Toby Birch, Managing Director, Oppenheim & Co Limited, Guernsey, makes  some good points about the sector in a recent essay. Read below.

Ready for Retail?

Toby Birch, Managing director, Oppenheim & Co. Limited, Guernsey; gives an insight into Islamic banking.

Anyone with even a passing interest in Islam will be struck by the common sense and simplicity of its message.  As a non-Muslim this is most striking when visiting any mosque and witnessing the relative informality of the clerical structure during prayers. If one delves deeper into its economic lessons then similar themes appear. It soon becomes apparent that there is profound wisdom and age-old understanding of human behaviour. Westerners struggle to comprehend why interest is a problem and shrug it off as a religious idiosyncrasy. However, there is nothing superstitious about refuting the use of usury. The UK will be spending more on interest than it does on defence in 2011 while the entire Euro currency block wavers under the weight of debt; exactly who is being irrational by urging its avoidance? Some smug commentators lump gold bugs and the ‘interest-free crowd’ into the same category, implying they are somehow unsophisticated. As one who is associated with both bullion and Islamic Finance, I would appear to be firmly wedged in that pigeonhole.

We are now all-too-familiar with the tale of the Emperor’s New Clothes, post-2008. The children’s fable reminds us of our reticence to ask simple questions for fear of sounding stupid. It sometimes takes the naïve or innocent to bare the obvious (pun fully intended). Similar demands must be made of the Islamic Finance industry, especially in its formative years. Recent reports claim that the asset base of such institutions is set to hit $1.5 trillion in 2012. It is difficult to determine how such forecasts are derived given the wide variety of data sources for each industry sub-set. The total may well be swelled by the accumulation of petro-dollars at Islamic banks alongside the issuance of sukuk (bonds) plus takaful (insurance) business. While the numbers are impressive and the growth rates likewise, one wonders whether such bank deposits are actually doing anything useful for the wider economy or simply stagnating and devaluing with the dilution of the US dollar. Perhaps the real numbers to look at are those of penetration rates.  There are 80 million Egyptians, most of whom are Muslim, and more in Indonesia, yet Islamic finance is an after thought. Few institutions have a regional strategy, let alone international presence, to enable distribution.

Given the history of Islam, one would expect its financial system to be a grass-roots phenomenon. After all, the religion was propagated by word of mouth, assisted by the example set by Muslim traders, known for their honesty and fair dealing. However, the modern industry has a hard, institutional feel to it. Western investment banks are drawn by the hefty corporate finance fees on big sukuk bond issues. There is minimal appetite for offering retail financial services. Small but sincere fund providers struggle to afford the extra costs of Islamic compliance. Large institutions argue that if one cannot afford a single scholar for your fund’s fatwa, let alone an entire Sharia Board, then hard luck, that’s the market rate. Their wealth management arms have also attempted to milk money from the wealthy in the Middle East, offering Islamic-looking funds catering for exotic and esoteric themes. The average fund size is apparently around $30m so it would appear their uptake has been unspectacular.  It is tough to track both the size and performance of such vehicles as the data is often the preserve of subscription-only services. The open qualities that spurred the spread of Islam appear to be lacking in its implementation. Another missing aspect is the simplicity, especially if one has ploughed through a Prospectus with a dizzying array of arrows on transactional diagrams. It is reminiscent of the illustrations for mortgage backed securities that supposedly proved their high credit ratings.

Institutions can rightly counter that the retail approach has struggled, citing the example of the Islamic Bank of Britain, requiring on-going funding from its shareholders. Like all modern businesses, scale is essential to compete with interest-based banking services. This is why Islamic retail banking requires more than just a large pool of Muslims to succeed; the customers need to have money to deposit as well. This allows banks to upsell services which are more profitable for both the institution and customers alike, and ultimately more useful for the wider economy. These are in the form of restricted and unrestricted accounts that allow greater flexibility for risk and reward. Ultimately this ‘equity’ approach is the most economically useful activity a bank can perform. It reduces systemic risk and counters the inflationary effect of credit creation. There is huge demand for borrowing by SME’s (small to medium sized enterprises) that cannot find finance. Even when secured, credit is offered at extortionate margins by the interest-based lenders. The tragedy for western economies is that SME’s generate the jobs but are being starved of financial fuel. For too-big-to-fail banks, the bail-out has been the greatest coup of the century. A generation of tax payers will have to fund their liabilities with none of the benefits. Like an implanted cuckoo, our banking system acts like a sibling but is really a parasite that gorges our food and throws us out of the nest once they’ve outgrown us. The government, like the host parents of the innocent bird, is tricked into feeding the invader until they are exhausted by its constant demands.

There are also enormous barriers from regulators, mainly in the form of the Basel Accords that encourage debt rather than equity-based assets by their very nature. The old Latin maxim of ‘who guards the guards’ springs to mind when considering such decrees. The proponents of usury permeate every institution, designing laws to protect bond holders and receivers of interest over those who take greater risk in the form of equity. There are also benign barriers to Islamic banking, even in tolerant countries like Canada whose regulators want banking availability for all religions, not just Muslims.  Perhaps the religious tag needs to be replaced with an ethical one to widen its appeal and palatability. After all, the avoidance of usury is not just common sense but is also a common theme for People of the Book (a term encompassing several other religions).

One would expect to see leadership in the Middle East where retail banking has more potential for significant success. However, Malaysia appears to be taking pole position with greater uptake for Islamic products and services. Just like any other service, the benefits of Islamic finance needs to be sold to customers. It cannot depend on duty or devoutness alone, especially when customers pay a higher price for the privilege. After all, why should individuals invest according to Sharia values when Muslim countries’ Sovereign Wealth Funds fail to do so? Using these principals for investment and business transactions is not just the right thing to do but is beneficial for the economy and investors alike. It avoids the destabilising effect of derivatives and leverage while enhancing genuine yield generation and sustainability of the equity approach.

While recognising the need for capital markets one should not overlook the fact that institutional money is ultimately sourced from mass market deposits, pensions, insurance and investments. This stable source of capital could provide some of the liquidity and long-term funds Islamic banks are desperate for. Will a retail revolution arise in 2011? Probably not, if 2010 is anything to go by. We will likely endure another year of sponsor-driven conferences with their euphemisms, tales of growth paradigms and fancy funds. Like their western counterparts, some Islamic financiers want a speedy return to business as usual, finding formulae to mimic an interest-based – and ultimately self-destructive - system. Islam is the oldest yet the latest thing whose tenets stand firm as generations come and go.  The lack of consumer empowerment has allowed the industry to follow fashion, dictating trends from the top; it would be wonderful for Islamic finance to flourish organically from the bottom-up.