Religiosity And Efficiency

Religiosity and Efficiency Prof. Saiful Azhar Rosly, Ph.D Head, Islamic Banking Department International Center for Education in Islamic Finance (INCEIF), MALAYSIA nd 22 August 2008 Islamic banking first entry into the modern financial sector is primarily driven by religion as Muslims are becoming more aware about how it (ie. religion) affects their daily lives. This is true for Mit Ghamar Bank being the first Islamic bank in the world established in 1963 in Egypt. As a way of life Islam enjoins Muslims to conduct their economic activities according to the values ordained by God i.e the Shariah, among which include the prohibition of riba, gambling (maysir) and the avoidance of ambiguities (gharar) in business transactions. It is also well understood that these Shariah injunctions are not meant to introduce hardship but on the contrary strive to prevent harm and injury (mafasid) in the conduct of business affairs. For example, the prohibition of riba helps remove tendencies of fixing profits in making loans with the comfort of guarantees while the prohibition of gambling prevents the erosion of wealth and property through the game of chance. In the same manner, Shariah serves to generate benefits (masalih) when it enjoins trading and commerce (al-bay’) since from trading profits are generated by virtue of taking risk and effort. The obligation of zakat serves to eradicate poverty and reduce income gaps. In a nutshell, Islam as a religion promotes and secures justice for the masses. In a way, when Islamic banking business is driven by religious values, it does so to promote justice such that banking activities involving the bank shareholders, depositors and fund users are conducted equitably and fair. While religiosity seems to imply justice and fairness in the conduct of business, does it also guarantee efficiency and profitability? Economic efficiency occurs when the cost of producing a given output is as low as possible. What this means is avoiding waste and excesses. When religiosity guarantees permissibility of financial instruments, does it also mean that decision makers have less to worry about performance? Does availability or supply of halal products guarantee profitability? By offering permissible (ie. halal) banking products, Islamic banks can make gains in several ways. First the halal products may convey certain specialties and niche not available in mainstream banking. Secondly being able to do so means that Islamic products may be better priced

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and lastly, the Islamic banking risk management strategy is a clever one and therefore helps protects the company’s net worth. The question raised is whether religiosity affects profitabilty? The answer is both a yes and no. It is in the affirmative when religiosity affects decision making in business strategy such as pricing of deposits and financing or decision about buying and selling securities. It concerns question about how does the Islamic bank balance risk and profitability in making its financing and investments. Whether the bank is an Islamic or conventional one, the goal of bank management is to maximize the value of owner’s equity under the pretext of musharakah. It involves decision making to increase market value of the stock of the bank. A high risk mudarabah (ie. profit sharing) may increase the profitability of the bank but the high risk may lead to higher expected losses as well. A low risk murabaha (ie. installment sale) may keep the bank away from losses but tend to generate relatively low margins, hence low return on assets. Profitability can be measured in many ways. Some use financial ratio analysis to explain bank’s performance while others apply econometric techniques. For instance, Islamic banks can be found either efficient or inefficient based on a certain selected parameters. Some studies deals with comparative analysis between Islamic and conventional banks and make statements whether the former is more or less efficient than their conventional counterparts. Usually any findings on banking performances help decision-makers to understand more about the consequences of their banking policies and strategies adopted. The banking business is actually about the management of risk. Hence strategies taken up by banks boiled down to the acceptance of risk in order to earn profits. The recognition of risk and its impact on investment strategies hinges of how the banks undertake to manage total risk of the organization in the most appropriate manner. Religiosity in Islamic banking usually means inculcating divine values in the conduct of the banking business, including its risk/return appetites. The latter invokes the trust (amanah) placed upon the management to run the bank in the most efficient manner. This amanah is a divine imperative for bank’s decision makers to dutifully observe in their conducted of business. The divine values ordinarily deal with the legal and ethical dimension of bank behavior. Religiosity today tends to put greater weight on the legal values such as the permissible (halal) and the prohibited (haram) of financial products. This is true when legal values are defined on the 2

basis of certain Shariah complaint position or standard adopted by particular bank or banking groups. For example, a product is Shariah complaint to HSBC Shariah Board but may not be Shariah compliant to a say, to an Islamic bank in the Sudan. Or a bond or sukuk may be Shariah compliant to Bank Islam Malaysia’s Shariah Board but noncomplaint to Kuwait Finance House’s Shariah Board. Usually the compliance parameter hinges on the legality of contract (‘aqd). For example, the role of ijtihad and the issuance of legal opinions and resolutions concerning the legality and validity of financial derivatives are critical for the rationalization of Islamic banking hedging activities. Hence, risk management in Islamic banking is no longer a matter of business strategy but one constraint by Shariah as well. Lately, the ethical dimension of religion in Islamic banking gets the limelight when Muslim scholars began to echo the intent or purpose of Shariah (maqasid al-shariah) in legal rulings involving Islamic financial transactions. The protection of public interest (maslaha al-ammah) is paramount to the Shariah where the Quranic injunctions serving to protect public interest are tailored made by God for the preservation of benefits and the prevention of harm in society. In this manner, the legality of a financial contract is judged not only from the contract (aqd) aspect but equally important its impact economic and social (i.e. benefits and disbenefits) to the general public. For example, if Islamic financial products are found to encourage people to fall into debts and bankruptcy, how can we explain it as a worthy alternative to conventional financing? On the contrary Islamic products should enhance economic growth, reduce poverty and bring happiness to human beings. Although the maqasid approach to legal rulings plays a critical part in spelling out the ethical and moral dimension of Islamic financing, it remains to be product biased in the sense that scholars may need to address issues and problems of bank behaviour affecting efficiency and profitability. This concerns profit and loss arising from systematic and unsystematic risk. In balancing risk and return in seeking to maximize wealth of the shareholders, Islamic banks are constrained by several factors beyond their control such as the performance of the economy as well as competition. They are also constrained by legal and regulatory matters whose objective is to protect the consumer from bank failure or preventing Islamic banks from giving away too much installment based financing that may trigger inflation. These systematic risks are beyond the power of banks to control and remedy. On the other side of the coin are the controllable factors responsible for efficiency and profitability such as larger capital base, expanding market 3

size and branch networks and credible risk management system. Here management decisions to evaluate the impact of various strategies undertaken to generate profits usually deals with the amount of cash flows to be created from financing activities and also the timing of the cash flow. Most critical is the risks of the cash flow. In Islamic banks, it concerns installment payment risk, profit rate risk, liquidity risk, operational risk, displacement effect risk and market risk. This is where risk to earnings and capital are put in focus in Islamic bank risk management. Religiosity in this context means that decision makers in Islamic banks are expected to manage risk in the best possible way to prevent capital erosion and bank failure that could endanger the economy at best. The amanah is a sacred trust to be championed by all bank’s employees and senior managers who receives salary and other benefits from its owners. Amanah which is an ethical precept is also powerful in reducing agency problems and moral hazards in Islamic banks. Risks are intangible and unknown until it surfaced into losses. To make it visible is actually an effort that none but God can do. However, tracking risks is doable as one can look at observable losses and historical profit declines At the same time risk can be quantified by modeling them so that it can be given a value for decision makers to act upon. One example is value at risk (VaR) which is potential loss in nominal term at a given probability. It is no means a rule but a guideline for banks to gauge their current value. For this reason, risk management in Islamic banking is part and parcel of religiosity and not only about Shariah compliant banking products. In this manner, we can see the connection between religiosity and efficiency.

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