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Challenges facing Islamic banking industry

By Umer Ahmed
ARTICLE (November 12, 2010) :The emergence and growth of the Islamic finance industry is a phenomenonthathasgeneratedconsiderableinterestinthefinancialworldinrecentyears.Givenits ability to offer innovative financial solutions to an underserved market, it is seen as a socially responsible, faithbased banking niche with considerable growth potential. In the Muslim world and increasingly in the West, significant segments of the institutional and retail markets are increasingly choosingIslamicfinancefortheirfinancingandinvestmentneeds. Today,morethan500IslamicFinancialInstitutionsareoperatingthroughouttheworld.Westernbanks are also doing Islamic banking, through their Islamic Units in U.K, Germany, Switzerland, Luxembourg andothercountries.Theindustryisgrowingatarateofroughly15percentperyear,andcouldserve40 to50percentoftheworld'sMuslimpopulationwithinadecade. StateBankofPakistansreleasedfiguresindicatethatbranchnetworkofIslamicBanksinPakistanhas growninexcessof649branchesinMarch2010.ThetotalassetbaseoflocalIslamicBankingindustryis Rs.366bnandtheDepositbaseisRs.283bn.Theindustryhasshowntremendousgrowthrateof55% sinceinception.TheeverincreasingshareofIslamicBankinginthelocalBankingsystemstandsat5.9%.
Market Share of Islamic Banking Assets

Despite the impressive growth, the Islamic banking industry is facing a number of challenges that are preventing it from attaining an even higher pace of growth. Some of the most important issues are identifiedbelow.

7 6 5 4 3 2 1 0 1.5 0.5 Dec. 03 Dec. 04 Dec. 05 Dec. 06 Dec. 07 Dec. 08 Dec. 09 Mar. 10 2 2.8 4 4.9 5.6 5.8

Source: State Bank of Pakistan

SHORTTERMLIQUIDITYMANAGEMENT The lack of investment avenues, especially shortterm, has been one of the major problems faced by IslamicFinancialInstitutions(IFIs)inPakistan.IFIscannotinvestinconventionalinterestbasedsovereign debt instruments such as Tbills and Pakistan Investment Bonds. Therefore, short term liquidity managementhasbeenakeychallenge.AlthoughGovernmentofPakistanIjarahSukukin2008provided some relief as an alternative to PIBs; however, due to limited supply and increasing demand from Islamictreasuries,theseSukukarerarelytradedinthesecondarymarket.Ashorttermliquiditysolution isstillawaitedfromthegovernment. REGULATORYANDTAXREFORMS
Total Islamic Banking branches

Government patronage and regulatory/tax reformsplayapivotalroleforanyindustryto grow with leaps and bounds. On the international front, governments like United Kingdom and Malaysia are offering relaxed rules and taxation for tapping the great demandforShariahcompliantinvestmentby Muslim investors, specially from the Middle Source: State Bank of Pakistan East. Pakistan too can become a regional hub for Islamic finance if proper regulatory reforms are introduced.Toachievethisgoal,theGovernmentneedstorevamptheexistingstructureoftaxesand dutiestomakethemconducivetoIslamicfinance.Themostimportantareaswhereincentivescanbe offeredare:
700 600 500 400 300 200 100 651 654 515 289 150 17 48 70 0 Dec. 03 Dec. 04 Dec. 05 Dec. 06 Dec. 07 Dec. 08 Dec. 09 Mar. 10

I.STAMPDUTIES Stamp duties, especially the land revenue duties paid at the time of transfer of property increase transactioncostsandhampersassetsbasedfinancing. II.TAXINCENTIVESFORINVESTORS Islamic banks are new players in the market and they should be given some relaxation in terms of taxation. Theoretically speaking, depositors in Islamic banks are partners with Islamic bank and they share in actual profits and losses, as against interest based banks where depositors are creditors and their principal is protected. Therefore, to encourage people to invest in Shariah compliant products, Government should introduce incentives in the form of tax credits. When we look at international

markets, for example, the Malaysian government has given certain incentives for investors in Islamic financeindustrytilltheyear2016tomakeMalaysiaaregionalhubforinvestment. iii.REGULATORYRESERVESANDCAPITALREQUIREMENTS The regulatory capital requirements like Minimum Capital Requirement (MCR), Current Reserve Requirement (CRR) and Statutory Liquidity Reserve (SLR) requirements serve to stabilize the financial sector.However,thenatureofdepositorsintheIslamicbankingindustryisentirelydifferentfromthat of conventional banks; therefore, percentages for regulatory reserves for Islamic banks should be relaxedfurtherkeepinginviewtheirpeculiarriskprofile.Thiswillcreatealevelplayingfieldandbetter reflectrisksharingnatureofdepositsinIslamicbank. HUMANCAPITAL Sinceinceptionoftheindustry,thesupplyoftrainedorexperiencedhumanresourcehaslaggedbehind theexpansionofIslamicbanking.ThereisadearthofqualifiedbankerswhoarewellversedinIslamic lawsaswellascontemporaryeconomicsandfinance.Currently,fewuniversitiesandtraininginstitutes areofferingcoursesinIslamicfinancebuttheyalsofacelackofcompetenthumanresourcestoconduct thesecourses. At theexperts level, there are only a few scholarswith the requisite knowledge and expertise in the field of Islamic finance. Therefore, the industry has to rely on a handful of Shariah scholars for the product development needs and these scholars find it difficult to accommodate multiple requests for theirtime.Tocatertotheneedsoftheindustry,bothbusinessschoolsandreligiousschoolsshouldoffer specialist courses in conjunction with industry experts to prepare the next generation of Shariah scholarsandIslamicfinancialmanagers. INVESTMENTAVENUES Islamic principles stipulate certain conditions that need to be adhered to while developing Islamic banking products. Having left with no choice due to the absence of attractive investment avenues,Islamicbankingproducts mainly relyonassetbasedfinancingtogenerate returns for their depositors. SBP figures indicate a heavy concentration of trade based product of Murabaha (cost plus
Financing Mix of Islam ic banks Istisna 7% Others 5%

Salam 4%

Murabaha 36%

Diminishing Musharaka 32% Ijarah 14% Mudaraba 0%

Source: State Bank of Pakistan

Musharaka 2%

sale) in the total financing portfolio of Islamic banking to the tune of 37% as at March 31, 2010. Together, Murabaha, Ijarah and Diminishing Musharakah, which are all essentially assetbased, fixed returnproducts,constitutemorethan80%ofthefinancingportfolioofIslamicbanksinPakistan. AlthoughnolessShariahcompliant,thesefixedratetradebasedproductsdrawcriticismfromcertain quarters of the economy due to their apparent resemblance with conventional, interest bearing counterparts,usuallyintermsofreturnsonly.ThecriticsdemandamoreIslamicwayofinvestmentby wayofprofitandlosssharingarrangementsforinvestmentsbythebanksintheformofequitybased financing rather than trade based financing. However, this is easier said than done; due to lack of documentationintheeconomy,Islamicbanksarefindingitdifficulttoenterintoprofitandlosssharing based real business ventures with their customers instead of fixed return products. Moreover, entrepreneurs and industrialists are also reluctant to share profits with the financiers in low risk ventures. STANDARDIZATIONOFCONTRACTS The introduction of various Shariah standards by Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) has started to bring some uniformity into the Shariah based legal framework of the Islamic finance industry but efforts are needed to bring these agreements in conformity with the local taxation and related laws so as to make them more acceptable among all users. PERCEPTIONOFUSERS DuetounsatisfactoryexperiencesinthenameofIslamicBankinginthepast,somePakistanicustomers arenowskepticalabouttheauthenticityofIslamicbankingpractices.Partofitcouldbeattributedto psychological tendency to stick to the decades old banking habits and perception of banking. Most customershaveopinionsthatarebasedonmisinformationandrepresentlackofunderstandingofFiqh issues.ChangingtheseperceptionshasbeenoneofthegreatestchallengesforIslamicbanksthatcan onlybeaddressedthroughcollectiveeffortsbyall,speciallythemedia BENCHMARK Using the conventional interest based benchmark (KIBOR) as the base of pricing an Islamic financial productputsIslamicbanksaswellastheircustomersatthemercyofmovementsintheinterestbased money market. Also, a negative perception is created among the clientele that there is no real differenceinIslamicbankingproductsasthesearealsousingthesameinterestbasedbenchmark.Itis argued that Islamic banks should have their separate benchmark for investment pricing. This was not

possible initially due to limited market, however, some Pakistani banks have now taken the initiative andworkhasalreadystartedtodevelopanIslamicbenchmark. CONCLUSION To succeed as a viable banking option, Islamic banks not only need passionate supporters but also a number of supporting institutions/arrangements to perform functions which are being carried out by various financial institutions in the conventional framework. Attempts should be made to modify the existingstructuretoprovidebetterproductsandqualityservicewithintheambitofIslamiclaws.While interestbasedbankinghastakenhundredsofyearstomaturetothelevelwhereitistoday,expecting thesamematurityfromIslamicbankinginitsnascentstagewillbeexpectingtoomuch.Todevelopan economic system truly reflective of the sacred principles of Islam, all stakeholders should understand thelimitationsatthisstageandworktowardsitsadvancement. KeyRecommendations
DedicatedR&Deffortstodevelopviableshorttermliquidityproductsfortheindustry DedicatedlearningcentersatUniversityleveltotrainanddevelopcompetentworkforceandShariah scholars CollectivemassawarenesscampaignbyIslamicbanks StateBankshouldtakemeasuresforuniformityofIslamicbankingcontractsandproducts DedicatedresearchandproductdevelopmentteamsshouldbedevelopedatallIslamicFinancial Institutions.