BPR Microfinance Institution in Indonesia

BPR Microfinance Institution in Indonesia Chapter 1   Introduction 1.1  Background It is believed that microfinance helps low-income people alleviate their life from poverty circumstances in many developing countries. As an economic instrument which has been raised in the middle of seventies, the thought of microfinance came up from the fact that low-income people difficult to access financial services from commercial or formal banking institution which may disadvantage them or even not including them as potential clients. The reason is that, which often we may hear for several times, low-income people lack of collateral for guarantee some amount of money they want, and in the commercial financial institutions point of view it is costly to serve them due to unequal cost-benefit and high transaction cost: low-income people tend to borrow in small amount but the commercial financial institution maintain high cost for processing and assuring their repayment. These costs are not proportional with the amount of loan given to them. A formal microfinance institution existing in Indonesia is the Bank Perkreditan Rakyat/BPR (People’s Credit Bank or Rural Bank)[1] which is established by the Banking Act. The main objective of the BPR is to serve small businesses[2]. It means that BPRs can enhance their role and contribution in the development of micro and small business[3]. In Indonesia, like other developing countries, micro, small and medium enterprises (MSMEs)[4] play significant role in economy. The role of MSMEs can be viewed as an important factor for Indonesia to recover from economic crisis and to lead economic growth and employment. Statistics Indonesia (Badan Pusat Statistik/BPS) and Ministry of Cooperatives and Small-Medium Enterprises reported[5] that, the average contribution of SMEs’ share to total GDP Indonesia from the period of 2001 2007 was 60.77%, while at the same period large enterprises (LEs) contributed 39.23% which can be seen in Table 1. Source:  Statistics Indonesia (BPS) and Ministry of Cooperatives and Small-Medium Enterprises (various editions) In terms of employment creation, MSM enterprises have passed over large enterprises. Table 3 provides worker absorption by types of enterprises. It shows that small enterprises have absorbed approximately 91% of employment during 1999-2006, while medium and large enterprises have provided by 5% and by 4% of employment in Indonesia. Source  : Cooperative Statistics cited in Nazara and Gitaharie (2008), edited by author Based on the data which are discussed in the previous paragraphs, it can be concluded that micro, small and medium enterprises (MSMEs) have a big role and a potential as a driver of the domestic economy. Nevertheless, they still have several constraints, for instance, product market accessibility, lack of management skills, and limited access to financial sources, especially from commercial banks, to meet their demand for finance. A survey conducted by Statistics Indonesia (BPS) concluded that the biggest problem for micro and small enterprises is lack of capital for financing their business.  The survey recognized that  problem in finance for micro enterprises was accounted for 40.48%, while for small enterprises was 36.63% (Wardoyo and Prabowo 2003: 31). In Indonesia, small and medium enterprises can acquire their finance from several sources. According to Nazara and Gitaharie (2008) which refer to statistical data from BPS 2000; 82,960 SMEs got their finance from non banking financial institution; 385,383 SMEs got their finance from banks; and 661,630 SMEs got their finance from other sources. It is clearly from the data that most of SMEs rely on sources other than formal institutions. These figures were not taking into account for SMEs which have no legal entities (Nazara and Gitaharie 2008: 8). From SMEs point of view, they face kinky administrative procedure and also they have to provide collateral as guarantee to get loans from commercial banks. This condition leads SMEs favoring in Bank Perkreditan Rakyat/BPR (People’s Credit Bank or Rural Bank) and other financial institutions which provide simpler in administrative procedures, but higher in interest rates compared to commercial banks (Nazara and Gitaharie 2008: 8). Even though entrepreneurs are burdened with high interest rates, they do not much complain about it as long as they have access to formal credit (Berry et al. 2001 as cited in (Sunarto 2007: 2)). In line with the condition in which SMEs favoring in BPRs, Sunarto (Sunarto 2007: 4) stated that BPRs have several advantages in serving to SMEs, those are: (1) its location which is close to SMEs, (2) simpler in credit procedures, (3) accentuate a personal approach in its services and (4) more flexible.   This paper is focused on the role and contribution of BPR, one of the formal types of microfinance institutions in Indonesia, as the suppliers of funds to different types of enterprises especially to micro and small. The discussion emphasizes on credit allocation delivered by BPRs to the micro, small and medium enterprises. Comparative analysis will be made between commercial banks[6] and BPRs for analytical purposes in two things. Firstly, the comparison in terms of allocation of credit which does not consider other variables playing a role in borrowing, for instance interest rates and so on. The comparative result is not in the amount of the credit disbursed but in the percentage of allocation for each type of enterprise. Secondly, the comparison in terms of performance will be discussed through some indicators. Furthermore, the performance indicators of BPRs will be compared with their criteria which set by Bank Indonesia to see whether those indicators improving or deteriorating. 1.2  Research Objective and Research Questions Research Objective The objective of this paper is to study the role and performance of Bank Perkreditan Rakyat (BPR), as one of microfinance institutions in Indonesia, in financing micro, small and medium enterprises. Research Questions In order to achieve the research objective, this paper proposes research questions as follows: 1.  What is the role of BPRs as supplier of funds to different types of small and medium enterprises, in particular micro enterprises? 2.  What is the performance of BPRs in relation to credit provision to micro and small enterprises? 1.3  Research Hypothesis Bank Perkreditan Rakyat (BPR) was established with the main objective is to serve small-scale business and people in rural areas. Therefore, the first hypothesis is that BPRs are reaching their main objective as supplier of funds to micro, small and medium enterprises as mandated by regulation (i.e., banking act). In order to meet the objectives, it is needed good performances which are reflected from their performance indicators. Therefore, the second hypothesis is that performance indicators of the BPRs have met with the standards which set by the Indonesia banking authority. 1.4  Organization of the Paper This paper is divided into five chapters. Chapter 1 is introduction which contains background of the research, research objective and research questions, research hypothesis, and organization of the paper. Chapter 2 is review of the literatures and analytical framework for the research. Literature reviews discuss about definitions of microfinance and microfinance institution, the approaches can be taken by a microfinance institution in order to serve the clients, the models of microfinance institutions, the types of microfinance institutions in Indonesia and the pyramid of them in relation to potential customers and performance indicators. Analytical framework discusses about the way in which the research will be achieved. Chapter 3 is the microfinance institutions in Indonesia which contains their brief history and recent condition. Chapter 4 is analysis of the role of BPRs in financing micro, small and medium enterprises which contains overview of the chapter, data source for the analysis, methodology of the analysis, some information about commercial banks and BPRs, and analyzing to answer the research questions. Chapter 5 is conclusion.   Chapter 2   Literature Review and Analytical Framework 2.1  Literature Review There are many definitions about microfinance proposed by several researchers and institutions. This paper uses some definitions given by Robinson, Ledgerwood, Consultative Group to Assist the Poor (CGAP), and Asia-Pacific Economic Cooperation (APEC) to describe microfinance. Robinson (Robinson 2001: 9) defined microfinance as small size financial services (mainly saving and credit) given to people who having farm or fish or herd; people who running micro or small enterprises which producing, recycling, repairing or selling goods; people who offering services; people who working for commissions or wages; people who having earnings from renting the land, vehicles, draft animals, or machinery and equipment; and people or other individuals and groups from both rural and urban areas at the local level from the developing countries. Consultative Group to Assist the Poor (CGAP)[7] which uses terminology â€Å"poor people† and Ledgerwood which uses terminology â€Å"low-income clients† pointed out to person who receives basic financial services from microfinance including self-employed people. Furthermore, Ledgerwood (Ledgerwood 1999: 1) stated that definition of microfinance comprises not only in financial intermediation but also in social intermediation. Many of microfinance institutions (MFIs)[8] provide this social intermediation function (i.e., group arrangement, self-confidence development, training to enhance capabilities and to increase capacities in terms of financial literacy and managements) go along with financial intermediation. Moreover, she argued that microfinance is a development instrument and it is not just banking.   Asia-Pacific Economic Cooperation (Santoso et al. 2005: 7) defined microfinance into two understandings. Firstly, it refers to an institution when it designates to an organization which offer financial services or banking products, especially loans to the poor people. Secondly, it uses for different methods or activities which assigned to the poor people in order to access financial services. The poor people usually ask for loans, meanwhile commercial banks do not qualify them for loans. These understandings are close to each other. An institution which provides products for poor people called as microfinance institution. The usage of products (i.e., credits) which is provided by MFIs will be beneficial for poor people in generating more earnings.   Ledgerwood (Ledgerwood 1999: 65-66) stated that the approaches that can be done by microfinance institutions can be divided into two main categories: the minimalist approach or integrated approach. When MFIs do minimalist approach, they only perform functions of financial intermediation, although sometimes they offer social intermediation in limited services. Premise that underlie this approach is a-single missing piece that can be offered by MFIs to the clients in the form of access to credit for them due to the clients are getting less coverage of services from financial institutions, for instance to grow enterprises. On the other hand, integrated approach is a combination of four aspects those are social and financial intermediation, enterprise development and social services. Thus, it is needed a holistic view of the client when a MFI taking this approach. If MFIs are not able to meet all four services, MFIs only offer services that are really needed by the client as long as this service in line with goal and objective of MFIs. Since the large-scale demand for services microfinance activities is in existence, the activities are shown in many countries. The poor people are usually un-bankable, because of such conditions: low skills, poor capacity and severe inabilities. They might not be served in the commercial banking system. It is because the system needs for formal requirements, along with the proper economic scale and certain guarantee. In official terms, this kind of market is un-named and un-served. There are niche markets for the supply of services for MFIs (Santoso et al. 2005: 8). Clients of microfinance institution can not be classified as the poorest of the poor. Generally, they are self-employed and low-income entrepreneur, including; traders, food vendors at the street side, small farmers, small producers and artisan who produce souvenirs in at tourism area and so on. The nature of their business usually provides a stable source of income (Ledgerwood 1999: 2). In various forms, income is provided by micro enterprises owned by the poor. This is done by providing employment. The recycling and repairing better than littering a good, making cheap food, clothing, and transportation to be available are some examples. It is also made to them who are from the low level of formal sector that are usually very difficult to live with their salaries. The people of this kind of life are often can cope with such a problem with the typical cases mentioned above, but can not handle the more serious problem. The other types of problem that are often found are deficiency of capital, skill, official status, and business security. In the meantime, naturally they already have the ability to face sharp business sense, strong life skills, long hard work practice, market knowledge, extensive communication and informal support networks. They also used to have the ability to live supported by their flexibility basic consideration (Robinson 2001: 12). A recent study in Bosnia and Herzegovina carried out by Hartarska and Nadolnyak (Hartarska and Nadolnyak 2008) used the financing constraint approach. The approach states that microenterprises that have good access to credit will be less rely on internal funding in their investment. Using the Living Standards Measurement Survey and the existence of the MFIs in their area, they compare sensitivity of investment to internal funds in the microenterprises which there are MFIs in municipalities they located to microenterprises which there is no MFIs in municipalities they located. They concluded that the MFIs reduce the constraint of microenterprises funding when they are exist close to business. There are some models of microfinance institutions. The first model is Grameen Bank. This model is founded in many countries, especially in Bangladesh, from which it established for the first time by Muhammad Junus. In determining target poor clients, Grameen Bank will do it carefully which is usually done through a series of tests. Loans are given to the group in which each group typically consists of five people and each member of the group guarantee the loan of the other members. This model intensively requires supervision and motivation from the staff to the group borrowers. The second model is Village Bank. An implementing agency establish individual village bank together with 30-50 people and sets capital for on-lending to other members. Repayments of the loan are usually in a week until 16 weeks whereas the village bank pays the principal plus interest to implementing agency. The third model is Credit Unions (CUs). Credit Unions are non-profit financial cooperatives which owned and controlled by its members. Besides saving, CU also provides loans for both productive and non-productive purposes to the members. The membership of CUs compared to Grameen Bank is more heterogeneous and usually based on similar bond. The fourth model is ‘self-help’ groups (SHGs). This model is close to the second model, village bank, although their structure is less well compared to the village bank.  The membership of SHGs is based on the similarity in income and the number of membership approximately 20 people. In principle, they use internal funding, that is saving, to lend it to the members, even though they can also seek external funding as additional source of funds. Several NGOs are facilitating and promoting SHGs, but basically, SHGs are directed as an independent institution. The task of seeking additional financing from outside is usually helped by NGOs which link between SHGs and other external parties or other funding agencies. This NGO’s job close related to social intermediary function they have, while other NGOs are functioned as financial intermediaries which funding SHGs  (Conroy 2003: 4-5). In terms of forms, microfinance institutions can be classified as bank (government and commercial), nonbank financial institution, saving and loan cooperative, credit union and nongovernmental organization. Pawnbrokers, rotating saving and credit association, and moneylender also part of MFIs and hold significant roles in functioning financial intermediation although they are more informal in legal status (Ledgerwood 1999: 1). In Indonesia, several institutions have already served microfinance services for such a long period. Those institutions can be divided into four types. The first type is formal microfinance institutions (MFIs). This type of MFI is regulated and supervised as banking institution and therefore their activities as financial intermediaries subject to banking regulation and supervision. Such institutions included in this type are BRI Unit (state-owned microbank), commercial banks with microfinance services and Rural Bank (Bank Perkreditan Rakyat/BPR). The second type is semi formal MFIs which registered and or licensed by state authorities or local governments, therefore they are not regulated by banking authority (Bank Indonesia). Including in this type are cooperatives, Islamic-based cooperatives (Baitul Maal wat Tamwil/BMT), rural credit institution (Badan Kredit Desa/BKD) and microfinance owned and managed by NGOs. The third type is informal MFIs that operate outside the framework of government regulation, among others, are credit union, rotating credit and saving association (ROSCA), moneylenders, landlords and so on. The fourth type is microcredit programs established by the government in channeling credit to subsidize the poor through a variety of institutions (Nugroho 2008: 181-182). Further explanation about these four microfinance services especially the first three types of MFIs will be presented in chapter 3.   In Figure 1 we can see the pyramid of microfinance institutions with their potential customers in Indonesia. The top layer shows formal MFIs (BRI Unit, Rural Banks/ BPRs and LDKPs). They provide financial services for the top level of microfinance market. This type of MFIs is intended to serve small business which has characterized with stable income flows; therefore these MFIs’ potential clients are non-poor and not so poor people. In the middle layer, semi- formal MFIs serve microfinance services for the poor households. This layer includes rural credit institutions (Bank Kredit Desa/BKD), cooperatives, BMT and NGOs. Clients in this layer are characterized by unstable flow of income. At the bottom layer of the pyramid the huge number of potential clients which need microfinance services. They are very poor people which are characterized by unpredictable income. They need the microfinance services in order to ensure their uncertain income, so they need a small loan to overcom e the difficulties of life (Nugroho 2008: 184-185). Figure 1: The Pyramid of Microfinance Services in Indonesia Source: BI and GTZ (2000) cited in Nugroho (2008) As mentioned above, Rural Bank (Bank Perkreditan Rakyat/BPR) is one of the formal types of microfinance in Indonesia. Its existence is established by Banking Act number 7 of 1992 as amended by Banking Act number 10 of 1998. The main goal of the rural bank is to serve small business and rural communities. In order to deliver their services to the customers, a microfinance institution requires a good performance. This performance can be seen from some indicators. Looking at these indicators, we can decide how well they not only can do financially but also it can also build the future performance goals. There are a large number of performance indicators that can be used by MFIs in measuring the financial performance. One of the principles that can be used is the CAMEL system, ACCION. This system examines five traditional aspects which are regarded as the most important thing in the practices of the financial intermediaries. The five aspects (capital adequacy, asset quality, management, earnings, and liquidity) be the sign of the financial condition and operational strength of the MFI in common (Ledgerwood 1999: 205,227,229). 2.2  Analytical Framework Based on the theoretical framework that has been presented in the previous section, the author uses Figure 2 below describing the analytical framework used in the research which answering the research questions asked. There are two parties involved in the financial market.  On one hand, there is a supply side which is financial institutions that act as financial intermediation agents or it might be function as other than financial intermediation like social intermediation or something else. These financial institutions include commercial banks, non-banks financial institutions (insurances company, ventura capital, etc), and microfinance institutions (in different types and forms). On the other hand, on the demand side, there are some parties that require financing for different purposes, among others for working capital and investment usage which is belongs to micro, small and medium enterprises (MSMEs). The problem is that not all of these financial institutions allow MSMEs as their client due to several requirements which can not be fulfilled by MSMEs (collateral and bureaucratic procedures, for instances) or it might be comes from the MSMEs itself that no need too much funds (small financing). Here, microfinance institutions fit with the need of MSMEs. The mechanism then runs as common supply and demand in the market: MFIs, as financial intermediaries, offer credit or loan to MSMEs. Furthermore, MSMEs use the loan for running their operational activities (working capital usage) or for accumulating their physical capital (investment usage). At the end of the story, output of MSMEs will contribute to national income (GDP) and at the same time generates income for the owners and employees. Figure 2: Analytical Framework of the Research: Supply and Demand in Financial Market Source: author’s graph This paper focuses on the supply side of particular financial intermediaries in the financial market those are microfinance institutions. In other words, using Ledgerwood’s terminology mentioned in literature review, the paper mainly looks at the role of MFIs in terms of â€Å"minimalist approach†; how they perform as financial intermediations in delivering credit or loan. Special attention given to Rural Banks, one of formal MFIs in Indonesia in allocating their credit to different types of enterprises such as micro, small, medium and large enterprises. There are several reasons why this paper discusses on Rural Banks as unit of analysis. Firstly, it is states in the regulation (Banking Act) that the main objective of Rural Banks is to serve small scale business and looking into the pyramid of MFIs appeared in Figure 1. It means that Rural Banks have a specialization as small scale business’ banking, especially micro enterprises. This paper wants to see to which extent this mission is successfully executed. Secondly, Rural Banks are the second largest microfinance institutions in terms of asset, third party funds collected and number of debtors. According to Bank Indonesia (2008)[9], they posses 35% of total MFIs’ assets; 30.43% of third party funds collected on total MFIs and 29.15% of total number debtors on total MFIs.   This study proposes two research questions. The first research question relates to the role of rural banks as financial intermediaries in delivering credit to different types of business especially micro and small enterprises. In addressing the first research question, the paper uses comparative analysis and simple calculations in terms of credit disbursement for both commercial banks and rural banks so that the share (percentage) of credit allocation to different types of enterprises to be known. In order to obtain the result, some criteria and assumption are applied in the study. This is done due to there is no data available about the definite amount of credit disbursed by either Rural Banks or commercial banks to different type of enterprises. The discussion focuses only on the amount of credit allocation, so that other variables that determine the credit such as interest rate, collateral, and so forth are not discussed in this study.   The second research question indicates the performance indicators of rural banks in relation to credit provision to micro enterprises. These indicators include; Loan to Deposit Ratio (LDR), Returns on Assets Ratio (ROA) and Non-Performing Loan Ratio (NPL) which refer to Director of Bank Indonesia Decree number 30/12/Kep/Dir and Bank Indonesia’s Letter No. 30/3/UPPB about Rural Banks Soundness Evaluation. Furthermore, comparison will be made between these indicators and criteria. Chapter 3 Microfinance Institutions in Indonesia 3.1  Microfinance Institutions in Indonesia As developing country, Indonesia has long experience and history in developing microfinance institution which has made it possible for poor or low-income people to overcome financial constraints and to access financial institutions. For this condition, some researchers like Berenbach and Churchill called that Indonesia is â€Å"the most developed market for microfinance services in the world† (Barenbach and Churchill 1997 as cited in (Santoso et al. 2005: 43)). The development of microfinance institution began for the first time in Dutch colonial era when several well-educated local people saw deteriorating economy happened in their community and they looked for the need of this services and started organize it. The two famous institutions best known as pioneer in microfinance institutions and exist since colonial era are cooperative and Bank Rakyat Indonesia (BRI). As mentioned in chapter 2, microfinance institutions in Indonesia can be classified into four types (Nugroho 2008), those are; formal microfinance institutions, semiformal MFIs, informal MFIs and microcredit program which is established by the government for delivering credit to poor people through several institutions. In this chapter the latter type of MFI will not be discussed. The discussion is emphasizes on three other institutions. Formal MFIs are financial intermediary institutions which refer and subject to banking regulation and therefore supervised by Bank Indonesia. Semiformal MFIs are not regulated by Bank Indonesia as a banking authority, but they are licensed and or registered by other state authorities or local government. Informal MFIs operate outside government regulations. Nugroho (Nugroho 2008) described institutions which include in each type of MFI as follows: formal MFIs including BRI Unit, Rural Bank (BPR) and The Rural Credit Fund Institutions (Lembaga Dana Kredit Pedesaan/LDKP); semiformal MFIs covering rural credit institution (Badan Kredit Desa/ BKD), microfinance NGO, credit cooperatives including Islamic-based cooperatives (Baitul Maal wat Tamwil/BMT); informal MFIs including credit unions, rotating credit and saving association (ROSCA), moneylenders, traders and landlords. Table 3.1 provides map of microfinance institutions by types in Indonesia in terms of units and their financial services. Bank Rakyat Indonesia Unit Lembaga Dana Kredit Perdesaan (LDKP) – The Rural Credit Fund Institutions The Rural Credit Fund Institutions (LDKP) is the term of credit fund institution that operates in rural area, including a variety of non bank microfinance institutions with different names, ownership, organization, services and outreach, that was established on initiatives of provincial government. LDKP belongs to provincial, district or village government which, in their operation, have to obtain license from and was regulated by provincial government within the national regulatory framework. they get technical support and supervision from regional development bank (BPD) which are owned by provincial government.. since it was established in 1970s, the number of LDKP getting less from 1978 to 630 in 2000, this decrease due to the conversion of LDKP to peoples cerdit banks(BPR) and recently only about one quarter of LDKP  have become banks. The Badan  Kredit Desa (BKD) BKD is a profitable and sustainable village level financial institution that provide financial services with a outreach to low income people. it was operated by a committee that controlled by head of village and have sustained the operation since colonial era. On behalf of Bank Indonesia, BRI branch offices supervise and provide technical assistance  for BKD. in 1970s indonesian government did not pay much attention to this system. instead, the government  give more attention to the cooperative system. this make hard for BKD system to developed. in 1990s BRI tried to revive BKD by providing basic capital, improving administrative system and introducing new saving instruments, however, 1992 banking act burden the expanding BKD system. BKD is recognized as peoples credit bank (BPR) and has been operating as a licensed and regulated bank  since 1992 banking act but the frame work setting, supervision and technical assistance has not changed since 2000. Cooperatives Here, the brief history of cooperative in Indonesia refers to Santoso et al (2005) and Ministry of Cooperative, Small and Medium Enterprises’ website (www.depkop.go.id, 2009) as references. The thought of cooperative was delivered for the first time by Patih R. Aria Wiriatmaja at Purwokerto, a small town in Central Java, in 1896. Then, De Wolffvan Westerrode continued his efforts. In 1908, the year of national movement, Dr. Sutomo founded Budi Utomo which played a significant role for cooperatives improving the life of society. Then, Verordening op de Cooperatieve Vereeniging was established. Twelve years after that, in 1927, another type of cooperative called Regelling Inlandsche Cooperatieve was launched. In the same year, to develop bargaining power among local entrepreneurs, Islamic Trader Union (Serikat Dagang Islam) was established. Indonesian National Party (Partai Nasional Indonesia) which had activities in promoting cooperative spirit was established in 1929. 3.2  Bank Perkreditan Rakyat (BPR) Brief History Steinwand (Steinwand 2001) provided detail periodical history about Rural Bank. He divided the history into four parts of periods; the evolution of the colonial BPR (1895-1945), the period from independence to financial sector reform (1945-1983), the period from financial sector reform to financial crisis (1983-1999) and at the present condition. Rural Bank Position in Financial System in Indonesia Chapter 4   Analysis of the Role of Bank Perkreditan Rakyat (BPR) in Financing Micro, Small and Medium Enterprises 4.1  Overview Chapter 4 consists of 6 sections which each section aimed to answer the research questions. Section 1 is a general information about what will be discussed in this chapter; section 2 discusses about the source of the data used in the analysis; section 3 is the methodology; section 4 is about overview the condition of Bank Perkreditan Rakyat (BPRs) and commercial banks (CBs) in Indonesia using selected indicators, third party funds and credits; section 5 tries to reply the first research question by using comparative analysis between commercial banks and BPRs; and section 6 is the last section which answering the second research question about the performance indicators of BPR Microfinance Institution in Indonesia BPR Microfinance Institution in Indonesia Chapter 1   Introduction 1.1  Background It is believed that microfinance helps low-income people alleviate their life from poverty circumstances in many developing countries. As an economic instrument which has been raised in the middle of seventies, the thought of microfinance came up from the fact that low-income people difficult to access financial services from commercial or formal banking institution which may disadvantage them or even not including them as potential clients. The reason is that, which often we may hear for several times, low-income people lack of collateral for guarantee some amount of money they want, and in the commercial financial institutions point of view it is costly to serve them due to unequal cost-benefit and high transaction cost: low-income people tend to borrow in small amount but the commercial financial institution maintain high cost for processing and assuring their repayment. These costs are not proportional with the amount of loan given to them. A formal microfinance institution existing in Indonesia is the Bank Perkreditan Rakyat/BPR (People’s Credit Bank or Rural Bank)[1] which is established by the Banking Act. The main objective of the BPR is to serve small businesses[2]. It means that BPRs can enhance their role and contribution in the development of micro and small business[3]. In Indonesia, like other developing countries, micro, small and medium enterprises (MSMEs)[4] play significant role in economy. The role of MSMEs can be viewed as an important factor for Indonesia to recover from economic crisis and to lead economic growth and employment. Statistics Indonesia (Badan Pusat Statistik/BPS) and Ministry of Cooperatives and Small-Medium Enterprises reported[5] that, the average contribution of SMEs’ share to total GDP Indonesia from the period of 2001 2007 was 60.77%, while at the same period large enterprises (LEs) contributed 39.23% which can be seen in Table 1. Source:  Statistics Indonesia (BPS) and Ministry of Cooperatives and Small-Medium Enterprises (various editions) In terms of employment creation, MSM enterprises have passed over large enterprises. Table 3 provides worker absorption by types of enterprises. It shows that small enterprises have absorbed approximately 91% of employment during 1999-2006, while medium and large enterprises have provided by 5% and by 4% of employment in Indonesia. Source  : Cooperative Statistics cited in Nazara and Gitaharie (2008), edited by author Based on the data which are discussed in the previous paragraphs, it can be concluded that micro, small and medium enterprises (MSMEs) have a big role and a potential as a driver of the domestic economy. Nevertheless, they still have several constraints, for instance, product market accessibility, lack of management skills, and limited access to financial sources, especially from commercial banks, to meet their demand for finance. A survey conducted by Statistics Indonesia (BPS) concluded that the biggest problem for micro and small enterprises is lack of capital for financing their business.  The survey recognized that  problem in finance for micro enterprises was accounted for 40.48%, while for small enterprises was 36.63% (Wardoyo and Prabowo 2003: 31). In Indonesia, small and medium enterprises can acquire their finance from several sources. According to Nazara and Gitaharie (2008) which refer to statistical data from BPS 2000; 82,960 SMEs got their finance from non banking financial institution; 385,383 SMEs got their finance from banks; and 661,630 SMEs got their finance from other sources. It is clearly from the data that most of SMEs rely on sources other than formal institutions. These figures were not taking into account for SMEs which have no legal entities (Nazara and Gitaharie 2008: 8). From SMEs point of view, they face kinky administrative procedure and also they have to provide collateral as guarantee to get loans from commercial banks. This condition leads SMEs favoring in Bank Perkreditan Rakyat/BPR (People’s Credit Bank or Rural Bank) and other financial institutions which provide simpler in administrative procedures, but higher in interest rates compared to commercial banks (Nazara and Gitaharie 2008: 8). Even though entrepreneurs are burdened with high interest rates, they do not much complain about it as long as they have access to formal credit (Berry et al. 2001 as cited in (Sunarto 2007: 2)). In line with the condition in which SMEs favoring in BPRs, Sunarto (Sunarto 2007: 4) stated that BPRs have several advantages in serving to SMEs, those are: (1) its location which is close to SMEs, (2) simpler in credit procedures, (3) accentuate a personal approach in its services and (4) more flexible.   This paper is focused on the role and contribution of BPR, one of the formal types of microfinance institutions in Indonesia, as the suppliers of funds to different types of enterprises especially to micro and small. The discussion emphasizes on credit allocation delivered by BPRs to the micro, small and medium enterprises. Comparative analysis will be made between commercial banks[6] and BPRs for analytical purposes in two things. Firstly, the comparison in terms of allocation of credit which does not consider other variables playing a role in borrowing, for instance interest rates and so on. The comparative result is not in the amount of the credit disbursed but in the percentage of allocation for each type of enterprise. Secondly, the comparison in terms of performance will be discussed through some indicators. Furthermore, the performance indicators of BPRs will be compared with their criteria which set by Bank Indonesia to see whether those indicators improving or deteriorating. 1.2  Research Objective and Research Questions Research Objective The objective of this paper is to study the role and performance of Bank Perkreditan Rakyat (BPR), as one of microfinance institutions in Indonesia, in financing micro, small and medium enterprises. Research Questions In order to achieve the research objective, this paper proposes research questions as follows: 1.  What is the role of BPRs as supplier of funds to different types of small and medium enterprises, in particular micro enterprises? 2.  What is the performance of BPRs in relation to credit provision to micro and small enterprises? 1.3  Research Hypothesis Bank Perkreditan Rakyat (BPR) was established with the main objective is to serve small-scale business and people in rural areas. Therefore, the first hypothesis is that BPRs are reaching their main objective as supplier of funds to micro, small and medium enterprises as mandated by regulation (i.e., banking act). In order to meet the objectives, it is needed good performances which are reflected from their performance indicators. Therefore, the second hypothesis is that performance indicators of the BPRs have met with the standards which set by the Indonesia banking authority. 1.4  Organization of the Paper This paper is divided into five chapters. Chapter 1 is introduction which contains background of the research, research objective and research questions, research hypothesis, and organization of the paper. Chapter 2 is review of the literatures and analytical framework for the research. Literature reviews discuss about definitions of microfinance and microfinance institution, the approaches can be taken by a microfinance institution in order to serve the clients, the models of microfinance institutions, the types of microfinance institutions in Indonesia and the pyramid of them in relation to potential customers and performance indicators. Analytical framework discusses about the way in which the research will be achieved. Chapter 3 is the microfinance institutions in Indonesia which contains their brief history and recent condition. Chapter 4 is analysis of the role of BPRs in financing micro, small and medium enterprises which contains overview of the chapter, data source for the analysis, methodology of the analysis, some information about commercial banks and BPRs, and analyzing to answer the research questions. Chapter 5 is conclusion.   Chapter 2   Literature Review and Analytical Framework 2.1  Literature Review There are many definitions about microfinance proposed by several researchers and institutions. This paper uses some definitions given by Robinson, Ledgerwood, Consultative Group to Assist the Poor (CGAP), and Asia-Pacific Economic Cooperation (APEC) to describe microfinance. Robinson (Robinson 2001: 9) defined microfinance as small size financial services (mainly saving and credit) given to people who having farm or fish or herd; people who running micro or small enterprises which producing, recycling, repairing or selling goods; people who offering services; people who working for commissions or wages; people who having earnings from renting the land, vehicles, draft animals, or machinery and equipment; and people or other individuals and groups from both rural and urban areas at the local level from the developing countries. Consultative Group to Assist the Poor (CGAP)[7] which uses terminology â€Å"poor people† and Ledgerwood which uses terminology â€Å"low-income clients† pointed out to person who receives basic financial services from microfinance including self-employed people. Furthermore, Ledgerwood (Ledgerwood 1999: 1) stated that definition of microfinance comprises not only in financial intermediation but also in social intermediation. Many of microfinance institutions (MFIs)[8] provide this social intermediation function (i.e., group arrangement, self-confidence development, training to enhance capabilities and to increase capacities in terms of financial literacy and managements) go along with financial intermediation. Moreover, she argued that microfinance is a development instrument and it is not just banking.   Asia-Pacific Economic Cooperation (Santoso et al. 2005: 7) defined microfinance into two understandings. Firstly, it refers to an institution when it designates to an organization which offer financial services or banking products, especially loans to the poor people. Secondly, it uses for different methods or activities which assigned to the poor people in order to access financial services. The poor people usually ask for loans, meanwhile commercial banks do not qualify them for loans. These understandings are close to each other. An institution which provides products for poor people called as microfinance institution. The usage of products (i.e., credits) which is provided by MFIs will be beneficial for poor people in generating more earnings.   Ledgerwood (Ledgerwood 1999: 65-66) stated that the approaches that can be done by microfinance institutions can be divided into two main categories: the minimalist approach or integrated approach. When MFIs do minimalist approach, they only perform functions of financial intermediation, although sometimes they offer social intermediation in limited services. Premise that underlie this approach is a-single missing piece that can be offered by MFIs to the clients in the form of access to credit for them due to the clients are getting less coverage of services from financial institutions, for instance to grow enterprises. On the other hand, integrated approach is a combination of four aspects those are social and financial intermediation, enterprise development and social services. Thus, it is needed a holistic view of the client when a MFI taking this approach. If MFIs are not able to meet all four services, MFIs only offer services that are really needed by the client as long as this service in line with goal and objective of MFIs. Since the large-scale demand for services microfinance activities is in existence, the activities are shown in many countries. The poor people are usually un-bankable, because of such conditions: low skills, poor capacity and severe inabilities. They might not be served in the commercial banking system. It is because the system needs for formal requirements, along with the proper economic scale and certain guarantee. In official terms, this kind of market is un-named and un-served. There are niche markets for the supply of services for MFIs (Santoso et al. 2005: 8). Clients of microfinance institution can not be classified as the poorest of the poor. Generally, they are self-employed and low-income entrepreneur, including; traders, food vendors at the street side, small farmers, small producers and artisan who produce souvenirs in at tourism area and so on. The nature of their business usually provides a stable source of income (Ledgerwood 1999: 2). In various forms, income is provided by micro enterprises owned by the poor. This is done by providing employment. The recycling and repairing better than littering a good, making cheap food, clothing, and transportation to be available are some examples. It is also made to them who are from the low level of formal sector that are usually very difficult to live with their salaries. The people of this kind of life are often can cope with such a problem with the typical cases mentioned above, but can not handle the more serious problem. The other types of problem that are often found are deficiency of capital, skill, official status, and business security. In the meantime, naturally they already have the ability to face sharp business sense, strong life skills, long hard work practice, market knowledge, extensive communication and informal support networks. They also used to have the ability to live supported by their flexibility basic consideration (Robinson 2001: 12). A recent study in Bosnia and Herzegovina carried out by Hartarska and Nadolnyak (Hartarska and Nadolnyak 2008) used the financing constraint approach. The approach states that microenterprises that have good access to credit will be less rely on internal funding in their investment. Using the Living Standards Measurement Survey and the existence of the MFIs in their area, they compare sensitivity of investment to internal funds in the microenterprises which there are MFIs in municipalities they located to microenterprises which there is no MFIs in municipalities they located. They concluded that the MFIs reduce the constraint of microenterprises funding when they are exist close to business. There are some models of microfinance institutions. The first model is Grameen Bank. This model is founded in many countries, especially in Bangladesh, from which it established for the first time by Muhammad Junus. In determining target poor clients, Grameen Bank will do it carefully which is usually done through a series of tests. Loans are given to the group in which each group typically consists of five people and each member of the group guarantee the loan of the other members. This model intensively requires supervision and motivation from the staff to the group borrowers. The second model is Village Bank. An implementing agency establish individual village bank together with 30-50 people and sets capital for on-lending to other members. Repayments of the loan are usually in a week until 16 weeks whereas the village bank pays the principal plus interest to implementing agency. The third model is Credit Unions (CUs). Credit Unions are non-profit financial cooperatives which owned and controlled by its members. Besides saving, CU also provides loans for both productive and non-productive purposes to the members. The membership of CUs compared to Grameen Bank is more heterogeneous and usually based on similar bond. The fourth model is ‘self-help’ groups (SHGs). This model is close to the second model, village bank, although their structure is less well compared to the village bank.  The membership of SHGs is based on the similarity in income and the number of membership approximately 20 people. In principle, they use internal funding, that is saving, to lend it to the members, even though they can also seek external funding as additional source of funds. Several NGOs are facilitating and promoting SHGs, but basically, SHGs are directed as an independent institution. The task of seeking additional financing from outside is usually helped by NGOs which link between SHGs and other external parties or other funding agencies. This NGO’s job close related to social intermediary function they have, while other NGOs are functioned as financial intermediaries which funding SHGs  (Conroy 2003: 4-5). In terms of forms, microfinance institutions can be classified as bank (government and commercial), nonbank financial institution, saving and loan cooperative, credit union and nongovernmental organization. Pawnbrokers, rotating saving and credit association, and moneylender also part of MFIs and hold significant roles in functioning financial intermediation although they are more informal in legal status (Ledgerwood 1999: 1). In Indonesia, several institutions have already served microfinance services for such a long period. Those institutions can be divided into four types. The first type is formal microfinance institutions (MFIs). This type of MFI is regulated and supervised as banking institution and therefore their activities as financial intermediaries subject to banking regulation and supervision. Such institutions included in this type are BRI Unit (state-owned microbank), commercial banks with microfinance services and Rural Bank (Bank Perkreditan Rakyat/BPR). The second type is semi formal MFIs which registered and or licensed by state authorities or local governments, therefore they are not regulated by banking authority (Bank Indonesia). Including in this type are cooperatives, Islamic-based cooperatives (Baitul Maal wat Tamwil/BMT), rural credit institution (Badan Kredit Desa/BKD) and microfinance owned and managed by NGOs. The third type is informal MFIs that operate outside the framework of government regulation, among others, are credit union, rotating credit and saving association (ROSCA), moneylenders, landlords and so on. The fourth type is microcredit programs established by the government in channeling credit to subsidize the poor through a variety of institutions (Nugroho 2008: 181-182). Further explanation about these four microfinance services especially the first three types of MFIs will be presented in chapter 3.   In Figure 1 we can see the pyramid of microfinance institutions with their potential customers in Indonesia. The top layer shows formal MFIs (BRI Unit, Rural Banks/ BPRs and LDKPs). They provide financial services for the top level of microfinance market. This type of MFIs is intended to serve small business which has characterized with stable income flows; therefore these MFIs’ potential clients are non-poor and not so poor people. In the middle layer, semi- formal MFIs serve microfinance services for the poor households. This layer includes rural credit institutions (Bank Kredit Desa/BKD), cooperatives, BMT and NGOs. Clients in this layer are characterized by unstable flow of income. At the bottom layer of the pyramid the huge number of potential clients which need microfinance services. They are very poor people which are characterized by unpredictable income. They need the microfinance services in order to ensure their uncertain income, so they need a small loan to overcom e the difficulties of life (Nugroho 2008: 184-185). Figure 1: The Pyramid of Microfinance Services in Indonesia Source: BI and GTZ (2000) cited in Nugroho (2008) As mentioned above, Rural Bank (Bank Perkreditan Rakyat/BPR) is one of the formal types of microfinance in Indonesia. Its existence is established by Banking Act number 7 of 1992 as amended by Banking Act number 10 of 1998. The main goal of the rural bank is to serve small business and rural communities. In order to deliver their services to the customers, a microfinance institution requires a good performance. This performance can be seen from some indicators. Looking at these indicators, we can decide how well they not only can do financially but also it can also build the future performance goals. There are a large number of performance indicators that can be used by MFIs in measuring the financial performance. One of the principles that can be used is the CAMEL system, ACCION. This system examines five traditional aspects which are regarded as the most important thing in the practices of the financial intermediaries. The five aspects (capital adequacy, asset quality, management, earnings, and liquidity) be the sign of the financial condition and operational strength of the MFI in common (Ledgerwood 1999: 205,227,229). 2.2  Analytical Framework Based on the theoretical framework that has been presented in the previous section, the author uses Figure 2 below describing the analytical framework used in the research which answering the research questions asked. There are two parties involved in the financial market.  On one hand, there is a supply side which is financial institutions that act as financial intermediation agents or it might be function as other than financial intermediation like social intermediation or something else. These financial institutions include commercial banks, non-banks financial institutions (insurances company, ventura capital, etc), and microfinance institutions (in different types and forms). On the other hand, on the demand side, there are some parties that require financing for different purposes, among others for working capital and investment usage which is belongs to micro, small and medium enterprises (MSMEs). The problem is that not all of these financial institutions allow MSMEs as their client due to several requirements which can not be fulfilled by MSMEs (collateral and bureaucratic procedures, for instances) or it might be comes from the MSMEs itself that no need too much funds (small financing). Here, microfinance institutions fit with the need of MSMEs. The mechanism then runs as common supply and demand in the market: MFIs, as financial intermediaries, offer credit or loan to MSMEs. Furthermore, MSMEs use the loan for running their operational activities (working capital usage) or for accumulating their physical capital (investment usage). At the end of the story, output of MSMEs will contribute to national income (GDP) and at the same time generates income for the owners and employees. Figure 2: Analytical Framework of the Research: Supply and Demand in Financial Market Source: author’s graph This paper focuses on the supply side of particular financial intermediaries in the financial market those are microfinance institutions. In other words, using Ledgerwood’s terminology mentioned in literature review, the paper mainly looks at the role of MFIs in terms of â€Å"minimalist approach†; how they perform as financial intermediations in delivering credit or loan. Special attention given to Rural Banks, one of formal MFIs in Indonesia in allocating their credit to different types of enterprises such as micro, small, medium and large enterprises. There are several reasons why this paper discusses on Rural Banks as unit of analysis. Firstly, it is states in the regulation (Banking Act) that the main objective of Rural Banks is to serve small scale business and looking into the pyramid of MFIs appeared in Figure 1. It means that Rural Banks have a specialization as small scale business’ banking, especially micro enterprises. This paper wants to see to which extent this mission is successfully executed. Secondly, Rural Banks are the second largest microfinance institutions in terms of asset, third party funds collected and number of debtors. According to Bank Indonesia (2008)[9], they posses 35% of total MFIs’ assets; 30.43% of third party funds collected on total MFIs and 29.15% of total number debtors on total MFIs.   This study proposes two research questions. The first research question relates to the role of rural banks as financial intermediaries in delivering credit to different types of business especially micro and small enterprises. In addressing the first research question, the paper uses comparative analysis and simple calculations in terms of credit disbursement for both commercial banks and rural banks so that the share (percentage) of credit allocation to different types of enterprises to be known. In order to obtain the result, some criteria and assumption are applied in the study. This is done due to there is no data available about the definite amount of credit disbursed by either Rural Banks or commercial banks to different type of enterprises. The discussion focuses only on the amount of credit allocation, so that other variables that determine the credit such as interest rate, collateral, and so forth are not discussed in this study.   The second research question indicates the performance indicators of rural banks in relation to credit provision to micro enterprises. These indicators include; Loan to Deposit Ratio (LDR), Returns on Assets Ratio (ROA) and Non-Performing Loan Ratio (NPL) which refer to Director of Bank Indonesia Decree number 30/12/Kep/Dir and Bank Indonesia’s Letter No. 30/3/UPPB about Rural Banks Soundness Evaluation. Furthermore, comparison will be made between these indicators and criteria. Chapter 3 Microfinance Institutions in Indonesia 3.1  Microfinance Institutions in Indonesia As developing country, Indonesia has long experience and history in developing microfinance institution which has made it possible for poor or low-income people to overcome financial constraints and to access financial institutions. For this condition, some researchers like Berenbach and Churchill called that Indonesia is â€Å"the most developed market for microfinance services in the world† (Barenbach and Churchill 1997 as cited in (Santoso et al. 2005: 43)). The development of microfinance institution began for the first time in Dutch colonial era when several well-educated local people saw deteriorating economy happened in their community and they looked for the need of this services and started organize it. The two famous institutions best known as pioneer in microfinance institutions and exist since colonial era are cooperative and Bank Rakyat Indonesia (BRI). As mentioned in chapter 2, microfinance institutions in Indonesia can be classified into four types (Nugroho 2008), those are; formal microfinance institutions, semiformal MFIs, informal MFIs and microcredit program which is established by the government for delivering credit to poor people through several institutions. In this chapter the latter type of MFI will not be discussed. The discussion is emphasizes on three other institutions. Formal MFIs are financial intermediary institutions which refer and subject to banking regulation and therefore supervised by Bank Indonesia. Semiformal MFIs are not regulated by Bank Indonesia as a banking authority, but they are licensed and or registered by other state authorities or local government. Informal MFIs operate outside government regulations. Nugroho (Nugroho 2008) described institutions which include in each type of MFI as follows: formal MFIs including BRI Unit, Rural Bank (BPR) and The Rural Credit Fund Institutions (Lembaga Dana Kredit Pedesaan/LDKP); semiformal MFIs covering rural credit institution (Badan Kredit Desa/ BKD), microfinance NGO, credit cooperatives including Islamic-based cooperatives (Baitul Maal wat Tamwil/BMT); informal MFIs including credit unions, rotating credit and saving association (ROSCA), moneylenders, traders and landlords. Table 3.1 provides map of microfinance institutions by types in Indonesia in terms of units and their financial services. Bank Rakyat Indonesia Unit Lembaga Dana Kredit Perdesaan (LDKP) – The Rural Credit Fund Institutions The Rural Credit Fund Institutions (LDKP) is the term of credit fund institution that operates in rural area, including a variety of non bank microfinance institutions with different names, ownership, organization, services and outreach, that was established on initiatives of provincial government. LDKP belongs to provincial, district or village government which, in their operation, have to obtain license from and was regulated by provincial government within the national regulatory framework. they get technical support and supervision from regional development bank (BPD) which are owned by provincial government.. since it was established in 1970s, the number of LDKP getting less from 1978 to 630 in 2000, this decrease due to the conversion of LDKP to peoples cerdit banks(BPR) and recently only about one quarter of LDKP  have become banks. The Badan  Kredit Desa (BKD) BKD is a profitable and sustainable village level financial institution that provide financial services with a outreach to low income people. it was operated by a committee that controlled by head of village and have sustained the operation since colonial era. On behalf of Bank Indonesia, BRI branch offices supervise and provide technical assistance  for BKD. in 1970s indonesian government did not pay much attention to this system. instead, the government  give more attention to the cooperative system. this make hard for BKD system to developed. in 1990s BRI tried to revive BKD by providing basic capital, improving administrative system and introducing new saving instruments, however, 1992 banking act burden the expanding BKD system. BKD is recognized as peoples credit bank (BPR) and has been operating as a licensed and regulated bank  since 1992 banking act but the frame work setting, supervision and technical assistance has not changed since 2000. Cooperatives Here, the brief history of cooperative in Indonesia refers to Santoso et al (2005) and Ministry of Cooperative, Small and Medium Enterprises’ website (www.depkop.go.id, 2009) as references. The thought of cooperative was delivered for the first time by Patih R. Aria Wiriatmaja at Purwokerto, a small town in Central Java, in 1896. Then, De Wolffvan Westerrode continued his efforts. In 1908, the year of national movement, Dr. Sutomo founded Budi Utomo which played a significant role for cooperatives improving the life of society. Then, Verordening op de Cooperatieve Vereeniging was established. Twelve years after that, in 1927, another type of cooperative called Regelling Inlandsche Cooperatieve was launched. In the same year, to develop bargaining power among local entrepreneurs, Islamic Trader Union (Serikat Dagang Islam) was established. Indonesian National Party (Partai Nasional Indonesia) which had activities in promoting cooperative spirit was established in 1929. 3.2  Bank Perkreditan Rakyat (BPR) Brief History Steinwand (Steinwand 2001) provided detail periodical history about Rural Bank. He divided the history into four parts of periods; the evolution of the colonial BPR (1895-1945), the period from independence to financial sector reform (1945-1983), the period from financial sector reform to financial crisis (1983-1999) and at the present condition. Rural Bank Position in Financial System in Indonesia Chapter 4   Analysis of the Role of Bank Perkreditan Rakyat (BPR) in Financing Micro, Small and Medium Enterprises 4.1  Overview Chapter 4 consists of 6 sections which each section aimed to answer the research questions. Section 1 is a general information about what will be discussed in this chapter; section 2 discusses about the source of the data used in the analysis; section 3 is the methodology; section 4 is about overview the condition of Bank Perkreditan Rakyat (BPRs) and commercial banks (CBs) in Indonesia using selected indicators, third party funds and credits; section 5 tries to reply the first research question by using comparative analysis between commercial banks and BPRs; and section 6 is the last section which answering the second research question about the performance indicators of