Despite its relative nascency, Islamic finance is growing at a staggering rate. Between 2000 and 2016, the capital of Islamic banks rose from $200bn to $3trn, and according to Ernst & Young’s 2016 Islamic Banking Competitiveness Report, there are now over 65 Islamic banks worldwide.
In 2014, the UK became the first non-Muslim country to issue ‘Sukuk’, or ‘Sharia-compliant bonds’. Five years on, over 20 UK banks offer Islamic products and there are five licensed Islamic banks. Similarly, Germany and Luxembourg have issued several sukuks over the past few years, and in 2015, Germany opened its first entirely Islamic bank, KT Bank AG.
So, what is fuelling this growth and what does it mean for debt collections processes?
Islamic banking: a brief history
Islamic banks are run according to Sharia law. In practice, this means their operations differ greatly to those of Western banks.
The first Islamic bank was opened in a rural area of Pakistan in the late 1950s, its most notable feature: interest-free loans. Fast-forward 60 years and Islamic or ‘Participant’ banking is fast outgrowing conventional banking methods.
One of the main reasons for the growth of this once niche segment of the global financial sector is a simple case of supply and demand.
Of the 25 ‘rapid growth market’ countries identified by Ernst & Young, 10 have a high Muslim population. The study shows that these high growth regions will help to increase the global value of the Islamic banking market to more than $1.6 trillion by 2020.
In 2014, in Saudi Arabia, the Islamic banking market grew by 18%, compared to only a 7% growth rate in Western banking. In the same period, Qatar saw a 20% growth in Islamic banking and Malaysia saw a growth of 4% compared to a 1% growth in non-Islamic banking.
And this growth isn’t just confined to Muslim countries. A commitment to transparency and investment in the real economy have given these ‘participant banks’ broader appeal among many outside of the Muslim community. In the wake of the 2007 financial crisis, the idea of a banking system which does not use capital to artificially inflate asset prices is one which more people are turning to.
Speaking to the Financial Times, Humphrey Percy, CEO of Bank of London and The Middle East, said: ‘Since its establishment in 2007, BLME has witnessed a growing demand among medium to high net worth individuals for a banking option that incorporates the transparent and ethical principles inherent in Islamic finance with competitive returns. With the financial climate improving, individuals are looking to diversify their investments that were previously solely held by UK high street banks’.
What makes a bank Islamic?
While there are a number of features particular to Islamic banking such as not dealing with businesses which are ‘haraam’ or unethical (gambling, alcohol, pornography and pork), the most significant difference is in the way they lend. This comes from a fundamental difference in attitude and beliefs.
Under Sharia law, a bank must provide real service to earn money; they cannot simply use money to make more money. The Islamic banking system views real assets as the product and money as simply the medium of exchange.
In Western banking, money is both the product and the medium of exchange. In Islam, a creditor and debtor are free to enter into a borrowing agreement but they must do so fairly and ethically.
When conventional banks lend to customers, they charge fees and interest on the loan, and must be repaid in full regardless of circumstances. Losses are not shared by the banking organisation; they are the sole responsibility of the borrower.
Under Sharia law, usury or ‘riba’ is forbidden, so while Islamic banks still make money through lending capital, they do it through alternative methods.
Mudharabah is the equivalent of profit share or venture capitalism: the bank invests financially and the borrower invests their time and entrepreneurship. Any returns the bank receives are based on how financially successful the business is.
Musharakah, a similar joint venture deal, sees business profits divided according to relative capital inputs.
Murabaha, a type of sale and buy-back agreement, is another way in which Islamic banks can lend to borrowers. The bank buys a commodity, such as a house, and sells it to the buyer at a profit, allowing them to pay in instalments. Any profit the bank stands to make needs to be a fair reflection of the bank’s costs, one which is agreed on by both parties.
In all these types of lending, should the enterprise fail, the bank loses their capital and the borrower, their time. In short, the loss is shared by both the bank and the borrower, increasing the risk for the bank. In this way, Islamic banks incur higher costs than non-Islamic banks.
So, is there a way in which banks can recover debts more efficiently while still upholding the Sharia banking model?
In countries like Saudi Arabia and many other Middle Eastern countries, the losses incurred are often subsidised by the state. However, as Islamic banking expands into new markets and competes with conventional banks, this model is unsustainable.
One of the best ways to minimise losses is to identify credit risk. Managing risk within Islamic banking is a challenge. This is partly due to the complex, nuanced nature of the borrowing contracts on offer and the way in which borrowers are pre-qualified under Sharia rules.
Risk management and segmentation is widely used in conventional banking as a way to track and assess risk at every stage of the lending journey. While this presents greater challenges in Islamic banking due to Sharia compliance, with the correct software deployment, such as EXUS’ Rapid Deploy Methodology, it is achievable.
When it comes to collections, taking a proactive rather than reactive approach allows banks to customise and structure payment plans rather than responding with punitive measures.
By creating profiles and segmenting customers by things like values and lifestyle choices, Islamic banks can stay true to their culture of fairness and understanding while making the collections process more efficient and cost-effective.
Another way to reduce costs and effectively manage debt collections is by standardising the loan products that Islamic banks offer. Varying interpretation of Sharia law from bank to bank and region to region means that, as a whole, the lending process is less efficient than in conventional banking.
Again, this can be achieved through effective data collection. When you know exactly what your customers want and need, you can tailor your products to fit the bill.
This growing need to manage both efficiency and risk ultimately comes down to a need for better data, automation and digitisation.
For example, the Islamic banking practice of Murabaha or Ijara (leasing a property to a borrower) has historically had a large turnaround time compared to the process of acquiring a mortgage through conventional banking. However, as more Islamic banks automate their processes, these types of lending are becoming faster and more streamlined.
Islamic banking has undoubtedly come a long way in the past decade. As Sharia banks look set to take on the big retail banks, their success will largely come down to how effectively they can marry their principles with the demands of the modern world. Rather than being mutually exclusive, with the right software and methodology, the debt collections process can actually enhance their offerings and increase customer satisfaction.