Dynamic Relationship between External Economic Shocks and Banking Stability: Empirical Evidence from Indonesia Banking Sector

Abstract

Banking stability is a crucial element for the resilience of the national financial system, particularly in an open economy which is vulnerable to external shocks. Indonesia, as a developing country with high connectivity to the global market, faces significant challenges from external factors such as the dynamics of the US Dollar Index, fluctuations in foreign exchange reserves, and increasing of foreign bank penetration. These variables have the potential to influence the banking intermediation function, as measured by the Loan-to-Deposit Ratio (LDR), and therefore require comprehensive analysis. This study aims to examine the long-term relationship, short-term dynamics, the impact of external shocks, and the direction of causality between external factors and banking stability in Indonesia. The data used is a monthly time series from January 2020 to December 2024, with an observation period that covers the latest developments in the Indonesian economy and financial sector. The applied methodology is the Vector Error Correction Model (VECM), which is capable of identifying long-term relationships and short-term responses between variables. It is complemented by Impulse Response Function (IRF) analysis, Variance Decomposition (VD), and Granger causality tests. The estimation results indicate that in the long run, the strengthening of the US Dollar Index and the dominance of foreign bank assets tend to suppress the banking intermediation function, while foreign exchange reserves strengthen intermediation stability. In the short term, Indonesian banking has proven vulnerable to external shocks, particularly from the US dollar and foreign bank penetration, although foreign exchange reserves continue to function as a stabilizing buffer. The IRF and VD confirm that shocks from external factors have a significant influence on LDR variations, while the causality results indicate that foreign exchange reserves and the foreign bank asset ratio are more determinants of banking stability than vice versa. These findings emphasize the importance of policies to strengthen foreign exchange reserves, exchange rate flexibility, and more prudent regulation of the role of foreign banks in maintaining the intermediation function of Indonesian banking amid global volatility. Coordination between Bank Indonesia, the Financial Services Authority, and the government is key to strengthening the stability of the national financial system.