Grow and adapt: The sector continues to show strong potential for expansion

As some of the most profitable and liquid banks in the region, Indonesian lenders have attracted growing interest from foreign institutions seeking to profit from the country’s sustained growth. Banks account for around 77% of financial sector assets, and their willingness to lend has traditionally been one of the main determinants influencing wider economic growth. With outstanding loans worth just 27% of GDP and savings rates only slightly higher – at 32% in 2011 according to Bank Indonesia (BI) – the sector’s penetration remains one of the lowest in the region, lagging far behind Thailand’s bank credit ratio of 97%, Singapore’s 102% and South Korea’s 109%. Yet the legacy of conservatism since the Asian financial crisis of 1997-98 is slowly giving way, with lending to productive sectors of the economy growing as banks expand funding for domestic firms’ working capital and investment needs. Yet access for retail clients remains constrained to the (growing) middle class, with a mere 20% of Indonesia’s roughly 140mstrong adult population served by formal financial services, according to the OECD.

Having bolstered the sector to safeguard against potential downturns, the focus is now increasingly on enfranchising a greater share of the population and expanding access to small and medium-sized enterprises (SMEs), key to the country’s longer-term growth. Amidst political debate over the role of foreign banks in the market, authorities are enacting significant reform by 2014 that will improve banks’ counter-cyclical provisioning, associate corporate governance tests with new ownership ceilings and spur lenders to expand their reach across the vast archipelago.

RESILIENT PROFITS: Emerging relatively unscathed by the global economic crisis in 2008-09, Indonesian banks have remained the most profitable in the ASEAN region in terms of returns on assets (ROA) and returns on equity (ROE), which have grown from 2.21% to 2.5% and 19.25% to 25.19% between 2006 and 2011, respectively, according to BI data. Still highly dependent on deposit inflows as a source of funding, Indonesian banks have mainly relied on net interest margins (NIM) as a driver of profitability. Also the highest in ASEAN, Indonesian NIMs have narrowed only slightly from 5.7% in 2010 to 5.3% by April 2012, according to local ratings agency Pefindo, far higher than the 3.4% in Thailand and 4.8% in the Philippines. Fiercer competition on prime lending rates, an inflow of foreign investment into alternative corporate finance instruments and lower benchmark BI interest rates have placed downward pressure on NIM. Bank Negara Indonesia (BNI) expects NIM to narrow to 5.3% for 2012 as a whole.

TRADING FIGURES: Yet despite pressure from BI to lower prime lending rates, banks argue that an analysis of nominal NIM values is misplaced given that the industry’s NIM is lower than a multiple of benchmark interest rates at 5.75%. “It is misleading to look at absolute NIM since our cost of funding is so high,” Destry Damayanti, chief economist at Bank Mandiri, told OBG. “Our NIM is only equal to our cost of funding, whereas Singapore’s is several multiples.” Interest margins have rebounded somewhat due to lower cost of funding in the third quarter of 2012, however, as banks have sought to convert more expensive time deposits into lower-cost savings accounts. That said, as loan growth has continued to outpace the rise in deposits in the banking system, banks will have to find more expansive alternative sources of funds through the capital markets, control costs and develop more fee-based revenue streams. The sector’s average loan-to-deposit ratio (LDR) has risen from 66.3% in 2007 to 82.5% in the first half of 2012 as banks increased lending from Rp1qrn ($100bn) to Rp2.5qrn ($250bn) in the same period. “In the face of slightly falling net interest margins, banks have tried to cut costs by encouraging a flow from more expensive time deposits to cheaper yet more volatile savings accounts,” Anton Gunawan, chief economist at Bank Danamon, told OBG.

GROWING COMPETITION: While banks remain highly liquid with leverage ratios of around 7.6 times in April 2012, low by regional standards of between 15 and 25 times, with borrowings accounting for a mere 6% of total liabilities in the first half of 2012, according to Pefindo, competition for deposits has been growing significantly in 2012. Loan growth has consistently outpaced growth in deposits in recent years, with third-party funds expected to increase by a mere 12% to 15% in 2012. With pressure on NIM, banks have been seeking to reduce their cost of funding by mobilising a greater share of time-deposits, yet the scope for further reducing the cost of funding appeared limited in late 2012 as deposit rates stood at historic lows already according to the ratings agency Fitch. “All major banks are now rushing to issue bonds, but 2009 showed us that the issuance window can quickly close,” Susanto, the assistant vice-president of Panin Bank, told OBG.

Despite high margins, the industry remains inefficient as measured by the ratio of operating costs to operating income (BOPO). While it had fallen from 84.1% in 2008 to 76.75% by May 2012, according to BI, the industry’s average BOPO remains much higher than the regional average of between 40% and 60%. As the top lenders increasingly expand towards the mass market and compete head-on, there has been growing upward pressure on BOPO. “The 10 leading banks are all moving towards the mass market, which entails higher costs and more competition on rates,” Susanto told OBG. “As the industry’s NIM narrows – we expect by 0.5% to 1% in the next three years – lenders will need to drive higher volumes and improve efficiency.” Another area which has increasingly attracted the attention of the central bank has been the inefficient payment systems that have developed in parallel and do not interlink (see analysis). Banks have focused on cutting operation costs by upgrading IT systems and combining back office operations, but BI still expects further improvements in efficiency will be necessary. Despite structural challenges, profitability is expected to remain resilient, with forecasts of 20% annual growth in banks’ earnings in 2013, according to Bank CIMB Niaga.

FRAGMENTED INTERMEDIATION: The banking market remains highly fragmented, with 120 commercial lenders in 2012. Although consolidation has remained an ambition since the Asian financial crisis, mergers and acquisitions (M&A) have remained driven primarily by foreign institutions seeking access to the domestic market rather than by already established players. A number of different institutions coexist, with four of the largest banks state-owned, 36 foreign exchange commercial banks, 30 non-foreign exchange banks, 14 banks involving foreign partners in a joint venture and 10 fully-owned foreign banks. Another 1667 rural banks cover more remote areas, alongside some 30,000 savings cooperatives and a great number of smaller formal and informal microfinance institutions, although commercial banks still controlled roughly 95% of banking deposits and assets in 2011, according to BI.

WORKING TO ADAPT: Although the single presence policy was effectively scrapped in 2012, foreign investors seeking market access have driven a growing amount of M&A. Recent examples of successful foreign deals have included Qatar National Bank’s acquisition of a majority stake in Bank Kessawan in December 2010; Malaysian Rashid Hussein Bank’s (RHB) proposed acquisition of 40% of Bank Mestika Dharma, due to be completed by June 2013; and the attempt by South Korea’s second-largest lender, Bank Woori, to buy 33% of Bank Himpunan Saudara 1906 in June 2012, which was still awaiting regulatory approval in late 2012. “Four years ago larger banks would be willing to buy smaller banks at a premium to turn them into sharia-compliant subsidiaries, but now that all banks will be required to hold Rp5trn ($500m) in capital, there is no incentive to pay anything but book value for them,” Susanto told OBG.

The repeal of the single presence policy clarifies the medium-term ownership for state-owned banks, which are likely to remain independent and majority owned by the government despite minor divestments. As banks expand beyond the urban centres, particularly in Java, they will increasingly compete head-on in the retail mass market. Larger banks will benefit from a flight to quality as they leverage their established franchises to expand lower-cost CASA deposits and grow their loan books in more profitable segments of consumer finance as well as corporate and SME portfolios. BI is encouraging foreign-linked lenders to shore up their capital bases to support their rapid loan growth.

REGULATORY UPHEAVAL: Traditionally the most conservative and cautious financial regulator in Indonesia, BI has pursued its banking architecture (API) over the past decade to establish strong counter-cyclical buffers for the industry, move risk management processes towards Basel II and III standards, and gradually reduce the number of players on the market to those with the efficiency and scale necessary to compete in an enlarged regional market, with restrictions on competition within ASEAN expected to be fully lifted by 2020. A 1998 revision to the Banking Law established two types of banks – conventional and sharia – and two categories of commercial and rural banks. A new draft bill, under consideration by parliament in late January 2013, would also require all foreign banks to convert into local, or "PT", institutions, in order to continue operations.

RAISE THE ROOF: Tier-1 capital requirements for the industry have been raised to Rp100bn ($10m) from 2010 while the floor for capital adequacy ratios (CAR) was set at 8% – yet these requirements made Indonesian requirements the least onerous in ASEAN. Banks’ CARs have witnessed a downward trend recently in the face of rapid loan growth, with the industry’s average CAR dropping from 21.2% in 2006 to 15.36% by 2010, before rebounding slightly since then as banks have sought to preserve capital through higher earnings retention, lower dividends, slightly lower loan growth and by the raising of new equity, according to Fitch. While all lenders remain comfortably above the 8% threshold – the industry’s average CAR reached 17.97% by April 2012 – BI has announced new capital requirements of Rp5trn ($500m) for banks wishing to operate nationwide. Meanwhile, CAR floors will rise to up to 14% for banks with higher risk profiles. Significant revisions to the API were announced in November 2012, with a new multi-licence regime and requirements for physical branch expansion in more remote provinces based on level of the bank’s capitalisation. Although the regulatory framework continues to be strengthened, 2013 will bring significant upheaval and potential overlap as BI’s bank supervision functions are incorporated into the new unified financial services regulator, the Otoritas Jasa Keuangan (OJK), by the start of 2014. The central bank has clarified that micro-prudential regulations will fall under OJK’s remit while BI will maintain macro-prudential oversight, yet the strict demarcation between the two was unclear in late 2012.

In line with its responsibilities as a member of the G20, Indonesia has pledged to implement Basel III regulations by 2020. Significant steps have already been taken, such as the requirement for general provisioning of at least 1% of performing loans since 2005. While the cost of implementing the stricter risk management rules may lead to lower ROE for local banks in the long run, leading lenders already maintain CARs well above the levels that will be required, while their non-bank investments are limited, according to Fitch. “Although Basel II has not been fully implemented yet, most Indonesian banks hold tier-1 capital ratios well in excess of 10%,” Clifford Rees, the director of PwC Indonesia’s advisory service, told OBG. “The implementation of Basel III will require new capital raising by Indonesian banks; no timeline has yet been set.” Meanwhile, the number of banks strengthening their risk management processes and conducting internal fraud risk assessments in the last two years has risen markedly from 57% of banks in 2010 to 78% in 2012 according to a PwC Indonesia survey in April 2012. The gradual increase in CAR depending on banks’ ratings and risk profiles up to 14% in the coming years, according to the new licensing regime announced in November 2012, will further strengthen banks’ risk-weighted capital requirements.

EXPANDING REACH: Banks have traditionally clustered their branch networks in urban centres, particularly in Java and Bali, and there are a total of 15,000 commercial bank branches nationwide. Economic growth in the more peripheral provinces has prompted banks to seek expansion beyond the more densely populated areas, however. The ratio of 12,000 Indonesians per bank branch is misleading given the relative lack of reach, particularly in eastern Indonesia. The central bank announced new requirements effective from January 2013 forcing banks to match branches in more densely populated centres of Java by building branches in more remote areas like west Sumatra, Maluku and Papua. According to PwC Indonesia’s survey, some 40% of banks expected to open more than 25 new branches by 2013, 11% planned on opening more than 100 while only 19% of respondents did not plan on opening new branches. Despite calls for reciprocal access for Indonesian banks to markets like Singapore’s, opportunities for domestic expansion are widely acknowledged. “Indonesian banks are better off expanding domestically than overseas given the low rate of credit penetration and the better brand recognition of these lenders locally,” Fauzi Ichsan, managing director and senior economist at Standard Chartered Bank, told OBG.

With high turnover in the industry as a whole, however, staff requirements for such expansions are proving challenging for banks. PwC Indonesia estimated in April 2012 that average turnover was between 10% and 20% a year. Meanwhile the move by banks into new businesses such as bancassurance and mobile banking has stretched existing staff resources, causing intense competition for specialised professions. “Lenders will need to expand staffing in specific niches at a time when the labour market is tightening, particularly for specialised profiles like consumer and micro-lending,” Herianto Pribadi, a partner at Skha Consulting, told OBG.

SUSTAINING LOAN GROWTH: Such challenges reflect a more positive attitude by banks towards lending to the real economy however. As recently as 2009 banks were diverting a significant portion of their capital towards government bonds and BI certificates (SBIs), effectively sterilising such funds – only two of the 10 leading banks held more than 70% of their assets in loans in 2009, with BCA holding as much as 40% of assets in the two instruments. Banks still hold a large share of liquid assets including inter-bank placements, government bonds and short-term bank paper, which accounted for 39% of banks’ assets in the first half of 2012, according to Pefindo. Although BI has mandated that banks maintain loans-to-deposit ratios (LDR) at between 78% and 100%, many banks historically chose to pay the penalty fee for non-compliance, which stands at 0.1% of third-party funds, rather than expand their loan books aggressively.

INTERESTING TIMES: Yet in the last few years this has started to change, particularly driven by a new rebalancing of lending away from consumer loans towards productive loans for companies’ working capital and investment. By July 2012 the share of loans towards investment, working capital and consumption reached 29.6%, 27.3% and 18.9%, respectively, according to BI. The growth in aggregate lending reached 25.7% y-o-y by April 2012 to Rp2.32qrn ($232bn), driven primarily by 28% growth in lending to industry to Rp1.6qrn ($160bn) and 28.7% growth in lending to households to Rp447.7trn ($44.77bn) according to Pefindo. Industrial leaders have maintained pressure on the central bank to encourage lower prime lending rates, ideally to single-digit levels. Since 2012 BI has required all banks to publish the formulas used for calculating prime lending rates in newspapers. Lending rates had already dropped from above 12% in March 2011 to 11.12% a year later, although bankers see this as linked to competition in lending rather than the impact of the new name-and-shame approach.

PREDICTIONS: Amidst this rapid loan growth average default rates have dropped to historic lows, with nonperforming loan (NPL) ratios falling from 3.1% in November 2010 to 2.1% by the third quarter of 2012, according to Fitch. Although the ratings agency expects defaults to rise from 2013 given the recent high growth and potential headwinds for the wider economy, the leading banks are in a good position to weather even significant growth in NPLs given high NIM and healthy provisioning for performing loans, although it is not expected to double. While most banks’ NPL ratios continued to drop into the third quarter of 2012, a slight rebound in state-owned banks’ ratios from 2.55% in December 2011 to 2.63% in August 2012 is a source of concern. Meanwhile, non-foreign-exchange private banks and foreign joint ventures achieved the lowest rates of default, at 1.44% and 1.6%, respectively.

The rate of loan growth cooled slightly in 2012, following consistent growth of between 25% and 30% annually since 2009. While some cooling in consumer loans was due to new caps on the value of loans imposed by BI from July, the impact of lower commodity prices also affected demand from commodity-linked sectors. Yet by October 2012 investment loans and working capital loans were still growing at 30% and above 20% a year, respectively, while consumer lending growth had slowed to below 20% a year, according to Fitch. Annual loan growth forecasts for 2012 have been adjusted downwards from 27% to 24%, although LDRs of 82.6% in the first half of 2012 – particularly of domestic banks in the 80% range – give room for more growth.

FROM CORPORATE TO SME & MICRO: Larger Indonesian corporates have traditionally had easy access to bank credit. Although corporates, particularly from banking, multifinance, plantations and commodities, are increasingly raising funds through the domestic public debt markets, bank debt still plays a significant role. “Bank loans are more flexible than corporate bonds since with them you have the flexibility to draw down your loan, whereas you must make bond payments every month regardless of circumstances,” Bret Ginesky, a senior vice-president and head of investor relations at Bank Mandiri, told OBG. Stalling investment on the part of plantations and natural resource companies in 2012 in light of falling commodity prices has been more than compensated by resilient investment in industries catering to domestic consumption, particularly in manufacturing. Financing for cross-border expansions, both within ASEAN and farther afield, has also stimulated high growth in investment loans. According to a Standard Chartered survey in April 2012 of high net-worth businesspeople, some 63% of respondents saw opportunities for growth in Europe and 51% in the Middle East and Africa, almost double the Asian average. Strong corporate earnings of slightly above 28% in 2011 and forecast at close to 20% in 2012 have sustained the attractiveness of lending to the larger tier. Although corporate loan growth may slow in 2013, with Mandiri forecasting its corporate lending to grow only 15-18%, this is due to leading banks’ rebalancing towards the retail and SME market, not a lack of dynamism.

With some 51.3m registered SMEs accounting for 55.6% of GDP and 52.9% of total investment in 2011 according to BI, the strongest potential for long-term growth lies in lending to smaller firms, however. “Around 80% of all business units in Indonesia are SMEs and can absorb a large amount of the country’s workforce,” Antonius Napitupulu, president director of Asuransi Kredit Indonesia (ASKRINDO), told OBG. “They thus play a vital role in economic development.” Banks have increasingly channelled limited lending to SMEs in trading, agriculture, and food and beverages, although the absence of a dedicated programme to cap risk has constrained growth. Nonetheless respondents to the PwC Indonesia survey expected 35% growth in loans to SMEs and 43% growth in SME deposits in 2013.

The government has taken a more active role in channelling credit to micro-enterprises. A people-based business loan project (Kredit Usaha Rakyat, KUR) is supported by state-owned banks both nationally and provincially, with examples such as Bank Jatim in Surabaya, for instance. Mostly centred on Java, the programme provided Rp30trn ($3bn) in small-scale loans with subsidised interest rates to micro-business and smaller infrastructure projects. The donor-funded National Community Empowerment Program, meanwhile, provides lending to some 5000 projects of around Rp1.5bn ($150,000) a year in developing small-scale infrastructure. The largest lenders in micro-finance have been Bank Rakyat Indonesia (BRI), for which micro-lending accounted for 32% of loans in the second quarter of 2012, Bank Tabungan Pensiunan Nasional and Bank Danamon. BRI’s very healthy NIM of above 8% in 2012, according to AM Best, has been sustained by micro-lending yields of between 22% and 30%, while prudent loan monitoring has kept its NPL ratio at a mere 1.34%. The more than 1700 rural banks operating some 3900 offices provide important services to over 29m clients. BI has sought to support rural banks’ expansion of lending to SMEs and micro-enterprises in recent years in conjunction with Japan’s International Cooperation Agency. However, given capacity constraints on often very small rural banks, BI plans to revise rules operations for rural banks in 2013.

GOING BRANCHLESS: Indonesia’s vast geography and low banking density still pose challenges for banks seeking to extend their reach. Although most banks are aggressively expanding their branch networks to cater for growth in more outlying regions and comply with new BI requirements, the imperative is to find new ways of expanding financial access and distribution channels which will not incur as high a rise in operating expenses as physical expansion. Banks have focused on ATMs as a means of conducting simple transactions such as deposits and withdrawals, with the number of ATMs doubling in six years to over 60,000.

The post office has attracted growing attention as a means of bridging the significant distribution gap in remote regions. With 4000 offices and 1000 mobile service points, PT Pos Indonesia already holds the exclusive franchise for Western Union, playing a key role in handling the over $7bn in inwards remittances Indonesia receives annually according to the US Agency for International Development. A number of commercial banks have been seeking to partner with the post office for simple transactions. In 2010 authorities also launched a “My Saving” (TabunganKu) plan through a large number of commercial banks as a simple savings product. With no administration fee and low minimum deposits and balance of Rp20,000 ($2), BI claims to have opened 2m accounts in the two years to 2012 with an aggregate value of Rp2.45trn ($245m).

The rapid expansion in mobile phone ownership, growing at an average of over 30% annually since 2006, initially raised expectations for the mobile money channel – indeed, banks estimate the cost of servicing clients through mobile agents is one-fiftieth of the cost through a branch. Most leading banks have unveiled mobile money platforms using both SMS platforms for conventional phones as well as smartphone applications, while telecoms operators have launched their own services capped at $250 per user. Smaller third-party operators have emerged, although their client base has remained minimal. Neither major mobile money group has aggressively sought to market such services to anyone other than existing customers, meaning mobile money is viewed as an plus for existing users rather than a means of attracting new clients. Another current issues lies in the fact that less than 15% of SIM cards currently in circulation are pre-paid, contributing to challenges for tracking users. “A key challenge for branchless banking is ‘know-your-customer’ requirements,” Bret Ginesky told OBG.

OUTLOOK: Relatively insulated from the volatility of international markets and supported by strong domestic consumption and rising incomes, Indonesian banks stand on a healthy footing with high profitability and sufficient liquidity to expand both their physical presence and lending. The sector’s small size means such capital will be required at home rather than abroad as part of international expansion. Stronger regulatory impetus from 2013 will force banks to expand access and improve corporate governance. Foreign investors appear undeterred by new and more onerous requirements, a sign of growing competition for both lending and deposits. Financial stability will be sustained, but the imperative will be to extend the reach of the financial system to help support wider economic growth.