Sunday, January 20

Only a negligible bit of Islamic bank financing in Malaysia is strictly Islamic

Now here's a surprise, these two academics in a recent paper have determined that only 0.5% of Islamic Bank financing on the asset side is based upon true Islamic finance principles. On the liability side, the situation is different and has true Islamic deposit which account for 70% of the overall deposit base. In other words, if I understood this correctly, the depositors are doing well according to the Islamic Finance theory, but the lending side is not.

But the situation is a bit different when they dig into the deposits side. The authors further determine that the rates on the mudarabah deposits is lower than conventional rates and very closely follows the conventional rates (but not vice versa). In other words, to determine the mudarabah deposit rate, take the conventional interest rate, subtract a discount and offer to customers. I quote from their conclusions:

First, unlike conventional banking, PLS financing encounters severe principal–agent problems. Moral hazard problems associated with ex-post information asymmetry, for example, are especially significant in PLS financing because the entrepreneur (borrower) has incentive to under-declare or artificially reduce reported profit.

Also, in the case of mudarabah (profit-sharing) contracting, the entrepreneur has an incentive to undertake high-risk projects because the entrepreneur is actually given a call option whereby he or she gains on the upside but bears no losses at all on the downside. PLS financing, thus, requires more costly monitoring.

Second, the adoption of PLS financing is disadvantaged by a lack of management and control rights.

Finally, our study suggests that the adoption of the PLS paradigm is constrained by competition as well as by best practices from conventional banking. Religion notwithstanding, individuals can choose to bank with an Islamic bank and/or a conventional bank. Thus, in terms of best practices, Islamic banking practices often cannot deviate substantially from those of conventional banking because of competition. In particular, our study shows that the returns on the Islamic deposit accounts are effectively pegged to the returns on conventional banking deposits because of competitive reasons.

I concur with the two conclusions, but that is no different from any other venture, initial, angel, initial feedstock, project or any other kind of entrepreneur or corporate funding. In other words, you will hit these problems anyway irrespective of what kind of banking system that you run. If you remove conventional banking, then the third problem goes away (ostensibly!).

So even if you remove conventional banking from your country, you will still have an (implied) interest rate because other countries have conventional banking systems, and you have a currency exchange rate. So I can determine what an implied interest rate would be. Only way around this problem would be to convert the entire world's financial system to Islamic Banking.

But that still does not remove the problem of actually determining the proper rate of return in the absence of an interest rate. While large projects can have that kind of Private Equity or investments structure, for smaller sums, it is simply not effective or efficient for you to determine a suitable rate of return. Each transaction will take so long that you will become constrained very soon. In other words, if you have to do a full analysis every time anybody wants a mortgage, overdraft, working capital loan or what have you, the banking system will soon come to a grinding halt. On the other hand, you simply cannot expect every depositor to understand how the bank is performing to really evaluate the profit contribution of deposits kept in the bank.

Very interesting indeed. If Malaysia, which has the arguably most advanced Islamic Banking Market is showing these signs, then well, there is much further to go before the market is developed and settled down, avoiding problems like this.

Here's the paper in question:

Beng Soon Chong and Ming-Hua Liu, Islamic Banking: Interest-Free or Interest-Based, Pacific-Basin Finance Journal In Press, Abstract: A unique feature of Islamic banking, in theory, is its profit-and-loss sharing (PLS) paradigm. In practice, however, we find that Islamic banking is not very different from conventional banking. Our study on Malaysia shows that only a negligible portion of Islamic bank financing is strictly PLS based and that Islamic deposits are not interest-free, but are closely pegged to conventional deposits. Our findings suggest that the rapid growth in Islamic banking is largely driven by the Islamic resurgence worldwide rather than by the advantages of the PLS paradigm and that Islamic banks should be subject to regulations similar to those of their western counterparts.

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