Next Generation of Microfinance: Leveraging Indonesian Experience

Sep 2014
Indonesia, September, 11 2014 - The most important players among microfinance institutions in Indonesia are the commercial banks and the rural banks. These are regarded as representing the best Indonesian experience in the development of microfinance institutions.

The history of microfinance institutions in Indonesia dates back more than 100 years. The primary reason for their initial establishment was to combat extortionate lending practices in rural areas and to impose tight restrictions on money lenders. The first rural bank in Indonesia was the Hulp-en Spaar Bank der Indlandsche Bestuurs Ambtenaren or Bank for Civil Servants, founded by R. Bei Aria Wiraadmadja in 1895. The bank then expanded its operations to farmers and other local residents and offered saving facilities at fair interest rates.

Many “paddy banks” or Lumbung Desa institutions were also established to provide savings and loans facilities for rice farmers. During the colonial period, the Lumbung Desa, Bank Desa, farmer banks, market banks and village trade credit institutions became the pioneers of microfinance in Indonesia and the forerunners of today’s rural banks. In the 1970s, microfinance institutions became established throughout the country under government sponsorship for Village Fund and Credit Institutions (LDKP).

In 1992, the government enacted a new Banking Law that extended formal recognition to rural banks as distinct from commercial banks. This law also allowed a transition period for LDKP to transform themselves into rural banks by fulfilling the specific requirements applicable to rural banks.

The relationship between lenders and borrowers is characterized by the asymmetry of information. There are two main problems: Adverse selection and moral risk. The first involves the creditor’s lack of knowledge in relation to the type of borrower; that is, the lender does not know how risk-inclined the borrower is, or how honest, how responsible, etc. On the other hand, moral risk involves the lender’s lack of information regarding the type of action the borrower can have. In this particular case, it is in relation to what the borrower will do with the loan and what type of investment he or she will choose.

Stiglitz and Weiss (1979) describe how the rationing of credit occurs in equilibrium. According to them, the bank’s return does not always grow with the interest rate increase, since after a certain point of increase in the rates, there is a reduction in the average quality of borrowers.

This leads to the attraction of less honest and less well-intentioned borrowers, or simply those with more risk and who are more inclined to perform riskier investments, therefore reducing the compliance rate, due to a simultaneous problem of adverse selection and moral risk.

There is an optimal interest rate, which therefore brings maximum return to the banks, and if there are more credit buyers than suppliers for the interest rate, there will be credit rationing. That is, many agents will not have access to credit even though they are willing to pay a higher interest rate.

Microfinance providers in Indonesia are currently divided into formal and informal sectors. In the formal sectors, at least 15 out of 120 commercial banks run special divisions of microfinance, and in addition there are, 1,667 rural banks, 155 Islamic rural banks, 600,000 microfinance institutions and cooperatives, 5,500 Islamic microfinance institutions and more than 500 zakat (alms) fund institutions.

The players in the vast informal microfinance sector range from various NGOs, community self-help groups (PHBK), money lenders, informal savings and loans groups and informal cooperatives. The number of informal entities in operation possibly exceeds 40 million, spurred by economic growth in rural areas that has led to a significant increase in small and medium enterprises (SMEs).

Indonesian commercial banks have become a success story in terms of micro-lending by commercial banks.

The most important players among microfinance institutions in Indonesia are the commercial banks and the rural banks. These are regarded as representing the best Indonesian experience in the development of microfinance institutions.

Below are major players in microfinance in Indonesia:

Commercial banks’ achievements demonstrate that financial services to micro-entrepreneurs can generate a commercially competitive rate of return and achieve the strategic goals of commercial banks.

The key success factors of Indonesian commercial banks in microfinance are: loans based on the needs and repayment capacity of the borrowers; retention of good borrowers and use of debtor performance as a key consideration in subsequent borrowings; provision of simple and professional services to customers; close supervision of loan performance by assigning special supervisors; simple administrative procedures; and efficient organizational structure with limits on staff numbers to keep overhead costs low.

While rural banks are part of the banking system, they operate under specific limitations. Rural banks are only permitted to accept savings and provide loans.

Despite these limitations, rural banks have the advantage of their location in rural and urban areas, which affords close proximity to their specific market segments.

They are able to identify potential clients and maintain relationships with depositors as well as debtor customers.

Source : The Jakarta Post

Research Analysis Tools

The fund indexes, institution benchmarks and other market information displayed here are all Symbiotics designed analysis tools, created in-house by our analysts and experts. Symbiotics has one of the oldest track records in microfinance investment analysis dating back to the late 1990s; its indexes and benchmarks have been regularly used as markers by investors, asset managers, financial institutions and practitioners. These, as well as several other research products, are available through the Research Account. Click on the link below to find out more.

Learn More