Future challenges of Islamic banking and finance
Monday, 17 March 2008
Dr. M. Mizanur Rahman
Islamic banking practices which started in early 1970s on a modest scale, has made tremendous progress during the last 35 years. A number of Islamic banks have been established during this period under heterogeneous social and economic milieu. Recently, many conventional banks including some major multinational western banks, have also started using Islamic banking techniques. However, Islamic banking and financial services, which are currently catering to a particular segment of population in several Muslim countries, are creating interest among non-Muslim investors and fund managers, too. They consider Islamic financial assets to be a distinct assets class.
Islamic banks have enjoyed strong performance, which has been driven largely by positive external forces. It can be noted here that the global Islamic finance sector encompasses around 270 banks, of US$265 billion in assets, and over US$400 billion in investments. Moreover, this sector is growing at a clip of roughly 15 percent per year, and could serve 40 to 50 percent of the world's Muslim population within a decade. That is the growth of Islamic banking is year-on-year outstrips conventional banking. Besides gaining a foothold both nationally and internationally in the financial world, Islamic banking and financing sector offers regular degree programs at the university level in different parts of the world. The true underlying strength of incumbent Islamic bank will be tested as new waves vying for market share. Many Islamic banking institutions have celebrated 2007 as another great year for Islamic banking. Despite indications determining continued growth, Islamic banking achievement and development need to be careful not to celebrate it too soon. Their very success may be the source of future challenges, as new attackers move in to try to capture a share of this lucrative market. In this topic various kinds of issues, which Islamic banking industry faces, will be discussed to explain the future challenges of this sector.
First issue is the survival of Islamic banking and finance sector which mostly depends on its economic viability, stability, identity and confidence of depositors and savers. Economic viability is not an issue as Islamic banking is just another way of banking and also this banking offers a better financial architecture, on economic grounds. That is Islamic banks will always be able to address financing concerns of their clients. It is also noteworthy that Islamic financing implies direct linkage between financial flows and real flows in the economy. That is, funds will flow from Islamic banks only against real economic activity. Thus, investors will approach Islamic banks only when they have genuine needs.
Second, stability of Islamic banking sector can be assessed from the comments recently made by Dr. Tariqullah Khan of the IDB which is "A banking system would be unstable if it concentrates asset risks on bank capital. Since Islamic banking principle is based on risk sharing and it spreads risks between bank depositors and bank capital, it is inherently more stable. If this inherent quality is coupled with prudential regulations and supervision and with implementation of internationally acceptable standards of risk management, transparency and corporate governance, Islamic banking can practically become an ideal alternative to the traditional banking system in achieving equity, stability and efficiency".
Third, Islamic banking has its different identity of business. Although, there are different mode of Islamic banking but the commonly practiced mode is Murabaha financing i.e., financing via sale on deferred payment basis. That is bank first buys the thing and then sells the same on credit. It is possible to define a financial instrument such that there is little or no time lag between creation of banks obligations to the supplier and its claims against the client and also the physical commitments on the bank parts are negligible. That is, the process is materially not different from that associated with supplier's credit currently in vogue in interest-based banking. Thus, if Murabaha financing works as mentioned, sooner or later questions may be raised about its claim to a separate identity. Similar points may be raised about some other financial instruments adopted by Islamic banks. Change in labels and terms are unlikely to be a lasting defence. So, the line of distinction between Islamic financing and interest-based financing must be above reproach in order to avoid identity crisis for Islamic banking.
Fourth, depositors and savers confidence is also an important challenge for Islamic banking which can be understood from Dr. Tariqullah khan's recent comment "A bank licensed as an Islamic bank may be running on a very sound financial footing. However, if the depositors came to know that the bank has violated its Shariah mandate, the depositors will lose confidence and the finding will trigger deposit withdrawal and probably collapse of the bank. By contagion effect this can lead to financial instability threatening economic development". Therefore, caution is warranted against any thing that creates doubts about the Shariah credentials of Islamic banks' transactions, especially on the financing side.
Fifth, the Islamic financial services industry should be fully integrated into the global financial markets while maintaining its distinctive nature and the uniqueness of its services. These institutions should be subjected to the full ambit of the banking regulations and supervised as intensely as other financial institutions. The depositors and investors must have the same level of comfort as they enjoy under conventional banking that their interests are being constantly watched and safeguarded by a vigilant regulator. Any laxity in the standards, practices or enforcement on the part of the regulators would not only be counterproductive but also act as an impediment to the acceptance of these assets by international financial markets. These would be a major setback.
Sixth, the industry faces competition from a number of angles, that is Islamic banks should be ready to brace not only intra-industry competition but also inter-industry competition from interest-based banks. Well established, western-based global financial players continue to open and expand operations in Muslim regions of the world and have built infrastructures to enter markets across the world. They are using their considerable operational, marketing, and technology skills to produce and distribute Islamic financial products in direct competition with indigenous financial institutions.
Seventh, the vested quarters can also misuse the Islamic banking to bypass the Ahkam on riba, unless there are effective checks and monitoring. For example, in the existing Murabaha financing, banks do not directly come into the picture as buyers would be dummy suppliers as well. This gives dishonest fund-seekers a window for getting credit from the bank through fictitious purchases. Moreover, without effective checks and monitoring, some bankers under financial pressures may be tempted to provide funds through dummy transactions.
The shariah boards as the financial regulatory agencies should therefore consist of people with credibility who command trust on the basis of their knowledge and integrity. The fragmentation of shariah boards at individual institution level can hamper the process of standardization, uniformly in interpretation and therefore the growth of the industry and the process of broadening the access and deepening of the financial sector.
Eighth, the trained or experienced bankers supplying has lagged behind the expansion of Islamic banking. There is a widespread training need involving related aspects such as financial feasibility studies, monitoring of ventures and portfolio evaluation. The training needs affect not only domestic banks, whether Islamic or non-Islamic, but foreign banks as well. Most professional training courses in banking tend to be geared toward conventional banking rather than Islamic banking. In reality, a limited number of institutions offer training for Islamic institutions.
This is, however, not surprising, since the conventional banking system is more ensconced with conventional systems. Hence, the lack of professional courses and training tailored for Islamic banking has resulted in a lack of qualified staff. The absence of the required trained staff has made Islamic banks resort to the next best alternative recruiting staff from conventional banks. With the vastly different concepts of the two systems, it is not rare to see such staff having difficulty adjusting to the Islamic banking system. The lack of trained staff, in turn, brings about an array of problems that could be related to other problems discussed earlier. This training lacked staff partly contributed to the slow innovation of the Islamic banks' products and instruments. In addition, training lacked staff affects relations with central banks due to the inability to clarify and explain various issues to them.
Ninth, Islamic banks have been established as separate legal entities; therefore, their relationships with central banks and/or other commercial banks are uncertain. Problems may be further accumulated when an Islamic bank is established in a non-Muslim nation, and is subject to that nation's rules and requirements. Government finances will remain a problem in the way of Islamic banking until sufficient new financing tools are developed and a consensus develops on the economic and social role of government.
It appears that domestic banks and foreign banks will experience continuing difficulty in adopting Islamic banking practices until they can become more confident of the results of investing ventures. The progress of Islamic banking will also depend on its ability to innovate financial instruments for yielding stable income flows for orphans, widows, pensioners and other weaker segments of the society.
Besides, ability to innovate financial instruments for meeting government's financing needs, security for financing in particular shariah compliant alternatives for penalty on payment defaults and formulas for pricing of Islamic financial products etc are also challenges for Islamic banking.
Tenth, standardization in any respect of banking is necessary, and it is bound to happen as the world is a global village. Islamic finance has long been criticised for its lack of standardisation especially the disunity in the interpretation of shariah law which is not unlikely for the rapidly-expanding new industry. However, it is assumed that customer's consciousness and competition among Islamic banks will lead to standardization of Islamic financial products. Ultimately, barring exceptional circumstances when large and long-term fund commitments and/or a lot of financial engineering is involved, only price competition will rule in the Islamic banking industry. In passing, one may note that in the long run standardization in the financial instruments will require consensus of fundamental Shariah principles for designing financial contracts. Unless this happens, Islamic banking may become a clash of dogmas. With Islamic banking gaining ground, new challenges are already emerging for redrafting the rules for international trade and accommodating Shariah compliant foreign trade financing. A good deal of work has been done, but a lot more is needed. If Islamic financing is adopted at the state level, inter-governmental financial flows will change, in both form and size.
Finally, from the above discussion it can be concluded that although a lot of challenges coming ahead still, if this sector can maintain a high-ethical, well-regulated and beneficial Islamic financial architecture then it would not be impossible to face the future challenges of Islamic banking and finance sector. Indeed, working in this field with more transparency, with effective corporate governance and with better interaction with relevant international, regional and national institutions, will definitely help all who wish to contribute to the welfare of their community as well as to the welfare of the world as a whole.
The writer is an economist and researcher. He may be contacted at email: mizan12bd@yahoo.com, mizan12bd@gmail.com; mobile: 01817-146335
Islamic banking practices which started in early 1970s on a modest scale, has made tremendous progress during the last 35 years. A number of Islamic banks have been established during this period under heterogeneous social and economic milieu. Recently, many conventional banks including some major multinational western banks, have also started using Islamic banking techniques. However, Islamic banking and financial services, which are currently catering to a particular segment of population in several Muslim countries, are creating interest among non-Muslim investors and fund managers, too. They consider Islamic financial assets to be a distinct assets class.
Islamic banks have enjoyed strong performance, which has been driven largely by positive external forces. It can be noted here that the global Islamic finance sector encompasses around 270 banks, of US$265 billion in assets, and over US$400 billion in investments. Moreover, this sector is growing at a clip of roughly 15 percent per year, and could serve 40 to 50 percent of the world's Muslim population within a decade. That is the growth of Islamic banking is year-on-year outstrips conventional banking. Besides gaining a foothold both nationally and internationally in the financial world, Islamic banking and financing sector offers regular degree programs at the university level in different parts of the world. The true underlying strength of incumbent Islamic bank will be tested as new waves vying for market share. Many Islamic banking institutions have celebrated 2007 as another great year for Islamic banking. Despite indications determining continued growth, Islamic banking achievement and development need to be careful not to celebrate it too soon. Their very success may be the source of future challenges, as new attackers move in to try to capture a share of this lucrative market. In this topic various kinds of issues, which Islamic banking industry faces, will be discussed to explain the future challenges of this sector.
First issue is the survival of Islamic banking and finance sector which mostly depends on its economic viability, stability, identity and confidence of depositors and savers. Economic viability is not an issue as Islamic banking is just another way of banking and also this banking offers a better financial architecture, on economic grounds. That is Islamic banks will always be able to address financing concerns of their clients. It is also noteworthy that Islamic financing implies direct linkage between financial flows and real flows in the economy. That is, funds will flow from Islamic banks only against real economic activity. Thus, investors will approach Islamic banks only when they have genuine needs.
Second, stability of Islamic banking sector can be assessed from the comments recently made by Dr. Tariqullah Khan of the IDB which is "A banking system would be unstable if it concentrates asset risks on bank capital. Since Islamic banking principle is based on risk sharing and it spreads risks between bank depositors and bank capital, it is inherently more stable. If this inherent quality is coupled with prudential regulations and supervision and with implementation of internationally acceptable standards of risk management, transparency and corporate governance, Islamic banking can practically become an ideal alternative to the traditional banking system in achieving equity, stability and efficiency".
Third, Islamic banking has its different identity of business. Although, there are different mode of Islamic banking but the commonly practiced mode is Murabaha financing i.e., financing via sale on deferred payment basis. That is bank first buys the thing and then sells the same on credit. It is possible to define a financial instrument such that there is little or no time lag between creation of banks obligations to the supplier and its claims against the client and also the physical commitments on the bank parts are negligible. That is, the process is materially not different from that associated with supplier's credit currently in vogue in interest-based banking. Thus, if Murabaha financing works as mentioned, sooner or later questions may be raised about its claim to a separate identity. Similar points may be raised about some other financial instruments adopted by Islamic banks. Change in labels and terms are unlikely to be a lasting defence. So, the line of distinction between Islamic financing and interest-based financing must be above reproach in order to avoid identity crisis for Islamic banking.
Fourth, depositors and savers confidence is also an important challenge for Islamic banking which can be understood from Dr. Tariqullah khan's recent comment "A bank licensed as an Islamic bank may be running on a very sound financial footing. However, if the depositors came to know that the bank has violated its Shariah mandate, the depositors will lose confidence and the finding will trigger deposit withdrawal and probably collapse of the bank. By contagion effect this can lead to financial instability threatening economic development". Therefore, caution is warranted against any thing that creates doubts about the Shariah credentials of Islamic banks' transactions, especially on the financing side.
Fifth, the Islamic financial services industry should be fully integrated into the global financial markets while maintaining its distinctive nature and the uniqueness of its services. These institutions should be subjected to the full ambit of the banking regulations and supervised as intensely as other financial institutions. The depositors and investors must have the same level of comfort as they enjoy under conventional banking that their interests are being constantly watched and safeguarded by a vigilant regulator. Any laxity in the standards, practices or enforcement on the part of the regulators would not only be counterproductive but also act as an impediment to the acceptance of these assets by international financial markets. These would be a major setback.
Sixth, the industry faces competition from a number of angles, that is Islamic banks should be ready to brace not only intra-industry competition but also inter-industry competition from interest-based banks. Well established, western-based global financial players continue to open and expand operations in Muslim regions of the world and have built infrastructures to enter markets across the world. They are using their considerable operational, marketing, and technology skills to produce and distribute Islamic financial products in direct competition with indigenous financial institutions.
Seventh, the vested quarters can also misuse the Islamic banking to bypass the Ahkam on riba, unless there are effective checks and monitoring. For example, in the existing Murabaha financing, banks do not directly come into the picture as buyers would be dummy suppliers as well. This gives dishonest fund-seekers a window for getting credit from the bank through fictitious purchases. Moreover, without effective checks and monitoring, some bankers under financial pressures may be tempted to provide funds through dummy transactions.
The shariah boards as the financial regulatory agencies should therefore consist of people with credibility who command trust on the basis of their knowledge and integrity. The fragmentation of shariah boards at individual institution level can hamper the process of standardization, uniformly in interpretation and therefore the growth of the industry and the process of broadening the access and deepening of the financial sector.
Eighth, the trained or experienced bankers supplying has lagged behind the expansion of Islamic banking. There is a widespread training need involving related aspects such as financial feasibility studies, monitoring of ventures and portfolio evaluation. The training needs affect not only domestic banks, whether Islamic or non-Islamic, but foreign banks as well. Most professional training courses in banking tend to be geared toward conventional banking rather than Islamic banking. In reality, a limited number of institutions offer training for Islamic institutions.
This is, however, not surprising, since the conventional banking system is more ensconced with conventional systems. Hence, the lack of professional courses and training tailored for Islamic banking has resulted in a lack of qualified staff. The absence of the required trained staff has made Islamic banks resort to the next best alternative recruiting staff from conventional banks. With the vastly different concepts of the two systems, it is not rare to see such staff having difficulty adjusting to the Islamic banking system. The lack of trained staff, in turn, brings about an array of problems that could be related to other problems discussed earlier. This training lacked staff partly contributed to the slow innovation of the Islamic banks' products and instruments. In addition, training lacked staff affects relations with central banks due to the inability to clarify and explain various issues to them.
Ninth, Islamic banks have been established as separate legal entities; therefore, their relationships with central banks and/or other commercial banks are uncertain. Problems may be further accumulated when an Islamic bank is established in a non-Muslim nation, and is subject to that nation's rules and requirements. Government finances will remain a problem in the way of Islamic banking until sufficient new financing tools are developed and a consensus develops on the economic and social role of government.
It appears that domestic banks and foreign banks will experience continuing difficulty in adopting Islamic banking practices until they can become more confident of the results of investing ventures. The progress of Islamic banking will also depend on its ability to innovate financial instruments for yielding stable income flows for orphans, widows, pensioners and other weaker segments of the society.
Besides, ability to innovate financial instruments for meeting government's financing needs, security for financing in particular shariah compliant alternatives for penalty on payment defaults and formulas for pricing of Islamic financial products etc are also challenges for Islamic banking.
Tenth, standardization in any respect of banking is necessary, and it is bound to happen as the world is a global village. Islamic finance has long been criticised for its lack of standardisation especially the disunity in the interpretation of shariah law which is not unlikely for the rapidly-expanding new industry. However, it is assumed that customer's consciousness and competition among Islamic banks will lead to standardization of Islamic financial products. Ultimately, barring exceptional circumstances when large and long-term fund commitments and/or a lot of financial engineering is involved, only price competition will rule in the Islamic banking industry. In passing, one may note that in the long run standardization in the financial instruments will require consensus of fundamental Shariah principles for designing financial contracts. Unless this happens, Islamic banking may become a clash of dogmas. With Islamic banking gaining ground, new challenges are already emerging for redrafting the rules for international trade and accommodating Shariah compliant foreign trade financing. A good deal of work has been done, but a lot more is needed. If Islamic financing is adopted at the state level, inter-governmental financial flows will change, in both form and size.
Finally, from the above discussion it can be concluded that although a lot of challenges coming ahead still, if this sector can maintain a high-ethical, well-regulated and beneficial Islamic financial architecture then it would not be impossible to face the future challenges of Islamic banking and finance sector. Indeed, working in this field with more transparency, with effective corporate governance and with better interaction with relevant international, regional and national institutions, will definitely help all who wish to contribute to the welfare of their community as well as to the welfare of the world as a whole.
The writer is an economist and researcher. He may be contacted at email: mizan12bd@yahoo.com, mizan12bd@gmail.com; mobile: 01817-146335