Transformation away from debt to risk-sharing finance is needed if the IBF industry is to rejuvenate itself and survive long term

pic by TMR FILE

THE days when Islamic banking and finance (IBF) as a sector grew exponentially at rates exceeding 20% seem to be long gone.

According to the Islamic Financial Services Board’s (IFSB) latest report for 2019, Islamic banking globally grew at a pathetic 0.9% while Takaful at 4.3% (2018). Two recent reports on the global prospects for sukuk by Standard & Poor’s (S&P) Ratings Services and Moody’s Investors Service point to a decline in issuance volume this year.

Already, for the first half of 2020 (1H20) the decline is 40%. This is certainly surprising since many Muslim governments faced with plunging oil prices and rising social welfare expenditures due to Covid-19 have sought to raise financing to meet their budget gaps.

One would have expected sukuk issuance to rise sharply, not decline. Interestingly, while sukuk issuance has shrunk, global bond issuance for the 1H20 rose by 25.5% or US$4.5 trillion (RM18.68 trillion).

One could argue that growth rates tend to taper as an industry grows large. This may be true, but the entire IBF sector is currently valued at about US$2.3 trillion, which places it at a mere 1% of total global financial market valuation approximating US$230 trillion.

Given these relative numbers, it is hard to make the case that Islamic banking has reached a size that makes rapid growth difficult.

For perspective, at a 0.9% annual growth rate, Islamic banking grew less than the average GDP growth rate of OIC countries in 2018 of 3.1%. It would also have been lower than the OIC’s population growth of about 2%.

Thus, in relative terms, even within the OIC countries, Islamic banking has been shrinking in relative size. For an industry which in its present form is barely 35 years old, this is premature ageing.

The contrast in growth performance between IBF and its conventional counterpart is indeed stark. And much of the blame for this relative underperformance lies with Islamic bankers and the industry’s practitioners, including the regulators. A strategy of imitating conventional products through replication may have been sensible in the early years when IBF was very new and needed to put down its roots.

But more than 30 years later, there seems to be little more than continued replication. The thinking within IBF seems focused on how to modify conventional products to fit the Shariah requirements, rather than innovating new products that can change the narrative of debt-based banking.

Financing based on risk-sharing principles, which would not only be more congruent to Maqasid Shariah but offer the world an alternative to debt and its problems, is largely absent.

What began as a strategy of replicating products, went on to replicate processes and finally ended up replicating even the regulations.

For example, the IFSB, the standard setter for Islamic banking, has capital adequacy requirements that mirror the Basel requirements for conventional banks. Thus, when financing is based on debt contracts like Commodity Murabaha, the capital requirements are much lower than those of risk-sharing contracts like Mudarabah or Musyarakah, effectively discouraging Islamic banks from risk-sharing finance.

As a result of such blind copying with little thinking, we see today an IBF ecosystem that is fully compatible with debt financing.

So, compatible that the reason for the recent decline in sukuk issuance, according to S&P is the substitution of sukuk with conventional bonds, even by Muslim governments.

For today’s industry players, this may be the easy path, even a seemingly rational one with easy pickings. But, looking beyond the horizon it is obvious that the industry is headed towards further convergence and increasing irrelevance.

When an industry’s products and services have higher transaction costs but offer the same features and outcomes, it cannot be sustainable over the long haul.

Given the years of entrenchment, moving the entire ecosystem out of its current path is not going to be easy.

Yet, transformation away from debt to risk-sharing finance is needed if the IBF industry is to rejuvenate itself and survive long term.

Unfortunately, given competition within the system and conflicting interests of the different stakeholders, shareholders versus depositors, etc, individual Islamic banks may not be able to initiate such changes on their own.

For change to happen, a broad-based regulatory push will be needed. A well-sequenced approach with clear milestones and timelines can alter the industry’s course with minimal disruption.

The need is for innovation, good thinking and political will.


Prof Dr Obiyathulla Ismath Bacha is the professor of finance at the International Centre for Education in Islamic Finance. The views expressed are of the writer and do not necessarily reflect the stand of the newspaper’s owners and editorial board.





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