COMPETITIVE PRICING OF ISLAMIC FINANCIAL PRODUCTS
WARREN EDWARDS
Conventional wisdom states that Islamic banking in its present form dates back to the late 1970s; the theme, however, is not new. Usury was an issue 400 years ago in Europe. In Shakespeare’s Hamlet, a Danish father advised his son: “Neither a borrower nor lender be; for loan oft loses both itself and friend and borrowing dulls the edge of husbandly”
In a Venetian setting, he wrote about how a money-lender demanded his “pound of flesh”. Even before the advent of Islam, in Roman times, Horace wrote: “Happy the man who far from schemes of business, like the early generations of mankind, ploughs and ploughs again his ancestral land with oxen of his own breeding, with no yoke of usury on his neck.”
Competitive advantage is a function of either providing comparable buyer value mor e efficiently than your competitors, providing a product or service at lower margins, or performing activities at comparable market costs but in unique ways that create mor e buyer value than competitors, and hence command a premium price (product differentiation). Price can be defined as value plus a reasonable sum for the wear and tear of conscience in demanding it.
A traditional non-Islamic financing product involves the lending of principal for interest. The LDC debt crisis of a decade ago and continuing problems in many, if not most, African countries shows that interest servicing can soon overwhelm a nation’s GNP. Banking principles are confused with interest – self-interest.
Nevertheless, many Islamic banking products are really not so very different from some banking products available in the conventional market. Islamic products, like non-Islamic ones, produce either a fixed pre-determined return for the investor in a Murabaha or Ijara form, or a return depending on the performance of the underlying business, in a Musharaka or Mudaraba, which in the West one might call venture capital or equity investment.
During a presentation at the Institute of Islamic Banking and Insurance, Iqbal Ahmed Khan, of the Islamic Investment Company of the Gulf (IICG), discussed how IICG was creating a fund of stock market-listed Islamically-ethical investments. Ethical “green” investment funds in the West have also been established and provide a comparison.
Clearly, if the products have close substitutes in the conventional banking world, significant product differentiation does not exist. Th e Islamic bank’s clients will see a large premium over a Western near-substitute and demand a lower price or better performance – or more than likely there will be new entrants to the market – both Western and Islamic.
There is now clear evidence that markets are increasingly global. Turbulence caused in the Mexican markets can have an effect on markets as far away as Thailand and Indonesia. Funds are increasingly foot-loose and move in search of value wherever opportunity shows itself Not so long ago, the South African bond market was in a world of its own. With the opening of markets, Rand interest rates now track interest rates in the rest of the world.
News and information travels fast. This is the age of the information superhighway. Financial products will soon be available throughout the world via the Internet. Barclays Bank has a World Wide Web page and so has Fidelity. First Mortgage Securities has just closed its first mortgage through the Net. It would not be too surprising if early in the next millennium, the largest financial institution in the world turned out to be not Tokyo Mitsubishi or some other product of Japanese or US bank mergers – but Microsoft Bank. Islamic investors in the Gulf could be buying financial products from Malaysia, the UK or the US directly from their computers and satellite-linked modems.
Nevertheless, cultural differences do exist. The retail market is traditionally parochial. The only major foreign retail banks in the UK are Australian or Irish. National Australia Bank has retained the regional names of Clydesdale and Yorkshire Banks. British banks have generally had disastrous results in the US and patchy results in the rest of Europe. Citibank, a firm that has recently announced it will be opening an Islamic bank in Bahrain, experimented with a retail network in the UK some 20 years ago, without much success.
Margins will fall through competition. Fixed rate home mortgages were introduced to the UK market some six years ago. Initially they were a novelty and margins were attractive. Now, every bank and building society is offering them. The same happens in the capital markets.
US commercial paper issued by prime corporates was issued at 200 basis points below LIBOR in the early 1980s. The margin below LIBOR now would be about 25 basis points. Islamic banking is like any other banking business and the same market forces apply. Profit margins fall as new financial institutions enter the Islamic banking market.
Of course, a devout Muslim may wish to invest in an Islamic fund. Other politicallysensitive Muslims may wish to be seen to be investing in Islamic instruments. They would be prepared to sacrifice some return for the privilege. However, the market is no longer in its infancy, bankers from Western institutions compare returns directly with returns on haram investments. Competition has already reduced returns on Islamic products and an Islamic bank cannot take its clients for granted.
Delphi Risk Management introduced Islamic retail products for a South African client – a major Western bank. The local Islamic banks were providing low returns in an environment where direct comparisons with conventional banking products could be made.
The superior returns and service offered by Delphi’s client over the Islamic banks, combined with the prime rating of the bank, proved attractive to Muslim private clients and businesses. What helped, of course, was the fact that whilst interest was taxed in that jurisdiction, capital gains were not.
Fairly or unfairly. Western banks are regarded as better credit risks than Islamic banks. It is incumbent on Islamic banks to reduce their costs and improve customer service. They do not have a captive clientele.
Costs are a function of overheads and the pricing of risks. Overheads can be streamlined through business process re-engineering. Risks have to be identified and measured. Risks can take a number of forms. The following list is by no means exhaustive:
• Accounting: In most countries of the world, there is a tradition of legitimate tax avoidance. In some countries, evasion is the norm. Several sets of accounts are kept. Profits are understated. How does an Islamic bank gain the true return on a profit-sharing investment?
• Competitive risks: The risk that the bank’s new product has is copied and business is transferred to a competitor. Financial products cannot be patented – or can they?
• Counter-party risks: As with conventional banking, but with the added risks of lack of a mortgage or specific or general charge over assets and weak enforceability.
• Country: Many of the Islamic clients are in emerging markets or in politically unstable zones.
• Credit: A detailed analysis of the client’s accounts prior to investment may not be possible.
• Cultural: Can loans be recovered? Does the debt have to be forgiven? Are late repayments permissible?
• Currency: The strongest “Islamic” currencies are linked to the US dollar, not exactly a strong currency these days. Currency forward markets in such currencies may not be liquid. In any case, some Sharia boards may not approve of forward currency hedging.
• “Interest” rate: In a world of free information, the market interest rate is inevitably going to be used as a benchmark for fixed return transactions. Variations in global and local interest rates have an effect on the value of the transactions. Early repayment could lead to a loss of value.
• Image: Customers may be dissatisfied if the returns on investments prove inadequate or they have been charged excessive rates. Witness the effects on Bankers Trust following the sale of leveraged swaps to Proctor & Gamble and Gibson Greetings.
• Legal: Even if loan recovery is culturally possible, is debt recovery legally enforceable? Clearly in a profit-and-loss-sharing transaction, this is not possible.
• Liquidity: Can assets be realised to meet calls from investors? Investments are made in commodities for liquidity purposes by some Islamic banks, but liquidity also requires price stability of the liquid asset.
• Operational: Are the internal controls adequate?
• Regulatory: How does the lack of short-term interest-bearing investments square with regulatory requirements? What is the appropriate risk/asset ratio for a portfolio dominated by equity-type investments?
• Sharia: Could the transactions be deemed haram after initially being deemed halal?
• Tax: Is VAT payable on Murabaha type transactions? Banks cannot generally recover the full VAT in many jurisdictions. Banking transactions are often regarded as exempt from VAT and not zero-rated.
The probability of losses due to these risks must be evaluated and incorporated into the pricing of the product.
A common theme at Islamic banking meetings and conferences is the need for greater innovation. Bankers, Islamic and Western, should apply more creativity in the creation of products that meet the genuine needs and demands of Islamic investors and borrowers. During the Prince of Wales Innovation awards for 1995, the winner said: “we were prepared to listen to the marketplace and then look at the things we were good at and then put the two together”.
The successful purveyors of Islamic financial products, which may be Western ones, will be those which are the first to identify the emerging and evolving needs of the Islamic consumer and to offer product improvements which satisfy those needs. Banks should seek out buyers with the most difficult needs – they will become part of the firm’s research and development programme.
Trends will have to be spotted early. The successful Islamic bank will be the one that leads the market, having identified the trend. Even if the bank is on the right track now in providing a range of Islamic products, it will simply get run over if it just sits there. Competition is inevitable and is healthy. It is only when you are pursued that you become swift. And do not worry if a competitor imitates you.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
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