Indonesia can serve as a testing ground for PLS bank financing

The latest figures (from March) show that Indonesia's Islamic banking market continues to expand rapidly (at a 50% year-on-year pace), with a lot of the assets in mudaraba and musharaka financings (roughly 20% of the total assets).  As I mentioned at the beginning of the year, "As the market becomes more and more saturated in Malaysia, there is a huge opportunity within Indonesia, where Islamic finance is at a much earlier stage of development."  There remains a huge opportunity in Indonesia where Islamic banking represents just over 4% of total banking assets (compared to over 20% in Malaysia).  This market also seems to buck the trend in the share of assets in mudaraba and musharaka, which many people think are better assets for Islamic banks to hold (or at least more "Islamic"). 

Indonesia then should be a big test about whether Islamic banks offering mudaraba and musharaka financing can be sustainable on a large scale.  There are two prevailing theories about why the profit-and-loss sharing contracts get a much smaller share of total bank assets: 1) Islamic banks have been captured by Western bankers and lawyers who want the banks to operate on similar lines to their conventional counterparts (due to either familiarity or regulatory environment); 2) profit-and-loss sharing contracts are inherently more difficult to operate in a banking environment because of adverse selection and moral hazard. 

Indonesia could prove to be a testing ground for both of these theories.  I am not an expert on banking regulations of Islamic banks in Indonesia, but by the mere degree to which Islamic banks in the country have engaged in mudaraba and musharaka financing suggests that the regulatory restrictions are diminished compared to other markets.  It also seems from my limited research that Indonesian Islamic banks are more focused domestically and on banking in particular (rather than investment banking/private equity/etc).   There are also potential regulatory changes that will encourage the domestic focus by limiting new foreign (and domestic) ownership of banks to either 30% or 40% for a single investor, from the 99% allowed now. 

Viewing the development of Islamic banks' profitability, and more importantly, the stability of their profits, over time will be a metric of how well the mudaraba and musharaka model can work on a large scale in the context of regulatory systems which allow both conventional and Islamic banks.  The key point is whether the internal risk management of the Islamic banks can engage in potentially volatile mudaraba/musharaka financing and either pass that risk through to depositors (mudaraba account holders) or manage their profit-equalization reserves to smooth payouts to depositors without taking large losses for shareholders (either in order to maintain competitive rates of return for depositors, or in the worst case, eating losses to retain depositors' principal amounts).