Islamic Microfinance in Indonesia

Indonesia, the largest Muslim country, has a highly differentiated micro- and rural finance sector which has evolved over more than a century. Islamic finance has emerged in 1991, comprising Islamic commercial banks and banking units, rural banks, and financial cooperatives. In this study the authors deal with the emerging Islamic microfinance sector in Indonesia, particularly rural banks and financial cooperatives: how they have evolved, how they compare with conventional institutions, and what their prospects for growth are. Islamic finance, after 13 years, accounts for a mere 0.74% of total assets of the banking sector. However, since Bank Indonesia gave official recognition in 1998 to a dual banking system, conventional and Islamic, interest in Islamic meso and macro finance has spread among commercial banks, fuelled by low rates of non-performing loans, and the share of Islamic commercial banks more than quadrupled during 2001-2003: from 0.17% to 0.74%.

Islamic rural banks (BPRS) are under the same effective prudential regulation and supervision as commercial banks and conventional rural banks (BPR). After a promising start in the early 1990s, their development has almost come to a standstill. Despite the fact that they had only two years less than conventional BPR, they have attained a mere 4% of the number and 1.5% of the assets of the rural banking sector. Islamic financial cooperatives (BMT) suffer from the same regulatory and supervisory neglect as the rest of the sector. After a period of rapid growth during most of the 1990s, they are now in decline, with perhaps not more than one-fifth in good health. Fresh money pumped into the sector without effective regulation and supervision will contribute to their downfall, as has been the case in the state-supported cooperative sector.

So Islamic microfinance, lacking popular demand and Islamic banking expertise, is not off to a promising start in Indonesia. Only commercial banks appear to be able of acquiring the art of Islamic banking by training young and dynamic people, but lack experience in Islamic microfinance. Islamic, unlike conventional, rural banks, have failed to prove themselves as effective and efficient providers of microfinance services; Islamic, like conventional, cooperatives are an outright menace to their shareholders and depositors, who risk loosing their money. On the basis of 13 years of experience with Islamic finance in Indonesia, decision-makers in favour of promoting Islamic financial services are now confronted with two major options:

  • Focusing fully on Islamic commercial banks in Indonesia and assisting them to establish branch networks with Islamic microfinance products.
  • Re-assessing in a participatory process the challenges and realistic opportunities of Islamic rural banks and cooperatives, taking into consideration the lack of broad popular demand, be it from poor or non-poor, and the lack of dynamic growth.

The authors conclude by recommending decision-makers in Islamic organizations, government agencies and donor organizations to cautiously examine the following opportunities for the development of a healthy Islamic financial sector in Indonesia:

  1. Encourage Islamic commercial banks, in setting up branch networks of Islamic MFIs, to learn from the rich experience of successful microfinance strategies and institutions within Indonesia, particularly the BRI Microbanking Division, one of the most successful microfinance programs in the developing world.
  2. Revamp the Islamic rural banks or they will play only a marginal role in Indonesia. This will require an overall development plan for the BPRS sector mutually agreed upon by all stakeholders and a strong banking association to provide a full range.

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