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2.2. Regulation on Non-performing Loans (NPLs) in Indonesia

2.2. Regulation on Non-performing Loans (NPLs) in Indonesia

Efficiency indicates that banks run their business activities with relatively MI title loans low costs. Berger and DeYoung (1997) find that reduction in cost efficiency of the US commercial banks precedes an increase in the future loan defaults. This is caused by managers who are unable to control their operating expenses as well as to practice appropriate daily operations and loan portfolio management. Nonetheless, when a subset of relatively efficient banks is scrutinized, an increase in cost efficiency is followed by a hike in loan defaults, proving the skimping hypothesis. Under this hypothesis, an increase in loan defaults occurs because the banks choose to spend a low price on underwriting and monitoring loans in the short run and bear the risk of having loan performance problems in the future.

Therefore, the OJK supports the BIs macro prudential regulations through its roles in monitoring and assessing individual bank soundness and health indicators not only in the capital adequacy ratio (CAR) but also liquidity, solvability, profitability e

Bank capital also empirically affects the NPL ratio in the opposite direction. On one hand, due to the moral hazard incentive, managers of low-capitalized banks tend to get involved in high-risk loans which area issued through inadequate credit scoring and monitoring (Keeton Morris, 1995). These risky credit activities induce a rise in loan defaults, implying a negative relationship between capital and NPL ratio. On the other hand, managers in high capital bases apply liberal policy when granting credits because they are assured that the banks are less likely to go bankrupt and are “too big to fail” (Rajan, 1994). Therefore, these banks are engaged in high-risk credit activities, suggesting a positive relationship between bank capital and NPL ratio.

Earnings received by banks can be distinguished as interest income coming primarily from lending activities and non-interest income coming from trading and derivative transactions. Banks with more diversified income (other than interest income) tend to be more prudent and lower their risks by having less involvement in high-risk credit activities. Hence, these banks have better loan performance, suggesting an inverse relationship between income diversification and NPL ratio (Ghosh, 2015). Another work of research by Hu, Li, and Chiu (2004) implies that income diversification per se cannot be used to associate the lower NPL ratio, because it is highly dependent on how banks diversify their income effectively. Thus, they suggest that income diversification and NPLs have no relationship. Table 1 shows the summary of literature review on non-performing loans determinants in the banking sector.

In Indonesia, the asset of the banking sector continues to dominate its financial system; however, the ratio of bank assets to GDP is relatively low (50.8 per cent in 2016). Consequently, bank intermediation activity is also relatively low. In 2016, there were 115 commercial banks in Indonesia with different subjects of ownership, including state-owned banks, regional development banks, national private banks, joint ventures, and foreign banks. The Indonesian banking sector has successfully maintained its capital adequacy ratio (CAR) of 23 per cent well above the OJKs benchmark of 8 per cent.

After the Asian Crisis in 19971998, the Indonesian banking sector underwent restructuring processes aiming to strengthen the supervision function and to adopt good governance. g., NIM), asset quality (e.g., NPLs), efficiency (e.g., operating expenses to operating revenue), and intermediary function (loan to deposit ratio/LDR).

The reforms involve taking from the establishment of the deposit insurance corporation (the Lembaga Penjaminan Simpanan/LPS) to the split of banking supervision between the central bank (the Bank Indonesia/ BI) for macro prudential and the OJK for micro prudential regulations

In terms of NPLs, the BI requires commercial banks in Indonesia to maintain their NPL ratio under 5 per cent of their gross loans. NPLs in Indonesia are defined as the bank loans in which the debtors have not made their scheduled installments or interest payments for 90 days or more. The NPLs are then classified as sub-standard (SS), doubtful (D), and loss (L), regarding the earning assets quality (Bank Indonesia, 2012): (1) sub-standard: the debtor has not made his scheduled installments or interest payments between 90 to 120 days, (2) doubtful: the debtor has not made his scheduled installments or interest payments between 120 to 180 days, and (3) loss: the debtor has not made his scheduled installments or interest payments in more than 180 days.

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