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ndonesia'€™s banks have been riding a big wave over the past five years, enjoying some of the highest growth in assets and strongest returns in the world. However, the year ahead raises a big question: will the confluence of tougher macro-economic trends and new regulations cause a significant slowdown for the sector, with particular pain for smaller banks?

In the near term, we remain optimistic about the banking sector in 2014 for four reasons. First, even if real gross domestic product (GDP) growth slows to around 5 percent, as some are projecting, it should still result in double-digit growth in the banking sector. Also, higher interest rates will have mixed impacts on bank profitability with the overall effect largely neutral '€” and return on equity (ROE) should remain attractive.

Meanwhile, non-performing loans are low by historical and international standards. And a final reason for optimism: while new regulations and macro-prudential measures may put the brakes on some near-term growth, their ultimate objectives are primarily aimed at ensuring the stability and sustainability of the banking system. They should not affect the structural growth of the sector.

Although there is a lot of room for different kinds of banks in Indonesia to grow, conditions will likely become more challenging for some of the smaller banks as the larger banks benefit from increasing economies of scale and the lower costs of funds. Slower economic growth and higher interest rates have already begun to highlight the distinctions between different types of banks and the challenges smaller banks face.

For example, as of the end of June 2013, the average cost of funds for the top five banks was 2.4 percent, compared to 4.5 percent for the next 10 banks, according to OneSource. The average ROE of the top five banks was 23.9 percent versus 17.2 percent for the next 10 banks. Furthermore, the Indonesian banking sector is still relatively fragmented by international standards.

The top five banks in Indonesia represent 51 percent of total loans. Compare that to 77 percent in Brazil, 64 percent in Turkey and 90 percent in Malaysia. Look for some banks to gain more ground than others in 2014 and for the large universal banks and some select challengers to outgrow the rest and advance as the market consolidates.

In the medium term, there is a different question the industry should be asking: How to build a winning model to take advantage of Indonesia'€™s growth potential, regardless of any near-term economic and regulatory headwind. We see two global trends holding the key to success for most retail banks in Indonesia.

Going digital

Let'€™s start with the hottest global trend in banking: digitalization. Digital banking is beginning to transform retail banking globally with the possibility to provide a more convenient customer experience at a far lower cost. Bain & Company research predicts that more than 95 percent of all retail banking transactions in the world will likely be digital by 2020.

In Indonesia, customers already conduct more of their interactions through digital channels than in branches. Fully 45 percent of interactions take place digitally compared to 13 percent in branches. Not only is it less costly for banks to provide routine services through digital channels, it also opens up the opportunity for efficiency on other fronts.

For example, banks can operate fewer and smaller branches, and use those branches mostly for sales and other high-value services. This can radically change the way banks grow in Indonesia '€” but will require significant innovation.

The shift to online and mobile channels is taking hold just at a time when Indonesia'€™s retail banks are well-positioned to use it as a platform for growth. Indonesia is a young, digitally advanced country that is rapidly adopting digital technology.

The low-cost nature of digital banking can make it easier to draw in low-income customers, serving them in a way that is both economical and sustainable '€” and addresses the government policy objective for the inclusion of underserved segments such as rural areas.

Meanwhile, online and mobile banking is increasingly popular with wealthy customers, according to a recent Bain survey of more than 1,700 retail bank customers in Indonesia. In that survey, participants with monthly income above Rp 15 million (US$ 1,241) are nearly three times as likely to interact with the banks using online channels, compared to those with a monthly income of less than
Rp 3 million.

 The message behind these findings: Digital banking opens new doors for banks hoping to boost growth by selling more products to the wealthiest customers '€” and that digital channels will become more important as incomes rise for Indonesia'€™s growing middle class.

Innovative new digital banking models will enable retail banks to accelerate their growth and develop new ways to serve clients. They'€™ll introduce different branch formats '€” such as the online only or '€œdirect'€ model of banking. They'€™ll hone their '€œOmni-channel'€ approach to manage all channels in an integrated way. Banks in Indonesia are already actively testing new branch formats, like digital lounges. What they learn from these experimental branches '€” and how new regulation will treat innovations like new cash-free branches '€” will begin to reshape the sector.

Winners will be the banks that get five things right: creating digitally enabled customer experiences, building an Omni-channel sales and service model, positioning technology at the heart of their strategy and execution, funding investments through efficiency gains and reprioritization, and organizing as an innovative enterprise that can create and test new ideas more like leading technology companies than traditional banks.

Earning customer advocates

This will be a big year for Indonesia'€™s retail banks to make significant progress in innovative digital models that will propel growth and profits. But there'€™s another, related trend that will play a major role in helping banks advance: the increasing importance of customer advocacy.

In Indonesia, as elsewhere in the world, frequent digital users are more likely to give the banks higher Net Promoter Scores (NPS), a common measure of customer loyalty that was developed by Bain, and recommend the bank to others. As digital banking expands, it creates the opportunity for banks to boost their NPS. With digital options, banks can more easily communicate with customers and tailor products to serve the needs of different customer segments.

To determine a company'€™s NPS score, customers are asked, on a scale of zero to 10, where zero represents '€œnot at all likely'€ and 10 represents '€œextremely likely'€ how likely they are to recommend their primary bank to a friend or relative. Our study of Indonesian bank customers found that those who are promoters of their primary bank (those who give an NPS of 9 or 10) on average own three of the bank'€™s products, compared to 1.7 for detractors (those giving an NPS of zero to 6). In addition to buying more products, loyal customers stay longer with a bank, generally cost less to serve and are more likely to recommend the bank to other people.

A recent Bain survey of 190,200 retail bank consumers in 27 countries, including Indonesia, sheds light on how banks are using (or failing to use) loyalty to improve the economics of the business. The survey results from Indonesia show that Indonesian customers cite ATM location as the most important factor in choosing a bank, followed by the ease of opening an account. Bain'€™s 2013 research in Indonesia shows that the large universal banks are creating the most loyal customers. Not only are these banks winning in the pursuit of customer loyalty but they'€™re also the most profitable.

Despite the possibility of a slowing GDP, tightening credit and tougher banking regulations, Indonesia'€™s retail banks sit in an enviable '€” but increasingly competitive '€” spot. The market is modernizing fast. This should be another healthy year for the strongest institutions and a moment in time to assert themselves as leaders in digitalization and customer loyalty. In the year ahead, we'€™ll also see more progress by banks finding new ways to reach all segments of the population.

Greater financial sector efficiency and inclusion contributes to the development of the Indonesian economy. Digitalization and innovative ways to meet different customers'€™ needs '€” along with prudent regulation '€” will be important contributors to these objectives and to the health and competitiveness of the sector. The party may be a bit less noisy in 2014, but it should continue.