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Chapter 2
Theoretical Foundation
2.1 Bank in Indonesia
2.1.1 Definition of Bank
According to the Law of the Republic of Indonesia, number 10, year 1998, “bank is
a business entity which collects funds from the public in the form of savings and
channels them to the society in the form of credit and or other forms in order to
improve the standard of living of the people.”
While
under
PSAK
No.
31
in
the
Financial
Accounting
Standards
(1999: 31.1), bank is an institution which acts as a financial intermediary between
the parties that have excess funds with interested parties that need funds.
In general, bank serves two functions. First, banks serve as the tool to provide
efficient payment mechanism for customers. Bank provides cash, savings, and credit
cards as to provide efficiency in payment system to publics. Second, banks increase
flow of funds for investments by accepting deposit from customers and lend it to
those who need funds. The main purpose of Indonesian banks is as collector and
distributor of public funds that aims to support national development in order to
improve the economic growth , national stability, and as a result, improving the
living standard of people. (Bank Indonesia, 2008)
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2.1.2 Type of Banks in Indonesia
Under the law, the structure of banking in Indonesia consists of commercial banks
and credit unions or Bank Perkreditan Rakyat. The main difference in commercial
banks and credit unions are in terms of their operational activities. Bank Perkreditan
Rakyat (BPR) cannot create demand deposits, and has a range and limited
operational activities. (Bank Indonesia, 2008)
Graph 2.1 provides insights in recapitulation in Indonesian’s bank institution.
Figure 2.1
Recapitulation of Bank Institution in Indonesia
Source: Bank Indonesia website (2010)
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2.1.3 Sources of bank funds
Bank collect funds from society and channel them back in a variety of investment
alternatives. Because of its distinguished characteristic, bank sectors are regarded as
highly regulated industry in which government control and restrict its financial activities
(Dimitropoulos, 2010). The sources of bank funds can be gathered from internal and
external sources of funds. Internal funds include funds from bank’s own capital in the
form of funds from shareholders, bank profits that have not divided, and other reserves.
External funds come from other institution, government and publics such as deposits,
savings deposits, and public savings, interbank loans (call money), liquidity support
from Bank Indonesia (BLBI), and money market securities (SBPU). Bank performance
and soundness can be defined as the ability of a bank to conduct normal banking
operations and ability to meet all its obligations in a consistent way with the applicable
banking regulations (Pahlevie, 2009).
2.2 Financial Statement
2.2.1
Definition of financial statement
Financial statement is a report of recorded transactional activities in a company.
It is main source of financial information that reflects company’s performance.
IASB (International Accounting Standard Board) stated,
“The objectives of financial statement as to provide financial information about
financial performance, position and cash flow that are useful to the economic
decision making of their users. It also provides information that show the result of
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stewardship of management or the accountability of management for the resources
entrusted to it
(IASB Framework, paras.12-14). “
According to Weygandt et al., (2005), the users of financial information can be
divided into two groups: internal users and external users. Internal users are firm’s
manager or employees who use accounting internal data to plan and organize
business, compare performance, forecast sales and financial expenditure for the
following period. External users are company shareholder, financial institution
(creditor), prospective investor, government, and publics.
From financial statement, users could analyze and forecast:
a. Company’s ability to earn revenue
b. Company’s future loan needs and dividend to be distributed to company
shareholder
c. Company’s ability to pay mature obligation
d. Company’s financial activities includes investing, financing and operating
activities during the year
Financial statements typically include balance sheet, income statement, cash flow
statement, statement of retained earnings, notes to financial information. Financial
statements are required to meet four qualitative characteristics, which are
understandability, reliability, relevance, and comparability. Conceptual framework
provides guidelines to develop these four qualitative characteristics of financial
statement.
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2.2.2 Conceptual Framework of Financial Reporting
Financial Accounting Standards Board (FASB) stated that “conceptual framework is
a coherent system of interrelated objectives and fundamental that can lead to
consistent standards and that prescribes the nature, function, and limits of financial
accounting and financial statement.”
The framework’s concept contains four components, which are as follows:
1. Objective of financial statement
2. Qualitative characteristic of useful financial statement
3. Definition, recognition and measurement of financial statement’s elements
4. Concepts of capital and capital maintenance (IASB Framework, Para. 5)
According to FASB Concepts Statement No.2, the qualitative characteristics of
financial information differentiate them between better information from less-useful
information. Graph 2.2 shows framework of accounting which identified four
qualitative characteristics.
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Figure 2.2
The Framework
Source: Weygandt, Chalmers, Mitrione, Fyfe, Kieso, Kimmel (2005), p560
The most important qualities in financial statements are reliability and relevance,
while the other secondary qualities are comparability and consistency. Reliable
financial report presents faithful representation with unbiased and free of error
information. It should be verifiable, complete and prudent. In reporting financial
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statement, company should use a consistent method to obtain same result
(verifiability), and should exercise conservatism principle which is to choose
method that will not overstate asset and revenue. Financial report should also
represent faithfulness and neutrality in which they can’t present information in favor
of one’s interest over another.
IASB Framework, Para. 38 required complete
financial statement within bounds of materiality and cost.
Financial information are said to have ‘relevance’ if they capable in making a
difference in decision. It has three ingredients, which are predictive value, feedback
value and timeliness. Feedback value serves as verifying former expectation, while
predictive value provides basis to estimate future prospect of a company (Weygandt
et al., 2005). Relevance financial report should also be presented in timely up-todate basis. This research will mainly focus on this ‘relevance’ characteristic, to
analyze the value relevance of operational measure in effecting stock return
movement.
2.3 Bank Financial Ratio
Good performance banks will increase the value of shares in the market and hence,
increase the amount of funds from third parties. Good bank performance can be
characterized by high levels of profitability, ability to pay dividend, developing
business prospects, and comply with prudential banking regulation. One indicator of
increasing public confidence in the bank is appreciation of value in stock price and
increase the amount of funds from third parties. Trust and loyalty of publics are
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important factors for bank to develop a good business strategy. Performance of a
particular bank can be measured by analyzing financial statements. Financial
statement could provide real position of banks including its strength and weakness.
It also shows the performance of bank management during a certain period
(Ariyanti, 2010)
According to the Standar Akutansi Keuangan (SAK) No. 1, the objective of
financial statements is to provide information concerning the financial position,
performance and change in financial position. Ratio analysis helps to interpret the
relation among items in financial statement that could provide as the basis of
considerations about potential success of company's future. (Weygandt et al., 2005).
In accordance to Surat Edaran Bank Indonesia No. 3/30/DPNP dated 14 December
2001, confirmed that report to be presented in the quarterly condensed financial
statements at least consists of:
1) Balance Sheet
2) Calculation of Income and Retained Earnings
3) List of Commitments and Contingencies
4) Foreign Exchange and Derivatives Transactions
5) Quality of Earning Assets and Information
6) Calculation of Minimum Capital Adequacy
7) Financial Ratios
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Financial ratio provides information about financial position of an enterprise,
especially if these ratios are compared with the benchmark ratio. Each type of
financial ratios have their own usefulness to analyze different prospective of the firm
Ariyanti (2010).
As bank have different characteristic with other industries, they have specific
financial ratio. With Surat Edaran Bank Indonesia No 7/ 10 /DPNP dated 31 Maret
2005, bank are required to report financial ratio in five aspects, which are as follows:
1. Capital ratio
Capital ratio shows bank's ability to maintain adequate capital and ability of bank
management in identifying, measuring, supervise and control the risks that can
affects the amount of bank capital. It associates with the bank financial leverage.
Bank Indonesia required Indonesian bank to disclose Capital Adequacy Ratio and
Fixed Assets to Capital ratio.
According to Purwasih (2010), Capital Adequacy Ratio (CAR) does not have a
positive significant impact in the banking company's stock price that went public in
Indonesia Stock Exchange. Other Malaysian research conduct by Elyor (2009)
reveals that capital adequacy has positively but insignificant impact to their
commercial banks performance during 2004 - 2008 periods. In contrast, Study by
Nurhartanto (2010), stated that Capital Adequacy Ratio had a significant impact on
share price.
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2. Asset Quality ratio
Asset Quality shows the quality of assets relation to credit risk faced by banks.
Productive assets qualities are assessed by determining their collectability. It is
necessary to estimate the minimum size on earning assets which should be provided
by banks to cover the risk of possible loss. Credit risk should be organized and
control in certain rational limits (Ariyanti, 2010). In giving loan to debtor, bank
should conduct an analysis of the ability of borrowers to repay their obligations.
After they granted their loans, bank should monitor the use of the credit and the
ability of their debtor in meeting obligation. Bank should review, assess and monitor
their loans as to reduce credit risk.
In asset quality ratio, Bank Indonesia required Indonesian bank to disclose Non
Performing Earning Assets, Non Performing Loans (gross and net), Allowance for
Losses on Earning Assets to Required Allowance of Earning Assets and allowance
for possible losses on earning asset. The most widely used to measure bank
performance in controlling credit risk from debtor is Non Performing Loan ratio
(NPL). Research by Angbazo (2007) stated that NPL doesn’t have a significant
impact in the profit. Also, other study by (Nurhartanto, 2010) shows that NPL
variable doesn’t have an impact in the share price. In contrary, Prior study stated in
Elyor (2009) stated that NPL to total assets have the most significant impact to the
Indian banks’ performance.
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3. Profitability ratio
There are number of indicators used to evaluate how profit related to the
performance in banking industry. Bank performance in terms of profitability reflects
bank ability to support present and future operations. Profitability ratio that are
required to be reported by Bank Indonesia are Return on Asset, Return on Equity,
Net Interest Margin, and Operating Expenses to Operating Revenues (BOPO)
Afanasief et al (2004) stated that ROA, BOPO significantly affects profit in
Brazilian bank. Prior study stated in Elyor (2009) shows that net interest margin
(NIM) had a significant impact on Indian bank’s performance.
4. Liquidity ratio
Liquidity ratio is bank’s capability to pay debt and unexpected financial needs. In
order to meet their obligation, bank should hold non-earning asset. Efficient bank’s
liquidity supervision is able to meet customer loan demand and deposit withdrawal.
(Dimitropoulos, 2010). Loan to Deposit is a reported ratio that is required by Bank
Indonesia.
According to Purwasih (2010), Loan to Deposit Ratio (LDR) did not significantly
influence banking company's stock price. In contrary, research by Angbazo (1997)
concluded that LDR has a significant positive effect on profits. Also, Afanasief et al
(2004) stated that LDR significantly affects profit in Brazilian bank.
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5. Compliance ratio.
The success of the bank's management is based on qualitative assessment
of management. Surat Edaran Bank Indonesia No.6/ 23 /DPNP about Bank Rating
System of commercial bank, stated that a measurement of management factors
should include compliance of the provisions and commitments to Bank Indonesia
and other parties such as minimum reserve requirement, lending limit, and net open
position. In Hays, Lurgio & Gilbert (2009) study, they use salaries to average of
asset as an assessment of management quality as salaries expense is a non-interest
expense and could be manage by their management. Prior research stated in Elyor
2009 use interest expenses divided to total loans as a measurement of bank
management quality.
2.3.1 Bank Indonesia Regulation on Procedure of Bank Health Assessment
In the 1970, USA government Federal Deposit Insurance Corporation (FDIC)
develops methods to examine bank performance, which is known as CAMEL. Bank
supervisor examine performance from 1-5 scale, where 1 is the highest scale and 5 is
the lowest scale. Unhealthy banks are rated with 4-5 scale and bank supervisor limit
their activities. These banks are required to increase their capital, limit their
distribution of dividend and limit their payment in interest on deposit liabilities.
(Hunjak & Jakovčević, 2001)
It is the authority and role of central bank to maintain and control the health of banks
that exist in the banking industry. In order to implement ‘prudential’ banking
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principle and to establish public confidence, Bank Indonesia impose regulation on
bank soundness. With this regulation, banks are expected in continuous healthy
condition, so it will not inflict financial loss to the associated bank community. Bank
Indonesia regulation on banks soundness covers various aspects of bank activities,
ranging from fund raising to the use and distribution of funds. (Bank Indonesia,
No.6/ 23 /DPNP, 2004)
Board of Directors of Bank Indonesia has issued a decree No. 3011/KEP/DIR dated
30 April 1997 on Procedure Bank Health Assessment method known as CAMEL
(Capital, Assets Management, Earning, Liquidity). Bank Indonesia has set the
provisions concerning the health rating of the bank performance with Surat Edaran
Bank Indonesia No.6/23/DPNP May 31, 2004 and Bank Indonesia regulation
No.6/10/PBI/2004 April 12, 2004 which regulates rating system for commercial
banks. Banks are required to perform rating on the bank on a quarterly basis which
is in month of March, June, September and December.
Special assessment of performance of commercial banks are regulated by Bank
Indonesia Regulation No.6/10/PBI/2004 dated 12 April 2004 concerning Bank
Rating System of commercial bank. These new regulation add one aspect which is
the ability to anticipate market risk, namely sensitivity to market risk. Hence,
CAMEL changes its name into CAMEL(S). CAMEL(S) method includes
calculating the magnitude of each ratio in its components.
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According to Bank Indonesia Regulation Number 6/10/PBI/2004 dated April 12,
2004 on Rating System Health Commercial Bank and Surat Edaran Bank Indonesia
No.6/23/DPNP May 31, 2004 suggest all bank are required to provide minimum
capital of 8% of Capital Adequacy Ratio and minimum NIM ratio above 1,5% to
meet the criteria of health bank. Bank Indonesia also confirmed that NPL above 5%,
BOPO ratio above 96% and LDR above 100% is categorized as in unhealthy
condition.
In complying with Surat Edaran Bank Indonesia, predicate of healthy bank rating
are, as follows :
1) Predicate "Healthy" are equivalent to Composite Rating 1 (PK-1) or Composite
Rating 2 (PK-2);
2) Predicate "Quite Healthy" are equalized with a Composite Rating 3 (PK-3);
3) Predicate "Less Healthy" are equalized with a Composite Rating 4 (PK-4);
4) Predicate "Unhealthy" are equalized with a Composite Rating 5 (PK-5).
In banking industry, their operational performance could be measured by their
financial ratios as Bank Indonesia used these ratios to rate their performance.
The relevance of operational performance measurements can be explained by the
signaling theory and the efficient market theory. Signaling theory explains reasons
why firms have an incentive to report information to external parties, which is as to
reduce information asymmetry. Reduction in information asymmetry affects the
value of banking firms in gaining public confidence. Reduction information
asymmetry reduces stock price volatility as bank report information to the public to
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give a clear signal and useful information for investment decisions, credit and
similar decisions.
Efficient Market Theory is the basic theory of characteristic of an efficient capital
market where investors have a knowledge and information are available to investors
so that they can react quickly on new information that ultimately cause stock prices
to adjust quickly and accurately. Efficient Market Theory states that investors
always include available information as factor in their decision which will reflect in
share price traded. Thus, the share price prevailing on the capital market already
contains factor of the information. Characteristics of a capital market efficient are
knowledgeable investors with available information to react quickly on new
information that ultimately caused the stock price adjust quickly and accurately. So
share price will reflect from the information published by bank. Good bank
performance will increase their share price, and poor bank performance will
decrease bank share price (Purwasih, 2010).
2.4 Value Relevance of Earnings
Earnings or net income is a direct measurement of a company performance. Study
by Easton and Harris (1991) suggests that earnings have a significant impact in
security valuation. Study about Greek banking sector by Dimitropoulos (2010)
suggest that earnings have higher level of significance in explaining share return
compared to cash flows as change in earnings affect share returns positively. These
results clarify that earnings could be the explanatory variable for share returns.
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Although earnings could be considered to be more relevant for valuation purposes
compared to cash flows, earning could also present bias data due to manipulation
from manager requirements to report high net income.
Dontoh, Radhakrishnan, Ronen (2004) suggest that declining value relevance are
caused by non information based trading which cause to decrease the ability of stock
price to reflect financial information. Francis & Schipper (1999) and Lev (1989)
indicate that the explanatory power of earnings levels with stock returns have
significant decrease over time. This week relations are due to manipulation in
accounting number by manager. However, this could be prevented by intensive
monitoring from government or central bank.
2.5 Value of Firm
There have been many contrary debates on importance of shareholder as well as
stakeholder value. In United Kingdom and United States legal framework, it is
implied that shareholder is the owner of the companies, while board of director is
only the representative who is elected by them. Their goal is to maximize
shareholder value, as they believe that a company that focus on maximizing
share holder value, means the company also have capability in maximizing
stakeholder value (Copeland, Koiler, and Murrin, 2000).
According to Ohlson (1995), value of firm could be determined by present value
of expected dividends. Dividend and stock price are related to one another, as
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dividends are perceived as additional value to shareholder. Usually after
company announce dividend, share price will increase. Share is worth the sum of
its future dividends discounted back to dividend present value. Therefore, this
paper use share price deflated by their book value of equity to determine firm
value.
2.6 Literature Review: Prior Study
To test the relevance of financial statement, they use component of financial
statement as their variables. There have been many prior research of value relevance
in bank industry using different measures. Variables used in prior researches by
Dimitropoulos (2010) and Agostino, Drago and Silipo (2008), and other researchers
are earnings, cash flow, and book value of equity.
As stated in Dimitropoulos (2010) research, two prior studies observed return of
bank’s stock of the Malaysian and Australian banks over the period 2000–2004 as
well as 1998–2006. These researches revealed that accounting earning is relevant
when they have simultaneous impact on bank's share prices. Bank risk also have
significant impact in earnings response coefficient especially bank’s credit risk.
Study by Dimitropoulos (2010) examine relevance of earning and cash flow, also
considering bank’s risk such as interest rate risk, credit risk, liquidity risk and
solvency risk, using Greek bank’s data analysis over a period of ten years (1995–
2004), observed that earning provide higher relevance than cash flow in determining
share return since change in earning have positive impact in stock return. Interest
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rate risk has a positive but not significant influence on stock return but on the
contrary solvency risk, credit risk and liquidity risk have negative impact on the
stock return. They also revealed that cash flow has a significant impact when
transitory earning presented which means that investors seek for other measures of
banks' performance when there is an extreme increased in earnings.
Research by Agostino, Drago and Silipo (2008) about value relevance of IFRS using
221 European listed Banks from period 2000 to 2006 concluded that there is an
increasing impact on earnings before and after convergence of IFRS, while book
value of equity had a decreasing and insignificant impact. Equity’s book value is
less value-relevant since the marginal effect of equity’s book value is never
significant in the post-adoption phase. Prior research stated in their paper proposed
that book value of equity is more relevant when current earning do not predict future
earnings or when there is increased danger of bankruptcy.
In contrast, research by A. Dontoh et al. (2007) suggests that share price is not a
good measurement for assessing earning relevance. They analyze the predictive
content of share price with earnings, and other accounting information. Their result
revealed that there is a decline in the predictive content of earnings and stock. Their
analysis suggests the decline could be the effect of increase in non information based
trading volume.
Generally, bank performances are measured by financial ratio. Based on bank
financial statements, financial ratio could be calculated as a ratio to measure bank’s
condition.
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Study by (Wirnkar &Tanko, 2008) analyzes the adequacy of CAMEL ratio in
determining 11 commercial banks in capturing in Nigeria over a period 1997 – 2005.
The finding shows that these factors do not have ability in determining overall
performance of a bank as all hypotheses are rejected in this study. Resarch by Nurazi
and Evans (2005) titled "An Indonesian Study of the Use of CAMEL(S) Ratios as
Predictors of Bank Failure,” this study used logistic regression and multiple
discriminant analysis. The findings suggest that the variables capital adequacy ratio,
assets quality, management, earnings, liquidity, and bank size are statistically
significant in explaining Indonesian bank failure. However, the variable for
measuring sensitivity to market risk is not significant in predicting bank failure.
Study by Elyor (2009) evaluates performance of commercial bank in Malaysia from
2004 to 2008 using multiple regression analysis. His research shows that CAR,
interest expenses to total loans, and total loans to total assets ratio, influence their
ROA, while NPL to total assets, total operating profit to revenue, LDR, and NIM
ratios are not significant. His study concludes that this ratio predicts 66.9% of ROA
and 64.0% of ROE.
Indonesia requires their bank to maintain required standard rating to sustain their
soundness at specified rate. Indonesian study conducted by Nurhartanto (2010) and
Purwasih (2010), use financial ratio as variables in their researches.
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Indonesian study by Nurhartanto (2010), study about the effect of CAMELS on
stock price for the period 2004 to 2009 using 12 listed public banks in IDX. They
used CAR, EPS, NPL, BOPO, and LDR as their variables. They used multiple linear
regressions and the result showed that these ratios have significant effects on stock
prices, which are indicated by more than 50% of value of R square. As a partial,
CAR, EPS and LDR have significant effect on stock price, while the NPL and
BOPO variable have insignificant effect on stock prices. This is caused by less alert
management in terms of providing credit to customers as well as less efficient
management performance in minimizing costs.
Other Indonesian research by Purwasih (2010) observed 19 listed public bank
companies in 2006-2008 using multiple linear regressions. The variables used are
CAR, RORA, NPM, ROA and LDR. The result observes that RORA and ROA have
positive and significant impact in share price, while CAR, NPM, and LDR did not
have significant impact on share price. It is indicated that these variables provide
16.5% impact on share price. These variables provide lower significant impact
compared to research conduct by Nurhartanto (2010), which shows more than 50%
impact on share price. These discrepancies in their findings may due to different
periods in conducting the research, and also different variable tested.