Islamic Banking in Indonesia:

Determinants that Stimulate Its Role as Focal Financial Intermediaries

Fitri Hastuti
fitri.hastuti@fe.unpad.ac.id
Faculty of Economics and Business, University of Padjadjaran

Abstract
This study tries to analyze significant determinants of Islamic Banking that affect its role
as focal financial intermediaries in Indonesia. Islamic Banking in this research covers
Islamic Commercial Banks, Islamic Business Unit as well as Islamic Rural Banks. The
investigation will use descriptive and quantitative method applying regression method for
the 2013 Islamic Banking Statistics data. Financing to deposit ratio is preferred in
describing the intermediary function of Islamic banks. Independent variables used in
regression models are non performing financing ratio, difference between bonus from
musharaka financing and time deposit (spread), bank type, allowance for earning assets
losses, training cost, promotion cost, placement of funds in other banks and written off
earning assets. The results demonstrate that most of independent variables are statistically
significant in improving the intermediary function of Islamic banks at 95% of confidence
level. Non performing financing ratio, placement of funds in other banks and written off
earning asset should be maintained low, promotion cost needs to proportional enough to
training cost, while spread, allowance for earning assets losses, training cost should retain
high in developing Islamic banks as a focal financial intermediaries in Indonesia.

Keywords: Islamic Banking, Financial Intermediaries, Financing to Deposit Ratio, Non

Performing Ratio

I. Research Background
With the adoption of dual banking system in Indonesia, the existence of Islamic
Banking nowadays is an answer of the need of an alternative banking system that
complies with sharia principles. Islamic banking also gives more contribution for the
economy, especially through its purpose for financial inclusion and financial deepening.
Though its portion compare to conventional banking relatively small Islamic banking
1
would enhance system stability of national banking. More specifically, significant role of
Islamic Banking is to perform the function in supporting real sector through financing
based on sharia principles and real transaction (intermediation function). Another
substantial function of Islamic Banking are distribution of peoples welfare, performs
social function such as collecting funds such as Zakat, Infaq, Sadaqah, hibah and other to
be disbursed to organizations of zakat management, as one of the forms of Islamic
financial institutions receiving religious donation in the form of money (Bank Indonesia,
2012).
The enhancement of Islamic Banking as financial intermediary is supported by
improved economic performance. The exposure of international financial market
instability doesnt affect the capital of Islamic bank directly. However on 2012, the
annual growth rate of Islamic banking total asset was only 34%, lower than the annual
average growth rate of 2008-2012 as amount of 39.96%. Its third party funds growth was
only 27.81%, lower compare to the annual average growth rate of 39.69%. The growth of
paid in capital decreased by 4.54%, slow down compare to the annual average growth rate
reaching 59.23%. Its significant function as financial intermediary was reflected from the
annual average of 2008-2012 Financing to Deposit reaching 95.3%. While at the same
time conventional banks on 2012, its credit growth was 23.89%, higher than the annual
average growth rate of 22.35%. The growth of third party funds was 15.81%, lower
compare to the annual average growth rate of 16.40%. The growth of paid in capital was
9.36%, slightly higher compare to the annual average growth rate reaching 9.34%. The
position of conventional banks financial intermediary LDR on 2012 was lower than
Islamic banks FDR was 85.51%.
Islamic banks generally showed excellent performance on its annual average growth
rate from 2008-2012; i.e. 59.23% of paid in capital and 39.96% of total asset. Islamic
Banks also have 3.3% average of Non Performing Finance, 13.54% of Capital Adequacy
Ratio and 27.11% of Return on Equity. However, those remarkable accomplishments
need to be adjusted to the real condition of Islamic banks compare to conventional banks
in Indonesia. On 2012, the value of financing of Islamic banks was only 5.41% of
conventional banks, its paid in capital was 5.12% of conventional banks, and last its third
party funds was 4.57% of conventional banks.
As efforts to develop the growth of Islamic banking that can cover more customers
in different areas, Bank Indonesia has put into practice various policies in a range of
sectors. Those policies need to meet the 7 (seven) aspects in the Blue Print of Islamic
2
Banking, such as (i) high quality human resources, (ii) effective regulation and
supervision, (iii) supportive infrastructure, (iv) effective banking structure, (v) synergic
strategic alliance, (vi) effective customer empowerment, and (vii) product and market
development (Bank Indonesia, 2012). One pillar of the blue print puts emphasis on
human resources, where the main objective is to provide human resources in number and
competence in accordance with industrial need and to become the strength factor to the
competitiveness of sharia banking industry. Bank Indonesia also underlined the approach
of capital strengthening of Islamic banks by inviting the holding companies owning
Islamic bank to make commitment in reinforcing the capital of its sharia bank. Another
methods to further developing Islamic banks by conducting with more focused service
segment; i.e. international service segment, corporate service, individual service, micro
finance, retail sector and others.
This paper explores the significant determinants of Islamic Banking characteristics
that may have probability in affecting its role as focal financial intermediary. In the next
section, we review the progress in the theory of Islamic banking. The third section
analyses the presentation of Islamic banking in Indonesia and its trend. The final section
draws attention to the main issues of the paper and reveals significant factors of Islamic
banks FDR.

II. Islamic Banking in Indonesia: Recent Facts

The performance of Islamic Banking in Indonesia as financial intermediaries was

unbelievably excellent. From the 3 (three) types of Islamic banks; Islamic Commercial
Bank (ICB), Islamic Business Unit (IBU) and Islamic Rural Bank (IRB), the FDR value
was consistently above 80%, especially IBU and IRB whose FDR were more than 100%.
With the high level of FDR those banks also operated safely with the value of funds
placed in Bank Indonesia relative to their financing activities was around 25% for IRB
and 20% for ICB and IBU, although the trend was quiet fluctuate. More detail can be seen
from the table below.

3
 Financing to Deposit Ratio Islamic Ratio of Placement at Bank Indonesia
Banking in Indonesia (%) to Financing Activity (%)
35
140
30
120

25
100

80 20

60 15

40 10

20 5

0 0
2006 2007 2008 2009 2010 2011 2012 2006 2007 2008 2009 2010 2011 2012

ICB IBU IRB ICB IBU IRB

Source: Islamic Banking Statistics.

Although Islamic banks already have critical position as financial intermediary, they
still have un-excessive market compare to conventional banks. Hence they can only
serving fairly small customers. Although the trend was increase, on 2012 financing
activities of Islamic banks only reached 5.41% of commercial banks loans. Compare to
commercial banks, third party funds that can be collected by Islamic banks from their
customers was only 4.57%. Those circumstances cannot be separated from the value of
total asset of Islamic banks that was merely 4.58% of conventional banks and paid in
capital no more than 5.85%.
The comparison of Islamic Banking
to Commercial Banking Indicators (%)
7.00
6.00
5.00
4.00
3.00
2.00
1.00
0.00
2006 2008 2010 2012

Paid in Capital Loan (Financing)

Third Party Funds Total Asset

Source: Islamic Banking Statistics.

4
 The internal strength of Islamic banks was dominated by Islamic Commercial
Banks, both in the perspective of paid in capital value and total asset. The increase in paid
in capital was significant in 2010 for almost three times compare to previous year. Their
total asset in 2012 was also increase for more than three times than the value in 2009.

Paid in Capital of Islamic Banking Total Asset of Islamic Banking

(Billion Rupiah) (Billion Rupiah)

8000 7211 200000

6611
7000 180000
5965
6000 160000
140000
5000
120000
4000
100000
3000 80000
1701 1946
2000 60000
472.2
390.2
347.0
294.9

991 1001
221.7
176.7
150.6

1000 40000
0 16 51 0 0 0 0 20000
0
0
2006

2007

2008

2009

2010

2011

2012

2006 2007 2008 2009 2010 2011 2012

ICB IBU IRB ICB IBU IRB

Source: Islamic Banking Statistics.

Like any other financial intermediaries, depositors fund is a crucial source of funds.
For ICB and IBU depositors funds reached 89.3% while for IRB it was only 67.52%. The
second vital source of fund beside depositor funds is interbank liabilities that reached
19.44% for IRB and 4.75% for ICB and IBU. Other sources of funds are securities
issuance and received borrowings.

5
 Islamic Banks Source of Funds
(Percentage)

Source: Islamic Banking Statistics.

Real sectors is the group that received financing the most and hence financing was
accomplished to the level of 80% for ICB and IBU and 78.9% for IRB. Supporting
activity that can enhance earnings is dominated by placement in other banks for IRB
while for ICB and IBU is the placement in central bank that attained 12.94% in January
2013. Other activities for ICB and IBU include interbank asset and investment securities.

Islamic Bank Placement of Funds

January 2013 (Percentage)

Source: Islamic Banking Statistics.

6
 Other indicator of the prudential procedures undertaking by the Islamic banking is
their non performing financing ratio. From the total financing given to the customers, on
average only 2.5% was failed to repaid for ICB and IBU. For IRB the NPF was higher
around 7% in 2012.

Islamic Bank Trend of Financing

and Non Performing Financing

(a) Islamic Commercial Bank and Islamic Business Unit

(b) Islamic Rural Bank

Source: Islamic Banking Statistics.

7
III. Research Data and Methodology

The sample of the research is Islamic Banking, including Islamic Commercial Bank,
Islamic Banking Unit, and Islamic Rural Bank in Indonesia. The monthly data collection
covers data from January 2010 until December 2012. All the data used in this research
derived from Islamic Banking Statistics, published by Bank Indonesia.
Quantitative method is generated through regression analysis using ordinary least
square method. The dependent variable of the regression model would be FDR while
independent variables used to estimate the variability of FDR are NPF, SPREAD, BANK,
ALLOWANCE, TRAINING, OTHERBANK, PROMOTION, and WRITTENOFF.
FDR : financing to deposit ratio (%)
NPF : non performing financing ratio (%)
SPREAD : difference between bonus from musharaka financing and 1 month
time deposit (%)
BANK : dummy variable of bank type, 1 for IRB and 0 for other
ALLOWANCE : allowances for earning assets losses (billion rupiah)
TRAINING : training cost (billion rupiah)
OTHERBANK : placement in other bank (billion rupiah)
PROMOTION : promotion cost (billion rupiah)
WRITTENOFF : written off earning assets (billion rupiah)

It is expected that NPF, OTHERBANK and WRITTENOFF have negative and

significant effect to FDR while SPREAD, BANK, ALLOWANCE, TRAINING and
PROMOTION will have positive and significant effect to the variation of FDR.

8
IV. Research Findings
The estimation results are as follows:
FDRt = 223.56 3.58*NPFt-1 + 0.47*SPREADt + 28.03*BANK t + 10.5*LN_ALLOWANCEt
Prob. (0.000) (0.0003) (0.0141) (0.0333) (0.0146)
+ 10.47*LN_TRAININGt 19.45*LN_OTHERBANKt 7.48*LN_PROMOTIONt
(0.000) (0.000) (0.000)
5.38*LN_WRITTENOFFt-1 + et (Eq. 1)
(0.0001)

R2 0.984265
F-stat 484.7711
DW-stat 1.734

From the regression estimation above, ceteris paribus, we can reveal some worthy of
notes:
Non performing financing ratio in previous month negatively affect the variability
of financing deposit ratio, a 1% increase of NPF in previous month will decrease FDR by
3.58% and significant by 99% confidence level. NPF will decrease the ability of banks in
creating additional earnings, therefore the increase in NPF will decrease the intermediary
function of Islamic banks.
The difference between bonus from musharaka financing and 1 month time deposit
will cause the change of financing deposit ratio, a 1% increase in SPREAD will increase
FDR by 0.47% significantly by 95% confidence level. The greater the spread will
encourage Islamic banks to acquire additional earnings, therefore the increase in
SPREAD will raise efficiency of Islamic banks that will encourage further their function
as financial intermediaries.
The type of Islamic Bank IRB will increase financing to deposit ratio by 28.03%
significantly by 95% confidence level.
The allowances for earning assets losses will cause the variation of financing to
deposit ratio, a 1% increase in the ALLOWANCE will increase FDR by 10.5%
significantly by 95% confidence level. The allowance will protect Islamic banks from
negative exposure of their financing activity, thus it can strengthen the function of Islamic
banks as financial intermediaries.
The training cost for banks human resources positively affect the change of
financing to deposit ratio, a 1% increase in TRAINING will increase FDR by 10.47%
significantly by 99% confidence level. The training cost will enable Islamic banks
human resources to become more capable individuals in serving their customers. Hence
the increase in training cost will improve the intermediary function of Islamic banks.

9
 The placement of funds in other banks negatively influence the variance of
financing to deposit ratio, a 1% increase in OTHERBANK will decrease FDR by 19.45%
significantly by 99% confidence level. The placement of funds in other banks is an
alternative strategy in Islamic banks balance sheet, consequently the higher the funds to
be placed in other banks will decrease the intermediary function of Islamic banks.
The promotion cost negatively affect the variability of financing to deposit ratio, a
1% increase in promotion cost will decrease FDR by 7.48% significantly by 99%
confidence level. Promotion cost may have ambiguous impact for Islamic banks
intermediary function strengthen. To some extent promotional cost may increase the
intermediary function of Islamic banking because of the increase awareness of their
existence from the customers. However the value of promotion cost should be
proportional to training cost to support the intermediary function. In annex 3 we introduce
new variable (PCTC, ratio of promotion cost to training cost). It can be seen that ratio of
promotion cost relative to training cost statistically not significant in affecting the
intermediary function of Islamic banks, and at the same time promotion cost become
insignificant variable.
The written off earning assets have negative effect on financing to deposit ratio, a
1% increase in WRITTENOFF will decrease FDR by 5.38% significantly by 99%
confidence level. The written off earning assets will decrease potential earning of Islamic,
as a result the raise in WRITTENOFF will reduce the intermediary function of Islamic
banks.

V. Conclusion
The paper demonstrates a new idea of how to develop Islamic banks in Indonesia to
become focal financial intermediaries. Most of independent variables are statistically
significant in improving the intermediary function of Islamic banks at 95% of confidence
level. Non performing financing ratio, placement of funds in other banks and written off
earning asset should be maintained low, promotion cost needs to proportional enough to
training cost, while spread, allowance for earning assets losses, training cost should retain
high in developing Islamic banks as a focal financial intermediaries in Indonesia.

10
References

Bank Indonesia. 2006 2013. Statistics of Islamic Banking.

Elgari, Mohamed Ali. 2003. Credit Risk in Islamic Banking and Finance. Islamic
Economic Studies Vol. 10, No. 2.

Karwowski, Ewa. 2009. Financial Stability: The Significance and Distinctiveness of

Islamic Banking in Malaysia. The Levy Economics Institute Working Paper
Collection

Kahf, Monzer. 2000. Strategic Trends in the Islamic Banking and Finance Movement.
Proceedings of the Fifth Harvard University Forum on Islamic Finance: Islamic
Finance: Dynamics and Development pp. 169-181

Levine, Ross. 1997. "Financial Development and Economic Growth: Views and
Agenda. Journal of Economic Literature 35: 688726.

11
 Annex 1. Regression Estimation Result

Dependent Variable: FDR

Method: Least Squares
Date: 05/13/13 Time: 19:22
Sample (adjusted): 2 72
Included observations: 71 after adjustments

Variable Coefficient Std. Error t-Statistic Prob.

NPF(-1) -3.578455 0.926517 -3.862266 0.0003

SPREAD 0.470189 0.186224 2.524855 0.0141
BANK 28.03483 12.87729 2.177075 0.0333
LN_ALLOWANCE 10.50071 4.179104 2.512671 0.0146
LN_TRAINING 10.45687 1.486794 7.033169 0.0000
LN_OTHERBANK -19.45143 2.735444 -7.110886 0.0000
LN_PROMOTION -7.484680 1.387647 -5.393792 0.0000
LN_WRITTENOFF(-1) -5.375116 1.262882 -4.256230 0.0001
C 223.5589 27.97766 7.990624 0.0000

R-squared 0.984265 Mean dependent var 112.9620

Adjusted R-squared 0.982234 S.D. dependent var 18.01745
S.E. of regression 2.401513 Akaike info criterion 4.708051
Sum squared resid 357.5706 Schwarz criterion 4.994870
Log likelihood -158.1358 Hannan-Quinn criter. 4.822110
F-statistic 484.7711 Durbin-Watson stat 1.733739
Prob(F-statistic) 0.000000

Annex 2. Serial Correlation Test

Date: 05/14/13 Time: 07:22

Sample: 2 72
Included observations: 71

Autocorrelation Partial Correlation AC PAC Q-Stat Prob

. |*. | . |*. | 1 0.124 0.124 1.1428 0.285

. |*. | . |*. | 2 0.120 0.106 2.2269 0.328
.|. | .|. | 3 -0.012 -0.039 2.2371 0.525
.*| . | .*| . | 4 -0.082 -0.091 2.7536 0.600
.|. | .|. | 5 0.045 0.073 2.9146 0.713
.*| . | .*| . | 6 -0.153 -0.153 4.7930 0.571
.|. | .|. | 7 -0.034 -0.017 4.8893 0.673
.|. | .|. | 8 -0.033 0.005 4.9806 0.760
.|. | .|. | 9 -0.063 -0.054 5.3126 0.806
.|. | .|. | 10 0.038 0.026 5.4330 0.860
.*| . | .|. | 11 -0.070 -0.053 5.8618 0.882
. |*. | . |*. | 12 0.154 0.147 7.9331 0.790
.*| . | .*| . | 13 -0.106 -0.156 8.9342 0.778
.|. | . |*. | 14 0.071 0.091 9.3989 0.805
.|. | .|. | 15 0.019 -0.001 9.4320 0.854
.*| . | .*| . | 16 -0.097 -0.095 10.324 0.849
.|. | .|. | 17 0.011 -0.015 10.335 0.889
.*| . | .*| . | 18 -0.197 -0.131 14.140 0.720
.*| . | .*| . | 19 -0.077 -0.070 14.731 0.740
.|. | .|. | 20 -0.039 -0.000 14.883 0.783

12
 Annex 3. Introduction of New Independent Variable

Dependent Variable: FDR

Method: Least Squares
Date: 05/14/13 Time: 09:16
Sample (adjusted): 2 72
Included observations: 71 after adjustments

Variable Coefficient Std. Error t-Statistic Prob.

NPF(-1) -4.128441 1.154975 -3.574485 0.0007

SPREAD 0.484335 0.187594 2.581818 0.0122
BANK 21.38551 15.34816 1.393360 0.1686
LN_ALLOWANCE 8.317488 4.998105 1.664128 0.1012
LN_OTHERBANK -19.09940 2.778271 -6.874563 0.0000
PCTC -1.166146 1.454483 -0.801760 0.4258
LN_TRAINING 7.210167 4.315276 1.670847 0.0999
LN_PROMOTION -4.139185 4.398641 -0.941015 0.3504
LN_WRITTENOFF(-1) -5.835585 1.390668 -4.196245 0.0001
C 242.6180 36.77458 6.597438 0.0000

R-squared 0.984429 Mean dependent var 112.9620

Adjusted R-squared 0.982131 S.D. dependent var 18.01745
S.E. of regression 2.408461 Akaike info criterion 4.725737
Sum squared resid 353.8418 Schwarz criterion 5.044424
Log likelihood -157.7637 Hannan-Quinn criter. 4.852469
F-statistic 428.4966 Durbin-Watson stat 1.786371
Prob(F-statistic) 0.000000

13