At last, the long awaited draft amendment to the VAT law has been passed by the Indonesian legislative board (the "New VAT Law"). You can see the soft copy here. The law will be effective as of 1 April 2010. The most important thing here is the fact that the New VAT Law recognizes the existence of Islamic finance and exempts VAT for transactions that fall under the term of Islamic finance. Article 1A Paragraph (1) h of the New VAT Law states that with respect to delivery of taxable goods by taxable entrepreneur in the context of Islamic financing activities, such delivery shall be only considered between the taxable entrepreneur and the party needing such taxable goods. While the elucidation of this Article does not provide specific explanation, it gives an example of a murabahah transaction for a vehicle financing, where an Islamic bank buys a car from a taxable entrepreneur based on an order from the Islamic bank customer. In this example, the New VAT Law acknowledges that under such Islamic financing structure, the Islamic bank would need to purchase the vehicle first and then resell it to its customer, however the New VAT Law further confirms that the delivery of such car is considered to be directly done from the taxable entrepreneur to the Shari'a bank customer. In other words, we can conclude that the New VAT Law acknowledges the role of the Islamic financial institutions as financial intermediaries. In addition to the above, Article 4A Paragraph (3) d of the New VAT Law states that financial services are exempted from VAT. The elucidation of such Article further states that the definition of financial services include Shari'a based financing, whereas the financial services may be in the form of: (a) leasing, (b) factoring, (c) credit cards, and (d) consumer financing. Although the above wordings are not clear enough to capture all kind of Islamic financing structure, I am still very happy with this new development as I believe that the New VAT Law might be the right trigger for bringing the Indonesian Islamic finance to a new level. As you may be aware, before the enactment of this law, there is a huge confusion within Islamic finance players on whether their transactions are actually exempted from VAT or not. To add the confusion, in most of the time, the tax authorities were silent on the tax treatment. In short, it was like sitting on a deadly time bomb. In my opinion, there should not be any confusion in the first place, since from the accounting perspective, these Islamic financing transactions are recorded as ordinary financing transactions in the balance sheets of companies that receive such Islamic financing (substance over form) . In other words, there would be no record of sale and purchase or sale and lease back transactions in the financial statements since those structures are merely used to satisfy the Shari'a aspect and do not reflect actual transactions. However, a risk is a risk and without having any tax advisor who is brave enough to issue a clean tax opinion, most Islamic financial institutions were not eager to develop the business in Indonesia. Thus, there are no significant development of Indonesian Islamic finance until today. Hopefully, this should be no longer the case. In addition to the above, further implementing regulations are still needed to resolve the remaining issues as provided below:

• Will there be any criteria to determine the transactions that fall under Islamic finance transactions? I guess the Government will need to stipulate such criteria to avoid any moral hazard from business players who are trying to avoid paying VAT under the disguise of Islamic financing transactions.
• It is unclear on how Ijarah transactions (lease structure) will be treated under the New VAT Law, since there is no transfer of beneficial ownership in an Ijarah transaction. Should the transaction be considered as an ordinary lease transaction? Surely not, but I would like to know how this will be solved from tax perspective.
• While Ijarah Muntahia bit Tamlik financing structure (sale and lease back) should be accommodated under Article 4A Paragraph (3) d of the New VAT Law, it seems to me that this article only applies to leasing companies. What about IMBT financing provided by other kind of Islamic financial institutions, such as Islamic banks? Is there any requirement for securing a leasing company license before the exemption works?
• What about Sukuk? From the original wordings, it seems that the New VAT Law only covers plain vanilla Islamic financing transactions conducted by Islamic banks.

I guess that would be the preliminary issues related to the New VAT Law. I will give more updates on this subject after the Government has issued further implementing regulations.

In Part I of my article, we have discussed two of the major challenges that are being currently faced by the Indonesian Islamic banking industry, the taxation and regulatory issues. In this article, we will discuss the remaining two challenges, i.e the risk management issues and the segmentation and marketing issues.

1. Risk Management Issues

We will start our discussion by asking this question: "Why murabahah financing sits at the top of Islamic banking financing products in Indonesia?" As of June 2009, the murabahah financing which involves a sale and purchase of assets between an Islamic bank and its customers with a deferred payments mechanism plus margin is the queen of all Indonesian Islamic financing products, comprising of approximately 57% of the total Islamic financing products. Meanwhile, the mudharabah financing (revenue sharing financing) and the musyarakah financing (joint venture financing) only comprise 21.6% and 14.5%, respectively, of the total Islamic financing products.

To be honest this is not a shocking result, and as I will further discuss in this article, the above result is none other than a logical consequence of the current structure of the Islamic banking industry risk management which is actually being supported by the current regulations of Bank Indonesia.

1.1 The Problem of Mudharabah and Musyarakah Financing's Risk Management

Most of us know that Islamic banks should be famous for their profit sharing concepts in doing their business, which is reflected in the mudharabah and musyarakah financing products. However, in reality, these products have two critical issues related to the risk management of such financing.

First, these products use revenue sharing mechanism, which means that the Islamic bank will only receive revenues if the actual business of the customer produces revenues. Any losses caused due to business losses of the customer shall also be borne by the Islamic bank, provided that the amount of which shall not exceed the total mudharabah or musyarakah financing.

The above is correct under the Islamic law principle and has been adopted by Bank Indonesia regulation. No one should argue on that. But the problem is quite different for modern financing activities. Most of Islamic banks' source of funds comes from third party funds (as of June 2009, the third party funds comprise 76% of the total liabilities of Islamic banks). These are the funds of the Islamic banks' customers and are not actually owned by the Islamic banks.

From risk management perspective, putting money in a high risk business is unlikely, especially when the banks are mainly using other people's money and they will be responsible to return those funds. We must also remember that banking industry relies heavily on the people's trust. If people are losing their trust on the Islamic banking industry, it is possible for us to predict a financial collapse of major Islamic banks.

Second, the current regulatory regime limits the possibility of Islamic bank to execute the security (jaminan) for mudharabah and musyarakah financing products, and also limits the ability of the Islamic Bank to request for payment of losses. Again, this is in line with the Islamic law principles and no one should further argue on that. But, from risk management perspective, the risk of mudharabah and musyarakah is increasing. Not only that the Islamic banks are liable for possible business losses, they don't have an exit clause which can secure their financing.

What would be the logical consequences of the problems above? Islamic banks will not be using the mudharabah and musyarakah financing products as their main products, rather they will focus on financing products which are more secured for them, in this case, murabahah would be the proper choice.

1.2 Suggested Solutions

Why murabahah financing is widely used? Murabahah financing is flexible enough to be used for certain type of financing, ranging from working capital, investment and consumer finance. It is more secured because after the sale and purchase has been conducted, the customer will be indebted to the Islamic bank and the Islamic bank would be able to secure such financing by the customer's assets and then execute the assets in case the customer fails to pay its financial obligation. From any risk management perspective, it would be best for Islamic banks to focus on this financing product. And we can't blame them for this issue as there is indeed an inherent risk management problem with the mudharabah and musyarakah financing and we must work together to solve this issue.

Now, how can we claim that Islamic banks have a wide array of products where in reality the Islamic banks will focus on murabahah financing products? The solve this issue, we would need to amend the current regulations on Islamic banking products, especially to help the Islamic banks in reducing their risk with certain type of Islamic financing.

My proposed solution would be to make a clear regulation which can eliminate any bad incentives to the customer with respect to the mudharabah and musyarakah financing, i.e preventing them to make bad business decision which will resulting on losses to both sides. How can we achieve this? Some suggested solutions would be: (i) increase the Islamic bank's authority to review and be involved in the business activities of the customer, (ii) penalize the customer for conducting any material business decision without first consulting with the relevant Islamic bank, and (iii) enable the Islamic bank to execute the security for such financing in case the customer does not comply with the requirements stipulated by the relevant Islamic banks in doing their business.

With these solutions, we can expect that the business management of the customer will be handled in a more professional way and the Islamic bank will have an exit clause when they are dealing with bad customers. Further, by encouraging the Islamic banks to be more involved in the customer's business management, it would be easier for the Islamic bank to maintain its risk management and prevent bad business decision of the customer. An age of entrepreneurship may rise in Indonesia, if this can be conducted properly.

2. Segmentation and Marketing Issues

With a total assets representing only 2.64% of the total assets of the Indonesian banking industry (excluding the rural credit banks), the Indonesian Islamic banking industry still has a long way to go before it can dominate the market share in Indonesia. But how can this be happen when most of Indonesian citizens are moslem? The answer might lie on the issues on the Islamic bank segmentation and marketing. Apart from taxation, regulatory and risk management issues which might not be resolved directly by the Islamic banking industry (as government authorities involvement are needed), the segmentation and marketing issues are inherent issues within the core of Islamic bank industry.

From what I see until now, most of the Islamic banks in Indonesia do not have a clear segmentation or marketing policies, especially in getting new customers. This is not due to a cliche reason like the Shari'a bank is not aggressive enough in doing the marketing, etc. The main problem lies in the fact that most Islamic banks are not yet concentrating on getting specific customers and to certain extent are still being trapped with religious symbols and doctrines in doing their marketing activities.
On the segmentation issues, considering the number of Islamic banks' assets, it would be better for Islamic banks to focus on small to mid enterprises unless they have a huge amount of additional capital. And this is actually a potentially good business. Rather than competing with bigger conventional banks who have secured some loyal clients, creating new opportunities with new type of customers might be easier and can show some actual differentiation between Islamic banks and conventional banks in term of doing business activities.

In addition, some proposed plan on my mind for making specific segmentation would be: (i) Islamic banks could focus on micro financing using mudharabah and musyarakah financing products, since given the nature of these products, it would be best to diversify the financing to many parties to avoid high risk of default; (ii) Islamic banks could focus on targeting customers who like to have a secured financing liability, whereas in this case, murabahah financing products with its fixed margin system would be the best option to capture these kind of customers; and (iii) Islamic banks could also focus on assisting small to mid entrepreneurs in doing their business, becoming a "financial manager" for these kind of customers through mudharabah or musyarakah financing products, as this is possible under the current Bank Indonesia regulations.
On marketing issues, I've seen many marketing products in several branch offices of Islamic banks and can conclude that while it is good to tell people that Islamic banking products are the ones that have been blessed by God, it would be better to tell people that Islamic banking products are good and profitable.

I must say that it is ironic if Islamic banks are not focusing on marketing their competitiveness of their products. In term of savings and deposit products, Islamic bank offer a competitive rate of return with conventional commercial banks. Even in term of financing products, contrary to the common opinion that Islamic bank financing is a little bit more costly due to its fixed rate system, the margin rate of murabahah financing is fairly competitive with most of credit financing products and even lower compared to interest rate for consumer credit. I made all of these comparisons using Bank Indonesia's June 2009 Statistics.

To certain extent, I can understand why some of the Islamic banks are not focusing on this kind of marketing. After all, some of them are owned by the same party who own the conventional banks, which of course creates a conflict of interest. Creating a marketing strategy which shows the quality of Islamic banks to the highest degree would not always be acceptable by their colleagues in the conventional banks, thus, these Islamic banks can only focus on getting customers who use religious reasons rather than commercial reasons to become their customer.

In the end, what is truly matter when we are speaking about marketing is how the Islamic bank can provide marketing products that allow people to believe that Islamic banks are professional, accountable and profitable. It should be noted that Islamic banks are profit-seeking institution and should focus on getting those profits, because it is impossible to increase the market share of the Islamic bank if they can't obtain enough funds to expand their business.

For quite a long time, it is very common for us to hear critics saying that the Indonesian Islamic banking industry has failed to capture a bigger market share in Indonesia despite the fact that Indonesia is the biggest moslem country in the world. To certain extent, this might be true.

If we compare the total assets of Islamic banks (based on Bank Indonesia's Islamic Banking Statistic per June 2009, the amount of which is approximately Rp.55 trillion) with the assets of commercial banks (based on Bank Indonesia's General Banking Statistic per June 2009, the amount of which is approximately Rp.2,028 trillion), we will found out that Islamic banks' assets only represent 2.64% of the total assets of Indonesian banking Industry (excluding rural credit banks). True, that if we compare the current data with 2005's data, Islamic banks' assets have increased around 250%, but that is not significant enough if we see the total cumulative assets of the Indonesian banking industry.

Seeing this hard fact, what are actually the main challenges of our Islamic banking industry? What need to be done to surpass these challenges and how? In this article, I will discuss some of the most important challenges that are currently being faced by Indonesian Shari'a banks and some suggested solutions which may be considered in solving those challenges.

2. Major Challenges in Developing the Islamic Banking Industry in Indonesia