Middle East

Islamic Banking System: Threats and Opportunities

Traders at the sharia-compliant Saudi Investment Bank in Riyadh.

For more than a quarter century, Islamic banking and finance has been developing from an idea and an expression of Muslims' distinct identity to a mature and fast-growing industry. With the latest global financial crisis, Islamic banking and finance became one of the most debated issues around the world. Because all that is different in their shape and reaction is attractive, Islamic banks have been analyzed since the onset of the crisis in order to identify their characteristics, sources of resilience, weaknesses, potentials and opportunities for growth.

The Islamic banking system is an important component of Islamic finance. Islamic finance has unique features because its foundation is laid on the principles and rules of Islamic law (sharia), which states that everything is owned by Allah and man has only been permitted to use it. Accordingly, the use of funds is governed by several regulations.

In a general first assessment of Islamic banking, the risk and equity sharing characteristic stands out. The most essential feature of Islamic banking is the prohibition of interest (riba). Islamic banks neither charge nor pay interest in a conventional way where the payment of interest is set in advance and viewed as the predetermined price of credit or the reward for money deposited. Islamic law accepts the capital reward for loan providers only on a profit- and loss-sharing basis, working on the principle of variable return connected to the actual productivity and performances of the financed project. Another important aspect of Islamic banking is its entrepreneurial feature. The system is focused not "only on financial expansion but also on physical expansion of economic production and services." In practice, Islamic banks have concentrated on investment activities such as equity financing, trade financing and real estate investments.

Islamic banks are profit-driven institutions just like conventional banks, but they manage all their activities in accordance with sharia. Notably, the first modern Islamic banking phenomenon emerged as a result of the reaction of Muslim intellectuals to the use of conventional commercial banks in trade activities between local business communities and imperial powers. Colonial rule in Islamic countries heightened Muslims' need to maintain and protect Islamic law and principles, even in the financial sphere. Early experiments in this sector were undertaken in 1963 in Egypt and Malaysia. Without any references to Islamic principles (for fear of political repercussions), Ahmad El Najjar established the first Egyptian savings bank based on no-interest and profit-sharing principles. Muslim Pilgrims Savings Corporation was the first Islamic financial institution in Malaysia. It was set up to help people save for performing hajj. Today, Malaysia is the biggest issuer of Sukuk (Islamic bonds) worldwide and one of the main promoters of regimentations and innovation in the Islamic banking system.

The first genuine Islamic banks were not launched at the national level. Instead, during the 1970s, a number of these banks were established on a more local level in the Middle East and North Africa. The very first Islamic bank was Nasser Social Bank, which started to operate in Cairo in 1972. It was followed by Dubai Islamic Bank in 1975, and Faisal Islamic Banks was established in 1977 in Sudan and Egypt. The second step in the evolution of the Islamic banking system was to take the system to an international level by creating the first Islamic international financial institution, the Islamic Development Bank, in 1973. The third step came with the transformation of entire national banking systems into sharia-compliant systems. This is currently the case in Iran, Pakistan and Sudan.

Islamic banks operate mainly in Muslim countries, but currently they are also operating outside these countries. For instance, the United Kingdom has become the most important location for Islamic financial activity outside the Muslim world. Today, approximately 53 countries have Islamic banking institutions, and at least 70 countries have some sort of Islamic financial services. Almost without exception, the major multinational banks presently offer a broad range of sharia-compliant financial products and services. The largest Islamic banks are located in Gulf Cooperation Council countries (Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates).

For the last four decades, the Islamic banking system has experienced a tremendous evolution from a small niche visible only in Islamic countries to a profitable, dynamic and resilient competitor at an international level. The size of Islamic banks around the world was estimated to be close to $850 billion at the end of 2008 and is expected to grow by around 15 percent annually. While Islamic banking remains the main component of the Islamic financial system, the other elements, such as Takaful (Islamic insurance companies), mutual funds and Sukuk (Islamic bonds and financial certificates), have witnessed strong global growth, too. According to a reliable estimate, the Islamic financial industry now amounts to over $1 trillion. Moreover, the opportunity for growth in this sector is considerable. It is estimated that the system could double in size within a decade if the past performances are continued in the future.

In the decade prior to the financial crisis, the sharia-compliant financial system had quite exceptional returns. Assets doubled almost every two years, and net income doubled every year. There were some institutions with a posted return on equity of more than 30 percent and in some cases even more than 40 percent. They were also able to earn an average return on assets reaching 10 percent. Even if these figures are not exceptional compared to those posted by conventional financial institutions between the years 2000 and 2007, they are quite remarkable if we consider the timeframe and the dynamics of the Islamic financial system's evolution.

The global financial crisis that started in 2007 was the first real challenge for this fast-growing financial sector. The climate generated after the crisis hit the real economy, creating both challenges for its foundation and opportunities for rapid expansion. The crisis's aftermath could be divided into two important phases: its impact on the financial sector, and the effects generated by the financial crisis on the real economy. Due to the lack of comprehensive and detailed research, the analysis of the performance of the Islamic banking system during the crisis is mainly based on empirical evidence, testimonials and analysts' reasoning.

The first stage of the crisis, during 2007 and 2008, favored the Islamic banking system compared with the conventional system. According to a recent IMF study, Islamic banks performed better than conventional ones in 2008 in terms of profitability, credit and asset growth. The Islamic banks' profitability crunch was less than 10 percent, whereas the conventional banks' profitability slumped more than 35 percent in 2008 compared with 2007. The IMF study reported that Islamic banks have maintained stronger credit growth compared to conventional banks in almost all countries and in all years, suggesting that the system has great potential for further market-share expansion and a possible contribution to market stability through the available credit. The same trend was maintained on the assets side, which was less affected by deleveraging and grew on average more than twice that of conventional banks during the period of 2007 to 2009. Because the global crisis is an ongoing phenomenon, these results are provisional; however, they are supported by the Islamic banking system's characteristics.

The Islamic banking business model's features helped the system by protecting it from the first financial impact of global crisis. While conventional finance is largely debt-based and allows for risk transfer, Islamic financial intermediation is asset-based and focuses on risk sharing. Prohibition on excessive leverage and on risk transfer according to shariaprinciples made the system more resilient, less exposed and thus protected from the impact of toxic assets and derivatives' effects that triggered the global financial crisis.

The Islamic banking system's features make its activities more closely related to the real economy. This reduces its contribution to excesses and bubbles, but it also makes it more exposed and vulnerable to the second wave of financial crisis: the real economic downturn. Islamic banks lent a large part of their funds to the consumer sector and invested in assets that proved in time to be illiquid, sharing the losses of their activity with the stakeholders. According to the IMF study, Islamic banks' larger decline in profitability in 2009 was due to weaknesses in risk-management practices, mainly associated with high degree of concentration on, or greater exposure to, one sector and/or borrower.

This second-round effect has brought to the surface some shortcomings that may possibly jeopardize the Islamic banking system's capacity to grow and develop. Those challenges that have to be addressed in order for Islamic banks to maximize their potential include the need to improve management of certain market risks such as liquidity and reputation risk.

Liquidity management is difficult under Islamic finance rules due to the lack or limitation of practical instruments and the small number of participants on the money market. Because most of the conventional liquidity tools are banned according to sharia principles, Islamic banks sustain higher liquidity ratios compared to conventional banks. Nonetheless, the lack of contract standardization, the absence of instruments to hedge against the volatility in currency and commodity markets, the incomplete legal framework, and the insufficient expertise at the supervisory and industry level seems to weaken the potential of Islamic finance and affect its reputation.

Just like conventional banks, Islamic banks increasingly funded long-term assets with short-term funding, even if this was done in a sharia-compliant manner. Islamic financial institutions did not invest in the structured financial products that activated the crisis, but the assets in which they invested were just as illiquid. The degree of leverage increased because the expansion of the banks' activity was not supported by the proportionate increase in capital, which remained static due to the distribution of returns earned during the rapid growth period.

The Islamic banking system is not homogenous. Some banks have more sophisticated risk-management tools, varied financing sources and a diversified customer base. Others have less-complex activities and different levels of leverage and liquidity. Nonetheless, all Islamic banks are vulnerable to negative spillover effects from the real economy and have to overcome their current shortcomings, among which the most pressing are liquidity management, improvement and harmonization of regulatory and supervisory regime, and keeping the legal infrastructure updated in line with the pace of the rapidly changing financial landscape.

The Islamic banking system proved its resilience during the financial crisis, but it should not be regarded as a panacea for the conventional banking system affected by the crisis. There is no such thing as the perfect banking system; there are only systems best adapted to the market conditions in which they are operating. Islamic banks were less affected by the financial crisis but were unable to avoid the negative impact of the effects of the economic downturn on the credit worthiness of their clients and to prevent the repercussions of the high degree of concentration.

Before the crisis, the Islamic banking system could be regarded as a micro-system that performed great on that dimension. Lack of standardization and domestic-focused activity were Islamic banks' particularities. New market conditions have now taken the Islamic banking system to another level where different rules are in place and there are various risks to be mitigated.

Islamic banks can grow and consolidate their position by operating commonly on a cross-border basis. For that it would be necessary to offer diversified and standardized products and services, implement sharia compliancy recognition authorities and/or processes, and improve the management of counterparty/credit risk and liquidity risk. Some authors argue that the business model of many Islamic financial institutions will need to be rethought by building diversified sources of revenue, such as incomes from advisory services, asset management or financial services provided to retail clients. Even though Islamic banks have to achieve the scale economies that make them viable competitors, the solution is to adapt to targeted market conditions and requirements and not to imitate conventional instruments or risk management strategies. The focus, thus, should be on choosing and structuring the most adequate products, services and risk management tools, which are truly complaint with sharia and adapted to the needs of almost 1.3 billion Muslim customers.

The most important thing for all products, tools and activities of the Islamic banking system is that they are sharia compliant. Of course, profit is important, too. Nonetheless, when conventional banks subordinated all else to revenue maximization, the banks' activities no longer heeded reality, and the consequences were drastic. This loss of touch with reality was criticized by analysts long before the crisis started. Some even compared derivatives to "financial weapons of mass destruction," but the illusion of enormous gains blurred all participants' vision on the value-added mission of the bank as one of the important players in the chain of financial intermediation. The only hope is that the people responsible for shaping the future of Islamic banking have in mind the lessons of the current crisis and take the best out of the conventional banking system to be adapted to their own, and vice-versa.

This article was originally published by the Middle East Political and Economic Institute. The bibliography is available at mepei.com.