Islamic Banking in Singapore

Reuters reported that DBS, Singapore and south East Asia’s largest bank is scaling down on its Islamic banking operations, signalling the city-state’s efforts to promote Shariah banking are not bearing fruit.

DBS’ Islamic Bank of Asia (IBA), Singapore’s only wholly-owned full licensed Islamic bank, suffered a loss of US$77.1 million (RM256 million) in 2009 after making specific allowances on debt owned by customers in the Gulf region. The bank had US$725 million in assets as at end-2009, including US$453 million in payments due from non-bank customers. A source had earlier told Reuters the Islamic unit of DBS planned to get out of the lending business entirely. (Reuters; May 24, 2010)

What struck me was the statement on “lending business”. I have argued in past and still maintain my stand – Islamic banking is not about lending. Islamic banking is all about putting resources together and sharing risks and rewards in an economically beneficial business venture. Any lending should be kept at a minimum and should only be for exceptional cases and given interest free.

So, given my stand, I’m not surprised that Islamic banking is not making much headway in the non-traditional markets. While the traditional markets (read Muslim countries) have the added advantage of having religious obligation as a marketing tool, the non traditional markets needs more than that to push Islamic banking. Focus has to be on the uniqueness of system, the part that differentiates it from conventional banking. One of it is that it promotes risk and reward sharing instead of just plain borrowing and lending.

It is often lamented that Islamic finance lack knowledgeable practitioners. I want to add that the industry also lacks knowledgeable investors. By knowledgeable investors I mean investors who appreciate what Islamic finance stands for. For as long as investors demand a solution that mimics conventional products, Islamic finance will not take off, even in traditional markets. 

Two of a Kind

All of Malaysia’s anchor banks have Islamic subsidiaries. Three of the foreign conventional banks in Malaysia have Islamic subsidiaries. When BNM directed banks to set up stand alone subsidiaries in place of the Islamic windows, it effectively doubled the number of banks in Malaysia. The country’s sole building society is re-inventing themselves as an Islamic financial institution. A large co-cooperative bank “converted” to Islamic banking some years ago.

Call me a sceptic, an unbeliever but all I see from this is just increasing the number of banks instead of increasing the number of Islamic banks. Why do I say this?

First and foremost, the products are almost identical save for the name and legal documentation. Even the pricing is almost identical. How can that be? The objective of the financial products is the same, no argument about it but the means are not. It is ok to sell lemonade at the same price as beer but it is not possible to make lemonade using the same ingredients as beer.

Secondly, the Islamic subsidiaries are sometimes still treated like a window whereby they are not allowed to compete with the mother bank. What is the purpose of having a separate entity if it is not allowed to act independently? Some of the Islamic subsidiaries’ products are evaluated and approved by conventional mother bank’s product committee. This is akin to getting one’s product approved by a competitor!

Thirdly, the risks associated with Islamic banking are similar yet different from that of a conventional banking system. The fact is that the risks undertaken in a trade or partnership based transaction cannot be identical to that of a debt based transaction. But yet the credit and risk management process in some Islamic subsidiaries are undertaken by the conventional mother bank. Anomaly?

Ok, I’m a sceptic. Or maybe I just don’t see Shariah based banking the same way as the other bankers do. But I strongly believe that the same mindset and approach cannot be used to run distinctly different business models.

Islamic Bank – Modus Operandi

Shariah based financial system needs to be clearly distinguished from its conventional counterparts. Shariah based financial solutions can effectively promote itself only when it is seen as an alternative rather than a complement to the conventional banking system. To use transport as an analogy, Islamic and conventional banking should be seen as trains and cars and not as different brands of cars. The objectives are the same, i.e. to get from point A to point B but the mechanics, platform, driving methods, fuel system are different despite having some similarities.

So how does an Islamic bank differ from their conventional counterparts?

First and foremost is the basic principle. Shariah based banking is a built on trade and partnership whereas conventional banking is purely a lender-borrower arrangement. Therefore, the personnel in an Islamic bank must be trained towards managing a trade and/or business partnership relationship rather than that of a lender-borrower.

How different are the two relationships? When a lender lends, his objective to recoup the money lent plus a compensation for the opportunity cost, i.e. principal plus interest. Information on the utilisation of the funds is only for the purposes of obtaining credit approval and once the loan is approved, the lender plays no part in assuring the proper utilisation of the funds. The lender is only interested in getting back the loaned funds plus interest. Inability of the borrower to repay the loan will result in him losing his collateral and could even be slapped with late payment penalties.

On the other hand, when an Islamic bank enters into a trade or business partnership, the objective is to make a gain from the relationship but the gain is dependant upon the business and economic conditions. Unlike the lender-borrower relationship where the lender expects the funds to be returned regardless of the economic condition, an Islamic bank cannot demand the same. The bank has to work with the partner throughout the tenure of the relationship and any realised gains or losses are to be shared as agreed. If unfavourable economic conditions caused the venture to register lower returns or even losses; the Islamic bank cannot demand anything from the partner (unless it can be proven that the loss is caused by negligence of the partner). If the venture turns a loss, the partner should not be compelled to bear the loss alone but instead the bank should work together to recover or at least minimise the losses. The role of a Relationship Manager in an Islamic bank is wider; it also covers the role of active business partner.

Secondly, the credit evaluation process in an Islamic financial institution should not be identical to that of a conventional bank. The reason is simple; a conventional bank looks at credit from the perspective of the customer’s ability to pay whereas an Islamic bank looks at credit based on the viability of the business venture.

As with my other postings, the point I’m trying to drive through is that conventional banking and Islamic banking, despite its similar objectives, cannot be run on similar platforms. Islamic banking has to operate from its own platform, on its own terms. Unless it does, there is no point in its existence.

NPL and Islamic Banks

Technically NPLs should not exist in the Islamic banking system. NPLs are loans which are not repaid. There are two reasons for non repayment of loans; the first is the borrower’s inability to pay due to economic circumstances and the other is a blatant refusal to pay by the borrower despite having the ability to pay.

In the first instance, the banks should play the role of a caring organisation and restructure the repayment schedule to ensure repayment can be resumed and the borrower is not made worse off. The debt won’t turn bad because it has been restructured.

In the second case, the borrower should have his hands chopped off for stealing. Borrowing money and refusing to repay when the borrower has the means to repay tantamount to stealing. The penalty for theft under Shariah is cutting off the hands. So, instead of charging the defaulter (or robber) penalties (ta'widh) and compounded interest, the Islamic Bank should just charge in him court for theft.

Now, if that kind of ruling is put in place, would there be any NPLs in Islamic banks?

Banks from the Shariah Perspective

A bank is essentially an intermediary between those with excess funds (depositors) and those in needing funds (borrowers). Banks take in deposits from those with surplus funds and lends them to those in need of financing. The difference between the interest charged to depositors and the interest charged to borrowers represent the bank’s income. A very simple model indeed!

Everyone wants to own a bank because banks print money (refer to Fractional Reserve Banking Causing Complete Banking Disaster). Fiat money allows banks to make so much money out of thin air.

Let me illustrate, a 1% reserve requirement (imposed by BNM recently) allows banks to lend out RM100,000 from a deposit base of only RM1000. Let’s assume the deposit rate is 2% per annum and the base lending rate (BLR) is 5.5% per annum – banks will make RM5,500 (5.5% x 100,000) but only pays out RM20 (2% x 1,000) to the depositors. Now you see how the banks make money and why so many want to own banks. Even when banks are losing money the government will bail them out (using taxpayers’ money despite most of the taxpayers not benefiting from the banks’ existence!). Granted, the banks face lots of risks, especially risk of non payment but given the cushion, the banks can afford to have an NPL (non performing loan) ratio of 50% and still make money!

I hate to be a party pooper but I don’t think Shariah will agree with the model.

Firstly, money must be backed by real assets; creating money out of thin air is a no no.

Second, money is not a commodity hence cannot be traded.

Thirdly, interest bearing loans are not allowed under Shariah laws, it has to be given out under a partnership or trading arrangement.

Fourthly, money (deposits) cannot grow unless it is put into productive purpose.

Fifth, risk sharing is absent in the conventional banking model whereby the risk is borne wholly by the borrower, they have to repay regardless of their financial state.

Banks, from the Shariah perspective are in actual fact trading houses/venture capitalist/trading partners. They still play the role of intermediary between the two groups, but the modus operandi is different. For starters, fractional reserve banking should not practised. Money is not to be traded but instead be put into real economic activity, profits and risks are shared. The basic principle of Shariah based financing is doing business in a transparent, just and equitable manner. But if one party (the one without the capital) makes 5,500 while the capital owner makes only 20, where is the equity in that?