What’s next for Islamic Banking?

Think Piece By Prof. Dr. Obiyathulla Ismath Bacha

Islamic Banking, some 30 years after its emergence, is now at what appears to be an inflection point. Despite impressive growth and expansion, it is in need of rejuvenation as it approaches the second stage of development. In Muslim nations where they have been introduced, Islamic banking has been well-received thanks to latent demand from the Muslim populace. Looking back, the initial years have indeed been easy. Islamic banking expanded by merely replicating conventional products in shariah-compliant ways. Replication was a sensible strategy given the novelty of Islamic banking at that time. Products that looked and behaved like conventional banking instruments were easily acceptable to a customer base attuned to conventional banking products and services. Mimicking made penetration and expansion easy. Islamic banking had simply to reap the low hanging fruits. And indeed it did, growing to now exceed a trillion US $ in assets. Having now outgrown its infancy, both the industry and its stakeholders realise where mere replication has led them. Today Islamic banks have the same problems and outcomes as conventional banking. Replication has led to a heavy reliance on debt type, risk transfer rather than the risk sharing instruments prescribed by shariah. Ijarah, Murabaha and other fixed-rate contracts dominate the asset side of most Islamic Bank balance sheets. In countries like Malaysia, commodity Murabaha and other fixed-rate financing account close to 80% of assets. Even where Musharakah and Mudaraba labels are used, contract specifications effectively avoid risk sharing/taking. Ironically, since Islamic banks do not have the vast array of risk management tools available to conventional banks, their reliance on fixed rate financing on the asset side implies even larger duration gaps. This, in turn, implies that Islamic banks have even larger exposure to rate changes!

As we take stock and look ahead, it is obvious that continuing on the same easy path would mean full convergence and potential irrelevance. Already growth rates are tapering. There is a need to pull away from path dependency and towards maqasid al-shariah. True rejuvenation for the industry can only come from a movement away from fixed-rate contracts and into risk-sharing ones like mudaraba and musyarakah. Such a move would require much change. Among bankers, a change in mindsets, banking operations/ processes and customer relationships. Risk sharing would require a level of analysis that is much more in-depth than credit analysis. Customers and clients have to be educated about the need to take risks in order to earn returns, if the returns are to be shariah-compliant. Policymakers would have to put in place banking regulation that does not bias against risk taking by Islamic banks. Tax neutrality on sale/purchase of underlying assets would help. Finally, institutions established to set standards for Islamic banking, the likes of IFSB, must realign standards to be supportive of risk sharing. Currently, the use of Mudarabah/ Musyarakah type contracts by Islamic banks result in higher capital adequacy requirements.

These changes are necessary if Islamic banking is to play a more meaningful role in economic development. Shariah, in requiring financing to be rooted in real sector activities, requires banks to be partners rather than mere intermediaries. The prohibition of a predetermined interest rate is in many ways a requirement for risk-sharing partnerships. For an Islamic bank, risk sharing can and should be on both sides of the balance sheet. While the bank shares in the risks by sharing in the profits and losses of the businesses it funds, it links the returns it provides depositors based on its own returns. In essence, depositors would be participating in the underlying business through their bank.  One would be tempted to ask how such a model is superior, how would the returns compare and isn’t this exposing depositors to more risks? The answer is yes, there would be more risks to depositors but it would be well worth the higher returns. To understand why this so, one needs to merely compare real sector returns with contemporary bank deposit returns. The average Return on Assets for a 100 plus listed industry sectors across the world, from Morningstar, a US-based financial information provider is, approximately 14% for 5 years and 15% for 3 years. Yet, bank deposits would have provided a mere 2 to 4% average annual returns.  While real sector returns are about 5 times more, the risk isn’t that much more. Thus, on a risk-return basis, depositors ought to be much better off. More important than this, is the benefit that the proposed model holds in terms of vastly reduced economic vulnerability given the absence of leverage arising from fractional banking and the reduced contingent liability to governments from deposit guarantee and bank bailouts.

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