Islamic Vs Conventional

Paying the Price: Conventional versus Islamic

As Islamic finance steadily gains prominence in the global financial scene, never-ending debates have sprouted on whether Shariah or conventional banking products would provide more value for money. ANNA MARIA SAMSUDIN finds out whether pricing should be the main determining factor when choosing between the two.

“Which are cheaper — conventional or Islamic products?” is probably the question uppermost in the minds of consumers when trying to decide which would meet their financing needs. However, many financial experts believe that price comparison alone would not be an accurate indicator as each model has its own appeal and should be viewed in totality. At the end of the day, decisions should be made based on the investor’s risk appetite. One Singapore-based market observer points out that theoretically, prohibition on riba or interest (one of the pillars of Islamic banking) already renders Shariah financing cheaper than conventional products.

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In the olden days, transactions such as the lending of cash were considered a form of charitable or social service whereby the lender was barred from making any profit from his “generosity”. The borrower would have to pay the exact amount borrowed — no more, no less.

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However, in modern Islamic finance, such practice is no longer suitable because as business entities, Islamic banks need to make a profit to stay in business — subsequently adding cost to the transaction. Instead of charging interest from loans, these banks offer financing facilities in other forms such as lease, sale and partnership. This allows them to profit in ways that are permissible by Shariah law. “There are various products in the market and it would not be accurate to simply assume that all Islamic finance products Islamic Finance

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August/September 2008

are cheaper than conventional (ones). Price competitiveness will depend on various factors,” the observer noted. In the case of basic home financing, Islamic products under the Bai Bithaman Ajil (BBA) structure, which is deferred payment sale, might offer more competitive deals than conventional banking. In comparing the two models, Bank Negara Malaysia, on its website, explains an ordinary conventional housing loan is based on debtor-creditor relationship and the interest rate charged is based on a certain percentage above the base lending rate over loan period. Fluctuation in the base lending rate will affect total loan cost. Simultaneously, arrears in conventional loans are normally capitalized. However, under the BBA scheme, a seller-buyer relationship is established and the selling price is fixed upfront. The sale price is then repaid in installments, with the amount remaining fixed throughout the financing period. This eliminates the customer’s interest rate risk and furthermore, arrears will not be capitalized. In short, the BBA scheme eliminates additional or hidden costs that will change the price of the property purchased — providing clients with a better value-for-money option compared to conventional home financing. ‘Compare apples with apples’ Baljeet Kaur Grewal of KFH Research said the answer to whether Islamic products are cheaper than their conventional counterparts depends on various factors, such

Specific legal provisions such as tax exemption, in addition to having a complete value chain of Islamic products in the market, are among the contributing factors that would enable Islamic finance to offer products at competitive rates.

Baljeet Kaur Grewal

Picture source: i-VCAP Management

“This is not possible for countries that do not have a comprehensive framework and the necessary legal provision. For instance, issuance of Sukuk can be more expensive than that of conventional bonds in countries that have not addressed the double taxation issue. It boils down to the regulatory framework and incentives,” said the group chief economist and head of global research. Meanwhile, Bank Islam corporate investment banking director Mashitah Osman feels that price comparison would not be the right method to use. She pointed out Islamic finance should be viewed as a category on its own — and not as an alternative to Mashitah Osman conventional finance — as it provides the market with another financing option. “In order to be more accurate in your evaluation, it is important that you compare apples with apples. This is not the case when comparing Islamic and conventional products as both operate on two different business models,” she pointed out. Mashitah added that to be able to truly appreciate Islamic finance, one needs to look at the model in a holistic manner, not just at the costs involved, and try to understand the reasoning behind the restrictions imposed. She explained the five principles of Islamic finance — which prohibit interest (riba), uncertainty (gharar) and activities related to vice, alcohol and pork as well as the emphasis on profit and loss-sharing and asset backing principles — are mainly to promote good business practices.

“For Muslims, they should go for Islamic products because it is a religious requirement. Riba is a serious offence in Islam and the punishment in the hereafter is harsh. However, this should not be a deterrent factor for non-Muslims as the principles in Islamic finance are not just about religion. They are about transparency, ethics and fairness, as well as promoting entrepreneurship and sharing of risks between financiers and customers. “You do not have to be a Muslim to appreciate the beauty of Islamic finance. The principles of Islamic finance are more or less similar to the values emphasized in ethical and green investment, which steer clear of investment activities associated with vice, weapons and activities that may be harmful to the environment. In order to do this, players have to be more proactive in creating market awareness,” she added. To create clear distinction between Islamic and conventional products, many market experts stressed the need to come up with more genuine Islamic products instead of just coming up with adaptations of products offered by conventional banks. “If you want to compete, it is crucial to come up with a different product — not a copy version. Sukuk is an example of a truly genuine Islamic product that has succeeded in garnering interest not only among Muslims but non-Muslim investors as well. We need more of such products in order to expand the Islamic the finance share in the global financial market,” said an observer. Foster better understanding Aside from creating awareness, Mashitah said there is a crucial need for the Muslim community to play a part in improving understanding of Islamic financial products. Sharing her experience in dealing with potential customers in non-Muslim jurisdictions, she said she had come across situations where these customers were apprehensive of investing simply because of the name “Islam” even though they liked the products offered. In fact, some even requested that the word “Islam” be replaced with “Shariah”, fearing that it would trigger uneasiness among their regulators as well as clients, some of whom hold the view that Islamic finance activities could have been extended to support acts of terrorism. “This is among the key public relations challenges that need to be addressed, especially by key market players,” said Mashitah. One way to do this, she suggested, is for the Muslim community to work on a global public relations program. She fears that the overwhelming debate and overconcentration of issues relating to differences in interpreting Shariah law concerning Islamic finance could slow down the growth momentum of the sector. August/September 2008

. Islamic Finance Asia

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Picture source: i-VCAP Management

as the comprehensiveness of the existing regulatory framework. Baljeet said in Malaysia, which already has a solid framework and regulation in place and enjoys strong support from the government, there have been many instances when Islamic products proved to be more competitive in pricing.

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