Despite a turbulent history in financial services, Indonesia has plenty to offer overseas bankers. Some of what is compelling has long been so, such as the huge potential inherent in the world’s fourth-most-populous nation. Indonesia has for decades had a significant and largely untapped customer base – only about 20% of the country’s adults have any sort of ongoing financial services relationship. It was for this reason that some of the larger names in the industry, such as Citigroup and HSBC, original sought a banking licence in Indonesia.

RESILIENCE: Now there is more reason to enter the banking sector. The market has become both broader and deeper, and interest rates are sinking lower. These factors have combined to boost the already growing demand for financial services in the archipelago, from microcredit to mezzanine finance.

Since 2008 an extra incentive has been the country’s remarkable resilience in the face of economic adversity. As banks worldwide were asking for aid from politicians, Indonesia’s lenders did well, many of them even recording profits during the fourth quarter of 2008. Reactions to the global financial crisis of 2008 have helped sort out the well-managed financial sectors from those with improvements to make, and Indonesia has been one of the key winners in this process. Thanks in part to the fresh memories of the 1997-98 Asian financial crisis, the country’s regulators have shown themselves to be a competent group, and confidence in their leadership is a large reason why investors have stayed.

SOUND FUNDAMENTALS: But beyond that, what the crisis has proved is that Indonesia no longer suffers from the concerns that have sunk South-east Asian economies in the past – a drop in demand for imports from the region. Indonesia and its neighbours have grown in large part by supplying cheap labour and therefore exports, and when global demand has shrunk, the fortunes of these countries did as well. Now, in the aftermath of the 2008 crisis, it is clear that these countries, Indonesia perhaps chief among them, have enough domestic demand to sustain growth regardless of external economic cycles.

In the near term, it seems clear that Indonesia’s banks will do well with their current mix of activity, which focuses on short- and medium-term lending, and their generally conservative approach to business. Performance will also likely be boosted as more Indonesians start to use formal financial services as they move out of poverty and into the middle class.

CHANGING FOCUS: However, at the same time, there is pressure for financial institutions to do more, particularly with respect to the average length of maturity for loans. Only select clients receive repayment terms that extend into multiple years, which means that it is difficult to use bank financing to fund infrastructure development. Indeed, Indonesia is looking to build the roads, ports, bridges, power plants and other key public works that are needed to unlock the country’s economic potential. However, the government cannot afford to do all of this building and instead wants most of the money and expertise to come from the private sector. A mix of Indonesian and foreign investment is expected.

For the banks, the problem is that infrastructure projects typically require a long gestation period, and it is often more than a decade before profits materialise. That length of time is beyond the comfort zone of most Indonesian banks, whose loan officers expect to evaluate credit requests based on a faster turnaround. Guarantee funds and other methods have been created to help share the risk, and the overall performance of these groups of financiers will be closely watched in the next few years.

RETAIL OPERATIONS: The consumer finance side for banks will likely be more familiar in 2012 and beyond. Indonesia’s banks run the gamut from small rural lenders to international players, and Indonesians are progressing through stages toward sophisticated financial relationships, starting with small loans and deposits with microfinanciers and rural banks, and then moving to regional or national banks and deepening their relationships through lines of credit, credit cards, savings schemes and other options. The country remains one of the world’s most important markets for microfinance, which in Indonesia – unlike in some less developed countries – is commercially-oriented and centred on making small loans to entrepreneurs. Most of the main banks are involved in this segment (see analysis).

As the world’s largest Muslim country, Indonesia is also a growth market for Islamic finance – lending, saving and investing without the use of interest, speculation or excessive risk. Jakarta has not promoted Islamic finance from on high, as has happened in neighbouring Malaysia. There, the government has worked hard to establish one of the world’s largest and most sophisticated Islamic finance markets. By comparison, Islamic finance in Indonesia is evolving along with demand, which continues to increase steadily over time (see analysis).

HIGHLY FRAGMENTED: The country’s banking system has undergone a decade of significant change, as the 1997-98 crisis spurred bailouts, mergers, acquisitions, closings and a host of other changes. When things settled the banking roster ended up about half its previous size. According to the Bank of Indonesia (BI), the country’s central bank, as of August 2011, there were 120 commercial banks, holding assets worth Rp3252.7trn ($390.3bn). About 15 of these banks account for approximately 70% of the nation’s credit. Four banks, including three of the top four, are at least partially state-owned. Of the private lenders, 11 are Islamic banks. Indonesia does not require banks to choose between sharia-compliant or conventional operations, instead allowing them to open windows or units if they choose to do so. However, BI does offer licences specifically for sharia-compliant banking. It also offers a separate category of licence for rural banks, of which there were 1681 as of August 2011, holding assets valued at Rp51trn ($6.1bn). Rural banks do not have direct access to the national payment system, and they are restricted to operations in defined territories.

REGULATION: BI, the system regulator, uses as its governing framework the Indonesian Banking Architecture, a 2004 comprehensive plan introduced as a set of guidelines for development. Six broad goals are considered the pillars of the plan: a healthy banking structure, effective regulation, effective and independent supervision, adequate infrastructure, robust consumer protection and a strong banking industry. Overall the approach is a conservative one.

One of the issues that has seemingly slid down the regulator’s agenda is consolidation. In the wake of the financial crisis and with so many banks in the country, slimming the roster to a smaller number of larger players was a significant goal. For some, the number of banks is too large, and many believe that BI would still like to see some consolidation, but the reality is that this is unlikely to happen. Banks are motivated to get bigger just as anywhere else, but with such explosive growth in the system, organic expansion – increases in customer base, branch network, loan books and so on – is an effective a tool for gaining market share, and does not come with the potential challenges of doing a deal.

Acquisitions in the near future are likely to come from major banks buying specialist banks in order to access a specific market. Microfinance is an example, as lenders such as Bank Mandiri and Bank Tabungan Pensiunan Negara (BTPN) have recently bought microfinance lenders or are set to do so soon.

FOREIGN BANKS: Perhaps the biggest regulatory discussion in 2011 addressed the presence of foreign financial institutions in the system. The banking sector has been largely welcoming to foreign investors since 1999, when the government opened up its financial system in an effort to recapitalise its failed banks after the financial crisis. As of mid-2011 about a third of banks operating in the country were either partially or entirely foreign owned, with several in the top 10, including CIMB, Danamon, Bank International and Permata. Foreign lenders also account for about 27% of outstanding loans.

According to rules that have been in place since 1999, any entity, whether domestic or foreign, can own up to 99% of a bank’s shares. However, in July Darmin Nasution, the governor of BI, said that the central bank was considering a regulation to cap the maximum individual stake in a bank at 50%, to prevent a few people or companies from gaining too much control. Although the regulation would not single out foreign owners, there was sufficient speculation that this was the case such that Nasution made another announcement in August that the intent was not to target foreigners.

OWNERSHIP RULES: Foreign investors may have some basis for being concerned about the potential for the introduction of the new 50% regulation, having been subject to the government’s changing of ownership rules in the past. The single-presence policy, introduced in 2006, prevents any person or company from owning a controlling stake in more than one bank. This policy has affected three groups – Singapore’s Temasek sovereign wealth fund, a similar Malaysian government holding company called Khazanah and the Indonesian government itself. While Temasek and Khazanah have each since merged their multiple banks into single institutions, the Indonesian government asked BI for an exemption from the rule until 2012. The exemption was granted, and what happens next for the four state-owned banks in Indonesia is unclear.

It is also unclear whether or not Nasution’s proposed 50% cap on ownership would also apply to the state-owned banks, and how it would be implemented. The idea of finding new takers for up to half of the shares in more than 100 banks could create market confusion. It could also mean that assets would be sold at discounted prices. As Tony Costa, the president director of Commonwealth Bank Indonesia, told OBG, “There is talk of a new regulation limiting the ownership of a bank to less than 50% per shareholder. The major risk when implementing such measures is not to offer the owners the right timeframe to carry out the sale, which could lead to a severe decrease in the price of their shares.”

Another proposed regulation would force foreign bank branches to operate as limited companies, which under Indonesian law would give BI more scrutiny of them, and perhaps the ability to insist that top management jobs are filled by Indonesians only.

ENCOURAGING LENDING: The central bank has also been active in trying to boost lending through means other than a reduction in the policy rate. In September 2010 BI introduced new rules that require a bank to keep its loan-to-deposit ratio (LDR) above 78% and below 100%, although an LDR above the maximum is allowed if the bank’s capital adequacy ratio (CAR) exceeds 14%. The minimum is designed to spur lending while the maximum helps to ensure that banks do not take on unnecessary risk. For those banks that do not meet these requirements, they are obligated to hold more reserves with BI. At the same time, the central bank also raised the rupiah primary reserve requirement (for all banks, regardless of LDRs) from 5% to 8%, effective November 1, 2010.

The LDR rule, which did not go into effect until March 2011, has met with some criticism. While the policy appears to promote lending growth, in actuality, it may not. For banks that fall below the minimum, they could find it more profitable to incur the penalty rather than make loans that they perceive to be risky. At the other end of the spectrum, banks may be unfairly penalised for LDRs that exceed 100%, given that the rule does not take into account other sources of funding, such as debt or equity issuances, although this could be offset somewhat by the fact that banks with CARs that exceed 14% are not subject to the 100% maximum.

Setting aside the question of whether or not this policy was effective, lending nonetheless grew during the first half of 2011, despite the November 2010 hike in reserve requirements and a February 2011 increase in the policy rate to 6.75% from 6.5%, the first change since July 2009. By June 2011 total outstanding commercial bank credit amounted to Rp1951trn ($234.1bn), representing 23% year-onyear (y-o-y) growth. Of this total, almost half was accounted for by working capital loans, with consumer lending the next largest category, at 31%. The balance, at 21%, was made up by investment loans.

Finally, it is important to note that, when looking at the bigger picture, the sector’s LDR has increased over the past five years, with loans growing more quickly than deposits. In fact, looking ahead, it may be deposits that constrain local lending, rather than an unwillingness to lend on the part of banks. Also, because most deposits are short-term, it is difficult for banks to engage in long-term lending, such as is required for infrastructure projects.

SMALL BUSINESS LOANS: Lending to the micro, small and medium-sized enterprise (MSME) segment is an important part of Indonesian banks’ loan portfolios, accounting for Rp1035trn ($124.2bn), or 53.1% of total system lending as of June 2011. Loans to MSMEs grew more quickly than overall lending between 2005 and 2010, increasing at a compound average growth rate (CAGR) of 21.1%, compared to 20.5% for all loans. Moreover, MSME lending is expected to be a driver of loan growth in the banking system going forward. According to a 2011 survey by PwC, the global tax and advisory services firm, some 31% of Indonesian bankers surveyed expected the MSME sector to achieve the highest growth in lending 2011. That said, MSME credit quality is relatively weaker. In June 2011 the ratio of non-performing loans (NPLs) for the MSME segment stood at 2.87%, compared to 2.74% for the overall sector (see analysis). For this reason, banks are likely to actively manage their deployment of these loans and apply credit analysis to keep NPLs at manageable levels.

CONSUMER LENDING: While overall lending had grown by 23% y-o-y as of June 2011, the value of consumer loans increased more quickly over this period, rising by 23.2%. This was apparently a cause for concern at BI, with local newspaper Jakarta Post reporting in early August 2011 that the central bank governor had said that it was keeping a close watch on growth in auto and housing loans.

Through August and into early September, the central bank continued with this stance. In late August 2011 Wimboh Santoso, the director for banking research and regulation at BI, told local reporters that, although consumer loans had not exhibited the largest y-o-y growth as of June 2011 – working capital had increased by 23.8% – their growth had reached the highest acceptable level set by BI. He noted that the central bank had prepared measures to slow the rise in consumer loans.

In early September Wimboh again addressed this issue, telling the local media that the central bank would prefer that banks direct their lending towards productive investments rather than consumer purchases. “We aim for credit to be channelled to more productive purposes, instead of consumptive loans. Working capital and investment loans are the kinds of loans that will support growth, as they are closely linked with job creation and multiplier effects,” he said. This opinion has been echoed by private sector market participants as well. Kamal Osman, the president director of BNP Paribas Indonesia, told OBG that lending should be aimed at projects that stimulate new economic activity and not consumers. “The banking industry has a responsibility to ensure that an adequate amount of capital is directed towards financing projects that will create real economic growth and not simply be made available for credit cards and consumer financing,” he said.

However, as of late 2011, the central bank had taken no steps to curb lending to consumers. On the contrary, while consumer spending, and private consumption more generally, remained strong entering into the fourth quarter of 2011, BI lowered its policy interest rate twice during the final months of 2011, to 6.5% in October and 6% in November. The central bank cited a slowdown in global economic activity and the easing of inflation as the main reasons for this reduction (see Economy chapter).

INTEREST MARGINS: While the central bank’s policy rate may be falling, Indonesia’s net interest margin (i.e., the difference between lending and deposit rates) is the highest in South-east Asia, perhaps because banks remain cautious lenders as a result of the 1997-98 financial crisis. Moreover, the local capital markets remain relatively shallow, which means that borrowers have few alternatives to the banks when it comes to raising capital. Moreover, by regional standards, Indonesia’s inflation rates are both high and volatile, so banks have a more difficult time in forecasting their future liabilities.

However, the central bank has taken steps to address this issue. As of March 2011 BI has required that all lenders with assets above Rp10trn ($1.2bn) publicly announce their prime rates – the rates without the risk component – for corporate, retail and consumer credit. The idea was to foster competition, but BI data show that three months later rates were holding at similar levels. BI tracked the rates of more than 40 banks, and found that corporate loans were offered at 11.01% in March and 11.03% in June. Housing loan rates had dropped 20 basis points to 11.49% and non-housing consumer loans slipped to 11.84% from 12.1%. Those rates compare with a cost of funds ranging from 6.18% to 6.59%, according to BI data. Central bank officials told the local media that the plan to push rates lower through disclosure could require several months to take effect.

OUTLOOK: While profits could be squeezed if net interest margins fall in response to BI’s requirement that banks disclose their prime rates, such concerns may be more than offset by opportunities. The December 2011 decision by ratings agency Fitch to upgrade the country’s sovereign debt to investment grade is likely to reduce the cost of funds. At the same time, the central bank’s October and November reductions in the policy rate could also boost the sector. Finally, the development of infrastructure will support bank growth, not only in terms of financing opportunities but also as the multiplier effects of these projects attract new investors to the country.