As is well known, Islamic banking operations are driven by the shari’ah which defines the nature and character of the deposits mobilised and financing provided. Islam prohibits interest (riba) and permits trade (tijara). Accordingly, profits in Islamic banking operations are derived from the contract of trade (al-bai’), unlike the conventional banks’ profits which are derived largely from interest-bearing loans. In Islam, it is business risk taking, and not financial risk taking, that forms the basis for profits. The al-bai’ principle is manifested by an exchange of money with an underlying asset, whereas a contract of interest-bearing loan entails an exchange of money for more money.
Put in a nutshell, real sector connectivity and risk sharing distinguish Islamic banking from conventional banking. In Islamic banking, all financial transactions must relate to the real economy with no space for ‘financialisation’ or financing for the sake of financing. In the Islamic paradigm, the financial sector is inextricably linked to the real sector of the economy, which means that the financial sector would not exist on its own. In other words, in the Islamic order, the financial sector primarily functions as the facilitator for the real sector.
While Islamic banks have demonstrated that they are indeed different from their conventional counterparts, there are tensions between theory and practice of Islamic banking. This may be attributed to the perception that the Islamic products are no different from the conventional ones, going not only by the strong resemblence between the two but also by the prices charged for the products. According to the Law of One Price, two products bearing the same risk profile must assume the same pricing.
The crux of the problem lies in the fact that Islamic bank products are modelled after existing conventional bank products. For every conventional product there is a corresponding Islamic substitute with shari’ah compliance. Islamic banks offer ‘differentiated’ products by simply adopting conventional risk and return profile, subject to shari’ah constraints. Thus, the products offered by Islamic banks, in the first stage of evolution, are very similar but not identical to that of conventional banks.
It is envisaged that Islamic banks, in the second stage, would move away from ‘differentiated’ (shari’ah-compliant) to distinctly ‘different’ or ‘dissimilar’ (shari’ah-based) products that will have no bearings on the current conventional products. The third stage is a visionary one that would unveil innovative ‘home grown’ products based on research and development (R&D) efforts. To embrace this mature stage, Islamic banks will have to leap into a new development trajectory, with risk and reward sharing modes of financing in sync with the lofty Islamic ideals.
It took several centuries for conventional banking to evolve into what it is today. Islamic banking has a long way to go before it can reach its pinnacle. For now, even after four decades, Islamic banking is still in the initial stage of product differentiation. All indications are that Islamic banks are likely to remain stuck in this infant stage for a much longer period than previously thought, given the current trends in the banking industry.
The history of Islamic banking in Malaysia is chequered with several development phases. It started off with a single wholesome Islamic bank enjoying an enviable ‘monopoly’ position devoid of competitive pressures. The second phase witnessed the emergence of Islamic ‘windows’ in many conventional banks, amidst concerns that funds might get mixed up in ‘common kitchens’. In the third phase, more wholesome Islamic banks, both domestic and foreign, appeared on the scene. Finally, in the fourth phase, conventional banks’ Islamic windows were replaced by full-blown Islamic subsidiaries, both local and foreign, rendering the ‘common kitchen’ concern a non-issue, although one may still argue that the sharing of facilities by conventional parents and their Islamic subsidiaries is tantamount to using ‘common utensils’.
The banking industry in the country is currently dominated by conventional banks, with Islamic banks accounting for roughly one-fifith. Islamic banks established as subsidiaries of conventional banks outnumber wholesome Islamic banks. Clearly, there has been no level playing field. For conventional banks could do what Islamic banks could (through their Islamic subsidiaries or windows), while Islamic banks understandably cannot do what conventional banks can (by design). For instance, it is unimaginable for a wholesome Islamic bank to own conventional subsidiaries or windows.
Conventional banks continue to play a predominant role in the Malaysian economy, despite losing some market share to Islamic banks. The share of conventional banking in total deposits has declined from 92.5% in 2007 to 80.4% in 2012, while its share of total financing has also fallen from 93.4% to 78.0% between 2007 and 2012. But, their Islamic subsidiaries have taken up much of the slack, as the latter’s share of the Islamic banking industry assets has grown from 48.7% in 2007 to 79.5% in 2012. Islamic subsidiaries of conventional banks accounted for 77.2% of Islamic deposits and 83.1% of Islamic financing in 2012.
The share of Islamic subsidiaries of conventional banks in total bank deposits has risen sharply from 3.8% in 2007 to 16.4% in 2012, while that of wholesome Islamic banks has increased only marginally from 3.8% to 4.8%. Likewise, the latter’s share in total bank financing / loans has risen only incerementally from 3.2% to 3.7% between 2007 and 2012, while that of the Islamic subsidiaries of conventional banks has jumped from 3.4% to 23.7% during the same period.
Evidently, the wholesome Islamic banks pale in comparison. Their market share of the Islamic banking business has declined steadily over the years. Their share of total Islamic deposits has fallen from 53.4% to 22.8% between 2007 and 2012, while their share of Islamic financing has also shrunk from 48.9% to 16.9%. In terms of total Islamic banking assets, the share of wholesome Islamic banks has also fallen from 51.8% in 2007 to 20.3% in 2012.
With conventional banks having an overwhelming stronghold, as stakeholders, in the Islamic banking industry, the chances are that Islamic banks owned by conventional banks will continute to copy their prarents’ products with shari’ah compliance. And, the wholesome Islamic banks, which compete with the conventional banks and their Islamic subsidiaries, are likely to simply follow suit. While there may be nothing objectionable about all this from the shari’ah point of view, the ensuing fixation on shari’ah compliance is likely to scuttle the industry’s commitments to climb up the value-added chain. All this means that Islamic banks may stay focused on producing ‘shari’ah-compliant’ products rather than ‘shari’ah-based’ products.
To be sure, the products of Islamic subsidiaries of conventional banks are no less ‘Islamic’ than that of wholesome Islamic banks, as all of them adhere to the stringent shari’ah requirements and they are all subject to uncompromising oversights. Nonetheless, one would still wonder if the Islamic banks owned by conventional banks are as zealous or passionate about Islamic principles as the wholesome Islamic banks. It is a moot question who would take the lead in propelling the Islamic banking industry to the next levels: the former or the latter? They can do it together only if they equally share the zeal. If not, the onus will fall squarely on wholesome Islamic banks, but the pertinent question then would be whether they can call the shots when they are hugely outnumbered.
That said, one must not lose sight of the huge contributions conventional banks have made to the development of Islamic banking industry. In the mid-eighties, when the outreach of Bank Islam Malaysia was limited by its small branch network, the conventional banks’ Islamic windows were able to take the Islamic banking facility to every nook and corner of the country, thanks to their extensive branch networks. The conventional banks’ interest in Islamic banking, for whatever reasons, was then a boon to the fledging Islamic banking industry. Going foward, one may wonder if the strong involvement of conventional banks in the Islamic banking industry would constrain its advancement.
As mentioned earlier, real sector connenctivity and risk sharing are the hallmarks of Islamic banking. The current Islamic banking products are mirror images of conventional products,shari’ah compliance being the main differentiator. While real sector connenctivity is manifest in all these products, there is much controversy over tawarruq munazam, a substitute for the conventional personal loan facility, as its real sector connectivity is dubious, where commodities are bought and sold on the spot, not for profit but for the sole purpose of securing a bank loan.
There is very little risk-sharing activity going on currently in the Islamic banking fraternity as Islamic banks have been acting in a risk-averting manner. Contrary to the notion that risk sharing forms the bedrock of Islamic finance, musharakah (profit and loss sharing) plays an extremely insignificant role in the portfolio of Islamic banks. The problem lies on both supply and demand sides. On the supply side, Islamic banks are wary of high risks associated with the musharakahmode, while credible clients on the demand side find musharakah a costlier option as the cost of equity capital is much higher than that of borrowed capital, and hence the preference for bank loans instead. Therefore, only high-risk firms with questionable credentials would seek musharakaharrangements, and hence the high risk premium associated with such systematic risks.
Islamic banks face an identity crisis. Nowadays, the term ‘lenders’ and ‘financiers’ are used interchangeably, although there is a difference: all lenders are financiers, but not all financiers are lenders. Islamic banks do not ‘lend’ but do provide ‘financing’. All this begs the question: if Islamic banks are not ‘lenders’, need they identify themselves as ‘banks’ in the first place? Viewed in this perspective, the term ‘Islamic bank’ is arguably a misnomer if not an oxymoron. By associating with the banking (i.e. lending) business, Islamic banks may have unwittingly boxed themselves into the conventional banking mindset.
The above identity has led unfortunately to unintended consequences. The perception that Islamic banks are not really different from conventional banks stems from the fact that (a) Islamic bank products closely resemble conventional bank products, (b) Islamic banks follow conventional bank benchmarks in product pricing and (c) Islamic banks behave like conventional banks with hardly any risk sharing. Notwithstanding the confusion all this may have caused among the clientele, Islamic banks in reality are very different from conventional banks.
The Islamic banking clientele may be classified, based on casual empiricism, into four categories: the loyalists, the sceptics, the pragmatists and the opportunists. The Loyalist accepts Islamic bank products with no questions or qualms. The Sceptic has doubts about the purity of some Islamic bank products but is willing to tag along, assuming that things will improve over time. The Pragmatist is unsure of the purity of Islamic bank products but willing to give the benefit of the doubt on the ground that sin, if any, would fall on the financier and not the customer. The Opportunist is either indifferent or agnostic, subscribing to the view that riba refers to usury and not bank interest, and would switch freely from one to the other depending on costs and returns.
One would expect that there will be more and more ‘loyalists’ and fewer and fewer ‘sceptics’ as Islamic banks transcend to next level and beyond. The fact that Islamic banking is stuck in the first stage of product differentiation for four decades suggests that Islamic banks are either complacent or caught in what may be dubbed as the ‘shari’ah compliance trap’. To break out of the impasse, Islamic banks should first cease to be under the shadow of conventional banking, which means that they must set their own standards, norms, best practices and benchmarks instead of following the conventional peers’.
Annecdotal evidence suggests that Islamic banks are competing with conventional banks rather than among themselves. This ‘head-on competition’ with conventional banks may have led Islamic banks to concentrate on Islamic substitutes (with shari’ah compliance) for conventional products and follow the conventional benchmarks in product pricing. Thus, the returns on deposits and financing costs of Islamic banks are strikingly similar to that of conventional banks.
The ‘head-on’ strategy would enable Islamic banks to target at wider audiences, comprising both Muslim and non-Muslim, while it forces them to be on par with conventional banks in terms of ease of access, product mix and competitive pricing. This option, however, places Islamic banks at a huge scale disadvantage vis-a-vis their conventional couterparts in terms of economies of scale and scope and at the risk of being boxed into the ‘shari’ah compliance’ mould.
In contrast, the ‘niche market’ strategy would take Islamic banks closer to meeting specific Islamic needs by targeting primarily customers who care most about shari’ah rulings. The focus of Islamic banks would then be squarely on the Muslim clientele, meeting their basic banking needs and venturing into sophisticated areas, such as asset development and wealth management. The niche market approach can still be inclusive enough to appeal to the non-Muslims who care for the ethical content.
The niche market strategy implies that Islamic banks will compete less and less with conventional banks and more and more among themselves. This reorientation will compel them to come up with innovative shari’ah-based products that would meet customer needs at competitive prices, and this will empover them to distance themselves from conventional banking.
If Islamic banks can sell a ‘better’ product, there is no reason why they should not charge a ‘higher’ price, as the customers would not mind paying a bit more for a better product, what more if these banks can sell better products at lower prices. We will not be able to see the best of Islamic finance unless and until Islamic banks are able to leapfrog from a compliance mode to an innovative one.
At the same time, if they can cut costs through efficiency gains, they should also be able to share these with their clients in the form of better returns and lower costs. Conceivably, there may come a time when there will be Islamic banks with specialisations, such as Murabaha Banks, Mudarabah Banks, Musharakah Banks, etc. This way, Islamic banks may well create a ‘new’ market of their own without having to compete with their conventional counterparts. Under this scenario, competition with conventional banks, to say the least, would be indirect, not head-on.