Monday, August 10, 2009

The Current Challenges of Indonesian Islamic Banking Industry (Part I)

1. Introduction
For quite a long time, it is very common for us to hear critics saying that the Indonesian Islamic banking industry has failed to capture a bigger market share in Indonesia despite the fact that Indonesia is the biggest moslem country in the world. To certain extent, this might be true.

If we compare the total assets of Islamic banks (based on Bank Indonesia's Islamic Banking Statistic per June 2009, the amount of which is approximately Rp.55 trillion) with the assets of commercial banks (based on Bank Indonesia's General Banking Statistic per June 2009, the amount of which is approximately Rp.2,028 trillion), we will found out that Islamic banks' assets only represent 2.64% of the total assets of Indonesian banking Industry (excluding rural credit banks). True, that if we compare the current data with 2005's data, Islamic banks' assets have increased around 250%, but that is not significant enough if we see the total cumulative assets of the Indonesian banking industry.

Seeing this hard fact, what are actually the main challenges of our Islamic banking industry? What need to be done to surpass these challenges and how? In this article, I will discuss some of the most important challenges that are currently being faced by Indonesian Shari'a banks and some suggested solutions which may be considered in solving those challenges.

2. Major Challenges in Developing the Islamic Banking Industry in Indonesia
In my opinion, such major challenges include:

a. taxation issues;

b. regulatory issues;

c. risk management issues; and

d. segmentation and marketing issues.

Issues No. a and b will be discussed in this article, and the remaining issues will be discussed in Part II of the article.

3. Taxation Issues

The taxation issues might be the oldest and most important issue of all time when we are discussing Islamic financing products. And amazingly, despite the seriousness of the issue, no resolution has been made until now, as there is no clear tax regulation on the correct tax treatment for such Islamic financing products, especially for the "asset-based" products, such as murabahah (deferred payment sale with margin), istisna (purchase by order/manufacture) and ijarah muntahia bit tamlik (financial lease with purchase undertaking). To show the importance of this taxation issue, it is worth to note that per June 2009, these "asset-based" banking products comprise more than 60% of the total Indonesian Islamic banking financing (excluding Islamic rural bank), with murabahah products sitting at the top by covering 57% of the total financing.

It is a basic concept under the Islamic law principles that for "asset-based"
Islamic finance transactions i.e. the transactions involve certain underlying assets and such underlying assets are being "transacted" or used as the basis of such Islamic finance transactions, the transactions related to the underlying assets which may include sale and purchase or lease should not be treated as actual transfers, but merely as a financing arrangement. Thus, there would be only a transfer of beneficiary ownership or usufruct rights (hak manfaat) and there is no transfer of legal ownership within an Islamic financial transaction (which may involve value added tax (VAT)).

However, as there is no clear regulation on the tax treatment, a conservative opinion will state that there is a huge tax risk for this "asset-based" Islamic finance transactions which in the end will cause these transactions to become more costly. True,
that currently there is a "status quo" between Islamic banks and tax authorities, i.e. each party is being silent on the tax treatment. It is also true that under most of the contracts of Islamic finance transactions, any tax arising from the transactions shall be borne by the customers. But this is like sitting on a time bomb, or saying that all problems will be vanished by simply closing our eyes and dreaming that the problems are indeed vanishing.

Consider this fact, as per June 2009, the total murabahah financing provided by Islamic commercial banks has reached approximately Rp.24. 2 trillion (equivalent to US$2.4 billion). And then imagine that after seeing the data, the tax authorities decide to actually impose the VAT on the murabahah transaction, simply because now they can obtain almost Rp.2.4 trillion (equivalent to US$240 million). More importantly, imagine if the Indonesian Islamic banking industry has reached an equivalent position with the commercial banking industry, the tax costs would be absolutely huge. Before that kind of disaster can happen, a preventing action must be done.

Based on my own experience in giving a presentation on Islamic financial transactions in capital market for certain Indonesian tax authorities, I get an impression that the tax authorities actually understand the basic concepts of Islamic financial transactions. However, they can't provide any remedy for the taxation issues without having a proper legal basis, as there is a fear that if they act without clear regulation, such act will be considered as causing losses to the state and they will face the risk of facing allegation of corruption. Might be exaggerated, but the risk does exist.

Therefore, the only solution that can be done is to lobby the House of Representative and the Government to amend the Tax Law. I understand that the Income Tax Law has been amended to cover Islamic finance transactions, but the real problem lies on the VAT Law. The question is, what are we trying to ask from the regulator? Based on my discussion with a Director of one of the major Islamic investment banks in Malaysia, the most important thing to ask is to have a same treatment with commercial banks, and not asking for a tax evasion or tax holiday. It takes almost 20 years for Malaysian Islamic banking industry to convince their tax authorities to provide a same treatment between Islamic finance transactions and the conventional ones. Surely, we would not want that to happen in Indonesia.

What do we mean by asking the same treatment? It means that all Shari'a finance transactions will be considered as pure financing transactions. It would not be deemed as an actual sale and purchase or lease, there is no actual legal transfer of assets, and all of the "transfer" procedure should be treated as an element to be fulfilled under Islamic law principles. Therefore, all Islamic "asset-based" financing transaction, whether based on sale and purchase or lease, shall receive similar tax treatment with the financing products of conventional commercial banks, i.e. exempted from VAT.

I understand that this might seem as an issue, if Islamic Bank is proud of not using interest in providing financing products, why bother to have a same treatment with conventional banks? To this, I would reply that same treatment is extremely important because while each of them have a very different method in conducting their financing business, both of them are still doing business in their respective status as financial institutions, and thus need to have equal treatment. I've seen too many prospective investors in Indonesian Islamic banking industry come to our country and discuss the possibilities of establishing a new Islamic bank in Indonesia only to cancel their plan due to the tax issues. Whenever we reach the taxation issues, we know from the look of the investors' faces, that establishing an Islamic bank is not a viable option for them as long as the tax issued has not been resolved.

I hope that by focusing on the same tax treatment, the regulators will realize that they will not lose any potential tax objects, but instead gain access to a lot more of taxable incomes due to the development of Islamic banking industry in Indonesia. There is still a lot of homework for this issue, but no matter what this issue must be resolved without any further due. Being silent will not solve it at all. How can we expect for a real booming on Islamic banking industry if the Government cannot provide tax certainty to the industry?
4. Regulatory Issues

First of all, there is no single and binding interpretation of Islamic law around the world, as each different school of Islamic jurisprudence (mazhab) has its own methods in constructing and interpreting the Islamic law, especially for those aspects which fall under the term of muamalah (day to day life aspects), such as commercial and financing transactions. That is why in most of the Islamic countries, their Governments are actively involved in stipulating regulations in order to unify the implementation of Islamic law.

The case is similar in Indonesia. It is just recently that we are having an umbrella Law on Islamic Bank. Prior to the issuance of such Law, most of the regulations are issued by Bank Indonesia or the National Shari'a Board (Dewan Syariah Nasional). while these regulations are important, they are lacking specific provisions and need further implementing regulations. Something which have not yet been resolved until today.

It is a common thing that without clear guidance and regulations, business players are not willing to conduct the business because they may be exposed to uncertain risks and liabilities. To add the problem, before the industry can build a solid basis on their knowledge on Islamic finance, the Government issued an amendment to the Law on Religious Court, stating that all disputes related to Shari'a finance transactions should be brought to the Religious Court.

This is quite shocking.
Based on my discussions with a Director of one of the major Islamic investment banks in Dubai, it is pretty unusual even in the Middle East for bringing a dispute on Shari'a finance transactions to Religious Court which mainly deals with Islamic family law. Considering the fact that there is no single codification on Islamic commercial law, most Islamic banks prefer to have the Shari'a aspect reviewed by their respective Shari'a supervisory board (Dewan Pengawas Syariah) and thus any dispute made with respect to the transactions should merely focus on the financing aspects, such as repayment of the financial obligation of the customer, restructuring of the financing, etc.

Having to dispute the Shari'a aspects while in fact we don't have clear regulations and enough experts to deal with the issues is clearly not efficient for the development of the Indonesian Islamic banking industry. It is indeed fortunate that the Law on Islamic Banking has provided an exit clause for this issue by giving the opportunity for the Parties involved in Islamic finance transactions to choose their method of dispute settlement, including choosing a district court.

It is important to note that this does not mean that I'm trying to suggest the Islamic banking industry to not pay much attention to the Shari'a compliance aspect of their business. The Shari'a compliance aspect is without a doubt the core of the Islamic finance transactions. But at this current time, the role for maintaining the Shari'a compliance of the banking products should be given to the respective Shari'a supervisory board of the Islamic banks. An implementing regulation stating the power, authorities and qualification of the members of these Shari'a supervisory boards are absolutely necessary in this current conditions.

Further, as the Indonesian Islamic banking industry is subject to Indonesian laws, it is important to adopt all the relevant Shari'a aspects under the positive law of Indonesia. Bank Indonesia's plan to establish a Shari'a Banking Committee (Komite Perbankan Syariah) to adopt DSN's fatwas into BI Regulation is much appreciated since it will give a clear binding power of those fatwas upon the Islamic banks.

As discussed above, most of the regulatory problems can only be handled by the regulators. However, through this Article I would like to point out the necessity of those who are involved in establishing the regulations to always work together and ensure that all important aspects of the Islamic banking industry can be putted into certain regulations. Like it or not, there would only be one applicable laws in Indonesia, and that is Indonesian laws. As a result of which, Islamic law principles shall not have binding power unless they have been adopted and implemented in Indonesian laws and regulations. To protect the interest of all parties involved in the Islamic banking industry, it would be prudent to have all these scattered principles gathered into a single binding law.

The above paragraph concludes the first part of my article. On the second part of the article, I will discuss some challenges related to risk management and segmentation of the Indonesian Islamic banking industry.

4 comments:

MuqthiJurnal Friday, August 21, 2009 2:16:00 PM  

Notably on regulatory issues, I do agree that harmonization and intensive communiaction among involved parties are essential. Regulatory framework still a challenge problem for Indonesian Sharia Bank even we should appreciate that some banking or other laws related to the finance have accomodated sharia economic transactions.

Jhordy Kashoogie Tuesday, August 25, 2009 11:41:00 AM  

I have two remarkable comments on this part of your paper.
Firstly, Taxation issue and regulatory issue are already old issues which haven't been resolved yet. It happens because the reluctance of Legislative body (DPR) 2004-2009 to pass up and sign the regulation, specifically tax regulation in Islamic Bank. I hope this new upcoming DPR has the interest on Islamic Banking & Finance so it would be easier for Indonesian Islamic Banks to operate.

Secondly, Shari'ah law vis-a-vis Common law, In order the Islamic Bank's disputes to be settled in district court, it's a necessity to educate the judges about Islamic finance because without this education, it would worsen the problem. the judgment would be judged/treated like conventional bank's dispute as it happened in Malaysia regarding Bay Bithaman Al-Ajil case in Affin Bank VS Zulkifli.

Pramudya A. Oktavinanda Tuesday, August 25, 2009 11:56:00 AM  

Thanks Jhordy,

On your first note, completely agree. These are truly old issues which amazingly have not yet been resolved. That's why I put some emphasis on such issues, as we need someone to remind the government that there is a pending issue to be resolved. We simply can't expect that these issues will be just vanished to thin air without us doing a thing, right?

On your second note, I tend not to have a dispute regarding the Shari'a aspects in the court as it wouldn't be efficient. With too many opinions out there, there would be incentives for bad customers to dispute the validity of an Islamic finance transaction simply by using different opinions of Islamic scholar.

The task of ensuring that all Islamic finance products are shari'a compliant should rest on the hands of regulator and the respective Shari'a supervisory board of each Islamic finance institution. In Indonesia, any new Shari'a banking products which are not yet categorized in a regulation must be approved first by Bank Indonesia prior to use.

Thus, a dispute regarding shari'a finance transactions should related only to the general financing aspects and not the Shari'a aspects. Of course it would be nice to educate the judges of the district court on Islamic finance matters.

Jhordy Kashoogie Tuesday, August 25, 2009 12:46:00 PM  

Yes, we have to push up governments to implement regulations for Islamic Banking.
I see your perspective about the efficiency of court to settle disputes, I think it would be better for Islamic banks to have a harmonized regulations made by Bank Indonesia and Dewan Shariah Nasional to deal with the anticipating disputes.

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