Monday, December 03, 2012

Islamic finance development and the competition with conventional banking

I ran across two articles recently that provided two different ways of thinking about how Islamic finance can compete with conventional finance.  The first, which comes from an interesting article about the development and launch of the Al Hilal Bank in Kazakhstan, describes how one challenge with attracting interest in Islamic finance among businesses:
"It has taken our corporate staff and legal team a long time to convince our customers that even though Islamic finance is approached in a different way, the final results are the same"
The second comes from Malaysia, where an article contrasts the primary selling point used elsewhere as being a financial institution's Shari'ah-compliance, in Malaysia, they have to not only provide a Shari'ah-compliant product but compete (in a competitive market) on the value proposition, which is helped by a number of tax incentives for Islamic finance products (link to story behind the Zawya paywall). 

Besides these two approaches, there is a third one used mostly in countries where Islamic finance is new and relies upon its relative scarcity to target Muslims who avoid using conventional banks at all because they want to avoid riba.  In these markets, even if Islamic finance is not cost competitive with conventional financial institutions, they will find a market for their products among some segment of the Muslim population, even if they are more expensive. 

The three approaches roughly correspond to different stages on the development of Islamic finance in markets, from first introduction to maturation.  In new markets, there will be a push along the lines of Kazakhstan on the corporate side, and along the small market (focused on customers who are relatively cost insensitive who will only use Islamic finance). 

The newness of the product and business model will attract 'first adopters' who are actively searching for Islamic finance products, and will choose them even if it is at a higher cost than they could find financing alternatives from conventional financial institutions. The size of this market will likely determine whether or not the market is large enough to support Islamic finance, and in some cases it is not large enough to support Islamic financial institutions that are focused on the domestic market. 

On the corporate side, however, it is likely not enough to try and attract businesses motivated by Shari'ah-compliance alone (or not just this factor), and most businesses will want to compare the cost of Islamic with conventional finance, and an unusual structure and perhaps the Arabic terminology in countries where Arabic is not the primary language may deter some businesses.  However, the development of Islamic finance has in large part come from developing products that are economically very similar to conventional financial products (in part due to the need to fit within regulations that were not designed for finance that is not based on interest).  The similarity in the product economics between Islamic and conventional finance can serve as a source of comfort against their unfamiliarity with the particular structures used. 

However, once the market becomes developed enough, the ability to attract more customers will become limited as the early adopters have largely shifted to Islamic finance, or become skeptical because of its similarity with conventional finance and Islamic financial institutions will have to go in search of a share of the broader market.  This is the point where the value of the product and its cost competitiveness with conventional finance becomes an issue. 

In Malaysia, Islamic finance has become cost competitive, in part due to government incentives (which may be a double-edged sword).  But, this is not the answer for the long-run, or even the short-run in markets where the government may not be able to provide explicit subsidies for Islamci finance, and the industry will have to find another way of becoming cost competitive with conventional finance. 

To date, a lot of focus on this area has been placed on increasing the scale of Islamic financial institutions, building mega-banks.  And this is a way that Islamic finance can become more costs competitive.  A larger bank has more assets over which it can spread its fixed costs, and will be able to provide lower cost products while maintaining a margin competitive with conventional banks.  But with the global financial institutions increasingly active in Islamic finance, with assets far in excess of what any wholly Islamic mega bank can achieve, this will be an increasingly difficult path for the industry to travel. 

Yet there is another alternative, which is less traveled, and which I will admit is likely to be vague compared to the more concrete examples described above.  Can Islamic finance offer a product that has 'other' value besides just dollars and sense?  Can, for example, it offer more flexible terms that provide a benefit for the financial institutions' clients that a conventional bank--due to convention or regulation--not be able to offer?  I struggle to offer concrete examples here, and it may be that none exist, but if Islamic finance wants tbeo avoid becoming just a niche market subsumed into the global financial industry, it should find a way to ask the question and maybe try it and see what happens. 

Haidar Hamoudi, who offers excellent commentary on his blog, touched on the subject recently and suggests that the Islamic finance industry may have been oversold as both a more efficient and ethical form of finance, and one that can offer the same risk-return profile as conventional finance.  He suggests an alternative, which I think may be an accurate presumption of the choice facing the industry:
A more honest approach would be to inform the Muslim consumer that at some level and to some extent, there is a zero sum game at work here.  Some methods of financings might prove more efficient than others, who knows, but at the end of the day, there's a tradeoff to be made.  Either the industry mimics conventional finance, as it does now, and offers the same return and subjects itself to the same risk exposure in the process, using only differences in form to achieve the result, or it actually does do something different, something actually concerned with social justice, or the development of a moral economy, or the redistribution of wealth. But if it does that, then the money has to come from somewhere, and that somewhere are going to be the depositors, who will have to live with lower returns.
It may be true that depositors will just have to live with lower returns, or else have their deposits held by and invested by an Islamic bank that looks like a conventional bank with different structures used to receive the Shari'ah-compliant label.  But, maybe the post-financial crisis world will be one where overfinancialization, which led to a collapse in financial institutions' profits after decades of rising as a share of total profits will be one where this unsustainable growth begins to reverse, where the 'financialization' of the economy becomes less of a factor in juicing the returns of conventional banks, so Islamic banks don't have to replicate their business model as a way of keeping up with their returns.

If the 'new normal' in global financial markets comes with less use of leverage (which enhances returns both on the way up and the way down) and uses lower leverage, perhaps Islamic banks will be able to more easily be competitive on price without having to force their businesses to resemble so completely the business model of conventional banks, and can focus more on the other aspects of value to compete with conventional finance. 

1 comment:

Frank Weber said...

The substance you are penning blows out my nous.
Stock Orders