This paper highlights the policies and institutional setting of Small and Medium Enterprises (SME) development in Indonesia, followed by a discussion on the players in Islamic microfinance. Emphasis has been given to the potential role of Baitul Mal wa Tamwil (BMT, Islamic cooperative) as a strategic community-based micro lending initiative. The importance of Islamic microfinance initiatives as part of national program for the development of SMEs in Indonesia is also discussed. This paper argues that Islamic microfinance initiatives in Indonesia could represent an alternative source of finance for SMEs. The role of SMEs, especially after the Asian monetary crisis, was considered a safety valve for the national economic recovery both in enhancing economic growth as well as in reducing the unemployment rate. Credit distributed to SMEs has minimum risk and has sounder and better performance compared to larger enterprises. However, although having a significant role, SMEs actually have serious problems particularly as related to their capability in accessing formal financial institutions. This paper concludes by identifying the potential linkages between players in Islamic microfinance and highlights some critical points in their activities