Indonesia’s financial sector: A half-full glass
Published by Strategic Review.
In 1997-1998, Indonesia faced one of the most costly financial crises in recent history, as nearly its entire banking sector collapsed. This cost the government a staggering 50 percent of GDP – one of the highest fiscal costs paid so far by any country in history. The crisis ended a nearly 25-year span of continuous economic growth averaging more than 7 percent in real terms annually, which had helped to lift millions of Indonesians out of poverty. It hit Indonesia’s poorest citizens hard, causing poverty to jump from 17.7 percent in 1996 to 24.2 in 1998. It took another 10 years before Indonesia managed to reduce poverty levels consistently below that 1996 level. The crisis exposed weaknesses in governance and regulation, corruption and politically connected business relationships that had led to the collapse of the banking sector.
In the 14 years since, however, Indonesia’s banking sector has made a remarkable recovery. The sector’s performance has been strong, with high profitability and continued growth. Furthermore, the banking sector has achieved markedly increased stability and become more resilient to crises. The banking system went through a huge consolidation, from 236 to 128 banks. An independent central bank was put in place and regulation and supervision were substantially improved. All banks taken over during the crisis were sold back to the private sector. The role of state-owned banks, while still large at about one-third of all assets, went through a near monotonic decline.
More recently, the global financial crisis in 2008 tested the system, and Indonesia came out relatively unscathed with only a marginal and short-term impact on the banking sector. The Indonesian authorities acted decisively by implementing a wide range of measures to ease the global liquidity crunch and provide a stimulus to the economy. As a result of these measures, together with the inherent strength of the Indonesian economy at that time, the economy expanded by 4.5 percent in 2009, the third-fastest rate among the G20 economies. Also reflecting Indonesia’s strong fundamentals, in late 2011 and early 2012 key credit rating agencies upgraded the country’s sovereign rating to investment grade and its sovereign outlook to positive. These achievements were the result of a remarkable combination of sound macro policies, improved supervision and regulation, prudent banking and the authorities’ quick and timely responses to financial stress.
However, despite these achievements in the banking sector, Indonesia’s financial sector reform glass is still only half full. Although stability in the financial sector has been largely achieved, there are several other areas in the broader financial sector where a great deal still remains to be done, and progress on reform has been slow. Weaknesses exist that have the potential to destabilize the sector and damage the real economy. Specifically, diversification of the financial sector is low. The financial sector is still highly concentrated, with the banking sector dominating. Within the banking system, the top three state-owned commercial banks account for one-third of all banking sector assets and deposits, while the top 15 banks account for about 70 percent. Meanwhile, Indonesia’s capital markets remain small, which constitutes a missed opportunity to diversify the source of funding for the financial sector and provide long-term investment opportunities. The role played by pensions, insurance and other nonbanking financial institutions is also minimal for a country of Indonesia’s size and middle-income country status.
The challenge of improving financial sector intermediation also remains, and Indonesia continues to lag behind comparable countries in terms of depth and contribution of its financial sector to the real economy. While the Indonesian banking sector may be one of the most profitable in the Asian region, it provides a relatively low level of intermediation in terms of credit-to-GDP or loan-to-deposit ratios. Spreads and net interest margins remain high – and are higher than most of its peers.
Despite its overall growth, financial inclusion also remains a major challenge in Indonesia. Less than half of all Indonesians have access to formal financial sector services and less than 20 percent have ever borrowed from a bank. Meanwhile, access to risk management tools such as pensions and insurance (in particular for the poor) is extremely small. Findings from recent surveys underline the importance of expanding the ability of financial institutions to offer savings and credit services to a much wider range of customers, especially among the poor. The failure to provide more households and small and medium enterprises (SMEs) with financial services can only act as a brake on development. Therefore, sound financial sector policies that encourage competition and provide the right incentives for institutions and individuals to overcome barriers to access are central to growth, poverty reduction and a more equitable distribution of resources and capacities in Indonesia. The task falls to financial sector policymakers and the private sector to provide innovative solutions to ensure that financial exclusion in Indonesia becomes a thing of the past.
Building a diverse and inclusive financial system that provides a level of intermediation appropriate to Indonesia’s needs in the future will require more coordination across institutions than ever before, and also require a shared vision among respective agencies and officials. Typically, parts of government that have not traditionally worked together will now need to work together to lay out strategies and achieve diversification and inclusiveness goals. This will be Indonesia’s foremost challenge going forward. Since the Asian Financial Crisis, significant progress has been made in reforms that can be undertaken by a single institution or agency. However, reforms that involve interagency coordination remain challenging. This issue faces Indonesia not just in the financial sector, but also across a range of development issues and, unfortunately, it continues to be vexing. Only by addressing this next set of complex financial sector development challenges – increasing intermediation, diversification and inclusion – while also maintaining and improving the sector’s stability, will Indonesia’s financial sector offer the right kinds of products and services to support the country’s ambitions of becoming a high-income country by 2025.
Indonesia needs a strong financial sector
A substantial body of research has established that financial sector development is critical for economic growth, and that the size of the banking sector, as well as the size and liquidity of the stock market, has been shown to be highly correlated with subsequent growth of gross domestic product (GDP) per capita. There is also evidence that financial sector development causes economic growth. Linkages between economic growth and poverty reduction are also well established, as are the linkages between financial sector development and poverty reduction. The significant adverse impacts on growth and poverty reduction caused by financial crises over the years, including the Global Financial Crisis in 2008-2009 and the ongoing crisis in Europe, further illustrate the importance of a well-functioning financial sector for the Indonesian economy.
Historical reasons also underlie Indonesia’s need for a strong financial sector. The financial crisis of 1997-1998 clearly illustrated the need for (and at that time the lack of) a robust financial sector: Indonesia experienced one of the most costly financial crises in history both in terms of fiscal costs and poverty impact. The fiscal cost of the crisis in Indonesia was one of the highest in any country suffering a crisis in terms of percentage of GDP, costing nearly 50 percent. Even Mexico’s major financial crisis of 1994 cost less than half that of Indonesia’s crisis as a fraction of GDP.
The 1997-1998 financial crisis also meant that Indonesia’s poorest citizens paid a heavy price. Having made steady progress in reducing the levels of poverty pre-crisis, the crisis caused the poverty rate to jump from 17.7 percent in 1996 to 24.2 percent in 1998. It took another 10 years before Indonesia managed to reduce poverty levels consistently below that 1996 level again – 10 years of consistent progress in fighting poverty that were lost in the wake of the 1997-1998 financial crisis.
Indonesia also paid a heavy price in terms of losing three decades of consistent progress in economic growth. It is one of only 12 other countries that have ever enjoyed a period of 25 years of sustained growth at an average annual rate of more than 7 percent. This success was suddenly and severely interrupted by the 1997-1998 crisis, as Indonesia shrank in terms of real GDP per capita by about 15 percent. However, it should also be added that the nation recovered far faster and by far more than many other developing countries that have undergone similar crises in the past. For example, Brazil, the Philippines and Russia all took longer to recover from their own political-economic crises of the 1980s and 1990s. Russia, for example, took 17 years to recover to its pre-crisis level, while Indonesia took less than nine years. Indeed, since the Asian crisis, Indonesia has experienced a decade of robust growth, trailing only China and India.
Looking ahead, Indonesia will require a strong and stable financial sector to meet its future development goals. The government has set forth an ambitious plan for development and poverty reduction that requires a substantially more diversified and inclusive financial sector. In particular, in the recently articulated master plan for development, the Acceleration and Expansion of Indonesia Economic Development, 2011-25 (MP3EI), the government is aiming for a massive level of investment in the real economy of more than Rp4,000 trillion (about $414 billion at current exchange rates). In addition to potential external sources of financing, such a large investment can only come from a strong domestic financial sector – one that must be equipped and able to support such a huge level of investment.
Investment is also important, not just in terms of infrastructure but also in terms of creating jobs. Indonesia is currently experiencing a so-called demographic dividend, in which the percentage of Indonesians of working age far outnumbers the percentage of dependants and the elderly. In order to garner the wealth-creating potential of these young workers for the benefit of the country, Indonesia needs investment to create millions of new jobs for the extra workers coming into the job market. Time is of the essence here: this is a one-off opportunity in Indonesia’s development cycle that will not be repeated, and the dependency ratio will start to increase (worsen) after about 2030. The workforce is estimated to grow by 20 million over the next 10 years, so the financial sector needs to be able to support the investment required to create 20 million additional jobs if this opportunity is to be realized. A well-functioning and diversified financial sector can help to support the creation of good jobs within the economy, and also help to ensure that workers are better protected from the risks threatening their income security.
Achievements and challenges
Indonesia’s financial sector authorities have made important strides during the past decade in improving financial sector stability. This remarkable success was demonstrated during the Global Financial Crisis (GFC) of 2008-2009, when the banking sector showed far greater resilience to stress and came through relatively unscathed. In fact, during and since the recent GFC, banking assets, loans, deposits and loan-to-deposit ratios have all continued to grow.
Pre-GFC trends in banking sector growth in Indonesia were barely interrupted, despite the GFC’s adverse impact on some of the world’s largest economies. This stability was in stark contrast to 1997-1998, when the Asian Financial Crisis exposed the Indonesian banking sector’s vulnerabilities and the system collapsed. This time around, the Indonesian banking sector’s nonperforming loans ratio remained largely unaffected, actually falling from 3.3 percent in 2009 to 2.2 percent as of June 2012. Again, this is in contrast to the wake of the 1997-1998 crisis, when the nonperforming loans ratio reached as high as 92 percent in 1999. Similarly, capital adequacy ratios, which crashed during the Asian Financial Crisis to as low as -15.7 percent, hardly changed at all in the wake of the GFC. Furthermore, banks’ operational costs, their return-on-equity, their return on assets and their net interest margins all maintained relatively stable levels throughout the crisis.
As outlined in a recent financial sector assessment by the International Monetary Fund and the World Bank, despite substantial progress Indonesia still faces challenges to preserve financial stability and further develop its financial system. Indonesia’s sovereign spreads, as well as the spreads in the banking system and bond markets, are higher than its peers. Long-standing structural issues, in particular perceived political risk, continued weak enforcement of the rule of law and limitations in the governance framework remain to be addressed. The absence of legal protection for financial sector regulators is a critical gap that invites public questioning of and political interference in supervisory actions, resulting in a slowdown in decision making and occasional paralysis of the prudential system. Efforts on the part of authorities to improve governance and the rule of law in Indonesia will help address these weaknesses.
As mentioned above, banking fundamentals have improved, with most Indonesian banks reporting high capital, comfortable levels of liquidity and solid profitability. However, some risks need to be closely monitored. First, banks exhibit rising credit exposures to retail and small and medium enterprises (SMEs). While the move into SME and retail lending helps diversify bank balance sheets, it may expose some banks to new risks in an environment where the quality of information is still low. Second, stress tests show that banks are vulnerable to credit risk and a few midsized banks to liquidity risk. A sharp rise in domestic prices could depress domestic demand, sour market sentiment and lead to capital outflows and exchange rate pressure. Further strengthening the soundness of large state-owned banks should be a priority. Third, moral suasion and prudential regulations aimed at promoting credit growth are often at odds with stability considerations. Targeting higher loan-to-deposit ratios or reducing risk weights of certain loans independent of the associated risks weakens banks’ balance sheets and system stability.
Oversight of the financial system has improved substantially of late. The recent move towards full compliance with statement of financial account standards (IAS 39) will help bring greater transparency to business accounting. Bank Indonesia, the country’s central bank, and the Financial Institutions Supervisory Agency (Bapepam-LK) have established supervisory frameworks and methodologies that generally meet international norms. They regulate financial institutions with vigilance and have consciously focused on strengthening their staff competency. This has earned them the respect and credibility of the financial community in Indonesia and the region.
Despite improvements, gaps remain in banking supervision. Legally mandated, prompt corrective action would speed up Bank Indonesia’s actions to resolve weak banks and make decisions more transparent. A financial sector safety net law needs to be passed to ensure decisive responses in times of crisis. Central bank governance could be improved through a simpler and more transparent process for selecting its senior management. There also needs to be more legal clarity on how and when Bank Indonesia should provide emergency liquidity assistance during times of crisis. Although the central bank has established supervisory frameworks and methodologies that meet international norms, it falls short in dealing with problem banks. The recent financial sector assessment also found that the absence of effective legal protection for supervisors is a serious shortcoming in the banking supervisory regime. Consequently, supervisors are hesitant to make supervisory judgments as they may face legal proceedings. This affects their ability to take timely remedial action against problem banks. Issues also exist with the definitions of Tier 1 capital of banks and with some asset classification and provisioning rules, and these should be further tightened. More effective arrangements for cooperation between various domestic supervisory authorities, as well as with foreign supervisors, should be put in place to help with consolidated supervision.
One additional area that needs attention in the banking sector is deposit insurance. The Deposit Insurance Agency (LPS) covers insured deposits and is responsible for resolving failed banks. In December 2008, the deposit coverage was raised from Rp100 million to Rp2 billion. With the twenty-fold increase in coverage, the fund’s resources to cover insured deposits have declined substantially, especially after LPS intervened in Bank Century in 2009. International experience has shown that when a deposit insurance fund is undercapitalized, there is a tendency to either bailout banks or keep them open – beyond what is economically appropriate. Increasing the deposit agency’s capital base and addressing issues surrounding it – are essential.
While banking sector stability has largely been achieved, there are clearly still a number of areas where authorities could further strengthen their preparedness for future financial crises. Just because Indonesia successfully negotiated the financial pitfalls of 2008-2009 does not necessarily mean that its financial sector is without weaknesses. Far from it. If anything, the ongoing financial market volatility and the euro zone crisis continue to make preparedness for financial sector crisis management a top priority and within the Indonesia context, a legally mandated crisis management protocol would prove to be a useful tool to help coordination in times of crisis.
In October 2011, the Indonesian House of Representatives passed a law establishing the Indonesian Financial Services Authority (OJK) to take over regulatory and supervisory functions in capital markets and non-bank financial institutions from Bapepam-LK at the end of 2012, followed by the transfer of Bank Indonesia’s responsibilities for the supervision and regulation of the banking sector at the end of 2013. International experience suggests that no one model of regulation is best. Both the United States, with its multiple supervisors, and the United Kingdom, with its single Financial Services Authority, have had their share of problems. The main issue is that any regulator must have the technical skills, authority and resources to regulate properly, and should have proper independence, accountability and governance. While the establishment of the OJK provides an opportunity for improved coordination in supervision across the financial sector, there are also risks involved in the transition that need to be carefully managed – even more so at a time of heightened global financial uncertainties. It is therefore vitally important to ensure there is legal and operational clarity of roles and responsibilities, and despite tensions and rivalries which such transitions often create, there is close cooperation between the OJK as it takes up its mandate, and Bapepam-LK and the central bank as they transfer their functions and responsibilities. In addition, in view of the ongoing global risks, Bank Indonesia must be extremely vigilant in its ongoing macro-prudential supervision functions and avoid any distractions caused by the transition.
Intermediation
Comparing Indonesian banks with their regional peers, it is clear that Indonesian banks are among the most profitable in the region, having higher net interest margin and returns on assets than all their regional peers, while overall capital adequacy ratios and Tier 1 capital are at levels similar to Singapore and Hong Kong banks. In essence, the picture of the Indonesian banking sector is one of solidity and profitability.
But despite their highly profitable businesses, how much do Indonesian banks actually support the real economy? As it turns out, Indonesian banks have lower levels of intermediation than other banks in the region. In terms of loans-to-GDP and deposits-to-GDP, Indonesia is well behind India, Thailand and the Philippines. Indonesia’s loan-to-deposit ratio is lower as well. Meanwhile, Indonesia’s real lending rates are higher than its regional peers. The combination of a banking system that is seen to be well capitalized and highly profitable, but at the same time providing low levels of intermediation, has often driven regulatory authorities to try to do whatever they can to “push lending.” They can do so either through explicit regulation, such as reserve ratio penalties for banks with low loan-to-deposit ratios, or moral suasion. Neither of these is a preferred policy instrument. The fundamental structural questions about weaknesses in the legal system and overall governance framework, concerns about creditor rights, corporate governance, and confidence in disclosed information that leads banks to focus on consumer and SME lending since large corporate borrowers often have the economic clout to challenge contracts, need to be addressed.
Weak contract enforcement, particularly for unsecured loans to large and connected borrowers, is a major problem. According to the World Bank’s Doing Business indicators for 2012, Indonesia ranks 156th globally in contract enforcement, significantly below regional peers such as Thailand (24), Malaysia (31) and the Philippines (112). Banks reflect this cost in higher lending rates, as the recovery rate on some problem unsecured loans is less than 15 percent. Comprehensive reform is required to improve the performance and credibility of the judicial system. The cost of registering a business in Indonesia is also high and the process cumbersome. Only 5 percent of companies are formally registered or licensed to trade. As a result, Indonesia ranks 155th globally in registration to start a business and 129th in the general category of ease of doing business, according to Doing Business 2012. Only listed and public companies fall under Bapepam-LK’s jurisdiction and must adhere to corporate governance requirements. As a result, banks have limited information on unlisted companies, making it difficult to identify related parties and adding to the cost of funds. More stringent accounting and auditing standards, along with an improved information system on debtors, would help ensure sound credit underwriting. Indonesia’s Bankruptcy Law is infrequently used for rehabilitation and is not a credible exit mechanism for inefficient and insolvent companies. Banks indicate that out-of-court negotiations and loan restructuring, although leading to less efficient outcomes, is preferred to court-supervised rehabilitation. It is essential to strengthen the insolvency regime and creditors’ rights.
Improving corporate governance has been a major policy concern in Indonesia since the 1997-1998 crisis exposed shortcomings in the country’s corporate governance framework. Concentrated ownership by large, family-controlled groups, combined with weak rules on related party transactions and other forms of self-dealing, resulted in significant minority shareholder expropriation. In response to the crisis, the government and private sector implemented a variety of reform measures. Bapepam-LK amended its regulations to better protect investors. Bank Indonesia introduced rules for corporate governance in banks. Regulatory requirements and private actions have improved board professionalism and company disclosure. However, some elements of international good practice are not yet fully implemented. One significant weakness is a lack of reporting of ultimate ownership and control, which limits the effectiveness of rules on conflicts of interest. Courts are slow, and few lawsuits have been filed against companies or board members. The coverage of the central bank’s Credit Information Bureau could be improved and expanded. The submission of data is mandatory only for commercial banks and big rural banks. A wider range of institutions, including nonbank financial institutions and public utilities, should be required to contribute positive and negative data on debtors. All of these areas need strengthening as part of efforts to improve the efficiency of intermediation.
Convergence of local accounting and auditing requirements with internationally accepted standards has also been slow, and significant capacity challenges exist in the institutions responsible. The absence of an appropriate legal framework for institutional set-up and development of the accounting and auditing standards, and governing of the profession needs to be rectified. There have been improvements in the institutional framework of corporate financial reporting in Indonesia during the past 10 years, but more needs to be done. Areas of concern among market players include consistency of accounting policies and practices from one period to another, comparability of financial information from one entity to another in a similar business or sector, accounting for financial instruments, related party transactions and employee benefits.
Diversification
Indonesia’s financial sector more than quadrupled in size in nominal terms from 2000 to 2011. This period was also accompanied by significant reforms in a number of areas in the financial sector. Despite this, the level of diversification in the sector is still very low, with the banks playing a highly dominant role to the exclusion of other players such as finance companies, pension funds, mutual funds and insurance companies, which together account for only 20 percent of the sector. Despite growth in the overall financial system, the relative shares of different types of institutions in the sector have hardly changed, and the basic structure of the sector remains much the same as in the wake of the 1997-1998 Asian crisis. The challenge going forward is to make it less bank-focused and more diversified.
A well-diversified financial sector, with sound banks, capital markets as well as nonbank financial institutions (NBFIs), is key to supporting the government’s articulated development objectives of increased economic growth, greater job creation and higher living standards. Banks, capital markets and NBFIs are key elements of a healthy and stable financial system, complementing each other and offering synergies. Well-developed capital markets and NBFIs can play a major role in achieving Indonesia’s development goals and would enhance the stability of the country’s financial system. Capital markets and NBFIs have the potential to unlock long-term domestic resources for investment in sectors critical to growth such as infrastructure, and increase access to low-cost financial services. In line with the priorities of the Indonesian government in moving towards a higher-income country status, strengthening capital markets and NBFIs is now an urgent policy imperative. A discussion on capital markets and the insurance sector follows below.
Capital markets
Indonesia’s capital markets are currently not a major source of funding or a significant vehicle for long-term investment. Reluctance by some of the largest companies in Indonesia to publicly list severely limits the range of liquid instruments available for investment. Further development of the capital markets is needed to facilitate market-based price discovery for the fixed income securities market, to diversify and manage risk, and to provide investors with alternative investment opportunities. Development strategies focus attention on increasing the domestic investor base, while foreigners continue to play an important role in Indonesia’s capital markets.
Some steps to develop Indonesia’s capital markets include strengthening investor confidence. Investor confidence can only improve if no single market stakeholder or group of stakeholders can unduly influence the functioning of the markets. Augmenting the Capital Market Law to provide the Indonesian Financial Services Authority with the necessary tools, including appropriate enforcement powers, is essential. Sanctions available to discipline market participants must be of sufficient magnitude to deter violations. Legal and accounting standards, currently not perceived favorably, are critical components of market integrity. Second, use the government’s debt issuance strategy to assist in the development of a more diverse and liquid corporate fixed-income market. The government can further promote capital market development through listing additional shares of state-owned enterprises (SOEs) on the stock market. This would expand the limited pool of instruments, privatize (partially or wholly) more SOEs, and encourage SOEs and regional governments to raise long-term funding through the issuance of fixed income securities.
Third, encourage private corporations to use domestic capital markets for their financing needs by addressing some of these impediments. Currently, many of Indonesia’s largest companies choose to raise capital either offshore or via retained earnings. Fourth, expand the institutional investor base by further promoting the insurance, pension and mutual fund industries. As Indonesia continues to grow, these institutions will play an increasingly important role requiring access to a variety of instruments of longer duration, as well as tools to effectively hedge their risks. Fifth, make Indonesia more competitive vis-à-vis other offshore financial centers such as Singapore by reducing taxes and transactions costs. Sixth, promote the development of capital markets through educational programs and professional training organized by self-regulatory organizations. Such programs would both improve the credibility of capital markets and make working in the sector more desirable.
Bapepam-LK has taken impressive steps to increase regulatory transparency and institute comprehensive operational programs that meet the norms of the International Organization of Securities Commissions. However, deficiencies in the legal structure, including the absence of a comprehensive and updated capital market law, make enforcement a challenge. Therefore, greater independence and a full commitment to better cooperation among domestic and international authorities should be accelerated. As it merges with the new financial services authority, Bapepam-LK should focus additional efforts on improving and intensifying its oversight programs, develop cooperation arrangements in writing to assure information sharing in their joint oversight of regulated entities, and take steps to combat market abuses. The move towards accounting oversight and practices in line with international standards should be expedited.
Insurance
Indonesia’s insurance market is also small relative to the size of its economy. Although assets have gone up quite dramatically since the end of the Asian financial crisis, from about Rp7 trillion in 1996 to about Rp482 trillion now, it still remains a very small segment of the overall financial system in Indonesia, at less than 10 percent. A substantial percentage of the funds that insurance companies hold, which are long term, are invested in short-term time deposits. These resources should instead be used to finance investment and longer-term growth.
The development of the insurance sector should be a priority, not least to diversify the institutional investor base. The insurance industry is under stress. Around 25 percent of all life insurance policies in Indonesia are held by a small number of financially troubled companies. Liquidity problems within the troubled companies could interrupt claims payments. The audited financial statements of these insurance companies do not reflect these deficits, raising further concerns about the possibility of undiscovered liabilities. Their financial problems need to be addressed immediately to avoid further deterioration. This will most likely require recapitalization or a reduction in benefits for policyholders. A government guarantee to current holders will likely be needed to avoid potentially sizable withdrawals of policies, and allow for an orderly restoration of the solvency of the large troubled companies. However, the guarantee should be contingent on a viable recovery plan for the companies and tight management control. Smaller companies need to be closely monitored, and there must be intervention if they are found to be noncompliant.
Tax incentives could be provided to encourage a shift to long-term saving products, while the served segment of the population could be expanded by promoting the development of micro and Shariah insurance. The use of catastrophe insurance should be studied, given Indonesia’s exposure to natural disasters. A policyholder protection fund should also be established along with capacity-building within both the industry and at Bapepam-LK. The number of qualified actuaries needs to increase, while the quality of accredited accountants needs to be enhanced. Membership in the International Association of Insurance Supervisors would help substantially as a source of information and professional exchange. Supervisory powers to intervene and resolve insolvent insurance companies are incomplete. The insurance law supports supervisory actions against insolvent companies with respect to admonitions and sanctions, licensing restrictions and license withdrawal, but does not provide the authority to take control of the company’s assets. This shortcoming leaves policyholders unprotected. A legal framework is needed to involve the supervisor in the unwinding of insurance companies and force timely corrective action.
Financial inclusion
The survey revealed that less than 50 percent of Indonesians use financial services (savings/credit) in the banking sector. This is better than China, Pakistan, Bangladesh and the Philippines, but worse than Sri Lanka, Thailand and Malaysia. In short, there is much room for improvement. Since the total population is about 240 million, roughly 115 million people lack access to the banking sector. While just over 30 percent of all Indonesians can still access informal financial services, about 17 percent can be considered financially excluded. Almost 40 percent of the poor can be considered financially excluded (Figure 4). Access to banking services is only 20 percent among the poor. According to the Indonesia Statistics Agency, there are 35 million Indonesians below the poverty line, which means that 28 million appear to lack access to banking services.
The single most important financial service identified by households in the survey was a bank savings account, with the reason for this being “security.” While most Indonesian households save both formally and informally, about one-third of households have no access to savings. This leaves a huge proportion of Indonesians extremely vulnerable to unexpected life events.
These findings also underscore the challenge to Indonesia’s formal financial system, especially the banks, of significantly expanding its client base to reach a larger portion of the population. The “truly financially excluded,” or those who have neither a savings account nor a loan, are predominantly poor, poorly educated, live in rural areas outside of Java and do not own nonfarm enterprises. Indonesians living outside Java are more than twice as likely not to have a bank account or a loan than those living there. Taken together, these findings underline the importance of expanding the ability of financial services institutions to offer savings and credit services to a much wider range of customers, especially among the poor, to avoid holding back development. This is why sound financial sector policies that encourage competition, provide the right incentives for individuals, and help to overcome barriers to access are crucial if Indonesia is to see growth, poverty reduction and a more equitable distribution of resources and capacities. The task falls to financial sector policymakers and the private sector to provide innovative solutions to ensure that financial exclusion in Indonesia becomes a thing of the past.
The Indonesian government developed a holistic National Strategy for Financial Inclusion that was unveiled in June 2011 at the inaugural ASEAN financial inclusion summit in Jakarta. This is an excellent starting point to push the agenda forward. From a public sector perspective, strengthening the existing legal and regulatory framework for various formal financial institutions is a good first step in aiding the process. For every important service provider, there are aspects of the regulatory framework that could be reformed for the sake of improving access, without compromising prudential safety. For commercial banks and telecom companies, the most promising simple, low-cost regulatory reform involves steps to create a conducive environment for mobile money, which holds considerable promise in terms of improving access to financial services.
Mobile money would reduce costs and extend reach, although in line with international experience, it is likely to initially focus on payments services and remittances. Bank Indonesia recently made regulatory advances, although much more is still possible. For instance, revised regulations now permit nonbank service providers to issue e-money but only for payment purposes. If nonbank service providers want to offer person-to- person services, they need a remittance license. At present, eligibility requirements are a significant barrier to entry. Simpler ways are available to accomplish the same regulatory purpose, without creating such barriers.
To deliver mobile money services cheaply, the economies of scale offered by a network of nonbank retail agents is vital. This would entail allowing banks and telecommunications companies the discretion to outsource services using a network of nonbank third parties, with the banks remaining responsible for their agents’ activities. For mobile banking to meet the needs of the “financially excluded,” there are also important “know your customer” issues to be addressed. For example, simplified requirements for low- risk, low-value accounts and transactions would enable the opening of bank accounts in isolated areas, allowing nonbank agents to facilitate the opening of new accounts.
Smaller regulatory changes involving commercial banks might also be helpful. For example, an official policy on dormant accounts might help reduce banks’ monthly administration fees. Policies to make it easier for banks to unilaterally close inactive, non-zero accounts could be developed, with institutional arrangements in place for the management of such accounts after they are closed. Bank Indonesia’s recent arrangement with major commercial banks to introduce basic banking services, following a proposed saving product called Tabunganku (“My Savings”) in early 2010, is also a step in the right direction. In the area of reporting requirements, annual business plans could be combined with the banks’ annual reports. Regulations concerning the relocation of branches and ATM machines are currently unnecessarily restrictive, with a reporting and approval process required even for minor relocations. Instead, the regulations should require general descriptions of the location of such facilities. It would also be useful to ease official regulations on the establishment of new branches, at least to bring them into line with the central bank’s relatively liberal interpretation of theoretically stringent regulations.
Important regulatory steps could be taken to improve the capacities of cooperatives, pawnshops and other microfinance institutions, and to ensure they are better able to provide increased access to financial services. With cooperatives, the most important issues appear to be prudential. These should be addressed on a sectorwide basis before any significant problems surface and potentially erode memberships’ existing access to financial services. Concurrently, there needs to be an upgrading of the regulatory and supervisory capacity of micro, small and medium enterprises (MSMEs). Measures to address this could include the temporary outsourcing of certain functions to firms specializing in microfinance.
With pawnshops, the state-owned monopoly could be opened up to competition from the private sector. At present, a number of private pawnshops are already offering services on the fringes of legality, so opening this sector would serve the double purpose of encouraging healthy competition and facilitating better regulation of unsupervised and unregulated private pawnshops. In parallel, there needs to be a discussion on the extent to which these institutions needs to be brought under a formal regulatory umbrella, keeping in mind international experience. With regard to other microfinance institutions, the most productive step is probably to restore momentum in drafting a new microfinance law. A vital part of this process would involve encouraging public debate on relevant issues. The new law should emphasize facilitation and access, taking into account emerging global experience regarding regulation and supervision of such institutions. In support, linkage programs between commercial banks and rural banks could be expanded to include non-bank microfinance institutions.
Micro, small and medium enterprises (MSMEs) and Indonesia’s large migrant worker force have special needs for access to financial services, which also needs to be addressed. While the nation has strived to develop policies to promote access to finance by MSMEs, there is general dissatisfaction with results to date, despite large expenditures by the government. This is largely because previous government programs focused on subsidized credit. In line with international experience, these subsidized credit programs have not been overwhelmingly successful. The government continues to make access to credit for MSMEs a major policy issue. As part of its endeavors in this regard, it has initiated the Kredit Usaha Rakyat program as a means to consolidate existing programs and put in place an integrated credit guarantee scheme to bring previously unbanked MSMEs into the formal banking sector. Ongoing assessments and modifications to this program will be essential to ensure it provides sustainable access to credit.
Issues related to migrant workers and their access to finance are also high on the government’s agenda. From an access perspective, this group should be of particular interest to financial institutions, given the large remittances workers send home. In several areas, to assist migrant workers, Indonesia could seek to renegotiate the terms of its agreements on migrant workers with recipient countries to better balance the interests of workers with those of employers and recruitment agencies. From the perspective of increasing access to financial services, specific points of negotiation could include a discussion of acceptable forms of identification and the exemption of small transfers from these formal identification requirements, keeping in mind global efforts to fight money laundering and terrorist financing. To convince banks of the commercial value of this market, the possibility of developing innovative public-private partnerships to bring greater segments of these workers into the formal financial sector should be explored.
Conclusion
Notwithstanding that financial sector stability has been largely achieved and an initial and crucial set of financial sector reforms have been carried out, Indonesia’s financial sector authorities are now faced with an even more challenging and far reaching policy agenda. It requires the nation to maintain its momentum and avoid resting on its recent success in passing safely through global financial turbulence.
However, to ensure that Indonesia’s financial sector proves a match for the continuing global financial volatility and also reforms its financial sector so that it can provide the massive support that the country needs to develop into a high-income nation in the next decade or two, a policy agenda is a requisite for continued success. The next level of reforms also requires coordination across agencies and involves bringing together and harnessing resources of a large number of partners. If financial sector reform continues to build on the success and stability achieved in the past decade in the ways discussed, and rises to the challenge that presents itself now, there is every chance that Indonesia can continue to move forward towards its goal of becoming a high-income country.
