Principled lending: The sharia-compliant segment stands to benefit from new state-led initiatives

Home to around Rp617trn ($45bn) in Islamic financial assets as of the end of 2015, according to data from the Financial Services Authority (OJK), Indonesia’s sharia-compliant financial services segment is widely considered to be on a growth path. Indeed, in terms of total assets, the Islamic segment posted a compound annual growth rate of 24% during the period 2009-14, which represents significantly faster expansion than the country’s financial industry as a whole, which grew by 10% per annum. Islamic banks accounted for half of Indonesia’s total sharia-compliant assets, making the banking sector the segment’s largest contributor, followed by sukuk (Islamic bonds), with around 44% of the total. The remaining 6% is made up of funds, insurance firms and other miscellaneous financial entities. “Indonesia’s Islamic financial services segment has been slow to develop compared to some neighbouring countries, such as Malaysia,” Ninis Adriani, vice-president and head of investor relations at Bank Rakyat Indonesia (BRI), one of the nation’s largest banks, told OBG. “But recently this has changed, due in large part to ongoing government efforts to push the development of the segment. So long as this effort continues apace, sharia-compliant finance could be huge here.”

Obstacles On The Way

The OJK, which recently launched a roadmap for developing Islamic finance through to 2019, faces challenges in its efforts to expand the sharia-compliant segment. Islamic finance accounted for less than 5% of financial sector assets at the end of 2015, according to a 2016 report compiled by the Malaysian fund manager CIMB Islamic, Thomson Reuters and other research entities. While the segment has posted considerably more rapid growth than the conventional financial industry in recent years, it remains at a significant disadvantage in terms of scale. According to the OJK, additional issues currently faced by Indonesia’s Islamic financial segment include a historical misalignment between the state and domestic players; the high cost of financing relative to conventional institutions; a low number of products and services compared to conventional lenders and fund managers; and relatively underdeveloped regulations and oversight. Perhaps most importantly, due to the comparatively small scale of the industry, public awareness about the benefits of Islamic financial services is considered to be quite low. “Islamic banking, in particular, is not widely known or understood here,” Djoko Kurnijanto, director of the international division at the OJK, told OBG. “Our five-year plan for the industry aims to address this and other challenges currently facing Indonesian sharia-compliant institutions of all kinds.”

History & Current Status 

The nation’s first Islamic bank, Bank Muamalat, was established in 1991 after President Suharto began to soften his stance towards Islamic politics and, in turn, finance. In 1990 state-sponsored religious scholars carried out a study geared towards establishing a commercial Islamic lender, which eventually led to the passage of Government Regulation No. 72 of 1992 on profit-sharing banks. The system was further codified in 1998 under the Banking Act No. 10, which formally recognised the country’s developing dual conventional/Islamic banking systems.

Since then, the sharia-compliant segment has developed rapidly, albeit from a relatively late start compared to the conventional sector. According to Islamic banking statistics report from the OJK, as of June 2015, Indonesia was home to 12 fully Islamic national commercial banks and 22 dual-system national banks, the latter of which are conventional institutions that simultaneously operate Islamic banking units. By comparison, 118 conventional banks operated in Indonesia. At the same time, the country was home to 161 rural Islamic banks, compared to 1644 rural conventional banks. In terms of assets, meanwhile, sharia-compliant lenders made up just 5% of total banking industry assets at the end of 2014, according to CIMB Islamic, with similar percentages for total deposits and loans. Lastly, Islamic banking penetration – a measure of total sector assets as a percentage of GDP – was at less than 3% as of the end of 2014, compared to more than 54% among conventional lenders in the same period.

Plans Moving Forward 

In 2015 the OJK, which regulates the Islamic financial segment in conjunction with Bank Indonesia, published its long-awaited Islamic banking roadmap, which described the state’s plans for the segment through to 2019. As noted in the plan, despite the low level of sharia-compliant financial development relative to many of its neighbours, in 2014 Indonesia ranked ninth worldwide in terms of total Islamic financial assets.

By restructuring the industry, growing the customer base and instituting best practice regulations, the OJK aims to boost the segment’s ranking considerably in the next half decade.

The 2015-19 roadmap is organised into seven broad policy directions. First, the OJK plans to strengthen coordination among government authorities – namely the OJK itself and Bank Indonesia – and other stakeholders, including Islamic banks and other sharia-compliant institutions. Second, the OJK aims to expand capital and operational efficiency throughout the segment in an effort to facilitate better competition with the conventional segment. Third, in conjunction with commercial players, the state will improve funding structures in order to expand the Islamic financing segment, which is particularly small as compared to the conventional side. For its fourth goal, the OJK plans to work with the segment to develop new products and services, and to improve quality of service at all levels of the industry.

The OJK’s fifth policy target involves upgrading Islamic financial segment’s infrastructure, and specifically its IT framework and human resources pool, both of which are considered to be behind the conventional financial services segment. Sixth, the regulator aims to boost public awareness of Islamic finance via public relations campaigns, but also by raising the segment’s profile more generally. Lastly, the OJK aims to strengthen and harmonise the Islamic segment’s regulatory framework.

Building An Independent Industry 

Two specific components of the 2015-19 roadmap have topped headlines since the plan was launched. The first of these, which was initiated in January 2016, is a key regulatory change which will require all dual conventional/Islamic banks to spin off their sharia-compliant units into independent Islamic institutions by October 2024. The move has been widely taken to indicate the government’s expectation that the country’s Islamic banking segment will eventually serve as a standalone counterpart and competitor to the conventional industry.

While the regulation legislating the change has not yet been fully explicated, according to local news reports, the OJK has outlined two ways in which dual banks may spin off their Islamic units. First, a dual lender may establish a wholly new sharia-compliant financial institution to take over its Islamic loan and deposit portfolios. Alternately, a dual banking institution may transfer all of the assets controlled by its Islamic unit to an existing Islamic financial institution, essentially allowing the independent bank to acquire its sharia-compliant business as a whole.

The maximum amount of time allocated by the OJK to all dual banks to complete the transition is nine years. Institutions that complete the transition by 2018 will be allowed to maintain minimum capital equity of Rp50bn ($3.65m), compared to Rp100bn ($7.3m) for post-2018 spin-offs.

Major New Player 

The second high-profile component of the roadmap involves merging together the Islamic units of a handful of state-owned dual lenders to form a so-called Islamic mega-bank in the country. The new institution would in theory be able to compete on a more equal footing with Indonesia’s leading conventional banks. The state’s plan is to bring together the Islamic components of BRI, Bank Mandiri, Bank Negara Indonesia and Bank Tabungan Negara to form a new institution that would control around 40% of the country’s Islamic banking assets, or $8bn in total. According to the Indonesia Islamic Banking Association, an industry group, the megabank could boost the Islamic segment’s market share to 20% of the total banking sector by 2018, versus 10% without the merger. The mega-bank initiative was initially planned to be completed by 2015, but was pushed back to 2017 in late 2015.

Perhaps the principal hurdle to establishing an Islamic mega-bank is bringing together the many stakeholders that participate in the business of each individual institution. An additional challenge has to do with a country’s regulatory framework, which must be relatively well developed and enforced to ensure a smooth transition for the new institution.