Factors Influencing on Bank Capital and Profitability: Evidence of Government Banks in Indonesia

Abstract

The purpose of this research is to see if liquidity, non-performing assets, sensitivity, and efficiency have an impact on the profitability and capital of Indonesian state-owned banks. A random sample of public banks was used in this study. The data was collected from the first quarter of 2014 to the fourth quarter of 2019. Purposive sampling was used as the sampling technique. According to the findings of this study, liquidity (LDR) had a significant positive effect on capital but had no significant effect on profitability. Productive asset quality as proxied by the ACA and NPL ratios did not affect profitability or capital. As for the sensitivity ratio, which was proxied by the ratio of NOP and IRR, there were differences in behavior. Sensitivity had no significant impact on profitability or capital, while NOP had a significant positive impact on capital but not on profitability. In terms of efficiency, both OER and FBIR had a significant effect on profitability and capital, although in different directions. OER has a significant negative impact on both profitability and capital. Fee-based income (FBIR) had a significant positive impact on capital, but it had the opposite effect on profitability.

1. Introduction

The bank is a financial intermediary whose main job is to receive money deposits, take out a loan, and then return the money to the community in the form of credit or other banking services, to add value and raise everyone’s standard of life (Michael, 1971). Banks are required to maintain a certain level of capital, which can be quantified using financial ratios such as the Capital Adequacy Ratio (CAR). The Capital Adequacy Ratio (CAR) is one of the measures used to assess a bank’s capital adequacy (Berger et al., 1995). Banks operating in Indonesia are expected to follow certain standards, which are useful for absorbing risks associated with crisis conditions and non-performing loans. Therefore, banks must be willing to follow the regulatory standards as set by FSA and BI.

Financial Services Authority of Indonesia (Otoritas Jasa Keuangan) (FSA) is an Indonesian government agency that regulates and supervises the financial services sector. Bank Indonesia (BI) carries a three-fold responsibility as a monetary authority and the regulatory and supervisory authority for the banking system and payment system. As such, BI’s most important task is not only to safeguard monetary stability, but also financial system stability. The minimum Capital Adequacy Requirement (CAR) of 8% must be met by banks. In light of the downward trend in the average capital value (CAR) in some state-owned banks, it is vital to research to determine the causes that contribute to the banks’ declining capital adequacy ratio.

In addition to meeting the minimum capital requirement, banks must also achieve maximum profitability (Molyneux & Thornton, 1992). Bank profitability (ROA) can increase if the bank operates efficiently and seeks out additional revenue streams other than interest income, which is referred to as fee-based income. A company’s financial well-being is important (Widagdo et al., 2020). According to the above definition and empirical data, numerous elements of bank financial performance, such as liquidity, asset quality, sensitivity, and efficiency, can influence bank profitability as measured by the ROA ratio and bank capital as measured by the Capital Adequacy Ratio (CAR). This research is interesting because it not only examines the factors causing bank profitability but also examines the factors causing the increase in bank capital aspects.

2. Literature Review

2.1. Bank Financial Performance

The bank’s financial performance can be observed or examined regularly via its published financial reports on the Financial Services Authority’s (OJK) website, ensuring that the financial statements are easy to comprehend and that the bank’s financial statements are updated. The financial statements of a bank are highly important because it shows how much profit the bank can make or has made. Liquidity, asset quality, sensitivity, efficiency, and profitability are all indicators of a bank’s financial performance (Kunt & Huizinga, 2000).

2.1.1. Capital Adequacy Ratio

Bank capital is very important. Capital is supposed to protect a bank from all sorts of uninsured and unsecured risks apt to turn into losses. This is where we get to the two principal functions of capital – to absorb losses and to build and maintain confidence in a bank. The bank’s capital is divided into two, namely core capital and supplementary capital.

Capital Adequacy Ratio (CAR)

Capital Adequacy Ratio (CAR) is the ratio of a bank’s capital to its risk. In other words, it is the ratio of a bank’s capital to its risk-weighted assets and current liabilities. When this ratio is high, it indicates that a bank has an adequate amount of capital to deal with the unexpected losses. When the ratio is low, a bank is at a higher risk of failure, and so may be required by the regulatory authorities to add more capital (Nguyen et al., 2021). CAR calculation can be formulated as follows:

\(\mathrm{CAR}=\frac{\text { Total Modal }}{\text { Risk Weighted Assets (RWA) }} \times 100 \%\)

2.1.2. Profitability

Profitability is a measure of the financial gain that is generated from a given investment. Banks’ profitability can be measured using several ratios (Cashmere, 2019) as follows:

Return on Assets (ROA)

Return on Assets (ROA) is a type of return on investment (ROI) metric that measures the profitability of a business in relation to its total assets. This ratio indicates how well a company is performing by comparing the profit (net income) it’s generating to the capital it’s invested in assets. The calculation of ROA can be formulated as follows:

\(\mathrm{ROA}=\frac{\text { profit before tax }}{\text { Average of Total Asset }} \times 100 \%\)

2.1.3. Liquidity

Liquidity is used to measure a bank’s ability to meet its short-term obligations at maturity or when billed. Liquid assets are cash and assets that can be converted to cash quickly if needed to meet financial obligations. The liquidity aspect can be measured using several ratios as follows:

Loan to Deposit Ratio (LDR)

The loan to Deposit Ratio (LDR) is used to assess a bank’s liquidity by comparing a bank’s total loans to its total deposits for the same period. The LDR calculation can be formulated as follows:

\(\mathrm{LDR}=\times 100 \% \frac{\text { Credit Granted }}{\text { Total Funds of Third Party }}\)

Investing Policy Ratio (IPR)

The Investing Policy Ratio (IPR) is a ratio that assesses a bank’s ability to meet its obligations to some depositors by liquidating its assets. Asset quality is a metric used to determine if the bank’s assets are of adequate quality and value to generate income (Rivai et al., 2013). IPR calculation can be formulated as follows:

\(\text { IPR }=\times 100 \% \frac{\text { Securities }}{\text { third-party funds }+\text { Invest Sharing }}\)

2.1.4. Asset Quality

Asset Quality is an evaluation of a particular asset, stating the amount of credit risk associated with it. Assets of a company/individual determine their condition and ability to repay their loans in the future and conduct smooth functioning of their operations (Rivai et al., 2013). Aspects of asset quality can be measured using the ratio as follows:

2.1.5. Adversely Classified Asset (ACA)

Adversely Classified Asset (ACA) is a ratio to measure non-performing earning assets with substandard, doubtful, loss quality (compared to the total earnings). ACA calculation can be formulated as follows:

\(\text { ACA }=\frac{\text { Adversely Classified Asset }}{\text { Total Productive Asset }} \times 100 \%\)

Non-Performing Loan (NPL)

The Non-Performing Loan (NPL) ratio is the ratio of the amount of non-performing loans in a bank’s loan portfolio to the total amount of outstanding loans the bank holds. The NPL ratio measures the effectiveness of a bank in receiving repayments on its loans (Singh et al., 2021). The calculation of NPL can be formulated as follows:

\(\mathrm{NPL}=\frac{\text { Bad Debt }}{\text { Total Debt }} \times 100 \%\)

2.1.6. Sensitivity

Sensitivity is a measure of a bank’s capacity to cover the consequences of changes in market risk and the effectiveness of its market risk management (Rivai et al., 2013). The sensitivity aspect can be measured using several ratios as follows:

Interest Rate Risk (IRR) is a ratio used to measure the risk arising from changes in interest rates. Net Open Position (NOP) is the net difference between foreign currency assets and liabilities after taking into account the administrative accounts. Efficiency is the ratio used by banks to ensure the efficiency and quality of bank income in a precise and accurate manner (Rivai et al., 2013).

Interest Rate Risk (IRR)

Interest Rate Risk (IRR) is a ratio used to measure the risk arising from changes in interest rates. The IRR calculation can be formulated as follows:

\(\mathrm{IRR}=\frac{\mathrm{IRSA}}{\mathrm{IRSL}} \times 100 \%\)

2.1.7. Net Open Position (NOP)

Net Open Position (NOP) is the net difference between foreign currency assets and liabilities after taking into account the administrative accounts. The calculation of NOP can be formulated as follows:

\( \mathrm{NOP}= \frac{\text {(Forex Aset-Forex Passiva)+ Difference Off Balance Sheet }}{\text { Capital }} \times 100 \% \)

2.1.8. Efficiency

Efficiency is the ratio used by banks to ensure the efficiency and quality of bank income in a precise and accurate manner (Rivai et al., 2013). Bank efficiency can be measured using several ratios as follows:

2.1.9. Operating Expenses Ratio (OER)

The operating expenses ratio (OER) is a comparison of operating expenses and operating income in determining the efficiency and ability of banks to carry out their operational activities. It is important to note that the main business of banks is to collect funds from the public and then channel them back to the community in the form of credit, so the burden of interest and interest yield is the bank’s most significant position. The OER calculation can be formulated as follows:

\(\mathrm{OER}=\frac{\text { Weight of Operational }}{\text { Income of Operational }} \times 100 \%\)

Fee-Based Income Ratio (FBIR)

FBIR is the sum of income that can be from services other than interest and loan provisions. If the FBIR increases, the operating income in addition to interest income will also increase. FBIR is the sum of income that can be from services other than interest and loan provisions. The operating income, and interest income, will increase as the FBIR increases. The FBIR calculation can be formulated as follows:

\(\text { FBIR }=\frac{\text { Operational Income Out of Interest Income }}{\text { Operational Income }} \times 100 \%\)

2.2. Effect of Liquidity on Profitability and Capital

2.2.1. Loan to Deposit Ratio (LDR)

One of the liquidity factors that influences profitability (ROA) and capital (CAR) is the Loan to Deposit Ratio (LDR). When a bank’s LDR increases, that total credit given by the bank increases by a bigger percentage than third-party funds, causing the ROA and CAR to increase. If the LDR value decreases, CAR has a negative effect, implying that the percentage increase in total loans provided is greater than the percentage increase in total third-party funds. With the assumption of fixed capital, an increase in ROA results in a decrease in ROA and CAR. The finding is in line with Hadi and Anggraeni (2015), who found that LDR had a significant positive effect on CAR.

2.2.2. Investing Policy Ratio (IPR)

The Investing Policy Ratio (IPR) is a ratio that assesses a bank’s ability to meet its obligations to some depositors by liquidating its assets. Asset quality is a metric used to determine if the bank’s assets are of adequate quality and value to generate income.

2.3. Effect of Asset Quality on Profitability and Capital

2.3.1. Adversely Classified Assets

Adversely Classified Assets (ACA)

Adversely Classified Assets (ACA) have a negative impact on profitability (ROA) and capital (CAR). This happens when the bank’s ACA increases, implying that the non-performing bank’s productive assets have increased by a higher proportion than the overall earning assets. The increase in reserved expenses is more than the increase in income, resulting in a decrease in profitability for the bank. As a result, profitability (ROA) decreases, which has an influence on capital (CAR). This finding is in line with Hadi and Anggraeni (2015), who found that ACA had a significant negative effect on CAR.

Non-Performing Loan (NPL)

Non-Performing Loan (NPL) has a negative effect on profitability (ROA) and capital (CAR). When the NPL increases, there is an increase in non-performing loans with a greater percentage than the percentage increase in total loans. The increase in costs that must be reserved is greater than the increase in income, thus decreasing profitability (ROA) and Capital (CAR).

2.4. Effect of Sensitivity on Profitability and Capital

Interest Rate Risk (IRR)

Interest Rate Risk (IRR) is one of the sensitivity ratios that influence profitability (ROA) and capital (CAR). If IRR increases, then there is an increase in risk-sensitive bank assets (IRSA). Bank liabilities that are sensitive to risk are known as IRSL. A greater percentage of IRSA than IRSL will cause interest rates and interest income to increase, and an increase in interest income that is greater than the increase in interest costs will increase profitability (ROA) and capital (CAR).

Conversely, if the bank’s interest rate decreases, the bank’s capital decreases. IRR has a positive effect on both ROA and CAR. IRR also has a negative effect on ROA and CAR. If the interest rate decreases, then the increase in interest income is lower than the increase in interest costs. Thus, bank profitability (ROA) and bank capital (CAR) decrease. This finding is in line with Hadi and Anggraeni (2015), who found that that IRR has an insignificant negative effect on CAR at Go Public-Private National Foreign Exchange Banks.

Net Open Position (NOT)

The sensitivity ratio Net Open Position (NOP) has both positive and negative effects on profitability (ROA) and capital (CAR). The NOP ratio has a positive impact on both ROA and CAR because an increase in foreign currency assets is greater than the increase in foreign currency liabilities, and if this is followed by an increase in the exchange rate, it will result in an increase in foreign currency income that is greater than the increase in foreign exchange expenses. As a result, profitability (ROA) will increase, thus increasing capital (CAR).

NOP, on the other hand, has a negative impact on both ROA and CAR since an increase in NOP indicates that foreign currency assets have increased by a greater percentage than foreign currency liabilities have increased. If this is followed by a decrease in the exchange rate, it will result in a decrease in foreign currency income which is greater than the foreign exchange expense, resulting in a decrease in profitability (ROA) and thus a decrease in the capital (CAR). The finding of this study is in line with Hadi and Anggraeni (2015), who found that the NOP ratio has a significant positive effect on CAR.

2.5. Effect of Efficiency on Capital and Profitability

Operational Expenses Ratio (OER)

The operational expenses ratio (OER) is one of the efficiency ratios that has a negative impact on profitability (ROA) and capital (CAR). If OER increases, it signifies that the bank’s operating expenses are increasing at a faster rate than the bank’s operating income. If bank profits (ROA) decrease, capital (CAR) will decrease. This finding is consistent with Hadi and Anggraeni (2015) who showed that OER had a negative effect on CAR although not significantly.

Fee-Based Income Ratio (FBIR)

The Fee-Based Income Ratio (FBIR) is an efficiency ratio with a significant impact on profitability (ROA) and capital (CAR). If the bank’s FBIR increases, it indicates that operating income excluding interest has increased by a higher proportion than operational income. If the bank earnings (ROA) increase, capital increases (CAR). This finding is consistent with Hadi and Anggraeni (2015), who found that the FBIR has a positive effect on CAR.

3. Research Methods

3.1. Sample

The sample used in this study was the Government Bank registered with the Financial Services Authority (OJK). Sampling using the census technique, so that the entire population could be used in this study. The four state banks are PT Bank Mandiri, Tbk; PT Bank Negara Indonesia, Tbk; PT Bank Rakyat Indonesia, Tbk and PT Bank Tabungan Negara, Tbk.

3.2. Research Data

The research period is from the first quarter of 2014 to the fourth quarter of 2019. The data used in this study is secondary data collected every quarter. The data collection technique includes collecting documents such as published financial reports from the Financial Services Authority’s website.

3.3. Research Variables

Capital, as measured by the CAR proxy, and profitability, as measured by the ROA proxy, are the dependent variables in this study. Liquidity, as measured by LDR and IPR, Asset Quality, as measured by ACA and NPL, Sensitivity, as measured by IRR and NOP, and Efficiency, as measured by OER and FBIR, are the independent variables in this study.

3.4. Research Model

To test the factors that determine capital and profitability, this study used the panel regression equation as follows:

ROA_it = 0 + 1LDRI_t + 2ACA_it +β₃NPL_it + 4IRR_it + 5NOPI_t + 6OER_it + 7FBIR_it + έ_it

CAR_it = 0 + 1LDRI_t + 2ACA_it +β₃NPL_it + 4IRR_it + 5NOPI_t + 6OER_it + 7FBIR_it + έ_it

Where:

CAR: Capital Adequacy Ratio; ROA: Return on assets; LDR: Loan to Deposit Ratio; ACA: Bad Earning Assets;

NPL: bad debt; IRR: Interest Rate Risk; NOP: Net Open Position; OER (Operating Earning Ratio); FIR: Fee Base Income Ratio.

4. Results and Discussion

4.1. Statistical Descriptive Analysis

Table 1 shows the descriptive results of the study. The CAR ratio, which was 19.06 percent, revealed the average level of capital held by state-owned banks in Indonesia. This indicates that the capital level meets the regulatory requirements of the Financial Services Authority Number, 11 /POJK.03/2016. State banks in Indonesia have an average liquidity level of 94.04 percent, as measured by the LDR ratio. In terms of asset quality, banks had an average ACA ratio of 2.04 percent, while their NPL ratio was also 2.04 percent. This meant that only 2.04 percent of the total loans disbursed by state banks were uncollectible. The IRR ratio was used to calculate the sensitivity ratio.

Table 1: Descriptive Statistics

The study period showed an average value of 103.94 percent while the NOP was at an average value of 2.79 percent. Meanwhile, the FBIR ratio is 16.19 percent on average. This means that the bank’s net income, excluding interest, is 16.19 percent on average. The ROA ratio of state owned banks indicates the level of bank profitability, which is 2.70 percent on average. Based on this ratio, the bank’s situation is very safe against interest rate changes. State banks have an efficiency ratio of 74.47 percent on average, as measured by the OER ratio. Based on this ratio, the bank’s condition is quite efficient, with the highest ratio in the range of 98.12 percent.

4.2. Partial Test Statistical Analysis

4.2.1. Model 1

Table 2 shows partial statistical test results. The liquidity ratio shows that the LDR has a probability value of 0.991 in a positive direction, and because the probability value is greater than the 5% (alpha) significant level, it can be concluded that the LDR has no significant effect on the ROA of state banks. The quality of current assets can be measured by the ACA/NPL ratio. Based on the partial T statistical test the ACA and NPL have probability values of 0.357 and 0.269, respectively. Because the probability values are above the significant level (alpha) of 5%, the ACA and NPL variables have no significant effect on the ROA of State Banks.

Table 2: Hypothesis Test Results

Note: Significance level (alpha) at 5%.

Based on statistical tests, the sensitivity variables proxied by IRR and NOP have probability values of 0.074 and 0.289. Since the probability values of IRR and NOP are above the significant (alpha) 5 percent level, IRR and NOP have no significant effect on ROA.

The probability values of the efficiency variables OER and FBIR are 0.000 and 0.003, respectively, with a negative direction. Since the probability values are below the significant level (alpha) of 5%, both OER and FBIR have a significant negative effect on the ROA of state banks.

4.2.2. Model 2

Table 3 shows partial statistical test results. The liquidity ratio shows that the LDR has a positive probability value of 0.0369, and because the probability value is below the significant level (alpha) of 5%, it can be concluded that the LDR has a significant positive effect on the CAR of state banks. The quality of current assets can be measured by ACA/NPL ratio. Based on the partial T statistical test, the ACA and NPL have probability values of 0.580 and 0.247 respectively. Because the probability values are above the significant level (alpha) of 5%, the ACA and NPL variables have no significant effect on the CAR in government banks.

Table 3: Coefficient Determination

Based on statistical analyses, the sensitivity variables, proxied by IRR and NOP ratios, have probability values of 0.404 and 0.000 respectively. IRR’s probability value is above the significant level (alpha) of 5%, while NOP’s probability value is below the significant level (alpha) of 5%. As a result, IRR has no significant impact on CAR, whereas NOP has a significant positive impact on CAR.

According to Table 3, in model 2, the R² value is 0.360 indicating that the factors of liquidity, sensitivity, productive asset quality, and efficiency accounts for 36% of the variance in bank capital (measured by the CAR ratio), while the remaining 64% is accounted for by variables outside the model. Whereas in model 1, the R² value is 0.762 indicating that the variables of liquidity, sensitivity, productive asset quality, and efficiency accounts for 76% of the variance in the profitability of government banks (measured by the ROA ratio), with the remaining 24 percent due to variables outside the model.

4.3. Discussion

According to the findings of statistical analyses shown in Table 2, different factors affect the capital and profitability of state banks in Indonesia. Liquidity, as measured by the LDR ratio, has an impact on increasing government bank capital (as measured by the CAR). On the other hand, an increase in LDR has no significant effect on profitability.

Based on the findings of statistical analyses, productive asset quality, which is proxied by the ACA and NPL ratios, has no effect on the CAR or ROA of state banks in Indonesia. This result is in line with Singh and Sudana (2018). There are differences in the effect of the sensitivity ratio, which is proxied by the ratios of NOP and IRR. The IRR ratio has no influence on CAR or ROA, but the NOP has a significant positive effect on CAR but no effect on ROA.

In terms of efficiency ratios, both OER and FBIR have a significant effect on CAR and ROA, but in opposite directions. The impact of OER on CAR (efficiency ratios) and ROA is significant. While the FBIR has a significant positive impact on CAR, it has a significant negative impact on ROA in model 2. Government Banks also need to pay attention to efficiency ratios since efficiency ratios have a significant impact on profitability. When compared to banks in other ASEAN countries, Indonesian banks are not yet efficient. A lack of efficiency is always the cause of a bank’s failure.

5. Conclusion and Limitations

Conclusions were drawn based on the test results about the factors that influenced capital and profitability at Indonesian state banks. The LDR ratio, which measures liquidity, has a significant positive impact on CAR but no significant impact on ROA. The ACA and NPL ratios, which are used to measure the quality of productive assets, have no effect on the CAR and ROA of Indonesian state banks. As for the sensitivity ratio, which was proxied by the ratio of NOP and IRR, there are differences in impacts. The IRR ratio has no significant impact on CAR or ROA, but NOP has a significant positive impact on CAR but no impact on ROA. Both OER and FBIR have a significant effect on CAR and ROA, although in opposite directions. The impact of OER on CAR (efficiency ratios) on ROA is significant. While the FBIR variable has a significant positive effect on CAR, it has a significant negative effect on ROA.

The research’s results can be applied in improving banks’ performance and making decisions about bank activities, particularly business capital and profitability in accordance with the provisions of the authorities or regulators in measuring a healthy bank. Model 2 requires state banks to pay close attention to aspects like liquidity, LDR, and fee based income (FBIR), as well as NOP and OER because these factors have a significant impact on bank capital. Similarly, the findings in model 1 indicated that banks should focus on efficiency issues as measured by the OER ratio; lowering OER has been shown to boost profitability, and banks should increase fee-based income.

This study used only state banks as a sample object with a limited research period (four years), focusing solely on the bank’s internal aspects/factors and ignoring external factors. It is preferable to extend the observation period and consider external factors, particularly macroeconomic variables such as inflation and interest rates, in future studies.