IT was only a few months ago that we heard our State Bank governor hail Islamic banking for having “more stability and resilience” than traditional banks, and point towards the various directions where Islamic banking can make a greater contribution. The poor penetration of the small and medium enterprise sector as well as small farmers and low-income housing is among these. Instead, Islamic banks have preferred to stay with the same customers that traditional banks cater to — government and large corporates, with a small but growing consumer segment. Additionally, the regulatory framework for Islamic banks needs more attention given that the segment’s share of the total banking industry has hit a plateau at 13pc. Without branching out into the currently unbanked sectors while hitting a plateau in its growth means that Islamic banks are likely to build up more friction against conventional banks in the days to come. This growing competition only underscores the need to ensure that the regulatory framework is capable of dealing with the unique challenges faced by this nascent industry.
In a report released this week, the IMF has given some pointers regarding the areas where the governance and regulatory framework needs to be strengthened, and where the State Bank might want to focus. Two potential problem areas that the report points to are liquidity management and the proliferation of hybrid products. Since Islamic banks are shut out of two of the largest markets that banks operate in — overnight lending and government securities (other than sukuks) — they are finding it increasingly challenging to locate profitable areas to lend to. The growth of hybrid products is of particular concern, because in some cases the State Bank has actually used its own muscle in the industry to push some of these products, like bai muajjal contracts, onto reluctant partners. The IMF argues that such hybrid products present challenges like “the emergence of new complex risks, the applicability of existing prudential regimes, governance and consumer protection issues, and reputational risk”. In addition, the regulatory framework needs further work in areas like “deposit insurance, lender-of-last-resort (LOLR), and effective bank resolution regimes” according to the report. Given the reality that Islamic banks are now facing, it is increasingly important that their operations and product offerings be regulated tightly so that they are held to the highest standards of morality by contributing to the development of the country while safeguarding the trust of the depositor.
Published in Dawn, February 23rd, 2017