Wednesday, November 02, 2011

Islamic finance complexity (Part Ib)

Another link I posted earlier on Twitter took a lesson from microfinance.  The article describes studies about transparency and disclosure in microfinance, particularly relating to disclosures on interest rates, costs and the outcome if things go wrong (i.e. default).  Any issue on disclosure and transparency (with regards to consumer disclosure) is common across any financial products targeted towards the broad consumer market because so many disclosures are essentially pointless for consumers because they are written in legalese and are usually too long for consumers to bother reading through in their entirety.  One example of overcoming this legalese is the efforts in the US by the Securities & Exchange Comssion to bring "plain English" into disclosure statements for companies and financial institutions (which is accompanied by an 83-page handbook on writing in plain English (pdf)).

However, there is more to the issue of disclosure and transparency than just the disclosures presented.  The CGAP article mentions specifically that consumers understand much more clearly fees when presented as dollar amounts, rather than in effective interest rates.  Consumers also are not familiar with "recourse" impacts of financial products (i.e. what happens when the s*** hits the fan).

The analogy to the Islamic finance industry is two-fold: cost and complexity.  On cost, the Islamic financial products are generally more expensive than conventional financial products.  Most Islamic financial institutions would prefer not to convert their fees into an annual percentage rate (APR) because of its roots in conventional finance referring to interest rates.  However, in most regulatory regimes, disclosures are required to include an APR.  As the CGAP study found, this may not be the most useful number to have included in the disclosures and so Islamic banks that want to embrace transparency should add additional disclosures that detail the fees of their products in a separate schedule.  It will both inform consumers better and also give an alternative to the (mandatory) disclosures of APR, as long as it is not deceptive in terms of the actual costs of the product.

The complexity issue is more interesting to me and has fewer requirements imposed in terms of disclosure from a regulatory perspective.  How many consumers can explain how the Islamic financial product they choose actually works?  In some Islamic financial products it takes hours for even people who read prospectuses for a living to understand exactly how an Islamic financial product works, even if the goal of the whole process is relatively simple.  This has attracted the interest of regulators like the Dubai Financial Services Authority, who criticized excessive complexity, citing the Nakheel sukuk.  Unfortunately, the article is subscription only so I can't read it all, but the Nakheel sukuk is a perfect (if extreme) example of an excessively complex sukuk. 

If Islamic financial products are complex, can consumers understand them?  Do consumers of the Islamic financial products know what happens in a default on the products they use and how they differ (or even if they do differ) from conventional products?  I would suspect that few people do.  Part of that is an education issue.  Consumers should learn how these products work, but financial institutions have a responsibility as well to not use overly complex structures.  The key should be meeting a financial need, but if the financial need requires elaborate structuring to re-create a conventional financial product, then perhaps Islamic banks should just take a 'pass'.

All in all, the Islamic financial industry should ensure that its products are understandable and understood by consumers of the product (I hold out little doubt that they will produce any clearer disclosures to consumers than conventional financial institutions) and that the fees are both comparable, fair and understandable.

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1 comment:

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