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

Banking stability is critical for financial resilience in open emerging economies exposed to external shocks. This study examines how external factors, the US Dollar Index, foreign exchange reserves, and foreign bank asset penetration, affect banking stability in Indonesia, proxied by the Loan-to-Deposit Ratio (LDR). Using monthly data from January 2020 to December 2024, the analysis applies a Vector Error Correction Model (VECM) comple-mented by Impulse Response Functions, Variance Decomposition, and Granger causality tests. The results reveal a significant long-run relationship between external variables and banking stability. US dollar appreciation and higher foreign bank penetration tend to weaken banking intermediation, while foreign exchange reserves enhance stability. In the short run, the banking sector remains vulnerable to external shocks, particularly from global dollar movements and foreign bank dominance. IRF and variance decomposition results confirm the growing contribution of external shocks to LDR fluctuations over time. Granger causality indicates that foreign exchange reserves and foreign bank penetration are key determinants of banking stability. These findings underscore the importance of dynamic reserve man-agement, exchange rate flexibility, and prudent macro prudential regulation to strengthen Indonesia’s financial resilience amid global volatility.