Summary of Final Research for obtaining Bachelor of Economics in Management Programme of Interested Banking (1998)

By Jeffry Merril Liando, School of Financial Economics and Banking of Indonesia

 

1.      Title “The Most Important Variables of Financial Ratios in Predicting Bank Success”

 

2.      Background

Global competition in the financial service industry requires commercial banks in Indonesia to establish a goal of strengthening bank performance toward APEC 2003. In 1996, banking industry in Indonesia apparently had lower size and performance compared to other countries in South-East Asia, such as Thailand, Singapore and Malaysia. The benchmark of stronger financial condition can be simply indicated by positive growth in assets and profit in one year of operation. Short-term success by the means of positive growth can therefore strengthen bank performance continuously in long-term as to cope with the competitive necessity in regional market. However, success in growth is influenced by many particular indicators regarding to the role of banking management, such as liquidity, profitability, solvability, efficiency and risks. This research accommodates 17 particular indicators of bank financial ratios in order to determine several of them, which are the most important ones in predicting success in short-term growth. This research is motivated by previous empirical studies in company’s bankruptcy prediction model conducted by Altman (1968 and 1977).

 

3.      Problem Formulation

What are the most important variables of financial ratios in predicting bank success?

 

4.      Research Objective

To find and interpret the most important variables of financial ratios in predicting bank success.

 

5.      Significance of Result

·        Provides academicians and regulators a reference of how to apply discriminant analysis for the purpose of banking industry examination.

·        Provides bank managers and regulators a reference of a bank performance model and its critical value that would give a set of standard in formulating bank tactical and strategic planning by controlling the selected variables of financial ratios.

·        Provides public and investors information about the financial condition and performance rating of Indonesian banking industry in 1996.

 

6.      Conceptual Framework

·        Assets: All assets, mainly financial assets, owned by commercial bank as a pool of allocated fund and investment that used for two main purposes, i.e.: to raise suitable profitability and to maintain liquidity.

·        Earning assets: Assets that can earn interest, capital gain and dividend, i.e.: loan, other bank deposits, call-money, securities, investment and shares.

·        Non-earning assest: Assets that cannot earn any income, i.e.: cash and fixed assets.

·        Profit: Differences between income, mainly from earning assets, (interest, fee-based, foreign exchange and provision) and expense mainly from customer deposits and other liabilities (interest, foreign exchange and employee expense).

·        Financial ratio: A comparison between two or more financial components posted in the financial statements, i.e.: balance sheet and income statement. This is used as a certain tool in financial planning and control to get the optimal solution of financial decisions (investment, financing and dividend) in order to maximize firm’s value.

·        Discriminant Analysis: A statistical technique for classifying samples observed into two mutually exclusive groups that qualitatively separated by loading a set of discriminate variables.

·        Bank financial ratios: Seventeen bank ratios chosen for the purpose this research that consist of six banking indicators of growth, profitability, liquidity, solvability, efficiency and risk. However, not all of the ratios are powerful enough to predict success in growth. For example, the discriminate power of the ratios in growth indicator becomes lower as the classification is originally based on growth. Therefore, some best predictors need to be selected.

 

7.      Research Methodology

·        Sample: Samples of 220 banks are taken from 239 Indonesian commercial banks in 1996 (approaches a population observation). Data of financial position and ratios 1995-1996 of samples is gathered using documentary method. The date is issued by InfoBank Research and Development Center, Indonesia.

·        Bank Performance Classification Method: All samples are qualitatively classified into two groups of “success” and “failure” based on growth achievement. “Success” is for banks, which have been growing in assets and profit for one year, whereas “failure” is for banks, which have not been growing in assets and/or profit.

·        Model, Variables and Discriminant Analysis Method:

Discriminant model: Z = f (X1, X2, X3, … , X17)

Original Classification: At first in the original classification, each sample is a priori defined into two groups notified by Z as a dependent variable.

Success = Zs Failure = Zf

Predictors Selection and Stepwise Method: Then, through stepwise method all predictors are loaded step-by-step by minimizing Wilks’ Lambda and removing variables with F multivariate less than 1 and entering those bigger than 1.77

Zs = aX1 + bX2 + cX3 + … + qX17

Zf = aX1 + bX2 + cX3 + … + qX17

min (lambdaX1, lambdaX2, lambdaX3, …, lambdaX17)

enter if F multvrt > 1.77 remove if F multvrt < 1

Discriminant Function and Best Predictors:

Stepwise process stops when there is no variable with F multvrt > 1.77 and discriminant function is formulated by linear combination of the best predictors and theirs standardized canonical coefficient resulting discriminant score.

Z’ = v1X1 + v2X2 + v3X3 + … + vnXn

Z’ = discriminant score vn = standardized canonical coefficient

Distribution, Critical Value and Predicted Classification:

Unstandardized canonical coefficient calculates the group means or centroids and the distribution of discriminant score determines a critical value, which defines limits for predicted classification of samples after analysis.

 

8.      Result

·        Bank Performance Equation:

Z’ = 1.29 X1 + 1.17 X2 – 0.88 X3 + 0.91 X4 + 0.82 X5 + 1.62 – 1.17 X7

·        The most important variable of financial ratios in predicting bank success:

X1 1.29 Net Profit / Assets

X2 1.17 Operating Expense / Operating Income

X3 -0.88 (Interest Income – Interest Expense) / Earning Assets

X4 0.91 Deposits / Assets

X5 0.82 Equity / Deposits

X6 1.62 Net Profit / Equity

X7 -1.17 Assets / Equity

·        Statistics testing: eigenvalue = 0.233 canonical correlation = 0.435

Wilks’ lambda = 81.10% chi-square = 0.000

·        Critical value and bank performance criteria:

Centroids of Failure Critical Value Centroid of Success

Z’ < -0.756 < Z’ < -0.07117 < Z’ < 0.305 < Z’

Very Bad Bad Good Very Good

·        Interpretation on changes and priorities in bank tactical planning:

ü      Increasing ratio Net Profit / Equity by growing net profit faster than equity.

ü      Increasing ratio Net Profit / Assets by growing net profit faster than assets.

ü      Increasing ratio Operating Expense / Operating Income by growing operating expense faster than operating income for the purpose of alteration from variable cost to fixed cost (R&D, information technology, trade mark and marketing) leading to marginal contribution of long-run profit.

ü      Decreasing ratio Assets / Equity by growing equity faster than assets.

ü      Increasing ratio Deposits / Assets by growing deposits faster than assets.

ü      Decreasing ratio (Interest Income – Interest Expense) / Earning Assets by growing earning assets faster than net interest income.

ü      Increasing ratio Equity / Deposits by growing equity faster than deposits.

·        Interpretation on bank long-term financing strategy: Equity financing is expected to grow faster than deposits financing that used for short-term operation and long-run investments, such as: purchasing IT equipment, capitalization for merger and acquisition with other financial institutions, investment banking activities and trust funds financing syndication for airports and environmental development.

 

9.      Conclusion

Indonesian banks need to be more concern on rising profit from fee-based income, and starting to reduce dependency on net interest income earned from domestic loans that mainly lead to non-performing assets. Furthermore, they need to put greater concern on equity than deposits liability in financing activity to achieve adequate capital by mergers and acquisitions in the industry.

 

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