Market Discipline in Indonesian Banking Sector: Has it Been Run Effectively?

Abstract

This research aims to conduct examination of market discipline effectiveness in Indonesia. Market discipline as one of three pillars of Basel II works effectively if depositors monitor bank financial performance and various risk of the bank and also conduct action in the form of withdrawal of deposit and or request of increase of deposit interest rate from a bank with higher risk. The authors examine the monthly data of 141 commercial banks in Indonesia from January 2002 to December 2005. The authors also distributed questionnaire to 138 depositors to investigate the awareness of the depositors of market discipline issues. The result of this research showed that there is some evidence of market discipline in Indonesia; however the effectiveness of market discipline is still weak. The weak effectiveness of market discipline can be concluded from the negative correlation of CAR, and ROA to the deposit volume and negative correlation of the ratio of Operating Expense to Operating Income and NPL to the level of deposit interest rate. This result then is confirmed by the low market discipline awareness from depositor's questionnaire. The weak effectiveness of market discipline should encourage the regulators, commercial banks and government to communicate it better to the depositors as the central bank (Bank Indonesia) will start to implement market discipline of Basel II regulations gradually in 2008.