Development of Islamic Banking and Its Impact in

Indonesia

M. Farhan Thaib Rianto

1606899182

Islamic Economic and Finance Midterm Exam

Case Study

Faculty of Economics and Business

University of Indonesia
2020
 Statement of Authorship

I, the undersigned declare the best of our ability that the assignment herewith is
an authentic writing carried out by myself. No other authors or work of other
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This paper has never been presented or used as a paper for other courses except
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reproduced and/or communicated for the purpose of detecting plagiarism

Name: M. Farhan Thaib Rianto

Course: Islamic Economic and Finance
Title: The Development of Islamic Banking and Its Impact in Indonesia
Date: 28 March 2020
Lecturer: Wisam Rohilina, M.Ec.
Signature:
 STATEMENT OF ACADEMIC HONESTY
For this exam, Islamic and Economics Finance
Name : M. Farhan Thaib Rianto
Student Number : 1606899182
I make the following truthful statements:

● I have not received, nor give any assistance to another student taking this
exam.
● I will not plagiarize someone else’s work and turn it in as my own.
● I understand that acts of academic dishonesty may be penalized according
to academic rules allowed by the Faculty of Economics and Business
Universitas Indonesia.
Depok, 03/04/2020

M. Farhan Thaib Rianto

 Islamic Banking is a topic that is oft-discussed among academic, financial, and
government circles in the 21st Century. Over the past decades, Islamic banking has grown at
a staggering rate. In 1971, it was estimated that the Islamic banking industry held USD 65
billion in assets worldwide (Salman, 2018), since then it has grown to USD 1.7 trillion in
2018 (IFSB, 2019). In Indonesia, the most populous Islamic country, Islamic banking has
grown at a rapid rate. This essay will discuss the development of Islamic banking throughout
the world and in particular in Indonesia, as well as its economic and social impacts in
Indonesia.

Although the roots of Islamic finance can be traced back to the Rashidun Caliphate of
the 7th century, the rise of the more recent and modern form of Islamic finance and banking
is generally attributed to the pioneering experiments of the 1960s. In Egypt during this time,
the Mit-Ghamr Islamic Saving Associatoin (MGISA) collected the savings of Muslim
investors and operated using a sharia-compliant operational framework. Perhaps the most
important event in modern Islamic banking was the establishment of the Islamic
Development Bank (IsDB) in 1975, which helped grow new and increasingly large Islamic
finance institutions around the world (Komijani., 2018).

There are several key principles in Islamic banking. The Islamic worldview in general
provides a framework for the relationship between Allah, Man and Community, with the
primary purpose of doing Maslahah (bringing good to others and deterring harm) by using
Maqasid Syariah to achieve falah (happiness in the hereafter). Based on the Islamic
worldview, Islamic finance has three objectives; wealth creation, justice, and benevolence. To
be considered sharia-compliant, Islamic banks must make sure that all of their products,
services, and operations are halal (permissible) by making sure that haram (or impermissible).
There are several key maxims in Islamic finance that must be followed; (1) Money does not
have any intrinsic value, and is used merely as a medium of exchange (2) Emphasis should be
on activities in the real economy and sharing of risks and rewards (3) Socially destructive
activities, such as trading alcoholic drinks, betting, and gambling are prohibited, (4) Riba
(interest) is prohibited, and (5) Gharar (ambiguous and risky transactions) is prohibited
(Moosavian, 2007).

As the world’s most populous Muslim country, interest in forming an Islamic bank in
Indonesia can be traced back to the 1980s, in which government officials and the Majelis
Ulama Indonesia discussed the need for Islamic banks as an alternative to conventional ones.
However, it was not until 1992 that the first Islamic bank - Bank Muamalat was founded
(OJK, 2014). The 1997 Asian Financial Crisis which heavily impacted the Indonesian
economy forced the country’s regulators to take a look into banking in general, and came up
with UU No. 10, 1998. This regulation put in place a dual banking system, dividing Islamic
and conventional banking (OJK, 2014). ​This regulation provided a new legal basis for
Islamic banks in Indonesia, and, along with the economic distraught brought on by the crisis
led to a flurry of new Islamic banks, most notably the large state-owned banks of Mandiri,
Bank Rakyat Indonesia, and Bank BTN forming Islamic banking branches.

There were several triggers for growth for Islamic banks in Indonesia throughout its
development in the 2000s and 2010s. One of the most important ones was the laws published
by the Indonesian government and Bank Indonesia which created Sharia national treasury
notes (SBSN) as well as Sharia Bank Indonesia Certificates (SBIS) in 2​008 (Fitriasari, 2013).
With the creation of these new notes, there were new instruments that could be used in the
Islamic banking market for liquidity management and for raising deposits (Fitriasari, 2013).
The further development of Sharia-compliant money and capital market instruments in
Indonesia also played an important role in providing more strategic options for banks, which
were then leveraged to increase lending and deposits by Islamic banks (Fitriasari, 2013).

In addition to the trigger that is the development of financial instruments, money and
capital markets that are Sharia compliant, government support has also played a key role in
the development of Sharia banking in Indonesia. The Blueprint of Islamic Banking
Development in Indonesia from Bank Indonesia in 2002 has provided guidance to Islamic
banks on how to develop its operat​ions (OJK, 2014). This included a creation of Islamic
banking infrastructure to create the groundwork for growth and development within the
industry. Furthermore, the Indonesian government has also eased foreign ownership limits on
local Islamic banks and created more concrete standards for Islamic bank products (the
previously discussed Sharia-compliant contracts) (Indonesia Investments, 2015).

The growth and development of Islamic banking since the 2000s has been staggering.
Islamic banks in Indonesia can be categorized into three types; Commercial Syariah Banks
(BUS), Syariah Working Units (UUS), and Syariah People’s Funding Banks (BPRS). BUS
banks are those that operate as their own entities. Meanwhile UUS banks are owned and
operated by conventional banks. Perhaps the most important decision by regulators in
Indonesia with regard to Islamic banks was to allow commercial banks to have UUS
branches, which had a significantly smaller capital requirement than BUS banks. This is
because it opened up the market to new opportunities for banks which wanted a low-risk
market entry into the Islamic banking. Lastly, People’s Funding Banks are smaller,
regional/local funding institutions that have few allowed capabilities/functions. In December
2004, there were only 3 BUS banks (Muamalat, Bank Syariah Mandiri, and Bank Syariah
Mega) and 16 UUS banks (SBS OJK, 2004). This number grew to 14 BUS banks and 20
UUS banks as of December 2019. Furthermore, from 2014-2018, it was reported that Islamic
bank assets exhibited a compounded annual growth rate of 15%, which is higher than the
10% growth of overall banking in Indonesia (Hastuti, 2019).

Banks have a special and important role in developing economies. As intermediaries

between funding deficit and surplus parties, banks can provide stable and considerable
returns for those who deposit, as well as loans to individuals and institutions that need to
make purchases and fund their productive operations. By conducting these activities,
economic actors are able to maximize returns and expand capacity.

Economic development enhances the productive capacity of an economy by using

available resources to reduce risks and remove impediments which otherwise could lower
costs and hinder investment (Wadhany and Arshad, 2015). Using this logic, Sharia finance
should increase economic development in two ways. Firstly, given the risk-sharing
properties, Sharia banks can have the impact of reducing risk by increasing the parties which
have exposure to such risk. Furthermore, Islamic banking also removes the religious barriers
that Muslims may face when taking part in conventional banking activities (e.g. taking loans),
thus providing more productive capacity for those Muslims. However, data regarding how the
development of Sharia banking in Indonesia has impacted economic development is mixed.

Wardhany and Arshad (2015) found that there were no significant causal impacts of
development in Islamic banks towards economic growth, although there is positive
correlation between the two. Furthermore, Andriansyah (2014) finds that even development
at the local (provincial) level of Islamic banks do not have significant impacts on various
metrics for economic growth and development. However, the main issue with these findings
is that they do not account for the small market share of Islamic banks. Despite the high
growth rate, Islamic banks only account for 5.78% of the total banking market in Indonesia in
2017. Considering this, Abduh and Omar (2012) utilized a more detailed methodology to find
that there is in fact a bi-directional causal impact between economic development and
development of Islamic banking.

In addition to the previous finding, the development of Islamic banks has also
provided more choice for businesses and individuals in finding and securing funding. This
choice has massive social and economic implications. Business owners who want to
minimize risks can utilize Islamic banks. Furthermore, in terms of social impact, Muslim
business-owners and individuals finally have the choice to participate in banking in a way
that is compliant to their beliefs. This is particularly important as Indonesia still has a lower
financial inclusion rate than its neighbors such as Malaysia and Thailand (at 76 percent in
2019) (Haryati, 2020). By making Sharia-compliant options, people not currently included in
the financial system will have no conflicting issues with regard to their religion.

To conclude, Islamic banks have been a rapidly growing market within the financial
industry throughout the world. In Indonesia, it is no different, with rapid growth in assets and
the number of banks themselves. Government support and development in Sharia financial
instruments have been key triggers for its growth in Indonesia. However, there are still key
issues such as the lack of a hedging mechanism for return risk, and even in the most populous
Muslim country, Islamic banking only accounts for a small percentage of the total market.
Despite this, there is already evidence for the positive impacts Islamic banking has in
Indonesia, both socially and economically.
 Works Cited

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