My page "For Islamic banks, Shariah compliance is a foundation attribute" was based on my "Letter from Amin" column in Islamic Finance News for November 2017. It introduced the distinction between foundation attributes and leverage attributes, before explaining why Shariah compliance was a foundation attribute.
I used my column the following month to consider what would be leverage attributes for Islamic banks. That is, attributes which give Islamic banks competitive advantage when competing against other Islamic banks.
My paradoxical conclusion was that the leverage attributes for an Islamic bank are the same as those for a conventional bank.
That conclusion should not be as surprising as it seems on first sight. As I have previously mentioned, Islamic banks and conventional banks provide essentially the same services to "depositors" and to "borrowers", so one should expect the sources of competitive strength to be the same.
You can read my column below.
Last month I explained the difference between foundation attributes (those which you must have to ‘play in the game’) and leverage attributes (those which give you a competitive advantage) and asserted that for an Islamic bank, Shariah compliance is merely [I regret writing this word!] a foundation attribute.
This month, as promised, I have illustrated some leverage attributes for Islamic banks.
The most important thing to remember is that Islamic banks are banks. What qualifies them as Islamic is operating within the rules specified by their Shariah Supervisory Boards and by any Shariah regulator which may oversee them.
A bank is a business which takes in money from one set of customers (depositors) and lends it to another set of customers (borrowers). While Islamic banks do not pay interest on deposits or make interest bearing loans, it is linguistically convenient to use the same terms, depositors, and borrowers, for the customers who either put money into the Islamic bank or who are financed by it.
To entice depositors to trust their money to them, Islamic banks need to give an impression of strength and stability. They also need to be accessible so that depositors are physically able to get to the bank and pay in money.
Historically, both have been achieved by having physical networks of imposing branches with large numbers of staff to reduce customer queueing. However, all banks, conventional and Islamic, have realised how expensive branch networks can be. In the conventional banking space, the Dutch bank ING was able to disrupt the deposit market in many countries by offering an internet only bank which provided only one service (deposits), thereby avoiding both the costs of a branch network and the costs of other expensive services such as cheque clearing.
Today, Islamic banks need to compete by providing electronic access, remote deposit facilities, and smart phone apps enabling depositors to carry out most of their deposit and money transfer transactions electronically. Given the economic and travel conditions in many developing countries, this should be the most cost-effective way for an Islamic bank to expand its footprint and appeal to depositors.
On the other side of the balance sheet, where the bank, whether conventional or Islamic, is financing customers, the key leverage attribute is accurate credit assessment, so that the bank can charge appropriately for the risk of customer default.
If the bank under-assesses the risk, it will suffer excessive credit losses from customer defaults. However, it is also a problem if the bank is too cautious in assessing customer default risk since it will fail to use all (beyond those required to be held as a liquidity buffer) of its deposits to finance customers. This will cause the bank’s financing income to be too low and is likely to make the bank unprofitable, possibly even loss-making.
In the corporate and investment banking sector, a further leverage attribute is to have bankers whose connections in the business community are so strong that they can create deals (such as corporate takeovers or partnerships) which then require financing by the bank as well as earning advisory fees.
Finally, since Islamic banking presently offers a narrower range of services than conventional banking, it is a leverage attribute for Islamic banks to be able to innovate and devise new Shariah compliant offerings not presently being provided by their competitors. The challenge is both in devising those offerings and in preventing their intellectual property then being copied by competitor Islamic banks.