ISLAMIC BANKING GROWING IN INDONESIA

UNCLAS SECTION 01 OF 06 JAKARTA 003244 SIPDIS SENSITIVE SIPDIS DEPT FOR EAP/MTS AND EB/IFD/OMA TREASURY FOR IA-JEWELL COMMERCE FOR 4430-GOLIKE DEPARTMENT PASS FEDERAL RESERVE SAN FRANCISCO E.O. 12598: N/A TAGS: EFIN EINV ECON PGOV PREL ID SUBJECT: ISLAMIC BANKING GROWING IN INDONESIA REF: Jakarta 2906 - MUI Head ¶1. (SBU) Summary. Indonesia's Islamic banking sector is small (under two percent of banking sector assets) but growing rapidly, and could reach nine percent by 2011, according to Bank Indonesia (BI) officials. BI regulates sharia banking and is encouraging the growth of the sector with a lower initial capital requirement and a three-stage blueprint for Islamic banking development through 2012. The two largest sharia banks in Indonesia, Bank Muamalat and Bank Sharia Mandiri, together control 73 percent of market share and Rp 15.6 trillion (USD 1.7 billion) in assets. Banking contacts in East Java are less optimistic about the sector's growth potential, with customers citing problems with service and lack of experienced personnel at sharia banks. A big boost to the sector could come through a possible decision by the Ministry of Religious Affairs to transfer to sharia banks in 2006 an estimated USD 650 million in annual hajj pilgrimage funds currently kept in conventional banks. The Indonesian Ulema Council's (MUI) National Sharia Board (DSN) issues "fatwas" or legal opinions regarding Islamic banking and sharia financial products in cooperation with BI. The non-bank sector also offers sharia products: Indonesia has about a dozen corporate sharia bond issuers, three purely sharia insurance companies, 29 conventional insurance companies issuing Islamic products, and three companies issuing sharia mutual funds. Analysts expect demand for sharia banking and financial products to continue to grow in Indonesia as services improve and become more widely available, but it is unclear whether the sector will ever be more than a niche provider. End Summary. Islamic Banking Small but Growing -------------- ¶2. (U) At present, Islamic banking represents less than 2 percent of total assets in the banking sector (about Rp 21 trillion or USD 2.3 billion in December 2005),up from Rp 2.7 billion (USD 0.3 million) in 2001 and only Rp 479 million (USD 52,000) in 1998 according to BI. BI officials believe the sector could grow to as large as nine percent of assets by 2011, though banking experts outside of Jakarta are less optimistic, citing problems with quality of �A;service. About 22 of Indonesia's 131 commercial banks now offer Islamic banking services. Three of the 22 are strictly sharia, while the rest are conventional banks with sharia branches (see Table 1 below). The three largest national players are Bank Sharia Mandiri (Rp 8.3 trillion or USD 900 million in assets) Bank Muamalat (Rp 7.3 or USD 791 million in assets) and Bank Sharia Mega (Rp 1 trillion or USD 108 million in assets). Sharia banks to date have demonstrated a greater ability to attract and retain borrowing clients than depositors. Loan-to-deposit ratios (LDR) for sharia banks remain high at an average 110 percent. Table 1: Sharia Banks and Branches in Indonesia -------------- -- Institution Number as of 12/2005 -------------- -------------- Sharia Commercial Banks 3 Sharia Business Units 19 Branch Offices 183 Sub-branch Offices 100 Cash Offices 181 Sharia Rural Banks 92 Total 578 Source: Bank Indonesia ¶3. (U) Indonesian sharia banks have some competitive advantages over conventional banks, chiefly their clean image, which many Indonesians find appealing. This is especially attractive to small Muslim borrowers who feel JAKARTA 00003244 002 OF 006 like they will get fairer treatment and a better chance of loan approval than at larger, more impersonal banks. Sharia banking targets the low-income and low-middle income customers of all religions. In addition, sharia banks can offer capital lease products for equipment or vehicles that conventional banks cannot. (Note: Under Indonesian banking laws, it is much easier for sharia banks to hold title to a collateral asset than conventional banks.) Regulation of Islamic Banking -------------- ¶4. (SBU) BI's sharia banking directorate told us that Islamic banking supervision is a challenge because BI must not only ensure compliance with banking regulations but sharia principles as well. BI issued more than a dozen new regulations relating to Islamic banking in 2005 and expects that it will issue a capital adequacy standard for Islamic banks in the first quarter of 2006. Despite the challenges, BI welcomes the growth of the sector as it will provide more diversification and an additional outlet for "idle money." A growing sharia bank sector should help banks manage their assets, BI told us, as well as attract funds from Muslim investors in the Middle East and elsewhere. BI officials testified before Parliament in February 2005 on a draft sharia banking law that may be completed by May 2006. Like conventional banks, all sharia banks must comply with Indonesia's Anti-Money Laundering (AML) requirements such as submitting suspicious transaction reports. The sharia banking sector may create more challenges for the Financial Transactions and Analysis Center (PPATK) given the number of small branches and the explicit wish to attract money from Islamic nations. ¶5. (U) BI officials describe Islamic banking as a "fast growing industry that has not yet reached critical mass." To encourage more sharia banks, BI has set a lower initial capital requirement of Rp 1 trillion (USD 108 million) for sharia banks, compared to Rp 5 trillion (USD 542 million) for conventional banks (based on regulation No. 7/35/PBI dated 29 September 2005. BI issued a regulation in January (PBI No. 8/3/2006) to permit conventional banks with a sharia unit to offer sharia transactions at all branches, removing the need to have stand-alone sharia offices and staff at every conventional bank location. The change in regulations should allow sharia banking services to become widely available in a relatively short period. Other proposals to encourage sharia deposit growth would permit longer-term deposits of up to three years. Conventional banks only offer one-month certificates of deposit and traditional savings accounts. Allowing sharia banks to accept longer-term deposits may promote greater stability in the core deposit bases of the banks while offering depositors additional convenience. Blueprint for Islamic Banking Development -------------- ¶6. (SBU) BI issued a "Blueprint of Islamic Banking Development in Indonesia" in September 2002 and provides annual reports on Islamic banking. BI sees three stages in Islamic banking development in four categories (see below). Stage 1 (2002-2004) was establishing a strong base for sustainable development; Stage 2 (2004-2008) is strengthening the institutional structure; Stage 3 (2008- 2012) is complying with international standards for financial products and services. In the current Stage 2, BI plans the following: A) Compliance with Sharia Principles: Supporting more efficient sharia supervisory activities; Developing incentives to improve compliance with sharia principles. B) Prudential Regulation: Developing risk-based regulations and supervision; Developing entry and exit policy. (Minimum criteria for starting a sharia bank and bank resolution/liquidation procedures.) JAKARTA 00003244 003 OF 006 C) Operational Efficiency and Competitiveness: Supporting strategic alliances; Establishing cooperation with related supporting institutions. D) Systemic Stability and Benefits to the Economy: Enhance role of sharia financial information center; Support involvement of rating agencies in sharia banking activities; Conduct studies about voluntary sector; Support use of share-base finance. Role of Sharia Bank Association and Ulema Council -------------- -------------- ¶7. (SBU) The head of the Indonesian Sharia Bank Association (ASBISINDO) Wahyu Dwi Agung told us his Association seeks to raise the profile of Islamic banking in Indonesia, including by persuading BI to support a dedicated BI Deputy Governor for Islamic banking and expanding the existing directorate. (Note: Currently, BI Deputy Governor Siti Fadjrijah has sharia banking as part of her portfolio.) He also admitted, however, that some banks have inadequate technology and human resources to expand sharia banking. Currently, some rural banks are in the process of establishing sharia units. (Note: Rural banks in Indonesia are much smaller than commercial banks and have a different regulatory framework.) ¶8. (SBU) The Indonesian Ulema Council (MUI) issues "fatwas" or legal opinions on Islamic banking and financial products. MUI head Ma'ruf Amin told us that the National Sharia Board (DSN),a MUI unit, is primarily responsible for issuing "fatwas" or legal opinions on Islamic banking. BI then turns these into regulations related to sharia banking. (See reftel for more on Amin.) DSN also approves sharia financial institutions and products, ensuring they conform to sharia principles. Amin also confirmed that investing in tobacco-related products and industries is a grey area. DSN works closely with BI and the Islamic Banking Association on issues related to Islamic financial services and products. MUI said it has been urging for several years that the Ministry of Religious Affairs (MORA) move hajj savings funds to sharia banks. Will Hajj Funds to Move to Sharia Banks? -------------- ¶9. (SBU) In November 2005, Vice President Kalla reportedly said all hajj pilgrimage savings funds should be placed in sharia banks. Bank Muamalat's President Director said he hopes Kalla's statement will eventually become a regulation and the MORA seems to be moving in this direction. Muamalat's senior managers acknowledged, however, that given Islamic banking's emphasis on honesty and transparency, "It is hard to do business with the government in a clean way." In a high-profile corruption case, the Central Jakarta District Court sentenced Said Agil Munawar, Minister of Religious Affairs from 1999 - 2004 was sentenced to five years in prison in February 2006 for embezzlement of hajj funds. ¶10. (SBU) Many Indonesians save for decades or a lifetime to make the hajj pilgrimage to Mecca, sometimes selling valuables, livestock or land. They deposit hajj funds with the MORA one year before the intended hajj and MORA then organizes the pilgrimage. The majority of Indonesians rely on MORA's organization rather than planning a hajj individually. MUI head Mar'uf Amin said that MORA may issue a Decision Letter (SK) to mandate that hajj funds be placed in sharia banks. There are an estimated 200,000 Indonesians who perform the hajj every year. At Rp 25-45 million (USD 2600 - 4900) per person, an estimated Rp 4.8 -9.0 trillion (USD 520-975 million) flows through the MORA's Hajj Fund Management Unit each year to conventional banks. Amin said that MORA initially wanted to choose which sharia banks would receive the hajj funds, but MUI objected. BI will select the banks after a "fit and proper" test. Bank Sharia Mandiri believes that BI will select three or four banks to JAKARTA 00003244 004 OF 006 be the operating banks for the hajj funds. Bank Muamalat and Bank Sharia Mandiri -------------- ¶11. (SBU) Established in 1992, Bank Muamalat is Indonesia's first purely sharia bank. The bank's shareholders include the Islamic Development Bank (28 percent),Kuwait's Boubyan Bank (21.3 percent); the Saudi Economic and Development Company (21.3 percent); three Indonesian businessmen who own a combined 15.5 percent (Abdul Rohim, Riza Ismael, Abbas Adhar); the MORA's Hajj Fund Management Unit (2.4 percent); and a group of smaller investors who own a combined 11.5 percent stake. Senior managers at Bank Muamalat told us that Muamalat opened 1000 branches at local post office outlets in 2005, and seeks to improve marketing to reach more customers in 2006. "Intensification rather than extensification [is the priority] for 2006," Muamalat's President Director A. Riawan Amin told us. Muamalat managers hope that sharia banking will reach five percent of assets by 2011. ¶12. (SBU) One of the bank's key marketing tools is a mass appeal, small format book entitled "The Celestial Management," published in 2004 by A. Riawan Amin. It is a collection of religious and inspirational stories, frequent quotations from the Koran, management principles and praise for Muamalat's business model, designed to appeal to a wide range of Muslim customers. ¶13. (U) Established in 1999 after BI issued its first sharia banking regulations, Bank Sharia Mandiri is currently the leading player in the industry. State-owned Bank Mandiri (conventional) is the majority shareholder with a stake of 99 percent. It controls about 40 percent of sharia market share, while Muamalat holds around 30 percent. Syariah Mandiri has grown from 8 to 165 branches in six years, around 60 percent of which are located in Java. Assets grew by more than 1,700 percent over the same period, from Rp 450 billion (USD 48 million) to Rp 8.3 trillion (USD 900 million). President Director Yuslam Fauzi told us 39 percent of the bank's lending portfolio goes to small and rural customers, and the bank intends to increase this proportion. The bank also plans to add 45 branches of various types in 2006. Around 15 percent of the customer base is non-Muslim. Like his counterpart at Bank Muamalat, Fauzi has a degree from the U.S. and speaks fluent English. ¶14. (SBU) Fauzi thinks that the draft sharia banking law will not bring any significant changes to the industry, but merely formalize relationships, responsibilities and principles already standard in the sector. He expressed some frustration with BI as a regulator, noting that industry is growing rapidly and BI is not keeping up. "BI needs to think about the whole range of sharia financial products, including sharia money market. It has not focused enough resources on sharia banking." Bank Sharia Mandiri offered five-year sharia bonds in 2003 and plans to issue subordinated sharia debt this year to improve its capital adequacy ratio (CAR). Sharia Banking in East Java and Sumatra -------------- ¶15. (SBU) Although East Java accounts for about 15 percent of total population and is the center of Nahdlatul Ulama (NU),it has a relatively small number of sharia banking customers and accounts for less than 5 percent of national Islamic bank assets. Attempts by more conservative Muslim groups to encourage Muslims to embrace Islamic banking, such as the Indonesian Muslim Council's (MUI) 2003 fatwa forbidding interest, have had little impact in East Java. ¶16. (SBU) The Regional Economic Development Institute (REDI) in Surabaya recently completed a sharia banking customer satisfaction survey analyzing responses from East Java sharia banking customers. REDI found that religious JAKARTA 00003244 005 OF 006 motivations were not the primary attraction for East Java depositors to sharia banking. Many of the larger depositors in East Java sharia banks were ethnically Chinese Indonesians attracted to the 1 to 2 percent higher returns delivered by the sharia banks over conventional bank deposit rates. At the same time, many East Java depositors lacked confidence that the relatively new sharia banks and their staff would be able to effectively manage their loan portfolio risk in an increasing interest rate environment. In addition, since sharia loan payments on business loans are typically tied to a percentage of sales, if sales decline in a slowing economy such as after the fuel price increase, depositors are concerned that falling sharia bank profitability will lower deposit returns. ¶17. (U) Sharia banking has about 5.2 percent market share in North Sumatra according to the head of Bank Mandiri Sharia in Medan. There are five sharia banks in North Sumatra and Bank Mandiri Sharia has about 20 branches. Commercial loans tend to go to plantations (though not tobacco) and personal loan eligibility is currently evaluated using the same criteria as conventional banks. Other Islamic Financial Products -------------- ¶18. (U) Other Islamic financial products are growing in Indonesia as well. At the end of 2005, 29 insurance companies were issuing Islamic insurance products. Most are branches of existing companies but three are "pure" sharia insurance companies: Aj Mubakarah, Asuransi Takaful Keluarga (Family Insurance) and Asuransi Takaful Umum (General Insurance). Regulations are in place for capital requirements and approval procedures for sharia insurance. A MUI advisor assists each company to ensure compliance with sharia principles. Indonesia currently has four re- insurance companies with sharia divisions: Maskapai Reasuransi Indonesia, Tugu Reasuransi Indonesia, Reasuransi International Indonesia, and Reasuransi Nasional Indonesia. ¶19. (U) In addition to Islamic insurance, three companies issue very small Islamic mutual funds. State-owned investment firm PT Danareksa has sharia mutual funds with a net asset value in February 2006 of Rp 11.6 billion (USD 1.3 million); state-owned Permodalan Nasional Madani (National Financing for Civil Society) with Rp 46.2 billion (USD 5 million) and Bhakti Asset Management with Rp 74.5 billion (USD 8.1 million). Relationship to Islamic Standard Setters -------------- ¶20. (SBU) In November 2003, BI became a member of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOFI) and since 2004, a Deputy Governor of BI has sat on the Board of Trustees. BI clearly seeks to become a bigger player in the international sharia banking community. It co-hosted a large Islamic Banking Conference in November 2005 with the Islamic Research and Training Institute, the International Association for Islamic Economics and the University of Indonesia. Approximately 60 senior regulators, industry players and scholars from ten countries attended and presented dozens of research papers. ¶21. (SBU) MUI does not comply fully with international sharia guidelines, but rather "adapts them for the domestic context." MUI head Amin told us that he was pleased that international standard setters welcome and respect the views of MUI. He noted other Islamic nations see MUI as representing a "moderate middle" on sharia financial products between conservative views from the Middle East and more liberal interpretations from Malaysia. Amin thought a consistent global standard methodology for issuing fatwas related to financial instruments should eventually be developed. However, Fauzi from Bank Sharia Mandiri said that, "We have to learn more from Malaysia," and said he has been trying to get colleagues in sharia banking more JAKARTA 00003244 006 OF 006 interested in Malaysia's model. Islamic Sovereign Bonds in Future? -------------- ¶22. (U) Indonesia has about a dozen Islamic corporate bonds issuers including bank, telecommunications, shipping property and trading companies. The current value of sharia bonds outstanding is still very small, at approximately Rp 6 trillion (USD 650 million). The conventional corporate bond market in Indonesia is about USD 6 billion. Indonesian companies that have issued sharia bonds include: - Indosat, Citra Sari Makmut (telecomm); - Bank Bukopin, Bank Muamalat (banks); - Apexindo Pratama Duta (drilling contractor); - Matahari Putra Prima (department stores); - Berlian Laju Tanker (shipping); - Humpuss Intermoda Transportation (shipping); - Berlina (plastic manufacturer); - Ricky Putra Globalindo (clothing); - PTPN and Ciliandra Perkasa (plantations). ¶23. (U) Islamic sovereign bonds, in contrast, would require an act of Parliament to amend Law 24/2002 requiring that bonds show interest. Muhammad Gunawan Yasni, a commentator on sharia economics at the Economic Faculty in the University of Indonesia told us he believes simply replacing the word "interest" with "coupon" or "profit sharing coupon" would be a sufficient amendment. The Ministry of Finance is reviewing an amendment to this effect. The International Islamic Financial Markets organization based in Bahrain must also approve Islamic sovereign bonds. MUI head Amin said the GOI plans to issue two types of sovereign bonds, new issues and bonds converted from conventional interest- bearing bonds. Comment -------------- ¶24. (SBU) Sharia banking in Indonesia has clearly entered a period of rapid growth from a low base. BI officials and bankers are convinced the underlying demand for sharia banking services in Indonesia's largely Muslim population will continue to broaden as sharia banking services become more widely available. BI is doing its part to grow sharia banking through its blueprint, lower initial capital requirements, and facilitation of sharia services at conventional bank branches. Strengthening sharia bank balance sheets by implementing proposed new regulations and developing new deposit products should help overcome depositor fears and allow sharia banks to expand into new lending areas. To grow more rapidly, sharia banks and branches will need to offer services widely at the village level, where religious values may have a greater impact on depositor behavior. Supervision of the sector is lagging somewhat behind its expansion as laws and regulations are still being put in place. PASCOE