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Indonesia story on Islamic Finance Development

By: Muhammad Shodiq*

Having the world’s largest Muslim population and experiencing sustained economic growth at a pace of about 5% implies that Indonesia harbours great potential for shariah banking.

Indonesia’s Islamic financial market primarily comprises Islamic banks, Islamic capital markets (including sukuk Islamic bonds and shariah-compliant equity) and takaful (a type of Islamic insurance). Islamic rural banks and Islamic micro-finance organisations also provide Islamic financial services, which although are still on a small scale, are expected to grow.

According to data from Bank Indonesia (BI), Islamic banking in Indonesia has become the world’s largest retail Islamic banking sector, having 17.3 million customers, 2,990 bank offices, 1,267 shariah services and 43,000 employees at the end of 2013.

Based on data from the Financial Services Authority (OJK), covering conditions in August 2014, there are 12 shariah-compliant commercial banks, 163 Islamic rural banks as well as 22 shariah business units that are also known as “Islamic windows”, operated by non-Islamic banks in Southeast Asia’s largest economy.
However, Indonesia is yet to tap the full potential of the Islamic financial services market. As an illustration, with a figure of US$20 billion (RM75.19 billion), Indonesia’s Islamic banks only held 4.5% of the country’s total banking assets in September 2014. Islamic finance 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.

There are at least two main issues in the development progress of Islamic finance: leadership and human capital. Leadership is one reason why the Islamic banking industry in Indonesia has yet to gain full momentum. Other factors that limit growth in the shariah banking sector are the lack of highly qualified human capital, innovation and creativity.

Driven by government influence and foreign investor interest, Islamic finance looks set to become a more meaningful part of Indonesia’s financial industry. The Indonesian authorities have recently begun to give more attention to the domestic Islamic finance industry and are now finalising a five-year road map, which includes the establishment of a new regulatory system. BI and the OJK target that Islamic banks will hold at least 15% of market share by 2023.

This can be realised 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.

The government’s slowness in drafting legislation and reforming taxes has clearly affected the sukuk market. There have been 50 sovereign sukuk issues totalling over US$14.9 billion since 2008, but only 46 corporate sukuk issues totalling US$700 million since 2003.

Indonesia’s sukuk market is dominated by sovereign sukuk. There is a need for some incentives, including changes in the way sukuk and other Islamic financial products are taxed as well as tax breaks that encourage the issuance of corporate sukuk.

Even though Indonesia is an archipelagic country with 34 provinces and 514 municipalities nationwide, we do not have single municipal bonds and sukuk that have been issued so far. One of the problems is because there is no clear guidance and regulatory frameworks on how to issue municipal bonds/sukuk.

Indonesia has more than 56.5 million micro, small and medium enterprises representing 99.9% of all enterprises in the country, contributing 59.1% of total gross domestic product (GDP) and also absorbing 97.2% of the national labor force. The informal sector plays a significant role in serving Indonesians on the lending side.

The largest providers of Islamic microfinance in Indonesia are 163 Islamic rural banks and more than 3,000 Islamic financial cooperatives. While accounting for a small portion of the banking industry, Indonesia’s microfinance sector is one of the world’s largest.

The supply of banking and finance practitioners with good understanding of shariah knowledge remains a big challenge to Islamic finance and the banking industry.

Banking practitioners may have attended many seminars and workshops on Islamic banking but they are not trained to deal with shariah-related problems in the banking business. Doing so requires an intimate knowledge of shariah.

There is no shortcut but to pursue formal education in Arabic. Many banks turn to people with shariah degrees for advice, but their understanding of economic principles and how banks operate is suspect. Shariah experts have categorically approved new financial instruments with less idea of how that would impact a bank’s earnings, consumer welfare, economic stability and income disparity.

The future introduction of Islamic values into financial activities will see the potential opening of Islamic business in the banking, insurance, capital market, venture capital and private equity industry. Should the supply of shariah-trained economists be given low priority, then the speed of development of the Islamic finance industry in this country may not change.

For example, most of the Islamic banks offered debt based on products such as murabahah, which is considered a mirror of a conventional product, however, the murabahah asset will not change when the market rates go up.

This feature will incur the customers on the interest rate risk. The murabahah contract is also found to be losing ground to conventional term loans since the profit rate is not adjustable.

We need more highly qualified Islamic bankers to create more innovative products to meet the customer requirement as well as comply with shariah principles.

These problems can be attended to with more rigour when banks open their doors to shariah-trained economics graduates. It would be too presumptuous to think that one or two conventionally trained personnel who may have attended some workshops and short courses on Islamic banking can deal with pressing juristic issues. – Jakarta Post, June 9, 2015.

* Muhammad Shodiq is vice-president of the shariah and microfinance academy, Bank CIMB Niaga.

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