Report on Islamic Banking in Indonesia

Submitted to:
Prof .Anirban Dutta

Submitted by:
H M Vikram Namrata Priya Nikta Roy Prateek Agrawal Sandeep Reddy

Introduction:
Indonesia is one of the largest countries in South-east Asia, between the Indian Ocean and the Pacific Ocean which contain mainly mountainous and covered with rain forests, swamps and consists over 13000 islands. Jakarta is the capital of Indonesia. Indone sia declared its independence on 17th August 1945 from Japan but Netherlands agreed to transfer sovereignty in 1949. Susilo Bambang is the President and Muhammad Yusuf Kalla is the Vice-President of Indonesia. Bahasa is the official language in Indonesia which modified form of Malay but the most widely spoken language is Javanese. 88% of Indonesians population is Muslim. It has a very large trading environment, with several countries ranging in products from gas to textiles. 22% of its population live below poverty line. (CIA- the World Fact book)

PESTEL Analysis:
Political and Legal factors:
Indonesia is considered as Republic country. It declared its independence on 17th August 1945 from Japan so 17th August is the national holiday. Indonesias legal rules and regulations are based on Roman-Dutch law. Political stability: In Indonesia after every five year election is being contested for president and vice president post by direct vote of the citizenry. Last time it was held on 8 July 2009 (next to be held in July 2014). Susilo Bambang has elected as president and Muhammad Yusuf Kalla is the Vice-President. Similarly, Cabinet also appointed by the president. So for next 5 years there are more chances of stability of the government. Prime lending rate: If we talk about their commercial Bank prime lending interest rate it is quiet decent which is 6.41% and their Central bank discount rate is 10.83% . (CIA, 2009) Business or individual tax system: Tax system has various rules and categories for example on first 25,000,000 income rate of tax is 10% then on next 25,000,000 it is 15% and on next 50,000,000 it is 30%. In the same way Income Tax on interest from Indonesian banks is fixed at a final 15% for both companies and individuals.

Economical factor:
Indonesia is considered as a developing country. Due to the government policies and treasure of national resources, their GDP growth has been increasing rapidly from last few years. They spend 23.5% of their GDP to develop their nation. According to last announced budget they had revenues $92.62 billion and expenditures $98.88 billion in 2008. They have hub of natural resources such as in Oil production, it has 23rd rank, in natural gas production and in export it is on 8th position.

GDP: Indonesia has made significant economic advances through last years. Indonesia's debt-to-GDP ratio in recent years has declined because of increasingly robust GDP growth which was 6.1% ($915.9 billion) in 2008 compare to 5.5% ($811.1 billion) in 2006 and compression to the world they are on 54th position in GDP growth. 14.4% of GDP earning from agriculture, 37.5% from service sector and the major part 48.1% comes from industry. (The World Bank, 2009) Per capita income: If we talk about per capita income, it was $3,500 in 2006 which was increase up to $3900 in 2008 and comparison to the world it is on the 157th rank in per capita income. Exchange rate: Indonesian rupiah (IDR) per US dollar - 9,698.9 (2008) compare to 9,159.3 (2006) Indonesian rupiah (IDR) per Indian rupee- 205.97 FDI: FDI is one of the most important factors for every country. It plays a vital role in Indonesia growth rate. It is a developing country so they have good inflow of FDI. It was $67.3 billion in 2008 compare to $58.96 billion in 2007 and they are on 45th position in FDI stock. Inflation rates: Inflation rate is still high but it has come down after a high of 20.7% in 1999. It was 9.9% in 2008 compare to 6.3% in 2006. The major reason behind it is economic downturn. Import: Due to change in population, income, import and export in Indonesia are increasing every year. The total import in 2008 was $125 billion compare to $85.26 billion in 2007. The major import commodities are machinery, equipment, chemicals, fuels and foodstuffs. The major import partners are Singapore 16.9%, China 11.8%, Japan 11.7%, Malaysia 6.9%, US 6.1%, South Korea 5.4%, Thailand 4.9% (2008) Export: In the same way due to economic growth improvement in productivity, government policies, export is also increasing rapidly. It was $93.3 billion in 2008 compare to $83 billion in 2007. The major export commodities are oil and gas, electrical appliances, plywood, textiles and rubber. The major export partner countries are Japan 20.2%, US 9.5%, Singapore 9.4%, China 8.5%, South Korea 6.7%, India 5.2%, Malaysia 4.7%. Balance of payment: The current account balance of Indonesia is $7.1million which was $8.8 million in 2008. The government spending has increased due to the country trying to alleviate widespread poverty and well being of the country. The government revenue has over doubled in the past 4 years while spending has increased by 3 times.

Social factor:
Population: Indonesia has a large population, which is increasing at a steady rate. It is on the 5th position all over the world with total 240,271,522 populations which is growi ng at 1.13%. The birth rate in Indonesia is 18.84births/1,000 and the mortality rate is 29.25 deaths/1,000 populations. The total life expectancy rate is 70.76 years in which for male its 68.26 years and for female its 73.38 years. 52% of total population live in urban areas which are increasing at 3.2% every year. Education: If a country has good literacy rate then it has bright future. Same thing apply on Indonesia. 90.4% of its populations are literate in which male are 94% and female are 86.8%. 3.6% of their GDP is spent on education. Religion: Indonesia is a multi culture and religion country where people from different religion work there. If we talk about majority it is a nation of Muslim with 86.1%, Protestant 5.7%, Roman Catholic 3%, and Hindu 1.8%.

Technological factor:
Transport system: Indonesia has effective and highly developed transport system with 139 airports, railways with 8529 km and water ways covering 21579 km. It has one of the largest merchant moraine with 971 in which 114 is already registered in foreign country. Communication system: The communication system in Indonesia is highly developed which maintained 17.33 millions of people use landlines where as 8 3.3 million of people use Cellular mobiles in the same way there are 13 million of internet users which is good sign for a country. It has interisland microwave system, HF radio police net and domestic satellite communications system coverage which makes its communication system better. Broadcasting technology: If we talk about media sources it has 678AM and 43 FM channels. Similarly it has 54 local TV stations (11 national TV networks; each with its group of local transmitters)

World Bank Assistance to Indonesia:

Indonesia has good relationship with other nations for enhance the economic growth cooperation, for this they have maintaining co-operation with regional level and international level as well. And this country plays a vital role in WTO, and Indonesia committed strong agreements with some of the globalized organization like APEC (Asia Pacific Economic Cooperation), then AFTA (ASEAN Free Trade Area) and FTAs (Free Trade Agreement). Since 1967 the World Bank has continued an energetic occurrence in this country for sustain high economic growth with the ultimate importance of reduction of poverty. Then the World Bank allotted around US$ 24.6 billion to develop 275 financial projects and programs in 1991. Due to financial crisis in 2000 the bank repositioned itself with the lower amount of annual lending around $450 million, at the time the bank has focused more investment on

different sectors like education, health, social development and environment, governance as well. By seeing the World Bank grant programs they are lending more than $2 US billion for 125 trust funds. By analysing in the pie chart they have captured high percent of other trust funds have 39%, urban development 19%, social development 12% and environment 5% respectively. Rests have the other percents for combined developments.

Indonesia and the future of ASEAN:

This country is a member of ASEAN (Association of South East Asian Nations). This group have many countries like India, Malaysia, Vietnam, Thailand, Singapore, Myanmar, and Cambodia .This group was started in 1967 8th of August from that time they have concentrated in Indonesian international co-operations. By the year of 1967 the Indonesias unsettling has changed. At that time this group has allowed the Indonesians to region and regional society. After that the group has gradually increased the peace and sustainability of the regional.

Benefits of the ASEAN for Indonesia:

It gradually increased the industrial production from 12.3% to 14.6% The sources from ASEAN group has increased, it leads to invest more money into new business in the country .The scale of economies and the scope of production have increased progressively, and the base of technology also improved as well. An international competitive have increased in the ASEAN industry of production. At certain time the participation of private sector have increased and industrial complementation as well. Then within the country the government allowed some schemes for the people enhance those are the plans which are implemented by the ASEAN group. They have come up with new schemes and agreements like AICO (Asian Industrial Co-operation Scheme); this leads to the country business improvement. Legal or political barriers: Tariffs: For doing the international trade business we have to know about the tariff and non tariff defence. Here for this country they have huge changes in their international trade policy progression. Licensing for import and export, then tariff, have been considerably decreased exploring domestic business to high international competitive business. The tariff for import has reduced faintly up to maximum of 5% in the year 2001 from 20% Whereas for the year 2003 again it has reduced 10% from 20%, with an transitional target of 20% in 2000.In 2003 the tariff reduced up to 10% for the chemical products, plastic goods, and metal as well. With the respect to export taxes, the country still sustain the export taxes for palm oil products, even though it reduced significantly the extent and tax rate level, these are all now reduced.

Industry Analysis
History
Indonesia banking industry suffered severe economic damage during the Asian currency crisis of 1997-1998. Capital injected during 1999 to re-establish banks employed an extremely generous set of capital adequacy ratio criteria; 4% or higher for healthy banks, 25% to 4% for banks that required capital Injections, and - 25% or lower for banks that were to be immediately shut down. However, the subsequent effort by the Indonesian government and rearrangement of the banking supervision structure enabled Indonesia eventually to exit the IMF program and the Indonesian Banking Restructuring Agency (IBRA) was dissolved after completing its task. From the political and economic point of view, Indonesia has overcome the damage from the Asian currency crisis to set out on another path of growth. Indeed, the Indonesian banking sector or the general macro economy has restored its confidence rapidly.

Major Reforms over last 10 years

Bank Indonesia is constantly trying to reorganise banking sector since late 90s.In 2005 bank Indonesia encouraged consolidation for improving prudential banking and supervision .In 2006 Bank Indonesia announced a single presence policy to further promote the industry Another important reform was to remove blanket guarantee on bank third party liabilities which was replaced with deposit insurance scheme.

Banking Structure
Banking sector operate at three levels: commercial banks, rural banks and sharia banks. Commercial banks are further categorized as state owned banks ,forex operational banks regional banks ,foreign and joint venture banks .There are total 122 commercial banks and 1715 rural banks in operation .

Sariah Banking systems

The principles of Islamic finance are laid down in Islamic law, the sharia, Islamic finance, comprising financial transactions in banks and non-bank financial institutions formal and non-formal financial institutions. It is based on the concept of a social order of brotherhood and solidarity. The participants in banking transactions are considered business partners who jointly bear the risks and profits. Islamic financial instruments and products are equityoriented and based on various forms of profit and loss sharing. As Islamic banks and their clients are partners, both sides of financial intermediation are based on sharing risks and gains: the transfer of funds from clients to the bank (depositing) is based on revenue-sharing and usually calculated ex post on a monthly basis. The transfer of funds from the bank to the clients is based on profit-sharing (lending, financing), either at a mutually agreed-upon ratio as in the case of mudarabah or at a mutually agreed -upon fixed rate. Such ratios and rates vary between institutions and may also vary between contracts within the same institution, depending upon perceived business prospects and risks. Islamic banking finances only real transactions with underlying assets; speculative investments such as margin trading and derivatives transactions are excluded. Lending, or financing, is backed by collateral since collateral-free lending would normally be considered as containing a speculative element, or moral hazard. Similarly, to avoid speculation and moral hazard, normally only investors with several years of successfully business experience are financed. The paying or taking of riba, interest, is prohibited. The same principle of partnership is applied to Islamic insurance. It is based on a collective sharing of risk by a group of individuals whose payments are akin to premiums invested by the Islamic banking institution in a mudarabah arrangement for the benefit of the group.

Islamic banking based on Islamic law, sharia, started just about 40 years ago. Few countries have adopted Islamic banking as its sole mode of operation, among them Iran and Sudan. Other predominantly Islamic countries have adamantly stayed away from Islamic banking; yet some have tolerated niches of Islamic microfinance as a concession to local culture, like Syria for example. In recent years, an increasing number of countries in both the developed and the developing world have seen the emergence of Islamic banks, banking units and Islamic products. However, this growth has not been mirrored in the microfinance sectors of most countries with Islamic financial services. This is probably due to Islamic banking principles like partnership and profit-sharing with investors, which require adequate bookkeeping and auditing, or, as an alternative, charitable credit to the poor without profit-sharing. As a result, the vast majority of the poor have remained without access to finance in these countries. In Indonesia, the largest Muslim country, Islamic finance has evolved since 1991, comprising Islamic commercial banks, commercial banking units, rural banks, and financial cooperatives. Indonesia also has one of the most differentiated micro- and rural finance sectors among developing countries, comprising both formal and non-formal financial institutions.

Global Existence
y y y y

Growing at 15 to 20% per annum Size estimated at USD 900 billion globally New markets welcoming Islamic banks and products More than 250 Islamic banks worldwide operating in over 75 countries

SWOT analysis

STRENGTHS

WEAKNESSES

1. Advantages of religious proposition in a country made on name of Islam i.e. Pakistan. 2. Competitive advantage: Less marketing is required than conventional banking and better cost control as a result. 3. Morale and commitment to serve is higher among bankers and staff due to religious value. 4. Huge amount of savings can be mobilized and thus boosting the deposit base of banks using charities and Zakat fund schemes, etc. 5. Less use of money for speculative purposes thus chances of investment failure and much volatility in investment is reduced. 6. Innovative aspect is also found in it, using phone banking, e- banking, etc. a blend of tradition and modern life can be easily served to customers. 7. Location wise & geographically, it is feasible and operational all across

1. Lack of standardization across the Muftis /scholars of the country and among the scholars and bankers. 2. Disadvantage of proposition is that there would be a hesitant and new thing not fully accepted / suited to World Bank, ADB, and other multinational donor agencies to invest through banking sector in country. 3. A lot of capital is needed to boost it in front of conventional banking, and also huge reserves have to be maintained, to meet any loss sharing situation in Islamic finance modes of investment. 4. Time/season factor becomes a major problem in case of Islamic banks, as people would like to shift their money from zakat deductible accounts or they wish to pay their zakat from Halal funds during Ramadan or on Eid festivals, etc. creating short term liquidity problems for the banks. 5. There are differences in theory and

the country, as Pakistan is 98% Muslim population country scattered in all nooks of national territory. 8. Quality of services will not less than conventional banking services so a competitor to established banking (interest based) in same market. 9. All Banks all over the world have opened a Islamic window offering wide range of Islamic products and to deal with Islamic operations

practice of Islamic banking in Pakistan to some extent creating an inherent weakness. 6. Management and staff need further training to serve Islamic financial services and relevant experience as well to done their job efficiently.

OPPORTUNITIES

THREATS

1. More opportunities now lie in Islamic banking as it has been accepted by BASEL, WB, ADB, international agencies, multinational corporations, non Muslim governments, etc. with creation of big sukuk and Islamic deposit base in Gulf and Malaysian regions. 2. Traditional interest based banking will have to defend through heavy marketing and advertising in Muslim countries which off course reduce their profitability. 3. Islamic banking is a complete solution to economic and to some extent social needs of Muslims from House building to education in addition to conventional help in commerce, business and industry. 4. Modern Islamic banking emerged in late 20th century with more or less advent of internet and information age, thus it is naturally blended with tools of internet, and computer based banking, and will witness a sharper growth than traditional banking growth of last 500 years. 5. New markets have been emerged with growth of Islamic banking as

1. A lot of legislation is required for Islamic banking worldwide and especially in non-Muslim countries; even in Pakistan some legal loopholes are present in its proper implementation. 2. Comprehensive Islamic economic and banking models have yet to develop or they are not in their maturity stage to provide a blueprint of economic development and prosperity. 3. IT developments and Research in latest Banking are in non-Muslim countries where conventional interest based banking have a very strong position thus Islamic banking will enjoy latest tools of IT, but lesser than conventional banking. 4. Environment for Islamic banking in west has been declined after 9/11 attacks on WTC, New York and later Prophet Mohammad (P.B.U.H.) protests in Muslim world, widening the gaps between the western investors and Islamic banking markets. 5. Market demand is good but very less as compared to conventional

well: Islamic mortgage, Islamic insurance, new investment projects etc. 6. In non-Muslim countries, like France where Muslim are in minority (around 10%) of population, Islamic banking will enjoy the benefit of niche marketing and if properly targeted will obtain better results.

interest based banking throughout the world, i.e. beyond some countries. 6. Sustainable financial backing by large multinational firms, investment banks, and World major economic powers is lacking.

Indonesia s Islamic banking opportunities:

Islamic banking in Indonesia is poised to be the next catalyst of growth for the banking industry and holds great opportunities for foreign investors as the country has the worlds largest Muslim population. At the moment, Islamic banking has only a 2% share of the banking sector in the country. Indonesia is still in its infancy in terms of Islamic banking. Many of Indonesias Muslim leaders do not believe that commercial interest in its modern form is prohibited, although others do. After some false starts, Islamic financial institutions are developing rapidly and have the enthusiastic support of many young people and intellectuals. The work of the Sharia Bureau of Bank Indonesia demonstrates that Indonesia, especially in particular parts of the country, has considerable unmet demand for Islamic banking.

The basic principles of Islamic Financial Institutions:

Islamic financial institutions must operate within the legal framework of the religion based on Quran and Sunna.Thus whatever their activities be related to transaction must adhere to these principles. 1. Business framework: Islamic Banking System is based on Sariah laws wherein the Sariah scholars ensure that they are in accordance with the Islamic laws and guidelines as compared to the conventional banks which are based only on man-made laws and no religious guidelines. 2. Riba (Interest): Interest in Islam in forbidden. So all activities related to banking should not charge interest. Instead of Interest the bank earns profit and fees on financing facilities it extends to customers. Also depositors earn a share of the Banks profit as opposed to interest. Islamic financial institutions must trade in real assets or services as compared to money which is traded in conventional banks. 3. Prohibited activities/Commodities: Sharia prohibits using or dealing with certain commodities or activities. It encourages the application of Islamic principles and law to

transactions of finance, banking and business affairs. It controls the engagement of investment companies in activities that are tolerable and consistent with the Sharia law. The Islamic Banks therefore does not finance liquor, manufacturing, transportation, storage or distribution companies. Sharia scholars screen the suitability of investments on an ongoing basis and provide guidance on products to the Banks management. 3. Uncertatinity (Gharar): Any contract based on future uncertain events within Islamic banking is mostly not allowed i.e. hedging and dealing with derivatives etc. 4. Contractual Relationships: Contractual relationship in Islamic institution depends upon the nature of transaction. It could be seller-buyer relationship, a lesser-lessee relationship. A partnership or a creditor-debtor relationship as compared to only one relationship in conventional banks i.e. the creditor-debtor relationship. 5. Participation and risk sharing: Islamic financial institutions offer investors/depositors participation in risk sharing type packages rather than fixed interest on deposits. In contrast to what is condemned in Islamic banking is the notion of a risk free reward or return. The Islamic financial system employs the concept of participation in the enterprise, utilizing the funds at risk on a profit and loss sharing basis, thus encouraging better resource management. The Islamic financial system is based on equity rather than on loan as by Conventional banks. 6. The Islamic ethics and behavior: The Islamic institution and its staff must behave and act within the framework of Islamic teachings in its broadest sense so that anybody approaching the Islamic institution should be given the impression that he is entering a distinguished place not only in the types and quality of its products but in the way the customer is treated with care, respect and eagerness to help facilitate them. 7. Contibutes to the socio-economic goals of the Islamic society: The Islamic financial institutions should contribute to the major socio-economic goals of the Islamic society. These financial systems stresses the ethical,socail and moral dimensions for wealth creation that enhance the overall equity and fairness of the society and must contribute in efforts of poverty reduction and people empowerment through creating social funds for poor and needy and provide education scholarships to students. 8. Accounting Standards: The Islamic bank abides by the accounting standards of Accounting and Auditing Organization for Islamic financial institutions AAOIFI formed in 1988 in Bahrain. 9. Balance Sheet: Due to joint participation among an Islamic financial institution, shareholders and depositors in equity investment, the structure of the balance sheet of an Islamic bank may differ from any standard conventional bank because the equity capital base of the former may be larger than the later. The balance sheet in Islamic banks will not show the interest earnings assets and interest bearing liabilities and will be more detailed than other conventional banks.

ISLAMIC LENDING AND BORROWING INSTRUMENTS:

LENDING FORMS:

Cost Plus FinancingMurabaha: A sales contract between the bank and the customer for the sale of goods at a price that includes a profit margin agreed to by both parties. As a financing technique it involves the purchase of goods by the bank as requested by the customer. Repayment is conducted by instalments within a specified period. Purchase with SpecificationIstishna: A sales contract between the bank and the customer wherein the customer specifies goods to be made. After the goods are made or shipped the bank sells them to the customer according to a pre-agreed arrangement. Purchase with Deferred DeliveryBai al Salam: A sales contract whereby the price is paid in advance by the bank and the goods delivered later by the customer to a designee.

Lease and Hire PurchaseIjarah Mutahia Bittamlik: A contract under which the bank leases equipment to a customer for a rental fee. At the end of the lease period the customer buys the equipment at an agreed price from the bank, with the rental fees already paid being part of the price. Trust Financing/Trustee Profit-sharingMudharabah/Mudharabah Muqayyadah The bank provides the capital (shahibul maal) and the customer manages the project (mudharib). The gross revenues from the project are split according to a pre-agreed ratio. Partnership/Participation FinancingMusyarakah: A partnership between the bank customer in which profits are shared on a pre-agreed basis but losses are shared on the basis of equity contribution. This partnership may be managed by the bank or the customer, jointly, or by a third party. Benevolent LoanQardh ul Hasan: An interest-free loan, generally with a charitable motivation. Collateral AgreementRahn: An agreement to provide collateral to the bank, either in the banks or the customers custody as appropriate. This is connected with some other form of lending. Agency/TrustWakalah An agreement to authorize another to be an agent to conduct some business. In this case, an authorization to the bank to conduct some business on the customers behalf. AgencyHavalah An agreement by the bank to undertake some of the liabilities of the customer. When the liabilities mature the customer pays back the bank. The bank is paid a fee for undertaking the liabilities concerned.

BORROWING FORMS
Ummat SavingsTabungan Ummat:A savings account from which money can be withdrawn any time at any Muamalat office or ATM. Customers share in the banks revenue. The Ummat Savings customers also receive life insurance and the opportunity to win a free Umrah pilgrimage to Mecca. Trendi SavingsTabungan Trendi: A savings account for teenagers and students. Besides accident insurance coverage, it offers special prizes for highly ranked students and one-year scholarships for 50 students. Arafah SavingsTabungan Arafah: A savings account designed specifically for the hajj pilgrimage. The saving scheme will help customers in planning their hajj in accordance with their financial capability and intended hajj date. Life insurance is also provided. The depositors are also eligible for prizes.

Fulinves DepositsDeposito Fulinves:A time deposit with a revenue sharing package available for various terms and with a chance to win prizes. Life insurance is provided to those with longer-term deposits. Wadiah Current AccountGiro Wadiah: A current account providing checking and allowing some profit sharing. Muamalat Financial Institution Pension Fund Dana Pensiun Lembaga Keuangan A pension fund for those who make regular deposits. The bank intends to add a variant that provides life insurance.

Sector Performance:
Services sector is a pillar of Indonesian economy contributing 38.5%to the countrys GDP, The value of the countrys banking system stood at IDR 982 Trillion as of 2010.Credit growth remained weak during 2009 with overall lending growing by only 11.5% as compared to 32% in 2008 .The slowdown was mainly due to global economic recession .Loan growth was 18% for 2010. From 1999 to 2003, the gross non-performing loan ratio (NPL) went down from 32.8% to 8.1% and net NPL from 7.3% to 1.8%. During the same period, the banks went from losses of 7.5% to (pre-tax) profits of 2.1% of total assets; the capital adequacy ratio (CAR) increased from 8.1% in 1999 to 20.7% in 2003 .

Business segment contributing to Banking Industry(IDR Trillions)

Agriculture 9% Mining 5%

Business Services 15%

Infrastructure 8%

Industries 27%

Trading 29%

Constuction 7%

Isl

ic b

There are 33 sharia banks hol ing an asset base of IDR 75 Trillion .There has been annual growth of about 40 percent in Islamic banking assets in Indonesia in recent years but still account for just 2.5 percent of Indonesia's total banking assets of $270 Billion, providing strong potential for growth. The assets of sharia banks have continued to show a significant growth of 34.1% in five years ending in 2008. The amount of third party funds held by sharia banks has also increased from year to year. In the 204-2008 the amount grew 32.8% annually from Rp11.8 trillion to Rp 36.8 trillion--higher than the average growth recorded by conventionalbanks. The non performing financing ratio of sharia banking in 2007 was at 4% which declined to 3.95%in 2008. The decline in the NPF ratio was recorded mainly in the trading and construction sectors. The market share of sharia banks is relatively small compared with that of conventional banks. In 2008, the assets of sharia banks were Rp49.5 trillion, or 2.2% of the total assets of conventional banks in the country. T share represented an increase fro he m 1.85% in the previous year. According to Bank Indonesia (BI) the assets of sharia banks rose to Rp 57 trillion in 2009 or 5% of the total assets of conventional banks in the country. Meanwhile, the numbers of customers and financing have increased from year to year. In 2007, sharia bank customers were only 2.845 million, which increased only to 3.799 million in 2008.

Reasons for less market share of Islamic Banks

y y

Less knowledge and awareness about the sharia banking system among the growing population and less marketing efforts done by the banks. Lack of skilled professional in sharia industry which results in higher retention costs of trained professional squeezing the profit margins.

Main players in sharia banking industry:

The market of sharia banking is currently dominated by three largest sharia banks --Bank Syariah Mandiri, which has assets at Rp16.5 trillion, or 33.3% of the total assets of sharia banks; Bank Muamalat Indonesia with assets of Rp12.1 trillion (24.4%) and Bank Mega Syariah with assets of Rp3.1 trillion (6.2%). The three banks control 63.7% of the market. Other sharia banks have the remaining 36.3%.

Reasons for sharia Banking Business.

y
A survey by Bank Indonesia showed that there is growing interest in sharia service. Almost 50% of the population of predominantly Muslim provinces indicates interest in sharia banking service. The survey also revealed that 11% of the populations have been familiar with the sharia products. The customers of sharia banks at present total around 2 million people while a potential customer of Muslim population is more than 100 million. Under the regulation, establishing a sharia bank require a capital of only Rp500 billion (US $ 6 mn). Earlier the minimum capital was set at Rp1 trillion. For opening a new bank or foreign branch paid up capital of US $ 330 mn is required. Despite high market share captured by top 3 banks, industry has a huge growth potential. Main reasons for this is the increasing trade relations with neighbouring countries such as Malaysia, Japan, Singapore, Australia, India, and China. Country has several bilateral agreements with countries which includes the recent US $ 20 mn trade target projected for the year 2015 with India. Government has also opened its doors in several sectors such as infrastructure; mining & energy .This will lead to huge investments and capital inflows from foreign players which will lead to increase in income of households of growing middle class which are 10 % of total population. Besides this Indonesia has enormous natural resource (oil and gas, coal copper gold, forestry, plantation products) and manufacturing capacity for domestic consumption as well as export.

y y

Reasons for route of M&A

y
According to the report published by Bank Indonesia sharia banking industry in Indonesia could not rely on organic growth for expansion. The industry needs non organic growth such by acquiring conventional banks to be converted into sharia banks. Based on a new regulation of the central bank, it has made easier to establish a sharia bank through spinning off sharia units into independent sharia banks.

Banking sector is overcrowded due to large number of banks .Therefore government is promoting merger of non profit banks with the profitable ones. Due to this it has not issued any license for opening a new bank. Government has kept the way open for entrance into Islamic banking system looking at its potential.

Government Policy
Development of the country's sharia banking industry has witnessed full support from the government .Since 1992; the government has issued a series of policies facilitating the expansion of sharia banking industry The Law No. 7 of 1992 on Banking and Government Regulation No. 72 of 1992 this government policy supports development of sharia banking to expand dual banking system in the country. The dual banking system will provide alternative for the people and in payment system.
y

The Law No 10 of 1998 (constituted an amendment to the Law No. 7 of 1992) Conventional banks is allowed to have UUS (sharia units). The law officially changes the term of profit sharing banks with sharia banks. Spin off is allowed only if assets of the Sharia unit have reached at least 50% of the total assets of the conventional parent bank.

Taxation
Taxation and licensing poses as a stumbling block in the establishment of a sharia bank. The taxation directorate general has stated that the sharia bank and conventional bank customers are treated equally in abolishing double taxation. However, it also imposes value added tax on sharia bank customers. Sharia banks face double taxation as sharia system adopts the sales and purchase or murabahah contract. Sharia banks are imposed with taxes twice - when buying from suppliers and when selling to debtors. A conventional bank is imposed tax only once--when borrowing. PBI No. 11/3/2009 was issued on 29 January, 2009 This regulation of Bank Indonesia rules that: y Paid up capital for a sharia bank is at least Rp1 trillion. y Principle license is needed to establish a sharia bank with capital available at least 30% of the minimum paid up capital y Regional administrations are allowed to establish or have sharia banks y Foreign investors in a sharia bank are allowed to have up to 99% of the shares of sharia banks.

The country's sharia banking industry was hardly affected by the global financial crisis in 2009.People, therefore, began to show greater confidence in sharia banking industry. The industry grew in assets, third party funds and financing, which grew 31%-35% last year. The fledgling industry has not expanded as expected in the predominantly Muslim country In addition; foreign investors especially from Middle East have indicated strong interest in investing in the country in sharia banks. Foreign banks such as HSBC and Standard Chartered Bank have already entered into the market