Why big Indonesian banks are buffered enough against losses

Thanks to 'loss-absorption' cushions.

Fitch Ratings believes Indonesia's major banks are able to withstand a reasonably high degree of asset-quality stress, largely due to their strong standalone loss-absorption cushions and/or - in some cases - likely support from highly rated foreign parents.

The rating Outlook for major Indonesian banks continues to be Stable, even though domestic macroeconomic conditions and liquidity have deteriorated and rapid credit growth in the country over the past three years has increased the asset-quality risk in the local banking sector, Fitch says in a special report.

Here's more from Fitch:

The major banks have sound earnings buffers from their superior profitability relative to other banking systems, allowing most of them to comfortably cope with higher non-performing loans (NPL) during the less favourable economic conditions that are expected over the next one to two years.

Under a stress test conducted by Fitch, the NPL ratio of Indonesia's nine major lenders could hypothetically rise to around 18% over the next three years from 2% at end-June 2013. Their annual loan losses therefore, on average, could be equivalent to around 4% of loans. In comparison, loan losses were only between 1.0% and 1.5% of loans over 2011-1H13, when operating conditions were fairly benign. Although the stress conditions would likely lower the banks' pre-provision profits to around 4.8% of loans from the current 6.0% level, that is still enough to cover the loan losses under the stress scenario. The risk of capital impairment is therefore likely to be low for most major Indonesian banks in a stress environment. In the event of outsized asset-quality shocks, many of the large lenders can also rely on their high core capital buffers. The average Tier 1 capital adequacy ratio (CAR) of the nine major Indonesian banks was 14.6% at end-1H13, slightly higher than 13.9% at end-2012. The Tier 1 capital in this ratio is made up entirely of common equity.

The outcome of Fitch's stress test is broadly captured in the banks' Viability Ratings (VRs), which reflect their varying vulnerabilities and resilience on a standalone basis through credit cycles. The steady core earnings base of the larger systemically important local banks, such as PT Bank Mandiri (Persero) Tbk, PT Bank Central Asia Tbk, PT Bank Rakyat Indonesia (Persero) Tbk and PT Bank Negara Indonesia (Persero) Tbk, reflects their funding strengths and explains their ability to cope with "stressed" losses with earnings alone.

The lower VRs of the medium-sized banks, such as PT Bank CIMB Niaga Tbk, PT Bank Internasional Indonesia Tbk and PT Bank OCBC NISP Tbk, incorporate their moderate tolerance to stresses on their credit-costs. The downside rating risks for the medium-sized banks are, however, tempered by ordinary support from their higher-rated foreign parents.

The outcome of the stress test does not represent Fitch's base-case forecast for the Indonesian banks, which are expected to continue to report strong profits in 2013 and 2014.