This study aims at understanding bank-level factors that determine non-performing loans (NPLs) in the Indonesian banking industry

By using a fixed-effects panel regression model, it is evident that NPLs in Indonesian commercial banks can be attributed to bank-specific factors, namely profitability and credit growth. These results shed light on the importance of micro-prudential surveillance on banks lending behavior to restrain the level of NPLs.

With regards to the empirical finding on profitability, policy makers should require banks to be financially healthy by having adequate profits. By doing so, banks are capable of performing proper credit management processes, such as underwriting, monitoring, and controlling, that finally reduce the number of loan defaults in the banks portfolio. Since banks earnings predominantly come from interest income, it can be implemented by tightening supervision on credit management practices in the banking sector. Moreover, the government can formulate a particular minimum standard requirement on banks profitability to make sure that banks can settle up on their operating expenses.

In addition, since credit growth evidently reduces the number of NPLs, banks should be encouraged to increase their credit supply and focus on lending activities. By being specialized, banks are expected to enhance their aptitude and ultimately lower the number of NPLs. However, an increase in credit supply will be exhilarating only if it is supported by the proper credit risk scoring (e.g. applying the 5C effectively) and management. Moreover, since there is a possibility that banks manufacture their NPL ratio calculation, the government should undertake additional analysis on banks NPL calculation and formulation to avoid the delivery of misleading information.

The classification of NPLs related to loan loss provisioning is set aside by banks to cover potential losses on loans

Further investigations are needed to better identify the effect of bank-specific factors determining NPLs in different years by using a dynamic model. It is possible that banklevel determinants in the current year do not necessarily affect NPLs in the respective year but in other years.

During the period of 2008-2013, the average bank NPL ratio in Indonesia decreased from 3.2 per cent to 1.69 per cent of gross loans. Nevertheless, since 2014, the NPL ratio has increased, reaching 2.9 per cent in 2016 . Although the average bank NPL ratio of 2.9 per cent is still lower than the prudential guideline of the webpage Indonesian Financial Service Authority (the OJK) of 5 per cent, the OJK report shows that 22 of the 115 commercial banks in Indonesia actually have an NPL ratio above 5 per cent (OJK, 2017). Accordingly, although the Indonesian banking sector is considerably promising, it is also risky.

In particular, banks with higher profits and credit growth are likely to have a lower amount of NPLs in their portfolio

Empirical evidence regarding the impact of banks profitability on NPLs also shows ambiguous relationships. Berger and DeYoung (1997) argue that highly profitable banks are less likely to become involved in risky activities that can lead to loan defaults in the future. This suggests a negative relationship between bank profitability and NPL ratio. On the other hand, Rajan (1994) suggests that a credit policy is dependent not only on the objective of maximizing profits but also on the management reputation. Therefore, bank management tends to manufacture current earnings to create a “liberal credit policy” resorting to loan defaults in the following periods. This implies a positive impact of profitability on the NPLs.

Therefore, a high NPL ratio indicates low health of banks, since it influences banks liquidity and performance. The high NPL ratio of particular banks is also associated with the systemic risk and effect to the whole banking sector, which lead to a financial crisis. For instance, prior to the Asian Crisis of 19971998, the Indonesian banking sector had a high NPL ratio of 49 per cent. In the aftermath, 60 commercial banks in Indonesia had to be closed down, and this disturbed the flow of funds in the economic system and adversely affected national economic growth. Having experiences with the financial crisis, the Parliament of Indonesia passed the Bill of Financial System Safety Net (the UU Jaring Pengaman Sistem Keuangan/JPSK) which serves as the legal basis for the Government of Indonesia, involving the Ministry of Finance, the OJK, the LPS, and the BI, to prevent systematic dangers from the financial crisis.