Islamic banking
Islamic banking, a new approach for financial inclusion
Khaled Zohdi Zamer
Mobile Money specialist – Researcher, Jordan
Correspondence address: Khaled Zamer, Al Fattan currency house, 23rd Floor, DIFC – Dubai. Tel: 971-555-472246. E-mail: [email protected]
Abstract:
This study aimed to explore using Islamic banking as a new approach to tackle the challenges of financial inclusion in middle east and sub-Saharan Africa where the majority of populations are Muslims and have challenges in accessing the financial instruments. There are different barriers to financial inclusion, one of these is the voluntary exclusion due to religious reasons and the other is the high cost of interest charged to small borrowers. Islamic banking seems to offer reasonable solution to these challenges where the interest is replaced with other tools based on partnerships and social cooperation. However, banks might be facing different type of challenges such as the regulation and customer reach in absence of profitable margins. The other factors impacting adoption will be to offer an economic access to the service without heavy investments from the banks, and maintain high service standard to create trust and drive adoption.
Keywords: Islamic banking, Mobile money, Islamic financial inclusion mobile money service pillars
Introduction:
The Middle East is home to 85 million of the world’s 2 billion unbanked adults. And despite the region’s financial inclusion woes, there is room for optimism: There is no doubt that access to financial services is becoming more important than ever to help in building sustainable and quality livelihood for the people and ensure the stability of socio-economical system. The majority of population in middle east and sub-Saharan Africa are Muslims yet this is the least financially inclusive part of the world. This paper study the relation between Islamic banking, economic development and customer perception to improve financial access to the mass population.
1.1. Modes and Instruments of Islamic Banks
The following section explain the Sharia’a- compliant Islamic banking modes of financing;
1.1.2 Murabaha (cost-plus) refers to a sales contract, whereby the Islamic bank (IB) sells a specific asset to a customer at a pre-agreed profit mark-up on the original cost. Kettel (2011) mentions that the actual sale of a real asset is a necessary condition for the contract to comply with Sharia’a principles. Al-Tiby (2012) also asserts that Murabaha is one of the most primarily used instruments by Islamic banks and constitutes over 70% of their assets.
1.1.2 Salam is a forward sale, where the IB pays in advance for buying specified assets at a predetermined price, quality and quantity specifications, which the seller agrees to supply on a future date. Siddiqi (2008) declares that it is used for products that can be traded on secondary markets such as agriculture or mineral products.
1.1.3 Ijarah (leasing) is an agreement made by an IB to purchase an asset and lease it to a customer for an agreed period of time against fixed rental charges. The bank must retain the risk and liabilities of asset ownership including maintenance. Ijarah wa iqtina, offers the lessee an option to own the asset at the end of the lease period as stated by Kahf et al (2007).
1.1.4 Istisna’a is an agreement to sell a non-existent asset to a customer, which is to be produced for future delivery at pre-determined prices and quality specifications. These contracts are used for financing manufacturing and construction as cited in Geelani(2005).
1.1.5 Takaful is a Sharia’a compliant system of insurance in which the participants donate part of their contribution to pay claims for damages suffered by some of the participants. Chapra (2012), Hassan (2010) and Kettel (2011) emphasize that the bank’s role is restricted to managing the insurance operations and investing the insurance contributions.
1.1.6 Mudarabah instruments are the cornerstone of Islamic Banking based on the profitloss sharing principle. Iqbal and Mirakhor (2011) indicate that it is a contract between two parties; an Islamic bank as an investor (Rabul Mall) who provides a second party, the entrepreneur (Mudarib) with financial resources to finance a particular project. Ikha et al (2011) assert that profits are shared between the parties in a portion agreed in advance, while the losses are the sole liability of the IB because the Mudarib (entrepreneur) sacrifices only his/her efforts and expected share in profits.
1.1.7 Musharka refers to an equity participation contract because the bank is not the sole provider of funds. Consequently, as affirmed by Geelani (2005) two or more partners contribute to the joint capital of an investment, hence profits and losses are shared strictly in accordance to the respective capital contributions written within the terms of the contract.
1.2. The study motivation
This paper is an attempt to explore using Islamic banking products to overcome the barriers in financial inclusion in Middle east and sub-Saharan Africa as alternative to conventional banking.
1.3. Source data:
Demographic data (World bank, IMF, Country profiles)
Number of account holders (Central banks, annual reports)
Cross country comparison of financial inclusion (CGAP, Financial inclusion measurement, 2017)
2 Assets growth and challenges
According to the World Islamic Banking Competitiveness report published by Ernst and Young (2012), “Islamic banking assets with commercial banks globally grew to $1.3 trillion in 2011, suggesting an average annual growth of 19% over past four years.
The Islamic banking growth story continues to be positive, growing 50% faster than the overall banking sector.” Recent studies carried out by Khamis and Senhadji, (2010), Hassan and Dridi (2010), Rashwan (2012), and Merchant (2012) to empirically contrast performance of Islamic banks (IBs) and Conventional banks (CBs) pre and post the global financial crisis argue that performance of Islamic banks during the 2008 financial crisis was more efficient than their counterpart conventional banks; as their mechanism complying with Islamic Sharia’a proved better resilience to negative profitability and speculation that tremendously affected conventional banks. Consequently, this led to the phenomenal widespread of Islamic Banking in an attempt to stabilize financial systems and restore investors’ confidence in the banking industry as affirmed by Jusufovic (2009).
Ernest ; Yong predicts a 14% growth in Islamic banking by 2020 to exceed 1.8 trillion USD with Saudi Arabia leading the industry with 683 billion, the total liabilities for Islamic banks were 21.8% in 2014 ; expected to reach the level (22%-25%) of total liabilities of the banking system in 2015 (ABJ, Annual Report, 2014). Total Assets of Islamic Banks (LAIB) can predict the economic growth as affirmed by AL-Hersh (2016) as well (Ahmad, 2004) and (Muhamad. A and Azmi Omar. M, 2012) predicted that Islamic banking would control over 50% of savings in the Islamic countries within the next decade. With the previous researches confirming Islamic banking can drive the economic growth similar to conventional banking there is an emerging need to develop more cohesive financial products designed to the low income poor, however the outreach of formal financial services in the Arab world stands at only 21 percent when excluding the Gulf Cooperation Council (GCC) countries, the lowest worldwide as highlighted in the CGAP report (2017).
According to the Findex Note on Financial Inclusion in the Middle East (Demirguc-Kunt et al. 2015), account ownership is the lowest, most notably for women, low income people, and youth which represent the majority of Middle East population. CGAP report highlighted the region shows equal or higher financial activity, but lower outreach of formal financial services, be it for account ownership or for credit. This gap between demand, accessibility can be bridged by offering a wider access channel to financial instruments at a lower cost of service which can maintain the profitability ratios for the Islamic banking sector. To build a partnership model between Islamic banks and the low income Asli (2013) highlighted several questions relevant to the Islamic finance industry:
(1) Are Muslims less likely than non-Muslims to use formal financial services in their current form?
Muslims are significantly less likely than non-Muslims to have an account and save at a formal financial institution, when controlling for other individual- and country-level characteristics. As a Muslim is associated with a 6 percent decrease in the probability of having a formal account, which is larger than the gap between men and women and roughly equal to that of an exogenous shift from the third to the first (lowest) within-country income quintile. However, Muslims are more likely than non-Muslims to report religion as a barrier to account ownership.
With this in mind, there is a definitive need to offer Islamic products to the poor in order to avoid further exclusions of the poor, Sana Beg ; Naushadul Mulick (2016) concluded to increase financial inclusion, countries with higher Islamic population need to develop products that are compatible with the principles of Islamic finance.
(2) Do unbanked Muslims differ from unbanked non-Muslims in their self-reported barriers to financial inclusion?
Similar to non-Muslims, Muslims are more likely to cite cost, distance, and documentation as barriers to account ownership. Relatedly, there is no evidence that religion plays an important role in the financial behaviours of Muslims as compared to their non-Muslim counterparts. Critics, however, argue that Islamic banks are different than conventional banks in name only, with some claiming that, because of underdeveloped standards and a lacking regulatory-supervisory framework, Islamic banks are in fact more risky than conventional banks (Musa, 2010).
Robert MorrisseyE (2012) highlighted that even in Saudi Arabia, a country distinguished by its Islamic practices, the Islamic Development Bank saw 92% of its income in 2007 come from non-PLS structures such as murabaha and ijara (Khan, 2010). This imbalance indicates that while Islamic banks satisfy many devout Muslims in name, the underlying financial structures they employ— and thus the risks inherent in Islamic banking— in many ways resemble those of conventional banks.
(3) How prevalent is awareness and use of Sharia-compliant financial products?
Izah Tahir et al (IBTRA) highlighted 5 gaps between customer expectations Vs awareness and quality of services offered by Islamic banks:
Gap 1 (Understanding): the difference between consumer expectations and management perceptions of consumer expectations
Gap 2 (Service standards): the difference between management perceptions of consumer expectations and service quality specifications
Gap 3 (Service performance): the difference between service quality specifications and the service actually delivered
Gap 4 (Communications): the difference between service delivery and what is communicated about the service to consumers
Gap 5 (Service quality): the difference between customer expectations of service quality and customer perceptions of the organization’s performance
And concluded that customers using Islamic banking products are not fully aware of the different products and services as well there is lack of regulatory framework with absence of international Sharia board widen the gap and would cause misconceptions.
(4) To what degree are Muslims willing to pay a premium for Sharia-compliant financial products and services?
OliverWyman (2011) indicated that banking clients are willing to pay a premium for Islamic banking services, and a majority of Muslim customers who currently use conventional banking products claim that they would switch if Islamic products were available. However, there is a need to build the right balance when setting the pricing structure to serve two objectives, follow the Islamic finance guide lines and ensure customers are not excessively charged for the service, and maintain profitable margins to the banks. The banks can offer modern products using Shaira principles in a way that can promote financial stability and growth, The Economist (2014) highlighted that in Islamic mortgage, for instance, a bank does not lend money to an individual who buys a property; instead, it buys the property itself. The customer can then either buy it back from the bank at a higher price paid in instalments (murabahah) or make monthly payments to the bank comprising both a repayment of the purchase price and rent until he owns the property outright (ijara).
(5) What are the barriers for owning a bank account?
Gallup research on number of bank account holders (2015) showed a growth in number of adults whose been introduced to financial services, however with 43% of the world unbanked population resides in middle east and sub-Saharan Africa there is a big room for improvement. The Muslim population represent 30% of the sub-Saharan Africa and 91% of the Middle east region according to Pew research center (2011).
Findings and Recommendations
The success of Islamic financial inclusion is based on three pillars (Product structure, Access Channels, Service Quality):
Product structure and pricing:
Banks in general and Islamic banks in specific needs to offer financial products that can cater for the mass market and specifically design services with the following principles in mind (Low cost, Mobile, minimum collaterals, accessible and easy to use), Becky Carter (2013) highlighted different reasons for exclusions which must be considered when designing new products to ensure proper adoption and benefits.
Institutional formal exclusion: Where banks and microcredit opt to avoid doing business with the poor or people in remote areas
Institutional formal exclusion: sales agents avoiding offering services to people with certain segments
Client informal exclusion: lack of confidence, trust or awareness
Client exit: if the institution is not implementing pro-poor policies the clients will not do repetitive transactions
Rajiv Lal & Ishan Sachdev (2015) indicated that target marketing is the key driver for adoption as that provides customer with the right education on usage, as well when certain behaviours are incentivized customer are more likely to use the service
Access channels
Despite the increase in number of branch networks ATM access and availability of online banking services the gap between rich and developing countries is still big. The world as a whole had 47 ATMs and 17 commercial bank branches per 100,000 adults in 2011. Low- and lower-middle-income countries had 3.2 and 13.1 ATMs per 100,000 adults in 2011, respectively, while this figure is 76 in upper middle-income countries and 123 in high-income. This is showing a higher need for a more viable and economic ways to reach people especially in remote areas. Banks deploy ATM devices in main cities, shopping centers and other urban areas where there is a need and potential of use as well access to customer who in nature are mostly have a bank account, while the actual need remains in rural under developed regions. The GSMA real-time tracker showing more than 8 billion devices and over 5 billion unique mobile subscribers. This might give the answer to which channel can reach most of the customers in the shortest period without compromising the profitability margins for the bank. While mobile financial services seem to be the answer to all financial inclusion access, there are still some roadblocks in the way such as regulation, KYC and building the ecosystem as well the technology might not help all the time where mobile network coverage is not available, advanced 3G services are not affordable and absence of a national ID platform. However, despite all these burdens mobile remain the best option for now. The policy makers need to work on regulations to allow banks, correspondent banking and digital only banks to operate freely to offer financial services to the mass public.
Service quality
It is without doubt, that service availability and quality plays a significant role in building trust and deliver value which in turn translates into recurring transactions and results in profitable operation. Houn?Gee Chen (2012) affirmed that service quality not only has a positive impact on customer satisfaction, but also plays a role gaining customers’ trust and deliver value, which in turn lead to customer satisfaction. Zeithaml (1987) mentioned that service quality is considered to be a cornerstone in the customer perception towards trust and excellence. With the later in mind (Crosby, 1991; Reichfeld and Sasser, 1990; Edvardsson and Gustavsson, 1991; Adil, 2012; Adil, 2013a, Adil, 2013b) summarized the direct impact of service quality on customer perception:
Satisfied and retained customers and employees
Opportunities for cross-selling;
The attraction of new customers;
Development of customer relationships;
Increased sales and market shares;
Enhanced corporate image;
Reduced costs and increased profit margins and business performance.
The banks should focus on delivering a service quality to the end customer at an affordable price to ensure they maximise the benefits from financial products which in return will reflect on banks profitability and economic development.
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