A Simple Stress Test on Indonesian Islamic Banking Industry

Banking Stress Test

The purpose of this study is to conduct a stress test on Indonesian Islamic Banking industry in order to assess the capability of the industry to absorb the extreme risks that may happen in the future. Using data from April 2008 to September 2014, the study employs balance sheet approach in performing the stress test on profitability and capital position and the value at risk technique for liquidity stress test. The results of this study show that in term of profitability, Islamic banks in Indonesia are immune from losses if the default rate (Non-Performing Loan) is less than 8.5 %. If the industry can improve the profit margin, the resistance will be higher. In term of capital position, by assuming loss given default (LGD) is constant at 40%, the industry will not go bankrupt if probability of default (PD) is less than 9%. If the PD is more than 9%, total expected loss is more than available capital. Using the value at risk (VaR) at 99% confidence, the study finds that possible deposit flight will not exceed IDR 26 trillion and the liquid asset available is IDR 28 trillion. The study concludes that there is no liquidity threat for Islamic banks in Indonesia. The findings also uncover the risky condition
that even though the capital adequacy ratio (CAR) is on average 14%, real
capital measured by Equity to total asset (ETA) is only 5.4%.

A stress test helps the authority and management to develop the knowledge in risk assessment process, and improve understanding and perception of
risks (BCBS, 2009). Therefore, this study attempts to develop a stress test model for Islamic banking in Indonesia. There are obstacles in conducting this study, especially those associated with the relationship between macro-economic variables and bank specific variables. Many unexpected results were found that made this study staggering. That situation inhibits the European Central Bank (ECB) to introduce the stress test standards in 2010. the At the beginning of the study, we assume that there will be an exact relationship between real sector variable and Islamic banking performance since as per our understanding, Islamic banks are attached to the real economic. However, the relationship is totally different. These including the relationship between the index of retail sales or industrial development on Islamic bank financing quality and profitability. It is found that these have no correlation to the performance of Islamic banking in Indonesia.
Of course this result is contradictory to our assumption since we expect the real sector will provide information on the performance of Islamic banking.
The statistical test showed a no significant relationship so that they do not qualify to enter the model to estimate the performance of Islamic banking.
Time series real sector variable becomes irrelevant. It seems that if we look deeper into Indonesian Islamic banking, it is actually similar to the global
phenomenon of Islamic banking. They are more likely to murabahah syndrome. This means that there are many Islamic banks which tend to apply the murabahah principles of Islamic finance than profit loss sharing or shir’kah and mudarabah (Smolo & Mirakhor, 2010).
With this type of business model, it is clear that Islamic banking in Indonesia is more influenced by the movement of interest rate rather than real sector variables. Therefore, in order to test the relationship between economic performance and bank performance such as on credit risk and liquidity and earnings, it appears that the indicator of interest rate
of Bank Indonesia or BI-rate was more significant than real sector variables such as industrial production index. Interest rate gives more information in
determining the performance of Islamic banking. Of course this could be considered as an irony of Islamic banking. Islamic banking has become more convergence towards conventional banking in general.
A study by Chong & Liu (2010) confirmed that Islamic banking was not free of interest but it is still an interest-based banking.
Currently, stress test is becoming a new fashion among bank supervisors. Stress test is aimed to identify a condition that may affect the viability of
a bank. As banking failure always means an economic crisis with a huge impact on the economy, regulators around the globe always assume that
identifying the problem before it arises is always much better, Stress test is a way to identify the weakness of a particular bank or industry in general.
They expect banks to hold sufficient capital to cover losses under such adverse economic conditions. It is also used as a tool for bank supervisors
to require bank to hold more capital (Bernanke, 2013).
Literature reveals that stress test is a very good tool as it is forward looking. It means stress test can provide a base for future action necessary after
certain conditions are assumed to happen. Certain conditions mean generally highly adverse scenarios that banks may face. It can provide supervisors with information about extreme risk event and its impact
on a particular bank (Drehmann, 2008). Regulator can set a scenario that may apply to all banks such as European Banking Authority that regularly
issue a scenario for the stress test.
When a common scenario is applied to banks and similar methodology, authority will have information from the stress test. It provides consistent
supervisory information on the weakness across

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