Bright Future of Islamic Banking

The concept of Islamic Banking and its inherent benefits, seem to be catching on globally. Many countries are now following in the footsteps of Malaysia in instituting financial products and services that offer certainty and transparency.

Basically, Islamic banking refrains from the practice of usury and unfair banking penalties such as “interest upon interest”. It focuses on an equitable sharing of profits between the bank and the customer or depositor.

The United Kingdom and several other European countries, as well our closest neighbour Singapore, have ventured into Islamic banking. And they all aspire to be an Islamic Banking hub.

In Malaysia, the government’s efforts in positioning the country as an international Islamic financial hub have shown much progress. This is seen in the high growth rate of Islamic-based assets and liabilities of the banking sector of the past few years.

Other initiatives include the liberalisation of the Islamic banking sector with the granting of Islamic banking licences to major foreign Islamic financial institutions and the launch of the International Currency Business Unit (ICBU) with a 10-year tax break. These steps further prove that Malaysia is keen to expand its master plan in the growth of the Islamic banking sector.

Most local banks have already set up full-fledged Islamic subsidiaries and a foreign bank has also obtained approval for similar establishments. It is expected that some other foreign banks will follow suit.

The recent approval by Bank Negara Malaysia for the setting-up of a full-fledged Investment Bank under the ICBU platform marks another milestone for Malaysia.

The Islamic banking system can attain significant growth if the value proposition is better understood.

Any misconception about Islamic banking, once eliminated, will certainly encourage more customers to switch from existing conventional banking practices to Islamic banking.

Perhaps, the true value propositions have not been highlighted by financial institutions with full-fledged Islamic banks, fearing that such a move may “cannibalise” their existing conventional banking business.

One of the main misconceptions (although Islamic banking has been introduced in Malaysia since 1983) is that Islamic banking is exclusively for Muslims. With the affixing of an “i” to Islamic products rather than applying the Arabic contract name, we hope that this change will make the product acceptable to non-Muslims.

Islamic banking products and services address the requirements of all, regardless of race and religious belief. For Muslims, it will fulfill their religious obligations where they must refrain from taking usury (or interest). For non-Muslims, it provides viable alternatives to their conventional banking products.

Comparatively, conventional banking is predominantly driven by a floating interest rate system, as opposed to Islamic banking which subscribes to fixed or a hybrid of fixed and variable profit-rate mechanism. Thus, Islamic banking promotes certainty, clarity and predictability in its financial transactions.

In addition, Islamic banking also offers profit-sharing contracts. Customers, particularly the depositors (or investors in the true sense of risk and reward arrangement), can enjoy higher returns (at an agreed profit-sharing ratio) from profits generated from the bank’s investment in financing and other ventures. This measure is in contrast with the conventional banking model where profits generated from the bank’s business is not shared but predetermined on placement of the deposits.

Technically, in a rising deposit rate trend, depositors who place funds under a long tenure, conventional fixed deposits will lose out while depositors of Islamic deposits will continue to enjoy uptrend movement of the profit rates (irrespective of their placement tenure) which normally is benchmarked against the “interest rate trend” due to competition.

Nevertheless, two important differences between conventional fixed deposit and Islamic fixed deposit that most customers are not aware are: (a) profit rate for longer tenure placement is generally higher than the shorter tenure to ensure principle of fairness is applied; (b) there is no penalty for premature withdrawal.

With regards to Islamic financing products, the pricing is determined as a fixed selling price which incorporates and pre-determines the profit levels that the Islamic bank will charge for the whole financing tenure. This will enable the customers (or the borrower as termed under conventional banking) to better manage their cash flow, unlike conventional banking loans where the interest rate is on a floating basis.

The 1997 financial crisis taught us a great lesson where floating interest rate pricing caused hardship to both businesses and consumers alike. On top of that, the “interest upon interest” or compounded method used by conventional banks is strictly prohibited under Islamic banking.

Late charges on overdue instalment is normally charge as a deterrent and whatever income derived from late charges are given to charity. (Late charges are part of the bank’s income under conventional banking.)

A series of articles on the value proposition of Islamic banking on various products and services offered by Islamic banks will be published to help consumers and business entities understand better and appreciate what Islamic banks can offer and the benefits associated with Islamic banking.