Africa PE Insider: Is Islamic Finance A Better Option For Africa?

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Written by Anna B. Wroblewska

Islamic finance is expanding globally, and Africa seems a natural outlet for that growth. With low access to banking and a huge need for finance, Africa presents an interesting outlet for Islamic finance and banking institutions. 

Africa, like the Middle East, has relatively low levels of financial inclusion, similarly to the Middle East, and a significant minority of Muslims.

To find out if Islamic banks could fulfill an unmet need, a group of International Monetary Fund economists asked whether these banks could help foster financial access and conducted a study to find out.

“There has been positive but limited impact of Islamic banking on financial inclusion… households are no more likely to hold a formal banking account, nor are they less likely to cite religious reasons for not having an account,” the researchers — Adolfo Barajas, Sami Ben Naceur, and Alexander Massara– said in an email interview with AFKInsider. 

Altogether, the outcome was surprising.

The researchers said, “This goes against our assumption going into the study; since Islamic countries reported lower inclusion and also a greater proportion of their populations referring to religious reasons as to why they did not hold an account.”

Of course, that doesn’t mean Islamic finance can’t help expand financial access for Africans.

“The general philosophy of profit-sharing… make Islamic finance an appealing alternative or, more accurately, a complement to conventional banking, with the potential for providing stability and benefits in terms of expanding access to the previously unbanked,” the reearchers said.

That complementarity might have something to do with the foundations of Islamic finance, which hinges on a strict code of ethics more stringent than can be found at conventional banks.

These requirements, referred to as the Five Pillars of Islamic finance, include: a ban on charging or paying interest, a ban on speculation (risk taking is allowed, according to Standard & Poor’s, only when terms and conditions are clear and known to all parties), a ban on financing industries such as alcohol and gambling, a profit- and loss-sharing principle, and the requirement that financial transactions are backed by tangible assets.

Those underlying principles could make for kinder banking from a customer’s perspective.  

“It would be difficult to imagine an Islamic bank throwing a family out of a house to resell the asset” Mohamed Damak, global head of Islamic finance with Standard & Poor’s, told AFKInsider.

Unconventional risks

Of course, this also exposes the institution to a greater level of risk, in the sense that an Islamic bank has to, in a manner of speaking, eat its own cooking.

And given the lack of access to hedging products or derivatives, the profit- and loss-sharing principle implies that all the depositors in an Islamic bank which made a bad financial decision would have to share in that cooking.

“It could result, in some cases, in a higher vulnerability to deposit funds because one of principles of Islamic finance states that all the participants to every transaction have to share not only the profit in the case of profit but also the losses in case of losses,” said Damak. “Which means, in theory, that an Islamic bank could serve a negative interest rate to their customers on deposits.

“I think in practice it would be difficult to implement, because the depositors would be incentivized to withdraw their money, which would lead to a liquidity crisis for the bank itself.” 

Damak explained that there are measures banks can take to reduce the risk.

“These are specifically the profit-equalization reserves that consist in making a provision based on the profitability of good years in order to cover the profitability of bad years, or the investment risk reserves which are similar but which cover the loss on financing operations.”

In addition, Standard & Poor’s notes that in order to prevent the loss of customers in the case of losses, banks are likely to reduce or waive their management, or mudarib, fee, which typically ranges between 20 and 40 percent of distributable cash flows.

Could these significant incentives towards conservatism provide hidden benefits in terms of corporate governance?

“It can enhance governance and it can enhance the incentive for senior managers of Islamic finance to manage the balance sheet in a more conservative way, in terms of squaring the risks on both sides of the balance sheet and making sure there are no significant open positions,” Damak said.