COOPERATION BETWEEN ISLAMIC AND CONVENTIONAL BANKS
ERIC HIRSCH
In recent years there has been a great increase in the expansion of Islamic banks in Islamic countries of the Middle and Far East. Contacts with conventional banks have remained, with few exceptions, very limited. Where such contacts exist, they usually consist solely of the adoption of conventional banking products such as letters of credit within the framework of murabaha transactions, or structuring of leasing transactions. Products taken over by Islamic banks in such cases are established instruments used by conventional banks.
It has been the case so far of Islamic banks’ tending to adapt products of conventional banks rather than conventional banks’ adapting to the needs of their Islamic colleagues. The fact that Citibank has confirmed that it will be opening an Islamic bank in Bahrain some time next year is the clearest proof of the fact that opportunities for mutually profitable cooperation exist. Otherwise, Citibank would hardly be inclined to take such steps.
The foundation for co-operation between Islamic and conventional banks consists of regulatory levels. In international operations, the regulatory level for conventional banks consists of specific business practices or conventions which govern transactions ranging from handling letters of credit to bidding in connection with Eurobond issues.
Not only are these business conventions or customs uniform but, even more important are international and national laws which constitute the second level. These laws must be observed for every financial transaction.
Conventional bankers have grown used to these levels, and know how complex these regulations are; in particular, national tax laws and international tax legislation. In this context, co-operation between an Islamic and a conventional bank would be anything but out of the ordinary. However, in addition to the regulatory stages, a third level comes into play when cooperating with Islamic banks: the Qur’an and its interpretation by the Sharia board. This crucial point has been a potential source of problems.
The first problem for co-operation is that of understanding the extent of the cooperating partner’s knowledge; i.e., conventional banks’ knowledge of Islamic banking.
In this context, a comment appeared in New Horizon in October 1994, entitled “Islamic Banking – Too Many Conferences?” Considering that co-operation between Islamic and conventional banks is fundamentally a problem of understanding, there are by no means enough conferences on Islamic banking. However, these conferences should not be held in Tehran, Dubai or Kuala Lumpur. The critic is right when he writes: “when talks are held on Islamic banking in these cities, it is not sufficient to give a general explanation of Islamic banking because the audience is already familiar with the basics.”
No one should see Islamic banking as a closed shop with a few exotic offshoots like Citibank, Kleinwort Benson, ANZ, Goldman Sachs and now the Vereinsbank Group. On the contrary, if the aim is to develop co-operation on a broad front, informative events such as conferences are necessary, and not just in London, which is certainly an exception, but in Frankfurt, Paris and Zurich.
In the context of the third regulatory dimension, the Sharia board of Islamic institutions must be more active in approaching conventional banks in order to better these regulatory levels.
The second obstacle to cooperation is the general lack of knowledge on the part of conventional banks about this Sharia regulatory level and its interpreters, the Sharia board. There is no generally binding standard for interpretation of the Sharia with reference to structuring financial transactions. For example, fundamental aspects of cooperation with an Islamic bank in Malaysia are subject to other interpretations of the Sharia than is the case in Saudi Arabia or Iran.
For co-operation in a multitude of areas, however, there is a need for a body of regulations which conventional banks know, and can rely on, because in the final analysis, everything depends on the individual who must carry out the various transactions.
The first time a conventional-bank officer does business with an Islamic bank, he calls in his legal department, the member of the board of management responsible for this area. Once this initial transaction with an Islamic bank has been concluded successfully, for example in Malaysia, the officer goes to other customers and offers them a similar deal. He finds a new client, who is interested in performing this very transaction, but in Iran instead of in Malaysia. The Sharia board of the Islamic bank in Iran rejects the transaction as not “Islamic”, hopefully with some indication as to how it should be structured, in order to make it “Islamic”.
The officer from the conventional bank can go back to his board of management or legal department, which naturally is time consuming and unpleasant in every respect. If he overcomes these obstacles and the transaction is concluded, it is likely that the deal was big with a high margin, because the individual departments of conventional banks are organised as profit centres, and the deal must warrant the amount of time and trouble invested in it.
Once a certain type of business is approved, conventional banks do not submit each individual transaction to the legal department for approval. Analogously, a formula must be found for co-operation with Islamic banks which will provide clear guidelines at least on a national level so that the bank’s Sharia board need not be called in for every transaction.
Can this be done? A step in this direction is the establishment of the Council of the Islamic Fiqh Academy at Jeddah in Saudi Arabia under the supervision of the Organisation of Islamic Conference (OIC). This approach needs to be developed further.
To achieve co-operation in day-to-day business, banks would inevitably have to advertise, by means of active marketing in European and American financial centres, and to establish national Sharia boards for this purpose. Should this happen, there would be many opportunities for co-operation on several levels since conventional banks can not only learn a great deal, but can also benefit on account of Islamic bank’s liquidity overhang, from transactions which would be profitable for both sides.
Administrative problems are of less importance. Considering the risk involved, it is necessary and wise to have the Sharia board make individual decisions and to call in legal departments. Moreover, time plays only a secondary role. It is not by chance that Islamic banking has taken hold at merchant banks, which specialise in transaction-orientated deals and not at commercial banks, which are geared to standard business. The only exception so far seems to be Citibank.
However, in large individual transactions, we encounter a structural problem for Islamic banks: the client of an Islamic bank gives his liquid assets to this bank so that this liquidity, in compliance with the regulations of the Sharia, is introduced into the economy. The client can always demand that these funds be returned to him. A bank must therefore maintain a high liquidity reserve at all times. This is because there are no Islamic capital markets, so far, where an Islamic bank can turn its long-term assets into tradable securities and where a bank can find daily liquidity.
Furthermore, co-operation between Islamic banks in large individual transactions is only worthwhile if the Islamic bank can participate in financing over the long term. Large individual projects are usually long-term infrastructure projects, involving financing the construction of atomic energy plants, airports, roads and hotels, etc. Only under certain circumstances do banks have the opportunity to offer financing for such projects, either in countries which themselves do not have the funds for these projects or in countries where the bank, as financier, is supposed to bear part of the economic risk, i.e., what is called project financing.
These two situations present problems for conventional banks. Only countries which cannot borrow money long-term in the capital market to finance infrastructure projects turn to banks for a solution. This is because calling in conventional banks to structure a deal naturally makes financing the project more expensive. The problem for conventional banks is then the credit risk. If investors do not want to invest in the country in question, why should banks?
As a rule, this only happens if banks are better informed about the infrastructure project than the normal investor. If this is the case and the bank believes the project will be a success, it provides credit facilities whereby the project itself represents the collateral.
However, this is not the PLS or profit-loss sharing principle. The conventional bank does not invest in a project in order to participate in the profit or loss, but takes the profitability of the project into consideration as the main aspect of the collateral construction.
Although this cannot be harmonised with the PLS principle of the Sharia, there is a strong rapprochement of the interests of conventional and Islamic banks which can supplement each other ideally.
Infrastructure projects are urgently required for the economic development of those very countries which have trouble accessing capital markets. Usually, these are third world countries, but must also include countries such as the Czech and Slovak Republics, Hungary and the successor states of the Soviet Union.
In contrast, much of the machinery and construction material comes from companies in the industrial countries with which conventional banks have maintained ties for decades, and in some instances even for centuries. So much for the customer base. What conventional banks have very little of, or because of their philosophy have never had, is the willingness, in line with the PLS principle, to participate with the customer in the infrastructure project.
Here might lie the beginning of a well-balanced co-operation between Islamic and conventional banks, since their interests are complementary. Islamic banks have been able to invest in projects over the long term (more than five years). Yet this is precisely the time-frame required to finance dams, airports and other infrastructure projects.
The development of an Islamic capital market, where long-term risks are exchanged for liquidity, is an extremely important prerequisite for co-operation between conventional and Islamic banks. Co-operation between the two does however exist. In most cases, co-operation has to do with leasing or short-term commodity financing. The spread of Islamic leasing funds is an area with potential for co-operation with those conventional banks that are not willing to make their tax base available for specific leasing structures.
The big advantage of conventional banks is their customer base and their customer and market know-how. Opportunities are available to co-operate, in particular in financing the client’s liquid assets. Working capital loans are very frequently extended for purchasing and processing raw materials. A conventional bank can function as a broker and arrange a murabaha transaction for a fee, specially in situations in which a working capital loan may be more expensive since the client has already exhausted his credit lines with conventional banks and now must obtain liquidity from other sources.
The PLS principle which results in higher administration costs is one possible reason for this. What is important is that Islamic and conventional loans cannot be obtained. Islamic banks will have a difficult time in highly developed markets such as those in Europe or the US with their multitude of financing possibilities.
This does not appear to be the case in emerging markets. In South Africa, there are good opportunities for developing cooperation between Islamic and conventional banks. In reference to an article in New Horizon, September 1994, “Islamic banks pricing themselves out of the market in South Africa,” there should be no reason why in this market an Islamic mortgage has to be more expensive than a conventional one: “The real shock comes when the bottom line is reached. Very often the Islamic banker will concede that the mortgage repayment is equivalent to the conventional base rate plus a certain number of percentage points above the conventional interest rate for mortgage bonds. As such it is not surprising that potential Muslim clients of Islamic banks walk out in disgust.”
In emerging markets like South Africa, there is no reason why Islamic banks cannot be competitive; or are Islamic banks not willing to compete with conventional banks? Do they separate the Islamic banking system from the conventional one on purpose?
Conventional banks in South Africa, which were banned from international capital for political reasons not only do not know enough about obtaining cheap capital, but the risk assessment of conventional correspondent banks abroad is so conservative that obtaining capital is very expensive for South African banks. In a market like this, Islamic financing methods most certainly can compete with conventional banks when it comes to prices, but they must want to compete.
In general, co-operation is likely to be far more successful in newly developing countries than in the markets of industrial countries. Initial steps in the direction of co-operation have already been taken. To put these moves on a broader footing. Islamic cooperation partners must make it clear to their conventional partners that they have an additional regulatory level, the Sharia, which makes cooperation more difficult.
Conventional banks which are not used to or are not familiar with these regulations can offer their entire product range passively. The Sharia board of the Islamic bank must decide which products they can accept, with or without changes. In order to do this, Islamic banks themselves must develop the entire range of product expertise so that they can invite the more independently acting conventional banks to co-operate after the Sharia board has made its evaluation.
There will be close co-operation agreements in future. As markets continue to develop further and further, the margins of conventional banks will become increasingly narrow. Opportunities for arbitrage within the system of conventional banks will be limited. It is an elementary law of economics that in such a case, those involved will then seek profitable opportunities for arbitrage. Where could opportunities for arbitrage be greater than between different banking systems?
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
Comments
John Doe
23/3/2019Lorem ipsum dolor sit amet, consectetur adipisicing elit, sed do eiusmod tempor incididunt ut labore et dolore magna aliqua. Ut enim ad minim veniam, quis nostrud exercitation ullamco laboris nisi ut aliquip ex ea commodo consequat.
John Doe
23/3/2019Lorem ipsum dolor sit amet, consectetur adipisicing elit, sed do eiusmod tempor incididunt ut labore et dolore magna aliqua. Ut enim ad minim veniam, quis nostrud exercitation ullamco laboris nisi ut aliquip ex ea commodo consequat.
John Doe
23/3/2019Lorem ipsum dolor sit amet, consectetur adipisicing elit, sed do eiusmod tempor incididunt ut labore et dolore magna aliqua. Ut enim ad minim veniam, quis nostrud exercitation ullamco laboris nisi ut aliquip ex ea commodo consequat.