Basking in an environment of rising demand for credit in a growing economy, Indonesia’s banks have become some of the most profitable in the world. In recent weeks, two of the big three global ratings agencies have given the banking system a strong vote of confidence. However, there is also a downside. The sector could be hit by rising non-performing loans (NPLs) and changes in government policy that could affect the rupiah.
In late February, Standard and Poor’s (S&P) issued a report saying the banks are likely to maintain strong profitability, high loan growth and robust capitalisation in 2013, despite some internal, economic and political risk factors.
S&P said Indonesian banks’ margins are among the highest in the region, and noted that the country’s benign macroeconomic environment would continue to benefit them. GDP growth is expected to top 6% in 2013 and 2014, with inflation expected to remain at moderate levels. The firm added that ongoing improvement in asset quality was likely to slow over the coming years. However, S&P stated, “banks’ profitability and loan loss coverage provide adequate buffer against a rise in credit costs”.
The agency cited a number of possible risks, including changes in government policy that could affect the rupiah and a rise NPLs if banks fail to manage rapid loan growth, which central bank officials suggest will come in at more than 20% in 2013. However, it is believed these risks will be relatively low for the coming 12 months. NPLs stood at just under 2.2% in mid-2012, low by both regional and international standards.
S&P’s analysis of Indonesia’s banks came after a similar report from Fitch Ratings, published on January 30. Fitch said that it was keeping its outlook for most of Indonesia’s major banks at stable, as they are in a good position to withstand stress, and remain more profitable and with higher margins relative to those in other emerging markets. The agency noted that most big institutions either had strong loss-absorption buffers, or strong support from parent banks – or both.
Fitch noted that asset quality risk has risen over the past three years, but that banks still remain well provisioned. Its stress test suggested that big lenders are expected to experience average loan losses of 3.8% of their portfolio, amply covered by pre-provision profits of 5.2% of loans.
The agency found that bigger, more “systemically important” banks could cope better with stressed losses from their own earnings, while medium-sized lenders had less capacity to do so, but could often rely on support from foreign parent institutions. With earnings likely to cover loan losses in the major banks, capital would be likely to stay intact in the case of stress. However, Indonesia’s smaller lenders are less well capitalised and more at risk, as the central bank recently noted.
The ratings agencies are not the only ones seeing the strength of Indonesia’s banks. Recent research by financial reporting firm Bloomberg suggests the country’s lenders are the most profitable among the world’s 20 biggest economies. Return on equity at the five largest banks by market value (all over $5bn) averages 23%, just above China’s lenders of the same size (21%) and more than twice that of the US (9%). Bloomberg asserts that Indonesia’s banks could be even more profitable if they improved efficiency – they currently have high costs relative to asset bases, partly due to the burden of operating branch networks over a huge archipelago.
Profits are driven largely by interest rate spreads – the gap between the rate banks offer for deposits and those they offer for loans – which averages 7 percentage points at the biggest banks. This is partly due to high demand for credit in an economy that has been growing strongly for 10 years.
Another reason for the large spreads is to cover those relatively high costs; greater efficiency might enable Indonesia’s banks to lower their lending rates without affecting profitability. And there is still significant room for growth. Banking penetration as a proportion of the population who have loans stands at 28%, but as a proportion of GDP, it represents just 30%.
Indonesia’s big banks have come a long way since the 1997-98 crisis. With credit growing so quickly, the risk of bad assets is rising with it, but most banks seem to be in a position to withstand losses. High profitability and growth are attracting foreign institutions, which can take a stake of up to 99% in Indonesian banks. This may in time increase competition and bring spreads down.