Winarno Zain, Jakarta – The decision by the Bank Indonesia (BI) Board of Governors to maintain its current benchmark interest rate at 6.5 percent in their last meeting was not surprising because the inflation rate, despite a spike in June, is still overall benign.

BI's concern has now shifted to the high interest rates on bank loans that still have to be paid by Indonesian businesses.

Acting BI Governor Darmin Nasution announced after the meeting that BI is taking measures that would force banks to lower their interest rates. Complaints have been voiced by Indonesian businesses for some time, that high rates of interest would discourage investment and erode their competitiveness.

The persistent high interest rates that are still being charged by banks remain a sticking point in the overall BI monetary policy.

It is hard to understand why, after BI cut its benchmark rates five times between mid of 2008 and August 2009 by 300 basis points, banks have not cut their interest rates.

Bank lending rates currently stand between 16-18 percent, the highest in the region, and amid weak and uncertain global economic recovery, this could stifle Indonesian corporate sector in their drive for further growth.

But even if BI took the measures it would not mean that banks would reduce their lending rates immediately.

Efforts to reduce bank lending rates, especially in Indonesia, are a long-term process, so it could take some time before we see banks actually responding to calls for that to happen. There are several reasons why reducing bank lending rates is a long-term process.

The first reason has to do with the market structure of bank loans. There are now 121 banks operating in Indonesia, but most loans come only from a few of the biggest banks.

Latest BI statistics show that in the March quarter this year, five state-owned banks contributed 36 percent of total bank loans. If we extend the review further, it is clear that the loan distribution among banks become highly skewed.

Around 70 percent of bank loans are provided by 14 largest banks, representing only 11 percent of total number of banks. This seemingly oligopolistic structure of bank lending market, mean that there is little competition, as these largest banks wield power in setting rates.

Because these banks charge high lending rates, their profit rose considerably. In 2009, in the aftermath of the global financial crisis, Indonesian banks managed to reap 28 percent more profit from previous year to Rp 61.8 trillion.

Last year, Bank Mandiri, the largest bank in the country earned Rp 7.5 trillion net profit, a 35 percent increase from previous year.

The net profit of Bank Central Asia (BCA) the largest private bank in the country amounted to Rp 8.8 trillion, 30 percent more than previous year. This year, bank profits are poised to again grow strongly.

In the first quarter of this year, the net profit of Bank Mandiri jumped by 43 percent while the state saving bank (BTN), which specializes in providing mortgages, experienced a 70 percent jump in net profits.

No wonder then that the net interest margin (NIM) – defined as the difference between interest earned and interest paid expressed as a percentage of earning assets – of Indonesian banks at 11.9 percent was the highest in the region, which sits at 3-4 percent on average.

When a bank sets its interest rates, it has to factor in several risk premiums above the cost of their loan. In Indonesia, the biggest risk premium in determining interest rates is inflation.

Historically, inflation in Indonesia is high and volatile, so it is difficult for banks to determine risk premiums from inflation with certainty. Default risk amid weak economic growth, coupled with legal uncertainty, are additional risks that banks have to face in extending loans.

They have to create a buffer to protect them against risk uncertainty, thus the interest rate they set tend to be on the high side.

The other factor that makes lending rates tend to be high is the high dependency of corporate financing on bank lending. "The persistent high interest rates that are still being charged by banks remain a sticking point in the overall BI monetary policy."

Unlike in neighboring countries, where capital markets have played an important role in corporate financing, in Indonesia, banks provide 80 percent of corporate financing. Stocks and bonds market remain a fraction of corporate financing, and do not pose credible competition to banks.

Capital market and non-banks financial institutions still play a very small role, reflecting the shallowness of the capital market. As businesses have limited options in their financing, except through bank loans, loan pricing becomes inflexible as banks have a stronger bargaining position.

The other obstacle for lowering lending rates is symmetric information that is being faced by banks regarding the financial reports of their corporate clients.

Because the quality of financial reports of Indonesian companies generally lack credibility and transparency, it is difficult for banks to make a proper analysis, so they resort to the availability of adequate collateral in making loan decisions. The unreliability of corporate information becomes risk premium that is built up in their interest rate decision.

BI has tried to curb upward pressure on lending rates when in September 2009 it asked 14 largest banks to "cap" their deposit rates. The move managed to lower deposit rates slightly, but then there were no tangible pressures for banks to cut their lending rates. Lending rates remain high.

This is because the supply and demand dynamics of the deposits are different than those of loans. In the last several years, in terms of percentage of GDP, while loan increased, bank deposits declined.

This is because depositors have more alternatives to keep their money beside bank deposit, like equities, government bonds and fund management. Fierce competition to lure depositor's money among banks, rule out the chance to reduce their lending rates.

In the long term, efforts to lower lending rates would be tied to the success of the BI monetary policy in managing inflation expectation, and efforts of the government to deepen capital market, and to improve regulatory frameworks regarding the credibility and transparency of the Indonesian corporate financial reporting. Until these efforts produce results, bank lending rates will remain high.

[The writer is an economist.]