* Bank lending growth of 25% a year may be too fast
* Strong capital ratios mask growing dangers
* Regulator requires high loan-to-deposit ratio
By Nachum Kaplan
April 2 (IFR) - Are Indonesia's banks really as safe as they look? Perhaps a better question would be to ask whether the Indonesian banking system is as robust as it seems. While there are many individual success stories, there is more risk in the system than at first appears to be the case - and those risks are growing.
Indonesia recapitalised its banking sector after the Asian financial crisis 15 years ago, and the headline numbers regarding the banking system's health are overwhelmingly positive.
The country's banks are well capitalised, with capital adequacy ratios generally far above the 8% minimum with new regulations requiring a level of up to 14% about to take effect. Non-performing loans stand at a modest 2%.
Additionally, the banks enjoy strong and growing deposits with almost 80% of funding coming from their deposit bases, meaning they are well protected from the vagaries of wholesale funding markets.
The threat to this positive story lies in the fact that over the past three years Indonesian banks have been lending more - much more - often at the expense of credit quality. The loan-to-deposit ratio for the Indonesian banking system now stands at 84%, up from 66% in 2007, according to data from Bank Indonesia.
This trend has accelerated over the past two years, with annual loan growth now running at almost 25%.
It is tempting to view this as a product of the country's impressive economic growth, but that is only part of the story. What is driving much of it is a central bank regulation that requires banks to maintain a loan-to-deposit ratio of at least 78% from March 2011.
That unusual measure was aimed at increasing lending and spurring economic growth, and banks that fail to meet this target are liable for penalties in the form of additional reserve requirements.
Boosting that ratio requires a bank to either increase lending or scale back deposits. Indonesian banks have clearly chosen to do the former: scaling back deposits is not something that comes naturally to any bank, and certainly not in an economy that is expanding at more than 6% a year.
In fact, the Indonesian economy's rapid growth is exacerbating the problem. Wealth is being created quickly, and the resulting deposit growth is increasing the pressure on banks to lend.
Increasing lending to meet a central bank requirement rather than because it makes commercial sense to do so is hardly a sound strategy. It virtually forces banks to lower their credit standards which, axiomatically, must produce a corresponding rise in non-performing loans when things go wrong.
Analysts often overlook this threat to the system because they confuse the strength of individual banks with that of the banking system. Indonesia has some strong banks, to be sure, and the biggest institutions play a big role in shaping perceptions of the sector.
That is fair enough given that the country's top five banks account for half the market.
However, there are still way too many others. Despite consolidation in the banking sector in recent years, including some foreign acquisitions (notably by Malaysian institutions), the country still has 120 commercial banks. That is too many and explains why systemic threats can remain despite Indonesia boasting some very strong banks.
History shows us that Indonesia's smaller banks do not fare well when credit cycles turn sour. Ironically, increasing lending to meet a mandatory 78% loan-to-deposit ratio is just the kind of thing that could make them even more vulnerable.
Indonesia has some of Asia's strongest banks, but it does not follow that it has one of the strongest banking systems.
Lenders and investors would be well-advised to draw that distinction because, while the outlook for the banking sector looks rosy right now, the risks are building within the system.