As defined by the UK’s Financial Services Authority, banks are not actually “banks” but rather “credit institutions” which exist to create credit, backed by their capital base in line with capital requirements set out in the Basel Agreement. Such credit creation/intermediation is a very profitable business to be in, since any return in excess of the costs of providing the service and of borrower defaults is pure profit. Islamic banks are able to create such credit, repackage it into Islamic finance/quasi-investment and then move it off their balance sheet by selling it to investment institutions. In this way, the risk of default – itself already relatively low due to the ethical quality of the customer base – disappears, leaving a handsome profit margin. Global investors should be queuing up to invest in Islamic banks – since to reapply the famous description once made of the UK’s then extraordinarily profitable Granada TV – they truly have a “license to print money”.
Islamic banks are often more profitable than their conventional counterparts as they enjoy a lower cost of funding. Although depositors can get competitive returns through investment accounts based on Mudarabah, in practice much money is held in current accounts that yield no return. As the cost of Shariah compliant financing is similar, or even slightly higher than conventional financing, this makes Islamic banking operations highly profitable. A major factor enhancing profitability during the last three years has been the oil price boom, as the largest Islamic banks are based in the oil rich states of the Gulf. The favourable impact of higher oil revenues, and the resultant increases in government spending, however, extends beyond the oil exporting states. Some countries such as Jordan, and hence the Jordan Islamic banks, have profited from an increased flow of remittances. Others such as the Dubai Islamic Bank have benefited from the inflow of foreign direct investment into the Emirates from Saudi Arabia. The profitability of Islamic banks has favourably affected their share prices, most notably in the case of the Al Rajhi Banking and Investment Corporation and the Bank AlJazira in Saudi Arabia and in the huge over-subscription of Bank Albilad shares, as investors perceived the new Islamic bank would be a winner. Only time will tell however if the capital gains enjoyed by investors will be sustainable, especially if oil prices decline.
PROFESSOR RODNEY WILSON
To be able to perform strongly, of course is the benchmark for any competitive undertaking. It reassures and confirms own talents and it helps attract new business. However, continuous outperforming most of the time is dangerous. Riding on the wave of success, sometimes the need to perform gets bigger than the need to protect. At such moments, carelessness and recklessness easily tend to find their way into financial organizations. All investments follow the cycles of time. No one escapes the laws of finance. Profit and loss really are unpredictable. The same goes for economical and financial evolutions. Only one thing is sure: what goes up will come down – one day. The present boom on the one side certainly underlines the viability of the market and will bolster the acquired maturities. Success on the other side also attracts market players of all kinds, out for a fast profit. In the “heat of expansion” (both geographical, product wise, volume of money), the sector should build platform moments for structural evaluation and updating in order not to lose control. Know your competition, but certainly learn your own weaknesses and prepare for the future. Inflated expectations and bubble-splashes – known from traditional markets – together with insolvencies should be avoided as much as possible. After all, we talk of investment and profit sharing – not speculation.
Islamic banks have indeed proven to be very profitable in recent years but so has been the case for their conventional counterparts, especially in the Middle East but also elsewhere in the world. The current profitability of Islamic banks can partly be explained by the property boom that has swayed the whole globe in a huge way. Additionally, the oil price hike has also helped them in collecting funds locally and investing in big projects with attractive returns. Economies of scale have certainly helped them in increasing their profitability. Some recent published research suggests a positive relationship between Islamic banks’ profitability and equity-to-total asset ratio. This is an interesting finding with implications for sustainability of Islamic banks’ profitability. Given that there is now an emerging trend of setting up “mega” Islamic banks, profitability is expected to keep on increasing in the years to come. However, Islamic banks will have to focus on customer satisfaction and an increase in benefits to the customer if the banks wish to retain their clientele base. An increasing number of conventional banks have started offering Islamic financial services, and it will be rather difficult for Islamic banks to retain their customers if they do not receive benefits clearly differentiable from what their conventional counterparts get from their respective banks. Unambiguously differentiable Islamic products, more tangible benefits than mere Shariah compliance and a sense of sharing in success in terms of higher profitability are likely to help Islamic banks retain their clientele, and, thus, continue prospering.
Professor Humayon Dar