Islamic Finance in Indonesia: Sharia Banking Has Large Untapped Potential

Having the world’s largest Muslim population and experiencing sustained economic growth at a pace of +5 percent implies that Indonesia harbours great potential for Islamic finance (sharia banking). However, Indonesia is yet to tap the full potential of the Islamic financial services market. As an illustration, with a figure of USD $24 billion, Indonesia’s Islamic banks only held 4.9 percent of the country’s total banking assets in 2013. This is small compared to Malaysia (where Islamic banking holds a 20 percent market share).

Even in the UK, where Muslims form a minority among the population, Islamic banking is more impressive than Indonesia as the six Islamic banks in England hold a combined USD $19 billion in assets.

This is unfortunate as Islamic banking may be one of the fastest-growing segments in international finance today. Sukuk, an Islamic bond, usually offers a higher return and is considered a relatively safe investment choice as it is backed by tangible assets. For Indonesia, this industry can be one of the tools to deepen the country’s financial markets, thereby making the country more resilient to global economic turmoil or shocks (as it causes a reduced need for local companies to obtain foreign loans).

Investors have already shown their appetite for Indonesian sukuk offerings. On 2 September 2014, the Indonesian government raised USD $1.5 billion from 10-year dollar-denominated sukuk. Foreign investors submitted USD $10 billion worth of bids, six times the amount offered, displaying confidence in Islamic investment assets as well as Indonesia’s economic prospects.

One reason why the Islamic banking industry in Indonesia is yet to gain full momentum is weak government management. While in the UK and Malaysia, there has been ministerial-level coordination in this sector, Indonesia has been lacking such high-level coordination. Moreover, the current legal environment in Indonesia can be labelled as uncertain. Other factors that limit growth in the sharia banking sector are the lack of highly qualified human capital, innovation and creativity.

Therefore, Indonesian authorities have recently begun to give more attention to the domestic Islamic finance industry and are now finalizing a five-year roadmap (which includes the establishment of a new regulatory system). Indonesia’s central bank (Bank Indonesia) and the Financial Services Authority (Otoritas Jasa Keuangan, or abbreviated OJK) target that Islamic banks will hold at least 15 percent of market share by 2023 (from last year’s figure of 4.9 percent).

This can be realized through several strategies: merging several existing Islamic banks, the conversion of an existing conventional bank into an Islamic one, or creating a new Islamic bank. The main idea behind these strategies is that a larger Islamic financial entity will reduce operating costs and can thus offer more competitive rates. Moreover, the new framework seeks to integrate Indonesia’s Islamic banks into the global financial system (for example by revising capital requirements in order to bring risk management at Indonesian Islamic banks in line with international standards).

Based on data from the OJK (covering conditions in August 2014), there are currently 12 sharia-compliant commercial banks, 163 Islamic rural banks as well as 22 sharia business units (which are also known as ‘Islamic windows’) operated by non-Islamic banks in Southeast Asia’s largest economy. It is interesting to note that the number of sharia banks has been rising, while the number of Islamic windows is on the decrease. By 2023, Islamic units of existing conventional banks are required to be spun off into separate entities, a move which could spur industry consolidation in the years ahead.

Despite the low market penetration of sharia banking products, there is considerable growth visible (although coming from a low base). Between the years 2010 and 2013, sharia-banking assets in Indonesia rose at a compound annual growth rate (CAGR) of 35 percent. This growth pace is expected to continue in the years ahead.

According to data from Bank Indonesia, Islamic banking in Indonesia has become the world’s largest retail Islamic banking, having 17.3 million customers, 2,990 bank offices, 1,267 sharia services and 43 thousand employees at end-2013. In an effort to develop the nation’s Islamic banking industry (or in other words to transform Indonesia into the ‘Mecca’ of global Islamic banking), Bank Indonesia organized a National Seminar on 6 November 2014 in Surabaya (East Java).

Key Findings:

• Despite recent robust growth, Indonesia’s Islamic banking potential is yet to be fully tapped by the authorities and financial institutions

• A well developed domestic Islamic banking industry will deepen Indonesia’s financial markets, thus making it more resilient to global economic shocks

• Bank Indonesia and the Financial Services Authority are finalizing a five-year roadmap to develop the nation’s Islamic banking system and integrate it into the global financial system

Originally published on www.indonesia-investments.com