Fintech and Islamic segment stimulate Indonesian finance sector

With a population of approximately 260m and the fourth-largest economy in Asia, Indonesia is one of the world’s biggest potential banking markets. Growth in profitability, loans and assets has been stronger than in other ASEAN countries, although an economic slowdown in 2015 and early 2016 curbed sector growth before an upswing in 2017.

The Indonesian market has historically been – and continues to be – highly profitable in comparison to more developed economies. The banking sector still offers plenty of untapped potential and room for competition, leaving opportunities for higher margins and new product development. Elevated levels of profitability, fuelled in part by demand for new products, should begin to decline, however, as consumers become increasingly sophisticated.

CHANGES AFOOT: With increased consumer sophistication comes a number of expected market changes: trends indicate the sector will experience a rise in costs, particularly in terms of employee compensation; an uptick in non-performing loans (NPLs); an increase in exchange-rate volatility putting stress on both financial institutions and their clientele; more costly customer acquisition channels; and a greater number of institutions with poor cost-income ratios and a lack of overall scale.

While the market is beginning to exhibit some of these characteristics, it is already moving towards cost reduction. Long-term prospects remain positive due to continued economic growth and further opportunities to expand financial inclusion, providing services to more of the still-large unbanked population. Although risks are slowly increasing and the government has voiced intentions to reduce the cost of lending as more competition enters the market, the sector had yet to realise any significant margin compression as of end-2017.

STATE OF PLAY: Steady GDP growth, averaging 5.6% from 2006 to 2016, has propelled the sector upwards as banks rush to cater to the largely under-served market. This organic expansion has fuelled a compound annual growth rate (CAGR) of assets of 13% between 2011 and 2016, while the value of total loans nearly doubled from Rp2200trn ($165.8bn) to Rp4200trn ($316.6bn) in this period. Over the same six-year interval, third-party deposits showed a 10.7% CAGR as their value expanded from Rp2790trn ($210.3bn) to Rp4630trn ($349bn).

In 2016 the overall banking sector loan portfolio expanded by 3% over the previous year, despite the broader national economy having a generally mixed performance. With infrastructure spending increasing, the top-three-performing sectors for loan growth were construction, utilities and finance, which grew by Rp41.8trn ($3.2bn), Rp36trn ($2.7bn) and Rp29.3trn ($2.2bn), respectively. Depressed commodity prices continued to affect loans to the mining and quarrying sector. Primarily based on coal, copper and gold production, these loans similarly declined by Rp8.9trn ($670.9m) in 2016.

Total assets have grown in conjunction with the profitability of banks, with national banking assets reaching Rp6730trn ($507.3bn) as of December 2016, up from Rp6130trn ($462.1bn) the previous year and R4260trn ($321.1bn) in 2012, according to data from the Financial Services Authority (OJK). The country’s top-10 banks controlled roughly two-thirds of banking assets at the end of 2016.

The largest two banks by asset value were state-owned Bank Mandiri, with assets valued at Rp1040trn ($78.4bn) and a loan portfolio of Rp668trn ($50.4bn) followed by Bank Rakyat Indonesia (BRI) with Rp1000trn ($75.4bn) in assets and outstanding loans of Rp676trn ($51bn).

OPERATING ENVIRONMENT: A period of sustained robust expansion was interrupted in 2015 when falling global commodity prices negatively affected economic performance, which inevitably seeped into the banking system. Because Indonesia still produces a significant amount of commodity-based exports, the reduced prices for agricultural products, metals and minerals translated into a correspondingly weaker performance of the banking sector. Loan growth dropped from 12% in 2014 to 10% in 2015 before bottoming out at 3% in 2016, while third-party deposit growth similarly declined from 12% in 2014 to 7% in 2015, before reaching 5% in 2016. As a result of these conditions, the sector experienced an increase in NPLs and was required to restructure loans across multiple sectors.

REBOUND: Expectations of a rebound were met, to a large degree, in 2017 as the overall rate of NPL growth tailed off. There were a number of factors contributing to this, including 16 economic stimulus packages rolled out between 2015 and 2017; the arrival of additional liquidity brought onshore through a tax amnesty programme; improvements in commodity prices; and the government’s adoption of a general pro-growth approach, which resulted in a cut in benchmark interest rates by 150 basis points in 2016 as well as a reduction in banks’ reserve ratio requirements (see analysis).

The tax amnesty programme alone resulted in the declaration of Rp4970trn ($374.6bn) in assets through March 2017, equal to nearly 40% of GDP. Of these newly declared assets, 76% was declared onshore, with 21% offshore and 3% repatriated.

In addition to increased liquidity and government revenue, parallel transparency efforts could also significantly affect the banking sector through the passage of new regulations. New rules are expected to substantially increase the amount of data that banks are required to share with the government for tax purposes. This move is being made in conjunction with the country’s pledge to comply with the OECD’s Automatic Exchange of Information guidelines, which are anticipated to curtail some banking secrecy procedures. However, the finalised details are not expected to be made public until 2018.

For 2017 Bank Indonesia (BI) projected deposit growth at 11% and loan growth at 12%, while the OJK predicted slightly stronger expansion of lending at 13.2%. Liquidity is also expected to rebound, recovering from slower growth rates in 2016, when the sector’s loan-to-deposit ratio declined to 90.7%, compared to 92.1% the previous year.

GEOGRAPHY & DEMOGRAPHY: With over 250m citizens, Indonesia is one of the largest markets for banking and other financial services in the region. In addition, a substantial portion of the population remains underserved in terms of banking products. This largely untapped market makes it easy to see why the country is perceived as one of the most attractive markets in South-east Asia.

While this population holds significant potential, it is not entirely accessible, being spread across some 17,000 islands over 2m sq km of ocean and land, creating logistical obstacles and driving up costs.

This geographic dispersion creates two main challenges for lending institutions. The first is that customer acquisition can bear very high costs. This is a more significant problem for small banks, as larger state banks with widespread branches are already well positioned to serve these populations. Second, logistics and staffing are more challenging outside of the primary population centres, which further drives up the cost of providing services.

As a result, banking activity remains heavily concentrated in areas with the highest population densities: this is skewed towards Java, and to a lesser extent, Sumatra. As of December 2016, 78% of banks’ third-party deposits were allocated to Java and 11% to Sumatra. This left the remaining 12% dispersed between Kalimantan, Sulawesi, Bali, Maluku, East Nusa Tenggara, West Nusa Tenggara, Papua and other regions. The dispersion of loans tells a similar story, with Java accounting for 74% of all loans allocated, followed by Sumatra with 12%.

LENDING: Indonesia’s loan-to-GDP ratio has grown nominally in recent years, yet remains low compared to other Asian-Pacific countries, with a rate of 33.6% as of 2015, up from 27.4% in 2010. Third-party deposit-to-GDP figures exhibit a similar trend, peaking in 2013 at 40.3% before tailing off to 36.6%by 2015. In comparison, domestic credit was measured at 33.6% in 2016, well below other regional economies such as the Philippines (59.2%), India (76.8%) and Singapore (121.1%).

Seeking to work against this trend and further its financial inclusion strategy, the government continues to encourage banks to tap into the underserved market though a “carrot” approach, incentivising financial institutions to expand to areas that may not be as attractive. For instance, the OJK is urging Indonesian banks to open more branches in the eastern part of the country – where penetration is particularly low – by providing additional incentives.

Many smaller banks are struggling to compete within the traditional distribution network, and are turning to newer, more innovative methods to attempt to level the playing field. This has contributed to the rise of financial technology (fintech), which is changing the way banking, shopping and other financial services are carried out, by moving many of these activities online (see analysis).

A BIGGER UMBRELLA: The number of active commercial banks in Indonesia has varied by only a limited degree, even with the sector continuing to register strong growth in financial performance and customer numbers. There has been a relatively small amount of merger and acquisition (M&A) activity in the industry, despite a relatively high net-interest margin and the government’s preference to increase competition in order to reduce the cost of borrowing. The main reason for the low levels of M&A activity is likely economic, in that banks are currently enjoying solid profit margins and positive future growth prospects, making them less likely to be tempted by a potential buyout.

Another obstacle to consolidation is the ownership restrictions on foreign banks in Indonesia, as well as overseas banks’ own challenges in integrating their operations within different regulatory environments across the world. Although attempts are under way to adopt more common practices globally and within regional blocs such as ASEAN, disparities persist on a variety of different issues. “Integration poses a challenge to a democratic country, as it is more difficult to find integrated international regulations that also benefit Indonesia,” Achmad Friscantono, executive director of the Indonesian Banks Association, told OBG.

Between 2012 and April 2017 the number of commercial banks operating in Indonesia decreased marginally, from 120 to 115. Between 2002 and 2017 only 25 M&As took place in the country, although the rate of activity has picked up somewhat, with four deals in 2015 and another five in 2016.

M&A ACTIVITY: In 2016 China Construction Bank Corporation acquired a 40% stake in Bank Windu Kentjana International, which bought out 100% of Bank Antardaerah. There were a number of other deals taking place that year: APRO Financial Corporation acquired 40% of Bank Andara, Cathay Financial Holding purchased a 15% stake in Bank Mayapada Internasional and the government of the Banten province acquired 50% of Bank Pundi Indonesia, according to a 2017 report by Ernst & Young.

Apart from the approval of the buyout of a number of smaller chains on a case-by-case basis, the government and its regulators have shown little appetite to open up the market any further. At the moment, there are few opportunities for high-level buyouts given the state’s attitude towards foreign investment. Since 2012 single-party ownership of Indonesian banks has generally been limited to 40%. This has discouraged many foreign investors and international financial institutions, especially those based in the US and Europe. However, banks within the region have been less reticent to invest, with institutions from Japan, South Korea and China all becoming active investors in the sector.

There are also circumstances in which these limitations do not apply, such as the simultaneous acquisition of multiple banks. This was the case in 2015 when Shinhan Bank purchased majority stakes in smaller Indonesian banks – 75% of Centratama Nasional Bank and 98% of Bank Metro Express – and merged them. Another exception to the limit was made in 2014 when J Trust Bank bought 100% of Bank Mutiara – previously known as Bank Century – after the Indonesian government bailed out Bank Mutiara during the 2008 global financial crisis , after which it was run by the Indonesian Deposit Insurance Corporation. Though foreign ownership is not officially capped at present, the draft banking law moves to limit this at 40% (see analysis).

In the absence of M&A activity in the private sector, consolidation of the four large state-owned banks is under consideration. Already present across at least five other industries, including cement and fertiliser, the government is considering creating a new holding company in the banking sector to bring the ownership of Bank Tabungan Negara (BTN), BRI, Bank Mandiri and Bank Negara Indonesia (BNI) under one roof. A driving motivation for this is reducing the more damaging aspects of market competition and price wars between the lenders, while decreasing operating and borrowing costs among their constituent parts. It also allows for the specialisation of labour, with each bank focusing on its core competencies. BTN, for example, may work more heavily on mortgage lending, BRI could target micro-lending and Mandiri and BNI could address the needs of the infrastructure sector.

The four banks have already made progress towards greater cooperation in recent years, including signing a non-compete agreement for overseas clients and integrating their ATM and electronic data capture systems under a new common switching company: Jalin Pembayaran Nusantara.

NPL: Taken as a whole, Indonesia has been able to maintain a favourable NPL rate with only minor increases over the past few years. Apart from sound overall economic conditions, sector regulations have helped keep overall NPL rates low. In fact, authorities have capped the allowable NPL rate at 5%, rather than imposing regulations on higher capital reserve requirements, capital adequacy or similar measures. Banks that exceed this 5% threshold are subject to penalties from the government, a policy that has so far proven effective in ensuring banks play by the rules. That being said, some of the smaller lenders struggle with the capital limits, although industry-wide capital ratios remain generally high.

NPL rates peaked in 2006 at 4.8% and declined steadily thereafter, to less than 2% by 2012. Since 2012 these levels have inched steadily upwards to 2.9% in 2016 and 3.0% in August 2017. This growth in NPLs is mainly confined to certain sectors. Microloans and those for small and medium-sized enterprises, for instance, remain relatively healthy. The same can be said for loans at the high corporate level and at large state banks. The main area for concern, however, lies in the low corporate level, which is far less healthy. Much of this is due to changes requiring both banks and companies to adjust their lending and reporting policies.

Despite these increases, the most recent annual NPL rate – which was under 3% in 2016 – remains below that of many emerging markets around the world, as well as the global average of 3.9%. Indonesia has fared better than Brazil, with a 3.8% NPL rate, along with South Africa and Turkey, each at 3.2%. Furthermore, between the first quarter of 2016 and the first quarter of 2017, the formation of new NPLs and special-mention accounts – which are precursors to NPLs – have slowed their growth.

ISLAMIC BANKING SERVICES: Home to the largest majority-Muslim population in the world, Indonesia is a likely candidate for the launch of sharia-compliant banking products. However, these products have historically failed to experience the same levels of success that they generally achieved in other majority Muslim countries throughout the rest of Asia and the Middle East.

There is a pervading belief that it is difficult to for Islamic products to be as competitive as those offered by conventional banks, which have the advantage of achieving greater economies of scale. While this is true in certain banking segments, larger, established banks have created Islamic windows that have proven capable of offering sharia-compliant products on a par with conventional ones.

Sharia-compliant banking assets were valued at Rp357trn ($26.9bn) at the end of 2016, accounting for around 5% of total reported banking assets, according to data from Maybank. In recent years Islamic assets have expanded due to organic growth in the market and the conversion of some regional developmental banks to sharia-compliant banks. This helped the sector reach 5.1% of total banking assets in the first half of 2017. The contribution of sharia-compliant products towards pensions, outstanding corporate bonds and mutual funds were similarly underrepresented, accounting for 0.8%, 4.2% and 4.4% of each segment, respectively.

The primary obstacle to the wider adoption of sharia-compliant banking products is the higher cost of funding, which forces institutions to pursue second-tier and third-tier clients who provide greater profitability at higher risk, resulting in a higher rate of NPLs. “This issue affects not only Islamic banks, but all smaller banks because they have not achieved economies of scale, which leads to higher costs of lending,” Herwin Bustaman, head of sharia banking at Maybank Indonesia, told OBG.

INDICATORS: Overall financial indicators for Islamic banks are lower than those for conventional lenders due to a number of factors, including difficultiesin raising funds from debt and capital markets, which hurts capital adequacy ratios; limited fee-based income products forcing sharia-compliant products to rely on financing to generate revenue, which leads to a lower return on assets (ROA); and lower productivity as a result of limited products, branch expansion and smaller-ticket financing, causing higher cost ratios. “Although sharia finance is a growing trend, it is important to offer more benefits to consumers in order to make it more competitive with conventional lending products,” Jodjana Jody, the president director of Astra Sedaya Finance and the CEO of ACC group, told OBG.

RESPECTIVE ROA: According to Maybank, the ROA for Islamic banks continues to rank well behind that of its conventional counterparts, although the gap has been narrowing in recent years. The sharia-compliant ROA has increased from 0.8% in 2015 to 1.5% in April 2017, closing in on conventional ROA, which inched upward from 2.3% to 2.5% over the same period. Similarly, in 2016 the ratio of capital to its risk – measured by the capital adequacy ratio – of sharia-compliant products was 16.9%, which was significantly lower than conventional banks’ 22.9%.

Structural issues with loans, in part due to higher costs of financing, are also pushing up the rate of NPLs in the Islamic segment, as managers are forced to take on riskier assets and are often less experienced than their counterparts in the conventional sector. While the NPL rate for conventional banks was roughly 3.0% in August 2017 and has been growing at a low rate in recent years, the rate for sharia-compliant banking products was 4.5%.

“There are structural issues with Islamic products compared to conventional products. Sharia-compliant products are 200-300 basis points higher in terms of cost of funds and lending,” Bustaman told OBG. “In this situation with few viable options, the only segment left to target is people with a greater risk of defaulting on loans. However, even for conventional banks, this group is unbankable.”

While there are advantages to be gained from Islamic banking units operating out of large conventional banks, these often do not extend past retail operations. Even in the big state-owned banks – which are able to secure loans for large infrastructure projects – these substantial loans have little effect on their sharia-compliant subsidiaries. As a result, these banks remain in a cycle of targeting primarily high-return time deposits, as they are unable to compete with larger players.

ISLAMIC GROWTH: Efforts by the government and private sector to increase uptake of sharia-compliant products have taken a variety of forms. In late 2016 a new regulation was enacted that allows banks with at least 10% of their assets classed as sharia-compliant to take advantage of lower capital requirement thresholds for new branches. This is expected to underpin the target of having 10% of total bank assets be sharia-compliant by 2020.

Another way the government could encourage further uptake of Islamic banking products is to tap into its massive infrastructure spending programme, which is seen as a key growth driver across a wide range of financial segments. By mandating that even a small percentage of funding for these projects be sourced from sharia-compliant lenders, the state could direct a relatively large amount of capital flows into the Islamic financial sector.

Growth is also possible by capitalising on opportunities more suited for Islamic finance, or simply not available at conventional institutions. One growing segment is Hajj funds, which are mandated by law to be sharia-compliant. Previously managed by the country’s Ministry of Religious Affairs, in June 2017 these funds were transferred to the more-transparent government institution, Hajj Fund Management, which allows participation from the banking sector. Developed as a means to save for the pilgrimage to Mecca that Muslims are expected to make at least once in their life, Hajj funds were valued at roughly $10bn as of mid-2017, growing at a rate of between $500m and $600m per annum. These are also seen as stable, long-term investments, as customers are required to wait a minimum of 15 years to withdraw their money from the fund. Another possible growth area is through expansion of zakat (alms) and waqf (endowments), which can serve as a type of trust fund, built up over time to be used for religious purposes. While these are not new, their uptake ratio remains small compared to countries such as Malaysia, in which the market is valued at between $5bn and $6bn, according to Maybank.

Challenges exist alongside these opportunities. Growth could be hindered by an upcoming regulatory change. Following the lead of Middle East models such as Qatar, the BI has issued requirements that sharia finance must be completely independent of conventional banking operations by 2023. This could create challenges for Islamic products in the future, as it will likely drive up costs of lending for these banks, as they will no longer have the backing and leverage gained from association with more heavily capitalised conventional partners.

ALTERNATIVE FINANCING: In terms of access to credit, new opportunities are also emerging outside traditional banking products and even Islamic finance, with Indonesia posting one of the highest growth rates in the Asia-Pacific region in alternative finance activity in 2016. The segment’s total market size expanded by 1462% to $35.4m, according to a report by the University of Cambridge, Monash University and Tsinghua University published at the end of September. The study found that peer-to-peer (P2P) business lending had come to dominate Indonesia’s alternative finance market, accounting for just over 60% of the 2016 total, with P2P consumer lending representing 18% of the figure, or $6.5m.

Donation-, equity- and reward-based crowdfunding combined for $6.6m, with other categories, such as P2P marketplace real estate lending and debentures, contributing the remainder. “Given this influx of market activity in 2016 and into 2017, we expect to see a substantial market development of activity in Indonesia for 2017 building on the rapid growth of 2016,” the report stated.

One factor that has helped foster continued P2P lending is the establishment of a regulatory framework for the platform at the end of 2016. Issued by the Financial Services Authority (OJK), the regulations set a minimum capital requirement of $260,000 for lenders and a ceiling on single loans of $150,000. In addition, foreign ownership of a financial (fintech) lender is capped at 85%, meaning overseas operators need a domestic partner.

FINTECH: The rollout by the OJK of these regulations, among others (see analysis), was also undertaken with the aim of accommodating expansion in the burgeoning fintech industry and the increasing popularity of electronic banking applications. These two evolutions are likely to solve challenges that the geography of the country has created for traditional banking by facilitating service of the more remote regions at minimal expense. With fintech still in its infancy, there is a significant opportunity for innovation to take place and for banks – even smaller players – to position themselves advantageously.

While Indonesian regulations still largely protect the interest of the country’s banks, the growing start-up ecosystem in Indonesia would likely gain from the development of a stronger fintech market. Indeed, tech start-ups have been catching the eye of investors, having raised close to $3bn in funding in the year to September 13, 2017, a substantial increase on the $631m received in 2016.

Moreover, Indonesian tech start-ups attracted the second-highest amount of investment in Southeast Asia between 2012 and September 13, 2017, at $4.6bn, behind Singaporean companies, which raised $7.3bn over the same period. To build on this position of strength, some industry stakeholders suggest that the market needs a closer working relationship between parties in order to offer stronger support to local start-ups and overcome shortfalls in Indonesia’s fintech infrastructure.

DIGITAL BANKING: At least part of this gap is already closing, as digital banking penetration is expected to rise on the back of increasing connectivity. Optimism is high among some market observers, with an August 2017 report by corporate consultancy Solidiance stating that enhanced infrastructure links, combined with the expectation of further smartphone and internet uptake, and an expanding young and affluent customer base, will drive digital retail banking penetration to 60% by 2020. With technology advancing rapidly and an increasing proportion of Indonesia’s population utilising mobile devices, the banking sector will have to embrace innovation or risk being disengaged from their market, the report concluded. Ultimately, the institutions that become the most successful in tapping into the potential of technological innovation could simply be those that manage to attract the best tech-savvy talent, as competition intensifies.

OUTLOOK: Given its strong economic fundamentals and large population of underbanked citizens, Indonesia’s banking industry appears to be primed for promising further growth for the foreseeable future. The low penetration rate of banking and relatively high net-interest margin will provide significant opportunities to investors across a number of segments, from conventional lenders and Islamic banking institutions to fintech firms, in both the short and the long term. Substantial changes in banking practices are unlikely to occur in the short term until the increased cost of credit or other cost increases force companies to develop enhanced efficiencies. If this trend changes enough to considerably affect net margins and cost-income ratios, it could become a driver for change, as banks will be compelled to address these declining margins.

In the short term, increased liquidity resulting from the tax amnesty programme, and other economic policies such as infrastructure spending, will continue to drive growth. These infrastructure improvements should increase the long-term efficiency of trade and provide a further boost to banks.

These broad-based factors aside, optimism regarding future growth patterns varies, depending on the subsector. Large, state-owned banks with sizeable portfolios, for instance, are among the most bullish for 2017 and beyond. Private foreign and domestic institutions tend to be more cautious in their short-term outlook, with some banks expecting flat or negative growth, as smaller banks are forced to contend with lower cost and income ratios.

The government’s desire for consolidation through M&A has taken a back seat for the time being, and in the short term most banks appear content to focus on organic growth within the underserved market, rather than expansion through acquisition.