How to improve Islamic Banking and Finance

Posted on September 13, 2018
Muhammad Arif
Muhammad Arif : Chairman Centre of Advisory Services for Islamic Banking and Finance (CAIF), Former Head of FSCD SBP, Former Head of Research ArifHabib Investments and Member IFSB Task Force for development of Islamic Money Market, Former Member of Access to Justice Fund Supreme Court of Pakistan.

For years, many Islamic banks have witnessed double-digit growth rates, surpassing their conventional peers. At first glance, all seems well for the Islamic banking industry. There is ample room for growth as Islamic banking rarely exceeds a third of total market share, even in the Gulf Cooperation Council (GCC) countries and Malaysia. Several potential markets with large Muslim populations remain largely untapped, such as India and the Commonwealth of Independent States countries, made up of the former Soviet republics. In addition, overall banking penetration in many of the industry’s core markets is still low. For example, GCC countries have not yet achieved the banking penetration levels of countries such as France or the United Kingdom. At the same time, several new markets have opened up for Islamic banking, with even more on the horizon

A closer look, however, suggests the market dynamics always change like a decline from 2014-2017. Two key indicators should be cause for reflection in the Islamic banking industry: growth rate and profitability.Some major Islamic banks, notably in the GCC, have witnessed declining profit margins over the past five years.

To sustain profitable growth, a more sophisticated leveraging of the Islamic banking potential-much of whose potential has not yet been exploited—is required. Strategically, this means that Islamic banks, which so far often purely emulate a conventional bank’s offering, need to revisit their positioning. Operationally, they need to seek greater efficiency across the value chain.

Fundamentally, Islamic banks have two strategic choices—exploit the Islamic banking niche or compete head-on against conventional banks.

Fully exploiting the Islamic banking niche means targeting customer segments that care most deeply about Sharia compliance in their financial dealings as well as offering products and services that meet not only general financing but also Muslim-specific customer needs. While Islamic banking products for basic banking abound (for example, auto finance and credit cards), and while there is still “white space” in some more sophisticated areas (for example, asset management and wealth management), such products tailored to Muslim-specific needs provide a platform for true differentiation.

In retail banking, target customer segments may include religious conservatives, muftis, awqaf employees, or employees of ministries of Islamic affairs. One good example of a Muslim-specific retail banking product is financing for the pilgrimage to Mecca. This is highly relevant even for customers who generally place less importance on Sharia compliance in their financial dealings. Such products exist already in some parts of the Islamic world, for example, Tabung Haji Banking in Malaysia and Brunei. In private banking, target segments may include owners of halal industry companies. Providing specialized advice to high-net-worth individuals planning an awqaf set-up could represent a highly specialized, differentiated service in this segment. In corporate banking, target segments may include Islamic charities as well as the halal industry. A niche Islamic banking service for this segment will include asset management for awqaf, or expertise on providing Islamic financing in Western countries to companies acquired by Sharia-compliant private-equity firms. In institutional banking, other financial establishments may be targeted for the provision of pure-play Islamic banking expertise to support the development of their Islamic finance offering.

Fully exploiting the Islamic banking niche also requires pricing considerations. Some international banks have Islamic footprints in many countries, such as HSBC Amanah, and some Islamic banking groups domiciled in the GCC have a remarkable geographic coverage. However, most focus on one country, signaling geographic expansion as a clear growth opportunity for niche-focused banks—the market is under-served in many markets outside of the GCC and Malaysia. Potential opportunities include Muslim-majority emerging markets such as Indonesia and Iraq, and wealthy, Muslim-minority developed markets such as Germany and France. Co-operative ventures might be the best entry strategy in these latter countries.

The market gaps are many and varied. Opportunities to better meet Muslim-specific client needs with dedicated banking products aligned with Islamic core values are under-developed and present attractive platforms for profitable growth for players willing to exploit the niche.

It is a fact that many Islamic banks are competing head-on against their conventional peers. However, not all may realize that a head-on strategy has fundamentally different implications than a strategy of exploiting the Islamic banking niche. Competing against conventional banks means attracting customers who place less importance on Sharia compliance in their financial dealings, and more importance on competitive products and efficient services vis-a-vis the banking market at large.

Three elements are key to targeting the right customer segments. First, identification of customer segments least open to Islamic banking (for exclusion). Second, identification of segments with needs not fully met in a Sharia-compliant manner (to address shortfalls). And third, identification of segments open to ethical banking (to tap into a wider audience of both Muslims and non-Muslims).

Successfully attracting customers requires meeting a broader set of customer needs, while remaining on par with conventional banks in terms of ease of use and pricing.

To compete successfully, head-on with conventional banks, particular focus on two areas is required.

Firstly, Islamic banks should explore the use of alternative channels such as online banking and phone banking to gain market share. It will be important to use them much more as a sales channel rather than the current service focus.

Secondly, the use of different branch models should be explored, depending on target segments’ needs, ranging from light, kiosk-style sales outlets focusing on retail mass customers to full-service branches covering all customer segments. Alternative branch models have the additional advantage of potentially reducing capital investments, operating costs and set-up times, and are particularly powerful if coupled with alternative channels.

In deciding to compete head-on with conventional banks, a first step is to build a strong domestic base before expanding internationally. Domestic mergers and acquisitions (M&A) can offer attractive opportunities to achieve scale-related synergies from larger operations. Strategic M&As allow Islamic banks to compete more effectively with the larger conventional banks by expanding branch networks, taking advantage of operational synergies, and expanding their financial clout.

Whatever strategic positioning an Islamic bank chooses, it will typically need to seek greater efficiency across the value chain. Here we see three main areas for improving customer focus.

  • Salespeople often are poorly prepared and have little understanding of the products they are selling. This is even more pronounced in Islamic banking, where customers may require additional explanations of Sharia-compliant product structures. There is a need to improve responsiveness, as customers do not receive a callback within the promised time, if at all.
  • When customers do not receive important information about a product before purchase—for example, discovering extra charges after a sale—this typically results in severe, lasting damage to brand loyalty.
  • Touch points.Customers often have limited call-center or website service options and are repeatedly referred from one department to another. Few Islamic banks have a multi-channel view of the customer.

Mostly an asset transfer is often cumbersome in Islamic Banking. Redesigned processes can yield significant efficiency improvements, in some cases reducing resource requirements by 50 percent. While automation is important, it is not always required, particularly given the low labor costs in the GCC. Targeted IT investments are important, as is aligning the entire organization on strategy and streamlining the structure, which can significantly improve efficiency.

Outsourcing and offshoring provide options for centralizing business processes, improving service levels, and increasing control. Although it is a relatively new concept in the GCC, several regional banks have successfully outsourced less complex functions to India and Egypt.

A structured approach to procurement—analyzing spending and identifying savings for both strategic and operational costs—can reduce costs by up to 30 percent in some categories.

Monitoring and properly rewarding high achievers is key to improving performance levels. Rewards can be in the form of financial compensation, career progression, or acknowledgements such as tried and tested “employee of the month” awards. A properly structured incentive system can become a powerful tool for retaining staff, particularly important in Islamic banking given the general shortage of skilled resources. The key is linking rewards directly to performance measures—pre-defined at the employee level—to ensure that hard-won improvements are sustained.

Growth over the past several years continues to generate optimism for the future of Islamic banking. But as competition ramps up, and early warning signs show growth slowing down, Islamic financial institutions have plenty of work to do. Whether the strategy is to focus on niche positioning, compete with conventional banks head-on, or a blend of both, sustaining growth will require most Islamic banks to achieve greater efficiency across the value chain.

Islamic banks that take the time now to consider strategic choices and address operational fundamentals will be in a stronger position to capture untapped market opportunities and master the changing dynamics of their industry.

It is widely held that customers fall into three categories. The first two include “Islamic bank loyalists” and “conventional bank loyalists”, both with clear-cut preferences. The third and largest category is “floating mass”—in some estimates about 60 to 70 percent. They typically make their banking decisions based on pricing and service quality, and will require an Islamic offering to be at least on par with a conventional one.

While profitability may not be a key driver for some Islamic banks, it certainly remains important for most. Qatar is a notable exception, as the central bank has ordered Islamic windows to be closed.

Regarding the first choice, the Islamic banking niche, assets rarely surpass 30 percent of total market share, and as such, Islamic banking is still a niche market even in the GCC and Malaysia. A notable exception is retail banking in the Kingdom of Saudi Arabia, where Islamic banking has a much larger share and has effectively grown out of the niche.

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