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Finance | Indonesia's Islamic Banking Industry: Bright Prospects Ahead Despite Constraints

Indonesia’s Islamic banking industry remained under pressure throughout 2015 after experiencing limited growth, a rise in non-performing financing (NPF) and inefficiency still hampered the further development of the Islamic banking sector. The Financial Services Authority (OJK) issued a wide range of incentives over the course of 2015 to drive the domestic Islamic finance industry including easing regulations on the loan-to-value (LTV) ratio, risk-weighted assets (RWA), NPF restructuring, and capital participation. In addition, a number of other policies such as codification, leveraging and hedging regulations aim to improve the competitiveness of Indonesia’s shariah-based banks which are still lagging considerably behind conventional banks (See Indonesia’s Banking Sector; Under Pressure but Staying Strong).

Indonesia's Islamic Banking Industry: Bright Prospects Ahead Despite Constraints
The government has continued to push ahead with its plan to strengthen domestic shariah-based banks through consolidation or a merger of state-owned Islamic banks. 

That being said, Islamic banks continued to innovate to increase their market share through various creative ways. These include exploring opportunities to manage endowment funds (waqf) and entering into a mini master repurchase agreements with other shariah-based banks to increase liquidity. Meanwhile, at the same time, the Indonesian government is also continuing its efforts to merge state-owned Islamic banks into a mega shariah-based bank by 2017.

Marginal growth

The market share of the Islamic banking industry in Indonesia in 2015 remained low compared to conventional banks. This is evident from the total Islamic banking assets which are less than 5% of total Indonesian banking assets. Based on data released by the OJK as per July 2015, the recorded assets of Islamic banks and shariah business units of conventional banks totalled 273.48 trillion IDR, or 4.6% compared to the total assets of commercial banks that reached 5925.67 trillion IDR. Also, the net profit of Islamic banks and shariah units of commercial banks as of April 2015 only increased slightly by 0.97% yoy to 1.04 trillion IDR from 1.03 trillion IDR in April 2014.

This was partly due to the national economic slowdown affecting the growth of third party funds in Islamic banks in Indonesia. As a result, Islamic financing growth slowed throughout the year. The weakening of the rupiah was also responsible for the increase in the NPF ratio that had eroded the capital adequacy ratio (CAR) of Islamic banks. In fact, the slowdown in economic growth since the beginning of 2015 has made the CAR of three large Islamic banks; BRI Syariah (11.03%), Bank Syariah Mandiri (11.97%), and BJB Syariah (12.20%), plummet to below 15%.

Until the first half of 2015, the NPF of Islamic banks had increased to 4.73% or 9.7 trillion IDR from the previous 3.9%. Large companies accounted for 57% of the NPF while SMEs contributed to the rest. In terms of its use, working capital financing topped the list with a contribution of 50.20%. The second position was occupied by investment with 25.87% and the consumer financing sector ranked third with 23.81%. The OJK had actually given the green light to Islamic banks to clean up their NPF problems through an asset management unit (AMU). However, most Islamic banks prefer to resolve their bad financing internally.

Until September 2015, Bank Syariah Mandiri (BSM) established itself as the largest Islamic bank, accounting for 24.20% of overall assets. BSM’s position is getting stronger after pocketing a capital injection of 500 billion IDR from its parent bank, Bank Mandiri in November 2015 which helped it to be the first Islamic bank achieving the BUKU III category.

Inefficiency and lack of competitiveness

Although it has been present for a long time, Indonesia’s Islamic finance industry is still unable to compete with its conventional counterparts despite the high proportion of Muslims that make up the population. According to the OJK, there are seven factors that hinder the growth of shariah-based banks. First, a lack of synergy and government support. This is evidenced from the lack of incentives in the form of tax allowances, research funding and technological development from the government.

As an illustration, nearly all state funds are deposited in traditional banks, not in Islamic banks. In Malaysia, on the other hand, the government deposits a substantial amount of state funds  in Islamic banks. The only state fund deposited in Indonesia’s Islamic banks is the hajj fund amounting to 17 trillion IDR out of a total of 70 trillion IDR. Even so, starting in 2016, Islamic banks will have to scramble for hajj funds because the government prohibits the overflow of hajj funds from their parent banks.

Another factor that inhibits the growth of the Islamic finance sector is the lack of capital, which leads to inefficiencies in operations. Currently nearly 60% of third-party funds in Islamic banks are public deposits and only 40% are low-cost funds. The government has made this situation worse by taxing shariah deposits at the same rate as traditional deposits. Since the Islamic deposit margin is floating, its tax should be similar to those applied to mutual funds and dividend income.

A further factor that hampers the growth of Islamic banks in Indonesia is their relatively limited range of products and services such as the small number of their automated teller machines (ATM). The quantity and quality of human resources for the sector is also an issue (See Islamic Finance Education in Indonesia). The same holds true for the technology and information systems in use that cannot support the development of new, innovative products and services (See Indonesian Enterprises Look to ICT for Higher Productivity).

Furthermore, the license for branch office operations of Islamic banks is more complicated than for traditional banks. For example, there are several types of branches that can only provide financing and are not allowed to raise third-party funds. The inefficiency in Islamic banks is also characterised by the high ratio of operating costs to operating income (BOPO). Based on data from the OJK, as of June 2015, the average BOPO of Islamic Banks was 84.5% versus the 75.45% of conventional banks. This is on top of a relatively high NPF ratio. Until Q1 2015, the NPF of Islamic banks had risen to 4.73% from 4.67% in the previous year. This was mainly due to the inability of the Islamic banking industry to entice credible debtors who are resistant to economic turmoil. This is due in part to the fact that Islamic banks have two major weaknesses: they cannot disburse loans without a clear underlying transaction; and, their return cannot be determined upfront.

Improved government support

The OJK is paying considerable attention to the Islamic banking industry. The agency relaxed no less than 14 regulations to help the recovery of national Islamic banks. On 24th August 2015, the OJK launched four stimulus measures to spur Islamic banking growth through Regulation No. 12/POJK.03/2015 which came into force in September 2015. These stimuli aim to ease regulations on loan-to-value, risk-weighted assets, NPF restructuring, and investments.

Another incentive offered by the government is concerned with foreign exchange hedging to respond to the increase in foreign currency financing by Islamic banks following a decline in the rupiah exchange rate. The new regulation will enable shariah-based banks to hedge foreign exchange swap and forward transactions.  This is useful to manage exchange rate risk during the pilgrimage season where cost components are mostly denominated in US dollars.

To spur further growth, the OJK also finalised the codification of Islamic banking products which allow shariah-based banks to launch new products without having to wait for the permission from the OJK. The codification rule was included in the Fifth Policy Package issued by the government at the end of October 2015. Another important incentive in the package is the simplification of requirements for opening branches which allows Islamic banks to use the existing network of their parent banks. The synergy between Islamic and conventional banks and the OJK’s plan to form a National Shariah Committee is also expected to help Islamic banks deal with the integration of ASEAN banks following the implementation of the ASEAN Economic Community by 2020 with the goal of boosting their market share up to 15% by 2019.

Islamic bank merger

Over the past year, the government has continued to push ahead with its plan to strengthen domestic shariah-based banks through consolidation or a merger of state-owned Islamic banks which will include BNI Syariah, BRI Syariah, Bank Syariah Mandiri and the shariah unit of BTN. The OJK has accelerated the deadline for the merger to 2017 from the original plan in 2018. A mega Islamic bank will enable the Islamic banking industry to compete with larger conventional banks and to extend their financing to the corporate segment; particularly in the infrastructure sector (See High Stakes for Indonesia's New Infrastructure Push).

Exploring new markets and opportunities

In addition to various incentives and stimulus measures from the government, Islamic banks in Indonesia continue to innovate to increase their market share. A total of 18 Islamic banks formed a mini master repurchase agreement (MRA) in 2015 to increase their liquidity. The Mini MRA is an agreement to repurchase Islamic securities as collateral to secure loans from other banks.

To overcome the limited number of branches that Islamic banks operate, since the end of 2015 several Islamic banks have been preparing to implement the branchless banking programme known as Laku Pandai (Officeless Financial Services for Inclusive Financing). BRI Syariah became the first Islamic bank to launch the programme in Mataram, West Nusa Tenggara (NTB) in December 2015. The programme will make it easier for people in remote areas to access financial services and products without having to come into a branch.

Moreover, to increase the market share of shariah-based banks, some Islamic banks in Indonesia are exploring opportunities to manage endowment funds or waqf assets which are scattered throughout Indonesia. Unfortunately, Islamic banks are still barred from becoming a nadzir or endowment manager because the Waqf Law mandates that only social and religious institutions approved by the Indonesian Waqf Board are allowed to assume the role.

Beside endowment funds, some Islamic banks are also scrambling for third-party funds by partnering with governmental and religious institutions. For example, the Ministry of Religious Affairs disburses salaries to their employees through BNI Syariah.  Other Islamic banks such as BSM tried to raise public funds by becoming a retail selling agent of Islamic bonds or sukuk (See The Rise of the Sukuk in Indonesia’s Islamic Finance Industry). The bank expects the sales of the government retail sukuk series SR-007 in 2016 to reach 500 billion IDR. 

In 2016, a number of Islamic banks plan to increase their capital to expand their business coverage. For example, BSM announced that it will increase its capital by 500 billion IDR while BNI Syariah will acquire a fund of 1 trillion to 2 trillion IDR from its parent bank in 2016. Increased capital is expected to boost Islamic banks’ financing which only posted 4.04% growth amounting to 206.05 trillion IDR as of November 2015 compared to 198.37 trillion IDR in November 2014.

Remains lucrative for foreign investors

The Indonesian Islamic banking industry is still considered attractive for foreign investors despite various constraints plaguing the sector. The Islamic Development Bank (IDB) has been lobbying the OJK to allow them to expand more freely in Indonesia’s Islamic banking market by acquiring the shares of state-owned shariah banks. The IDB plans to finance infrastructure projects in Indonesia through an Islamic-compliant financing scheme.

Similar steps are being taken by the International Finance Corporation (IFC) which is also exploring opportunities to gain entry into Indonesia’s Islamic banking industry. They want Islamic banks to focus more on the micro sector. Previously in Q1 2015, the IFC and Sumitomo Mitsui Banking Corporation (SMBC) approved an additional investment of $300 million USD in BTPN whereby IFC provided $75 million USD and mobilised another $225 million USD in the rupiah currency from SMBC, the owner of a 40% stake in the bank. The IFC is encouraging the bank to be more agressive in providing Islamic microfinancing; an area of significant potential in Indonesia for the future.

Global Business Guide Indonesia - 2016

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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.