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

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.

Of course, there are still risks.

Damak explained that while 80 to 90 percent of products are largely equivalent to their conventional counterparts in terms of risk, there are unique risk factors in the remaining product mix.

“We took the example of sukuk, where investors who think they have taken a credit risk from the sponsor find that they are exposed to a residual asset risk,” he said.

Sukuk refers to the Islamic equivalent of bonds.

Unlike conventional secured bonds, however, which involve an exchange of financing for a pre-determined series of coupon payments or cash flows, all backed by collateral should something go wrong, sukuk gives the lender an actual ownership stake in the underlying asset. Instead of interest, sukuk provides for real cash flows from that asst.

In this case, if the asset loses value, so too does the ownership stake and thus the value of the sukuk — a risk not shared by traditional lenders.

“In terms of the way we look at it from a ratings perspective, we’ve just updated our methodology to rate sukuk, and we’ve identified instances where the rating on the sukuk can be different from the rating on the sponsor, capturing specifically these risks,” Damak said.

In light of this, there is an obvious need for Islamic banks to understand the features and risk factors of underlying assets when considering a financing decision. For example, an Islamic bank might need to focus more aggressively on understanding local real estate markets, where they tend to have greater exposure.

Friendlier banking at a higher cost?

Combine this with a strong principle-based business model on the whole, and the extra legwork Islamic banks put into their operations could result in relatively higher pricing for customers. 

“On the products… they are obviously relying on Islamic principles, but they tend to mimic conventional products. That’s where we see difference in pricing, and the pricing seems to be unfavorable to Islamic products because of that,” Samira Mensah, associate director in the financial institutions sector for Africa with Standard & Poor’s, told AFKInsider.

However, for some customers at least, that extra cost is worth it.

A survey in Pakistan revealed a widespread perception that customer service is higher at Islamic banks: in fact, service and customer satisfaction are the main reason survey-takers gave for using Islamic banks as opposed to their conventional counterparts. Only 23 percent cited religion.

In terms of growth, Islamic financiers still have much work ahead of them. As of 2013, Islamic banks held $1.7 trillion in assets — comparable to the size of Wells Fargo, the fourth-largest American bank.

To gain market share in Africa, which is wide open for innovative financial products, won’t just be a matter of appealing to religious beliefs, then, as the above studies make abundantly clear. Rather, it will be about mass education.

The Pakistan survey found that 83 percent of banking customers simply didn’t feel they understood Islamic finance, and there was significant confusion about the different types of institutions and the rules they follow.

Barajas, Ben Naceur, and Massara would probably agree.

They wrote, “A major obstacle is an informational one, both in terms of communicating to the public what institutions and services are available, and the nature of the contracts that are implicit in these Islamic financial transactions.

“Getting past these informational hurdles will be crucial—along with the actions we propose in other areas—to ensuring that Islamic finance becomes a more mainstream actor, side by side with conventional banks and contributing to financial access and equitable growth.”