Wednesday, November 02, 2011

Islamic finance complexity (Part Ia)

Earlier tonight, I posted an article on Twitter from CGAP about microfinance product development that I think has lessons for the Islamic finance industry as a whole.

The article discusses the way that microfinance institutions use daily journals from a sample of their customers or potential customers to determine how people actually use their money and how they engage with financial institutions to develop what financial needs are not being met currently by financial institutions (i.e. what are they using cash for that a financial intermediary could help them get a better outcome).  While I don't believe that Islamic financial institutions are flying blind in regards to their clients needs, it does appear that in some cases they are developing products that they can make money selling and then taking them to market and hoping that the supply will create a demand.  In other cases, they see a need (e.g. a financial product not being offered by Islamic banks and developing their own Shari'ah-compliant version and bringing it to market).

The problem with these approach is that they take as their premise either that the products that they develop to be profitable (for the bank) have a natural market or that conventional banks are offering products that always suit the needs of consumers.  My idea of "going back to the basics" for Islamic finance is based on the premise that financial institutions creating products to suit their own needs (in terms of generating high profits) or by replicating conventional products (which creates added complexity) do not do the best job in fulfilling the financial needs of the consumers who look to Islamic banks for Shari'ah-compliant alternatives to conventional banks (mostly Muslims, but non-Muslims should be the market as well if Islamic banks have a change of growing across the world).

One aspect of the article that I think makes it useful for Islamic banks is that it is developed from the perspective of microfinance institutions that have a small market share in terms of the customer's business that they want to see grow.  Islamic banks start by trying to attract customers who either do not use banks or are with conventional banks.  Similarly, microfinance institutions are trying to get the business of people who rely on cash for most of their transactions because they don't have access to banks.

The analogy is not perfect, but an Islamic bank that is developing new products would be well served asking Muslims who don't use banks (or who have non-interest-bearing deposit accounts only) what aspects of their financial life are most inconvenienced by their lack of access to banks.  With that need in mind, they can develop financial products that fulfill that need, whether or not it ends up being a product identical to a conventional offering.  Instead, it seems that banks are assuming that people need a credit card (for example) and are structuring a complex series of murabaha transactions to create a payment/credit system that extends credit to the customer without formally being structured as a loan from the bank to the customer that is repaid with interest.

If Islamic banks want to cater specifically to the portion of the Muslim population that wants a credit card, but don't want to pay interest, then creating Islamicized versions of credit cards etc. will work fine, but why would a non-Muslim get an Islamic credit card that has all the metal trading behind that adds cost when a regular credit card will charge far less?  Even if the underlying goal is to include Muslims into the financial system, there will be plenty of Islamic banks offering complex structured versions of credit cards.  Working from a bottoms-up perspective (starting with the institution rather than trying to effect top-down change on the Islamic finance industry), an Islamic bank can choose not to offer every conventional product as an Islamic finance product without having to be concerned with overall access to finance among devout Muslims who don't work with conventional banks.

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