Financial deregulation, banking development, and the likelihood of banking fragility: the case of Indonesia

The objective of this thesis is to examine the relationship between interest rates, saving through the banking sector, credit from banks, and private investment using the financial deregulation hypothesis and the determinants of the probability of banking fragility for the Indonesian case. Some of the financial deregulation hypothesis related to those variables and the determinants of the likelihood of banking fragility has been tested using cross country data, but only a few studies have been performed using country specific data and there is no study for the particulars of the Indonesian case. Therefore, this study is intended to fill those gaps and add to the literature on the links between financial deregulation, banking intermediation, and banking fragility in the Indonesian economy. Moreover, this study will add the additional credit fiinctions associated with state banks and national private banks and add additional variables to the credit fiinction to consider specific issues associated with the Indonesian financial sector such as borrowing from Bank Indonesia. In addition, this study covers the 1997 financial and banking crises period, therefore this study will use a unit root test to consider the possibility of the presence of a structural break associated with the 1997 financial and banking crises for variables most relevant to the monetary and banking sectors in Indonesia. To investigate the relationship between interest rates, saving through the banking sector, credit from banks and private investinent using the financial deregulation hypothesis, it is hypothesised that real interest rates will encourage saving through the banking sector. Furthermore, it is hypothesised that credit from banks plays important role as a channel between saving through the banking sector and private investinent. It implies that financial deregulation contributed to increasing private investment through the availability of credit from banks and in turn it contributed to increasing economic growth. This hypothesis is in line with Shaw's views on debt intermediation. However, private investment is also hypothesised to be related to net capital flows of the private sector which essentially were foreign borrowings. Therefore, it suggests that private investment is not only financed by domestic banks but also by foreign borrowing. If most of the foreign borrowing is unhedged, a sudden large depreciation of the domestic currency will reduce the net worth of the borrower, which in tiim, will contribute to increasing banking problems. The problem in the banking sector, however, is often associated with other factors. Therefore, it is hypothesised that the probability of banking fragility is influenced by three groups of variables namely financial deregulation variables, macroeconomic variables, and group bank specific variables. This thesis found that positive real interest rates significantly affect real saving through the banking sector and that real saving after being reduced by the minimum reserve requirement is positive and significantly affects real credit from the banking sector in the long run. Real credit from the banking sector is also positively affected by borrowing from Bank Indonesia. Moreover, real credit from the banking sector positively and significantly affects real private investment and real private investment is also positive and significantly related to net capital flows of the private sector in the long run. This finding supports the evidence that real private investment was associated with credit from the banking sector and net capital flows of the private sector. By examining the impact of real interest rates on real saving through the banking sector, real saving through the banking sector adjusted for minimum reserves on real credit from the banking sector, and real credit from the banking sector on real private investment, there is evidence that an increase in real interest rates accompanied by a credible financial policy is associated with an increase in real private investment through the credit availability effect at least up to the second quarter of 1997. This finding is consistent with Shaw's views on debt intermediation, which are that an increase in banking intermediation contributes to increased private investment. An increase in banking intermediation which is indicated by increased credit to the private sector, however, is also often associated with an increased probability of banking fragility. This thesis found that the probability of banking fragility in Indonesia is significanfly related to financial deregulation variables and group bank specific variables for both the sample periods 1986:3-1997:2 and 1986:3 1999:2. On the other hand, macroeconomic variables are not significant in influencing the probability of banking fragility for the sample period 1986:3-1997:2, but are significanfly related to the probability of banking fragility for the sample period 1986:3-1999:2.