What is Islamic Finance/Banking?

Islamic finance is banking that is consistent with the principles of sharia (Islamic law). For example, the prohibition of interest (riba) payments and excessive uncertainty (gharar) or gambling (maysir). Instead, risks and rewards should be shared by the stakeholders and the transaction should have real economic purpose without undue specification. Islamic banking involves banking, leasing, sukuk (Islamic bonds) and equity markets, investment funds, insurance and micro finance. However, the banking and sukuk assets account for about 95 percent of total Islamic finance assets. In recent years, the global market for sharia-compliant financial instruments has risen sharply.

Differences between Conventional and Islamic Banking:

Conventional Banking Islamic Banking
Money is a commodity besides medium of exchange and store of value. Thus, it can be sold at a price higher than its face value and it can also be rented out Money is not a commodity though it is used as a medium of exchange and store of value. Thus, it cannot be sold at a price higher than its face value or rented out
Time value is the basis for charging interest on capital Profit on trade of goods or charging on providing service is the basis for earning profit
Interest is charged even in case the organization suffers losses by using banks' funds. Thus, it is not based on profit or loss sharing Islamic banks operate on the basis of profit/loss sharing. In case the businessman has suffered losses, the bank will share these losses based on the mode of finance used (Mudarabah, Musharakah)
While disbursing cash finance, running finance or working capital finance, no agreement for exchange of goods & services is made The execution of agreements for the exchange of goods & services is a must, while disbursing funds under Murabaha, Salam & Istisna contracts
Conventional banks use money as a commodity which leads to inflation Islamic banking tends to create a link with the real sectors of the economic system by using trade-related activities. Since the money is linked with the real assets it therefore contributes directly to economic development

Source: mib.com.mv

Based on data from the International Monetary Fund (IMF), the world's Islamic finance assets have climbed by annual double digit growth rates from USD $200 billion in 2003 to USD $1.8 trillion in 2013. The Organization of Islamic Cooperation (OIC) expects total assets to grow to USD $3.5 trillion by 2018. However, the Islamic banking industry is still mainly concentrated in the Middle East (particularly Iran and Saudi Arabia) and Malaysia. Other countries that have a relatively high share of global Islamic banking assets are UAE, Kuwait, Qatar, Turkey, Bahrain, Indonesia, Bangladesh and Egypt.

Islamic Banking in Indonesia - an Untapped Potential

Remarkably, the market share of sharia banking in Indonesia remains low while nearly 90 percent of the population adheres to Islam. In absolute terms, it means that the country, Southeast Asia's largest economy, contains more than 210 million Muslims. However, as of 2015, assets controlled by Islamic financial institutions in Indonesia only account for five percent of the nation’s total banking assets. For comparison, in Malaysia - where 'only' 61 percent of a population that numbers just over 30 million people is Muslim - Islamic financial institutions control 20 percent of the country's total banking assets. This is a remarkable contrast and shows both the underdevelopedness of the Islamic finance industry and Indonesians' low awareness of Islamic banking. Meanwhile, in Saudi Arabia (which contains the world’s largest Islamic finance industry) Islamic banks account for over half of the country’s total banking assets. On the other hand, these facts show that there is still ample room for growth of Indonesia's sharia-compliant financial services industry.

Coming from a low base, Indonesia’s Islamic finance industry has shown rapid in recent years on the back of growing awareness of Islamic banking as well as government support programs. Between the years 2010 and 2014, Islamic banking assets in Southeast Asia's largest economy grew from IDR 100 trillion (approx. USD $8 billion) to IDR 279 trillion (approx. USD $22 billion), or at a compound annual growth rate (CAGR) of 29.2 percent. This growth pace is considerably higher than growth posted in other Islamic banking markets. It is also interesting to note that Indonesia's conventional banking assets expanded at a much slower pace (with a CAGR of 16.9 percent over the same period).

Islamic Banking Assets in Indonesia (in trillion IDR):

 2010  2011
 2012  2013  2014
Islamic Commercial Banks & Islamic Business Units   975  145.5  195.0  242.3  272.3
Islamic Rural Banks    2.7    3.5    4.7    5.8    6.6
Total Assets  100.3  149.0  199.7  248.1  278.9

Source: Financial Services Authority (OJK)

Indonesian Government Increases Support of the Domestic Islamic Banking Industry

The Indonesian government is eager to turn Indonesia into a major global hub for Islamic banking as this would deepen the country’s financial markets, hence making the nation less vulnerable to the negative effects of global economic turmoil.

In this context, Indonesian authorities stepped up efforts to boost the Islamic banking industry. Indonesia’s Financial Services Authority (OJK) developed and launched a five-year roadmap in early 2015. This roadmap targets to triple the market share of Islamic banks to 15 percent by 2023 through various strategies, such as the reduction of fees on sharia-compliant banking products and the development of educational and training programs (as the institutional framework and human resources within this industry need to be improved). It also involves intensifying coordination between the central government and the private sector as well as strengthening monitoring in the Islamic banking industry and enhancing legal certainty. This roadmap also supports the consolidation of state-owned and commercial Islamic banks, which will in turn increase the size of the banks' capital bases, enhance cost efficiency, and allow increased underwriting in the corporate and infrastructure sectors.

A huge USD $8 billion sharia bank, created by merging existing Islamic units of state-controlled banks Bank Rakyat Indonesia (BRI), Bank Mandiri, and Bank Negara Indonesia (BNI), would reduce operating costs and make it possible to offer more competitive rates, while making integration between Indonesia's Islamic banks and the global financial system easier (for example by revising capital requirements in order to bring risk management at Indonesian Islamic banks in line with international standards). This mega Islamic bank would also quadruple Islamic banks’ market share in Indonesia to 20 percent by 2018 according to the OJK. The three aforementioned banks together currently account for about 40 percent of Indonesia’s Islamic banking assets.

In 2015 the Islamic banking industry of Indonesia comprised 12 general sharia banks, 22 sharia business units of conventional banks and 163 sharia people's credit banks (rural Islamic banks).

Apart from launching the roadmap and the ‘I Love Sharia Finance Program’ in 2015, Indonesian financial authorities are also considering to ease foreign ownership limits on local Islamic banks (currently foreign investors cannot own more than 40 percent of local Islamic banks) and promote new sharia-compliant financial tools in a bid to make the country's Islamic finance industry more attractive to foreign investors and Indonesian companies (in April 2015 Indonesia’s national sharia board approved sharia-compliant currency hedging tools and a standard contract template for sharia-compliant repurchase agreements, which allows the use of government-issued sukuk as collateral, was launched by Islamic banks in Indonesia).

The target of Indonesian authorities to raise the market share of Islamic finance to (at least) 15 percent of the country's total banking assets by 2023 is considered a too ambitious target by analysts who say it will require substantial reform in the country's Islamic banking industry for the target to be achieved.

The Indonesian government plans to issue about IDR 13.7 trillion (approx. USD $1.4 billion) worth of Islamic bonds (known as sukuk) in 2016, nearly double the amount of sharia-compliant sovereign debt paper in 2015. Proceeds will be used to finance infrastructure development (such as roads, ports, power plants, rail lines, bridges and Islamic universities). Demand for Islamic bonds may be stronger than demand for their conventional counterparts as sukuk usually offers a yield advantage (with a relatively identical risk). Indonesian sukuk is also less volatile compared to conventional bonds as investors tend to hold sukuk until the maturity date.

Indonesia also announced to be co-founder (together with Turkey and Saudi-based Islamic Development Bank) of the Islamic Investment Infrastructure Bank (IIIB), a new cross-border Islamic infrastructure bank that is to start operations in the second half of 2015. Indonesia contributes over USD $300 million for start-up capital of the new bank which aims to boost infrastructure development in various countries.

What Blocks More Rapid Development of Indonesia's Islamic Finance Industry?

One key problem in Indonesia’s banking sector (not only confined to the Islamic banking sector) is the low financial literacy of the Indonesian population, hence (general) banking penetration remains at a relatively low level. Based on data from the World Bank, only 36.1 percent of Indonesia’s adult population owned a bank account in 2014.

Another obstacle is that Islamic banks or banking units are unevenly distributed across Indonesia. Most of these banks are located on Java, the most populous island of Indonesia. In the less populous eastern parts of Indonesia most people lack access to Islamic banking services. However, it also needs to be emphasized that conventional banking services are also scarce in the eastern part ("under-banked") and it also has to be noted that there are much fewer Muslims in the eastern region (both in absolute and relative terms) although adhering to a different religion does not mean that a person cannot use Islamic banking services.

Islamic banking in Indonesia has also had difficulty to expand due to weak government management (a lack of ministerial-level coordination), an uncertain legal environment and the lack of highly qualified human capital, innovation and creativity in the country.

Updated on 6 November 2015