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Why are Indonesian banks only lending to a small segment of the population?

Dino Setiawan has worked in a number of large banks covering, treasury risk management, commercial lending, investment banking, and more recently headed a Silicon Valley based fintech lender providing access to finance for the US underbanked. He blogs to democratize institutional lending issues for mainstream discussion. Afterall, if you knew what went into your bakso, you’d improve your eating habits. Same goes for loans, you become a healthier borrower.

Indonesian banks and regulators look at the proportion of loans where borrowers fail to repay against all the loans they lend out. This is called the Non-Performing-Loan (NPL) ratio. Should this ratio rise above a certain level, regulators will scrutinize a bank's activity to prevent further deterioration of the offending NPL ratio. If the ratio gets high enough, the bank will be forced to stop lending activities until it can bring down its NPL ratio.

This regulatory oversight is to make sure banks don't put depositor funds at risk by lending recklessly, both banks and regulators certainly should focus on managing NPLs.

And here, it's time to introduce the concept of gross vs. net NPL. Net NPL takes into account money (usually from fees and interest, not depositor funds) set aside by the bank for loans the bank expects won't get repaid. This is called provisioning.

So it is theoretically possible for a bank to lend with a high gross NPL (they are lending to high risk people), but offset that with high provisioning to end up with a low net NPL.

One could argue that banks should lend to higher risk borrowers in the interest of financial inclusion (more people can get access to finance). They simply charge higher interest to lend to those who currently cannot get access to loans.

Take your corner warung, or small entrepreneur - without property collateral is unlikely that small business can get a bank loan because banks have seen a high level of these borrowers fail to pay back their loans (high risk). Should all warungs and small entrepreneurs without property be excluded from working capital loans that can help grow their businesses? Or should banks set a higher interest rate to lend to these class of borrowers?

Unfortunately, because both banks and regulators focus on gross NPLs, setting aside additional money against loans they expect to fail does not make a difference. Yes net NPL improves, but not gross NPL.

When investors, media, regulators, the whole industry looks at gross NPL, a bank's hands are tied even if they want to consider financial inclusion. Thus, they have to stay conservative and only lend to those who they are certain will pay back. Hence why banks only lend to a small minority of the Indonesian population.