The Promise and The Peril of Microfinance Institutions in Indonesia

This article was downloaded by: [Gazi University]
On: 03 February 2015, At: 13:53

Publisher: Routledge
Informa Ltd Registered in England and Wales Registered Number: 1072954 Registered office: Mortimer
House, 37-41 Mortimer Street, London W1T 3JH, UK
Bulletin of Indonesian Economic Studies

Publication details, including instructions for authors and subscription information:
http://www.tandfonline.com/loi/cbie20
THE PROMISE AND THE PERIL OF MICROFINANCE

INSTITUTIONS IN INDONESIA
a b b b
Jay K. Rosengard , Richard H. Patten , Don E. Johnston Jr & Widjojo Koesoemo
a
John F. Kennedy School of Government, Harvard University
b
Independent Consultants , United States and Indonesia
Published online: 08 Nov 2007.
To cite this article: Jay K. Rosengard , Richard H. Patten , Don E. Johnston Jr & Widjojo Koesoemo (2007) THE PROMISE
AND THE PERIL OF MICROFINANCE INSTITUTIONS IN INDONESIA, Bulletin of Indonesian Economic Studies, 43:1, 87-112, DOI:
10.1080/00074910701286404
To link to this article: http://dx.doi.org/10.1080/00074910701286404
PLEASE SCROLL DOWN FOR ARTICLE
Taylor & Francis makes every effort to ensure the accuracy of all the information (the “Content”) contained
in the publications on our platform. However, Taylor & Francis, our agents, and our licensors make no
representations or warranties whatsoever as to the accuracy, completeness, or suitability for any purpose of
the Content. Any opinions and views expressed in this publication are the opinions and views of the authors,
and are not the views of or endorsed by Taylor & Francis. The accuracy of the Content should not be relied
upon and should be independently verified with primary sources of information. Taylor and Francis shall
not be liable for any losses, actions, claims, proceedings, demands, costs, expenses, damages, and other
liabilities whatsoever or howsoever caused arising directly or indirectly in connection with, in relation to or
arising out of the use of the Content.
This article may be used for research, teaching, and private study purposes. Any substantial or systematic
reproduction, redistribution, reselling, loan, sub-licensing, systematic supply, or distribution in any
form to anyone is expressly forbidden. Terms & Conditions of access and use can be found at http://
www.tandfonline.com/page/terms-and-conditions
Bulletin of Indonesian Economic Studies, Vol. 43, No. 1, 2007: 87–112
THE PROMISE AND THE PERIL OF

MICROFINANCE INSTITUTIONS IN INDONESIA
Jay K. Rosengard*
John F. Kennedy School of Government, Harvard University
Richard H. Patten, Don E. Johnston, Jr and Widjojo Koesoemo*

Independent Consultants, United States and Indonesia
Downloaded by [Gazi University] at 13:53 03 February 2015
After the 1997 East Asian crisis, central banks throughout the region tried to reduce
the risk of future bank failures by promulgating regulatory reforms. The results
in Indonesia have been to concentrate rather than mitigate banking risks, and to
decrease the access of low-income households and enterprises to formal financial
services, especially in rural areas. The most severe casualties of the ‘reforms’ have
been local government-owned microfinance institutions. In the provinces where
these institutions have functioned best, they have addressed a market failure by ex-
tending coverage to areas not served by conventional financial institutions. Under-
standing the past performance and potential for replication of these success stories
continues to be important because of the substantial gaps that remain in the access
of rural Indonesian households and microenterprises to financial services.
INTRODUCTION: THE UNINTENDED

CONSEQUENCES OF REGULATORY REFORM
After the 1997 monetary and economic crisis in East Asia, central bankers through-
out the region tried to reduce the risk of future bank failures by promulgating
a series of regulatory reforms. The main assumptions behind the reforms were
that bigger financial institutions were safer than smaller ones, and that traditional
banking practices were less risky than non-conventional financial services.
Indonesia was no exception to the trend of financial sector re-regulation.
This meant that relatively small, community-based financial institutions were
instructed to merge into larger, centralised entities, and that innovative micro-
finance services were viewed with suspicion and hostility.
* The research for this article was commissioned by the German aid agency GTZ GmbH.
The authors thank Dr Alfred Hannig, Dr Dominique Gallman and Ibu Aimee Patalle for
their kind support of this work; the managers and staff of the regional offices of Bank Indo-
nesia for their insights and for their assistance in arranging interviews with local financial
institutions; and the management and staff of provincial development banks and micro-
finance institutions for their time and patience. Finally, the authors wish to express their
appreciation to the editor and two anonymous referees for their helpful comments. We
retain full responsibility for any remaining errors.
ISSN 0007-4918 print/ISSN 1472-7234 online/07/010087-26 © 2007 Indonesia Project ANU

DOI: 10.1080/00074910701286404
88 Jay K. Rosengard, Richard H. Patten, Don E. Johnston, Jr and Widjojo Koesoemo
The results have been to concentrate rather than mitigate banking risks, and to
decrease the access of low-income households and enterprises to formal financial
services, especially in rural areas. Among the casualties of the regulatory reforms
have been two broad categories of microfinance institutions, the first owned by
local governments and operating at both the sub-district (kecamatan) and village
(desa) levels, and the second owned by villages and operating at the village level
only.1 The generic terms for these are, respectively, village credit institutions (lem-
baga dana kredit pedesaan, LDKPs) and village credit bodies (badan kredit desa, BKDs).
But these institutions go by a variety of names in different parts of the archipel-
ago, resulting in a bewildering array of acronyms (see appendix). To avoid confu-
sion, in this paper for the most part we shall use the term ‘GMFIs’ to refer to local
government-owned microfinance institutions operating at the sub-district and
village levels, and ‘VMFIs’ to refer to village-owned microfinance institutions.2
The unintended consequences of the reforms are especially important because,
although Indonesia is recognised as a world leader in commercial microfinance,

it is also unique among developing countries in that its most successful micro-
finance institutions to date are public sector institutions such as the GMFIs and
VMFIs. In fact, the best-known microfinance provider in Indonesia is Bank Rakyat
Indonesia (BRI), a full-service commercial bank that was owned entirely by the
central government until the end of 2003, and whose majority owner is still the
state. But because BRI has been written about extensively elsewhere, it will not be
reviewed here.3
The purpose of this article is to offer suggestions on how the lessons from past
GMFI and VMFI accomplishments and failures can be utilised to guide current
efforts to expand the coverage of formal financial institutions, particularly in
provinces that do not yet have such institutions. In the provinces where they have
functioned best, GMFIs and VMFIs have proven to be sustainable, and have made
a significant contribution to increasing the access of low-income households and
microenterprises to microfinance, particularly in rural areas.
Understanding the past performance and potential for replication of GMFIs and
VMFIs continues to be important because substantial gaps remain in the access of
Indonesian households and microenterprises to microfinance services—despite
the success of a number of such institutions to date and despite the strong desire
of some senior policy makers to reduce the current degree of financial exclusion.
Indeed, recent surveys indicate that nearly 50% of Indonesian households con-
tinue to lack effective access to microcredit, while the proportion of rural house-
holds who actively use savings accounts is still below 40%.4
We begin our examination of the relevance, effectiveness and potential of the
GMFI/VMFI approach by reviewing the origins and development of these insti-
1 The new regulations also failed to address critical ambiguities and uncertainties in ear-
lier legislation, further constraining the strategic and operational options of these local
government-owned microfinance institutions.
2 See Holloh (2001) for a survey of microfinance institutions in Indonesia.
3 For further information on BRI and its village units, see Patten and Rosengard (1991:
ch. 5) and Patten, Rosengard and Johnston (2001).
4 See, for example, BRI Survey Team and CBG Advisors (2001: section IV).
The promise and the peril of microfinance institutions in Indonesia 89
tutions. We then assess their potential contribution and identify the key factors
determining their performance. These findings are used to develop recommenda-
tions for the development of GMFIs and VMFIs, with special attention given to
provinces that do not yet have such institutions.
DEVELOPMENT OF VILLAGE-ORIENTED
MICROFINANCE INSTITUTIONS
The development of institutions delivering banking services at the village level
can best be understood if looked at in three phases: development to the late 1970s;
development during the 1980s and up to the passage of the Banking Law of 1992;
and development (and deterioration) from 1992 to the present.
Development until the late 1970s

Indonesia’s original microfinance institutions, the VMFIs, began life in the 1890s as
bank desa (village banks) and lumbung desa (paddy banks, or facilities to store rice
rather than cash). They were first set up in Java and Madura during the Dutch colo-
nial period as community organisations, and were supervised by BRI. Although
they proved to be highly durable, most notably by surviving the Great Depression
in good condition, nevertheless two major economic dislocations—the Japanese
occupation during World War II and hyperinflation during the mid-1960s—
resulted in the need for some to be revived with loan capital from BRI.
In the early 1970s the governor of Central Java set up a new type of organisation,
the sub-district credit body (badan kredit kecamatan, BKK), to provide microfinance
in villages where VMFIs had ceased to operate. Each BKK was headquartered in
the sub-district, with the sub-district head assigned responsibility for oversight.
These institutions reached borrowers in the villages by sending a motorcycle team
to each village once a week, or on market day in the five-day market cycle based
on the Javanese calendar. They relied on the recommendation of the village head,
who affirmed that the loan applicant was a village resident, had an enterprise
as stated and was financially reliable; their credit terms were modelled on those
of the VMFIs. Each BKK received a loan of Rp 1 million as start-up capital, to be
repaid in three years. By 1977–78 they had learned how to make loans at the vil-
lage level, but in the process many of them had lost much of their original capital
and were not operating on a sustainable basis.5
Development until the passage of the Banking Law of 1992

The VMFIs experienced no significant change in their operations during the 1980s.
They continued to make very small loans at the village level for petty trading,
agriculture and handicraft enterprises. In 1988, at the initiative of BRI, the super-
vision of market banks and other local banks that could potentially compete with
BRI village units (the microfinance offices of BRI) was transferred to the central
bank, Bank Indonesia (BI), to avoid any conflict of interest. Unfortunately, BI mis-
understood the nature of the VMFIs and took over direct supervision of them as
well. This was quite unnecessary: there was virtually no overlap between VMFIs
5 For more on the origins and evolution of the BKKs, see Patten and Rosengard (1991:
ch. 4).
and BRI village units in the markets they served, so the potential for conflict of
interest was negligible.6 When it became clear that BI could not directly supervise
the more than 5,000 VMFIs, it instructed BRI to again supervise them on its behalf.
Beginning in the mid-1990s, BI paid part of the costs of such supervision; before
that, the VMFIs had covered all of these costs.
In 1978–79, the central government, with assistance from the United States
Agency for International Development (USAID), launched the Provincial Area
Development Program with the objective of testing ideas on how government
might reach the poor and assist them to improve their income-earning capacity.
The program was managed by a team from the Ministry of Home Affairs, the
National Development Planning Agency, the Ministry of Finance and BRI, and
operated in selected districts7 in six provinces: West Sumatra, West Java, East Java,
South Kalimantan, West Nusa Tenggara and (later) Bali. Local governments pro-
posed projects to the provincial development planning agencies, where they were
cleared with the appropriate technical agency. A large percentage of the projects
proposed were for the provision of loans.
The Provincial Area Development Program tested 39 different methods of deliv-
ering loans at the local level, including through technical agencies, cooperatives
and special groups organised to rotate credit among their members. Although
expansion of the existing VMFI system to additional villages was not tested, of all
the credit delivery systems that were trialled, the only one found capable of deliv-
ering credit at the village level on a sustainable basis was that of a sub-district-
level credit institution serving its constituent villages through motorcycle teams
operating village posts. These institutions needed to be supervised, trained, sup-
ported with simple asset and liability management facilities, and inspected by
a commercial bank such as a provincial development bank.8 At the start of the
program, additional capital was injected into the BKKs in five pilot districts in
Central Java. These institutions immediately expanded, began to make a profit
and became fully sustainable. This encouraged a similar injection of capital into
the remaining BKKs outside the pilot districts, with the same result.
In the early 1980s, the basic idea of a lending organisation located in the sub-
district, and sending motorcycle teams to villages to deliver credit services, was
expanded to test districts in other provinces participating in the Provincial Area
Development Program. These bodies included the credit institutions for small-
scale activities (lembaga kredit usaha rakyat kecil, LKURKs) in East Java, the rural
credit institutions (lembaga kredit pedesaan, LKPs) in West Nusa Tenggara, and the
BKKs and small enterprise financing institutions (lembaga pembiayaan usaha kecil,
LPUKs) in South Kalimantan. They were successful in delivering credit at the vil-
6 Despite their name, BRI village units actually operate at the sub-district level, so do not
compete with the VMFIs. In contrast, the market banks operate at the sub-district or district
level, thus potentially competing with BRI branches and village units.
7 For brevity, in this paper the term ‘district’ should be taken to include kabupaten (dis-
tricts) and kota (municipalities). Both are Level II governments directly under the Level I
provinces.
8 Each province had one provincial development bank (bank pembangunan daerah, BPD),
jointly owned by the provincial and district governments.
lage level on a sustainable basis, and later became known collectively as LDKPs—
or GMFIs as we refer to them here.
It soon became apparent that supervision by a provincial development bank
was crucial to the success of these GMFIs; they succeeded best where there was an
authorised and competent provincial development bank to supervise them. The
system was less successful in delivering credit to villages on a sustainable basis
in places like West Java, where the local government decided to set up its own
supervision system and use the provincial bank only to monitor financial reports.
In West Sumatra, the local GMFIs, known as pitih paddy banks (lumbung pitih
nagari, LPNs), were located in the pitih, a traditional level of local government that
was no longer active. The Provincial Area Development Program encouraged the
provincial government to give responsibility for supervision and support services
to the West Sumatra provincial development bank, but by the time this actually
occurred, many of these institutions were barely operational.
In the mid-1980s, the USAID-funded Financial Institutions Development project

expanded the development of financial institutions to additional districts in the
provinces covered by the Provincial Area Development Program (West Sumatra,
West Java, East Java, South Kalimantan and West Nusa Tenggara). In the second
phase of this project in the latter part of the decade, Bali was added to these prov-
inces. In Bali, the operations of the village credit institutions (lembaga perkreditan
desa, LPDs) were headquartered in the village, not the sub-district, so there was
no need for mobile teams to travel to the villages. The villages in question were
Bali’s traditional villages (desa adat) rather than the official villages (desa dinas) of
the formal government organisation, and therefore gained strength from being
tied into the island’s cultural traditions.
Development (and deterioration) from 1992 to the present

The GMFIs, along with the VMFIs, village banks and other institutions delivering
microenterprise credit at the village level, were recognised in article 58 of the 1992
Banking Law.9 The law’s implementing regulation again recognised these exist-
ing community and village-level financial institutions,10 but it also lumped them
together with all other people’s credit banks (bank perkreditan rakyat, BPRs—essen-
tially, community banks), set a minimum capital requirement of Rp 50 million and
gave them five years to become fully licensed as BPRs. At the time, Rp 50 million
was far more than the capital required by a village-level credit institution. It was
possible that the best of the GMFIs organised at the sub-district level, including
many BKKs in Central Java, would be able to achieve this requirement within
the five-year period. However, the implementing regulation did not clarify what
would happen to institutions that did not become BPRs within this period. Since
that time, further large increases in the minimum capital requirement have only
strengthened the initial impact. The 1992 Banking Law became one of the two
defining events of the decade for VMFIs and GMFIs, the other being the Indonesian
monetary and economic crisis beginning in 1997. As microfinance institutions, the
VMFIs and GMFIs turned out to be in a far better position to deal with the mon-
etary and economic crisis than with the effects of inappropriate regulation.
9 Law 7/1992 on Banking (see McLeod 1992).

10 Government Regulation 71/1992 on People’s Credit Banks.
CURRENT STATUS OF VILLAGE-ORIENTED

MICROFINANCE INSTITUTIONS
BKDs in Java and Madura
The first village credit bodies (badan kredit desa, BKDs) were established in the
1890s during the Dutch colonial period.11 At the end of May 2003, Java and
Madura had 4,518 active and 827 non-active BKDs. The active BKDs had a total of
Rp 186.8 billion of loans outstanding to 438,938 borrowers—implying an average
loan size of Rp 426,000 (about $51). Their combined equity (including retained
profits) totalled Rp 222.5 billion, resulting in a combined, system-wide capital
adequacy ratio (CAR) of more than 100%. One of the results of this high CAR is
that most BKDs do not need to mobilise savings to have sufficient loanable funds
to meet village loan demand. Nevertheless they had 524,671 savers with Rp 35.3
billion in their savings instrument, Tabungan BKD.
The elected village head is ex officio principal commissioner of the BKD, and
chooses two other commissioners. The accounts are discussed at least once a year
at a general meeting of the members of the village. Most BKDs are open only once
a week, on market days. A book-keeper serves four or five BKDs, and is trained
and paid by BRI with funds the BKDs themselves provide on the basis of their
loan portfolio size.
The BKDs are reasonably successful at delivering microenterprise loans at the
village level. Their interest rates are almost double those of the BRI village units,
but the loans involve much lower transaction costs for the borrower. They typi-
cally go to very small enterprises operating almost entirely within the village,
and owned mainly by women. If borrowers in outlying villages had to travel to
sub-district headquarters to arrange and service their loans, they would find their
transaction costs much higher than the interest they actually pay.
The BKDs also provide savings services, but savers are able to make withdraw-
als only on the days they are open. This is not completely satisfactory, since a
major reason for saving by low-income people is to meet family emergencies,
which cannot be programmed for a certain day of the week. But most BKDs have
little incentive to provide savings services, since additional funds are surplus to
lending requirements; the savings they collect are therefore simply deposited in
an interest-bearing account at BRI. Savings deposits in the BKDs are not insured,
though with their large equity the chances of loss through collapse of the institu-
tion are small.
BKDs are supervised by BRI branch staff ‘on behalf of BI’, which pays part of
the supervision costs. The BRI supervisor goes through the books of each BKD at
least once a month and checks on borrowers who have defaulted on their loans.
Any problems found are reported to the district government, which is charged
with ordering the action necessary to correct them. Asset and liability manage-
ment is very simple. If there is a surplus of liquidity, it is deposited in a BRI branch
or village unit; if there is a shortage of loanable funds, as might happen in a rela-
tively new BKD, the BKD may be able to borrow from BRI.
In the past there has been some misunderstanding about the financial condi-
tion of the BKDs’ credit portfolios. Because the procedures for writing off bad
loans were complicated, BKDs simply left bad loans in their portfolios, inflating
11 For further information on the BKDs, see BRI International Visitors Program (1998).
the nominal level of loans outstanding, and displaying misleadingly high levels
of bad debt to the casual observer. In addition, they often did not fully reserve
against the bad debt in their portfolios, leading to some over-statement of profits
and equity. Under instruction from BRI, the balance sheets have recently been
cleaned up. Once the backlog of bad debt had been written off, BRI instructed the
BKDs to establish a routine, formula-based system of reserving for bad debt; they
were also instructed to automatically write off unrecoverable loans (which were
to be 100% reserved against) by moving them from the balance sheet to an off-
balance ‘black list’ after a certain period. BRI also instructed its local branch man-
agers and BKD supervisors to work with local governments to develop action
plans for the 800-odd inactive BKDs, many of which were insolvent.
To support BKDs that have not built up enough capital to fully meet loan
demand in the villages they serve, BRI has asked BI for permission to lend to
them.12 BRI’s compliance division considers special permission to be necessary
because of continuing uncertainty over the legal status of BKDs. Along with the
GMFIs, they were specifically recognised in the Banking Law of 1992. However,
subsequent decrees under this law did not differentiate between their capital
requirements and those of privately owned BPRs, even though the capital require-
ments of a BPR are far greater than those of an institution serving a single village.
Legal uncertainty also extends to the BKDs’ status as deposit-taking institutions,
largely preventing their spread to new areas since 1992. Because deposit taking
has typically not been a core activity for them, it should be possible to develop
a way around this legal obstacle without waiting for a new law on microfinance
institutions; one possibility would be for them to act as savings agents on behalf
of a commercial bank such as BRI.
BKKs in Central Java

Over the past decade the sub-district credit bodies (badan kredit kecamatan, BKKs)
in Central Java have employed a number of strategies with respect to the 1992
Banking Law. As of 31 December 2002, 350 of them had succeeded in achieving
the status of BPRs (or BKK–BPRs, as we call them here), while 160 continued to
operate as before (table 1).13
Two important trends can be observed for BKKs that have succeeded in becom-
ing BPRs or are attempting to do so. First, during the process of becoming BPRs,
many BKKs consolidated their operations at the sub-district level and eliminated
the motorcycle teams that had previously provided credit at the village level.
Thus, the period since 1992 has seen a withdrawal rather than an expansion of
banking services in the villages. This tends not to show up in the statistics on the
number of village posts; instead, the level of service to the village simply drops
from weekly to monthly or less.
Second, at least since the crisis of 1997–98, payroll deduction lending to salaried
workers has been heavily emphasised. Such loans have become a much larger
12 At the time of writing, BI was still considering this request.

13 BI data do not differentiate local government-owned (perusahaan daerah, PD) BKK–BPRs
from the more numerous privately owned (perseroan terbatas, PT) BPRs. However, the au-
thors were able to obtain detailed data on both BKK–BPRs and BKKs from the Central Java
provincial development bank.
TABLE 1 Microfinance in Central Java a
BPRsb BKK– BKKs BKDs BPD BRI Village

BPRs Units
(12/02) (12/02) (12/02) (5/03) (12/02) (5/03)
Offices (no.)
City/district level 230 119
Sub-district level 350 160 80 783
Village posts 3,327 1,046 1,653 27
Credit outstanding
Rp trillion 1,328.9 595.2 127.8 42.4 2,351.3 2,411.8
No. of loans (‘000) 390.4 457.4 128.7 137.2 625.7 690.8
Savings
Rp trillion 1,304.7 534.4 120.6 13.6 840.0 3,721.5
No. of accounts (‘000) 852.5 975.4 500.1 234.9 625.7 5,470.3
aCentral Java had 29 districts, six municipalities, 534 sub-districts and 8,543 villages in
2003. Its population was 31.8 million (8.24 million households) in 2002. See appendix for
an explanation of the various types of financial institutions.
b Excluding BKK–BPRs.
Sources: Bank Indonesia; Bank Jateng; Bank Rakyat Indonesia; Badan Pusat Statistik.
part of these institutions’ loan portfolios, while the percentage of the portfolios
comprising loans to microenterprises has declined accordingly. This same trend is
apparent in the portfolios of BRI village units and provincial development banks,
as well as those of the former GMFIs in other provinces.
The operations of Central Java’s BKK–BPRs have been adversely affected by BI
regulations, which have diminished the role of the provincial development bank
in providing asset and liability management services. Connected-party exposure
limits are being applied to the deposits of local government-owned BPRs with the
provincial development bank, and to the latter’s loans to the former, because the
ownership of both types of institution is considered to be the same. In practice,
this means that a BPR must go to at least one other bank, other than the provincial
development bank and other Central Java BPRs, to place its excess liquidity if this
is more than 10% of its equity. Previously such deposits were a valuable source of
liquidity for the provincial development bank, which used part of the earnings on
these funds to help pay the cost of BKK supervision and training. With the BKKs
now forced to spread their deposits to other banks, the provincial development
bank is finding it less attractive to support local government-owned BPRs. Ulti-
mately, this means that the bank is unwilling to supervise BKK–BPRs as carefully
as before. Application of the connected-party rules in this way makes BKK–BPRs
riskier, not less risky. The regulation that the provincial development bank is not
permitted to lend an amount more than 10% of its capital to the BPRs has not
yet restricted such lending, but it may in the future. For this calculation, all the
local government-owned BPRs are lumped together as if they were a single bank,
because their ownership is considered to be the same.
TABLE 2 Microfinance in East Java a
BPRsb LKURKs BKDs BPR BPD BRI Village

Jatim Units
(12/02) (4/03) (5/03) (4/03) (12/02) (5/03)
Offices (no.)
City/district level 357 22 84
Sub-district level 156 39 651
Village posts 2,291 39
Credit outstanding
Rp trillion 1,116.1 10.4 134.2 85.5 2,180.5
No. of loans (‘000) 264.6 14.7 546.3
Savings
Rp trillion 972.9 3.0 19.3 96.0 3,856.9
No. of accounts (‘000) 560.8 0.0 228.7 67.2 4,759.1
a East Java had 29 districts, nine municipalities, 624 sub-districts and 8,457 villages in 2003.
Its population was 35.2 million (9.87 million households) in 2002. See appendix for an
explanation of the various types of financial institutions.
b Excluding BPR Jatim.
Sources: Bank Indonesia; BPR Jatim; Bank Jatim; Bank Rakyat Indonesia; Badan Pusat
Statistik.
One result of the movement to transform BKKs into BPRs appears to be a signif-
icant increase in competition at the sub-district level for microcredit and savings
customers. Although BKKs (like other GMFIs) tend to make somewhat smaller
loans on average through their sub-district offices than BRI village units, there is
considerable overlap in the market segment served. Such competition is certainly
beneficial to borrowers and savers in the areas surrounding the sub-district cen-
tre. It is unfortunate, however, that this has been accompanied by a withdrawal of
services from relatively distant villages.
The overall status of microfinance activity in Central Java is shown in table 1.
LKURKs in East Java

In East Java, the change in status of the credit institutions for small-scale activities
(lembaga kredit usaha rakyat kecil, LKURKs) established in the early 1980s has gone
through two stages. First, many of the more successful ones were able to meet BI’s
criteria and become BPRs. Next, in 2001, 62 of these BPRs were consolidated into
a single institution, BPR Jatim, with one head office, 21 branches and 39 cash posts
(table 2). The main reason cited for this consolidation was to eliminate the large
number of commissioners and directors required by BI regulation for each BPR;
it would also allow the movement of personnel from branch to branch as needed
and facilitate the setting up of regular staff training courses. It was hoped that the
consolidation would protect BPR Jatim from government interference in the selec-
tion of staff, allowing it to base its choice on education, mathematical competence
and other objective criteria.
The consolidation into one institution has simplified the audit task of BI,
which does not have the capacity to audit a large number of small BPRs. Even if
undertaken annually, a BI audit would not be an adequate substitute for the close
supervision previously provided by the provincial development bank. It had one
supervisor in each of its branches, thus allowing the semi-monthly or monthly
checking that has been found necessary to keep microfinance institutions healthy.
Supervision of the remaining 156 LKURKs that were not consolidated into BPR
Jatim has been moved from the provincial development bank to BPR Jatim. It is
expected that in time many of these will become offices of BPR Jatim rather than
remain separate BPRs.
The same trends as were apparent in the development of BKKs in Central Java
are also found in East Java. There has been consolidation of credit and savings
operations at the sub-district level and withdrawal of the motorcycle teams that
formerly delivered credit services to more distant villages. (This occurred at the
time of conversion to BPR status, not at the time of consolidation of the 62 BPRs
into a single BPR Jatim.) There has also been the same movement towards lending
to salaried employees who agree to repay their loans through automatic payroll
deductions.
The overall status of microfinance activity in East Java is shown in table 2.
LKPs in West Nusa Tenggara

The situation in West Nusa Tenggara (Nusa Tenggara Barat, NTB) is similar to
that in East Java. The province’s rural credit institutions (lembaga kredit pedesaan,
LKPs) were set up on the same general lines as the LKURKs, with a staff of three
or four and direct supervision and support from the provincial development
bank, each branch of which had at least one officer whose job it was to visit all
LKPs on a regular basis—at least once a month. After the BI regulations for BPRs
under the 1992 Banking Law became known, the provincial government decided
to convert all LKPs to BPRs (here called LKP–BPRs), although in some cases small
or problem institutions were first merged into neighbouring LKPs. As a result, all
sub-districts in West Nusa Tenggara continue to be served by an LKP–BPR, some
serving more than one sub-district (table 3).
In the conversion to BPRs, the close supervisory role of the provincial develop-
ment bank was lost. Instead, BI attempted to supervise each BPR directly, but it
simply did not have enough staff to do so; the head of one BPR told us that his
institution had been audited only twice in the five years since its establishment. A
second important problem is lack of control by BPR management and supervisory
boards over the hiring of staff. Each staff appointment is made by the provin-
cial government as if it were an appointment to the provincial bureaucracy. As a
result, insufficient consideration is given to candidates’ specific qualifications for
bank employment.
At the time of writing, the provincial government was seriously considering
whether to consolidate the LKP–BPRs into a single BPR for the whole of the prov-
ince, as was done in East Java. However, there appeared to be a difference of
opinion between the provincial and district governments, with the latter gener-
ally favouring more limited consolidation of all sub-district-level LKP–BPRs into
district-level BPRs with sub-district-level branches. The core of the disagreement
TABLE 3 Microfinance in West Nusa Tenggara a
Privately Local LKP– BPD BRI

Owned Government- BPRs Village
BPRs owned BPRs Units
(12/02) (12/02) (12/02) (12/02) (5/03)
Offices (no.) 0
Sub-district level 46 51
Village posts 17
Credit outstanding 0
Rp trillion 13.4 69.0 399.1 197.0
No. of loans (‘000) 34.9 41.8
Savings 0
Rp trillion 49.3 21.1 527.1 209.7
No. of accounts (‘000) 139.3 88.3 391.9
a West Nusa Tenggara had six districts, two municipalities, 62 sub-districts and 703 vil-
lages in 2003. Its population was 4.2 million (1.1 million households) in 2002. See appendix
for an explanation of the various types of financial institutions.
Sources: Bank Indonesia; BPD NTB; Bank Rakyat Indonesia; Badan Pusat Statistik.
had little to do with efficient operations or optimal coverage; rather, it was about
the allocation of dividends from the profits of the BPRs.
Since the implementation of regional autonomy in 2001 and the handing of
new responsibilities to the districts and provinces, most local governments have
perceived themselves to be short of funds. District governments are particularly
eager to acquire or establish sustainable, wholly owned financial institutions of
their own in the hope of realising a steady dividend stream (although consid-
erations of prestige and patronage also play a role). Consolidation into a single
LKP–BPR at the provincial level would probably involve the provincial govern-
ment taking a significant share of ownership, without paying full compensation
to the current local government owners of the merging institutions for the dilu-
tion of their equity. The latter would then receive a correspondingly smaller share
of the profits contributed to the new institution by the LKP–BPRs in their district.
As noted above, under the present set-up with individual BPRs, district govern-
ments have relatively little influence over staffing and operations. Whether con-
solidation into district-level BPRs would mean more government interference in
staffing and operations would depend on whether the supervisory boards of the
BPRs were given full control over such matters.
Not only has financial pressure proven to be one source of disagreement between
the provincial and district governments, but pressure to increase dividends rap-
idly has resulted in a repeat of the same trends observed in Central and East Java:
consolidation of operations at the sub-district level; abandonment of lending
services at the village level by eliminating motorcycle teams; and concentration
on loans to salaried employees. Although in most cases village service appears to

have been profitable, regulatory pressures, combined with staff shortages, effi-
ciency concerns and pursuit of short-term profits in faster-growing urban mar-
kets, have consistently led to withdrawal of services at the village level.
The overall status of microfinance activity in West Nusa Tenggara is shown in
table 3.
LPDs in Bali
In terms of effective access to and utilisation of microfinance services, the island
province of Bali has achieved far more than any other area in Indonesia. With
nearly as many microfinance loans as households, no other province approaches
Bali’s ratio of microfinance loans to total households. The phrase ‘Bali is differ-
ent’ was a recurring one during the authors’ field visits to Bali. The success of
microfinance in Bali is not due to a single institution. Rather, it is the result of
several microfinance institutions all showing strong outreach performance. While

the BRI village units reach about the same proportion of households as elsewhere,
Bali’s privately owned BPRs are unusually active, and appear to be reaching more
borrowers in total. Indeed, Bali is in the unusual position of having more BPRs
than BRI village units (table 4).14 In addition, some privately owned commercial
banks, the best known of which is Bank Dagang Bali, are active in commercial
microfinance. While the provincial development bank makes most of its loans to
employees rather than enterprises, its wide outreach to private sector workers
makes it another important source of micro-scale finance to households.
However, the greatest difference in microfinance access between Bali and other
provinces is due to its village credit institutions (lembaga perkreditan desa, LPDs).
They are an integral part of the desa adat (traditional village), as distinct from
the desa dinas (official village)—the smallest unit of local government through-
out Indonesia. On average, there are more than two desa adat for each desa dinas,
but this ratio can vary widely from area to area, and the borders of the two vil-
lage types frequently cut across each other. Desa adat are highly participatory and
accountable local religious–social institutions. Bali’s generally vibrant and micro-
enterprise-friendly economy, the strong bond of ethnic Balinese to the desa adat,
and scrupulous traditional attitudes towards fulfilling debt obligations and the
attendant maintenance of social standing, combine to create an environment that
is very nearly ideal for the success of the LPDs.
While some LPDs are quite large, with total assets in the tens of billions of
rupiah, in general they have consistently and successfully resisted changing their
status to become BPRs. According to the managers and supervisors we inter-
viewed, their governance and focus on serving the (Balinese) residents or mem-
bers of a particular desa adat do not match well with the structure and regulations
of BPRs. At least one desa adat, Sanur, owns a BPR in addition to its LPD, but the
purpose of the two institutions is quite different: while the BPR is considered a
purely commercial enterprise, the LPD is intended to ensure that all residents
have access to basic financial services.
Local government is supportive of the LPDs, and desa dinas appreciate the con-
tribution of desa adat to the infrastructure and development budgets of the villages.
14 See Winship (2003) for a more in-depth look at the BPR sector in Bali.
TABLE 4 Microfinance in Bali a
Privately Local LPDs BPD BRI

Owned Government- Village
(12/02) (12/02) (12/02) (12/02) (5/03)
Offices (no.)
Sub-district level 3 34 95
Village posts 1,206 6
Credit outstanding
Rp trillion 489.1 16.3 670.6 1,440.7 342.7
No. of loans (‘000) 99.5 4.3 283.5 159.1 69.6
Savings
Rp trillion 421.7 17.6 672.5 1,776.5 934.8
No. of accounts (‘000) 570.7 26.7 857.1 2,915.9 550.9
a Bali had eight districts, one municipality, 53 sub-districts, 678 desa dinas and 1,406 desa
adat in 2003. Its population was 3.2 million (848,000 households) in 2002. See appendix for
an explanation of the various types of financial institutions.
Sources: Bank Indonesia; Bank BPD Bali; Bank Rakyat Indonesia; Badan Pusat Statistik.
At the provincial level, the governor was active in advocating to BI that the LPDs
be allowed to maintain their special non-bank status while continuing to mobilise
savings from within the village. At present BI is quite supportive of them. The
current BI branch manager pointed out to us that the central bank already has a
big job supervising more than 140 BPRs; attempting to supervise more than 1,200
LPDs as well would be impossible.
Each LPD is staffed by a minimum of three persons—a manager, a teller and a
book-keeper—all from the desa adat. Most are open five or six days per week, and
most employ staff on a full-time basis, even during the start-up phase. This entails
a certain amount of sacrifice on the part of staff in a new LPD, who are not well
compensated for the hours worked, but also provides a strong incentive to build
up the business. Because each LPD is a stand-alone institution, its managers have
no real career path, except to develop their own LPD. To provide an indicator of
the ability of managers as well as a degree of job status, a training certification
system has been developed.
Within the desa adat, each LPD is supervised by a supervisory committee,
which receives an honorarium. Typically, the desa adat appoints more members
to the supervisory board than are required by regulation, in order to allow wider
accountability and daily supervision. In such cases, the honorarium for super-
visory board members is also divided. External supervision has been relatively
weak, though the underlying strength of most LPDs at the local level has generally
prevented significant problems from developing. Recently, the provincial govern-
ment has taken steps to modify the system of supervision substantially. Under the
new system, the provincial development bank will be responsible for financial
supervision (essentially, audit and monitoring of regular financial reports), while

a newly formed, district-level supervisory body will oversee training and opera-
tional supervision. Financing to cover the cost of this new body is intended to
be generated by the LPD system itself, though the implementation of this is still
evolving. Up to the present, much of the development of the LPD system has been
externally facilitated, with significant policy and training inputs from the Promo-
tion of Small Financial Institutions project of Deutsche Gesellschaft für Technische
Zusammenarbeit (GTZ). With the new approach to supervision, however, most
training and much of the institutional development of LPDs will be shouldered
by the new supervisory structure.
In addition to its role as financial supervisor, the provincial development bank
fulfils a number of other functions for the LPDs: management of excess liquid-
ity; providing a line of credit; monitoring and reporting; and playing a key role
in institutional development. According to supervisors from both the provincial
bank and the new district-level supervisory body, the provincial government
currently has plans to establish LPDs in all the desa adat that do not yet have
one—over 200 in all. This will probably create a need for a workable ‘part-time’
operating model along the lines of the BKDs, as many of the remaining desa adat
are unlikely to be able to support a full-time LPD.
Uniquely among Indonesia’s VMFIs, Bali’s LPDs were able to retain their status
and prosper throughout the 1990s, when regulatory issues created serious opera-
tional difficulties for VMFIs in every other province. A strong sense of local own-
ership, support from local and provincial governments, consistent support from
the provincial development bank, timely realisation by BI of the benefits of the
system, and capable technical assistance and institutional development played
mutually reinforcing roles in preserving the character and mission of the LPDs.
As a result, of all the VFMI systems in use across Indonesia, the LPD system has
come closest to achieving the goal of providing universal access to microfinance
services. While not all aspects of the LPD experience—particularly Balinese atti-
tudes towards debt and the cohesiveness of the desa adat—can be replicated else-
where, the ‘win–win’ institutional relationships developed in Bali could serve as
a model for any province.
The overall status of microfinance activity in Bali is shown in table 4.
BKKs and LPUKs in South Kalimantan

In contrast to the happy outcome in Bali, the story of the sub-district credit bod-
ies (badan kredit kecamatan, BKKs) of South Kalimantan is largely one of missed
opportunities and unrealised potential. Established under a governor’s decree in
1985 (EKU 09/1985), they were intended to finance micro- and small-scale enter-
prises, mainly in rural areas. Over time the provincial government established 34
BKKs, which were initially permitted to mobilise savings. This changed following
the enactment of the 1992 Banking Law, when the provincial government decided
to follow the new law literally and immediately. Apparently overlooking both
article 58 of the law, which formally recognised GMFI operations such as those of
the BKKs, and the implementing regulation providing for a five-year transition
period, the provincial government prohibited BKKs from accepting savings, to
take effect immediately. For most BKKs, this left only their initial capital for use
as loanable funds.
TABLE 5 Microfinance in South Kalimantana
Privately Local BKKs LPUKs BRI

Owned Government- Village
(6/03) (6/03) (6/03) (6/03) (6/03)
Offices (no.)
Headquarters & other 6 1
Sub-district level 20 14 75 72
Village posts 3
Credit outstanding
Rp trillion 26.2 12.1 1.2 4.2 162.5
No. of loans (‘000) 2.9 8.1 6.3 12.7 36.6
Savings
Rp trillion 20.3 7.2 479.6
No. of accounts (‘000) 9.5 23.2 505.7
a South Kalimantan had nine districts, two municipalities, 119 sub-districts and 1,946
villages in 2002. Its population was 3.1 million (830,000 households) in 2002. See appendix
for an explanation of the various types of financial institutions.
Sources: Bank Indonesia; BPD Kalimantan Selatan; Bank Rakyat Indonesia; Badan Pusat
Statistik.
Despite this, the provincial government went on to establish, through another’s

governor’s decree (316/1993), 75 small enterprise financing institutions (lembaga
pembiayaan usaha kecil, LPUKs) in the remaining sub-districts that did not have a
BKK, plus one special unit in the governor’s office (table 5). These provide credit
to microenterprises but do not collect savings. At the same time, some BKKs (20 at
the time of writing) have changed their status to become BPRs, because they have
grown enough to fulfil the minimum capital requirement for doing so. Of these,
15 are considered sound by BI.
The staff of most BKKs and LPUKs consist of a manager, cashier, book-keeper
and credit officer. The manager is responsible to the sub-district head for the per-
formance of the BKK/LPUK. The sub-district head is an employee of the district
government and reports directly to the district head. The minimum staffing of a
BKK or LPUK is two persons. This is considered risky by supervisors owing to the
lack of separation of jobs, but is nevertheless implemented in some of the smallest
BKKs and LPUKs for reasons of efficiency. The local government-owned BPRs,
on the other hand, carry the full staffing structure required of BPRs: a board of
supervisors, board of directors, internal controller, funds manager, loan manager,
cashier and book-keeper.
The capital of the BKKs/LPUKs originates from provincial government equity
participation of Rp 10 million in each institution. Some of the funds (Rp 500,000)
are used for basic financial institution training and the remainder for financing
operations. In some districts the district government has also made an equity con-
tribution. Several district governments have expressed a preference to establish
new BPRs fully owned by them, rather than share ownership with the provincial
government. Existing ownership is distributed between the provincial govern-
ment, district governments and the provincial development bank. For example,
77% of PD BPR Martapura is owned by the province, 20% by the district of Banjar
and 3% by the provincial development bank.
Changing the status of BKKs and LPUKs has a number of disadvantages,
according to the head of the provincial economic infrastructure department. First,
a BPR is required to follow all banking regulations, which complicates procedures
and adds substantially to the administrative burden. Second, BPR status requires
that the institution pay company income tax and withholding tax on the interest
earnings of customers; BKKs and LPUKs are not liable for these taxes. Finally,
becoming a BPR inevitably means that the institution must increase its capital sig-
nificantly—not an easy task when the provincial government budget is limited.
As they attempt to extend their outreach throughout the sub-districts, the BKKs
and LPUKs face serious limitations in relation to capital, human resources and
infrastructure. With its initial capital alone, a BKK or LPUK may reach only 20
borrowers if the average loan amount is Rp 500,000. Given that each sub-district
has on average approximately 7,000 households, they clearly need additional
funding if they want to reach a significant proportion of potential borrowers. One
option is savings mobilisation from sub-district residents, but this would appear
to require a new law permitting microfinance institutions to mobilise savings
from the people.
Besides capital, these institutions face human resource constraints. Even though
staff have been trained by BI, the provincial development bank and other institu-
tions, supervisors feel that this has had little effect on their competence, profes-
sionalism or motivation; most cite low salaries as the underlying cause of this
poor outcome. Distance and inadequate road infrastructure, lack of vehicles and
inconvenient office locations also limit the business potential of BKKs and LPUKs.
Most are located in the back of sub-district government office complexes, making
it difficult for customers to find them.
Supervision was formerly carried out by a supervisory body consisting of
members of the provincial development planning agency, the provincial eco-
nomic bureau and the provincial development bank, although in practice the
latter played the main role in supervision. The provincial development bank
developed operational guidelines, conducted staff training, selected candidates
in the recruitment process and supplied trained supervisors to conduct site visits
for purposes of financial control. However, the issuing of new BI regulations on
connected-party lending and cross-ownership were interpreted to mean that the
bank should not be allowed to remain deeply involved in direct financial (often
called ‘technical’) supervision, even for the non-bank BKKs and LPUKs. Its role
was therefore reduced to providing ‘consultancy services’, while supervision
became the responsibility of the economic bureau. This change affected the qual-
ity not only of supervision but of reporting as well. In the past, these institutions
regularly sent their financial reports to the provincial development bank, which
prepared a consolidated report, with analysis, to present to the government. At
present, accurate consolidated figures are no longer easily obtainable.
The overall status of microfinance activity in South Kalimantan is shown in
table 5.
REBIRTH OF VILLAGE-ORIENTED MICROFINANCE INSTITUTIONS

Three approaches to serving rural communities
To make sense of the GMFI/VMFI experience, this section divides the institu-
tions featured in this paper into three distinct groups: sub-district-level GMFIs;
BPRs owned by local government; and village-owned financial institutions. Each
of these major types is subject to variation, as detailed below.
Sub-district-level GMFIs
The GMFIs set up by provincial governments between 1978 and the late 1980s
were modelled on the BKKs of Central Java, which had been set up in the early
1970s. Under this ‘classic’ model, the microfinance institution provided credit and
savings services to villages by dispatching teams from a sub-district-level office.
In the villages these teams were assisted by the village head or other village elders
in evaluating loan applicants and collecting loans that had fallen into arrears. The
sub-district head was the official head of each GMFI, supervising a minimum
staff of three. Staff were paid a profit bonus, which in many cases amounted to
much more than their regular salaries. Most GMFIs broke even within a reason-
ably short period of time.
The GMFIs were supervised and supported by the provincial development
banks. One supervisor from each district-level branch of the bank supervised the
GMFIs within the district, visiting them at least once a month to go through the
books and review action taken, or to be taken, on loans in arrears. Problems were
reported to the sub-district head or, in the rare cases in which the sub-district
head was unable to correct the situation, to the district head. The head office of
each provincial development bank maintained a section responsible for training
GMFI staff and supervisors, as well as intervening if a particularly difficult situ-
ation developed that could not be resolved by the branch supervisor or branch
head. Asset and liability management simply meant depositing surplus funds in
a savings account at the branch, or borrowing from it if there was a shortage of
loanable funds.
Off Java, the sub-district-based model was used in both South Kalimantan and
West Nusa Tenggara. Before conversion to BPRs, some GMFIs served villages
with motorcycle teams, although the BKKs in South Kalimantan never extended
services to the village level in this manner. Some of this difference in history has to
do with basic questions of economic scale: villages in South Kalimantan tend to be
smaller and spaced further apart than those in West Nusa Tenggara. Much of the
difference, though, is related to the combined effect of low levels of capitalisation
and the uniquely detrimental interpretation of BI regulations on the development
of BKKs in South Kalimantan.
Local government-owned BPRs

As GMFIs have converted to local government-owned BPRs, many have consoli-
dated their operations at the sub-district-level office and withdrawn the teams that
previously made banking services available at the village level. Both the GFMIs
and BI perceive this to lower risk while still generating reasonable returns—at
least until markets are saturated. Certainly, lending at the sub-district office is
easier than dispatching teams each week to the villages. In the best cases, these
BPRs have complemented the services of BRI village units by serving somewhat
smaller microenterprises than the latter would normally reach. In most cases,
though, they have tended to focus on lending to salaried workers, especially civil
servants. While increasing competition within this market segment and contrib-
uting to the financial sustainability of the institution, this has done little to expand
local access to microcredit more generally. In short, even though many GMFIs
were reaping considerable profits from their village operations without explicit
or implicit subsidies, regulatory interventions have caused a retreat from the vil-
lages and a reallocation of resources in pursuit of low-hanging (if not the sweet-
est) fruit.
Among GMFIs, sub-district-level BPRs have proven to be the weakest model
to date, even in relatively densely populated Java. Current regulations effec-
tively require BPRs to be stand-alone organisations, capable of meeting regula-
tory, organisational and administrative requirements and their own liquidity and
asset–liability management needs, and of managing the internal development of
human resources. However, most of the ex-GMFI BPRs had fared much better
when they were receiving close support from the provincial development banks
before conversion to BPR status. The smaller district-wide BPRs have suffered
from similar difficulties.
Over time, the province-wide BPR model, as exemplified by BPR Jatim in East
Java, may prove to be the most successful of the various types of local government-
owned BPRs in terms of sustainability and political non-interference. However,
this begs the question: is the new, BPR-based arrangement better and safer than
what it replaced—a network of sub-district-based, savings-taking, microfinance
institutions closely supervised and supported by the provincial development
bank? Without exception, conversion to BPR status has entailed a loss of cover-
age at the village level, while the removal of close operational supervision and
the imposition of additional regulatory-related administrative burdens and new
forms of political pressure and interference have been detrimental to the sustain-
ability and safety of the new BPRs.
The remarks presented here should not be viewed as criticism of BPRs in gen-
eral. At the same time, it is important to understand the respective limitations of
government-owned and private sector BPRs in terms of performance and opera-
tions. The latter are not featured in this paper because they are in effect urban and
semi-urban microfinance institutions. The overwhelming majority have barely
touched rural areas. Instead, they typically offer competition and choice in the
districts and in the largest sub-district-level markets.
Village-owned financial institutions

This paper has identified two successful, sustainable models of village-owned
financial institutions: the LPDs of Bali and the BKDs of Java and Madura. Of the
two, the Bali institutions are by far the more dynamic and fully developed. Some
of the reasons for the success of Bali’s VMFIs—the close ties to a cohesive, account-
able desa adat, traditional Balinese attitudes towards debt and mutual obligation,
and a tourism-driven local economy that has remained conducive to micro- and
small enterprise development over several decades—would be difficult to repli-
cate in other regions. But other factors should be more easily replicable: a win–
win accommodation between BI’s prudential and regulatory requirements on the
one hand and enabling local legislation on the other; ownership, accountability
and service at the village level; and close support and financial supervision by
a commercial bank, in this case the provincial development bank. In Bali, it has
been possible to rely on the strength and organisational capacity of the desa adat;
in other areas, more support and closer supervision may be required from the
supervising bank, though this need not necessarily impose a financial burden on
it. Aspects of both the Java–Madura and Bali approaches should be incorporated
into the development of any new village-based model.
The case for government-owned financial institutions

This study has examined several types of financial institutions delivering micro-
finance at the village and sub-district levels, including the VMFIs in Java–Madura
and Bali and the GMFIs in Central and East Java, West Nusa Tenggara and South
Kalimantan. At some point, however, it is necessary to examine the basic appro-
priateness of the institutional form. In short, is there a case for creating or support-
ing financial institutions owned by local government? Based on the experience

to date, the answer must be in the affirmative. In particular, VMFIs and GMFIs
have provided coverage in areas not served by conventional financial institutions.
They are addressing a market failure to profitably provide vital financial services
to under-served communities.
Furthermore, provincial, sub-district and village officials have shown them-
selves willing to support and protect the public purpose of VMFIs and GMFIs
in a way not seen with local government-owned BPRs. Some of the reasons for
this lie in the nature of local government at the lowest levels: local enough to be
responsive to community needs without (yet) being highly politicised. In addi-
tion, expectations about profitability play an important role: local governments
invariably seem to expect a significant dividend from their general-purpose BPRs,
while the special-purpose GMFIs and VMFIs have not been pressed nearly as
hard in this respect.
Of course, there are caveats. Not all GMFIs have performed well, and there are
dangers inherent in attaching a financial institution to a politicised or dividend-
hungry local government. Furthermore, GMFIs should not have any sort of
monopoly power or benefit from restricted entry of financial institutions in rural
areas; savings and loan cooperatives, rural banks and branch offices of commer-
cial banks should be allowed to develop freely. Ultimately, though, these caveats
simply mean that the governance and support mechanisms for GMFIs should in
the future try to stay closer to the best-case examples mentioned above, and work
to avoid the worst.
Experience to date argues for three key attributes of a successful GMFI. First,
the institution should be placed at the lowest feasible level of local government
(the sub-district or village) to minimise politicisation and a focus on dividend
earnings, and to encourage a sense of mission and—in the case of a village—com-
munity ownership. For village-level institutions, ownership should be vested in
the village. For sub-district-level institutions, majority ownership by the province
has encouraged a stronger sense of mission than is the case in district-owned insti-
tutions, but at the cost of tensions with the district government. No province has
yet attempted to place ownership of its GMFIs with the provincial development
bank—an alternative that would appear to carry a number of advantages—pre-
ferring instead to exercise ownership directly.
Second, the institution should develop a strong relationship with a commercial

bank (or, as a second-best case, a large BPR) that is able to provide both super-
vision and institutional support—including management of excess liquidity; a
credit line; training and institutional development; and continuous, system-wide
monitoring and reporting. While the provincial development bank is usually the
first choice for such a role, other banks with strong experience in rural finance
and an adequate branch network in the province could also fill this role. Such a
relationship need not be a financial drain on the supervising bank, and has the
potential for significant positive effects on the business growth of the supervising
bank. How to arrange such a relationship in the current regulatory environment is
an important question and a major focus of the recommendations below.
Finally, the institution should actively avoid conversion to BPR status. To date,
such conversions have inevitably weakened the institution’s sense of mission,
eroded the level of effective supervision (and, ultimately, soundness), undermined
support arrangements and added to the administrative burden. At the same time,
pressures to produce a large annual dividend have caused local government-
owned BPRs to redirect their short-term focus away from the villages in favour of
lending to salaried employees, and undermined their ability to expand services
by reinvesting profits.
Minimum required economic scale at the village level

One of the key determinants of the success of GMFI/VMFI-style banking institu-
tions is scale. This is important in at least two ways. First, an effective operating
model for such institutions must be capable of being scaled down to a very small
minimum feasible level of operations. Second, participants and policy makers
must also be realistic about the minimum scale of activity needed to support a
fully self-sustaining microfinance institution. Similarly, cost-effective provision of
support and supervisory services is made much easier when the villages served
are clustered relatively close to each other—it is much easier for GMFI village post
staff or the VMFI book-keeper to cover a ‘route’ when villages are relatively close
to each other.
That said, the experience of VMFIs and GMFIs strongly suggests that, beyond a
minimum level of activity, village scale may not be a strong predictor of financial
success. This point is illustrated in table 6, which shows the average size of rural
villages in the provinces included in this study. On population measures alone,
it is not obvious that the VMFIs of Bali should, by far, be the best-performing vil-
lage-level institution: the average population of Bali’s rural villages, particularly
the desa adat (on which the VMFIs are based), is relatively small compared to that
of some of the other provinces studied. At the same time, the statistics for South
Kalimantan (and the provinces of interest for future GMFI development) suggest
that it may be difficult to find very many villages outside the sub-district centre
with the necessary minimum scale of activity to support a village bank or GMFI
village service post.
More generally, the VMFIs have shown a strong ability to operate consistently
and sustainably at a very small scale—and in economic and social conditions that
are not as ‘special’ as those found in Bali. According to a recent sample survey of
96 VMFIs conducted by the authors, most serve between 41 and 220 borrowers.
(This range represents the middle 50% of the VMFIs surveyed.) Furthermore, the
TABLE 6 Average Population per Rural Village, Selected Provinces
Province Rural Population No. of Average Population

(thousand) Rural Villages per Rural Village
Central Java 18,213 7,145 2,549

East Java 20,025 7,190 2,785
Bali
Desa dinas 1,489 571 2,609
Desa adat 1,489 1,184b 1,258b
West Nusa Tenggara 2,552 703 3,630
South Kalimantan 1,906 2,125 897
East Nusa Tenggaraa 3,259 2,405 1,355
Bengkulua 1,135 1,090 1,041
Central Sulawesia 1,823 1,372 1,329
aProvinces without GMFIs, but of especial interest for future GMFI expansion.
b Estimate.
Source: Badan Pusat Statistik.
survey results and interviews with VMFI supervisors indicate that sustainability
can begin at low population levels, at least by Javanese standards. In the survey,
only the bottom 10% of VMFI villages—those with less than 1,953 people—have
rates of profitability much below the average. While not too much should be read
into this statistic,15 it does support the basic point that it is possible for VMFIs to
be sustainable while serving a fairly low population base. Reinforcing this point,
the survey results suggest that both village participation rates and loan quality—
as measured by the median percentage of borrowing households and median
annual loss rate, respectively—are negatively correlated with village size. Higher
participation and lower loss rates tend to boost the sustainability of VMFIs in
smaller villages. In terms of number of borrowers, two-thirds of VMFIs with 50
borrowers or less were profitable, rising to and levelling out at around 90% for
VMFIs with 88 borrowers or more. About 60% of the VMFIs surveyed had at least
88 borrowers.
Qualitatively, supervisors felt that, under the previous book-keeping system,
individual VMFIs became comfortably self-sustaining with total outstanding
loans of Rp 50–100 million. Under the present book-keeping system, this range
might be lower by one-third or more. Using an average loan size of approximately
Rp 400,000, this translates into roughly 100 borrowers, most of them making
weekly repayments on their loans.
For VMFIs to be successful, it is best to have a cluster of five or six relatively
close to each other so that they can be served by one book-keeper who travels to a
15 Note that this is a measure of short-term profitability among institutions that have sur-
vived to the present, rather than a comparison of survival rates over time. The sample size
was too small to determine statistical significance. A final note: because many of the VMFIs
were still carrying out the book-keeping adjustments described earlier in the text, profits
for the current year may have been artificially low.
different one each day. Particularly for new, smaller VMFIs, it is important to have
a critical mass of borrowers taking out loans with weekly instalments and repay-
ing them on time: weekly instalment loans for high-turnover trade, services or
home-based enterprises typically carry the lowest risk. As a VMFI develops and
accumulates excess funds, it will add loans with monthly and seasonal payments
to its portfolio according to demand in the village; it may also choose eventually
to open more than one day per week.
WHAT COULD HAVE BEEN DONE TO AVOID

CONVERSION-RELATED DIFFICULTIES?
It is possible to identify at least two alternative courses of action that might (par-
tially) have avoided the difficulties caused by the conversion of GMFIs to BPRs,
and the rigid ‘one-size-fits-all’ regulations applied to them by BI. First, provincial
governments could have followed the same course with the GMFIs that BRI fol-
lowed with its village units, by incorporating them as sub-district-level offices
of the provincial development banks. Procedurally this would have been quite
easy, as the ownership of the GMFIs and the banks in each province was essen-
tially the same. The legal changes of the 1990s and BI regulations would not have
disturbed the functioning of these sub-district-level offices, which would have
been inspected by BI only as part of its supervision of the provincial development
banks—not separately. This course of action was in fact suggested to the board of
directors of the Central Java provincial development bank in the early 1990s, but
was rejected for reasons that remain obscure.
Alternatively, BI could have recognised its own lack of capacity to supervise
hundreds of local government-owned BPRs and adopted the same principle that it
has adopted so far for BRI’s supervision of the VMFIs. The provincial development
banks could have undertaken supervision of the local government-owned BPRs
‘on behalf of BI’, and the central bank could have agreed to the provincial devel-
opment banks continuing their support of the GMFIs, including human resource
development and assistance in asset and liability management. This last measure
would have required that BI not limit the amount that a local government-owned
BPR could deposit in the provincial development bank, and that it not place tight
restrictions on the total amount that a provincial development bank could lend to
all the local government-owned BPRs in the province.
RECOMMENDATIONS
Provinces without GMFIs
If a province without GMFIs would like to increase the availability and acces-
sibility of sustainable village-level financial services, it can employ one of two
basic models that have worked relatively well in Indonesia: establishment of sub-
district-based, village-oriented GMFIs, or establishment of village-based VMFIs.
In choosing between these two models, the following should be considered.
• Whether the financial needs of microenterprises and households are well served at the
sub-district level. Despite the extensive network of sub-district-level BRI village
units, this is not an idle question. BRI does not reach every sub-district, and not
every BRI village unit places an equally strong emphasis on microenterprise
lending. Weak service at the sub-district level would tend to support the case
for establishing a sub-district-level GMFI.
• The number of villages outside the sub-district centre that are likely to have at least
the minimum economic scale necessary to support a VMFI or GMFI service post.
A small number of such villages would tend to favour a sub-district-based
approach, perhaps with one or more motorcycle teams to cover the remaining
villages with some business potential. A larger number would probably favour
a VMFI-style approach, particularly if the villages were widely spread across
the district.
• The degree of accountability in village-level government, including the functioning of
the village head vis-à-vis the village council. High levels of accountability would
tend to favour VMFI-style institutions.
• Evidence of a ‘common bond’ within the villages. This would tend to favour VMFI-
style institutions.
• Whether the goal is to be a fully self-sustaining institution, or whether there might be

a source of finance to provide modest, continual subsidies for supervision and support.
Acceptance of cross-subsidies or indirect subsidies would tend to argue for an
institution organised above the village level.
• BI’s willingness to accept sub-district or village-level institutions as deposit-taking
institutions in the areas in which they operate, perhaps by recognising these institutions’
basic similarity with member-based ‘common bond’ organisations. Straightforward
acceptance similar to that of BI’s acceptance of Bali’s VMFIs would make the
legal issues much more straightforward, and lessen the need for a ‘savings
agent’ arrangement with the supervising bank.
• The willingness and capacity of the provincial development bank to take on the job of
supervision. If the bank is not willing or able, the best option may be to take a
village-based approach and discuss support and supervision with BRI or other
banks. At a minimum, a provincial development bank should be rated as sound
and operate free of political interference in operational decisions—ideally
including staffing—before being allowed to take on the job of supervision.
Broad experience in micro- and small enterprise lending would of course be
helpful.
Once the organisational model is determined, more practical matters must be
considered. Appropriate savings and credit products, pricing, and delivery sys-
tems must be developed to meet effective demand in a financially viable manner.
In most cases, the sub-district model may offer the promise of faster implemen-
tation and a more professional staff, the trade-off being somewhat higher costs
(because there would be less use of shared and village-based personnel) and a
weaker sense of ownership and participation at the village level. Regardless of the
model chosen, some of the key operational issues to be dealt with are as follows.
Supervision and support

This requires agreement with a solvent and profitable bank that is willing and
able to provide competent, credible technical supervision, support and training,
including management of excess liquidity and maintenance of a credit line; it also
requires agreement (or ‘no objection’) to the arrangement on the part of BI. For
sub-district-based institutions, the first choice would generally be the provincial
development bank, assuming it met the criteria just mentioned. If it is unqualified
or unwilling, another bank with a strong branch presence in the province could
be chosen. Because BRI has village units at the sub-district level, it would typi-
cally not be an appropriate choice to support a sub-district-based institution. It
would, however, be a possible candidate to supervise and support village-level
institutions.
With full legal cover from a nationwide microfinance law (or provincial legis-
lation defining the relative responsibilities of local governments and provincial
development banks), the supervising bank could carry out a full supervisory role,
including closure and liquidation of unsound GMFIs. Also feasible, though some-
what less desirable, would be a structure in which the supervising bank’s actions
would be limited to technical supervision, while local government at some level
would be responsible for issuing orders and taking action based on the supervis-
ing bank’s findings. If there were a nationwide law, BI would retain regulatory
authority and the ability to approve supervising banks. Otherwise, its authority
would be exercised less directly, through its role in protecting the savings of the
public and as supervisor of the provincial development bank and other financial
institutions—the same basis as motivated its informal accommodation with Bali’s
provincial government. In either case, though, BI would only be ‘supervising the
supervisors’, much as it does now under the VMFI system.
Legal basis and regulatory compliance

Ideally, GMFIs would have the option of organising themselves in accordance
with a special purpose microfinance law covering the licensing, operation and
(delegated) supervision of local microfinance institutions. Failing this, at the sub-
district level, there are two choices. The first is ownership by the provincial devel-
opment bank, either directly (by making the sub-district-level office a sub-branch
of the bank) or indirectly (by making the province-wide GMFI a wholly owned
subsidiary of the bank). The second is ownership by one or more districts (since
province-level ownership other than through the provincial development bank
complicates the regulatory issues), with some oversight by the sub-district head,
and with supervision and support by the provincial development bank or another
bank. Either affiliation should provide adequate incentives to both parties to
develop and maintain the relationship, while complying with all BI regulations.
At the village level, the main option would be to create a village-owned enter-
prise under district and/or provincial legislation, with a supervision and support
(and possibly savings agent) agreement from a qualified bank. It would be ideal if
accommodation could be reached with BI to recognise the GMFI’s ability to mobi-
lise savings from the local area—on its own, with insurance cover (from an insur-
ance company, not the government) and/or through a savings agent agreement.
Governance
It is essential that local government not interfere in the commercial operations
of the GMFIs, including the hiring and firing of employees, the location of vil-
lage posts and the allocation of loans. In the case of village-owned institutions,
some outside oversight (by the supervising bank, provincial authorities or even a
designated non-government organisation) may be required to verify that account-
ability measures (such as village meetings, oversight by the village council and an
active role on the part of supervisors) are actually implemented.
Provinces with GMFIs

In provinces that already have GMFIs, the best way to increase the availability and
accessibility of sustainable village-level financial services will vary depending on
the degree to which the province has altered institutional forms and operations
to comply with new banking laws and regulations. In most cases, the challenge
is to provide incentives for GMFIs to focus on their core village-based businesses
rather than chase the same markets as other banks, and to re-engage the provincial
development banks in active technical oversight of and assistance to the GMFIs as
part of their own strategic plans for increased growth, outreach and coverage.
In Central Java, for example, two key initiatives could well be taken. The first
is to re-establish the mutually beneficial relationship between the BKK–BPRs and
the Central Java provincial development bank for both savings mobilisation and
credit outreach. This would entail convincing BI that its interpretation of several
standard banking regulations is inappropriate and counter-productive when
applied to the BKK–BPRs. The second is to establish some sort of formal affiliation
between the provincial development bank and the BKKs that have not yet become
BPRs, along the lines described above, rather than forcing them to become BPRs.
In addition, because Central Java is already home to 1,653 active VMFIs, the pos-
sibility of establishing new VMFIs in villages that do not yet have them might
also be explored. The same holds true to varying degrees in the other provinces
reviewed in this study, with the exception of Bali, which would be best advised to
stick to its chosen path.
REFERENCES
BRI International Visitors Program (1998) Introducing the Badan Kredit Desa, PT Bank Rakyat
Indonesia, Jakarta.
BRI Survey Team and CBG Advisors (2001) BRI Micro Banking Services: Development Impact
and Future Growth Potential, PT Bank Rakyat Indonesia and Center For Business and
Government, John F. Kennedy School of Government, Harvard University, Jakarta,
October.
Holloh, D. (2001) Microfinance Institutions Study, ProFI (Promotion of Small Financial Insti-
tutions) Economic Reform Paper, Ministry of Finance, Bank Indonesia and Gesellschaft
für Technische Zusammenarbeit (GTZ), Jakarta.
McLeod, R.H. (1992) ‘Indonesia’s new banking law’, Bulletin of Indonesian Economic Studies
28 (3): 107–22.
Patten, R.H. and Rosengard, J.K. (1991) Progress with Profits: The Development of Rural Bank-
ing in Indonesia, ICS Press for the International Center for Economic Growth, San Fran-
cisco CA.
Patten, R.H., Rosengard, J.K. and Johnston, D.E. Jr (2001) ‘Microfinance success amidst
macroeconomic failure: the experience of Bank Rakyat Indonesia during the East Asian
crisis’, World Development 29 (6): 1,057–69.
Winship, G. (2003) Present Status and Future Perspectives of the BPR Sector in Bali: Recom-
mendations for an Appropriate Support Strategy, Final draft report, World Education,
Jakarta, June.
APPENDIX: BANKING AND MICROFINANCE

ACRONYMS USED IN THIS STUDY
Acronym Name in Indonesian Name in English
BANKS
Central bank
BI Bank Indonesia Bank Indonesia
Commercial banks
BRI Bank Rakyat Indonesia Indonesian People’s Bank
BPD bank pembangunan daerah provincial development bank
People’s credit banks

BPR bank perkreditan rakyat people’s credit bank
PT BPR perseroan terbatas bank (privately owned)
perkreditan rakyat people’s credit bank
PD BPR perusahaan daerah bank (local government-owned)
perkreditan rakyat people’s credit bank
PD BKK–BPR perusahaan daerah badan (local government-
kredit kecamatan – bank owned) BKK that has
perkreditan rakyat been converted to a BPR
PD LKP–BPR perusahaan daerah lembaga (local government-
kredit pedesaan – bank owned) LKP that has been
perkreditan rakyat converted to a BPR
NON-BANK MICROFINANCE INSTITUTIONS

Local government-owned
microfinance institutions (GMFIs)
LDKP lembaga dana kredit pedesaan village credit institution
BKK badan kredit kecamatan sub-district credit body
LKP lembaga kredit pedesaan rural credit institution
LKURK lembaga kredit usaha credit institution for
rakyat kecil small-scale activities
LPN lumbung pitih nagari pitih paddy bank
LPUK lembaga pembiayaan small enterprise
usaha kecil financing institution
Village-owned microfinance
institutions (VMFIs)
BKD badan kredit desa village credit body
LPD lembaga perkreditan desa village credit institution

The Promise and The Peril of Microfinance Institutions in Indonesia

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

The Promise and The Peril of Microfinance Institutions in Indonesia

Uploaded by

Copyright:

Available Formats

This article was downloaded by: [Gazi University]

On: 03 February 2015, At: 13:53

Bulletin of Indonesian Economic Studies

THE PROMISE AND THE PERIL OF MICROFINANCE

To link to this article: http://dx.doi.org/10.1080/00074910701286404

PLEASE SCROLL DOWN FOR ARTICLE

THE PROMISE AND THE PERIL OF

Richard H. Patten, Don E. Johnston, Jr and Widjojo Koesoemo*

INTRODUCTION: THE UNINTENDED

ISSN 0007-4918 print/ISSN 1472-7234 online/07/010087-26 © 2007 Indonesia Project ANU

although Indonesia is recognised as a world leader in commercial microfinance,

Development until the late 1970s

Development until the passage of the Banking Law of 1992

In the mid-1980s, the USAID-funded Financial Institutions Development project

Development (and deterioration) from 1992 to the present

9 Law 7/1992 on Banking (see McLeod 1992).

CURRENT STATUS OF VILLAGE-ORIENTED

BKKs in Central Java

12 At the time of writing, BI was still considering this request.

TABLE 1 Microfinance in Central Java a

BPRsb BKK– BKKs BKDs BPD BRI Village

TABLE 2 Microfinance in East Java a

BPRsb LKURKs BKDs BPR BPD BRI Village

LKURKs in East Java

LKPs in West Nusa Tenggara

TABLE 3 Microfinance in West Nusa Tenggara a

Privately Local LKP– BPD BRI

on loans to salaried employees. Although in most cases village service appears to

several microfinance institutions all showing strong outreach performance. While

TABLE 4 Microfinance in Bali a

Privately Local LPDs BPD BRI

supervision (essentially, audit and monitoring of regular financial reports), while

BKKs and LPUKs in South Kalimantan

TABLE 5 Microfinance in South Kalimantana

Privately Local BKKs LPUKs BRI

Despite this, the provincial government went on to establish, through another’s

REBIRTH OF VILLAGE-ORIENTED MICROFINANCE INSTITUTIONS

Local government-owned BPRs

Village-owned financial institutions

The case for government-owned financial institutions

ing financial institutions owned by local government? Based on the experience

Second, the institution should develop a strong relationship with a commercial

Minimum required economic scale at the village level

TABLE 6 Average Population per Rural Village, Selected Provinces

Province Rural Population No. of Average Population

Central Java 18,213 7,145 2,549

Central Sulawesia 1,823 1,372 1,329

WHAT COULD HAVE BEEN DONE TO AVOID

• Whether the goal is to be a fully self-sustaining institution, or whether there might be

Supervision and support

Legal basis and regulatory compliance

Provinces with GMFIs

APPENDIX: BANKING AND MICROFINANCE

Acronym Name in Indonesian Name in English

People’s credit banks

NON-BANK MICROFINANCE INSTITUTIONS

You might also like