Indonesia needs to improve market competition to lower interest rates, improve bank services and make its domestic banks more competitive in international markets.

The Indonesian banking system is centered around 30 inefficient public sector banks that control over 40 per cent of bank assets. The central government owns four banks, and 26 regional development banks are owned by one province or jointly by a number of provinces. The dominance of public banks stems from policies issued in 1967 by the New Order government, which required all public sector entities (including about 150 state-owned enterprises) to deposit their financial assets at state-owned banks. Meanwhile, the financial assets of local governments (including their enterprises) had to be deposited only at the local province-held bank. In 2012, the four state-owned banks still controlled 36.3 per cent of all assets held by banks in Indonesia. So what does this mean for Indonesian banks, and what structural reforms can help fix their problems?

First, the domestic banking industry needs to generate Tier I capital if Indonesia is to meet Basel III capital requirements. Indonesian banks still need to reduce the share of their capital base that is made up of volatile sovereign bonds, injected in 1998 to restore their capital base after the Asian Financial Crisis. When sovereign bonds rise in price domestic banks improve the amount of capital they hold and are better able to deal with non-performing loans. But conversely, there is a big problem if the value of sovereign bonds fall — in 2003, 2008 and 2010 Indonesia’s mutual funds industry collapsed when bond prices fell. Such a heavy reliance on volatile bonds makes Indonesia’s banking system uncertain.

To stabilise the domestic money market the authorities should deepen and enlarge it by revitalising the postal savings bank. The wide network of post offices that exist in Indonesia can be used to mobilise domestic savings cheaply because of the low overhead cost. Indonesia should follow the example of Japan and other countries, which used domestic savings deposited in postal savings banks to absorb sovereign bonds and reduce their dependency on volatile short-term capital flows. The capital generated could finance government projects such as infrastructure. Other avenues to creating money markets, such as developing insurance and pension funds, may take longer, but pursuing these options would have positive consequences for Indonesian financial policy. A deeper money market and more competitive and healthier banks would also make Indonesia’s monetary policy more effective.

Second, Indonesia must address the productivity and competitiveness of its banks, particularly its public sector banks. If Indonesian banks are to compete regionally, particularly after the ASEAN Economic Community is established in 2015, they will need to upgrade their skills and technology and introduce new products.

Third, Indonesia needs to reduce its net interest rate margin, or the gap between lending and deposit rates of the banking industry, which is now the highest of all the ASEAN countries. The average net margin of all banks in December 2010 was 5.73 per cent, but that of state-owned banks is much higher than privately owned foreign and domestic banks, which shows just how inefficient state banks are.

Indonesia wants its banks to compete internationally, and the new governor of BI has promised to use the reciprocity principle to force other countries to open their domestic markets to Indonesian companies. Perbanas, the Indonesian banking association, will be pleased, but ensuring foreign markets are open is not the end of the story. If Indonesian banks are to meet local standards or be able to build up a customer base overseas, then reform is needed.

Indonesia’s new banking regulations may help protect the domestic industry, but BI is yet to undertake the structural reform necessary to strengthen Indonesian banks. Failing this, Indonesia’s banks will remain relatively uncompetitive and inefficient.

Anwar Nasution is Professor of Economics at the University of Indonesia and Senior Institution Specialist at the Support for Economic Analysis Development in Indonesia (SEADI).