The Chronicles of a Capitalist Lawyer

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.

"It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest" (Adam Smith - British Economist and Father of Capitalism) What is Capitalism?

In the simplest way, Capitalism can be described as the economic system which maintains the idea that owning and accumulating private wealth are the basic rights of every person, and those rights must be preserved and protected by the State on a first priority basis. In general, Capitalism believes that the preservation of the above rights and the freedom of people to enjoy such rights will enable the society, as a whole, to gain maximum prosperity. However, we must always remember that Capitalism is not a divine system established by God. It is an economic system created and developed by men through countless trials and errors.

There are many ways in implementing Capitalism in various parts of the world and even until today, we have not found yet a definitive and final form of Capitalism. To make it short, Capitalism is still evolving and I believe that the process itself is unlimited. In this article, I will explain some of the basic concepts of Capitalism. I'm not an economist, but my job as a corporate lawyer is directly related to the practice of Capitalism. Through my job, I realize that Capitalism makes sense and its principles are built on a solid basis. As I will further argue in this article, and despite the critics and the current global financial crisis, I still consider Capitalism as the best economic system that men ever have.

What Are the Basic Principles of Capitalism?

Capitalism is derived from three basic principles: 1. a common man will put his self interest as his first priority; 2. all men are interdependent; and 3. free competition is the most effective safeguard mechanism of Capitalism.

Could You Explain the First Principle of Capitalism?

Capitalism believes that a common man will put his personal interest as his first priority. It is not surprising that, using the above argument, many people claim that capitalists are evil individualists who only think about themselves and who will do anything to obtain what they want. But, those people are exaggerating, too exaggerating. I even dare to say that they are actually fooling themselves for not letting to believe their exact nature as men. Let us go through this simple test.

Say that you are an average man, having some decent work with a considerable good salary for living and you are not in a dire need. Then, you somehow get the opportunity to receive US$10 legally from someone. Now, answer these questions truthfully. Would you really want to reject that money and say to the generous man that the money should be given to other people in dire need? Then, try increase the number into US$100, US$1,000, US$10,000, and so on. And then keep asking the same question, would you reject that money?

How about if you are also in a dire need, will your answer remain the same? Or, try to imagine this: Having work really hard in your office, you soon realize that up to 30% (depends on the amount of your gross salary) of your salary is going to our beloved country for paying your income tax, which means in one year, there is a probability that you might spend more than 3 months doing charity work, working without any payment, acceptable or not? For the first question, I'll be honest, I'll take the money for sure (especially when the amount is significant). For the second question, I must be damned if I call that kind of legalized robbery as acceptable (though the new Indonesian Income Tax Law provides a lower tax rate and a higher limit of taxable income, for which I say Hooray!!!). I bet my X-BOX 360 that most people will also take the money and reject the high rate of tax (or even the tax itself).

This is natural, it's in our blood. You're not turning into a bloody parasitic dark lord for pursuing your self interest, you're basically trying to survive in this vast world. Capitalism happily embraces this fact and establishes it into its first principle. Interestingly however, some people pretend to forget their own nature on these issues and say crap things publicly about the need to promote social interests above individual interests while in reality these guys would absolutely chase their own interests before even thinking about the interests of the society. By this, I refer to the majority of the politicians.

How Come the Pursuit of Self-Interest Are Not Causing Misery?

You see, after acknowledging the basic nature of men, Capitalism puts the second basic principle: not a single man can pursue his self-interest without cooperating with others. Thus, every man is interdependent with another man. Whether they like it or not, they need to work together and reach mutual understanding in order to satisfy their needs. What a beautiful concept!

Have you ever imagined how you can get your nice nasi padang at the Sederhana Restaurant? Who supply the rice, the meat, the coconut milk and those other spices? Who cook the tasty food? Who serve the food? Who provide the place of the restaurant? The creation of Nasi Padang Sederhana actually involves a huge amount of actions, actors and factors, from the production of the rice to the distribution of the Sederhana franchise (including the recipes).

The most interesting part of the above scheme is the fact that none of the actors involved in such scheme are doing their part of actions due to their compassion for the greater good of the society. All of them are pursuing their own needs and interests! The farmers grow and sell the rice so that they can earn some cash to buy their needs, the waiters at the restaurant serve the guests nicely so that they can earn their salary (and maybe some tip) and buy their needs, and so on. And amazingly, no one actually have a global and full control over such process despite its complexity. If you think that there is a conspiracy back there which force all of the above actors to work together in order to provide a Nasi Padang, you must be crazy. So, in the end it is all interrelated.

Capitalism believes that the pursuit of self interest should not cause misery to each other, because through the existence and exchange of various self interests, men can actually satisfy their needs. The words of Adam Smith stated in the opening of this Article would be excellent to summarize this second principle. I must also add a note that this second principle is being greatly supported by the existence of money. With money, people has an easier mechanism to value goods or services that they want to produce or obtain. I will reserve the discussion about money on a separate article.

I Don't Buy This Idea, There is Something Missing, Isn't It?

True, as beautifully crafted as it may be, there is still a weak point in the second principle: not all men have equal power and status. Though all men are interdependent, the difference of power may disrupt the balance and thus opening a way for the emergence of the darkest part of human soul, the hunger for everything, even if it costs other people's life and needs. Without any safeguard mechanism, Capitalism will definitely crumble into dusts as a result of this problem (as once predicted by Karl Marx). Thus came the third principle of Capitalism: Free Competition. Too simplistic? Not at all.

Free competition is actually a brilliant way of ensuring that power is distributed efficiently among men. The concept is actually simple and can be explained by the following example: Some years ago, there were only two telecommunication providers in Indonesia using a dual-monopolistic system. To cut it short, these two companies have absolute control over the Indonesian telecommunication services. Result? Expensive telecommunication tariff and poor infrastructure. In 2004, it only cost me Rp80,000 per hour to make an international call from Seoul to Jakarta using a Seoul public telephone. That was very cheap at that time compared to the cost for doing international calls from Jakarta to Seoul.

But now, with the increasing number of telecommunication providers, we see the new era of cheap telecommunication services. Those telecommunication providers spend billions of Rupiah just for claiming in TVs and radios that they are the cheapest operator. Indeed, they don't have many choices. If they don't cut their prices, provide better services, and make the most entertaining advertisement, other operators will claim their customers and in the long run, losses will become the end result. Of course, how can they cut their prices if they can't increase their business efficiency? Like it or not, this competition game forces those operators to find new ways in increasing their business outputs. Efficiency, creativity, innovation, name it, and they will get it. Such are the results of competition, incredible!

In fact, the free market, the free competition, is actually doing better than the Anti Monopoly Supervisory Committee (KPPU) in the telecommunication sector. This is related to one case when KPPU brought the case of Temasek, a Singaporean State Owned Company, to Indonesian public attention for having control in two major Indonesian telecommunication companies. In that case, KPPU claimed that such control has caused monopoly and unfair competition and thus increasing the consumer cost for getting telecommunication services. So much hours and money are wasted to force Temasek to release its majority ownership in one of the operators and to cause those two operators to reduce their tariff. Yet, without having to wait for the final judgement, those two telecommunication operators have already reduced their tariffs for the sake of winning the competition. And this is the current trend, as I've once discussed it with an executive of a major telecommunication provider. Do we actually need a better example for understanding the power of free competition? I guess not.

Okay, Enough with Capitalism Principles, What About the Market?

Ah, good timing! As discussed in the second principle of Capitalism, all men are interdependent. But, how can they cooperate with each other? The answer is the market. The market is the most important facility of any economic system, even for the so called communism, since it provides a place for people to meet, trade and exchange their self-interests. Of course, I'm not referring to a traditional market in a remote village where you can find living stocks and fresh vegetables. I'm referring to the concept of market as an abstract place, a structure where goods and services are offered and traded, where supply meets demand, where buyers meet sellers.

There are countless numbers of markets in this world, telecommunication market, energy market, stock market, financial market, commodities market, you name it. But the basic is same, within the respective market, people may look out for what they want and try to obtain those things with certain price. The issue of price brings us to one of the most important aspects of the market under the system of Capitalism, one that has become a never ending subject of debate, the market equilibrium and the self-efficiency of the market.

Until today, no one has ever reached a perfect theory which can explain how the market can reach those conditions, where the prices of each goods and services reflect the actual supply and demand, and all market participants have obtained the necessary information in making their economic decision. It is almost impossible for me to explain those complicated issues within a single article without having the readers getting lost in understanding the concept. So, let me put this simply.

Under the basic principles of capitalism, the market will work best if there is a minimum intervention from forces outside the market, BUT, it does not mean that the market itself can always maintain its equilibrium and efficiency, some interventions would be need for certain cases, especially when the principle of fair competition has been breached due to unfair or illegal activities. The key issue here, is to find the best policy that can HELP the market to avoid its own weaknesses without having to sacrifice the freedom and the unlimited opportunities that market can produce through free enterprises.

I can't answer that yet, but am hoping through the times of my journey here, I would be able to provide certain solutions and insights on how we can create such best policy.

Why Promoting Capitalism?

Simply because Capitalism is applicable in every part of the world, even in the so called Communist Republic of China, and because it has survived for many times during the last 200 years. Economic crises come and go for many times, people have gone through some pessimistic and optimistic periods in doing their business. You know, during crisis, like in 1933, 1987, 1997, and 2008, people always claim about the end of capitalism. Of course this is a politically correct maneuver and it is easy to reach such conclusion. But, if you analyze it further, in the end it is a part of a grand business cycle. What goes up, will go down, and vice versa.

During the Asia financial crisis in 1997, most people blame us for our fragile economic fundamentals, and you know how the western countries see Asia at that time, a failure. But now, it is Asia who has the better economic fundamentals and can maintain such fundamentals despite the crisis in the US. Amazingly, most of Asia Countries and US use capitalism principles in making their economic policy. I believe that the basic nature of human is always the same, everyone want the same opportunity to do business and reap profits, and they want to do it without too much of restrictions and inefficiency, the way that capitalism has always preached about.

In general, the application of Capitalism principles has created an accumulation of wealth and development in many countries, and Indonesia, without a doubt, has also received benefits from capitalism. Of course, like I've said in the beginning of this article, Capitalism is not without any flaws, there will always be a problem, such as the problem of distribution of wealth, power disparity between market players, etc. But, we can't stop using a system or even try to replace it in entirety because of some flaws, that would be horrendous. It is our job to modify and fix the flaws in capitalism to ensure that it can work properly rather than spending times on building a new entire system which would be most likely not efficient. This is a never-ending process, and I expect to see many new developments in the future of capitalism.

To end this article, I would like to share a piece of wisdom from Milton Friedman, an American Nobel Laureate, "What kind of society isn't structured on greed? the problem of social organization is how to create an arrangement under which greed will do the least harm; capitalism is that kind of a system."