Interview: Jahja Setiaatmadja, Michael Young, Zulkifli Zaini, David Fletcher
To what extent will the industry be able to maintain current increases in loan-to-deposit (LDR) ratios while ensuring adequate risk management?
JAHJA SETIAATMADJA: Bank Indonesia’s (BI) policies on LDRs and declining BI rates are a clear indication of its determination to increase lending and lower interest margins to facilitate intermediary function. While we and the banking industry are committed to support BI regulations for achieving a minimum 78% ratio requirement. The increase should be reached gradually over time on the basis of solid loan demand – rather than aggressively pursued – in order to mitigate risk. Therefore, many banks are prepared to pay the necessary fines to a certain extent to avoid lending on poor-quality assets, which would trigger a rise in non-performing loans (NPLs). We have to act prudently and continue to ensure that proper risk management controls are in place. That being said, strong domestic demand for commercial and consumer loans has allowed us – and the industry as a whole – to increase our LDRs without compromising our NPL ratio. The commercial and small and medium-sized enterprise (SME) segments have achieved over 33% growth for the first nine months in 2011 as compared to that period in 2010, while the consumer segment increased over 28% year-on-year for the same period, driven by mortgage and vehicle loans.
Based on the country’s economic trajectory, it is likely that these trends will continue and LDRs will climb towards meeting the targets set by BI eventually. However, given the uncertain international financial situation (particularly global liquidity issues), we must carefully monitor the risk associated with capital flight and consider the impact it could have.
MICHAEL YOUNG: BI has implemented a strategy to encourage lending, and as part of that strategy it requires banks to maintain an LDR between 78% and 100%. However, to mitigate the risks, we have adopted a methodology which calculates our LDR based only on core deposits. From our perspective, a more conservative approach – one only including core deposits – would be prudent.
As a result, we fall just shy of meeting the requirements of BI and thus are required to lend more. However, based on our internal controls we think we are not liquid enough. If we were to maintain our internal controls and calculate LDR on core deposits while meeting BI requirements, we would have an LDR of 150%.
We think high-risk flight capital should not be included as part of our LDR calculations. This refers to money that would leave the country at the onset of any potential crisis. Admittedly, this is a conservative approach, but we feel it is prudent. There is a concern that some banks have not adopted a sufficiently conservative approach to lending. There are two systemic issues when evaluating the money market. First, deposits tend to flee the country as it is a fairly convertible market and people can take their money to Singapore very easily. The deposit-to-GDP ratio is less than 40%.
Measures should be employed so that deposits are encouraged to stay in Indonesia to foster improved credit growth. Second, the largest four banks tend to control a major portion of the liquidity in the country.
As a result of a lack of a well-developed interbank market, liquidity does not tend to be intermediated. BI is aware of this issue and they have been trying to develop a better functioning repo market to intermediate that liquidity, but in the absence of that, and given the high credit growth the industry has experienced, banks need to be prudent about liquidity in the coming months.
The 78% minimum is understandable, but allowing a 100% maximum may need re-examining.
ZULKIFLI ZAINI: The enactment of the new regulation demonstrates that Indonesian banks can improve their inter-mediation role, as the industry LDR has gradually increased over the course of 2011.
In fact, the industry LDR exceeds the 78% minimum requirement of BI. As an intermediary, the banking industry continues to apply prudent principles along with strict regulations on risk management through the implementation of Basel policies including operational risk, credit risk and market risk in calculating the capital adequacy ratio. Over the past six years the banking industry, including us, has taken steps to ensure adequate risk management. We personally have implemented sound credit scoring and monitoring policies, with centralised credit analysis. This has led to our NPL ratio decreasing to under 3%, representing one of the best credit-quality levels in the Indonesian banking sector. That said, threats of foreign capital outflows from Indonesia will continue to remain a concern as significant outflows could interfere with the nation’s economic stability. Steps are being implemented to anticipate and secure Indonesia’s economy to offset the risk of capital flight. One tool is BI’s plan to repatriate funds from exports that settle in accounts overseas, an act that could bring billions of In addition, raising the LDR regulation and requiring a minimum LDR for each bank with the intention of increasing the bank’s penetration into the real sector will support the development of this sector as a major driver of economic growth, thereby implying a greater domestic focus to lending. The recent rise in foreign direct investment implies that more funds from overseas are willing to invest in long-term projects in Indonesia, a sign that outflows might be less volatile FLETCHER: I think the LDR ratio is quite interesting; BI proscribes that banks should operate between 78% and 100%. Currently, the industry as a whole is running at a low 70s average, but it you remove the “big four” it is probably running at over 90%. So, with LDRs one has to be careful not to gauge it from only an industry average perspective. In terms of risk management, what it does highlight – and what should be at the forefront of everybody’s minds – is how the competition for deposits affects liquidity at individual banks. The vast majority of basic deposits are onshore so there is not much of a risk that a large portion could take flight. When you have LDRs that are around 90% on average for the industry, excluding the big four, it means that you need to have a bit of caution from a liquidity point of view. That being said, risk management seems to be adequate and there is no real cause for alarm. It is just something you need to take into account, particularly when you have an economy that’s doing well and growing.
We have, and rightly so, a regulator who wants to see lending increase to support economic expansion, which is all very good, but it’s important that it is not done at the expense of certain basic disciplines. However, at this point I have no reason to believe that the industry is beginning to lose that discipline.
To what extent should commercial banks increase the amount of project financing made available as a means to encourage infrastructure development?
DAVID FLETCHER: I personally do not believe in what I would call “managed lending”. If the projects are right and the terms are right, then the financing will be there. I think what does need to happen, and it would certainly be valuable for infrastructure as well as mortgages, is that the capital markets become more developed in regards to term structures, both term liability structures and the ability for more term assets. That should evolve in time, but to force institutions to finance infrastructure without better developed term structures is getting ahead of the game. If the right project has the right legal structures and has the right commerciality, then it will receive adequate financing. If the correct commercial structure does not exist, then I would argue that it is not appropriate for commercial entities to finance and the government, which has other means to acquire the necessary capital, should do so.
Retail lending does contribute to the real economy. It helps to drive consumer demand, which has a direct impact on the domestic economy. What it demonstrates is that you need a more liquid capital market structure that will enable longer-term financing. The reality is that if you look at government budgets and government budget deficits, they are not spending all of the money they have available to them. The government has the ability to fund a lot more infrastructure projects than it currently does. Additionally, the public-private partnership (PPP) model needs to be developed further, and the country needs to resolve issues related to land acquisition. This will create a far more conducive environment for project financing. It is easy to say that banks have a responsibility to provide infrastructure financing, however, their intermediary role with SMEs is equally important. What many studies have shown is that SMEs tend to be the backbone of an economy. They provide the majority of employment and, along with micro-financing, play a pivotal role in the development of the real economy.
ZAINI: The government has targeted 7.7% economic growth by 2014. To do so requires more than Rp2000trn ($240bn) per year until 2014. This will require private investment and long-term bank financing, each contributing 50% of the total investment. In connection with the government’s targets, the national banks – including the state banks – will support the development of infrastructure improvement programmes through lending (both syndicated as well as individually) to major projects. State-owned banks represent three of the four largest banks in Indonesia and if the environment from a regulatory point of view is attractive, we would definitely be the major lenders for bank loans and through syndications for project finance. For power generation, development is being driven by the presence of government programmes focused on expansion of new facilities along with a shift of energy policy to renewable sources.
YOUNG: Infrastructure financing is purely based on market factors. Confidence is key and right now. There is too much risk involved and that is why we are not seeing major project financing. Tenders need to be offered beyond the current average of seven years in order to be more attractive. Additionally, the government needs to develop a more cohesive climate from the regulatory point of view, address issues within the legal system and resolve problems surrounding land acquisition should it be able to provide banks with the confidence and security to finance longer-term projects. HSBC has played a role in financing major infrastructure projects in other countries but those countries do not rely on only commercial banks to finance such large-scale projects. To finance a five-year project, you cannot finance it with it one-month deposits.
Therefore, to bridge that gap it requires some sort of PPP model and the need for some sort of infrastructure-financing arm of the government. Commercial banks are limited by the size and scope of their balance sheets in financing major infrastructure projects.
How would you respond to those that claim that as Indonesia improves economically, customers will move their business to foreign banks?
YOUNG: As the economy improves and the competitiveness of the banking industry continues to intensify, local banks will improve their systems and be able to offer closely competitive services and products with those of foreign banks. Therefore, it is quite possible that locals may begin to move their business to local financial institutions. Moving forward, a core group of local and international banks will emerge that will dominate the industry. Local banks are becoming more professional and are better managed. Today’s trends indicate that in numerous instances local institutions are taking talent away from foreign banks, where the dramatic increase in salary levels has become the main source of employment attractiveness.
SETIAATMADJA: Over the past several years the intense nature of the banking industry has forced domestic banks to improve the quality and sophistication of their products and services. Foreign banks may still have a competitive advantage in regards to the depth of their products, but that gap is rapidly deteriorating and the distinction between local and international is eroding.
The international financial crisis did not help the situation for foreign banks either. In fact, it exacerbated a growing mistrust of foreign banks among the local population. As a result of the improved performance of domestic financial institutions, it has been easier to recruit talent. It used to be that the best recruits would automatically take up offers from foreign institutions before even considering an offer from a local bank, but this is not the case anymore.
ZAINI: The attractive picture of Indonesia’s national economy and banking industry has encouraged existing players and newcomers to supply Indonesian customer demands in term of banking products to run their businesses. With our open banking system, it has become vital to maintain high customer loyalty. Domestic banks have been focusing on offering fee-based products and services that are on par with foreign banks. The focus that banks place on improving transaction services will be a vital in attracting new customers.
To what extent will SME lending be a major focus in terms of growth for the banking industry?
ZAINI: Competition in the banking sector remains tight, especially in the retail and SME segments, as many financial institutions have engaged in these segments due to their strong resistance to the financial crisis, as well as attractive margins. Overall, the industry continues to be driven by the six largest lenders. During 2011, working capital loans represented just under half of the total national banking credit. The increase in the number of SME loans, which reached Rp1035trn ($124.2bn) and which rose 210 basis points compared to 2005, implies that SME loans are already – and will continue to be – a driver of loan growth in the system. Over the last five-years SME loans have grown on an annually by 60 basis points more than overall loans.
Though SME credit growth was well ahead of the national bank credit expansion of 23% year-on-year, SME credit quality is relatively weaker than that of the overall industry. In 2011 SME NPLs increased to a level above the overall industry NPLs. With the trend of higher SME NPLs it is imperative that banks actively manage their deployment of these loans and apply strong credit analysis to keep NPLs at manageable levels.
FLETCHER: I think it is very important across the country, but I would say it is particularly important outside of Jakarta and in other large cities. It is a sector in which it is difficult to take a programme lending approach and it is a business which requires you to be close to the customer as you need to build relationships with them.
Therefore, for banks that have historically done that, have a network and are prepared to invest in their network, it is a very good business. The SME industry will continue to grow and so will the banks. For Permata we have historic strength in the SME sector and it remains a major focus for us.
SETIAATMADJA: The SME segment will continue to be a major driver of growth within the Indonesian banking industry. Foreign banks are less likely to focus their attention in this area, especially in the lower end of the SME business. Success requires an intimate knowledge of your customers and a much more hands-on approach – evaluating SMEs through documents such as audited financial statements and tax returns. An emphasis therefore must be placed on knowing your client and relationship banking, which provides a competitive advantage for domestic financial institutions. With the sector expected to reach between 80 and 100m accounts within the next five years, combined with the fact that it achieves higher-than-average net interest margins, it is an area that banks must focus on to fuel their internal growth.
As a result, the competition to secure new business has intensified quite dramatically over the past couple years and this is likely to continue for the foreseeable future. Those who can capitalise will be the banks that can provide solutions and products that will help their customers grow. They have to reach out to the low-to-middle-income population. Having an extensive operational branch network will be vital in doing so.
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