Finance - Islamic Banking

Islamic Banking

Literature: Practice

Recent years have brought an increasing flow of empirical studies of Islamic banking. The earliest systematic empirical work was undertaken by Khan (1983). His observations covered Islamic banks operating in Sudan, United Arab Emirates, Kuwait, Bahrain, Jordan, and Egypt. Khan's study showed that these banks had little difficulty in devising practices in comformity with Shariah. He identified two types of investment accounts: one where the depositor authorized the banks to invest the money in any project and the other where the depositor had a say in the choice of project to be financed. On the asset side, the banks under investigation had been resorting to mudaraba, musharaka and murabaha modes. Khan's study reported profit rates ranging from 9 to 20 per cent which were competitive with conventional banks in the corresponding areas. The rates of return to depositors varied between 8 and l5 per cent, which were quite comparable with the rates of return offered by conventional banks.

Khan's study revealed that Islamic banks had a preference for trade finance and real estate investments. The study also revealed a strong preference for quick returns, which is understandable in view of the fact that these newly established institutions were anxious to report positive results even in the early years of operation. Nienhaus (1988) suggests that the relative profitability of Islamic banks, especially in the Middle East in recent years, was to a large extent due to the property (real estate) boom. He has cited cases of heavy losses which came with the crash of the property sector.

The IMF study referred to earlier by Iqbal and Mirakhor (1987) also contains extremely interesting empirical observations, although these are confined to the experience of Iran and Pakistan, both of which have attempted to islamize the entire banking system on a comprehensive basis.

Iran switched to Islamic banking in August 1983 with a three-year transition period. The Iranian system allows banks to accept current and savings deposits without having to pay any return, but it permits the banks to offer incentives such as variable prizes or bonuses in cash or kind on these deposits. Term deposits (both short-term and longterm) earn a rate of return based on the bank's profits and on the deposit maturity. No empirical evidence is as yet available on the interesting question as to whether interest or a profit-share provides the more effective incentive to depositors for the mobilization of private saving. Where Islamic and conventional banks exist side by side, central bank control of bank interest rates is liable to be circumvented by shifts of funds to the Islamic banks.

Iqbal and Mirakhor have noted that the conversion to Islamic modes has been much slower on the asset than on the deposit side. It appears that the Islamic banking system in Iran was able to use less than half of its resources for credit to the private sector, mostly in the form of short-term facilities, i.e., commercial and trade transactions. The slower pace of conversion on the asset side was attributed by the authors to the inadequate supply of personnel trained in long-term financing. The authors, however, found no evidence to show that the effectiveness of monetary policy in Iran, broadly speaking, was altered by the conversion.

The Pakistani experience differs from the Iranian one in that Pakistan had opted for a gradual islamization process which began in 1979. In the first phase, which ended on l January 1985, domestic banks operated both interest-free and interest-based 'windows'. In the second phase of the transformation process, the banking system was geared to operate all transactions on the basis of no interest, the only exceptions being foreign currency deposits, foreign loans and government debts. The Pakistani model took care to ensure that the new modes of financing did not upset the basic functioning and structure of the banking system. This and the gradual pace of transition, according to the authors, made it easier for the Pakistani banks to adapt to the new system. The rate of return on profit-and-loss sharing (PLS) deposits appears not only to have been in general higher than the interest rate before islamization but also to have varied between banks, the differential indicating the degree of competition in the banking industry. The authors noted that the PLS system and the new modes of financing had accorded considerable flexibility to banks and their clients. Once again the study concluded that the effectiveness of monetary policy in Pakistan was not impaired by the changeover.

The IMF study, however, expressed considerable uneasiness about the concentration of bank assets on short-term trade credits rather than on long-term financing. This the authors found undesirable, not only because it is inconsistent with the intentions of the new system, but also because the heavy concentration on a few assets might increase risks and destabilize the asset portfolios. The study also drew attention to the difficulty experienced in both Iran and Pakistan in financing budget deficits under a non-interest system and underscored the urgent need to devise suitable interest-free instruments (7) . Iran has, however, decreed that government borrowing on the basis of a fixed rate of return from the nationalized banking system would not amount to interest and would hence be permissible. The official rationalization is that, since all banks are nationalized, interest rates and payments among banks will cancel out in the consolidated accounts. (This, of course, abstracts from the banks' business with non-bank customers.)

There are also some small case studies of Islamic banks operating in Bangladesh (Huq 1986), Egypt (Mohammad 1986), Malaysia (Halim 1988b), Pakistan (Khan 1986), and Sudan (Salama 1988b). These studies reveal interesting similarities and differences. The current accounts in all cases are operated on the principles of alwadiah. Savings deposits, too, are accepted on the basis of alwadiah, but 'gifts' to depositors are given entirely at the discretion of the Islamic banks on the minimum balance, so that the depositors also share in profits. Investment deposits are invariably based on the mudaraba principle, but there are considerable variations. Thus, for example, the Islamic Bank of Bangladesh has been offering PLS Deposit Accounts, PLS Special Notice Deposit Accounts, and PLS Term Deposit Accounts, while Bank Islam Malaysia has been operating two kinds of investment deposits, one for the general public and the other for institutional clients.

The studies also show that the profit-sharing ratios and the modes of payment vary from place to place and from time to time. Thus, for example, profits are provisionally declared on a monthly basis in Malaysia, on a quarterly basis in Egypt, on a half-yearly basis in Bangladesh and Pakistan, and on an annual basis in Sudan. A striking common feature of all these banks is that even their investment deposits are mostly short-term, reflecting the depositors' preference for assets in as liquid a form as possible. Even in Malaysia, where investment deposits have accounted for a much larger proportion of the total, the bulk of them were made for a period of less than two years. By contrast, in Sudan most of the deposits have consisted of current and savings deposits, apparently because of the ceiling imposed by the Sudanese monetary authorities on investment deposits which in turn was influenced by limited investment opportunities in the domestic economy.

There are also interesting variations in the pattern of resource utilization by the Islamic banks. For example, musharaka has been far more important than murabaha as an investment mode in Sudan, while the reverse has been the case in Malaysia. On the average, however, murabaha, bai'muajjal and ijara, rather than musharaka represent the most commonly used modes of financing. The case studies also show that the structure of the clientele has been skewed in favour of the more affluent segment of society, no doubt because the banks are located mainly in metropolitan centres with small branch networks.

The two main problems identified by the case studies are the absence of suitable non-interest-based financial instruments for money and capital market transactions and the high rate of borrower delinquency. The former problem has been partially redressed by Islamic banks resorting to mutual interbank arrangements and central bank cooperation, as mentioned earlier. The Bank Islam Malaysia, for instance, has been placing its excess liquidity with the central bank which usually exercises its discretionary powers to give some returns. The delinquency problem appears to be real and serious. Murabaha payments have often been held up because late payments cannot be penalized, in contrast to the interest system in which delayed payments would automatically mean increased interest payments. To overcome this problem, the Pakistani banks have resorted to what is called 'mark-down' which is the opposite of 'mark-up' (i.e., the profit margin in the cost-plus approach of murabaha transactions). 'Mark-down' amounts to giving rebates as an incentive for early payments. But the legitimacy of this 'mark-down' practice is questionable on Shariah grounds, since it is time based and therefore smacks of interest.

In the Southeast Asian context, two recent studies on the Bank Islam Malaysia by Man (1988) and the Philippine Amanah Bank by Mastura (1988) deserve special mention. The Malaysian experience in Islamic banking has been encouraging. Man's study shows that the average return to depositors has been quite competitive with that offered by conventional banks. By the end of 1986, after three years of operation, the bank had a network of fourteen branches. However, 90 per cent of its deposits had maturities of two years or less, and non-Muslim depositors accounted for only 2 per cent of the total. Man is particularly critical of the fact that the mudaraba and musharaka modes of operation, which are considered most meaningful by Islamic scholars, accounted for a very small proportion of the total investment port folio, while bai'muajjal and ijara formed the bulk of the total.

It is evident from Mastura's analysis that the Philippine Amanah Bank is, strictly speaking, not an Islamic bank, as interest-based operations continue to coexist with Islamic modes of financing. Thus, the PAB has been operating both interest and Islamic 'windows' for deposits. Mastura's study has produced evidence to show that the PAB has been concentrating on murabaha transactions, paying hardly any attention to the mudaraba and musharaka means of financing. The PAB has also been adopting unorthodox approaches in dealing with excess liquidity by making use of interest bearing treasury bills. Nonetheless, the PAB has also been invoking some Islamic modes in several major investment activities. Mastura has made special references to the qirad principle (8) adopted by the PAB in the Kilusang Kabuhayan at Kaunlaran (KKK) movement launched under Marcos and to the ijara financing for the acquisition of farm implements and supplies in the Quedon food production program undertaken by the present regime.

So far no reference has been made to Indonesia, the largest Muslim country in the world, with Muslims accounting for 90 per cent of a population of some 165 million. The explanation is that a substantial proportion, especially in Java, are arguably nominal Muslims. Indonesians by and large subscribe to the

Pancasila ideology which is essentially secular in character. The present regime seems to associate Islamic banking with Islamic fundamentalism to which the regime is not at all sympathetic. Besides, the intellectual tradition in Indonesia in modern times has not been conducive to the idea of interest-free banking. There were several well respected Indonesian intellectuals including Hatta (the former Vice President) who had argued that riba prohibited in Islam was not the same as interest charged or offered by modern commercial banks, although Islamic jurists in Indonesia hold the opposite view. The Muslim public seems somewhat indifferent to all this. This, however, does not mean that there are no interest-free financial institutions operating in Indonesia. One form of traditional interest-free borrowing is the still widely prevalent form of informal rural credit known as ijon (green) because the loan is secured on the standing crop as described by Partadireja (1974). Another is the arisan system practised among consumers and small craftsmen and traders. In this system, each member contributes regularly a certain sum and obtains interest-free loans from the pool by drawing lots. The chances of an Islamic bank being established in Indonesia seem at present remote (cf. Rahardjo 1988).

Finally, in the most recent contribution to the growing Islamic banking literature, Nienhaus (1988) concludes that Islamic banking is viable at the microeconomic level but dismisses the proponents' ideological claims for superiority of Islamic banking as 'unfounded'. Nienhaus points out that there are some failure stories. Examples cited include the Kuwait Finance House which had its fingers burned by investing heavily in the Kuwaiti real estate and construction sector in 1984, and the Islamic Bank International of Denmark which suffered heavy losses in 1985 and 1986 to the tune of more than 30 per cent of its paid-up capital. But then, as Nienhaus himself has noted, the quoted troubles of individual banks had specific causes and it would be inappropriate to draw general conclusions from particular cases.

Nienhaus notes that the high growth rates of the initial years have been falling off, but he rejects the thesis that the Islamic banks have reached their 'limits of growth' after filling a market gap. The falling growth rates might well be due to the bigger base values, and the growth performance of Islamic banks has been relatively better in most cases than that of conventional banks in recent years.

According to Nienhaus, the market shares of many Islamic banks have increased over time, notwithstanding the deceleration in the growth of deposits (9) . The only exception was the Faisal Islamic Bank of Sudan (FIBS) whose market share had shrunk from l5 per cent in 1982 to 7 per cent in 1986, but Nienhaus claims that the market shares lost by FIBS were won not by conventional banks but by newer Islamic banks in Sudan.

Short-term trade financing has clearly been dominant in most Islamic banks regardless of size. This is contrary to the expectation that the Islamic banks would be active mainly in the field of corporate financing on a participation basis. Nienhaus attributes this not only to insufficient supply by the banks but also to weak demand by entrepreneurs who may prefer fixed interest cost to sharing their profits with the banks.

Courtesy of Mohamed Ariff, University of Malaya