CHAPTER 6 EMERGING ISLAMIC BANKING AND FINANCE
6.2. The Islamic Banking Sector’s Development
In the early stages of the development of the Islamic banking sector, the BMI and BPRS in particular faced a dilemma since the banking system was predominantly conventional in character. Arifin (1999) states that the lack of non-interest-based monetary instruments was one of main limitations for Islamic banks to function under the Sharia framework.59 In many cases, the banks were forced to engage in conventional transactions. Furthermore, Antonio (2004) identifies several fundamental constraints that hindered the development of the Islamic banking sector, including tax treatment, the accounting system, lack of capital and appropriately trained personnel.
In consequence, the Islamic banking sector had difficulty competing with the dominant conventional sector, as well as expanding its own networks and increasing its market share. As an example, the Islamic banks faced double tax treatment in mark-up financing, with the consequence that its financial products were less attractive than the interest-based loan schemes although mark-up financing provided some advantages to borrowers. In the period before the financial crisis, the Islamic banking sector
59 To ensure the bank operation complies with religious jurisprudence, the Islamic council (MUI) established an internal supervisory board (Dewan Pengawas Syariah or DPS) in the BMI organisational structure. The primary task of DPS is to produce Islamic-compliant guidelines and to monitor the overall bank transactions as well.
comprised of only one commercial Islamic bank (BMI) and 11 BPRS, which together accounted for less than one per cent of the overall banking market share.60
In 1997 the banking and financial sectors were hit by the Asian banking crisis, in which numerous banks were closed and others were bailed out by the government (Batunanggar 2002; Djiwandono 2005). Interestingly, although the magnitude of crisis was huge, and severely hit the country’s economic and the banking industry, a number of Islamic banks achieved very sound performance and successfully maintained sustainable growth and profitability (Antonio 2004). In this respect, the Islamic banking system shows its resilience and strength, since the principle of Islamic banking is related to the real economic sector and prohibits speculative transactions (see further discussion in Chapter 2). Another relevant explanation is that most of the Islamic banks were involved in the micro and SME finance segments, which are resistant toward the global financial turmoil with their focus on foreign exchange-based and derivatives financial contracts.
Following the financial crisis, the Islamic banking sector made considerable progress, particularly when the Habibie government changed the banking laws: Banking Law No. 10/1998 and Bank Indonesia Law No. 23/1999. These regulatory frameworks provide a stronger legal foundation for the Islamic banks to play a more significant role in the banking and financial market. Moreover, during the short period of Abdul Rahman Wahid’s presidency and the Megawati administration, the central bank introduced a number of substantive policies to foster Islamic banking and it networks.
For instance, the conventional banks were allowed to offer Islamic banking services (UUS) under the banks’ existing organisational structure. Through this mechanism, the conventional banks were able to establish UUS with modest capital investments and conduct an Islamic banking business with the same infrastructure as their established services (Juaro 2008).
In order to enhance the stability of Islamic banking, subsequent monetary policies have been introduced by the central bank such as the Islamic central bank certificate (SWBI), interbank money market (PUAS) and an emergency financial facility if any Islamic
60 During this era, new Islamic financial institutions such as insurance, a multi-finance company and a mutual fund were established both by the government-owned companies and by the private sector.
bank faces liquidity problems (Antonio 2004). Equally important, in within the central bank organisational structure, a new Islamic banking bureau (later it became the Directorate of Islamic Banking) was set up to control and supervise the Islamic banking sector including the design of a grand strategy for the development of Islamic banking (The Indonesian Islamic Banking Development Blueprint 2002–2011). This blueprint provides a general platform and foundation for Islamic banking development and, more specifically, it enhances the structure of the industry so that it is as strong as the conventional banking sector through improving its efficiency and service quality, and ensuring it complies with standards of global Islamic banking.
In line with the banking reforms, the Indonesia Islamic Council (MUI) formally set up the National Islamic Board (Dewan Syariah Nasional or DSN) with the primary role to publish Fatwa regarding Islamic banking operations and other related economic and commerce transactions, and the National Islamic Arbitrate Body (Badan Abritrase Syariah Nasional or BSSN) to mediate any business dispute beyond the formal jurisdiction. According to Hasanudin (a member of DSN), another important milestone was in December 2003 when MUI ultimately declared the status of the conventional banking transactions as Riba Nasiah, which means that every Muslim is recommended to abandon interest-based practices immediately (interviewed on 18 May 2009). It is quite interesting to note that the MUI Fatwa was introduced five years after the fall of the Suharto regime, but despite this, MUI was not confidence of making the decision without significant support from the Islamic political elites and civil society leaders.
Recently, in the era of President Susilo Bambang Yudoyono, the legal platform of the Islamic banking sector has been further advanced by the introduction of three fundamental acts: the Islamic Banking Law No. 21/2008, the Islamic Bond (Sukuk) Law No.19/2008 and Tax Law No. 42/2009. The enactment of these laws enable the Islamic banking and financial sector to operate on an level playing field and to raise the confidence of Muslim customers to engage in financial transactions according to their choice of faith (BI 2010b).
Table 6.1. Legal Framework of the Islamic Banking and Finance Sector
Law category Impact on Islamic banking sector
1. Islamic Bond Law No.19/2008 Allow the government and private sector to raise funds by selling bonds under the Islamic finance system. This law provides a broadened money market for the Islamic banking sector.
2. Islamic Banking Law No.21/2008
The law specifically regulates the Islamic banking sector. One of the key issues in this law is the establishment of an Islamic banking committee. This committee works under the coordination of the central bank to formulate policies and practical guidelines for the Islamic banking sector.
3. Tax Law No.42/2009 The amendment to this law reduces value-added tax toward the mark-up financing contract. This tax-neutral status would increase the competitiveness of the Islamic banking financing scheme.
Source: Author compilation from Bank Indonesia Regulations