Islamic Bank Development in Indonesia

By Bambang Setiaji1

I. Background
For several decades, there has been rising anxiety in the Muslim world about
economic tendencies that have grown without regard to ethics and religion. Experts
have tried to solve this problem by digging into their academic assets. Since the 1980s,
a number of books and articles have been written in Indonesia, which has arrived later
in the discussion than other Muslim countries. In the 1960s, Egypt began experimenting
with Islamic Banking, and in the 1970s when the price of oil increased, Islamic Banking
commenced its development, financed by the Middle Eastern petrodollar. Malaysia and
Pakistan went ahead with established International Islamic University that began an
Islamic education focused on studying science and art rather than traditional religious
knowledge. Some works which were written in the West also significantly influenced
Indonesian Islamic studies Capra (2001), Wi lson (1997).
Due to the increasing academic discourses and an interest in Islamic banks
demand for labor, in the 2000s some prestigious universities in Indonesia established
new study programs in Islamic economics and business. They are: Indonesia
University (UI) - Jakarta, Gadjah Mada University (UGM) - Yogyakarta, Airlangga
University - Surabaya, State University of Surakarta (UNS), State Islamic Universites in
Jakarta, Jogyakarta, Malang, Surakarta, and Bandung, and the Indonesia Islamic
University (UII), and Muhammadiyah Universities network.

II. ISLAMIC ECONOMICS

Religious economics is the study of behavior that is not only based on an
assumption of homo economicus/rational man, but also homo ethicus and homo
religious (Wilson, 1997). To some extent, ethics has been taken for granted in
economics considerations. For instance, in public finance, why should the poor pay a
lower percentage (progressive principle) in taxes, and why should a state run welfare
1

Muhammadiyah University of Surakarta. Paper will be presented in Charles Darwin

University, 2nd June 2011.

programs? Why major economists agree in minimum wage? In addition, one reason in
the efficiency wage theory (Krueger and Summer, in Setiaji, 2002) where bottom laborer
have been paid higher than market price is to narrowing wage gap.
Ethics for justice, non-exploitation, fair trade 2, more egalitarian i.e. the widest
participation (Quran Al Hasyr:7), can be found in economics (indirectly), but in Islamic
economics there is a very explicit discussion between religion and economic behavior.
Thus far, it is done by adjusting the existing conventional market or liberal economics.
Islamic Banking is the first subject that has gained much devotion, then micro and
macroeconomics theory (Karim, 2010) and some other works in management and
accounting, beside philosophical works.
In fact, the first concern of Islamic economics is public finance by making the
zakat as one of five Islamic pillars. The five Islamic pillars are syahadat (witnessing),
sholat (praying), zakat, syiam (fasting), and visit the holy land.
Zakat initially is the obligation of citizen to the Islamic state and is used to finance 8
main programs. The eight programs are almost similar to the welfare state programs in
developed countries. These include financing fakir (people without income because of
unemployment or retirement), and miskin (poor people). Afterward, gharim (to finance
bankrupt firms in order to prevent additional unemployment), ibnu sabil (travelers, also
students, and discovery activities). In addition, it is given to muallaf (weakness people
i.e. backward tribes, immigrants), to freeing slaves (aid to low-wage labor, empowering
union), amil (administrative costs), and fi sabilillah (to finance public goods).
With those concerns, Muslim countries actually should have formed welfare
states (see Cohrane, et.al. 1996). Kholifah Umar bin Khatab (634-644) established the
first office of public money and has contributed to the groups or asnaf and programs
that were mentioned above (Karim, 2004). However, first generation of Moslem
community uses a market mechanism that is characterized by private ownership and
business freedom(Boumol, 2007). The Prophet and his companion lived as private
businesspersons where the Arabian Peninsula had been set as a tariff-free zone.

Since the beginning, Islamic teaching supported to freeing slavery, give a banquet to
woman whom does not have it before, and similar with this concern to the weakness people,
orphan, poor, job less etc.

Nevertheless, public goods and public needs (water, fire/electricity, and grass land)
cannot be privatized (Hadist).
Nowadays, the economy of the Islamic world is characterized by state capitalism,
where important sectors such as energy, electricity, telephone provider and some
valuable mines are managed by state enterprises ( Bremmer, Ian, terj. 2011). Alike
state enterprises in Muslim countries even going excessively where family or
government related groups occupy the cores of businesses. This is why pure private
business is less developed (Bremmer, trans. 2011, Boumol, trans. 2007).
Afterward, state capitalism should be differentiated if it works in the more
democratic countries like Indonesia, Malaysia, India, and Turkey, and if it works in less
democratic countries, such as China, Middle Eastern countries and African Countries.
The main weakness of state capitalism tends to be corruption, i.e. making a state
enterprises assets look like private assets. Meanwhile, in private or enterprise
capitalism the benefits of big enterprises that serve public needs have became private,
so they do not need to be corrupt. State capitalism and its enterprises that serve only
public needs and are parliamentary controlled might be considered as a reasonable
solution.

III. Islamic Banking

As we have noted, the development of Islamic banking has had a significant role
as an engine in Islamic economics studies. Banking practices, especially lending
money with usury has been practiced since B.C. The three monotheistic religions
Judaism, Christianity, and Islam forbid the practice of usury (Karim, 2010) to prevent an
exploitative relationship between capitalists (the lender) and the borrowers, who are
implicitly viewed as the weak party.

At least in Islamic teaching there are three degrees of banking institution, which are:

1. Banking with zero real interest rate3 (subsidizes bank)

2. Risk sharing bank (based on the syirkah wa mudharabah principle)
3. Leasing Bank (based on the murabahah/trading scheme).
1. Banking with zero real interest rate (Subsidize Bank)
Banking with a zero interest rate is only possible if it is run by a government
where a part of public money is used to pay a part of the interest. The Muslim concern
about unemployment (fakir group) only can be solved by creating new jobs, and not by
distributing money. As the frame age class is forbidden to have zakat or public money,
they are supported to accept any lawful job (Hadist).
The scheme above is suitable for the Islamic world today, which is facing
extremely high unemployment and especially a massively underutilized labor force.
Indonesia itself has over 11 million unemployed and three times as many underutilized
laborers in the informal sector. Overall, up to 50 million new job seeker will be available
if the economy successfully creates new productive jobs with US$120 monthly expected
wages.
Many Moslem countries such as Pakistan, Egypt, Somalia, Nigeria, Iraq,
Afghanistan, Yemen and even Saudi Arabia face the same problem. When facing mass
unemployment, the pure Keynesian school advises the use of public money to empower
aggregate demand, such as distribution to the unemployed, so they will spend the
money and industries will respond by maintaining existing production and jobs. In this
proposal, public money will be distributed as interest subsidies so the real interest rate
will decrease and investment will increase and so will job availability. In addition, it will
create a new source of income for the unemployed as well as poor families.
The above story is depicted and simulated in the general equilibrium model as
figure 1a and 1b. In the figure 1a, interest subsidy makes the investment demand curve
shift upward, entrepreneurs will pay lower interest than that of market price. The
government will pay the rest of the interest.
3

Allah abolishes usury and replaces it with sedekah (public money).

Figure 1A
S
is
rm

Inew
I

rI

I dan S
r

Im

II
LM

FIGURE
1B

is
rm

IS1

rI

IS0
Ym

Y=GDP

YI

The effect of the shifting investment curve in the economy is shown in figure 1b.
IS curve, as equilibrium of investment and saving shift upward, national income will
grow from Ym to Yi. Finally the production growth will need a new labor input and flow of
expected income will occur to alleviate poverty.
The pure Islamic bank concept above has never been implemented in the
Moslem world, which is facing extremely high unemployment. In Indonesia when the
economic crisis happened in the late 1990s, the government distributed public money to
poor families. Economic growth was only pushed out by consumption and not by
investments and entrepreneurship. Experience in conventional market economy started
in the Suharto Era, which lasted for 32 years, and has continued in the liberal era for 13

years. The unemployed have already waited for 45 years, so that is why we need a
progressive-radical policy. The standard conventional policy is only suitable for
countries with a small population and small unemployment figures.

2. Banks with Risk Sharing

Because usury is unlawful and state intervention in the loan market does not
exist in the Muslim world, the problem is solved in the competitive market. Modal per se
is also unlawful to getting income in Islam, but it is lawful in the risk sharing relation.
Islamic Banks with a risk-sharing scheme as main Islamic Bank have not been well
implemented, due to the following reasons:
a. Not all bank clients do accurate, standard, and valid reports.
b. Moral hazard may happen in the scheme of loss and profit sharing, due to
the tendency of reporting the loss rather than the profit.
c. A simple product design that can be massively implemented in the risk
sharing scheme has not been found yet. 4
As a result, the scheme of profit and loss sharing is difficult to put into practice.
3. Banks with a Buy and Sell scheme
Islamic banks also act or operate as a leasing company, called murabahah. The
scheme is a buy and sell, where customers who want to buy cars, houses, factory
machines, and even raw material come to the bank to buy the product by credit
installment. Banks now become traders instead of lenders. Banks take a profit similar to
traders, which are free from the market interest fluctuation.
This type is now commonly operated in the credit/financing market among Islamic
banks. Within its limitations, Islamic banking has grown two times faster than the other
banking industry in recent years. With a focus on this buy and sell scheme, Islamic
banking shows a significant role in developing the real sector.

we try to formulate a community based micro finance that work with that scheme,
www.bambangsetiaji.co.cc

IV. The Data

Sharia bank was established in Indonesia in 1993. As the one and only sharia
bank, it belonged to the few banks that were not bailed out by the government. When
the crisis occurred, the Indonesia Central Bank increased the interest rate. Commercial
banks responded by adjusting their credit, while sharia banks that work in the buy and
sell scheme still maintain the price. The effect of insolvent credit is much higher in
conventional bank than in the sharia ones. The historical figures of both types of banks
are shown in table 1.
Universities output in Islamic Economics and Business match the demand for
labor in Islamic Banks as shown in table 1. Over six years, the demand for labor in
Islamic banks increased four-fold, from 300 offices to 1200 offices. Banking is one of
the highest paid industries in Indonesia and has highly selective candidates.
Universities have responded to the demand by opening Islamic Economics and
management programs.
The data also shows that the growth of Sharia Bank is faster than the growth of
the other types of banks. Some indicators show growth twice as fast as conventional
banks, as they have seen in term of deposits, assets, and lending. The role of sharia
banks in improving the real sector is shown by LDR loan to deposit ratio, which is
showing how high fund in bank use by the industries in the real sector. In terms of
profitability, sharia banks show a lower profitability because most sharia banks are run
as a new entities and new branch offices. Many Sharia banks are formed by acquisition
of small and sometimes problematical banks. In terms of NPL, Sharia banks are
slightly better than the rest of the industry due to their focus of business on SMEs, for
which the credit is usually full coverage by collateral value.

Tabel 1. Historical data of commercial banks work in conventional and Sharia

Banks. 2005 2010
Indicator
Number of entity
Number of Offices
Convent Bank
Number of Banks
Numb of offices
continued

2005

2006
2007
2008
CONVENTIONAL BANKS

131
8,236
3
301

130

130

9,110
9,680
SHARIA BANK
3
3
346
398

2009

2010

124

121

121

10,868

12,837

13,837

5
576

6
711

11
1,215

2005

Performance
2006
2007

2008

2009

2010

Growth,
(averages)

Deposit

1,128

CONVENTIONAL BANK
1,287
1,511
1,753

1,973

2,339

14.6

Lending

695

792

1,002

1,308

1,438

1,765

18.6

1,201

1,539

1,792

2,067

2,372

2,912

17.7

41
50
48
2.64
2.78
2.33
61.6
66.3
74.6
6.07
4.07
3.20
SHARIA BANK
20.7
28.0
36.8

62
2.60
72.9
3.31

75
2.86
75.2
2.56

22
2.62
68.3
4.46

52.3

73.0

30.6

46.9

68.2

29.6

97.5

30.5

Asset
Profit
ROA (%)
LDR (%)
NPL (%)

34
2.55
59.7
7.56

Deposit

15.6

Lending

15.3

Asset

20.9

20.4

27.9

26.7

36.5

38.2
49.6

66.1

Profit

.238

.355

.540

.432

.791

1.051

29.1

ROA (%)

1.35

1.55

2.07

1.42

4.01

3.02

2.23

LDR (%)

97.7

99.9

99.8

103.6

89.7

89.8

96.75

NPL (%)

2.82

4.75

4.05

3.95

4.01

3.02

3.76

Source: Banking Statistic, www.bi.go.id

V. Islamic Microfinance

Since the 1980s, about 3,300 BMTs (Baitul Maal wa Tanwil), which operate as
microfinance institutions, have been founded. Management of BMTs varies widely form
amateur to professional. However it has sustained in helping micro business (Ismail
and Mislan, 2009). The BMTs sometimes gives a very small amount of credit,
approximately US$ 100, in a short-term length of credit. Because of the transaction
cost, the margin rate of BMTs is very high; usually the margin is equivalent to a 4 %
effective rate monthly. In this situation the cost of capital structure is regressive, the
smaller the business the greater the cost of capital.
One more, the role of government is needed to release the micro business from
hyper cost of capital. Interest or margin subsidy is reasonable for government to
release the micro businesses. With government aid, it is helpful for micro business to
break out their circular poverty. Their businesses are so simple, and their advantages to
creating income and jobs have been recognized. With interest subsidy, expect that their
young generation will take advantage to create a better size and better content of
business. The absent of government, make we wonder why to take US$ 100 for
creating businesses and a jobs which are socially and economically desperately needed
they should pay such high interest.

VI. Summary and Conclusion

a. There is an increasing effort to making a dialog between secular economics and
its branch and ethics and religion, as is signaled by a significant number of
published books and articles.
b. There is a rapidly growing demand for labor in Sharia Banking and related
industry, and prestigious and good universities have been responding to meet
them by opening suitable programs.
c. The core of Islamic economics is concerned about protection for the weak.
Welfare programs or welfare states are actually suitable with Islamic teaching,
although they stay behind the West.

d. Meanwhile market economy is suitable with Islamic teaching, except for some
vital public needs. However, the Moslem world is going excessively by forming
many state enterprises and government crony enterprises that make the private
sector less developed.
e. To protect the weak, usury is forbidden. Islamic Bank with zero interest has
demonstrated suitability with very high unemployment and half unemployment.
This radical policy is needed, that is government intervention to subsidize bank
interest, and a decreasing interest rate approaching real zero.
f. Islamic bank with risk sharing scheme cannot be implemented because of lack of
report, and because they have not formulated a simple and mass banking
product yet.
g. Islamic Bank with buy and sell scheme, which is free from interest fluctuation in
the market, is a representative of Islamic bank with rapid growth.
h. Moreover, Islamic banks show twice-faster growth in deposit, credit, and asset
than conventional bank.
i. Some Islamic microfinance (BMT) is done as a secondary job, however some of
them do it in a professional manner.
j. The role of Islamic Microfinances, BMTs shows a good role in helping micro
business to maintain product, as well as job creation.
k. Government is needed to help SMEs that face a very high cost of capital, both
from BMTs or MFIs. Like the argument before, it is suggested to give interest
subsidy, while improving administrative capacity.

Reference

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