Modelling the risk of banking system instability in Indonesia using a cross-sectional dependence panel data model

Abstract: Since the Asian financial crises in 1997, the Indonesia’s banking system has undergone significant transformation. Bank Indonesia has increased the minimum capital requirements for the country’s banks; however, its financial system may still be fragile and possibly vulnerable to unexpected macroeconomic shocks. This paper explores the financial health of the Indonesia’s banking sector and specifically, we develop a credit risk model containing a set of macroeconomic and bank specific factors. Using a cross-sectional dependence panel data regression, we estimate these factors and determine under which conditions this banking system may be susceptible to financial distress. The paper concludes that macroeconomic fundamentals (i.e. RGDP growth, inflation, stock market performances, net exports and depreciation of domestic currency) and financial soundness (i.e. reserve for money bank deposits and ratio of net foreign assets to GDP) are the factors most likely to influence its stability. Furthermore, bank efficiency can predict banks’ credit risk. The study highlights several limitations and future directions for this research topic