Indonesia's central bank has recently embraced new regulations for Islamic banking, which it sees as key to building on last year's strong economic growth. In a country that is home to more than 200 million Muslims, the potential for expansion is enormous, although Islamic finance still accounts for a small part of the country's financial market.
Over the past six years Islamic banking has averaged 36 percent annual growth in Indonesia. But its $7 billion in assets makes up only 2.5 percent of the country's total banking sector.
Banking analysts say unclear regulations on banking that conforms to Islamic law and pervasive corruption have kept investors away from Indonesia.
The central bank, Bank Indonesia, wants that to change. It has drafted a blueprint that includes expanding Islamic lending to small and medium-sized enterprises, scrapping a tax law that imposes extra costs on Islamic banking transactions and improving risk management.
Under Islamic, or Sharia, law, charging or paying interest is banned, as are investment in businesses that Islam finds unacceptable, such as liquor companies.
Some financial experts say Islamic banking principles, which limit the use of sophisticated derivatives and require transactions to be backed by real assets, could prevent the excessive leverage that undermined the global financial system two years ago.
Bank Indonesia senior bank researcher Dadang Muljawan says those characteristics helped convince the government to develop its dual-banking system. "The Islamic bank can survive very well the economic crisis. This is maybe what has been seen by the Indonesian government as an opportunity …. If we have two systems that can work together and then if one goes bust - I hope not - the other one can sustain," he says.
That does not negate the need for better supervision. The system still requires proper supervision. "Jokingly we sometimes say that we can't say Islamic banks are too holy to fail … it's not the magic word," he says.
Bank Indonesia expects more banks to enter the Islamic market after April, when the new tax law takes effect. Research head Dhani Gunawan says the central bank also hopes to draw in foreign investors to increase the funds available for infrastructure projects and for small and medium-sized businesses. "Islamic banks are focused on small and micro-financing, more close(ly) with real sector financing, so it will support the economy," he says.
If Indonesia is to meet the central bank's goal of seeing Islamic banking account for 10 percent of the market by 2015, it will have to look for high-profile investors, especially in China and the Middle East.
But Dadang says Islamic banks in the country need to focus on the small customers. "We have to also give sufficient attention to micro-finance. Why? Because well, maybe 40 percent of the Indonesian community will still need financial services - capital, bank financing. Most of them are still unbankable (can not access banks), they have the potential to produce something, but they need capital for them to be more efficient, to start a business," he says.
This is where domestic banks can help. B.S. Kusmuljono is a bank executive and chairman of the national committee for microfinance empowerment. He wants to expand an existing system that extends up to $500 in credit to small entrepreneurs, mostly farmers looking to develop their production. "Our aim now is to eradicate poverty and to train as many people as possible to be entrepreneurs. That means the borrower should have a capacity building process. He has to be educated to be a businessman," he says.
But that requires training and added oversight to monitor lending to more than 40 million business owners. Kusmuljono says that may be part of the reason Indonesia has not seen more growth in Islamic finance. "We see that the development is not what we expected 10 years ago. We thought it would grow rapidly. But we are optimistic that the Sharia banking will take an important role because most of the banks in Indonesia have a Sharia affiliate," he says.
Many conventional banks in Indonesia have opened Islamic banking units, as a way to enter the market.
For now, the focus will remain on building small and medium-sized businesses in the financial sector. But there is hope that improved regulations and new government measures could see Indonesia grab a bigger slice of what the central bank says is a $900 billion global market for Islamic banking.