Why the Islamic Banking model needs a rethink

Islamic banking being a fairly recent institution could have been based on a more resilient, less vulnerable model. A mutual or asset management model would not only be more resilient to shocks, but also attuned to Shariah requirements for risk sharing. While banks and the banking system have had to be repeatedly bailed out, no mutual fund needed to be saved. A testimony to the resilience of the asset management or mutual fund model. In essence, both banks and mutual funds are intermediaries that mediate between deficit and surplus units. The difference lies in the fact that one is risk sharing while the other is risk shifting. The bank depositor does not take any risk of the investment that his money ultimately ends up in. The depositor shifts the risk to the bank. The bank, too, shifts the risk of the borrower's underlying business risk to the borrower. Thus, under the banking model, neither the depositor nor bank take the business risk. The bank's borrower takes both the business risk and the financial risk arising from the leverage of debt financing. In the case of mutual funds, risks are shared. The investor in a fund gets an equity stake which allows him to share the business risk of the listed companies with other shareholders.

Aside from risk profile, there is another key difference. The mutual fund company is a pass-through, the investors get direct exposure to their underlying equity risks. The mutual fund investor's returns are entirely dependent on the underlying portfolio performance. They share the risk and rewards. In the banking model, the depositor's returns are determined entirely by the bank and have no correlation whatsoever with where his money was invested. Thus, unlike the mutual fund investor, the depositor at a bank cares little about where his money is lent to. And since the bank's returns, too, are not linked to the businesses they lend to, the bank, too, has no incentive in ensuring success of the businesses they lend to, no more than ensuring their debt is repaid. This detachment of returns from the risk and underlying business performance in the banking model is a key contributor to moral hazard and system failure.

In addition, there is a third key difference. A depositor can withdraw his money anytime, but a bank cannot recall a loan to meet withdrawals. This maturity mismatch is absent in mutual funds. When an investor notifies his intention to redeem, the fund manager simply sells the portion of portfolio held by the investor. The absence of maturity mismatch in the mutual fund model is due to the fact that all assets in a funds 'portfolio are readily traded in secondary markets.

Having replicated the conventional banking model, its processes and products, Islamic banking (IB) has had the same outcomes and vulnerabilities. Though the replication model was sensible at a stage when the Islamic banking idea had to take root, today, with some 3 or 4 decades post introduction and a conventional banking system lurching from one crisis to another, the Islamic banking model is in need of recalibration. Continuing with the current model would mean IB has no means of beating its own path. Their inability to have a price discovery mechanism due to prohibition of debt trading and infantile secondary markets means that IBs will have to continue relying on interest rate benchmarks.

There is still a chance to slowly adapt the mutual fund model, at least in parts. To overcome the issues highlighted above, there are 3 steps that IBs can take to differentiate and be truly value additive. First, on the asset side, there is a need for IBs to use risk sharing contracts like mudarabah. Modified mudarabah contracts can be highly profitable for the marginal increase from business risk. Since mudarabah provides ownership of the underlying asset, it is secured/collateralized financing. Second by securitizing such funding as mudarabah sukuk, they could be sold to depositors on the liability side and, where necessary, secondary markets. The key is to tag the asset side funding to liability side deposits with the bank required to hold at least 10% on its books to ensure skin in the game. As part of this second step, there is no reason why the other assets funded under Ijarah, Wakalah and the like cannot also be securitized under the same their respective contracts and tenor. With securitization and out placement, the bank would be passing through the risk on its asset side to liability side. While the credit spread will now have to be shared and so profit margins will be thinner, the bank will be able to turnover a much larger asset portfolio on the same capital, since it is only required to keep 10% of assets on its books. In addition, having carved out assets from its balance sheet, its capital adequacy and statutory reserve requirements should be lower, significantly reducing the bank's costs.

To overcome the maturity mismatch problem, papers resulting from the securitization of IB assets should be traded on secondary markets. Malaysia's proposal for an Investment Account Platform fits this need. Such secondary trading not only eliminates the maturity mismatch problem, as an investor can get out at any point by selling the instrument, more importantly, it enables price discovery. The yields that result from such trading can be indicative of the cost of funds to IBs and be used in pricing new funding. Where necessary, they could also be used in marking to market IB assets.

This proposed evolution of the IB model can occur progressively in stages; thus, there need not be any disruption to their existing processes. With this, IBs can truly move away from a reliance on interest rates, differentiate their products and beat their own path. Society gains as risk concentration within banks is avoided and financial crises are side stepped. The addiction to debt, including that in the Muslim world, can be weaned.