A decade behind neighbouring Malaysia in the development of Islamic banking, Indonesia is making great strides as the sector grows at twice the rate of conventional finance. With the unbanked accounting for more than half of the population, the potential for growth in the world’s biggest Muslim population is immense, says Edy Setiadi, Executive Director and Head of the Islamic Banking Department at Bank Indonesia, the country’s central bank.

 Bank Indonesia is accelerating reforms, including the development of liquidity instruments and capital markets, says Edy. Starting January 2014 all financial institutions including Islamic banks and cooperatives will come under the supervision of the Financial Services Authority (FSA). By the year 2020, Bank Indonesia expects one in five banks to be a Shariah-compliant bank. “One of the reasons that Islamic finance is growing well in Indonesia is because economic conditions have been very stable especially during the past five years.”

Economic growth in Indonesia has averaged about 6% since 2008. Shariah-compliant financial service providers currently account for only 4.5% of total banking sector assets. Between 2008 and 2012, Islamic bank assets tripled, increasing by an average of 31.5% annually. Strong growth in the past five years was helped by the Shairah Banking Law introduced in July 2008. Since then, the number of Islamic banking outlets has increased from 241 to 517, comprising 11 fully Shariah-compliant banks, 24 Islamic banking units and 158 Shariah-compliant rural banks. Islamic bank’s network has spread with the number offices rising at a rate of 27% year-on-year, says Edy.

Despite its Muslim population, Indonesia is a relatively latecomer to the Islamic banking industry. United Arab Emirates, which recently established the Center of Islamic Finance as part of its efforts towards promoting Dubai as the world’s capital city for the Islamic economy, has a headstart of about 20 years. Indonesia’s first Islamic bank, Bank Muamalat, was established in 1992 and Bank Indonesia was only allowed to make use of Islamic instruments as part of its monetary policy in 1999.

Islamic microfinance
At the forefront of Indonesia’s Islamic banking is microfinance, which is helping to bolster rural sector expansion and contributing to the country’s economic growth. Amid the industry’s recent expansion, the government has said efforts will be focused on financing to micro, small, and medium enterprises, or MSMEs, in so-called productive sectors, which include infrastructure and agriculture.

Microfinance includes microcredit as well as other value-added activities such as financial advice, and the provision of savings and insurance services. Microcredit is defined by Bank Indonesia as a loan below Rp.50m ($5,373).

Indonesia has more than 50 million MSMEs, representing some 97% of all enterprises and contributing no less than 30% of GDP growth in 2012. Many of these do not have adequate access to bank financing. About 40% of the population is employed in the agricultural sector, followed by trade with around 23% and industry with 14.5%. According to the 2011 Global Financial Inclusion Index, only 19.6% of Indonesia’s population have formal accounts.

While accounting for a small portion of the banking industry, Indonesia’s microfinance sector is one of the world’s largest. Murabaha contracts dominate the business of Islamic microfinance. Murabaha is a contract of sale between the bank and its client for the sale of goods at a price plus an agreed profit margin for the bank.

“In my country, the loan to deposit ratio is more than 100%, which means that money is transferred directly from depositors to debtors,” says Edy. “It is simple banking and the money market has no role in it because that money is channelled directly to the real sector as a loan or in the form of equity participation.”

The real sector, more often referred to as the real economy, denotes the part of the economy that is concerned with the actual production of goods and services, in contrast with the paper economy, or the financial economy, which is concerned with the buying and selling of financial instruments.

Bank Indonesia has been conducting research on creating a real sector return index in order to provide a cross-sector guidance or a reference rate for product-pricing in Islamic finance, says Edy.

The largest providers of Islamic microfinance in Indonesia are 150 Islamic rural banks (BPRS) and more than 3,000 BMTs (Baitul Maal wat Tamwils), which are a network of Islamic financial cooperatives. Bank Rakyat Indonesia Syariah (BRI Syariah) is an important player. It is a subsidiary of Indonesia’s largest microfinance institution Bank Rakyat Indonesia (BRI).

“We have our own microfinance Islamic model in Indonesia where we channel funds through what we call linkage programmes from the commercial banks to the rural banks and on to individuals,” says Edy. “The purpose of Islamic banking is to serve the public direct through these linkage programmes.” As microfinance grows, poverty is eradicated and Islamic finance flourishes.

“Islamic banking has the potential to help boost economic equality through financial access,” says Edy. “Islamic finance should benefit the underprivileged communities and small-micro economic groups, in line with the nature of Islam.”

With a Capital Adequacy Ratio of about 14.13% and a Return on Assets of 2.14%, Islamic banks and cooperatives are resilient, says Edy. Financing growth is about 40%, compared with conventional banks at between 17% and 18%. Combined, Islamic services and product providers boast assets hovering around $20bn.

The rapid expansion in recent years has also led to the need for increased legislation and reforms. “The government and Bank Indonesia is working with the National Shariah Board and the Indonesian Accountant Association on product innovation to attract customers and to set standards for products, says Edy. “Islamic institutions must be able to offer pure and genuine Islamic products that bring up the uniqueness of Shariah principles.”

In order to improve the effectiveness of cross-sector regulation and supervision, the FSA, set up earlier this year, will regulate all financial institutions starting next year, says Edy. “Bank Indonesia has prepared some steps to ensure that the shift in control to the FSA will run smoothly, especially in terms of the transfer of information, staff and information technology.

“It is expected that under a single supervisory authority, the policy to improve Islamic finance industry will be more comprehensive and beneficial to all sectors.”

Islamic money market
Edy adds the central bank is exploring ways to enhance features of Sertificat Investasi Mudharabah Antarbank (SIMA) to be used as an underlying instrument for the Islamic money market. SIMA is similar to the interbank call money in conventional markets. “Bank Indonesia has introduced a Shariah commodity trading scheme to add to Islamic money market instruments,” says Edy. The central bank is also coordinating with the Capital Market Supervisory Agency (CMSA) in developing Shariah-compliant products such as Musharakah Sukuk and Istishna Sukuk. Further, the CMSA is currently reviewing the possibility of issuing a Shariah-compliant Exchange Traded Fund.”

Among the most prominent Islamic product is the Sukuk. However, Indonesia did not issue its first Sukuk until 2008. Its current outstanding sovereign Sukuk stood at nearly $10bn and corporate issuance at $690m. While Indonesia was the second-biggest issuer of Sukuk in Asia in 2011, it lagged a long way behind Malaysia, accounting for just 6% of its neighbour’s total issuance. However, analysts expect the gap to close as Indonesia seeks funds for a large number of infrastructure projects planned in the coming years.

More than 80% of the financing at the fully fledged Islamic banks in the country is based on three contract types – Murabaha (54%), Musharakah (partnership structure with profit/loss sharing) (18%) and Mudharabah (10%), adhering more closely to the classical Islamic model of economics than possibly any other country.

Differing approaches
Indonesia has taken a much stricter approach to Shariah compliance, compared with neighbouring Malaysia. This not only curtails the number of products available as well as limits the depth and liquidity of the market.

Products offered in Malaysia, such as Bay al Dayn (trading of debt), Bay al Innah (sale and buyback agreement), Tawarruq (the purchase of a commodity  on deferred payment by way of Murabahah), and Bay al Wafa (a sale in which the seller has the right to repurchase an underlying property from the buyer by refunding the purchase price) are not considered to be Shariah compliant in Indonesia.

“As far as prudential standards are concerned, these are standardised around the world but when it comes to Shariah principles, there is a different situation,” says Edy. “We have to understand the culture of each individual country and Islamic beliefs are different in Indonesia and Malaysia.”

While Malaysia’s Shariah Advisory Council, the country’s highest Shariah authority in Islamic Finance, falls under the jurisdiction of the central bank, Indonesia’s Shariah committee is an independent body.

“In Malaysia, the directive for whether a product is Shariah complaint is streamlined,” says Edy. “In Indonesia, for any new products, we have to involve the National Shariah Board, the Islamic Banking Committee and Shariah Supervisory Board.”

The board regularly launch Fatwas, which means Islamic principle, and if the central bank or the government would like to approve the product from a bank, we have to obey the Fatwas, says Edy.

Early in 2011 a working party comprising representatives from Bank Indonesia, the National Shariah Council and the Indonesian Institute of Accountants was established to review the approvals process, but to date no recommendations have been issued.

“We are trying to persuade all parties to sit down together to discuss how we could develop the Islamic industry further,” says Edy.