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ISLAMIC BANKING – Book Sample

Role of Islamic Banking in Financial Inclusion: Prospects and Performance

Abstract According to Global Financial Development Report 2014, the proportion of adult population holding bank accounts in 25 out of 48 Organization of Islamic Cooperation (OIC) member countries surveyed stands below 20 %.

Part of the reason is Muslims’ voluntary exclusion of interest-based financial services. On average, 28 % adults in the OIC countries hold a bank account at a formal financial institution. On the other hand, only 7.7 % of the poorest 40 % people in the OIC countries borrow from financial institutions.

Furthermore, in the OIC countries, like Guinea-Bissau, Gabon, Chad, Sudan, Syria, Mozambique, Gambia, and Iraq, microfinance outreach are not even catering to the 1 %of the poor people in these countries. In 26 out of 36 OIC countries where sufficient data are available, we find that not even 10 % of the poor people are under the microfinance radar. Thus, this presents a challenge as well as an opportunity for Islamic banks to increase their outreach toward fostering inclusive finance in the OIC countries.

INTRODUCTION

The empirical literature largely supports a positive association between financial development and economic growth. In general, countries with more developed financial systems enjoy greater eco-nomic growth rates. North (1990)and Neal (1990) concluded from their study that regions that developed relatively more sophisticated and well-functioning financial systems were the ones that were the subsequent leaders in the economic development of their times.

Odedokun (1998) also concludes that the growth of financial aggre-gates in real terms has positive impacts on economic growth of developing countries, irrespective of the level of economic develop-ment attained. Levine (2002) using cross-country data argues that financial development is robustly linked to economic growth. Even for the Organization of Islamic Cooperation (OIC) member coun-tries, Hassan, Sanchez and Yu (2011) find a positive relationship between financial development and economic growth.

However, the issue in developing countries is that financial services are not accessible to the masses of poor people. Voluntary exclusion due to faith reasons creates yet another hindrance in the way of financial inclusion in the OIC countries. According to World Values Survey sixth wave (2010–2014), 75.4 % respondents in 21 OIC member countries regard religion as “very important” as compared to 36 % holding the same view in the non-OIC countries.

According to Islamic scholars, modern day interest is Riba, which is prohibited in Islam (Verse 275: Al-Baqarah). Therefore, voluntary exclusion from interest-based banking products and services in Muslim societies could be significant. A survey of 65,000 adults from 64 economies reveals that Muslims are signifi-cantly less likely than non-Muslims to own a formal account or save at a formal interest-based financial institution after controlling for other individual and country-level characteristics (Demirgüç-Kunt et al.

2013). For instance, in countries, like Afghanistan, Morocco, Iraq, Niger, and Djibouti, the percentage of adult population with no bank accounts for religious reasons stands at 33.6 %, 26.8 %, 25.6 %, 23.6 %, and 22.8 %, respectively (Naceur et al. 2015). Thus, Muslims, in parti-cular, need financial solutions that are Shari’ah compliant. To cater to this need, Islamic banking institutions were established in various parts of the world.

Globally, Islamic banking first appeared as social finance in the 1960s. Mit Ghamr Islamic Savings Bank was started in Egypt by El-Naggar in 1963. Around the same time, the Pilgrims

Fund Corporation or Tabung Haji started operations in Malaysia in 1963 to enable Muslims to save for meeting expenses of the Hajj pilgrimage (Chachi 2005).

However, modern incorporated Islamic commercial banking began in 1979 with the establishment of Dubai Islamic bank. Since then, the Islamic financial institutions have been established in many OIC regions, including the Middle East, South Asia, East Asia, and Northern Africa.

Global Islamic banking assets exceeded $925 billion in 2015. Among individual countries, market share of Islamic banking in national banking remains at 51.2 % in Saudi Arabia, 45.2 % in Kuwait, 29.3 % in Bahrain, 25.8 % in Qatar, 21.6 % in the United Arab Emirates (UAE), 21.3 % in Malaysia, and 10.4 % in Pakistan. In the aftermath of the financial crisis of 2007–2009, Islamic banking has maintained higher Compound Annual Growth Rate (CAGR) than conventional banks in all countries except the UAE.

In countries like Indonesia, Pakistan, Turkey, Qatar, and Saudi Arabia, the CAGR have exceeded 20 %. Table 3.1 gives a growth comparison in Islamic and conventional banking in selected countries.

In this chapter, we explore the strategic positioning of Islamic banking on ideological and economic grounds. In Sect. 2, we discuss the role of Islamic banking as seen by the idealists and the realists. Despite the lack of consensus on the idealistic and realistic schools of thought on the strategic direction and positioning of Islamic banking, we argue that it has an extremely important role to play in dealing with financial exclusion in Muslim majority countries.

In Sect. 3, we look at the state of financial inclusion in the OIC countries. In Sect. 4, we estimate the microfinance outreach gap in the OIC countries. Finally, in Sect. 5, we discuss how…

ISLAMIC BANKS AS INTERMEDIARIES: IDEALISM VERSUS REALISM

Islamic banks use Shari’ah compliant contract structures to design and offer financial products. However, they work as commercial financial intermediaries. Pioneer scholars envisioned Islamic banks to be not only Shari’ah compliant, but also distinctively contributing toward the achievement of equitable income distribution, enhancing social mobility, achieving broad based financial inclusion, and fostering need fulfillment.

However, the demands of the industry hamper in achieving these ideals on priority basis. This has created a wedge between the realists and the idealists. The realists are the executioners of Islamic banking on the ground and who have to compete alongside conventional banking within same legal, governance, and market conditions. Hence, they are obliged to pursue an evolutionary assimilation of Islamic banking to penetrate from ground zero into the mainstream and the dominant conventional banking system.

The products though Shari’ah compliant are structured to compete with mainstream conventional banking indus-try. The idealists want a more revolutionary assimilation of Islamic banking to create a distinctive mark on financial landscape right from the beginning. In what follows, we give a brief sketch of how the idealists and the realists have assessed the performance of Islamic bank-ing practice so far.

Akram and Furqani (2013) explicate three specific ends (Maqasid) in Islamic finance, namely wealth circulation, fair and transparent financial practices, and justice at the micro- and macro-level. They argue that fulfilling minimal Shari’ah legal compliance in product structuring is insufficient to make progress toward these specificends.

In defense, Khir (2013) explains that mainstream Muslim scholars supporting the Islamic finance movement contend that Islam recognizes the legitimacy of the time value of money in Islamic financial transac-tions such as deferred sale and bilateral rebate.

Khan (2014) thinks that critics of Islamic banking do not appreciate how important debt financing is for value creation in an economy and especially for inclusive growth and economic development through making financial services accessible for asset acquisition. Chapra (2007) argues that even if debt financing is predominantly used in Islamic banking practice, asset backed financing does not allow the debt to exceed the growth of the real economy. He argues that the introduction of such a discipline would ensure greater stability as well as efficiency and equity in the financial system.

On the other hand, Islamic economists holding on to the more egalitarian vision like Siddiqi (2014) argue that the role of debts needs to be drastically reduced and replaced by participatory modes of finance. However, revealing the ground reality, Kayed (2012) observes that the experiences of Islamic banking in various Muslim countries have shown that the profit and loss sharing (PLS) model has been marginalized. Hassan and Bashir (2003) explain that Islamic banks’ loan portfolio is heavily biased toward short-term trade financing.

Islamic economists like Siddiqui (2007) who expect a lot from Islamic banks than just acting as financial brokers like conventional banks think that unless Islamic banking gradually moves away from debt like financing, it cannot claim to be a substantive alternative of the conventional banking system.

On the practical difficulties of moving toward PLS modes, Khan (1989) notes that informational asymmetry and higher monitoring costs hinder the widespread use of equity contracts. Khan and Bhatti (2006) explain that 38 S.A. SHAIKH ET AL.

banks do not find it feasible to enter into the PLS relationship with business people whose majority maintains double sets of accounts for the sake of avoiding exorbitant tax payments. The absence of a just and speedy judicial system also discourages banks from adopting the PLS system. Business people also show high reluctance to enter into the PLS relationship in order to preserve privacy of their business operations from outside stakeholders.

Other critics of Islamic banking dismiss the notion that the current models and institutional structure can result in any real and meaningful transformation of the way banks function. Choudhury (2012) unequivocally remarks that Islamic banking is a mainstream enterprise, good for the rich shareholders in the narrow preconceived notion of avoidance of financial interest, while not understanding the epistemological meaning underlying this principle.

Haniffa and Hudaib (2010) argue that Maqasid al-Shari’ah (purposes of the law) has been unduly used to justify the innovation of financial products to compete and converge with conventional banking. Another staunch critic of Islamic finance practice, El-Gamal (2005) observes that Islamic finance as it exists today is a prohibition-driven industry, which attempts to provide Muslims with permissible analogs of conventional financial services and products that are generally deemed impermissible in Islamic jurisprudence.

El Gamal (2007) in another study contends that growth in Islamic finance over the past three decades has been led by rent-seeking Shari’ah arbitrageurs, whose efforts continue to be focused on synthesizing contemporary financial products and services for classical nominate contracts, without regard to the corporate structure of financial institutions.

Thus, we find that there is a drift in the idealist and realist camps. But, given the low levels of financial inclusion and outreach of financial services to the lower segments, Islamic banks have an important role to play.

If they are able to contribute in these dimensions, it can hopefully lead to reduce apprehensions and drift in the idealist–realist camps. In the next two sections, we highlight the important gaps that exist for Islamic bank-ing to fill in the area of financial inclusion and outreach in Muslim majority countries.

STATE OF FINANCIAL INCLUSION IN THE OIC COUNTRIES

In this section, we explore the state of financial inclusion in the OIC countries. We look at the proportion of adult population holding bank accounts and borrowing from banks. We also look at how easy it is to come up with emergency funds in the OIC countries for the poorer and richer