Indonesia is sitting on an unexploited customer base larger than the entire population of the UK. These people have never had a bank account, or been granted a loan.
It represents a tremendous opportunity for banks, local and international alike.
The country has one of the lowest bank penetration rates in Asia at 30% of gross domestic product (GDP), compared to more than 90% in Singapore and Malaysia.
The key untapped client base consists of small but productive individuals operating businesses outside the major cities. These micro enterprises are the future of Indonesia’s banking.
They employ 91% of Southeast Asia’s largest national population, yet only 27% have access to credit. That leaves a potential customer base of 75 million. And with economic growth of up to 7% this year, many are doing well.
Lenders such as Bank Mandiri, Bank Danamon and BPTN want a slice of the action. They are rapidly expanding outlets in outlying areas to steal market share from century-old small-to-medium-sized enterprises (SME) lending leader Bank Rakyat Indonesia (BRI).
The returns are already eye-popping. As of February 2013, Indonesia’s five largest banks have the highest return on equity (RoE) among the world’s 20 largest economies at 23%, compared to China’s 21% and 9% for US firms, according to Bloomberg. Bank shares are benefiting, having risen as much as 51% in the past year versus a 21% rise in the Jakarta Composite Index.
This could be just the beginning.
“Total shareholder return in excess of 100% looks achievable over the next three to four years, given [that] Indonesia is only at the start of the well-trodden path of rising credit penetration,” stated a March 10 Goldman Sachs report authored by Ben Koo and Melissa Kuang. “We believe these positives have not been priced in.”
But banks are trying to grow the micro-lending space too fast. Funding micro-lending establishments is pricey, leaving banks with little room for failure. As the fight for market share intensifies, high lending rates could quickly fall. More funds will be needed to build this business too, yet pressure on liquidity is mounting with the implementation of Basel III.
The danger is a liquidity squeeze, according to Bank Mandiri CEO Zulkifli Zaini.
“One of the main challenges for banks in Indonesia that are not able to gather the deposits is the liquidity problem in the future. That is a very significant challenge,” the chief executive tells Asiamoney at his office in Jakarta.
Indonesian bankers have been known for their prudence following the damage done by the 1997 Asian financial crisis. But their desire to rush into the country’s microenterprise goldmine could create some sizeable new threats.
FOLLOW THE MONEY
Lending to micro enterprises is appealing because of the interest rates involved. A micro loan will typically charge an almost usurious average interest rate of 25%, allowing lenders to rake in dizzying returns on the money they lend.
Yet demand is growing. CLSA estimates that the percentage of micro enterprises that will obtain loans will double in the next three to five years, and the total outstanding amount of these micro loans will easily surpass US$100 billion this year.
The banks are looking to take advantage. Bank Mandiri has more than tripled its number of micro outlets from 610 in 2008 to 2,200 in 2012 through its Mitra Usaha partner, and it intends to double micro loans to 10% of its total outstanding this year, says Zaini. BRI is eyeing growth of 20% per annum.
The push into micro-lending comes as intensifying competition for deposits forces banks to excavate new sources of revenue amid tightening liquidity. Loan-to-deposit ratios reached a 15-year high last year of 84% as credit growth outpaced deposit collection, according to a January 30 report from Moody’s Investors Service. The credit agency expects the ratio to trend even higher this year.
“The strong credit growth of the past few years – at a compound annual growth rate of about 23% since 2006 – is a concern,” says Wee Siang Ng, senior analyst at Moody’s.
Attracting more deposits is crucial for banks to maintain a loan-deposit ratio at reasonable levels. Analysts say it should not go above 90%, and these banks are close to breaching that mark. But increasing competition for deposits makes winning additional accounts costly, forcing banks to look for areas that can boost their margins such as micro-lending.
The problem is that higher operating costs inherent in micro-lending force lenders to gamble with their capital.
Micro-lending is cost-heavy because it requires personnel to keep a close eye on its customers due to their informal nature.
“Our on-the-ground checks show that many Indonesian entrepreneurs do not actively record and track their own cash flow or inventory,” wrote Jayden Vantarakis in a March 11 report from CLSA.
Because a customer’s financial inflows are hard to monitor, micromanagement is essential. The tendency for fraud and incidental charges contributes to higher non-performing loan (NPL) levels of 5%-6% compared to the industry average of below 2%.
“One of the things that we watch out very carefully for is fraud. This kind of business is fraud-prone [as some] customers… [may] submit fraudulent documentation,” says Henry Ho, CEO of Bank Danamon, which is waiting for Bank Indonesia, the central bank, to approve its sale of a 99% stake to DBS worth IDR66 trillion (US$6.77 billion).
Rising competition among banks in the micro sector also makes it crucial to cater to customers’ needs. For example, borrowers prefer banks that will send officers to their shops to collect payments, or have outlets near their shops, because these businesses employ only one to two people. Bank Indonesia added additional pressure on employee costs after it banned banks from outsourcing loan-origination staff.
Bank Mandiri had 13,248 employees focusing on micro-lending at the end of last year, which is nearly half of its total workforce and a step up from 11,499 in 2011. Danamon had a total of 72,089 employees and Bank Rakyat Indonesia had 72,625 at the end of 2012.
The number of employees and branches required to effectively man this sector has deterred some institutions.
“You really need to have scale, it can be operationally very intensive,” says PermataBank CEO David Fletcher. “We haven’t gone that path [as] we see a lot of opportunity with our existing consumer, SME and commercial banking that at this stage we don’t feel the need to complicate by trying to get scale business in micro-financing … It needs a significant investment.”
DISCIPLINE REQUIRED
Because these businesses are expensive to run, banks need to discipline themselves over their cost and expansion strategies. But keeping costs down is not an area in which they have traditionally excelled.
Indonesian banks already have the highest operating cost-to-income ratios in Asia due to a combination of still-developing bank efficiency, the large number of personnel required to service customers and its archipelagic geography. Those operating cost ratios reached 79.6% in January, compared with the 40%-60% recorded from its neighbours, according to a March 14 report in The Jakarta Post.
These high ratios leave the banks with little room for error. The consequences of inaccuracy could badly hurt the margins of any bank that fails to get its calculations correct. That could quickly lead to solvency concerns.
Put simply, Indonesia’s banks cannot afford to fail in micro-lending.
Yet many feel that they cannot turn their back on it either because of the revenue opportunity it offers. Micro-financing returns are estimated to be more than 20% per annum, according to banks, which is understandably tempting.
Besides the seduction of hefty returns from micro-financing for Indonesia’s banks, the central bank won’t allow them to ignore the sector.
Bank Indonesia has announced a string of measures since December stipulating that banks must increase their exposure to micro and small and medium-sized businesses to 20% by 2018. Lenders are also required to open branches in less developed areas outside Java, the country’s most populated island and home to the capital.
These plans are part of Indonesian president Susilo Bambang Yudhoyono’s efforts to include more Indonesians in the financial system. But it will be challenging for some banks to increase lending in that sector if their business model is based on something entirely different to other parts of their operations.
For example, nearly 86% of Bank Tabungan Negara’s lending comprises mortgage financing, and the new regulations will force them to rejig their business model and credit risk-management systems. It’s a risky venture as the bank’s loan-to-deposit ratios are 100.9% as of the end of last year.
“The recent imposition of lending quotas… may weaken lending standards,” says the Moody’s report. “An increase in such interventionist policies could have negative credit implications.”
BIGGER IS BETTER
The best way for Indonesia’s banks to successfully raise competitiveness in various sectors, including micro-lending, is to grow in scale – either organically by expanding franchises or through acquisitions.
The bigger the bank and the more geographic reach, the more it will be able to capture a steady flow of deposits that will support credit growth. Without deposit growth, the bank will not able to lend quickly enough and that will shrink net interest margins.
“Some banks that don’t have [a] good franchise [will find it] quite difficult to have the deposits that they need to grow their loans,” says Mandiri’s Zaini. “The first challenge for the banks that cannot get the deposits [or] enough deposits for supporting the loans [is that they] will not be able to grow their loans and that means that their business will not grow as fast as others. And if that happens from year to year, then there will be confidence problems for these kinds of banks. There will be liquidity problems.”
According to CLSA estimates, banks can protect risk-adjusted returns from shrinking through economies of scale, lowering their overall overhead and credit costs as they increase their number of franchises.
CLSA draws two scenarios to see how risk-adjusted returns are affected when a bank’s size and scale grows. It estimates, for example, that Bank Mandiri registers a 14.2% return if its overhead costs are at 17%. But if its overhead costs fall to 13% thanks to greater scale, its returns jump to 40.7%.
“These estimates are highly sensitive to overhead and credit costs, which is why building up scale is so important,” according to the report.
Not only is scale important to keep returns desirable, it is also needed so that a bank can achieve competitive wholesale rates and deposit rates as well as digest higher NPL levels.
Smaller lenders are already becoming stretched, and some are already talking about raising time deposit rates by up to 50 basis points, says equity analyst Vantarakis at CLSA.
“That’s the beginning of what you see when liquidity starts to get a bit tied up,” says Vantarakis.
Lenders such as BPTN or Bank Danamon are candidates that will have to pay out more to attract funding, he predicts. However Danamon’s Ho says that his bank can sustain a loan-to-deposit ratio (LDR) of more than 100% because it has sufficient capital, and he can supplement the difference with wholesale funding.
One Jakarta-based analyst says that the DBS offer, which is expected to go through, will also raise its credit rating one notch higher from the ‘Ba2’ level by Moody’s, ‘BB’ by Standard & Poor’s and ‘BB+’ from Fitch.
“We have no liquidity problems, we don’t have funding problems,” says Ho. “I can go over 100% [in LDRs] simply because I have the financial strength to be able to tap into the bond market and to use my capital to fund the growth.”
RACE TO THE BOTTOM
Banks eager to expand into micro-financing are also likely to face another problem in a year or two: deteriorating returns.
Their desire to gain market share is likely to encourage less responsible lending practices even as it pushes interest rates down. This has already been seen with a six-to-seven-percentage-point decrease in micro-finance interest-rate levels in the past two years, according to CLSA. Lenders will need franchises to make up for lighter margins.
“There will probably be some banks that may not be able to expand micro-lending in the future because of a lack of funding, and secondly, because of practices that will lead to higher NPL levels. So they will either have to slow it down or stop lending. It will probably centre on smaller and even larger banks,” says Tjandra Lienandjaja, deputy head of equity research at Mandiri Sekuritas. “If banks do not have good deposit franchises, then it will be difficult [for them] to expand it without sacrificing their margins.”
Vantarakis says a liquidity crisis could occur within three years, when the banking sector’s average loan-to-deposit ratio would begin exceeding 90% based on its current trajectory. Larger banks are best equipped to take these hits, which is why he recommends investors buy shares of top banks such as Bank Mandiri and Bank Rakyat Indonesia.
Zaini of Bank Mandiri says these liquidity concerns have been factored into his credit risk-management practices already to limit contagion risk.
“We know which bank has a good balance sheet [and] which bank doesn’t … We are quite selective in choosing the partners we are going to lend our money [to].”
He believes that banks without enough deposits will be forced to raise wholesale funding from the capital markets. But as more and more banks decide to beef up their capital bases due to rising competition for deposits and the implementation of Basel III in Indonesia come 2014, the cost of funds is bound to rise.
Asian issuers have already tapped the US-dollar bond markets early over concerns that US Treasury yields will rise as the global economic outlook improves and the Federal Reserve stops its bond-buying programme.
CONSOLIDATION CRUNCH
Both the government and Bank Indonesia need to act more aggressively if they are to simultaneously promote micro-financing and prevent a funding race from threatening the banking system.
They should encourage the merger of weaker banks by stronger peers so that deposits are not wasted and competition reaches a healthy plateau.
For more than a decade, Bank Indonesia has said it would like to see more bank consolidation. But it has failed to lower the number of lenders, which stands at an unwieldy 120. In its national banking plan in 2004, the central bank said it wanted to cut the number of lenders to as little as 38. Fewer banks would make it less costly and time consuming for the central bank to supervise lenders spread across 18,000 islands.
But the government has done little to induce this, even though it is in its interest to increase market efficiency to support economic growth. It doesn’t help that domestic banks such as Bank Mandiri, CIMB Niaga and Bank Negara Indonesia have successfully grown their franchises through organic growth and joint ventures (JVs), which weakens the justification for acquiring another lender.
Bank Mandiri CEO Zaini says his bank is targeting two to three acquisitions, but his bank’s organic strategy is based on fulfilling retail and wholesale transaction banking, not bargain hunting. Mandiri has recently entered into a JV with Pos Indonesia and Tabungan Asuransi Pegawai Negeri that will allow it to nearly double its outlets without significant cost.
But many institutions still prefer other means of expansion.
“The bigger banks may prefer organic growth – many feel if they continue to invest in their people to grow the business, they may achieve faster growth than acquiring and restructuring a smaller bank,” says Boon-Kee Tan, head of Southeast Asia’s financial institutions group for investment banking at Goldman Sachs.
In addition to banks finding ways to divert from the M&A route, mergers have been bogged down due to pricing obstacles, according to Lienandjaja. He says bank mergers have become difficult to price because transactions completed before the Asian financial crisis priced the targets at four times historical price-to-book ratios, and suitors have found that too expensive.
HSBC’s purchase of Bank Ekonomi Raharja for US$607 million in 2008 priced the lender at an expensive 4.1 times book value.
“This has set a benchmark for the M&A for other smaller banks. Of course at this level, you may have to think about it,” says Lienandjaja.
The central bank should set up a task force that can identify potential suitors and acquisition targets as well as broker merger talks. Regulators can also support weaker banks by providing consultation services to help them pinpoint loopholes in their risk-management systems or improve business models so that they can focus on areas of strength.
If an outright merger is too extreme a solution, banks can test a relationship with JVs and projects to allow them to experiment first. The government could also encourage foreign investment into the sector.
TAKING THE LEAD
Bank Indonesia appears well aware of the issues and concerns that its banking system harbours, and its desire to have the banks offer funding to micro enterprises is sensible.
But it must forge ahead with bank reforms, particularly given the pressing need to consolidate in light of Basel III.
PricewaterhouseCoopers says in its 2012 Indonesia Bank Survey Report that the implementation of the new bank rules will incur “significant” costs that will lower RoEs.
The central bank needs to offer sensible policy moves to keep banks healthy, solvent, and firmly focused on risk management. Consolidation would be one positive step, as would encouraging more foreign partners.
Fostering M&A among more than 100 banks is a daunting task for the central bank, but a good way to start would be to set clear guidelines and deadlines to meet specific targets in preparation for a more mature and liquid bank market.
However, Bank Indonesia should be aware of forcing banks to commit to goals that may not fit their business models, particularly in the micro-financing sector. No matter how ethical a policy’s motivations may be, they should not come at the expense of detrimental side effects such as eroding asset quality, especially when the country is about to embrace Basel reforms.
One way for the central bank to kill two birds with one stone would be using its desire to expand micro-lending to encourage consolidation. It could reward banks that traditionally haven’t conducted much micro-lending by providing tax incentives to buy, merge or conduct JVs with institutions familiar with the sector.
Encouraging more foreigners to buy smaller banks with micro-lending franchises could bring more investment into a sector that would benefit from advanced technology and management expertise, boosting market efficiency.
“It will take time, it will take energy for them so probably they can acquire one bank and use that to boost their micro-lending,” says Lienandjaja.
It is important for Bank Indonesia to implement policies that address the issue at hand and also consider the circumstances banks face.
It will not be easy. But if Indonesia is able to draw a clear regulatory path for banks and investors alike the government could ensure that its lenders fund one of Southeast Asia’s most promising economic stories.
