A recent report by the consulting firm A.T. Kearney, The Future of Islamic Banking, and a Reuters article, ‘No windfall from Qatar ban on Islamic windows', have generated much productive chatter globally.
The report stated, " … declining growth rates and eroding profitability suggest it's time to better leverage Islamic banking potential … by revising strategy and improving operational efficiency…."
The report claims Islamic finance has reached its natural market share in certain markets, such as the UAE and Saudi Arabia, and makes comments on focusing on market segments (over product pushing), competition (niche, conventional banks or combination), delivery channels (internet to mobile banking), customer service (needs significant improvement), and so on.
The Reuters article stated, "There was little sign of the expected flow of money into Qatar's Islamic banks last year; their total assets grew 35 per cent … a slowdown from 39 per cent expansion the previous year. Meanwhile, the performance of Qatar's conventional banks improved; their assets grew 23 per cent in 2011, up from a 16 per cent rise in 2010."
The analysis is a preliminary ‘report card' on expectation divergence: anticipated benefits for Islamic banks versus how Islamic banking customers view their Islamic bank widows. It should be noted that Oman, which entered into Islamic banking in 2011, has said Islamic windows, unlike Qatar's position, are acceptable, aligning Oman with established Islamic finance hubs of the UAE, Bahrain and Malaysia.
A young industry (40 years old) with ancient roots cannot be said to have reached margin compression maturity when Deutsche Bank is saying it will be $1.8 trillion by 2016, S&P saying $1.6 trillion by 2016, and Ernst & Young saying it will reach $2 trillion by 2015.
Growth drivers
Today's growth drivers in Islamic finance include:
Political factors include Mena and Southeast Asian governments establishing a levelling playing field, for regulations and legislation concerning taxes, titles, etc, combined with G20 non-Muslim countries like the UK, France, Australia, etc, declaring themselves Islamic finance hubs.
Economic factors include the continued petro-liquidity surplus combined with non-Islamic participants seeking compliant funding and investing opportunities.
Cultural factors include a value-based resurgence among Muslims and increasing financial inclusion of the ‘man on the street.'
Product development factors include increasing the number of products and more sophisticated products that are more competitively priced.
Reaching scale
Today, dedicated Islamic banks are generally national in nature and, in certain markets such as the UAE and Saudi Arabia, have reached their ‘natural market share' for Islamic banking, according to the Kearney study.
Can it be said that in these markets an environment of ‘destructive competition' exists, as the (suggested) eroding of profits are proof of margin compression?
Will eroding margins eventually require bailout to prevent confidence-eroding run-on-deposits, i.e., a systemic risk (too small to fail)?
There are examples of Islamic banks with presence in other Islamic countries, such as Dubai Islamic Bank in Pakistan, Kuwait Fin-ance House in Malaysia, and Al Rajhi in Malaysia. However, a market cycle timeframe is needed before declaring true cross border presence.
Will dedicated Islamic banks follow the path of Islamic subsidiaries, such as HSBC-Amanah and Standard Chartered Saadiq in selected countries?
As organic growth has reached maturity in certain markets, acquisitions of other Islamic banks (as study suggests) would seem natural.
However, the evidence is otherwise. There are very few Islamic bank mergers; rescue by a better-capitalised Islamic bank is another issue.
A possible ‘new' approach for the small capitalised Islamic banks to ‘break' the natural market share capacity in home markets is acquisition, and conversion of local conventional banks. Obviously, the lessons from Qatar, stickiness of depositors, and emphasis on conventional bank customer service must be heeded.
The challenges associated with ‘conversion' have been successfully addressed over the years by an eminent and highly respected Egyptian Sharia scholar based in Dubai, Dr Hussain Hamid Hassan.
Competition
The Kearney study rightly suggests that for Islamic banks to grow, they should fully exploit the niche, compete against conventional banks or combination. However, with declining growth rates, eroding profits and sub-par customer service, it will be a challenge to compete against headwinds of conventional banks.
Islamic banks compete against fellow banks, Islamic windows and subsidiaries of conventional banks, non-bank banks, etc. For Muslims interested in Islamic finance, there must be Sharia compliance of the offering, (near) market performance and customer service.
Today, as expected, Islamic finance is not conventionally efficient, from range of product offerings to costs/returns to customer service. However, these dedicated customers are willing to tolerate ‘cost of being a Muslim' (CoBM).
Yet CoBM also has tolerance ‘limits,' as these Muslims do not want to be financially penalised for practising their faith. Hence, they will revert back to either conventional banking, or cash based transactions. It is possible the declining pockets of growth rates may be linked not to slowing down of Islamic finance, but to the shallowness of the offering at non-competitive rates without robust customer service.
Conclusion
The concerns on growth and profitability are part of the growing pains of a niche market. Islamic banks need to focus on achieving scale to obtain profitable growth as tailwind growth drivers will allow them to break their natural market share, and eventually it will allow them to compete head on against conventional banks.
The writer is Global Head, Islamic Finance and OIC Countries, Thomson Reuters. Opinion expressed here is the writer's own and does not reflect that of his own organisation or that of Gulf News.
