Islamic finance has established solid roots in the Gulf states, Malaysia and Indonesia and is set for a roll-out to the world’s 1.6 billion Muslims, with all the challenges that this entails. Joe DiVanna explains.
On a scale of market maturity where one equals embryonic and 10 is a mature economy in steep decline, the Islamic finance industry in 2007 achieved a score of 2.4 (in the early stages of the innovation phase), according to Maris Strategies
In our estimate, the global benchmark for the Islamic finance industry is $500.5bn, which is not a complete number as almost 45% of the institutions claiming to provide some type of sharia-based financial services have not reported figures on their Islamic operations.
Compiled from 47 nations where institutions have announced that they offer sharia-compliant services, the data suggest the market is moving from a late-stage embryonic state to an industry in the early stages of innovation. The review of financial services offerings in 2006-07 shows that most sharia-compliant products simply mimic the offering of conventional institutions. There are two clear reasons for this: customers needed to be able to compare and contrast sharia-based services with their conventional banking counterparts and the technological infrastructure of banking software was based solely on conventional banking models.
During 2007, these two factors have begun a radical transformation as sharia-compliant financial institutions have started to realign their value propositions to customers. In markets where generations of Muslims have been banking with conventional institutions, simply providing access to sharia-based services means that an initial wave of migration has been under way.
However, Muslims with sophisticated banking needs have compared the fees and returns of sharia-based services and found in many markets that there is a high cost for their faith. In several western nations, Muslim customers have opted to stay with conventional banking and reconcile any interest payments or receipts with an equal amount in zakat (tithes), and simply wait for the premium for sharia service to fall and match their current banking costs.
In many other markets, Muslims simply need access to sharia services. Perhaps the next big wave of Islamic banking expansion will be to the vast numbers of unbanked people across the globe.
The second change relates to sharia-compliant products themselves, as incumbent technological infrastructures (mostly software) are rapidly changing to meet the needs of a growing base of sharia-inspired products. A number of banks are now working with software vendors to redevelop or certify that their products provide adequate documentation and audit capability to meet the requirements set by sharia boards. Several more adventurous banks have set out on their own to rewrite or create software that enables them to bring sharia-compliant products to the market.
Conversion and compliance
Compliance to sharia principles by financial institutions varies from country to country as the need to interoperate with their non-sharia-compliant counterparts requires, at times, a broad interpretation of the boundaries of how sharia principles are applied to the world of financial instruments that are becoming more complex.
At a macroeconomic level, sharia-compliant institutions operate in three distinct economic environments:
Islamic nations that strive to maintain purely sharia-based banking systems.
Islamic nations that have mixed-mode financial systems
Non-Muslim nations that have established some level of regulation that addresses sharia-based banking.
Nations such as Saudi Arabia, Iran and Pakistan have a clear agenda by which they are realigning their regulatory structures to be in stricter compliance to more conservative interpretations of sharia principles.
Misalignment and growth
At present, access to sharia-based products and services are concentrated in the six Gulf Cooperation Council (GCC) states, Malaysia and Indonesia. Thus the vast majority of Muslims worldwide are currently not served by Islamic finance. This mismatch of service providers to potential customers is a normal progression for an industry in its early development. This also creates the next growth opportunity for banks to expand into other Muslim markets.
Within unserved markets, the opportunity for banks to grow their customer base falls within three distinct market segments: Muslim high net-worth individuals (HNWIs) and families; Muslims with conventional banking relationships; and the massive unbanked parts of society. Once again, this misalignment of banking services to populations that need access to financing is a good indicator to the overall maturity of the industry which is still in its adolescence.
Transparency and standards
In 1974, the Union of Arab Banks identified the need to create some level of standards across Arab banks. Today, organisations such the Auditing & Accounting Organisation of Islamic Financial Institutions (AAOIFI) and several central banks are working toward resolving numerous issues on transparency and the need to have standards across the industry.
That said, the lack of specific reporting of sharia-compliant holdings and activities separated from non-sharia holdings on balance sheets and income statements makes a total assessment of the market problematic. The central banks of Iran, Saudi Arabia and Pakistan have initiated steps to bring greater clarity in their countries on reporting sharia-finance activities; however, as an industry, there is much to be done to improve the quality of reporting. On an ironic note, despite calls for transparency in the banking sector, all the central banks contacted in the Americas, Europe and the rest of the world either declined to furnish data or were unable to calculate sharia compliancy within their nations. As an exception, the State Bank of Pakistan provided a complete listing of all the data requested for our research.
Participation by conventional banks
Universally conventional banks with sharia-compliant activities have not published figures that specifically reflect their overall performance in Islamic finance. They argue that reporting specific activities or a summary of activities resulting in balance sheet and income statement entries of sharia assets, sharia-generated profits or Tier 1 and 2 capital is technically not a requirement by regulators. Almost all conventional financial institutions contacted for this research elected not to disclose their sharia numbers, providing explanations such as a lack of available accounting mechanisms to separate sharia-compliant activities from non-compliant activities. Other institutions explained that the volume of their sharia activities is a “competitive secret”.
Globally, 524 institutions indicated that they were engaged in some form of sharia-compliant activities, with 317 institutions (60%) reporting financial activities; of the reporting group only 221 institutions (42%) reported sharia-compliant assets and activities separately. One factor to consider is that the lack of separate reporting is also adding to confusion on the part of customers who cannot readily assess whether their bank’s activities are 100% halal (permissable).
Facilitation of transnational commerce
One observation made in the review of individual institutional activities is the growing importance of facilitating transnational commerce and migrant remittances. Facilitating the movement of funds between nations for Muslim businesses is a big opportunity for Islamic banks. Although the volume of transnational commerce between Muslim nations is low, banks are reporting a steady rise in the past five years. Migrant remittances are increasingly gaining the attention of banks worldwide as financial institutions become more aware of the volumes of funds being transferred through regional informal money transfer networks.
In addition, capturing remittance traffic and moving these transactions into the formal banking systems is doubly important to Islamic banks because remittances represent large pools of untapped capital that is non-regulated, non-taxed and untraceable.
Innovation and market differentiation
As the fee structure of Islamic banking comes under greater scrutiny by customers, the need for innovation will be paramount for Islamic banks. The impact of innovation on the value proposition for Islamic banking is important not only in the sense that new products will need to be crafted to hide or justify higher operating costs; innovation will be needed to reduce operating costs, make reporting more transparent and enable customers to perform more self-service transactions under a set of automated sharia-compliant products.
Innovation is emerging as the differentiating factor in an Islamic bank’s value proposition. The analysis revealed banks innovating along three distinct fronts: to reduce costs by streamlining operations, developing more engaging customer experiences to encourage emotional attachments to a bank’s brand/services, and the development of new financial instruments targeted solely at the needs of commercial ventures in Muslim nations.
Islamic banks looking for expansion into unbanked populations are realising that technology is the key to viable access for customers, many of which will only use channels such as mobile phones or use intelligent ATMs. Thus for sharia-compliant banks, innovation is synonymous with leveraging the power of technology, which is reflected in the increasing volumes of banking technology sales throughout the Muslim world.
Joe DiVanna is the author of numerous books on banking including Understanding Islamic Banking: The Value Proposition that Transcends Cultures, and is the managing director of Maris Strategies, a Cambridge-based strategy think tank for financial services and applied economics.