Against the backdrop of a global financial crisis that has only barely passed, 2015 has seen yet another year of robust growth for the Islamic finance industry. The coming years are also expected to see increasing demand for Islamic consumer financing and Shariah compliant insurance products in many countries with a significant number of Muslims not yet served by Islamic banks and Takaful companies, including emerging economies in Africa and CIS countries (formerly part of the Soviet Republic). These countries are planning to, or indeed in the process of, developing their legal, tax, and regulatory infrastructures in order to accommodate this growth. DR KEN BALDWIN summarizes the development of the Islamic finance industry and the road ahead.
Economies of scale
While undoubtedly many would-be users of Islamic finance at the retail level in these countries are motivated by religious principles, it is natural to ask whether there will be sufficient demand for Islamic banking to provide the economies of scale for international banks looking to grow outside of their domestic markets. Certainly, GCC-based institutions are known to be looking to expand, but is it economically viable to set up and operate foreign branches or subsidiaries? One indicator of this in early 2015 was the resounding ‘no’ from DBS Group Holdings, Singapore’s biggest lender, which announced a progressive winding-down of its Islamic banking unit, the Islamic Bank of Asia, established in 2007 as a joint venture between the bank and Gulf-based investors. From a risk management perspective, Singapore is very well developed, having an Islamic deposit insurance scheme that was established in 2006, as well as a monetary authority that would act as lender of last resort if needed.
Having a large number of users of consumer financing is good for risk diversification. It provides Islamic banks a heterogeneous pool of receivables, and lots of small customers are better than a few large ones. But a few large ones are cheaper to service, so the counterbalance to the scale argument is a risk management argument. This challenge is greater in developing countries since depositors as well as recipients of finances are small, eg individuals and small businesses.
Financial inclusion
One of the most important justifications the Islamic banking industry puts forward for its own existence is social responsibility. Indeed, the IFSB has announced in 2015 that it is launching initiatives aimed at widening the reach of Shariah compliant banking to include the poor, especially farmers, small traders and poor households. This is a commendable initiative. In addition, the IFSB has also disclosed the forthcoming issuance of guidance on surveillance by regulatory supervisory authorities, which is intended to bring about increased monitoring of institutions and an early warning system which could reduce the probability of bank failures.
Systemic risk
This is a move in the right direction by the IFSB. But notably, few studies, if any, exist to describe how Islamic banks contribute to systemic risk in ways similar to, or different from, conventional banks. Systemic risk is a complex issue concerning contagion and propagation of financial distress when one or a number of banks fail, and banks are interconnected. Even in studies of conventional banking systems, there is no leading model which has emerged to describe this phenomenon. Having more equity than conventional peers, Islamic banks should, all other things being equal, be more stable. And more equity, as well as better quality equity, is exactly what Basel III is calling upon conventional banks to have in place. However, Islamic banks suffer from a lack of tradable liquid securities, leading to liquidity management problems which the International Islamic Liquidity Management continues to work to resolve through its product development initiatives.
Competition and margins
Retaining higher levels of liquidity in low-yielding assets manifests a drag on the income of Islamic banks. Islamic banks seek to recover profitability by levying higher financing charges on their assets, which renders them less competitive than conventional counterparts. Developing products which can ameliorate this situation is of paramount importance, but until that can happen, Islamic banks will continue to be considered an expensive alternative.
The future
Islamic banking has come a long way since the renaissance of Islamic finance in the 1970s. But growth from a low base is not an indicator of success. Several fundamental conundrums must be solved. One of these is the very basis of risk-sharing in investment accounts. There is little purpose in structuring investment accounts to allow participants exposure to risk, and then managing account return streams to transform their economic profile to that of conventional deposits.
The fundamental issue seems to be that investment account holders do not have the appetite for risk required of them. Nor do regulators have the appetite for systemic risk which variable account return streams could create (through bank runs following poor performance). There are, however, plenty of users of finance, many of whom are religiously motivated, who would like to be financed by Islamic banks. The intermediation model deployed by Islamic banks is being forced to run as hard as it possibly can, with workarounds and interim measures deployed to keep it viable. Perhaps, the woes of the Islamic finance industry are only a passing phase. Time will tell.
Dr Ken Baldwin is CEO of Islamic Financial Analytics, a training and advisory firm supporting the human capacity and financial management needs of the Islamic banking and finance sector. He can be contacted at [email protected]