Who Disciplines Indonesian Banks? A Study of Market Discipline in Indonesia 1980-1999

Abstract:     
This thesis examines market discipline exercised by Indonesian depositors and peer banks from January 1980 to December 1999. Discipline exists if risky banks are forced to pay higher interest and suffer deposit withdrawals. However, to be effective, market discipline requires monitors to access and process reliable accounting information. In the case of Indonesian peer banks, these may serve as better monitors than depositors because they have better resources to collect and process information about their counterpart banks.

In order to test discipline by depositors, this research uses Indonesian banks' call reports from January 1980 to December 1999 submitted to Bank Indonesia (the central bank). Detailed call money transactions from April 1993 to December 1999 are used to test the market discipline exercised by peer banks. Another data source relates to Indonesian business groups, whereby this research classifies banks according to their ownership associations with Commercial Power Centres.

The results suggest market discipline barely existed in Indonesian banking. Indonesian depositors only punish banks without associations to pressure groups. Moreover, within the population of bank pairs, the borrowing banks' financial performance does not determine the lending banks' call money exposures. Within the sample of pairs that engage more frequently, both the borrowing banks' financial performance and the lending and borrowing banks' interlock (in this study a term denoting the special relationship between bank pairs based on banks' share ownership, or owners' kinship, or bank rescue) determine the lenders' call money exposures. However, the effect of interlock is stronger.

Although convincing support for the existence of market discipline is lacking, this research contributes to knowledge about how two types of monitors - the depositors and the peer banks - exercise discipline in a country such as Indonesia. This is also the first research to study interbank interlock in market discipline exercised by peer banks. The overall findings suggest that Basel II's reliance on market discipline in its third pillar may prove less effective in the context of developing countries. Therefore, regulators may need to place greater emphasis on the first pillar (the capital requirements) and the second pillar (bank supervisory review of capital adequacy and internal assessment).

Keywords: market discipline, banking regulation, indonesia

JEL Classification: G21, N25, O53

working papers series