Sharia-compliant banking has been growing three times faster than the conventional industry since 2007. The segment’s asset base grew at a compound annual growth rate of 49% over the past five years, albeit from a low base – assets accounted for a mere 4.1% of the banking industry’s total in the first half of 2012, far lower than the 20% of banking assets in Malaysia. Sharia banking assets reached Rp144.3trn ($14.43bn) by April 2012, growth of 43.5% year-on-year (y-o-y), while lending reached Rp108.8trn ($10.88bn). Without the scale of their conventional counterparts, sharia lenders are constrained by lower profit margins in the absence of overt regulatory support of the kind Malaysian banks benefit from, which has contributed to Malaysia’s sharia banking industry’s 10 times larger pool of assets. Sharia banks’ return on assets (ROA) has remained stable at around 1.5% in recent years, roughly half the sector’s average of 2.4-3%. As the market continues to expand in coming years, banks will need to innovate to cut their operating costs and grow their scale, while the regulator will need to expand support for the industry.

SMALL BUT DYNAMIC: The market has developed significantly since the first forays by non-bank financial institutions (NBFIs) into sharia banking began in 1992. By October 2012 some 24 conventional banks were operating sharia banking windows alongside 11 fully-fledged Islamic banks and 156 Islamic rural banks running sharia-compliant micro-banking units. In line with the ambitions set out in the central bank’s successive strategies for the segment published in 2002 and 2008, sharia banking remains primarily a financing tool for individuals and small and medium-sized enterprises (SMEs), particularly of the smaller types. The network of 2408 branches selling such products has extended its reach to roughly 10m customers according to Bank Indonesia (BI), of which 9.5m were bank clients and over 700,000 were covered by rural banks. Sharia rural banks’ assets have been growing 25% annually to Rp4.2trn ($420m), or some 6.3% of total rural bank assets in the first half of 2012, according to BI. The significant growth prospects in the segment have attracted attention. “There is potential for Islamic banking in Indonesia to capture about 10% of the market for banking products,” Ibrahim Hassan, president director of Bank Maybank Syariah Indonesia, told OBG.

The largest such bank is the sharia subsidiary of Bank Mandiri, established in 1999 and operating 700 outlets, with Rp51.2trn ($5.12bn) in assets by September 2012. The second dominant force in the segment is Bank Muamalat, the oldest sharia bank, whose assets tripled from 2007 to 2011 to Rp32.48trn ($3.25bn). While the majority of sharia banks are subsidiaries of conventional banks, Middle Eastern investors are key backers of Muamalat, including the Islamic Development Bank, the majority owner with a 32.74% stake, and Kuwaiti investors such as Boubyan Bank, Atwill Holdings and the National Bank of Kuwait. Competition is expected to increase however, with a number of other Middle Eastern investors seeking opportunities in the segment. Qatar National Bank, following its acquisition of Kessawan Bank in late 2010, plans to roll out sharia banking products in 2013, for instance.

The raising of capital requirements for sharia banks from Rp1trn ($100m) to Rp5trn ($500m) for fully-fledged subsidiaries may attract new investor interest as a number of Middle Eastern and Malaysian banks eye opportunities in the segment. Over the longer term, regulators expect sharia banking windows operated by conventional banks to be spun off as separate subsidiaries; although this transition may take up to a decade, significant new investment will be required to adequately capitalise such institutions.

RETAIL FOCUSED: Lending in the sector remains more heavily skewed towards the micro, retail and SME segments than Middle Eastern markets. Close to 74% of Bank Syariah Mandiri’s Rp41.82trn ($4.128bn) in lending goes to the two segments. Of the over Rp108trn ($10.8bn) in sharia bank lending as of April 2012, of which 80% is extended by sharia banks and 20% by sharia windows of conventional banks, some Rp30.7trn ($3.07bn) is extended to productive financing in the form of mudbarahah and musyarakah, targeting utilities, industrial and mining sectors in particular, but also social and community services. In the consumer finance segment, the murabahah structure is the most prevalent, particularly in retail property finance, and has grown 45.8% y-o-y by April 2012 to Rp61.9trn ($6.19bn) in outstanding loans, according to local ratings agency Pefindo. While still much smaller, qardh and ijarah, used as short-term financing and auto finance, respectively, have been growing the fastest – outstanding qardh loans grew an astounding 703% y-o-y in April 2012.

EDUCATION: There remains some confusion in the minds of many bank over terms used in selling sharia-compliant banking products, however. “A key challenge for sharia banking is that those selling products tend to market them using conventional terms, which adds to clients’ confusion,” Wisnu Wardana, an economist at Bank CIMB Niaga, told OBG.

While Indonesia follows its own rules in certification of sharia bank products, set by BI rather than independent boards in leading Islamic financial centres like Bahrain or Malaysia, domestic lenders have called for stricter oversight of sales methods to clearly segregate sharia products from conventional instruments.

Loan underwriting has been of relatively lower quality than conventional bank loans, however, with nonperforming financing ratios for sharia banking units over 50 basis points higher than the industry’s average no-performing loan ratio of 2.33% in 2011 according to BI figures. Scale and efficiency have so far remained elusive for the nascent segment. The rapid growth in sharia assets has relied significantly on haj fund deposits, with a high financing-to-deposit ratio in excess of 95.39% in the first half of 2012, according to BI. This over-reliance revealed weaknesses in sharia banks’ funding profiles in April 2012, when the Ministry of Religious Affairs withdrew some Rp7trn ($700m) in haj funds from the banking sector to invest in government sharia bonds known as “haj fund sukuks”, causing growth in sharia third-party funds to slow from 51% y-o-y in April 2011 to a mere 3% one year later. This caused a sharp slowdown in asset growth from 48% y-o-y in 2011 to a 7% contraction y-o-y by April 2012.

SEEKING SCALE: Although the segment’s net profit has recorded healthy growth of 40% y-o-y in 2011 to a total of Rp1.47trn ($147m), sharia lenders are seeking ways of cutting costs and expanding their reach. While BI has extended some limited support to sharia lenders, such as lower capital requirements and a temporary exemption on consumer finance lending caps, both until 2013, it has stopped short of beginning overt subsidies for the sector.

This has caused banking analysts to question the scope for expansion, given Indonesians’ price sensitivity and lower interest in the religious aspects of the products relative to Malaysian consumers. “It is unclear how sharia banking can expand substantially without tax subsidies similar to Malaysia’s, which seems unlikely given the political landscape in parliament,” Fauzi Ichsan, managing director and senior economist at Standard Chartered Bank, told OBG.

Despite the relative absence of government support, Indonesian lenders are seeking to raise new equity to grow networks and reach. Banks like Muamalat and Syariah Mandiri have announced plans to float shares on the Indonesian Stock Exchange in 2013, in a bid to comply with new restrictions on bank ownership as well as fund expansion plans.

Yet BI intervened in September 2012 to ask lenders to delay such plans, arguing that the sector still faced a range of challenges, such as an over-reliance on Ministry of Religious Affairs deposits and a high financing-to-deposit ratio. Pending such new capital injections, lenders will need to focus on improving asset quality and reducing rates of non-performing financing.

“Sharia banks have higher costs because they don’t have the scale of conventional banks, so some lenders like Syariah Mandiri are seeking to combine ATMs and some office space in order to drive efficiencies,” Bret Ginesky, senior vice-president and head of investor relations at Bank Mandiri, told OBG.

Aside from tax incentives for expanding sharia lenders, sharia bankers have called for a more integrated roadmap for the sector, including approvals for new products. Meanwhile, more overt support could allow lenders to gain the scale needed to mobilise sustainable funding sources and improve loan-underwriting standards and asset quality. In the absence of more active support from the regulator, the segment is still set to sustain its rapid growth, although it is likely to remain a relatively marginal part of the overall sector.