T

hroughout 2014, the Indonesian banking sector has been facing tightening liquidity. One of the liquidity measurements, the loan-to-deposit ratio (LDR), has been fluctuating a couple percentage points below the minimum reserve requirement-LDR ceiling of 92 percent.

There are many factors that cause this tightening.

First, a substantial demand for credit that occurred during the economic boom had led to credit expansion, thus undermining the banking sector'€™s liquidity.

Second, the global economic slowdown resulted in a capital flight, which, in turn, eroded banks'€™ third-party funds that are sensitive to short-term returns.

Third, high domestic demand in the real sector led to increased imports, thus reducing demand for the rupiah. Consequentially, savings could not increase rapidly and deposit growth rates slowly flattened. Many experts and analysts expect this trend to continue until the end of the year.

Even though, overall, this figure is still within an acceptable level, particularly after gradual improvement in the last couple of months following the government'€™s fiscal expansion, which increases banks'€™ third-party funds (particularly those of regional banks and state-owned banks), the banking sector needs to formulate a new strategy to be able to grab more funding in the long run.

Liquidity is a very crucial aspect of the banking business. In the worst-case scenario, if a bank has a liquidity issue, it may not be able to fulfill its obligations to its savers. When that happens, the trust for that bank may collapse, thus resulting in a massive funds withdrawal from that bank. This is followed by an even more severe liquidity issue, which, in the end, could harm the bank'€™s business sustainability.

If this problem is faced by a big bank (i.e. a domestically, systemically important bank), the problem can cause systemic risk. When that happens the whole banking system could face a bank run, leading to a failure in the whole banking system.

Hence, considering these risks, maintaining liquidity positions, whether that of the whole banking system or of individual banks, has become a very important aspect for the financial system and the economy as a whole.

Looking from the LDR point of view, banking sector liquidity can be affected by deposits or loans. In other words, when liquidity tightens, it can be caused by either higher credit growth, slower deposit growth, or both. When the economy is growing, demand for credit will increase. As a consequence, assuming ceteris paribus, the LDR will get higher. Higher demand for credit is inevitable in a growing economy. Therefore, banks have to seek more deposits from households or corporations to maintain their liquidity.

Higher expenses also reduce the propensity to save. As a consequence, this causes lower deposit growth, which eventually reduces the banking sector'€™s liquidity.

Generally speaking, financial inclusion is one of the possible solutions to this tightening liquidity trend since banks can find new sources of funding from the previously unbanked market. Currently, access to financial services in Indonesia is still relatively low when compared to regional peers.

As a comparison, statistics from the World Bank'€™s World Development Indicators database show that Indonesia'€™s credit-to-GDP (gross domestic product) ratio was only 37.9 percent in 2013. The figure was substantially below Thailand'€™s (154.4 percent), Malaysia'€™s (124.3 percent) and Singapore'€™s (128.9 percent).

Meanwhile, during the same period, Indonesia'€™s savings-to-GDP ratio was only 31.6 percent, still relatively below those of its peers, such as Thailand (32.5 percent), Malaysia (35.4 percent) and Singapore (52.1 percent).

Considering Indonesia'€™s huge population base and its considerable number of unbanked people, there is still a lot of room to get new sources of funding and increase the liquidity position. For instance, banks can extend their services to previously unreached markets, such as in rural areas. However, expanding access to banks is usually costly and thus it increases the cost of funds and undermines profit margins. However, there are several ways it can be done in order to improve the efficiency of branch expansion.

First, if service extension is carried out on a massive scale, then economies of scale can be applied and thus the marginal cost of service extension becomes lower. As a consequence, this can push down a bank'€™s cost of funds.

Moreover, thanks to technological advancement, the costs of branch expansion can be pushed down even farther. For instance, branchless banking can be implemented as a convenient method for banks to extend their services in remote areas without much additional cost.

Financial innovations also matter. Banks need to invent financial products suitable for rural populations. These products should be flexible, particularly in terms of complexity, access and returns, in order to make them suitable for potential rural savers. Moreover, inventing a financial product that is linked to local cooperatives may also make it more attractive for rural dwellers.

Simultaneously, this should be accompanied by socialization. Societies in rural areas are mostly financially illiterate and tend to avoid financial services. Hence, providing education about financial products may persuade them to utilize financial services, particularly savings accounts.

Fortunately, financial authorities have acknowledged the necessity of finding new sources of funding for banks. They have also supported this movement by providing financial infrastructure, formulating accommodative financial regulations and establishing a customer protection framework to encourage banks to extend their services to rural areas.

Hopefully, banks will be able to carry out this program. Extending financial services to rural areas not only potentially increases banking liquidity, but also enhances financial inclusion. From the macroeconomic point of view, this will result in financial stability, as well as enhanced economic development.