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Sunday, 27 July 2008

The future of rapidly-growing sharia banking in Indonesia

Source: Jakarta Post
by Elvira Tjandrawinata and Dimas Angga Negoro
, Analysts
Sharia banking is gaining popularity in many parts of the world. The key driver of the growth has been the increasing wealth in the oil-rich countries in the Middle East.
But what exactly is meant by sharia banking? And what are its prospects in Indonesia?
Well, in a nutshell, sharia banking simply adopts the principals of sharia law. Payments and receipts of interest are not permitted. Instead, returns on funds that are lent out must be based on the actual profits generated and not on pre-set interest rates.
The provider of capital and the user of capital will equally share the risk of business ventures. In short, the depositor, the bank and the borrower should all share the risks and the rewards of financing business.
Another key point is that investments should only support practices or products that are not forbidden or even discouraged by Islam. Financing cannot be provided to businesses engaged in alcoholic beverages, for example.
The major difference between a conventional bank and a sharia bank is on the liabilities side (i.e. the deposits taken by the bank). This is because of the presence of unrestrictive accounts, including mudharabah savings and time deposit accounts, since under the mudharabah contract, funds placed in these accounts are deemed to be investments and therefore there are no guarantees on either the principal or the return.
As such, returns are dependent on the profits of the banks' debtors under a profit-sharing scheme. However, in practice, the principal (up to Rp 100 million) is guaranteed by the Deposit Insurance Agency (as is the case for conventional banks).
On the assets side (i.e. the financing provided by the bank), there are basically two types of financing: trade-like accounts and profit sharing accounts. The key contracts are murabahah, mudharabah, and musyarakah.
Murabahah basically uses a "mark up" sale mechanism. Based on the "interest-free" principle, the bank changes the transaction from a purely monetary transaction into a trade-like one.
The sharing principle applies to mudharabah and musyarakah contracts. The significant difference between these two contracts is that under musyarakah, the borrower also agrees to put some of its capital at risk.
Admittedly, sharia banking is still small relative to the size of the Indonesian banking sector as a whole. Yet growth in recent years has been strong (the industry's assets have grown a brisk 29 percent per annum over the last 3 years), with sharia banking proving to have been much more resilient to the financial crisis that erupted in 1997 than commercial banking was.
Indeed, one of the attractions of sharia banking is that it is based on risk-sharing rather than on pre-determined interest rates. It is then naturally more resilient during hard times.
Against this backdrop, the central bank appears keen to promote further expansion of sharia banking in Indonesia. It hopes the sharia banking business shall account for as much as 5 percent of the banking industry's assets by the end of 2008. It has its reasons.
First of all, despite being the world's most populous Muslim country, Indonesia's sharia banking sector is still far behind that of its smaller neighbor Malaysia (in Malaysia, sharia assets already total some US$62 billion).
Second, more and more companies from the Middle East are now keen to invest in Indonesia.
And third, regulations are supportive. The presence of many SOE sharia banks in Indonesia is testament to the commitment of the government that has just issued a regulation on sharia government bonds (sukuk).
All is not plain sailing, however, and some issues still need to be addressed.
First is the need for greater public awareness of sharia banking. But, sharia banks are relatively small in size, and therefore have limited capability to launch marketing campaigns. The government and the central bank will therefore need to take a role in the campaigns.
Second, the industry is relatively new here. This means that policies and procedures are still evolving. There may also be a lack of talented staff and expertise in the business.
Moreover, since most of the shariah banks' assets are dominated by murabahah contracts -- which are similar to a sale and lease back transaction -- the issue of double taxation surfaces. However, this should be resolved when a regulation on sharia banking is eventually issued.
Still, many conventional banks are keen to enter the sharia banking industry given its strong growth potential. Some banks have opted to acquire a small bank and then convert it into a sharia business unit. This was the strategy adopted by Bank Rakyat Indonesia (BRI) when it acquired Bank Jasa Arta for example.
Three banks -- Bank Mandiri, BNI and Niaga -- are particularly well placed to enjoy the rapid growth within the sharia banking industry.
Their sharia businesses have significant market share. Whether they will remain the dominant players remains to be seen. But one thing seems clear: the prospects for sharia banking are bright indeed.
The writers are economists at Danareksa Sekuritas
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