Global Business Guide Indonesia

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Finance | Indonesian Banking Sector Outlook: In Need of a New Growth Strategy

Benign inflation, low borrowing costs and a thriving economy helped Indonesia’s banking sector achieve remarkable growth following the 2008/2009 global financial crisis. Strong credit demand from businesses and consumers allowed for significant net interest rate margins, helping commercial lenders generate handsome earnings on their loan business. In 2013, however, the macroeconomic environment deteriorated as Bank Indonesia (BI) hiked its benchmark interest rate to counter rising inflation, while the domestic economy suffered from weaker foreign investment and a widening current account deficit. In 2014 and beyond, Indonesian banks must cut costs and identify new growth areas, which could open up opportunities for foreign investors.

Indonesian Banking Sector Outlook:  In Need of a New Growth Strategy
To capitalize on infrastructure lending Indonesian banks will need to leave their traditional comfort zone of shorter credit terms

Loan business to come under pressure

Outstanding earnings have become something of the norm in Indonesia’s banking industry in recent years. In 2012, net profits at commercial banks rose by 23.7% to 92.8 trillion RP, according to figures from Bank Indonesia’s Annual Report. Mostly, this was owed to a similarly strong increase in the volume of loans issued to companies and individuals. The total allocation of bank loans grew by 23.1% to 507.8 trillion in 2012 RP, marking only a slight slowdown from loan growth of 24.6% a year earlier.

However, with commodity exports still affected by low global prices and consumer spending threatened by inflation, demand for corporate and personal loans is set to soften. BI Governor Agus Martowardojo at the turn of the year said he expected credit to expand by a more modest rate of 15% to 17% in 2014. In the long run, Indonesia’s low ratio of credit to GDP (which increased to 32% in 2012 but remains far below levels in neighboring countries) points to rich potential for future growth. In the near future, however, banks will need to look elsewhere for new business potential. Several major institutions have stressed that they would be looking to fee-based services to generate revenue, including through e-banking .

Consumer loans business cooling

Ongoing uncertainty about the global economy will see Indonesian banks continue to rely predominantly on the domestic market. But this strategy is not without challenges. Elevated inflation could take a toll on consumer confidence, which is already strained by the recent increase in minimum down payments on mortgages and auto financing (See Opportunities in Indonesia’s General Insurance Sector). Weaker household spending would affect the corporate loans business as well, particularly in consumer-related sectors.

On the bright side, increased public spending and private investment could see the infrastructure sector make up for slower growth in consumer finance (See Indonesian Infrastructure: Tremendous PPP Opportunities). Indonesia is in dire need of new roads and railways, ports and airports and reliable electric power. Since the government on its own can only provide a small portion of the enormous funding needs, it relies on public-private partnerships (PPP) for most projects. Arranging syndicated loans and packaging bonds for infrastructure projects spells new investment-banking business. To capitalize on infrastructure lending, however, Indonesian banks will need to leave their traditional comfort zone of shorter credit terms.

BI rate hikes to squeeze net interest margins

While banks continued to perform quite strongly in 2013, the incremental increase in BI’s overnight lending rate by a total of 175 basis points between June and November is bound to squeeze net interest margins (NIMs) going forward. NIMs at many of Indonesia’s commercial banks are still among the highest in the region, but they have begun to come down slowly in 2013. This trend will likely continue as loan demand increases at a slower pace and as depositors will shop around for higher rates to protect their savings against inflation.

SMEs to receive more attention

The slower momentum in consumer and corporate lending forces banks to turn more of their attention on micro, small and medium-sized enterprises (MSMEs), a segment that is far from reaching its full potential (See An Outlook on Indonesia’s Microfinance Sector). For years MSMEs have been lamenting the difficulty of obtaining credit funding and the high interest rates they are normally charged. Regulations also require commercial lenders to take a harder look at MSMEs, so there will likely be some shift in credit portfolios towards this segment. As a result of rising competition in this formerly under-served segment, however, NIMs on MSME loans will also come under pressure. It is doubtful, therefore, whether MSMEs can provide enough new business to sustain the exceptional profit growth many banks have become accustomed to. Another aspect to bear in mind is that loans to MSMEs typically carry higher risk, which would point to higher rates of non-performing loans (NPL).

Deposit growth remains a challenge

Another constraint on loan growth is the challenge of attracting deposits. Rural or newly urbanizing areas around the country hold ample potential to invite new savers, largely because they are under-supplied with banking services. However, an expansion into the regions is unlikely on the forefront of managers’ minds in 2014 due to macroeconomic and political uncertainties, with legislative and presidential elections in April and July potentially altering the regulatory landscape. Before building new branches, banks will also want to size up the Financial Services Authority (OJK), which took over from the central bank as the principal banking regulator starting in 2014. That said, the long-term prospects on the deposit side are underpinned by Indonesia’s emerging economy and the fact that tens of millions of people have yet to open a bank account.

Limited systemic risks

Slower economic growth and higher interest rates along with the weak rupiah undoubtedly exert some pressure on consumer and corporate loans, which could reflect in higher NPL rates in 2014 and beyond – as could the greater share of MSMEs in banks’ loan portfolios. After consecutively falling, however, NPLs at most of Indonesia’s large – and generally risk-averse – lenders stood at less than 2% in 2013, which is low by international comparison. Even if defaults should rise a little, NPLs should remain within healthy limits.

Furthermore, years of strong earnings have allowed Indonesian banks to build capital cushions and boost resilience against adverse economic conditions. Moreover, the leading banks easily exceed capital adequacy ratios (CAR), and the fact that state-owned banks control about a third of all banking assets while some of the leading banks are owned by large foreign institutions further protects the system against financial stress. To nevertheless anticipate any build-up in risk, BI in August 2013 lowered the ceiling on the loan-to-deposit ratio (LDR) for commercial banks from 100% to 92%.

Competition to kick-start consolidation

There are 120 commercial banks in Indonesia as of 2013, comprising 116 private and 4 state-owned institutions as well as more than 1,600 ‘rural banks’ accounting for less than 2% of total banking assets. The booming loans business over the past years has distracted somewhat from industry consolidation, which in turn has practically come to a temporary halt. Yet more mergers and acquisitions are necessary to reduce fragmentation in the banking system and create institutions strong and efficient enough to compete beyond national borders. The upcoming ASEAN Economic Community (AEC) will in all likelihood intensify competition in the region and put consolidation squarely on the agenda again. At the same time, there is a fair degree of concentration in the industry, with the top 10 banks accounting for more that 60% of total banking deposits and total loans. Therefore, smaller and medium-sized institutions are particularly encouraged by the government to team up.

Pressure to consolidate also comes from the 40% ownership cap, which limits an investor to a maximum equity stake of 40% in an Indonesian bank. While exceptions can be granted on a case-by-case basis, the rule, introduced in July 2012, compels investors to divest or reduce their shares through M&A deals. It is too early to assess the effect that the new ownership rule will have on foreign investment. On the one hand, the 40% cap increases risk by limiting operational control, on the other hand the need for divestment could create buy-in opportunities. Much will depend on the exceptions granted for investors who wish to hold or obtain more than 40%. The requirements for exceptions are poorly defined, potentially allowing for the regulation to be misused to keep out foreign suitors. Yet local banks may seek investment or alliances with experienced foreign players as they seek to cut costs and increase operational efficiency.

To sum up, a less favourable economic environment tarnishes the immediate outlook for Indonesia’s banking industry, but the long-term prospects remain bright. Experienced foreign investors may find that their knowhow, technological sophistication and corporate culture may be just what local banks are looking for to up their game amid increasing regional competition.

Global Business Guide Indonesia - 2014

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Indonesia Finance Snapshot - Banking

Contribution to GDP: 2.87% (2016)
Return on Assets: 2.30% (Q4 2015)
Number of Commercial Banks: 120; 4 State/Partially State Owned, 10 Foreign, 16 Joint Ventures, 32 Non Foreign Exchange, 35 Foreign Exchange, 26 Regional Development Banks (August 2015).
Number of Islamic Banks & Units: 13 Banks, 32 Units (2016)
Total Assets: 6,244 trillion IDR (Q3 2015)
Government Bodies: Bank Indonesia, Ministry of Finance, Financial Services Authority (OJK).
Relevant Law: Bank Indonesia Regulation No. 14/8/PBI/2012 on Share
Ownership in Commercial Banks limits ownership by a single local/foreign financial institution to 40%, by a non financial institution to 30%, and by an individual to 20%. Larger stake is possible with the approval of Bank Indonesia.