Banking on the Unbankable

Q: As a scholar who has been very much immersed in the Islamic banking and finance sector, how would you assess the growth of this sector over the years and in comparison as it stands today?

A: The growth of the banking sector is crucial to the economic development of nations as it provides the fuel to economic transactions. As a financial intermediary, banks acquire funds from depositors and make loans to borrowing customers. The demand and supply of deposit funds and loans are largely determined by the level of interest rates which is associated with the money supply. 

At low levels of interest rates like today, it is cheaper to borrow as banks are now flush with liquidity. But if money supply increases faster than real sector growth, inflation sets up to raise borrowing and production costs which reduces corporate earnings. Consequently, firms will have trouble paying their loans. Things can get worse when central banks increase the interest rates to reduce inflation, which further escalates cost of servicing loans and default rates. 

Islamic banking is not spared from these financial volatilities as it operates in a dual financial system. Profitability is largely determined by factors such as capital, default rates, liquidity and operating expenditures. While many Islamic banks reported positive earnings, some have suffered losses from adopting wrong business and risk strategies. For these reasons, the growth of the Islamic banking sector must be meaningful enough to evidence its ability to generate profits as well as addressing social and equitable issues affecting banking customers.  

The role of shariah governance can be made better to improve the economic performance of Islamic banks. However, relatively too much attention is placed on increasing the share of Islamic assets in the banking system. For example, in Malaysia Islamic banking assets reached US$ 254 billion in 2019 with a 38% share of Islamic deposits. But such increments should also manifest the competitive advantage that Islamic banks hold over its counterparts based on the unique real-sector traditional contracts available. This however is futile as Islamic banks were set up as deposit taking banks which will subject them to high capital charges if they take on to offer real sale and equity products. At the end of the day, shariah people at the supervisory level can only proceed to approve financial products acceptable to prevailing banking and risk strategies such as tawarruq where capital charges are set based on collateral and guarantees commensurate to risk appetite of the bank.  

Q: What do you think are the major impediments preventing the rapid growth of the Islamic banking & finance sector and what are the reasons for this?

A: Much of the impediments are associated with establishing Islamic banks as a deposit taking bank, which many have overlooked. This funding side of Islamic banking has been relatively ignored by many people who expect wonders from these banks. Some insist that Islamic banks must offer profit-loss sharing financing, not knowing that banks have to fork up substantial amounts of capital doing so. Many also expected Islamic banks to promote financial inclusion, but were unaware that banks must hold adequate capital to cushion potential defaults from the poor borrowers.  

Also, many expected Islamic banks to finance the real sector by nurturing entrepreneurs, which can be a formidable task for them given that these banks are not developmental in nature. So a third sector, namely the voluntary sector is seen as the blue ocean for Islamic finance moving forward. Proposals to establish Islamic social banks are considered as the appropriate response to the ineffectiveness of Islamic commercial banks in addressing many social-welfare issues. 

Q: What are the areas you think Islamic finance should focus more on, especially in a context where innovation and venture capital are the main drivers in an increasingly competitive world?

Many will agree that the fundamental principle of Islamic banking is the use of al-bay (sale and commerce) and the rejection of riba. The impact of using al-bay in finance can mean only two things. One is the current convention in Islamic banking, namely the use of sale, lease and equity financing contracts much of which unfortunately is preoccupied with shariah compliance check-listing. Much of the sale and lease financing are carbon copy of conventional loans and hire-purchase finance. The equity contract is much established in the form of mudaraba investment deposit products, which is often plagued with an identity problem. While mudaraba is equity, the deposit label signifies a debt. 

The shariah check-listing method has been in vogue ever since Islamic banking was established in many countries. It is partly responsible for the weak shariah oversight of form over substance issues which is a great concern to many. The shariah fraternity is proficient in this kind of supervisory role but unfortunately less profound in assessing economic and financial performance of shariah-compliant contracts affecting the economy. 

This void is challenged by people who see maqasid al-shariah as the basis of Islamic finance.  The protection of wealth as one of the maqasid al-shariah, means that Islamic banks should make a positive impact on gross domestic product, financial stability and income redistribution. Ironically, the maqasid shariah has not been accorded with high reverence by shariah regulators. The shariah, by the way, is not short of innovative concepts such as salam, istisna, qirad and shirkat. What is lacking today is the mismatches of risk-appetite that frustrate innovation. At one end, loanable funds are sourced from depositors who by default take no risks for the money earned while the production sector faces risk all the time. 

The other side of al-bay is the funding side which is the investing component that can help reduce the mismatching of risk-appetites. For this reason, Islamic banks should give greater focus to the investment account products from which funds with matching risk profiles to business ventures can be offered. 

Entrepreneurship in small-medium enterprises has been the backbone of the real economy such that funds can be mobilised from prospective investors if they are well-informed of the available investment opportunities which fintech can make positive impacts on. Islamic banks can now possess the competitive advantage given that they can invest in direct business ventures as opposed to portfolio asset management products offered by mutual funds and private equity. However, this is not possible today if Islamic banks are still seen as a safe haven for money. 

The proper model for Islamic banks is to issue deposit products for transactional uses and  investment account products for investing purposes. This will free Islamic banks from high capital charges as real sector contracts are now funded by equity funds. Due to its transactional nature, deposits cannot be used to make loans/financing, and thus one eventually sees full reserve banking in operation.  

Q: New developments like Fintech and crowdfunding have grown exponentially in recent times. What are the reasons for this and how could it be taken forward to reach maximum potential?

At one time, banks were overburdened with loans provided to large and small firms. As the capital market developed, big corporations resorted to bonds and sukuk for funding. This leaves many deposit taking banks to drive retail banking. 

The emergence of crowdfunding is expected to fill the gap for these un-bankable public. With financial technology, the speed of financial services has rapidly improved with greater efficiency leading to easier access to liquidity. The challenge to Islamic crowdfunding is to spot potential business ventures and aligning them to prospective investors. Doing so requires reputation and goodwill.  

Read more about How Shariah-Compliant is Islamic Banking?