During 2008, as the extent of the mortgage crisis and the credit crunch became apparent, the global market for credit dried up. Businesses and consumers in the US and Europe were left searching for capital to facilitate their businesses and lifestyles. Conventional markets could be characterised by the saying “never have so many owed so much to so many” – and now history is recording our credit wisdom (or folly).
Credit, or more specifically debt, is the foundation of financial activity in Western nations, as consumers willingly push their personal debt well beyond their means to repay it.
Regulatory discipline
Debt is not bad when used as a tool of modern finance. Economic development shows there is a direct correlation between growth and a liberalisation of the financial markets, exemplified in Latin America during the past 20 years. The lesson learned in Latin America, however, is that financial liberalisation must be accompanied by a more disciplined regulatory environment to generate sustainable economic growth.
In the light of the current crisis, institutions offering sharia-compliant financial instruments have fared far better than their conventional counterparts. Islamic finance is not immune to the influence of the credit problems found in world markets, as numerous Islamic institutions have identified their exposure in recent weeks. However, what has become obvious is how sharia-based financing is substantively different from conventional debt-based finance.
According to Stephen Lange Ranzini, president of University Bank in the US: “The strength of the Islamic banking model is that risk sharing is inherent, which in turn improves a bank’s risk profile. If we do a good job avoiding risks, our depositors will benefit and more will come to us.”
In today’s socio-economic conditions, debt-based national economies are continually pushing the burden of public debt repayment to future generations. Consumers, meanwhile, speculate their repayment abilities against their future earning power – but are no longer as confident about this as in previous years.
Therefore, Islamic finance seems to offer world markets an alternative approach that, under the right economic conditions, coupled with growing regulatory supervision by central banks, contains the elements of higher-quality financial instruments.
The old adage in investing is “no risk, no return”. While this might sound as if it advocates rampant risk taking, risk within an Islamic context translates into “managed risk equals managed returns”.
Risk sharing concept
Islamic or sharia-compliant banking employs the concept of risk sharing. Its main tenet lies in the establishment of equality between parties during the life of a transaction and its settlement. A secondary tenet is the exclusion of financing based on a fixed, predetermined return.
The value of the core belief of Islamic banking in sharing the profits and risks in a business instead of becoming creditors is becoming more apparent as Western markets suffer new economic challenges.
Although it may seem a trivial point, the fundamental construct of Islamic banking (whereby the depositor, the bank and the borrower all share the risks and rewards of financing business ventures) is elevated to prominence. This feature of risk/reward sharing is unlike the interest-based commercial banking system, where all the pressure is on the borrower to repay the loan with an agreed interest, regardless of the success or failure of a business venture.
The foundation of Islamic finance is to encourage investment in order that the whole community may benefit.
Islamic bank card
In several Islamic finance markets, 2007/08 witnessed the introduction of Islamic bank cards, which work like debt and or credit cards, often linked to sharia-compliant credit instruments and mirroring their interest-bearing counterparts while preserving Muslim values. Ebrahim Fayez Al Shamsi, CEO of Emirates Islamic Bank, says: “Islamic finance charges a lump sum membership fee for each class of cards with a specific credit ceiling. When the customer pays on time and does not use the full credit ceiling allowed, he gets an optional rebate on his membership fees. In other words, customers are discouraged from running amok with their borrowing and indulging into conspicuous consumption, while they are encouraged to use credit wisely.”
Our research of the Top 500 Islamic financial institutions revealed that within the local consumer markets, a greater sense of social values has combined with an emerging set of economic conditions, creating regional consumers with a higher degree of credit quality. However, the longevity of this credit phenomenon has yet to be substantiated by any empirical evidence, which will be more apparent in subsequent years of analysis.
Perhaps the growth of Islamic finance will extend beyond the currently served market segments of wealth and employed consumers – and will address the financial needs of the vast Muslim populations that reside in the bottom half of the economic pyramid. Many Islamic institutions are considering consumers who have habitually been unbanked as the next challenge to demonstrate to world markets that sharia principles can be practised on a large scale.
Uncharted territory
Therefore, at the end of 2008, Islamic institutions are preparing to move into uncharted financial territory as the bulk of lending shifts from the wealthiest segments of society to lower-income earners.
Overall, Islamic consumer markets seem to have been insulated from the darker side of consumer credit to some degree, so conceivably, an undercurrent of Islamic values, a sense of community and a belief in doing what is right for society will reduce the number of credit problems suffered by Western economies.
However, arguably Islamic financial institutions must be proactive in warding off future credit problems by ensuring customers have a clear understanding of their products and use them within the context of a personal financial plan. Antoine Sreih, CEO of Europe Arab Bank, says: “Islamic finance is about relationship building, a series of interactions between an institution and a customer that enables a bank to understand better how consumers are using sharia-compliant financial instruments to facilitate their lifestyles.”
In Mr Sreih’s view, a bank must create a process that is a dialogue between itself and the customers, which in turn earns a customer’s loyalty, enabling banks to leverage their financial position.
Islamic finance offers consumers an alternative approach to financing their lifestyles. Consumer financing markets within Islamic nations will continue to grow across the globe along a predictable trajectory as has been seen in recent years’ analysis. Muslim consumers will continue to demand new financial instruments, challenging Islamic financial institutions to deliver a wider range of products, catering to numerous emerging Muslim lifestyles and to support the rising interest from non-Muslim consumers, investors and businesses.
Another factor to consider is that within the economies of emerging nations, during the past 18 months a significant shift has occurred in the sources of foreign direct investment emanating from Middle East and Asia to Africa, as traditional investment from the US and Europe has waned in the economic crisis.
Emerging markets
Islamic institutions are making significant inroads into emerging markets as a means of financing government projects, business and consumer needs. Moreover, institutions offering sharia-compliant financial services are entering markets such as Kenya (Gulf African Bank) and South Africa (ABSA Islamic Bank) with a clear mission to achieve a high degree of market share as early market entrants.
This brings to mind another old investment adage: “It is not timing the market but time in the market that counts.”
