The 28 September issue of Finance Forward did not identify that Michael Bennett, Head of Derivatives and Structured Finance for the World Bank contributed the first article on the IFFIm sukuk. We regret the omission.
The continuing emissions scandal at Volkswagon continues and VW faces the expensive task of refitting 11 million diesel vehicles (not including the eventual fines it faces once investigations are comleted into who was responsible for installing software to cheat on diesel tests). For countries all around the world and their shareholders, the latest corporate scandal highlights the costs associated with governance breakdowns, and highlights the value of one of the key parts of integrating ESG (environmental, social and governance) factors into financial analysis. MENASEA region banks have mixed rankings on financial transparency andanecdotal data suggests that ESG transparency remains poor in many countries. However, where investors can find enough data, it should offer fertile ground for investors who include these non-financial factors in their financial analysis to detect and profit from potential risks and opportunities that financial data alone doesn’t provide.
Fintech – A Disruptive Force For Islamic Financial Intermediaries?
The evolution and widespread applicability of fintech is a paradigm shift for the banking sector and keeping up with its pace should be a matter of concern for every entity which is likely to be affected be its tectonic shift. Before delving into its implications for the Islamic finance industry, we briefly outline what comes in the realm of fintech and what aspects of it can actually disrupt (in a positive way) to help Islamic finance work for greater financial inclusion. Fintech firms can be classified as a) Information technology and software firms supporting and facilitating the financial sector firms more so termed as bank technology service providers and b) Tech-startups and small innovative firms substituting the regular financial intermediary, the ease of accessibility to which can cause disruptions for mainstream banks and banking system.
Bitcoin, a form of crypto-currency based on the block-chain concept, might come across as an efficient, cost saving and a transparent platform of transacting money but the uncertainty and volatility associated with its price and regulatory treatment makes it far from being a threat for both the conventional and Islamic banks at this point in time. However, other innovations by fintech startups across the spectrum ranging from peer-to-peer lending and crowd-funding to payment services can create disruptions in the traditional financial landscape which should be the main cause of concern for the current Islamic and conventional financial institutions.
According to CB Insights, a research firm, global investments in fintech has grown from $4 billion in 2013 to approximately $12 billion at the end of 2014. Nearly all aspects of financial services can be substituted by fintech companies from deposits and lending to capital raising and investment management, from market provisioning payments to insurance services.
Peer-to-peer lending(P2P) and crowd funding are two forms of online lending platforms which have gained considerable momentum in the past few months in developed markets , the growing popularity of which is seeping in to emerging markets as well where the need of low cost financing is on the rise. Beehive and Blossom Finance, based in UAE and Indonesia respectively, both provide Shariah compliant platform which aim to provide low cost alternative financing to small and medium enterprises. Each company aims to connect creditworthy business looking for funding with smart investors to build mutually beneficial partnerships of growth by applying the innovative technology of crowd funding to eliminate costs and complexity of banks.
Beehive uses commodity murabaha contracts to underpin loads by purchasing and resale of traded commodity on the Dubai Multi Commodities Centre at specified prices. Beehive, which does not directly issue loans, has so far connected 32 businesses with USD 4 million in Sharia-compliant loans from investors. In the UAE, the SME market is underserved more so by Islamic banks, so the potential for Sharia compliant tech startups to act as a lending platform for SMEs remains high.
Blossom Finance on the other hand uses the block chain principal of Bitcoin and not the bitcoin entirely to crowd-sources capital to micro-lending institutions in Indonesia using a sharia model. The money transfer from investors to micro-lending institutions is done by using the block chain principle of bitcoin, thereby reducing the cost and time associated with cross border money transfer. Blossom Finance ensures that the whole process is in accordance with Sharia’s musharakah principle (a profit and loss sharing principle where the lender shares both profits and losses from a loan with the borrower) and the company doesn’t support businesses involving usury, gambling, pornography and other activities which are prohibited.
Given the volatility associated with bitcoin, a contract which stipulates bitcoin as an underlying currency should be deemed Sharia incompliant due to the excessive uncertain nature of the currency. Thus, Blossom Finance does not use bitcoin as the underlying currency in the contract, rather the company uses the block chain concept of bitcoin, implying that the company basically uses bitcoin in lieu of a wire transfer to move money. Beneficiaries receive local currency [Indonesian Rupiah] and investors can invest and cash out their returns into their local currency such US dollars, British pounds or euros.
The aforementioned case studies are just a drop in the ocean making way for a bigger wave which shows that fintech companies are more of a competition than facilitator for both the conventional and Islamic financial intermediaries and now is the time that formal channels of lending and financial intermediaries should realign their business models and strategy to deal with this wave before it washes their market share and profits away.
Islamic banks dull self-discipline effects of competition but raise overall financial stability
The presence of Islamic banks in dual banking systems has both positive and negative impacts for stability when greater competition is introduced, according to an IMF working paper. The empirical study builds on literature which tries to tease out the impact of competition on stability. From a theoretical perspective, the question revolves around how banks react in the face of greater competition or potential competition.
The theoretical position is split: introducing greater competition could benefit overall financial stability by eroding the competitive position of the existing banks and easing credit terms for companies who would be able to repay at a higher frequency (lower loan losses). This could be offset if the increased competition erodes profit margins enough to make bank’s capital level less resilient to loan losses.
The literature has focused on this solvency point and there has been much less focus on impact on capital levels and liquidity. On capital, the issue revolves around whether banks dynamically manage their capital levels above what is required by supervisors and how much liquidity banks hold and, again, whether this is dynamically managed based on the price competition they face (and their net interest margins).
The liquidity channel has become a more important area for regulators since the financial crisis showed how lack of liquidity could have dramatic, rapid, negative impacts on financial stability. If rising competition increases the incentives to use wholesale funding during periods of stability (as a lower-cost funding source), it could make the bank less stable if these funding markets dry up. Offsetting this is the prospect for lower margins and profits to have the contrary effect of incentivizing greater self-policing to limit the use of wholesale funding because it will be, on average, more expensive than deposits. If rises in price competition lead to lower reliance on wholesale funding, it will benefit financial stability.
The impact of Islamic banks in this picture relates to the higher liquidity they tend to hold because they are not able to access lender of last resort facilities and because their more limited liquidity. The impact that this has on financial stability is positive because, on average, the banking system will have fewer institutions susceptible to bank runs.
On the contrary, the study found that Islamic banks with a larger share in a banking system limits the degree to which greater competition has a positive impact on banks’ self-policing their own liquidity and capital positions. Where the Islamic banking share is high and where the financial sector is relatively more competitive, this should leave to more banks reaching for returns to offset the decline in profits that more intense competition has created.
As an example, consider the WIBC Leaderboard below comparing the return on average assets for Islamic banks with the share of non-performing loans. Return on assets should act as a proxy for the degree of price competition. All else being equal, more competitive banking systems will have lower returns on assets as banks compete over customers seeking financing. If banking systems are more competitive, they will have lower return on assets but higher NPL because banks will have competed away the profits from the safest customers and will be reaching to more risky borrowers. This seems to be the case in the limited sample shown here for
The study is an interesting addition to the literature and has some added perspective on the implications of the findings not discussed here on regulatory policy. Importantly, the largest findings of self-discipline from higher competition occur when markets are relatively open to new entry. However, this is not a blanket finding and good supervisory policies that limit entrants based prudential regulation (rather than primarily to shield incumbents from competition) can help impose self-discipline even where markets are difficult for new entrants to access.