The Imperative to Develop Indonesia’s Financial Sector

This article is originally published in The Jakarta Post on October 2024

Indonesia’s journey to high-income status hinges on developing a robust financial sector. However, the current state of the financial industry is a cause for concern. It is shallow, inefficient and plagued by governance issues, which is a stark contrast to the deep, efficient and well-functioning financial sectors of developed economies.

One key feature of a deep financial sector is the availability of long-term investment capital. To achieve this, participation in pension and insurance programs should be increased; at the same time, early withdrawals should be discouraged.

Some progress in enlarging pension and insurance participation has been seen recently. However, more public dissemination will be needed to overcome resistance.

Regarding efficiency, one key obstacle is the prevalence of high lending rates. This comes from high real interest rates (lending rate minus inflation rate) and wide banking margins (the difference between deposit and lending rates).

It is well known that banking margins in Indonesia are among the highest in the world. The upshot is inefficiencies and low competitiveness across the economy. Despite Indonesia’s recent low inflation, why are real interest rates still very high? The answer lies in the mandate of Bank Indonesia (BI) to stabilize the rupiah.

With a high global interest environment, the central bank must keep real interest high to stabilize the currency. What can alleviate the central bank’s burden? One key element is the repatriation of export proceeds. Doing so will increase foreign reserves, which has two effects: First, it will strengthen the rupiah; second, it will provide BI with ample ammunition to smooth any currency fluctuations.

To shrink banking margins, it is crucial to foster more competition in the banking sector. Despite the presence of over 100 commercial banks, Indonesia’s current banking landscape may not be conducive to healthy competition.

Large private banks, for instance, may refrain from reducing lending rates below those of state-owned banks to protect their margins. This lack of competition contributes to the sector’s high lending rates and inefficiencies.

Another example is that larger banks tend to shy away from high-risk clients. In other countries, lending to riskier borrowers carries higher rates and more stringent conditions. In Indonesia, high-risk borrowers do their business with smaller banks and as a result, the lending landscape is segmented.

Meanwhile, the lack of risk pricing leaves the banking sector fragmented, which means competition is limited. To increase competition, it is better to have fewer but larger banks.

The question is, why are there still so many banks in Indonesia? The answer is that there is a widespread belief that efforts to reduce the number of banks can raise systemic risk. This is the risk that an event at one bank could spread and destabilize the entire financial system.

And yet, we have seen several bank mergers and acquisitions recently that have hardly ruffled the system. It is therefore more likely that the potential benefits of reducing the number of banks outweigh the risks.

Strengthening consumer protection is a pivotal step in improving participation in the financial sector.

This has been a weak link in the financial industry, with recent insurance cases providing stark examples of client losses. Some of these losses are due to limited product knowledge, while others appear to be outright fraud. The primary cause of minimal recovery seems to be the protracted handling of these cases.

To address this, the Financial Services Authority (OJK) must be empowered with more investigative and regulatory powers to cease the operations of problematic entities.

At the same time, more forceful action is needed. OJK regulations should be fine-tuned so that consumer protection becomes the overriding objective. Other considerations, such as maintaining market confidence, should be secondary. More forceful action would deter wrongdoing and improve market confidence.

In addition, other measures essential to expanding the financial sector fall within the rubric of operational efficiency. One is reducing the cost of identifying customers. Another is increasing the availability of credit information, while a third is ensuring the outcome of insolvency cases. Identifying customers currently involves checking with separate authorities, which is costly and time-consuming. Establishing a digital ID number for everyone would be more efficient, and is common practice in several countries.

A national digital ID would simplify opening accounts and ease access to government services and subsidies, with the latter improving subsidy targeting. A national digital ID would also expand digital lending.

Indonesia has seen the rapid growth of payments using the Quick Response Code Indonesian Standard (QRIS). To increase further rollout, participation should be made even more accessible and costs lowered. It might also be worthwhile to consider subsidizing costs for small and medium enterprises, at least temporarily. At the same time, continuous security improvements are needed to maintain trust.

The availability of credit information is also critical to lower lending risk. The OJK’s financial information services system (SLIK) is currently available to the public, but it does not provide credit scores. Meanwhile, other data sources like credit bureaus are limited in scope.

The upshot is that financial firms have to use their own systems to assess borrower credit risk, which is inefficient. An example of the FICO scoring system in the United States would increase lending efficiency.

Insolvency procedure and outcome certainty is another source of lending inefficiency in Indonesia. The main issue is the high cost of proceedings, which excludes most firms except larger ones. Also, the system now allows insolvency practitioners to assign higher priority to certain creditors, which can penalize other creditors. This leads to unfair outcomes and further complicates the insolvency process.

The upshot is that financial firms typically increase their provisioning to cover legal costs while increasing lending rates at the same time to maintain profitability. Therefore, internalizing the cost of legal uncertainty is another source of inefficiency.

It is crucial that the incoming administration prepares a comprehensive plan to expand the financial sector. Without it, the financial industry will likely struggle to support the next government’s development goals, making them difficult to achieve.