markets. Restriction on lending to emerging markets could result from any or both of the following:  Stricter capital rules (international lenders may limit lending to emerging markets because it would require more capital to support)  New liquidity rules (the liquidity rules limit banks’ ability to lend long term (NFSR) and international lenders may prefer to lend to highly rated sovereigns so it would qualify as a liquidity buffer (LCR)).

• The slower economic growth in developed economies that would result

from the financial reforms may also have an impact on emerging markets, which rely on the developed economies as markets for their exports.

Other emerging market issues on specific elements

• f Basel III

Countercyclical buffer

• Emerging markets are expected to be the first to be bound to

build the countercyclical buffer as credit in these markets continue to expand due to large capital inflows.

• However, part of the emerging markets’ credit growth considered

excessive by the Basel methodology is but a natural consequence of their financial development.

 For example, the still increasing penetration of bank services in emerging markets may lead to a very significant expansion in credit. Capital

• Many emerging markets do not have established markets

enabling banks to raise the quantities of additional going concern Tier 1 capital and Tier 2 capital that are envisioned by Basel III.

Closing words…

 Implementation of Basel III will help fostering financial system stability in Indonesia but may bring additional challenges in efforts deepening the system.  Given current profile and condition of Indonesian banks, it seems there is no immediate concern about the implementation of Basel III.  Finally, this leads us to reflect on the words of the Greek philosopher Socrates (Athens, 469 BC - 399 BC), who wisely said that if a man is proud of his wealth, he should not be praised until it is known how he employs it.  Likewise, a national financial system that is proud of its stability and of its resilience to crisis should not be praised until it is known whether that system efficiently provides financial intermediation that contributes to economic growth and the greater welfare of the nation.

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Thank you

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