Islamic finance is becoming an increasingly attractive sector and financial players are seeking to take advantage of its development. The value of assets regulated by sharia principles has reached $500 billion and is expected to exceed $1 trillion by 2010. When compared to the $74 trillion of assets accumulated by the 1,000 top international banks, this number may seem insignificant. Yet, its implications are extremely important. It is indeed a significant indicator that Islamic finance is at a turning point. It is reaching a critical mass and changing from just a “niche market” to a main component of finance. This trend is reinforced by the phenomenal growth rate the field has been experiencing. Experts are talking about a yearly increase of 20-25% or even greater. Whatever the actual number is, it remains above the 11% average growth rate of the conventional financial sector. Furthermore, there are no signs indicating a slow down in the growth in the short term, on the contrary.
More than 78 new Islamic banks were created within the past three years. Competition is growing fiercer between two types of Islamic financial institutions: the sharia-compliant organizations and the sharia-based institutions. The former are usually Islamic windows, branches or subsidiaries used by conventional financial entities as an entry door to the Islamic market while the latter are fully fledged Islamic Banks. Both types of companies have the same purpose: offer their clients sharia-compliant financial products. To reach their goal, Islamic finance institutions apply a series of specific rules that insure the conformity of their operations to the fundamentals of sharia. They nominate a sharia supervision board that ensures that these regulations are respected and ascertains the sharia compliancy of the firm’s operations. Sharia-compliant institutions restrict their “Islamic” activity to these operational aspects and sharia has no further impact on the other activities of the organization. In fact, there is an evident decoupling between the bank’s main operations and its Islamic ones. On the other hand, in sharia-based institutions, the entity as a whole is in conformity with the sharia and all operations, on all levels, are sharia-compliant.
Furthermore, sharia can have a significant impact on the strategic behavior of these banks in that it can directly constrain some of their strategic options. Islamic finance institutions are limited to ‘halal’ (permitted) transactions. In fact, Sharia enacts a strategic environment where some elements of the ‘objective’ reality do not fit. This situation can be exemplified by the screening process used to choose the halal stocks an Islamic portfolio can integrate. The halal investment universe is therefore reduced from thousands of company stocks, used in conventional portfolios, to only hundreds that can be used in Islamic ones. Islamic financial institutions, of both types, are subject to these restrictions and the difference in their strategic behavior, if any, resides in the purpose underlying their activities.
Islamic banking and finance are often considered as a marketing tool or a subset of conventional finance in the case of sharia-compliant institutions. This is mainly the result of the strategic decision of conventional banks to open Islamic windows or branches that tap into the pool of wealth governed by sharia. In this respect, the sharia-compliant institutions are required to seek the main objective of the headquarters (conventional bank), i.e. the maximization of the shareholders’ return on investment.
It is important to note that this strategic objective creates tension between the actions of these institutions and the purpose of sharia. Indeed, the ethics of Islamic finance do not recognize the supremacy of individual interests according to the basic belief that man is a caretaker trusted by God to manage its creation. As such, man is meant to apply a set of moral guidances to ensure that the interests of all stakeholders are safeguarded.
The divergence between these stakeholder and shareholder approaches explains why most specialists consider that using Islamic rules in financial activities is banking under sharia constraints. The key word in this sentence is “constraints”, implying that there is a desired state of affairs that could not be reached due to a number of limitations. Within such a mindset, the strategist tries to get as close as possible to that desired state without breaching the restrictions imposed by the sharia. Consequently, sharia is considered as a constraining set of rules and guidelines. Institutions applying this view tend to mimic conventional finance operations and benchmark their performance on their conventional counterparts.
This is the case for sharia-compliant institutions designed to maximize stockholder return by mimicking conventional banks operations. It is surprising to see that it is also true for a number of sharia-based banks despite the fact that they fall in the core of Islamic financial ethics. This situation leaves the latter banks in a delicate strategic situation.
Islamic banks find themselves confronting, indirectly, conventional banks on their own territory despite the apparent disadvantage in resources. Banks such as UBS, Barclays Bank, BNP Paribas, Citigroup or HSBC have their own Islamic finance delivery vehicles and hold around $2 trillion of assets each. On the other hand, the total assets owned by the top 20 Islamic banks do not attain one quarter of that value — $338 billion to be exact. When institutions face such an intense competitive pressure from their opponent, they generally choose to apply a differentiation strategy. It allows them to avoid the confrontation by creating limited domains of operations where they can outperform their competitors. A number of Islamic banks opt for this kind of strategy but their actions have limited potential since they are based on the stockholder maximizing approach, ‘rule of the game’ of their opponent.
In fact, the real differentiation strategy would be a complete shift of the mindset replacing the “sharia as constrained” approach with an “enabling” vision of the role of sharia. This view would enlarge the scope of the sharia and its guiding principles making it possible to include a wider public other than Muslim communities and may result in an inversion of the strategic equation. Instead of being placid and defensive when facing the Islamic finance strategies of conventional banks, Islamic banks would have the possibility to be more active by looking for new markets in the realm of conventional finance.
Some banks have already begun to explore this approach. When it ‘Islamized’ its operations, a well-known bank in the GCC decided to create ethical products (sharia-compliant), to serve its non-Muslim clients given that the demand for ethical and socially responsible products is increasing worldwide.
Abdel-Maoula Chaar is Islamic Finance Projects Manager at Ecole Supérieure des Affaires, Beirut
