Regulatory constraints to financial inclusion in Indonesia | East Asia ...

Authors: Jay K. Rosengard, Harvard University, and A. Prasetyantoko, Atma Jaya Catholic University

Indonesia?s financial sector is characterised by two paradoxes: although Indonesia has been a global leader in microfinance for the past 25 years, access to microfinance services is now declining; and although Indonesia?s commercial banks are liquid, solvent and profitable, and the Indonesian economy has been doing quite well over the past decade, small and medium enterprises (SMEs) are now facing a credit crunch.

Indonesia is underbanked, especially for microfinance and SME finance. Of the six largest banks, only the portfolios of Bank Rakyat Indonesia and Bank Danamon include a majority share of micro, small, and medium sized loans. Despite potentially lucrative unserved or underserved markets, including low-income households and family businesses, the monetary policy and regulatory regime set by Bank Indonesia have unintentionally created barriers to outreach and innovation for microfinance institutions and incentivised commercial banks to forsake SME finance in favour of consumer finance and alternative non-loan investments.

In the 1980s, Indonesia deregulated its banking system without developing the technical capacity and political will to oversee banks with newly acquired freedom. The country paid dearly for this mistake during the Asian financial crisis in the late 1990s. Indonesia responded by reregulating its banking system: a freeze on new banks and the consolidation of existing banks was imposed, followed by a return to directed lending. This has resulted in a prudentially sound but inefficient, homogenised and non-inclusive banking oligopoly that discourages innovation and concentrates credit risk. The challenge now is to find a balance between these two approaches.

The government is convinced that banking reform by administrative fiat will produce faster results at a lower risk than waiting for behavioural change spurred by market-based incentives. Thus, with each disappointing outcome, the government issues increasingly stronger directives to force banks to lend to MSMEs. This approach is a great stride backwards for Indonesia, as the only thing more repressive than directed credit with central bank funds is directed credit with third-party deposits.

But Indonesia should not respond to financial exclusion by artificially pumping out and administratively allocating more credit, given that total credit has grown at an annual real rate of 14 per cent since 2002. Instead, it should promulgate smart regulation so that banks maintain their sound risk management without pursuing non-competitive and non-inclusive business practices. The fundamental problem today is not a slow rate of credit growth but the composition of lending; increasing the aggregate level of financial intermediation is a longer-term challenge best pursued incrementally.

Reregulation has had a disproportionately detrimental effect on MSMEs because large businesses are much more economically dominant and politically powerful, so they can act to ensure access to financing. Moreover, large business loans are conventional products that constitute the core business of banks, so they are not likely to be affected by these reregulation measures. Indeed, the loan portfolios of most of Indonesia?s big banks are dominated by loans to large businesses and corporate clients.

It is time for the government to recognise the unintended consequences of the banking sector reregulation, in particular the perverse incentives for banks to avoid MSME financing. Bank Indonesia might still wish to control the liquidity of the banking system to manage money supply, but at the same time also remove barriers to commercial banking competition. In this way, it will provide a catalyst for SME lending, recognise the need for non-bank financial institutions for microbanking, and adapt Indonesia?s regulatory regime accordingly.

But even if the government makes these changes, there is still a significant constraint to MSME lending because of the perceived high risks and low returns of this type of finance. There is certainly increased likelihood of defaults resulting from ineffective risk assessment and risk mitigation practices, coupled with significant cost overruns from inappropriate loan products and delivery systems.

Banks often treat MSME loans simply as smaller versions of large loans, despite the very different characteristics of MSMEs and the requisite financial model needed to profit from serving this market. Slow, centralised decision making based on extensive analysis of financial statements and industry-wide data for a handful of long-term loans must be replaced by quick, decentralised decision making based on cash-flow analysis and character assessment for a much larger volume of shorter-term loans.

Until banks have a viable model for financing MSMEs, they should continue to approach this market with great caution despite government prodding, especially if they have more attractive prospects for their funds. Only competitive pressures to develop new markets provide sufficient incentives for banks to figure out how to serve MSMEs in a commercially sustainable way, and forcing banks to act against their fiduciary responsibilities to their owners and depositors is rash and counterproductive.

Jay Rosengard is a lecturer in public policy and Director at the Financial Sector Program, Harvard Kennedy School.

A. Prasetyantoko is Chair at the Institute for Research and Community Services, Atma Jaya Catholic University, Jakarta.

A version of this article was first published here in Asian Economic Policy Review.

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