Islamic banking: Can conventional banks offer Islamic products.
Customers are often worried and sceptical when a conventional bank starts offering Islamic banking products alongside its interest-based business. It could be taken as a ploy by conventional banks to take advantage of the commercial opportunity offered by Sharia sensitive customers. After all, how can the same bank be both conventional and Islamic at the same timeTo answer this question, the bankers and the customers need to appreciate the unique aspects that make Islamic banks different to conventional institutions. Once these parameters are understood, they would serve as a reference point to assess the credibility of the Islamic window offering by financial institutions.
Concept of Islamic window
In most jurisdictions, it is permissible for conventional banks to operate Islamic banking business through a 'window' operation. The Central Bank of Oman has also endorsed this view, which suggests that the market could see a number of conventional banks entering the Islamic finance space.
The concept of Islamic banking window requires the conventional financial institution to have a distinct operational infrastructure for its conventional and the Islamic business. Compliance is monitored by the regulator as well as the Sharia authorities, and further strengthened through independent Sharia audits conducted by professional firms.
As a result, Islamic banking window operation is generally accepted as a successful model and in many markets, like Saudi Arabia and the UAE, Islamic windows of conventional banks are consistently gaining ground. In UAE, Islamic windows account for 11 per cent of the Sharia assets, whereas in Saudi Arabia their share is almost half of the total Islamic asset base. Successful Islamic windows understand various Sharia implications on the banking business and are able to apply this in their strategy, operations, product, governance and risk management functions.
Positioning strategy
For conventional banks, a good understanding of the Sharia sensitive customers would help define the go to market strategy, the operating model and the expected return on investment from Islamic banking business. Based on Ernst and Young's experience of well over 300 strategic projects in Islamic finance sector, we understand that there are trade-offs involved and choices to be made depending on the strategic objectives of the bank.
For conventional banks in Oman, the Islamic banking window is likely to serve a variety of objectives - including defending the existing customer and revenue base, growth, diversification to new segments, and access to Islamic liquidity.
Experience of other markets suggests that level of success may vary for each bank, depending on the real and perceived credibility of their Islamic proposition.
For example, in one case the Islamic banking subsidiary of a large regional bank was incurring substantial losses after few years of a successful launch. It turned out that its customers perceived the Islamic operation as 'too close' to the conventional parent and this undermined the credibility of its Islamic banking proposition. The situation was corrected through a brand re-positioning exercise to win back the trust of the customers while ensuring that the Islamic banking subsidiary continues to enjoy the cost and operational synergies accruing from conventional parent.
Product programmes
Islamic banking products are unique in that the same product may have a variety of different underlying Islamic contracts (for example, auto finance may be provided under Murabaha or Ijarah structure, or house finance may entail Murabaha, Musharaka, Ijarah or Istisna'a structure). Two points are worth mentioning here.
First, the choice of underlying contract requires a proper understanding of the local banking laws (which may restrict the type of 'asset risk' a window can assume) and tax laws (e.g. transfer duty in case of leasing contracts), and mapping these to Sharia acceptable structures. The choice of underlying contract will determine the level of financial and balance sheet flexibility that the Islamic banking window would be able to enjoy (for example, Ijarah contracts can be securitised whereas Murabaha would be considered a debt instrument with serious restrictions on sale of debt).
Secondly, the product design must follow a specific 'sequence' when executing a transaction as approved by the Sharia board; non-compliance may cause loss of income if the transaction is nullified.
Product structuring and process design are of paramount importance given the risk that income from a particular transaction can be nullified and be required to be donated to charity if it is established that the prescribed 'sequence' approved by the Sharia function was not followed. This has been the case with several Islamic financial institutions that were tempted to adopt an informal product design, and were subsequently penalised by the Sharia board upon non-compliance.
Operational implications
It is a necessary Sharia requirement that the sources and uses of Islamic funds must be accounted for separately than conventional funds. From operational perspective, this requires the technology and information system to be configured appropriately, and for accounting and internal controls to be customised according to prescribed standards. Here, leading practices as set by Islamic Financial Services Board and the Accounting and Auditing Organisation for Islamic Financial Institutions serve as a useful reference point.
Governance implications
Similar to full Islamic banks, all Islamic banking windows are generally required to have a Sharia Supervisory Board that is responsible for approving the products, transactions and conduct of the business. The board should comprise of Sharia scholars who are conversant in Sharia matters as well as contemporary banking business. The appointed scholars should also conform to the fit and proper criteria set by the regulator.
Additionally, Islamic windows and banks are also required to have a Sharia compliance function within the standard compliance department, which is responsible for facilitating and monitoring the day-to-day activities of the Islamic business.
The credibility of the windows is further strengthened through independent Sharia audits that may be conducted by professional firms. Internationally, there is growing demand to make this a compulsory annual requirement.
Risk and regulatory compliance
An important aspect of a successful strategy is to have a good understanding of the risks that are unique to Islamic banking business. For example, the choice of underlying Islamic contracts would have implications on the regulatory capital requirement, since each contract attracts different risk weightages.
Other unique issues involve the treatment of Islamic customer deposits as equity, equivalent to conventional deposits, or a hybrid instrument (depending on the Wakala, Amanah or Qard contracts involved). There are also discussions around the risk treatment of Mudaraba financing, treatment of displaced commercial risk and the application of profit equalisation reserve and investment risk reserve for Islamic windows.
A careful articulation of the strategy would help Islamic windows optimise regulatory capital charge and manage the overall risk profile of the Islamic business.
Opportunity follows credibility
In May 2011, Oman opened its doors to Islamic banking business through a royal decree. Oman has a population of 2.9 million and a GDP size of circa $50 billion. Total banking system assets were $42 billion, and customer deposits were $27 billion in 2010. For banks in Oman, the Islamic banking opportunity could be substantial. In Saudi Arabia, Sharia compliant financing account for 57 per cent of the total lending and all of the retail banking activity is Sharia compliant. In UAE and Qatar, share of Islamic banking assets have grown at a CAGR of 38 per cent and 50 per cent respectively, over past several years.
For Oman, a 10 per cent share of the market would imply Islamic banking assets of $6 billion by 2015. By conservative estimates, a three per cent market share could equate to $2 billion in Islamic assets. Either way, analysts agree that no major bank can afford to ignore the opportunity.
Ashar Nazim and Abid Shakeel - two experts on Islamic finance - are working with the Islamic Finance Centre of Excellence at Ernst and Young in Bahrain. Nazim is a director and leads the Islamic Finance Center of Excellence at Ernst & Young, while Shakeel leads the banking, capital markets and takaful team within the Islamic Financial Centre of Excellence with Ernst & Young.
The views expressed by our contributing writers in the article are their own and may not necessarily reflect those of Times of Oman.
Part:VII: (Special to Times of Oman)
Muscat Press and Publishing House SAOC 2011
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| Publication: | Times of Oman (Muscat, Oman) |
|---|---|
| Geographic Code: | 7OMAN |
| Date: | Jun 7, 2011 |
| Words: | 1363 |
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