Making Islamic Banking Resilient

Recently, I was invited to be part of a panel to present our views at the International Islamic University of Malaysia (IIUM) on how to make Islamic Financial Markets resilient. With great excitement I prepared my slides (panelists are given 20 minutes to present) and tried to figure out the best approach to present it in such a short time. However, when the session came, due to time overshoots and constraint, me as the last speaker was only left with 10 minutes. I had to make it count, so I talked fast.

Afterwards, however, I do not feel as if it was mission accomplished. Time was too short for me to put my argument properly and I had to drop many points in fear of cramming too much information into that 10 minutes. So I decided to post my slides up, and make a proper short commentary on what I meant to be communicated. Bear with me.

The Financial Industry Must be Resilient

  • STABILITY : The public must be confident on the resilience of the financial markets where the public is assured that there is not misconduct of public funds in the day to day operations of the banking industry. BNM has put in great lengths to ensure stability via sufficient capital, liquidity and funding. The operations of the bank must always meet the statutory requirement on financial stability with the introduction of the Liquidity Coverage Ratio (LCR), Net Stable Funding Ratio (NSFR), Rate of Return Framework (ROR), and Risk Informed Pricing.
  • SUSTAINABILITY : Any business, must intend to survive in the long run. Selecting your customers are important, and risk mitigation mechanisms must be available to defend the business. But at the same time, re-investment of profits must also be made for future growth, so it is a balance to be maintained.
  • INTEGRITY : As Bankers, integrity always plays an important, and fundamental, part.  But Islamic Bankers, another layer of integrity is also imposed which is Shariah. Banks are expected to be more and more of a moral champion in support of the various SDGs and ESGs where the idea of being good will eventually lead to better profits and prosperity. BNM’s Value Based Intermediation aims to expand the role of banks to be more than just profit driven, but more inclusive to embrace a wider range of customers and cater for their needs.

The Challenges are manifold.

Being resilient is always a challenge for the Banks, especially with so many moving parts in the financial world. New regulations, new competition, new structures, new products and new models continue to plague the banking industry. To change our mindset to make Banking and Financial Market more better requires a lot of soul searching and will power to make the change. I summarised the challenges into 3 broad categories:

  1. Consumer Market. Any major change in the banking model is not taken well by the consumer market. Customers come to the Bank mostly for advise on their banking services. The Banks struggle to introduce differentiating products, from the debt structures and into the thought of creating value through investments. I am not sure how successful introducing the VBI into the consumer market, but the has been a lack of awareness programmes to introduce to the public.
  2. Corporate Market. Corporates are driven by profits and benefits. It is their core function ie to increase shareholder value.
  3. Financial Markets. We lack sufficient financial instruments in the market. That is why the industry can only grow organically. It needs the strong-will to pump more capital into the market and creation of structures that do not mirror the conventional books.

The Reality is that Traditional Banks need to keep up.

  • Traditional Banks. Heavily regulated to ensure financial stability. But the speed of adaptation to new thinking and new technologies are too slow. It is high cost to make the change, but also it is high cost just staying where you are. Ask Nokia. If all Islamic Banks do is replicate, they are in danger of becoming obsolete in the near future.
  • Challenger Banks. Provides alternative banking structures or arrangement, with little or no hassle, with or without the use of technology. A lot of customers now by-pass banks to opt for the most convenient and fast banking products. With very minimal regulatory requirements.
  • Digital Banks. This new breed of banks are definitely very interesting. There are two differentiators i.e. 1) Banks that only digitalise their processes and paperwork and speed, but the fundamental bricks are the same, and 2) Banks that try to be different and offer a totally new proposition with a new set of bricks. Yet, Islamic Banks are expected to do all and adopt more stringent requirements when entering into the Digital space, while dealing with old issues such as constructive ownership and Aqad. More importantly, these issues can probably be resolved by NON-BANKS, offering the same terms and conditions, sometimes with slightly better proposition such as speed, accuracy and low cost. For example, big data companies such as Facebook and Grab intend to open their own “bank”. Facebook just launched its Libra bank trading in cryptocurrencies. Grab is rumoured to enter as well and these Big Data companies already have their database of ready customers for them to roll out their Digital Banks.

Stop Looking at Your Feet. Stretch out your hand and move to touch new Horizons.

A lot of discussions have been held between the academia and practitioners. It seems we are always looking ways to innovate and integrate into the future, but without any real solutions on how to actually do it. As mentioned, the will-power to affect change remains a huge challenge. Instead of “What Is….”  to be turned to “What If…” where solutions are always been discussed and developed for a solution, and “What Next…” clearly implying the shift in banking products from traditional to new developments.

It is no longer sustainable to just replicate. True innovation is on the rise. New solutions are needed to be offered to the customers.

The Next Generation bankers must familiarise themselves with all the blockchain and Internet of Things language and terms currently floating around. More importantly, there should be a look at the whole ecosystem to see where the Shariah elements can be included, and where others must be excluded. Collaborative discussions, between regulators, academicians, practitioners and Shariah scholars must work together for the growth in the industry. It is not just any growth, it involves a total paradigm shift to adopt the new ecosystem.

There is a need to differentiate and upscale the business practices. While we continue to focus on the Traditional Bank in making it more resilient, we might miss this opportunity to join the Industry Revolution 4.0 to revamp Islamic Banking and overlook the threats coming from other financial institutions (NON-BANK). This is the Banking disruption in real life.

Why Choose Islamic Home Financing in Malaysia?

ISLAMIC FINANCING HAVE SHOWN SUSTAINED GROWTH. WHY?

In the course of our job, we are often asked what are the value proposition and selling points of taking an Islamic Financing product as compared to a conventional loan. Are there certain conditions to qualify a person for taking Islamic Home Financing? There are misconceptions that Islamic financing are expensive, but if that is true, why would there be a growth in Islamic financing? Would people have to be extremely religious to accept an expensive / inferior product no matter what just because it is Shariah compliant?

There are certain features in-built in an Islamic structure that gives benefits that appeal to certain types of customers, based on their needs and requirements for the product. On the flip side there are also consumers that prefer other features not possible for an Islamic structure. It depends on your requirements when it comes to your usage.

BENEFITS OF ISLAMIC HOME FINANCING

  1. No Lock-in Period or Early Settlement Penalty for financing . In the banking world, there is a lot of effort to on-board a customer for a particular financing, and home financing is one of them. The process can take 3-9 months and involves a lot of people and it is natural for a bank to want to earn income as much as possible, as long as possible from the customer. That would not happen if the customer settles early. The bank will impose a minimum “lock-in” period of between 3-5 years where customers are prohibited to sell, settle or refinance their houses. If they do, an early settlement penalty (usually 1.0% on the amount to be settled) will  be imposed. Under Islamic financing, this feature is not generally accepted due to the concept that “Debt Cannot be Forgiven, even in Death”. Therefore to impose a penalty when a customer is attempting to pay off its debt remains an issue in the area of Islamic Banking. This is outline in the Ibra (Rebate) Guidelines issued in 2011 which prohibits such charge (Item 8.3). But that is not to say any penalties cannot be charged for the product. Such allowances are given if the product is sold based on a promotional rate, for example 2.0% p.a. lower than the normal financing rate for special campaigns or conditions. In such cases, the bank can recover the “discount” if the financing is settled within the lock in period. Actual cost or loss incurred by bank can be recovered (to avoid abuse). Another example is when a bank absorbs the legal fees for the financing, that actual expense can be recovered if early settlement is made within the lock in period. This Shariah requirement have proven popular for customers seeking short-term financing (plans to upgrade their properties within a few years) as well as property investors seeking for options to dispose properties when opportunities arises.
  2. 100% Stamp Duty waiver for Home refinancing. This feature is available in Malaysia where the government agrees to allow for a 100% stamp duty waiver for Islamic Financing when it is refinanced from a conventional bank. This is to encourage the refinancing market as it appeals to customers seeking additional financing on a property’s capital gains. For example, 10 years ago the customer took up  a loan for RM500,000 on a RM600,000 property which is now worth RM1,000,000. As the balance outstanding on the loan now is RM300,000, the customer is seeking another RM400,000 cash to finance a renovation. If the customer intends to move the loan, the customer will incur a stamp duty for RM700,000 (i.e. RM300,000 existing + RM400,000 additional). However, moving it to an Islamic bank, the existing  stamp duty for RM300,000 will be totally waived and only the additional (top-up) amount of RM400,000 will incur the normal stamp duty. This waiver is applicable for all refinancing from conventional bank to Islamic banks on the amount refinanced (provided the original loan has already paid for the stamp duty prior to the refinancing). This applies for individual customers as well as companies.
  3. Ceiling Rate Price Protection. While many years ago, this feature is mis-sold by many sales person as being oppressive and expensive, with the current climate of changes, this have instead become a competitive benefit for Islamic Banks. The key changes that happened in the past few years was first the Ibra’ (Rebate) guidelines issued by BNM in 2011 and also the Reference Rate Framework in 2014 (Item 8.10). The Ibra’s guidelines says it is ok for the bank to charge a ceiling rate to formalise the Aqad, but the day-to-day charging of the customer must be based on a mandatory rebate mechanism where the effective rate is at par which what a conventional normal benchmark rate is. This means that the customer is not overcharged. More importantly, the customer will not be charged more than the ceiling rate should the normal benchmark rate increase to above the ceiling rate. This provides the customer price protection against high fluctuations of the benchmark rates. Some might say that there is no way rates will breach the ceiling rate but if you look at the length of a financing product of up to 30 years, who is to say the benchmark rates won’t breach during an adverse economic cycle? More importantly, the Reference Rate Framework allows for punitive pricing where banks are allowed to increase the loan/financing rates based on customer’s risk profile to up to Effective Rates +3.50% p.a. If a commercial financing of BFR + 3.50% is about 10.30% p.a., that is not too far away from a normal ceiling rate ranging from 12% to 15% p.a. So, with a Ceiling Rate you get the best of both worlds; if the benchmark rate is below the ceiling rate, you enjoy the benchmark rate (same as conventional loans), and if the benchmark is above the ceiling rate, you only pay based on the ceiling rate (not the same as conventional loans).

GIVING BETTER SOLUTIONS THAT SATISFY SHARIAH REQUIREMENTS

The top 3 reasons above are some of the main drivers for Islamic Financing. For item 1 it is the BNM effort to provide Islamic Banks with a competitive edge based on Shariah instructions. For item 2, it is the government of Malaysia initiative to provide stamp duty incentive for a specific segment ie refinancing segment. For item 3, it is the Shariah requirement to have a ceiling rate which protects the consumer from uncertainty. All these 3 elements come together to provide a competitive advantage to banks and benefit to consumers.

There are a few smaller advantages to an Islamic financing structure (based on specific products such as No Commitment Fees for Islamic Revolving Credit or Overdraft), but it is too many to list down. Granted, these features are incentives and assistance by relevant parties to make the products attractive, and may not be applicable for products outside Malaysia.

In conclusion, the above demonstrates the ability to take a Shariah requirement to make it into a benefit for consumers. This aligns with the idea that Islamic Banking products must contribute to the sustainable practices that offers fair an equitable solution to consumers.

Risk Management in Islamic Banking

IS THERE SUCH A THING AS ISLAMIC RISK MANAGEMENT?

I had this conversation recently until the wee hours of morning, and although I never thought a lot about it, I have come to the conclusion that there cannot be an exact replica of the Risk Management in the conventional sense.

Risk Management is a tool used by all conventional banking institution in the name of good governance, risk mitigation and prudent practice. It looks at financial exposures and its inherent risks to the business, and deeply believe in the risk-rewards pay-off within the generally accepted risk appetite of the organisation. It focuses a lot on control processes, performance monitoring, collateral value, and decision making policies for credit, market and systemic risks.

To a large extend, the risk management framework employed by the conventional banking businesses can be easily adapted by Islamic Banking counterparts. The components are the same, and there is little argument on its applicability under Shariah law. However,  the risk management framework for Islamic Banking institutions must be inherently different as well, or maybe extended to include a bigger scope. It cannot just be seen as a replica of the conventional business; the foundation of Islamic Banking is definitely different.

There are a few divergence in the reason an Islamic Banking institutions should (ideally) follow. This is an on-going argument on the fact while Islamic Banking claims to be a different business model, but it is still engineered by the rules of a conventional organisation. But what are these divergent reasons for setting up an Islamic Banking business?

The lending of money to make money is forbidden.

This may seem like a trivial thing for Islamic Banking as many will say there is no difference between profit and interest. But for us practitioners, there is a big difference in its concept. Because of this difference, the way we think about how a product can be structured is paramount. Underlying contracts, assets, ownerships and roles and responsibilities becomes different from a tranditional / conventional bank (whom are essentially a money lender). To validate a transaction, all tenets and requirements in an Islamic contracts must be met or else it becomes an invalid transaction and any gains from it must be given to charity. Any gains obtained without fulfilling the transactional can be deemed as usury (riba’).

There are specific Shariah requirements that takes Islamic Banking beyond banking.

Some terms are pretty alien to traditional banks, such as commodity purchase, operating lease and rentals, sequencing and ownerships. This is where the divergent begins, because Islamic Banks espouses the concept of “trading” and “entrepreneurship” and “partnership” and “service provider”, away from the “lender-borrower” arrangement. Traditional banks struggle to understand issues of ownership of assets, risk and loss sharing, purchases of commodity and rental of assets. These activities are beyond traditional banking, and may become an operational risk issue if it is not fully embraced.

Islamic Banking should be more closer to a venture-capitalist, crowd-funding model than traditional banking.

The fundamental requirements for earning a profit (and to a bigger extent, how much we can earn from a transaction) is the element of risk sharing, which mean both customer and financier takes some form of the risks of the venture. At the same time, such “risky” venture is mitigated by way of ensuring it is not overstretched i.e. the transactions must be either asset-backed (including the presence of collaterals) or asset-based (evidenced by real trading or assets or commodities) to reflect economic activity.

The amount of risk taken under an Islamic contract can be higher (for contracts such as Mudharabah or Musyaraka financing) but it must be reflective of the economic reality and available assets.

The risk assessment of an Islamic contract must then be enhanced to behave similarly to what a venture capitalist can accept. There will be direct risks on equity, investments and returns. There will be corresponding returns as well. But such concepts will be difficult to digest if the bank is set up based on traditional banking fundamentals, which caters for a totally different profile of stakeholders.

As far as possible, the Shariah committee draws a line for transparency, fairness, and justice.

Islamic Banking should be an extended but integral part of economics. Islamic Banking is supposed to be more than a bank. It shoulders a broader responsibility to the people by looking at needs and providing products that serve a purpose. The idea of responsible financing, transparency and customer service should be the by-word of an Islamic Bank. The payment of Zakat (tithe) on profits which goes back into the community recognises the financial role that it needs to play. Corporate Social Responsibilities also play a role.

In this repect, the Shariah committee plays an important role as gatekeepers to the products and services on offer. Because of the unfamiliar territory of Islamic products, Shariah insists that transparency is critical to avoid uncertainty (gharar), the terms to the products are fair and the banks are ethical in its conduct to ensure justice. Fees and charges must reflect actual costs. Efforts are made to help a customer in distress. And conduct of the bank must comply with the requirements of Shariah.

SO, BASED ON THE ABOVE, WHAT ARE THE  OF RISKS FACED BY ISLAMIC BANKS? 

As a general rule, all risks faced by a conventional Bank must be “transferable” i.e the nature of the financial transaction must, as far as possible, allow for the TRANSFER OF RISKS. Wherever the opportunity arises, the Bank must be able to quickly pass the risk of the asset or valuation to the customer. Such understanding is also apparent in Islamic Banks. Looking at most Islamic Banking contracts, their structure allows for the transfer of risks, which follows the transfers of ownership, responsibilities and obligations from one party to the other. Contracts  such as Murabahah, Musawamah and Qard works by transferring the ownership, responsibilities and obligation from the Bank to the Customer.

Alternatively, mostly exclusive to Islamic Banks, are structures that allows for SHARING OF RISKS. The structure is more “participative” in nature, where there are benchmark by which determines the level of risks a party should have. The regular types of contracts that continues to share risks are Mudarabah, Musyarakah and Ijarah.

COMMON RISKS 

As mentioned before, the risks faced by a conventional bank and Islamic Bank should be very much the same, except for risks arising to the execution of Islamic contracts or pronouncement of the Shariah. While there will be common elements of risks for both types of Banks, the importance of Shariah ruling and decisions result in Islamic Banking becoming so unique. The following are the Risks commonly faced by Islamic Banks:

GENERAL RISKS – Risks existing in both conventional and Islamic banks. 

  • Credit  Risks – Arises due to counterparty risks (possibility of default by the party taking financing) where the counterparty fails to meet its obligations, in terms of payment, uncertainty of industry,  change of direction or diminished collateral value. This lead to settlement risks which means the Asset quality has diminished.
  • Market Risks / Interest Rate Risks – More macro in terms of effect on the risks. It relies on the performance of the market as well as the quality of the financial instruments (price, performance, valuation, demand, yields and inability to reprice. It leads to exposure to interest rate risks, where the risk of the bank increases with movements in the rates.
  • Liquidity Risks – Refers to the risk of inability to return cash to investors or stakeholder in stressed scenarios, resulting in forced borrowings from the market (usually at higher price) coupled with the possibility of not able to dispose assets. This may lead to valuation risks.
  • Operational Risks – Due to inadequate control of internal processes and operational practices, the risks may result in real loss of income and potentially reputation. Human errors may be difficult to unwind especially if there is financial implications. There may also be legal risks as it may be considered a breach in contract by the bank.

ISLAMIC SPECIFIC RISKS – Risks arising from operational and processing function

  • Transactional risks – Especially under Islamic Banking structures, transactions play an important role as part of the Aqad, where required.  For example, the sequencing of a Murabahah transaction. Failure to ensure compliance to the Aqad requirements will lead to potential invalid transaction and loss of income (or flow to charity).
  • Valuation Risks – Due to the nature of some Islamic Banking contracts, especially equity based structures, there will be challenges in valuation of the portfolio.  Reduction in valuation will result in real losses for the investors.
  • Displaced Commercial Risks – Displaced Commercial Risk (DCR) refer to the risk of mismatch between the fixed/contracted obligation to the depositors vs the uncertain returns on the financing (income) which may result in the income is insufficient to meet the obligations to the depositors. For example, the commitment for Islamic Fixed Deposit is 4% (contractual) but the Financing portfolio into which the Fixed Deposits is deployed into only earns 3% (actual returns). Therefore, the 1% shortage is the DCR where the Bank will have to flow 1% of  income from other portfolio to meet the deposit obligation of 4%.

SHARIAH RISKS – Risks arising to non-compliance of Shariah decisions and Shariah instructions.

  • Shariah Compliance Risks – The operation of an Islamic Bank is hugely dependent on the requirements of the Shariah Committee and approvals obtain on the process and procedure. Inability to comply with Shariah requirements puts the operations of the Islamic bank at risk as the department may be regarded as non-Shariah compliant business.
  • Fiduciary / Ownership Risks – Some of the structures under Islamic contract requires the bank to operate outside the scope of a financial intermediary. It requires the bank to hold property or trade commodities or own and lease assets, with various contracts using various roles and responsibilities. The risk of multiple roles and function must be clearly defined and implemented.
  • Regulatory / Reputational Risks – Changes in regulations requires quick adaptation to ensure compliance to regulation and maintaining the banking reputation intact.?

SO HOW DO YOU MANAGE ISLAMIC RISKS AND SHARIAH RISKS

As mentioned, Islamic management of risks should not be any different for the base of conventional bank’s methodology of measuring risks. There must be deep understanding of the products and structure for the bank to be able to assess the risks associated. To manage an Islamic Bank and its risks, the bank must first identify each of the risks and form safeguards to settle the above. Then only an Islamic bank can formulate suitable controls to ensure the Shariah specific processes and Shariah pronouncements are being monitored and implemented with sufficient support (internal or external). Wallahualam.

Connecting the Dots : Islamic Fintech

REVOLUTION OR EVOLUTION?

This posting is in the danger of being written too long, but I think it is necessary to close this year with this topic, simply because it looks at the future. The word “Islamic Fintech” has been buzzing for quite some time now and there have been pockets of excitement on what it should mean. Many financial institutions have jumped onto the bandwagon declaring they are also part of this new wave of what a bank could offer.

While all these are still early stages of development, I do notice a lot of effort is built into “digitalisation” and “apps-based application” and “efficiently and convenience” of EXISTING banking processes and relationships. These enhancements are still driven by financial institutions and centred around improving traditional processes for banking services, or short-circuiting the credit processing elements of financing. Although enhancements via technology is an important aspect, these should not be defined as “fintech”. There is an element of fintech in process improvements, but PROCESS IMPROVEMENT itself are not fintech.

DO PEOPLE NEED BANKS?

Traditionally, banks always hold the impression that “People need Banks, one way or another”. It is this understanding that the bank can continue investing into their brick and mortar business model, with customers always coming to them when they need capital, financing funds or products and services. The competition is that who can deliver existing products in the most efficient manner, with technology as the enabler. Money is spent to improve accessibility to the bank’s EXISTING products, services and proposition.

In improving processes, banks just needs to concentrate on all the products and services offered and build the corresponding infrastructure to ensure efficient delivery with technology. It can be “Apps-driven” based on inquiry or transaction-based, with new features attached to existing products. It is just creation of new delivery channels which will deliver existing products to customers faster than before.

But that in my view is NOT what fintech is all about.

IF FINTECH IS NOT PROCESS IMPROVEMENTS THEN WHAT IS IT?

The easiest google/cut/paste definition of Fintech is that “fintech is a new financial industry that applies technology to improve financial activities and FinTech is the new applications, processes, products, or business models in the financial services industry, composed of one or more complementary financial services and provided as an end-to-end process via the Internet”. The key words I believe are:

  • New Financial Industry
  • New Application
  • New Processes
  • New Products
  • New Business Model

While “Process Enhancement” can help support the “New Processes” element, but I think it falls short of the idea for fintech i.e to re-think the business model of financial services. The idea of fintech should be this: Understanding what the requirements of the Gen Y customers are and how they work, develop the products and services on platforms that they are most familiar with, and the proposition that the bank can offer on their chosen platform. It is a total re-think of delivering products and propositions to the up-coming Gen Y potential customers.

SHARING OF FINANCIAL WALLET

As much as banks and financial institutions like to believe the financial wallet cannot exist outside the regulated financial system, the evidence is slowly being presented as otherwise. Companies are finding ways to survive, live and thrive outside the banking system with facilities and opportunities in the New Economy, slowly eroding the traditional banks’ share of financial wallet.

Big Data companies have proven that their database is far more powerful (and valuable) than the database an individual bank would have on its existing customers. Bitcoin and other cryptocurrencies goes through thousands of transactions within blockchain and is only realised into banks network when actual physical cash is needed. eWallet lets value resides in tech platforms for purchasing and sales of goods and services (more like barter or exchange of goods and services), and up to a certain extent provides microfinancing. Prepaid and loaded value arrangement provides free seed funding and capital for businesses, without the cost of borrowing incurred via banks. Peer to Peer (P2P) arrangement links crowdfund Investors to Entrepreneur without complicated documentation with speed and transparency levels never seen before. Sharing of risks and profits (including potential pay-offs) are now more understood as compared to traditional financing arrangements. Mudharabah, Musyarakah, and Ijarah may now have a place in an economy where equity participation is expected and sought after.

“FINANCIAL SOLUTIONS” ARE JUST A SINGLE ELEMENT IN THE UNIVERSE

Technology can now provide a single-point possibility of all our needs; goods, services, food, shopping, bills payment, money transfers, investments, borrowing, deliveries, medical, transport, social interaction, travel, holidays, education, careers development, information and even branding. Financial services can be integrated into all these elements, now driven via apps. But for this new infrastructure, the various “relationships” are needed to be identified and re-looked and re-engineered. With the proper Shariah compliance consideration.

This “single point” proposition is where tech companies play a crucial part. Rethinking the financial model must happen with the involvement of tech companies due to the advantage of everything being on the internet (internet of things). There are still a lot of limitations to what a bank can do, understandably due to financial regulations. The space of where banks are continuously competing (or evolving) is the “FINANCIAL SOLUTIONS” box above, and maybe payment gateways linked to service providers. But tech-companies? The revolution of technologies move so quickly that regulations will continue to struggle to catch up.

In the diagram above, I attempt to identify some of the areas of traditional banking where fintech can come in and provide a like-for-like solution or even fully replace the proposition by traditional banks. Certainly a lot of the consumer touch-points can be easily replicated in a technology platform, and crowdfunding and crowdsourcing can replace traditional financing and working capital requirements as well. Some services are still embedded into a banking structure (such as Current Accounts or Treasury product propositions) but over time, such products may be linked to fintech and the banks may eventually become ancillary service providers rather than main bank, earning just fees for services provided.

The landscape of what a bank offers will ultimately change in the next few years, when consumers no longer go to banks for financing, services, remittance and settlement of business transactions. As the new generation grows up with tech and becomes financially affluent, their expectation of how a banking experience should be will also dictate the model a bank adopts.

CONNECTING THE DOTS

So where do I see the banking industry in the next 5 years? Personally, I think a “price-comparison platform” will emerge, as seen nowadays in the travel/hotel/tourism industry. Information from all the financial service providers are flowed into a single platform, and consumers are able to immediately compare products, services and prices on a single platform and choose their solutions. Instead of customers subscribing to multiple banks offering different products and services (at different pricing), they only need to subscribe to a single platform where all information on the products are available to select. This is where the promise of fintech can thrive; accuracy of information, convenience of access, and speed of transaction.

It is a matter of time the various industries converge. We may think regulatory pressure will halt some of the progress but mostly it have been reactive regulations. And the challenge is that these developments are driven by tech companies which has no loyalties to banking regulations as their scope of business cuts across various industries. It will be a period of “non-regulated” until the market starts to recognise the need to regulate and managing the risks. A regulatory sandbox will be usefull, but if the “New Economy” moves faster than the speed where regulations are being formalised, there will be a lot of speculative and arbitrage opportunities for the market to gain.

This also means the New Economy brings new risks that the consumers are not aware off. While the banks have been fine-tuning its risks that it takes over the past half-century or so, the fintech companies may not see the elements of risks other than technology risks or systemic risks. Almost all the risks faced by banks are also prevalent in fintech companies or non-banks, plus the specific risks by fintech companies. They might be great at integration of technology, but banks are still masters when it comes to understanding financial risks.

WHAT NEEDS TO BE DONE?

As I mentioned, banks understand risks better than a tech company. A tech company understand speed, efficiency and channels better than any banks can have. At the moment, banks are developing “fintech” on their own which is mostly a process improvement project. Tech companies are developing “banking services” on their own as well, where it linked investor’s money and economic entrepreneurs via technology. The question is really, “why not a bank consume or enter into a partnership with tech companies to provide a solution beyond traditional banking?” We have started to see this trend where banks attempt to purchase outright a tech company and use the company as an incubator for new products and services. It should look into having a different operating structure which encourages new ideas, innovation, internet-based solutions, as well as delivering to a larger segment of consumers (including the Unbanked segment).

The end-result might not look like what we recognise as banks we see today. This could be a separate line of business for banks, where the element of technology integrated into the wider economy is more dominant than its traditional banking products and services. You could have Bank A offering the traditional products and services, and Bank A-Tech offering fintech solutions to a new generation. The same bank catering to 2 business lines, employing different delivery channels.

But breaking away from such traditional infrastructure may take time, and the greatest fear is that the market cannot wait. Fintech companies may be able to offer similar proposition in half the time required, and this will not motivate fintech companies to join-venture with a financial institution. In an environment where new opportunities arise at the blink of an eye and regulations have yet to be formalised, the temptation to go on its own will drive innovation by the fintech companies, leaving behind banks. Fintech companies have the capability to look at consumer needs and develop the solutions from the bottom, and flow the linkages to the top. Connect the dots where the solutions provider are linked together in a platform.

Will fintech companies be the next driver in providing financial solution? I know my answer to that question. It is perhaps just a matter of time where future banking is done outside of a bank. Perhaps the model of banking needs to be re-imagined.

Wishing all my readers a Happy New Year in 2018. I appreciate the support I have received so far. But the new world beckons and hopefully we can do enough to ensure the continuation of the banking industry. I hope Islamic Banking can play a bigger role in taking the industry into this exciting online generation.

5 Reasons Why PLS Financing Does Not Fit Islamic Banks

Click on picture to go to point-by-point commentary on the above

Many months ago, there was this posting by Dr Daud Bakar, CEO of Amanie Group and Chairman of Shariah Advisory Council (SAC) of Central Bank of Malaysia (BNM) where he stated Profit Loss Sharing (PLS) structures are not suitable for Islamic Banks. It caused quite a stir in the market as there have been a lot of push by Shariah circles on Islamic Banks to develop Islamic Banking products based on PLS.  People were surprised that such comments were made by the Chairman of SAC, when BNM have been active in pushing Islamic Banks to develop these very contracts.

So what is the story then? Do we want to see Equity Products such as Mudarabah or Musyarakah Financing in the market, and is it feasible as a business model under current banking structures?

As much as I want to say we are ready for it, the reality is that there are other considerations where offering these financing products is maybe not the right fit for Islamic Banks. We may attempt to develop them nonetheless, but we have to be wary of the requirements set out in the Policy Documents and comply with it.

As I have written before in Disruption Islamic Contracts the industry is entering the era of Compliance rather than Innovation. If we were to develop for example Ijarah products, we will not be able to comply fully with the contract requirements (such as ownership risks and force majure), and Islamic Banks will opt for “easier to comply” contracts. The risks inherent in the contracts will also hamper full-blown development of such contracts into workable compliant structures. It is unfortunate; the Policy Documents issued by BNM are very extensively written but a challenge for Banks to fully comply with.

And when you expand your intention to go into equity-based financing (PLS), the risks would remain with the Bank as these Islamic structures do not allow for transfer of risks from the Bank to customers. This greatly hampers Banks used to mitigating only certain types of risks, or in the best case scenario, Banks are only willing to introduce basic or safe-feature products, with a lot of legal mitigants to protect Bank’s interest.   It is an uncomfortable territory for Banks where the issue of Banks holding “unconventional” risks cannot be satisfactorily addressed.

In Dr Daud’s assessment, he identified Five (5) reasons why PLS do not fit Islamic Banks, in this current, general model:

  1. Banks are set-up as Financial Intermediaries
  2. Fiduciary Relationship resulting in Conflict of Interest may arise from Bank’s participation
  3. Cost Required to ensure compliance
  4. High Cost of Capital for PLS
  5. Re-think of Accounting Standards for PLS

Click this link to go to the discussion page on this topic. I looked at the points by Dr Daud with comments based of my own personal view. Building a Participation Banking Model : Commenting on Datuk Dr Daud’s points

Go to Datuk Dr Daud Bakar's views

Click here to go to discussion

Why do we need to discuss PLS?

Our discussion are now becoming more relevant moving forward. In my view, traditional Islamic Banks and the way it was set-up, caters more for debt-based structures where risks are traditionally understood. The template used for building Islamic Banks was conventional banking. While we have “Islamised” the operations, systems, processes and products, the similarities between Islamic and conventional banks remains prominent. Leveraging on conventional banking infrastructure was a necessity.

That is essentially what traditional Islamic Banking did. Replication, compliance, and competition.

Needing a new Banking model. An Alternative Banking model.

So if PLS is not the right fit for Islamic Banks, where can it exist then?

I believe this is the right time and opportunity to ask this question of where PLS should thrive. With all this talk about Value Based Intermediation (VBI), Fintech, Investment Accounts, Crowd Funding, Private Equity, Venture Capitalists, Participation Banking and Challenger banks, perhaps the PLS structure should be the next inclusion into these discussion. The sandbox is open, and I sincerely believe this opportunity allows for the serious consideration to include PLS. The risk profile you see in these types of Fintech forums cater for a different thinking; banking the un-bankable, understanding of unconventional risks, investment into entrepreneurial ventures and community involvement in sharing of risks.

And more interestingly, most of the structures are already available in this “alternative banking model” and have significantly similar characteristics and behaviour expected from Islamic Banking practices. Especially on the sharing of risks and returns.

It is something that interest me immensely. I believe the next wave in Islamic Banking must be in this new digital world where speed, access, and business model (without financial intermediation) forces a monumental shift in banking practices. As we are starting from ground zero, why not put PLS / equity-based structures / participative banking / as the focus for all these new developments? If not now, then when?

Leave the debt-based structures with the traditional banks, where the familiarity with credit, collateral, sources of payment and audited financial statements will continue to drive traditional businesses.

Let PLS force a re-think into alternative Islamic banking, where entrepreneurial ability, direct investors, sharing of returns, performance of business, risks understanding, speed, low costs, access to the un-bankable population, big data mining, and technology-driven solutions become the main priorities for development.

There is little choice for us where change is now required. If change is needed, why not put PLS as part of the necessary change? The next wave must start. Watch this space. More on Fintech and alternative models soon.

Real Cost of Tawarruq

Recently, the topic of Tawarruq & Commodity Murabahah has been popular in the industry as both BNM and Shariah scholar have been asking operational questions on the implementation of Tawarruq arrangement in the industry. It seems, even with the Policy Documents, there are still some divergence in terms of operations and understanding of the minimum Shariah requirements for Tawarruq. Each financial institutions have their own operational abilities and processes that differs from one another; to have a standardised platform may be a bigger challenge than imagined.

The rise of Tawarruq in recent years should really not be a surprise to many observers. We are seeing that most financial institutions in Malaysia now consider a Tawarruq structure a “must have”, because there really is no options as other Banks also deals in it. It has become norm, and while scholars might take a view that Tawarruq should be a “last resort” option, there have been so much effort invested into making Tawarruq an efficient machine. Just take a look at the Bursa Suq Al Sila and what it is capable today.

Question : Is it Cash or Committed Limit?

The latest consideration of Tawarruq is on the treatment of Tawarruq funds after the transaction. What is it exactly and how is it been managed within the Bank, with the Capital Adequacy Framework for Islamic Banks (CAFIB) implemented a few years ago (latest update this year 2017). In particular, when a customer is approved a certain limit (let’s say $1,000,000) and a single Tawarruq is done for $1,000,000 for the line (instead of multiple small Tawarruq for each usage of the amount within the $1,000,000 limit), where does the money goes, and what is it exactly in the eyes of Sharia?

To clarify, upon the completion of Tawarruq, real money of $1,000,000 is generated. Cash. It is not a “line” in the conventional terms, but it is money (actual cash) now belonging to the customer. He can draw out the money anytime.

But the practice is that the money is kept in the Bank’s books unless requested by the Customer, and by keeping this the Bank will give a “rebate” on the money kept in the Bank, similar treatment as if a “principal payment” is made (although it is re-drawable). In the meantime, the Bank utilises the money (taken as principal payment made) for its own banking business activities.

The question that I believe we will have to eventually address are on the following:

  1. The Tawarruq is done on a single transaction for the full amount, therefore it is a full release of capital (i.e. fully funded). As such, it should have a “capital charge” consideration if it is not fully utilised by the customer. Bank has released fully the funds to customer (therefore Bank should be entitled to earn a full profit on the amount). The formula for profit would be $1,000,000 x Profit Rate – Cost of Capital. Note the Cost of Capital is on the full amount.
  2. Then, the subsequent mechanism instead is as follows: since the customer did not fully utilise the funds, the customer is given a “rebate”. For example the customer only uses $50,000 of the $1,000,000. The formula for rebate is that ($1,000,000 less $50,000 = $950,000) x Profit Rate x period unutilised. Banks earn full Profit Rate on $50,000 and gives rebate based on $950,000.
  3. Of course, Banks will utilise the $950,000 meanwhile but at what I imagine are for short-term instruments because the $950,000 is customer’s money (i.e. committed amount) and can be requested at anytime. Bank needs the funds to be as liquid as possible. So the Bank do not earn a lot from this “short term investment”.
  4. Also, there is concurrent discussion as to when the amount is kept and used by the Bank, what is the underlying contract used for this “unutilised, principal payment which is drawable on demand” amount? Is it kept by the Bank as Qard (loan), Wadiah (safekeeping), Amanah (trust) or can it be taken as Tawarruq deposit (monetised obligation) or Mudharaba (investments)? Different Banks have differing views on this, but I suspect BNM is trying to standardise this understanding and practice.
  5. But more importantly, while the Bank is giving customers “rebate” on the amount they do not utilise (but committed by the Bank), is there also “rebate” on Cost of Capital then? It seems unfair when it doesn’t. Tawarruq proceeds are deemed fully drawdown (based on full amount) and incurs full Capital Charge but is earning returns based on “only” the utilised amount. The rebate formula is very specific, and it does not contain the amount for “rebate” Capital Charge.

In the conventional Banking world, this is not so much of an issue. Their approach is simple: if the amount is “committed” to the customer, 2 things will happen:

  1. Once the amount is drawdown i.e. utilised by the customer (lets say $50,000 utilised of the $1,000,000), then full price is charged on the $50,000
  2. On the amount unutilised i.e. $950,000 the Bank will charge a “Commitment Fee” of 1.0% per annum (or any negotiated rate) on the unutilised (but committed) portion. While 1.0% per annum do not usually cover the full Capital Charge on the $950,000 it somewhat compensates the charge as the Bank (because $950,000 is still a “limit” and not Cash payout) can still use the unutilised amount in its day to day banking activities i.e. investment in short term financial instruments.

Scholars generally do not agree with the concept of Commitment Fees, and there is specific BNM guidelines prohibiting the charge of Commitment Fees in these specific scenarios.

The Capital Charge factor

I still think there is a disconnect somewhere that while we aim to achieve the same end result by the practice of Ibra’ i.e. “Rebate”, but with Capital Cost coming into play, it may eventually seem that the cost of running an Islamic Banking business can be higher than a conventional Bank. It really depends on how we interpret the guidelines and the treatment on Tawarruq especially the single Tawarruq structure where the full amount is transacted i.e. whether it is a full Capital Charge or otherwise.

I know what BNM usually advise i.e. it is a full Capital Charge. But this concurrently means, without Commitment Fees on the unutilised Customer portion, it may result in extra costs for the Bank. Now I am not suggesting we introduce Commitment Fees for Islamic Banking; this idea of Commitment Fees is a conventional banking concept for recovering opportunity costs, which may not sit well under Shariah consideration.

But in the world we operate today (where each $$$ is risk weighted to a cost), this translates to “Actual Costs” incurred by the Bank, based on the interpretation for the “single full amount Tawarruq transaction”. And Shariah may want to consider this as it is a real “Actual Costs” and not opportunity costs. By letting the money sit still, the Bank incur real, actual costs which is not recoverable as per guidelines. It may have started as “recovering opportunity costs” but if you really think about it, this is above opportunity costs. Maybe in the conventional space, they may even revise Commitment Fees to recover BOTH Opportunity Costs as well as Capital Charge.

So, my question is this: should both the industry and Shariah scholars re-look at the basis of Commitment Fees (in the context of how Tawarruq works), or re-think about the “Rebate” mechanism and perhaps have an adjusted formula to factor in a “Rebate on the Capital Charge”?

Can Shariah consider this mechanism to recover a real cost incurred by an Islamic Bank?

In the meantime, Happy Ramadhan to all, and may you have blessed month ahead.