Tuesday, February 15, 2011

Broadening the appeal of Islamic finance

I was reading an article on Indonesia providing advice on Islamic banking regulations and I was struck by one quote from Grace Stuart Ndyareeba, the deputy director of commercial banking at Bank of Uganda, the country's central bank. He said, "We in Uganda know that Islamic banking is not only for Muslims. It is another financial product. [And conventional banks charge] very high interest rates expensive for consumers".

Although Uganda has a significant Muslim population--12% or 4 million people--it still is better viewed as an example of a non-Muslim majority country creating opportunities for Islamic banks to provide their services. It is unlikely to develop a large Islamic banking industry that a country like Indonesia might based on its larger population and higher proportion of the population that are Muslim.

In this context, Islamic banks are best suited to focusing on the Muslim population, particularly in the early stages of development. It will thrive in the end if it is able to serve these people's needs well and will attract non-Muslims if it is able to provide quality efficient banking services. What it will not do is replace the very high interest rate products with products that are cheaper, at least not at first.

It is likely based on the small population of Muslim consumers and probability that there will remain additional costs and inefficiencies to Islamic banks in the country that the Islamic banking products will be more expensive than conventional alternatives. An analogy that should provide some forewarning about the benefits from a cost perspective alone in non-Muslim majority countries is the difference between the US and Canada, which both have Islamic finance companies offering products. Reports I have seen suggest that the Islamic financial products in Canada are more expensive than in the US. Canada is at an earlier stage in the development of its Islamic finance industry than the US and has a smaller population as well (both in total population and Muslim population, about 1/10th for total population and 1/7th for Muslim population).

This doesn't mean that Islamic banking cannot work in Uganda (or Canada), but it seems preferable that it be targeted first to Muslims and then, once it has matured and been able to better compete with conventional banks, the products should be marketed on their own merits to non-Muslims. They will not have any natural preference towards Islamic banking products unless they are cost-competitive and offer a tangible benefit compared with conventional products. A good example of a market where non-Muslims participate broadly in Islamic finance based on the cost of the product is Malaysia.

The cost aspect is easy to understand; if a product offers a better value for consumers (lower cost for equal or higher quality service), then consumers will be inclined to choose it. The "merits" of the Islamic banking products is a little more complicated.

There may be some consumers who, for whatever reason, want to avoid explicit interest in their financial dealings. There are others who want to ensure that their deposits are not being used for socially detrimental activities like selling alcohol or tobacco, producing weapons, or gambling and pornography. These consumers may be indifferent between Islamic and conventional products or even be willing to pay a premium for the more 'ethical' product.

However, many consumers will look at an Islamic banking product and see additional cost, limited 'ethical' screening (compared to socially responsible investments which use a broader set of screens) for a similar product to conventional financial products. This is particularly true for murabaha and ijara. Each are analogous to conventional financial products (loans and leases) and the benefits may not be apparent. They are often not apparent to many Muslims based on this similarity.

There are no easy answers for how to make Islamic banking products more appealing to consumers, Muslim or not. It is not even clear that the products abstracted from the benefit of Shari'ah-compliance, are better than conventional financial products. This is the largest challenge to making Islamic financial products more acceptable to non-Muslims absent a cost reduction (which is often not present because the products are benchmarked to interest rates and they are generally more costly to create). It also highlights the challenge to Islamic finance to attract a new set of Muslim consumers. How can Islamic banks operate in a way that differentiates their products from conventional financial products without confusing consumers, running into regulatory issues, raising costs further or creating stability concerns for the Islamic financial institution.

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