ISLAMIC BANKING PRODUCTS ARE EXPENSIVE?
It is one of the mysteries of the universe that there is this perception that Islamic Banking products are MORE EXPENSIVE than the Riba products counterpart. It never fails to surprise me that in Malaysia, whenever I open the session for Q&A after a talk on Islamic Banking, that the question put to me was “Why is Islamic Banking financing products more expensive than conventional banking products?”.
Honestly, I wondered if this question comes from the possibility of everyone reading from the same exact book published many many years ago, making that one point of contention again and again. Which book have people been reading? Can someone pass me this book? It seems everyone is reading or referencing the same book which says “Islamic Banking products are expensive”. Can someone tell me about it?
So I decided to ask around. I asked the persons asking the question on why does he/she say that? In what scenario? Which product? What feature of the product makes it expensive? In all attempts, they replied “It is the general view that Islamic Banking is more expensive”. But they have yet to give me any evidence when I asked for their source.
This is like a scary bedtime story that parents tell their children if they don’t behave. So now I am asking around for specific scenarios on why they made such comments. From what I gathered, these are some of what I think people are referring to. But I couldn’t be 100% sure, so please, do leave your comments and scenarios (and details) for me to evaluate and respond to.
Because, for the past 20 years (in Malaysia at least), this claim of “Islamic Banking products are more expensive than conventional banking” are simply not true.
YES, THERE ARE DIFFERENCES
Of course, before I delve deeper into this perception, there are differences in Islamic Banking that requires additional items or costs, but mainly these are operational costs or documentary costs or management costs which are linked to mainly Shariah requirement on Aqad. For conventional banking, it is just a loan agreement, For Islamic Banking, a trading transaction may occur, and if it does… there may be additional costs.
But these costs are usually absorbed by the Bank itself, and hardly passed on to the customers. So why would it be more expensive for the customer, if the Bank is absorbing these “costs” as part of their cost of doing Islamic Banking business?
And additionally, the costs borne by the Bank for doing Islamic Banking business are not significantly higher. The Bank have to remain competitive as well, either against conventional banks or other Islamic banks as well. So the costs, if significant, will not be passed to customers to remain competitive. It should be on par with other players in the market.
FINDING THE REASONS
As far as I can tell, some of the perception on Islamic Banking is more expensive than Conventional products are based on these:
- Selling Price – In some Islamic Banking products, there are trading requirements (Murabaha / Tawarruq / Istisna’a / BBA) and one of the tenets of valid sale is that there must be a Selling Price. Selling Price is the sum calculation of all the Installments the customer has to pay over the period of financing. The formula is that Selling Price = Monthly Installment x No of Months of Financing. Once this is agreed, it cannot change; anything above and beyond the agreed Selling Price (maximum) is considered Riba. Conventional Banking products do not have this as they only declare the Installment amount per month based on prevailing rate. Truth is, no one really know how much they eventually pay under conventional banking product, because there is no capping of the amount they may pay. The tenure can be extended, the installment can be increased, the rates may be revised upwards under conventional banking. There is no control of how much (maximum) conventional banking can collect from the customer. If conventional banking products add up the installments over the period of time, they can also see the amount equivalent to a Selling Price ie total amount payable over the tenure. But they don’t, because it ties their hands from collecting more. So, is Islamic products more expensive? It is possibly the opposite i.e. cheaper than conventional due the maximum Selling Price compared to a conventional loan without any maximum amount (sky is the limit).
- Ceiling Rate – Islamic Banking products may work on either a fixed rate structure or floating rate structure. If the structure is a fixed rate structure, it looks similar to the above. If is floating rate structure, then there is a need to put up a Ceiling Rate (a maximum rate that Shariah allows us to charge) for the purpose of the Aqad, where the certainty of price is required. However, once the Aqad has been concluded (Selling Price is contracted), the day-to-day running of the financing is charged at the Effective Profit Rate (usually below the Ceiling Rate) which is reflective of the prevailing market rates. Which is what the conventional banking products are charging. This makes the actual amount paid for Islamic Banking product at par with conventional banking products. The difference between the Ceiling Rate and the Effective Profit Rate is not charged on the customer therefore given as a Rebate on price (Ibra’). For example, if the Ceiling Price for the Aqad is 10% and the Effective Rate for day-to-day is 6.0% (ie customer is charged only 6.0%), then the difference of 4.0% is a pricing rebate to the customer. So, is Islamic products more expensive? No. It is on par after pricing Rebate. In fact, having a Ceiling Rate provides additional “protection” for an Islamic Banking customer i.e. during times of high volatility of Base Rate / Funding Rate, the Ceiling Rate serves as a rate protection for the customer. For example, should the all-in rate of the financing increase to be 13% or 14.0%, the customer’s rate will not exceed the Ceiling Rate of 10%, therefore saving the customer the excessive rate during periods of uncertainty. So, during period of high volatility of rates, the Ceiling Rate will not be exceed thus making the product cheaper than the Conventional product.
- More Documents – I acknowledge that some Islamic products do require additional products as a package. But as for main documents, where the most charges are incurred including stamp duties, are usually the same as any conventional banking product. Maybe there are earlier perception that because of the Selling Price based on Ceiling Rate, the stamp duty will be more expensive. It is not true. Stamping will still be made based on the principal amount even for an Islamic facility. Furthermore, secondary documents are usually stamped at nominal amount i.e. $10 per document. The additional documents for Islamic product, if we assume requires 5 additional, will cost the customer $50 extra. That is not significant. So, is Islamic products more expensive? For documents, maybe. But it is dependant on structure and the additional documents will be stamped nominal value.
- Early Settlement Rebate – I probably understand and agree with this point, provided it was made 15 years ago! Traditionally, when a customer takes a loan with a conventional bank and want to do an early settlement after a few months, an early settlement penalty was charged. For an Islamic Banking products, when BBA was offered many years ago, the method was to give a “reduced discretionary rebate” on the unearned profit. This means maybe some Islamic Banks want to earn the same early settlement penalties (like a conventional bank) via a reduced rebate as rebates are by nature, discretionary in the eyes of Shariah. However in 2011, BNM issued a specific guidelines on the treatment of rebate for early settlement of Islamic sale-based financing products. The guidelines ensures that the rebate given is mandatory, with a specific formula to be adhered to. The guidelines also included the required disclosures for transparency purposes. In short, Islamic Banks cannot charge early settlement compensation (only a couple of scenario where it is allowed) and the rebate given must follow a strict formula. So, is Islamic products more expensive? There might be a case for this argument before 2010 (for early settlement cases only) but with the Ibra guidelines issued in 2011, the product would possibly result in at par or cheaper than a conventional bank product.
- Commodities Trading Fees – This is a recent phenomena. A lot of structures are riding on the popular Tawarruq structure, and this structure involves the buying and selling of commodities via brokers or established trading platform and there are Trading Fees being charged. Generally, for retail consumers, the trading fees are absorbed by the Banks; you will never notice it. But for Large Corporates dealing in hundreds of million deals, a trading fee may be noticeable. However, these fees are also deemed small enough to be ignored. The standard trading fees at Bursa Malaysia is $15 for every $1,000,000 commodities traded. That’s 0.0015% charge. For a $100 million transaction, the trading fee will only be $1,500. I have not seen any Corporate customers refusing to pay this trading fees. And there are some brokers who are even charging lesser rates. So, is Islamic Banking more expensive? Only for Tawarruq, there is additional costs but for the quantum, I do not believe 0.0015% is considered significant, or expensive.
It really is testament that the men and women in the industry were always looking to enhance, resolve and improve on contentious practices to serve the public. The products were always evolving to be better for the consumers. In fact, I believe we are at the stage that some of the offerings under Islamic Banking is CHEAPER than the conventional banking products due to certain fees and charges and treatment on the account are instructed by Shariah Committee.
IT IS A PERCEPTION THAT NEEDS CORRECTION. IT IS NOT CLEAR WHICH PART OR PRODUCT FEATURE THAT THE PUBLIC PERCEIVES AS MORE EXPENSIVE. IS IT THE RATE, THE PRICE, THE PENALTIES?. IS THERE ANY UNFAIR TERMS LEADING TO THIS PERCEPTION.
COULD ISLAMIC BANKING FINANCING PRODUCTS ACTUALLY BE CHEAPER THAN CONVENTIONAL LOANS?
In some scenarios, I do believe so.
There are many areas that is governed by Shariah decisions formulated to protect or benefit customers for fairness. Especially in areas of fees and charges and compensation. IF YOU WANT TO KNOW MORE ABOUT ISLAMIC BANKING PRODUCTS BEING CHEAPER THAN A CONVENTIONAL BANKING PRODUCT, CHECK OUT MY COMING POST.
I really hope someday someone will pass me this mystery book to read. We are in 2017 and so much have changed in the past decade. Huge and big regulations have been introduced and most of it with heavy input and consideration from the Shariah Advisory Council (SAC) of BNM. These are learned individuals that I believe are not greatly motivated by money. There are huge responsibilities on their shoulders thus the decisions made will be for the benefit of customers in mind.
Again, I invite readers to provide me with the latest findings where it is believed that Islamic Banking is more expensive than conventional banking products. Let us discuss and evaluate them based on actual facts.
Since Islamic banking has a selling price (which is inclusive of profit rate and principal for the entire tenure), hence one is forced to somehow meet this “selling price”. In a scenario where I have excess money and would like to settle a loan earlier (which means that I am paying off well below the selling price), I am still liable to meet the “selling price”, which may not be the case in conventional banking, where principal reduction is allowed.
On the other hand, the good thing is the selling price is the maximum amount payable and regardless of any scenario (BR changes etc), this figure remain the same, not affected by any other factors.
Kindly correct me if I’m wrong.
In the scenario where there is settlement of principal, Islamic Banks is expected to provide Rebate on the principal paid. The Selling Price is therefore reduced via the rebate i.e. the “Unearned Profit” can no longer be “earned” as it given as a Rebate. Most Banks gives this Rebate immediately upon payment of that principal.
However, do check on certain structures, where the product allowed for “redrawing of principal already paid”. In such structures, the “unearned Profit” is not given as Rebate immediately, as the Bank allows for redrawing (and therefore you need to add-back the unearned profit if you have waived it).
The Ibra Guidelines issued by BNM is designed to bring the Islamic products on par to conventional products in times of early settlement. However, charges such as early settlement charges are not allowed (strict condition for allowance) and this makes Islamic banking product options cheaper than conventional.
And yes, I agree that the Selling Price results in a fixed maximum amount payable which protects customers in times of high market rates.
Interesting article Mr. Amir
Unfortunately, there are still comments saying that Islamic products are more expensive than conventional products. And many times I have asked for evidence of such so we can dissect it properly, to identify if there is any truth in it. Any evidence such as Letter of Offer, Statement of Claims, Schedule of Payment, System Calculations… anything.
So far, I have yet to receive any documents showing this. And yet, the perception continue to survive and thrive…
It is about time I try to address the misconceptions, where possible.
Keep writing. Do forward me any articles you want me to add to your page.
Thank you Mr. Amir.
Hi Mr. Amir,
May I know how you calculate the profit earned (column C) under the BBA financing?
Apologies for the late reply. The profit earned for BBA or Bai Inah is the same as how any other monthly-rest income is earned. The Outstanding Principal x Effective Rate x Number of days /365.
Hope that helps.
As Salam Tuan Amir Alfatakh,
Hope that you doing great.
I have inquiry on rebate for R&R account under Islamic Financing (in this case, let say we take Personal Financing product as example). Let say we have reschedule the financing account another 1 year due customer have difficulty to serve original instalment and we have decided to lower a bit the monthly instalment amount by lengthen the tenure.
So In case customer want to settle early the financing account, do we still need to provide rebate for this? Since the account already passed the original maturity date.
Thank you very much for your guidance on this.
In those situation the amount they have to pay is just the principal amount outstanding, and any profit due still not paid. Any other amount is the automatic rebate. Hope that helps
Thank you so much first time reading up on selling price and ibra