Before the festive break, article 40 concluded that the Islamic banks use Murabahah financing for shorter term transactions due to Murabahah being a fixed price sale contract where the profit element is immovable. Explaining this point further, if an Islamic bank enters into a Murabahah transaction for longer term financing, say 10-15 years, it will be exposed to market rate risk.
Ideally, Islamic banks should not be concerned with the rate prevalent in the market since it is the interest rate. However, it is important to note that the Islamic banks do not operate in isolation from the market and are part and parcel of a country’s economy, and are governed by the same regulatory authority in the shape of the central bank that supervises the conventional banks and which also controls the country’s interest rate mechanism.
In other words, Islamic banks operate in a mixed environment where conventional banking is practiced in an overwhelming manner, and the public is attuned to measuring Islamic banks’ offerings in comparison with conventional banks, particularly when it comes to paying a return on their savings or levying profit on their financing needs.
For an Islamic bank to exhibit the traits that are a natural outcome of its business model, it will need the environment devoid of conventional banks and a regulatory rate regime. A case in point is Sudan where conventional banking licenses are barred and all banks operating in the country are based on Islamic banking principles.
This is the reason why the Central Bank of Sudan does not quote any official interest rate so as to ensure strict compliance of monetary policy and practices with Islamic Shariah principles. However, without any compulsion from the central bank, Sudanese banks use the profit rate applied by the central bank on the Murabahah transactions it enters into with the licensed banks for liquidity management purposes as the notional benchmark rate for the market.
Reverting to our subject of discussion on market rate exposure and how it is mitigated by Islamic banks, Islamic banks utilize depositors’ funds to earn profit and distribute the same among the shareholders and depositors based on a pre-agreed distribution ratio.
Let us assume that an Islamic bank provided a Murabahah facility to its clients for 15-20 years and several transactions with the same tenor were entered into when the market rate was low. A few years down the line, the market rate started to pick up and the Islamic bank found it difficult to cope up with customers’ expectations to provide higher deposit rates, compatible to the market, since it had locked itself into long-term Murabahah transactions with low profit amounts.
As a result, the Islamic bank’s customers may consider switching to other banks (Islamic or conventional) that are in a position to provide a superior return on their deposits. Had the Islamic bank chosen the shorter term for its Murabahah portfolio, it would have been in a position to rightsize the profit rate on a recurring basis through entering into the new Murabahah transactions, and been able to retain the customer deposits in the process.
Another reason why Islamic banks needed to be wary of the market rate is customers’ predominantly conventional frame of mind. I remember an instance where I visited the treasurer of a large business group based in Dubai to commence a business relationship. After patiently hearing my sermon on the Islamic banking model and the products, he took out a pile of papers from his drawer and dumped them in front of me. Those were the facility offering letters from conventional banks with very attractive terms and the best interest rates without even making any formal demand by the group. I was told that he receives such unsolicited offers almost every other day.
The treasurer then smiled at me and said: “Thank you for increasing my knowledge on Islamic banking and its products; however, please tell me whether your bank can match or improve the terms and pricing you just saw in order to start the relationship.”
I left with a strange discovery that the old adage of “the higher the risk, the higher the return” is not always correct and has certainly failed me with the group since the Islamic banking products required by the group were high in risk in comparison to the conventional facilities the group enjoyed yet the treasurer demanded a profit rate which were even finer than the conventional banking facilities.
In view of the foregoing, Islamic banks ought to remain concerned with the fluctuating market rates and keep adjusting their financing portfolio to be as relevant to the market as possible.
The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinions of the Dubai Islamic Economy Development Centre, nor the official policy or position of the government of the UAE or any of its entities. The purpose of this article is not to hurt any religious sentiments either consciously or even unwittingly.
Sohail Zubairi is the projects advisor with the Dubai Islamic Economy Development Centre. He can be contacted at [email protected].
Next Week: Explanation of the Murabahah contract to continue.