Reform is a work in progress

In the aftermath of the Asian financial crisis of the late 1990s the Indonesian economy was all but devastated, posting a 13.4% decline in gross domestic product (GDP) in 1998. Fast-forward 11 years and Indonesia looks, if not smug, then decidedly comfortable. Now south-east Asia's largest economy, Indonesia entered the global financial crisis from a position of swelling economic strength, which has shielded the country's banking sector from the recent crisis. If Indonesia's burgeoning banks are to effectively support the country's much-anticipated economic explosion during the next decade, however, consolidation will be required. Fortunately, regulatory developments and an influx of foreign investment are helping to pave the way for structural reform.

Although a weakening of commodity flows, a sudden and dramatic outflow of foreign equity investors and a 40% depreciation of the rupiah conspired to trigger a rise in Indonesia's sovereign spread at the end of last year, the country has since rebounded at lightning speed. Indeed, Indonesia is one of a handful of Asian economies that have continued to post economic growth throughout the global financial slump. Following GDP growth of 6.1% for 2008, the country's economic expansion is expected to fall to a respectable 4% for 2009, rising slightly thereafter to a solid 4.8% in 2010. While this represents a substantial decline in performance compared with previous years, it still puts Indonesia just behind its closest regional peers, China and India, to become the third-fastest growing economy in the G-20, according to the IMF. The country's rate of inflation continues its deceleration from a high of 11.1% in December 2008, falling to a 10-year low of 2.7% in July 2009 and stabilising at about 5% for 2010, according to IMF predictions.

Robust economic growth has seen the country's banking sector, which was badly shipwrecked by the stormy seas of the Asian financial crisis, sail through the global economic slump with relatively little difficulty. The banking system BIS ratio stands at a robust average of 18%, while non-performing loans have experienced a very marginal rise, reaching 4.06% in April this year, according to Moody's. "The banking industry came into the crisis in relatively decent shape: Indonesia learnt the lessons of the 1997 crisis well and it was not exposed to subprime issues," says David Fletcher, CEO of Permata Bank, a top 10 local lender by assets.

Lending, which grew at an annual compound rate of 24% between 2005 and 2008, has declined dramatically however, falling to 2.1% for the first half of 2009. But according to Standard Chartered Bank Indonesia, this figure is likely to soon rebound in line with the global recovery. All in all, Indonesia's banking sector has stood firm in the face of the global crisis, with only one bank nationalised and another liquidated. But in a flabby and inefficient sector of some 123 banks, it seems the crisis has, at least in one respect, been wasted.

Consolidation incentives

The Indonesian government has long sought to bring about much-needed consolidation in the over-bloated banking sector, in which the top 10 lenders control some 60% of assets. There are a further 113 poorly capitalised commercial banks lingering on the periphery. Under Bank Indonesia's overarching banking architecture plan (the API), which was first introduced in 2004, the government introduced new, higher capital tiers for banks wishing to operate internationally, nationally or regionally in a move designed to bring about major consolidation before 2013. "It wants to have stronger banks that have a clear focus on what they are doing," says Edmund Tondobala, deputy division head for international banking at Bank Central Asia (BCA), Indonesia's second largest lender. "Do what you do best", is the central bank's message, he adds. But the government is "dragging its feet" and has failed to force recapitalisations, says Cliff Rees, financial services leader for PricewaterhouseCoopers, Indonesia. "The regulators are not as forceful as they should be," he adds.

If the capital rules have yet to galvanize the industry into action, however, Bank Indonesia's single presence policy, which was outlined in October 2006, promises to be more successful in bringing about significant structural change. The rule, which becomes effective next year, prohibits a controlling shareholder from owning more than one bank, leaving common stakeholders with three options: divest a bank, merge their banks, or establish a holding company to house their banks.

The policy has already forced the marriage of several major players, including the November 2008 merger of Bank Niaga with Bank Lippo, both of which were majority owned by Khazanah Nasional Berhad of Malaysia, to form CIMB Niaga. Temasek Holdings of Singapore, meanwhile, was forced to sell Bank Internasional Indonesia to Maybank of Malaysia early last year rather than force a merger with Bank Danamon Indonesia, its other major shareholding. These banks acted fast to satisfy the impending regulation, says Mr Rees, with some positive results for the sector. "The CIMB Niaga merger was massive: a merger of equals but with different markets that has created quite a strong bank with a fantastic customer base. That's something to watch."

More private-sector mergers are expected under the rule change, in what will provide a welcome fillip to consolidation. But the new policy leaves a question mark lingering over the condition of the remaining four state-owned banks, says Haru Koesmahargyo, head of investor relations at Bank Rakyat Indonesia (BRI), a state-owned lender that focuses on the rural micromarket and SME sector. The other three state-owned institutions, which together control about 25% of system assets according to Moody's, include export financing specialist Bank Negara Indonesia (BNI), Bank Tabungan Negara (BTN), which focuses on home loans, and the ambitious corporate giant Bank Mandiri. "Now the issue is, should they be one bank or not? It is difficult as each has quite a specific market focus," says Mr Koesmahargyo.

The Indonesian government plans to place the banks under a holding company but details on the arrangement are unclear. Mr Rees believes further consolidation in the state sector is already overdue. "There are probably one too many banks in that sector," he says. The best fit for a merger, he adds, would be Bank Mandiri and BNI, since the latter's strategy is not as well-differentiated, he adds.

Rakesh Bhatia, CEO of HSBC Indonesia

Foreign influx

But Bank Mandiri may not get the chance as many foreign banks are now jostling to scoop up Indonesian lenders. Burdened with an enormous holding of banking assets acquired during the Asian financial crisis, the Indonesian government has been forced to adopt a very liberal stance to foreign investment in the sector. Throughout the seven-year divestment programme, a slew of foreign banks have seized the opportunity to gain a foothold in the emerging economic powerhouse. In fact, every single deal has been with a foreign strategic shareholder, who can acquire a maximum 99% shareholding. Despite only four state-owned banks now remaining, however, the influx of foreign money has proved strong during the past year, which brought some transformative deals.

Late last October, HSBC acquired small and medium-sized enterprises (SME) lender Bank Ekonomi Raharja in a deal that has doubled its presence in the country. Barclays also moved to beef up its Indonesian retail business, completing the acquisition of Jakarta-based Bank Akita in February this year. Of the country's 123 commercial banks, 10 are majority foreign-owned and 28 are foreign joint-venture banks, with 60% of the top 10 banks foreign-owned, according to Moody's. This October, meanwhile, brought further news that Malaysia's RHB Capital plans to buy a controlling stake in Bank Mestika Dharma, while both State Bank of India (SBI) and Punjab National Bank are reportedly eyeing acquisitions in the country which is already home to Bank SBI Indonesia.

Aggressive moves

Australia's ANZ has also expanded its presence in the country, through the October purchase of Royal Bank of Scotland's Indonesian retail and wealth management assets via its local subsidiary, Panin Bank. The Australian bank plans to be "aggressive" going forward, says Mr Rees, with an ambitious programme to become the country's fourth largest lender by 2012. As such, Indonesia is regarded by many regional Asian lenders, in particular Malaysian and Singaporean banks, as a strategic location for further regional expansion. Mr Rees believes Singapore's OCBC, in particular, is poised to play a transformative role in the marketplace. "OCBC is another aggressive SME bank going places and it has a fantastic community strategy around the SMEs, providing all sorts of products to that up-and-coming sector," he says.

Foreign investors are attracted to Indonesia for the very macroeconomic fundamentals that have helped it withstand the global slump. The fact that Indonesia's economic output is poised to outstrip Japan by 2024 is not lost on banking chiefs globally. Nor is the sector's relative under-development compared with regional neighbours. Loans, for example, still represent only 26% of GDP, putting the country well behind India, the Philippines and even Thailand, whose population is a quarter of the size of Indonesia's.

Product diversity remains limited, while the country offers two lucrative developing markets: home to the world's largest Muslim population, Indonesia presents expanding opportunities in Islamic finance. Haryanto Budiman, an executive vice-president at Bank Mandiri, says the bank has had to repeatedly fend off advances from Middle East-based investors who want to acquire a stake in the bank's highly profitable subsidiary, Syariah Mandiri. Bank Indonesia estimates that sharia system assets will grow by 38% between summer 2009 and year-end 2010 alone.

Microfinance and microbusiness lending are also thriving high-yield markets, to say nothing of the country's 26 million-strong and rising affluent middle-class who increasingly require credit cards and auto loans. With fat interest margins typically averaging 5%, Indonesian banks also make excellent profits on their net interest income. "In almost every segment that banks operate in there is growth: the 10-year horizon holds a lot of promise and potential," says Rakesh Bhatia, CEO of HSBC Indonesia, whose recent acquisition will allow it to compete in a range of consumer segments.

Despite the recent influx of international investment, however, foreign banks still only hold a relatively small 14% of system assets as of April 2009 - although this is growing rapidly. This means there is still plenty of room for more foreign players, says Simon Morris, chairman of the Foreign Banks Association of Indonesia. "The opportunity to develop sustainable, good business exists broadly speaking in most areas of banking," says Mr Morris. "One of the aspects of doing business in Indonesia is that the reality is generally better than the perception."

Lack of control

Not everyone appreciates the compliment, however. Local bankers complain that the Indonesian market is far too liberal where foreign investment is concerned, and that this has been exacerbated by the failure under the API plan to introduce tiered licences, in line with the tiered capital requirements. Wayan Agus Mertayasa, deputy president director of Bank Mandiri, objects to foreign banks gaining full licences through the acquisition of a tiny rural lender. He and other bankers are also alarmed that many foreign banks, such as HSBC and Barclays, are straying into consumer territory rather than specialising in what Mr Mertayasa describes as "productive lending", that is, the wholesale banking activities in which local banks have less expertise.

"What we worry about is that we should own the market," says BRI's Mr Koesmahargyo. "Foreign banks are part of the market that we do not have the expertise to serve. Unfortunately, a lot of the foreign investors are penetrating the consumer market: this is a wake-up alarm for local banks." Fear of foreign ownership has led some bankers to suggest lowering the cap on shareholdings, a prospect that Mr Morris, who is also the CEO of Standard Chartered Bank Indonesia, does not rule out. "You do occasionally get thoughts given to more protectionist measures, but the authorities in Indonesia tend to be quite professional about these things. It's not beyond the realms of possibility that we see some tightening - as to what shape that will take only time will tell."

Tight leash

The issue might be less contentious were local banks afforded the same ease of access to nearby regional markets, but neighbouring regulators are proving more restrictive, says Bank Mandiri's Mr Budiman. Under the API structure, top banks such as Bank Mandiri and BCA should already be internationalised, he continues, but the government provides neither incentives nor assistance in realising this goal. "What do you get if you are an international bank: do you get easier access if you want to expand? Will they pressurise the foreign regulators to grant licences and provide you with support if you want to open branches overseas?" he asks. "This needs to be defined."

BCA meanwhile, regarded as the local bank most capable of expanding abroad, has no ambitions in this respect, and plans instead to expand its domestic reach. "We want to be a dominant player domestically because the [domestic] market is still large," says BCA's Mr Tondobala. The costs involved in expanding regionally are not practical, he adds.

HSBC's Mr Bhatia believes the API has provided a useful guiding principle for the industry, but it may now be time to re-examine it. "Every government or regulator is evaluating what should be the shape, size, direction of its own banking industry. Whether every part of the architecture is fully applicable and whether there should be a modification in some aspects - it is a good time to evaluate that," he says.

Bank Indonesia has indicated that a revision will take place. In the meantime, however, the country can expect foreign advances, as much as home-grown regulation, to bring about the industry's long-awaited consolidation.