Using Earnings-at-Risk to Assess the Risk of Indonesian Banks

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Using Earnings-at-Risk to Assess the Risk of Indonesian Banks

Elisa R. Muresan, Ph.D. 1 Nevi Danila, Ph.D. 2

JEL Classifications: F37, G20 Authors’ Keywords: Capital Adequacy Ratio (CAR) Earnings-at-Risk (EaR), Bank Risk, Indonesian Banks Questions and feedback may be directed to both authors.
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Elisa R. Muresan is an Assistant Professor of Finance at The School of Business, Public Administration, and Information Sciences, Long Island University, 1 University Plaza, Brooklyn, NY 11201, USA. Tel. +1 – 718 – 488 1150, Fax. +1 – 718 – 488 1125, Email: elisa.muresan@liu.edu Nevi Danila is the President of the Malangkuçeçwara School of Economics, Jl. Terusan Kalasan - Malang 65142, Jawa Timur (East Java), Indonesia. Tel. + 62 – 341 – 491813, Fax: + 62 – 341 – 495619, Email: nevida@stie-mce.ac.id

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Using Earnings-at-Risk to Assess the Risk of Indonesian Banks

ABSTRACT The implication of Asian Crises in 1997-1998 has been detrimental to many financial institutions in the Asia-Pacific region. Most severely, followed by political reformation throughout 1998 to 2000, almost all of approximately 250 banks registered in the Indonesian Central Bank (Bank Indonesia) database had to undergo major financial reformations, merged with other banks, or simply had to be liquidated. The CAR Methodology, which has been used as the main tool by Bank Indonesia to investigate and estimate the riskiness of Indonesian banks, was not able to accurately estimate the risk of these banks. In this paper, we provide a theoretical framework and empirical analysis on the potential use of Earnings-at-Risk (EaR) to complement the current risk assessment methods used for the Indonesian banks.

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INTRODUCTION
Asian Crises in 1998 have brought down many financial institutions in the South East Asian Nations to their lowest point of loss from their highest peak of glory during the Asian Tigers Economic period in the 1990s. More specifically in Indonesia, within 2 years (1998 – 1999), the government had to merge 4 state-owned banks (there were only 7 state-owned banks registered in the Indonesian Central Bank -herewith will be referred to as Bank Indonesia- since 1990), close 48 commercial banks, recapitalize 7 others, and merge another 9 into 1 bank (Raj and Rinastiti, 2001). According to many recent studies1, the main quantitative reasons to blame for this massive recapitalization and avalanche of closures are the undercapitalization and heavy dependence on foreign exchange loans of the Indonesian banks. The main qualitative reason for it, is the weak risk management enforcement by the country’s central bank (Enoch, 2000). The method adopted by Bank Indonesia to assess the financial viability of Indonesian banks since 1992 has been the Capital Adequacy Ratio (CAR)2. Whilst proven to be useful, CAR has several potential drawbacks, mainly because (a) it cannot be easily updated to provide the most recent picture of the bank’s financial condition, and thus may not be used as a continuous pre-emptive method to assess the risk of the banks; and (b) it does not assess the importance of the earnings volatility of the banks over a desired period of analysis. Earnings-at-Risk (EaR) methodology provides an estimate of the worst value of earnings that a bank may have to survive with during a certain financial period. It certainly has the potential to overcome the drawbacks of CAR, namely (a) it can be easily updated; (b) it assesses the earnings volatility of the bank; and (c) it incorporates many other factors that may influence the banks’ capability to generate ‘real’ earnings through usage of different assumptions. Having been used by many corporations in developing countries, EaR uses in Asia have been very limited (Delhaise, 1998). This paper provides a theoretical framework and preliminary empirical evidence that EaR is a viable and useful technique to estimate the risk of a bank in Indonesia.

See for example Claessens and Glaessner...
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