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The future of Islamic banking

Published on 22nd July, Edition 30, 2013

 

Islamic Banking and Financing has gained a foothold both nationally in Muslim countries and internationally in the financial world. For years, many Islamic banks have registered double-digit growth rates, surpassing their conventional peers. At first glance, all seems well for the Islamic banking industry. There is ample room for growth as Islamic banking rarely exceeds a 3rd of total market share, even in GCC countries and Malaysia.

Many potential markets with large Muslim populations remain largely untapped, such as India and the Commonwealth of Independent states countries, made up of the former Soviet republics. In addition, overall banking penetration in many of the industry’s core markets is still low. GCC countries have not yet achieved the banking penetration levels of countries such as France or UK. At the same time, several new markets have opened up for Islamic banking, with even more on the horizon.

Pakistan is also considered as one of the active and effective players in Islamic finance globally. The State Bank of Pakistan (SBP) is among few regulators that have introduced comprehensive legal, regulatory and Shariah compliance framework for Islamic banking industry. More presently in Pakistan, asset base of the Islamic banking industry registered growth during the 1QFY13 reaching Rs847 billion compared to Rs837 billion during the last quarter of FY12. In terms of share in overall banking industry, Islamic banking assets reached 8.7 percent during the period under review. Investments and financing were registered increase during the 1QFY13. On the other hand, the share of Islamic banking industry deposits in overall banking industry remained unchanged at 9.7 percent as of previous quarter. Consequently, ROE and ROA both declined compared to previous quarter.

Erode profitability

Although Islamic banks have generally outperformed conventional banks in terms of growth over the past decades, they have not consistently outperformed them in terms of profitability. For example, several small Islamic banks in the GCC have been struggling for years to turn profitable; others have been badly affected by the regional economic crisis. More importantly, some major Islamic banks, notably in the GCC, have witnessed declining profit margins over the past 5-year. Strategically, this means that Islamic banks, which so far often purely emulate a conventional bank’s offering, need to revisit their positioning. Operationally, they need to seek greater efficiency across the value chain.

Competing conventional banks

It is a truth that many Islamic banks are competing head-on against their conventional peers. However, not all may realize that a head-on strategy has fundamentally different implications than a strategy of exploiting the Islamic banking niche. Competing against conventional banks means attracting customers who place less importance on Shariah compliance in their financial dealings, and more importance on competitive products and efficient services vis-a-vis the banking market at large.

 

Successfully attracting customers require meeting a broader set of customer needs, while remaining on par with conventional banks in terms of ease of use and pricing. To achieve this, product innovation is paramount both in terms of broadening offerings using existing Islamic structures, as well as developing new Islamic structures. Banking services and products for small and medium-sized enterprises, which are still only emerging in Islamic banking, and ethical banking products such as funds focused on investments in sustainable energy, provide an opportunity to broaden the offering. New Islamic banking product structures not easily replicated in a Shariah compliant manner include hedge funds ‘ an alternative asset class for high net worth individuals and derivatives for corporate clients. While some Islamic banks offer Islamic derivative products, such products are not generally accepted as Shariah compliant. When competing against their conventional peers, Islamic banks typically are at a scale disadvantage, as they are often smaller in size. In retail banking for example, the disadvantage is most significant in the size and range of the branch network. To compete successfully, head-on with conventional banks, particular focus on two areas is required. Firstly, Islamic banks should explore the use of alternative channels such as updated online banking and phone banking to gain market share. It will be important to use them much more as a sales channel rather than the present service focus.

Secondly, the use of different branch models should be explored, depending on target segments’ needs to full-service branches covering all customer segments.

Alternative branch models have the additional advantage of potentially reducing capital investments, operating costs and set-up times, and are particularly powerful if coupled with alternative channels.

A modern, customer-centric image that emphasizes ethical values and social or environmental efforts will reach the widest audience of both Muslim and non-Muslim customers. Alongside this is the need for education programs on Islamic banking products and structures. In deciding to compete head-on with conventional banks, a first step is to build a strong domestic base before expanding internationally. Domestic mergers and acquisitions (M&A) can offer attractive opportunities to achieve scale-related synergies from larger operations. Strategic M&As allow Islamic banks to compete more effectively with the larger conventional banks by expanding branch networks, taking advantage of operational synergies, and expanding their financial clout.

Future outlook

Growth over the past many years continues to generate optimism for the future of Islamic banking. But as competition ramps up Islamic financial institutions have plenty of work to do.

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