With the world's largest Muslim population, one might question why Indonesia’s Islamic finance market lags behind that of neighbouring Malaysia. In 2013 only 4.9% of total banking assets were held by Indonesian Islamic banks, compared to more than 20% for the same period in Malaysia. A number of suggestions have been put forward for the historical apathy to Islamic finance in Indonesia; we discussed some of these in our recent insight “Islamic finance in Indonesia: Past, Present and Future”. In this follow-up insight, however, we look towards factors that might be key to developing the industry and, in particular, whether the rumoured proposal of the Indonesian financial services authority (Otoritas Jasa Keuangan (OJK)) to create the county’s first “megabank” is really the answer.

The international Islamic finance industry has grown rapidly over the past 20 years; worldwide Islamic finance assets totalled just US$137 billion in 1996, compared to with the consensus that such assets surpassed the US$2 trillion mark toward the end of 2014. As we enter 2015, questions naturally arise as to whether such growth is sustainable and, if so, what further developments can be made.

Advancements in the industry have, to date, predominantly focused on the Malaysian and Gulf markets due to strong government and investor led initiatives driving the desire for, and development of, shariah-compliant products. As these markets reach maturity, attention has moved to other jurisdictions with substantial Muslim populations.

Indonesian Islamic Megabank?
According to recent reports, the OJK first considered the merger of shariah-compliant banking units in May 2013 as part of its five-year plan to develop Islamic finance in the country, the overall aim being to create a large, standalone Islamic bank that could spur consolidation in the industry. There appeared to be three options available to create such an entity: (i) merging of existing Islamic entities; (ii) conversion of a conventional bank into an Islamic one; and (iii) creating a new Islamic bank. It seems the OJK may have looked to neighbouring Malaysia for inspiration: Malaysian consolidation in the late 1990s (creating, amongst others, CIMB, Maybank and the Public Bank Bhd) put the country in good stead to form the shariah-compliant hub that now exists. Also, the recent proposal to create an Islamic “megabank” amongst three Malaysian Islamic entities, while it did not come to fruition, highlighted the potential advantages of consolidation.

Advantages of a bigger institution are likely to include:

1. having the scale to reduce operating costs and provide services at more competitive rates;
2. helping improve public awareness of shariah-compliant finance;
3. having access to and ability to raise further funding for large projects by issuing a series of sukuk (Islamic bonds) with a variety of maturities in diversified sectors and regions.

The expectation is that an Indonesian merger would consist of consolidating the shariah-compliant units of three state-controlled banks: PT Bank Mandiri Tbk; PT Bank Rakyat Indonesia Tbk; and PT Bank Negara Indonesia Tbk. Together, these banks reportedly account for up to 40% of the Indonesian Islamic banking industry, and would create an entity with assets of US$8 billion.

The mooted merger would not create the OJK’s ideal-sized bank of around 200 trillion rupiah (US$16.5 billion). However, it would create an entity twice the size of the current largest Islamic bank in Indonesia, PT Bank Syariah Mandir. Furthermore, it is questionable whether the resulting entity can really be classified as a “megabank” when you compare the asset size of the resulting entity to the recently proposed, although now collapsed, Malaysian megabank merger of CIMB Group Holdings, RHB Capital and Malaysia Building Society, which would have created an entity with assets in the region of $US180–190 billion.

What is a “megabank”? In the everyday context, it would suggest a major bank with substantial assets and coverage; however, in a business and legal context, there is no specific definition of a megabank. In the world of corporates, “mega” suggests strong brand recognition and global operations. Amongst finance practitioners, it is generally accepted that any entity with assets in excess of US$100 billion is reaching “mega” status; however, it is really a matter of context.

With an aggregate of just US$21.4 billion (244 trillion rupiah), or 4.8%, of Indonesia’s total banking assets in 2013 funded through Islamic finance and an overall finance industry that makes up a mere 51% of 2013 GDP in Indonesia (compared to 350% in China and 150% in Malaysia), the Indonesian Islamic finance market as a whole is smaller than any of the largest banks in Malaysia. In a wider Asian context, the proposed Indonesian consolidation is, therefore, unlikely to affect the long-awaited call for an Islamic “megabank”. In the Indonesian market, the bank resulting from such merger could be classified as a megabank. Whilst the label given to the resulting entity does not lessen the argument for the OJK‘s proposed consolidation, one should not overestimate the immediate impact and opportunities such a proposition would bring to the wider Islamic finance industry.

Consolidation—will it work for Indonesia?
Although we have questioned labelling the Indonesian merger as a “megabank”, it is only natural to draw comparisons to the Malaysian merger. It has been reported that the Malaysian megabank proposal did not proceed as it failed to find enough cost savings amid a deteriorating economy, falling oil prices and decreases in share value. In drawing comparisons, it should be noted that the Malaysian merger came from a backdrop of an already developed Islamic finance industry and amongst banks that have already been through at least one prior consolidation and cost-saving exercise (notably CIMB, the second largest Malaysian financial entity).

By contrast, Indonesia’s Islamic banking industry is highly fragmented, with 12 shariah-compliant commercial banks, 163 Islamic rural banks and 22 Islamic windows, and so, consolidation would likely bring significant economies of scale, therefore making the industry more competitive. All the usual arguments for bigger business and economies of scale appear on the surface to be relevant here, without the failings that might otherwise be relevant if we were truly looking at the creation of a megabank.

Regulatory change
In addition to the OJK’s calls for consolidation, local commentators have highlighted a lack of experience in the industry and Indonesian perceptions over the most acceptable Islamic finance model as being significant blocks to development. Given the split in opinion on whether Malaysia’s model of Islamic finance is too advanced and not conservative enough, and those who feel that Saudi Arabia’s version is too conservative, Indonesian authorities will likely have a significant role in convincing the population that the route they eventually choose to adopt is the most appropriate for the country’s Muslim population. Increased size and opportunities will arguably create a greater pull to external and internal investors who wish to develop the market.

Conclusion
We do not anticipate that consolidation alone will secure the future growth of the Indonesian Islamic finance industry. Sustained regulatory support and marketing of shariah-compliant financing, together with increased training and development of experts in the field will also be necessary for Islamic banks to achieve the OJK’s desired aim of Islamic finance holding at least 15% of the Indonesian finance market by 2023. The Indonesian authorities have made a promising start and shown a clear intention over the past 12 months to assist in shaping the way forward for the country’s Islamic finance industry and in encouraging consolidation and proposals for building a new regulatory system. Foreign investors are watching these developments carefully and will likely continue to do so.