Strategies for Western Banks to Survive in Islamic Finance Environment

Can Western Banks Survive in Islamic Finance Environment?

Introduction

Islamic or sharia banking is a common phenomenon in Muslim countries, especially in the Middle East and other regions whose social, political, and economic aspects are organized according to the provisions of the Koran. However, western countries and capitals have emerged as Islamic banking centres due to conventional banks venturing into banking approaches that adhere to the tenets of sharia and it’s various interpretations (Reuters Staff, 2012). Therefore, contrary to the case in primarily Islamic regions, Islamic banking is a relatively new concept in the west where its feasibility in a western economic situation has not been verified at length. In fact, Islamic is in its early stages of implementation by conventional banks, and the field is lacking in proper standardization. For instance, every banking institution employs its own managers or directors who are conversant with Islam to help in formulating business practices that adhere to the provisions of the Islamic law.

Since some aspects of banking go beyond the provisions of the Koran, sharia and Sunna, other sources of law have to be identified to address the needs of the increased scope of Islamic banking. Due to the diversity in the western market environment, fiqh muamalat, which are Islamic rules on transactions, are derived from the Koran and Sunna, as well as collective opinions of scholars, analogy, and personal reasoning (Banking Info, 2009). In order for a western bank to be licensed to offer Islamic banking products, it must adhere to the provisions of religious law, and avoid economic activities that are prohibited by Islam. However, the banking services are not limited to Muslims, and a considerable proportion of Islamic banking customers are non-Muslims. In fact, the concept is so widespread such that London, a western economic capital, is one of the world’s hubs for Islamic banking.

Since contemporary banks have only offered Islamic banking over a few decades, the industry has not reached maturity, and although the benefits of Islamic banking are apparent, its benefits to banking institutions have not been assessed at length. The purpose of this study will be to assess available literature for the current state of matters in relation to Islamic banking, and find financial data from leading banking institutions to determine the positive or negative outcomes of Islamic banking to their businesses. The findings of this study will help ascertain the long-term feasibility of Islamic banking in a westernized market environment, and offer recommendations to maximize positive outcomes for western banking institutions.

Background

Islamic banking has a lot in common with conventional banking approaches, including the admissibility of institutions and customers from non-Muslim backgrounds to engage in Islamic banking. Therefore, as long as the provisions of sharia are adhered to, Islamic banking is allowed for contemporary banks and non-Muslim customers (Hassan & Lewis, 2007). However, due to differences in governing principles, institutions have a lot to learn, modify and adapt before venturing into Islamic banking. For instance, the religious basis of Islamic banking prevents institutions that offer sharia banking from engaging in activities that contravene the provisions of the Koran and other religious texts. In addition, some requirements may not be recorded in religious books, but the ethical and moral bases of Islamic banking require socially responsible banking institutions. This way, banks and other financial institutions can contribute to society growth in a morally acceptable manner. Despite the moral and ethical principles that give Islamic banking a high level of credibility and acceptability in the western world, it has some shortcomings that may limit its success in a contemporary market environment.

Principles of Sharia Banking

As is the case with conventional banking, Islamic banking has the aim of making money by lending out funds to make money for the lending institution as one of the main purposes. Islamic law and fair practice are at the core of Islamic banking, and Islamic rules on transactions are enforced to eliminate the occurrence of the perceived evil of lending money for interest. These rules, also known as Fiqh al-Muamalat, aim at limiting the practice of risk-transfer that is common in conventional banking, but instead promotes risk-sharing between the bank and its customers. The risk-sharing provision of sharia banking gives rise to concepts like Mudharabah, Wadiah, Musharakah, Murabahah and Ijar, which are profit sharing, safekeeping, joint venture, cost plus and leasing respectively (Visser, 2009). Therefore, instead of charging interest for loans to buy assets, a bank buys the house, vehicle or property of interest, and then sells it to the customer at a profit. The bank cannot make profit that seems too obvious, and there can be no charges for late payment, and the bank has to ask for strict collateral to protect itself in case a customer defaults payment. In this Murabahah arrangement, the property of interest is registered under the customer’s name from the beginning of the transaction. In addition, an EIjara wa EIqtina arrangement can be made, which allows the bank to retain ownership of the property until the customer completes paying the selling price of the property.

The Musharaka al-Mutanaqisa is an innovative approach for payment of home loans, whereby banks charge their customers rent as a floating rate for mortgage payment. The bank forms a partnership entity with the customer, and the partnership entity purchases the house at agreed ownership proportions between the bank and the borrower. Once the property is acquired, the borrower rents the house from the partnership entity and remits rent each month to the partnership entity. The bank and its customer share the proceeds of the property, and in the process the ownership of the property is transferred to the borrower. On completion of ownership transfer, the transaction is complete, and the partnership is dissolved as the objectives of the two partners are met (Kettell, 2011). In case a borrower defaults payment, the property is sold and the returns shared between the bank and its customer in ratios depending on their proportions in their ownership of the property.

The approaches taken by banks are highly variable depending on market needs and interpretations of the Koran by a bank’s sharia banking consultants or directors. For instance, most Islamic banking institutions offer floating rate loans to business entities, whereby the interest rate is tied to the profitability of the business. In this Musharaka arrangement, the bank’s interest amounts to a fixed percentage of the firm’s profits, and the profit sharing arrangement is terminated once the loan has been fully paid. In addition, a bank and it’s customer may have a Mudharabah arrangement in which the entrepreneur provides labour while the bank provides capital, which allows for sharing of profits and risk in a business venture. While Islamic approach is highly participative and allows for borrower protection and limiting economy monopolization by the lender, it does have its limitations to business practice. Islamic banking only promotes moral purchasing and ethical investing, and activities that involve pork, alcohol, and gambling are prohibited (Schaffer, Agusti & Earle, 2008). These and other principles form the basis for the provision of Islamic banking services, which have their advantages to customers, and some shortcomings.

Advantages of Islamic Banking

The participative nature of Islamic finance enables productive collaboration between financial institutions and their customers, which is a relationship that is devoid of exploitation of borrowers for the benefit of the lender. The first advantage of Islamic banking is attributed to sharia’s prohibition of charging or giving interest for loans and deposits respectively (Hell, 2006). Prohibition of Riba forces banking institutions to form working relationships with their customers, which protects customers from excessive risk and prevents the bank from charging too much interest on loans regardless of market conditions. Musharakah favours customers by allowing them to pay back their loan to the bank according to the returns achieved from the borrowed capital. The second advantage of Islamic banking over conventional banking is the basis of banking practices, whereby conventional banking is mainly centred on their products while ethical principles are at the centre of Islamic banking. In this regard, the moral basis of Islamic banking assures customers of the relationship with their bank, unlike the conventional banking situation in which the primary business of the bank is growing profits regardless of the market situation or customer needs (Schoon, 2010). Finally, Islamic banking has an intellectual advantage over conventional banking, especially in relation to the services offered to customers. In Islamic banking, products are structured according to customer needs whereas in conventional banking, the products are pre-designed and customers pick any of the available products. This ensures long-term viability of the relationship between the bank and its customers while conventional banking focuses on short-term relationships between the two.

Shortcomings of Islamic Banking

The unique nature of Islamic banking, and the high levels of risk involved for a banking institution that makes transactions in sharia banking more expensive for customers in comparison to similar transactions in contemporary banking (Henry & Wilson, 2004). First, borrowers are expected to provide mortgage deposits that are higher than the market average in Islamic banking in comparison to contemporary banking. Second, due to the higher risk for the lending institution, Islamic banking mortgages are usually more expensive to borrowers in comparison to conventional mortgages (Ahmed, 2010). Third, Murabahah monthly payments are usually higher than expected, and monthly payments for ijara instruments are highly volatile. Fourth, Islamic banking transactions are usually highly complex, and it is difficult to communicate messages to potential customers since multiple contracts are usually involved for each transaction. Fifth, in ijara mortgages, it is possible for parties to a transaction to suffer negative equity. Sixth, the international capital market is primarily not sharia compliant and does not have enough critical number and volume of transactions required to sustain a market under sharia (Islam, 2013). Finally, the sharia market does not have a market-marker mechanism, as is the case in the conventional market, which enables interactions between buyers and sellers to facilitate transactions (Iqbal & Mirakhor, 2013).

Statement of the Problem

Advantages and disadvantages of sharia banking in a conventional banking environment are obvious, whereby the positive and negative outcomes interact to produce mixed outcomes for conventional banks. However, their sum effects have not been assessed in depth using evidence from the market, and companies with the intention of investing in the Islamic banking market do not have a clear guideline on the possible outcomes of their investments. In addition, any successes or failures of banks that can be attributed to Islamic banking have not been clearly assessed despite the obvious conflicts on the frameworks between Islamic and contemporary approaches to banking. For instance, prohibition of interest collection by sharia eliminates the most paths to profitability by conventional means. In this regard, banks have to pursue other means of achieving profitability that are permissible to sharia, which includes participative banking approaches. Moreover, banks are limited to business practices that are not prohibited by sharia, which are stipulated by the Koran, religious texts and scholarly interpretations. Finally, contemporary banks and other financial institutions have to familiarize with provisions of Islam, especially by having managers or directors who are scholars to interpret and agree on acceptable banking activities under sharia economics.

Significance of the Study

Islamic banking is being adopted in various business environments globally, whereby contemporary banks in London and other western cities are the global centres for Islamic banking. Although Islamic cities drive most of the capital in the world’s Islamic banking industry, current growth in alternative approaches to banking is exponential and may be a considerable contributing factor in economic growth (Businessweek.com, 2005). However, there is lack of clear information on the feasibility of Islamic banking in a contemporary banking environment. This study will assess available data and information on the financial performance of Citigroup, Deutsche Bank, HSBC, Morgan Stanley and Goldman Sachs (Wolf, 2009). The evidence of improved, stagnated or deteriorated financial performance for these institutions as contributed by their participation in sharia banking will be used as a basis for formulation of recommendations for other banking institutions. The literature review and assessment of the companies’ financial performance will reveal the contribution of Islamic banking ventures to the financial growth of these institutions. Moreover, it will enable the identification of approaches that resulted in positive outcomes for institutions. Once contemporary banks have information on feasible approaches to Islamic banking, they will be able to make decisions that aim at maximizing the benefits of venturing into participative approach to banking as opposed to contemporary approaches.

Research Questions

General Research Question

- What is the extent to which Islamic banking has resulted in positive outcomes for contemporary banks in a contemporary banking environment?

Specific Research Questions

q1. What is the relationship between an increase in investment in Islamic banking and financial performance of conventional banks?
q2. With the current expansion of conventional banks to include Islamic banking in their product portfolio, does the profitability of institutions increase or decrease?
q3. What measures should conventional banks take to maximize positive outcomes in their investments in Islamic banking?

Synthesis

This introduction gives a perspective for the study, and other sections of the study will include the literature review, research methods, findings and discussion, conclusion, and implications. The literature review section will identify studies and other authoritative literature, and review it to determine gaps in the study of Islamic banking in a contemporary banking environment. The research methods section will elaborate of the measures taken to find data and information that was relevant in answering the research questions. Findings and discussions section will include the presentation of analysed information, which will then be interpreted to come up with conclusions about the implications of the findings to the research questions. Finally, the appendix section will include data and information sources that are relevant to this study but cannot be integrated into the main text. In addition, various documents will be included as appendices including any ethics forms, personal statement, and any other documents obtained for the study.

Literature Review

Due to the current demand for Islamic banking services based on curiosity or product appeal, Mahmoud and Kader (2012) observed that the current fast growth of Islamic banking is an important factor for economic growth. However, the authors stated that Islamic banking still takes second place in comparison to conventional banking in relation to marketing strategies and competitive advantages. In this regard, Islamic banking services are only viewed as supplementary products instead of possible substitutes for conventional banking products. Mahmoud and Kader (2012) recommended that banks with Islamic banking products should have competitive strategies for marketing, especially in response to customer needs for good bank reputation, attractive returns, and high quality services. Nevertheless, the authors commented that some positive progress has been made in regard to competitive advantage acquisition for Islamic banking products. For instance, banks have understood that offering good banking products is not enough, but the value of such products must be communicated effectively to potential customers. Lee and Ullah (2011) determined that sharia compliance is one of the many factors considered by customers when selecting an appropriate Islamic banking service provider. Other characteristics of an appropriate Islamic banking service provider include convenience, technology advancement and dependability of the firm’s capital security offering (Lee and Ullah, 2011). Therefore, any banking institution with the intention of offering Islamic banking services should offer value addition for customers, which can be done by identifying customer needs and expectations.

Principles of Islamic Banking

Unlike conventional banking policies and regulations that are specifically made to govern financial transactions between banking institutions and their customers, sharia necessitates incorporation of Islam as a way of life. The effects of sharia on banking transactions exceed the limited financial sector, and extend to other factors that affect transactions including the market, justice, economics, business principles and finance among others. Islamic justice advocates for equitable treatment of players in a market, which allows people from different backgrounds and financial ability to interact productively. In addition, Islam encourages the growth of a free market, but this should happen within a given ethical framework especially in regards to profitability and exploitation of price takers in a market. The Koran also provides clear guidelines on trade and commerce, work and production, poverty and riches, communal obligations, stewardship and resources, ethical standards, and ethical principles in finance and business. In Islamic finance, Usury is expressly prohibited, especially due to its disregard for the financial condition of the borrower and market situation, which may be exploitative and unfair (Lewis, 2011). Lewis (2011) confirmed that the need for fair trade and justice in exchange is not limited to Muslims, but the Koran, sharia and other sources of Muslim law have a comprehensive guidance for Islamic banking that is not available for contemporary banking. According to the author, this is what has made Islamic banking acceptable to customers in conventional banking environments, especially since Islam provides guidance and mechanisms for implementation.

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