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Equity-Gap in Islamic BankingProf. Saiful Azhar Rosly,

International Center for Education of Islamic Finance (INCEIF)22nd October 2008.

Investment in stocks is a risky affair since the nature of investment in equities warrants

shareholders to share profits as well as losses. Exposure of equity capital to volatilemarket movement renders it sensitive to depreciation and appreciation in value. Islamicbanking stockholders are not an exception. Low revenues from financing activities,inefficient use of resources and increasing write-offs from bad murabaha and al-baibithaman ajilmay erode banks capital. To some extent, the no pain no gain rule is auniversal one. Western and Islamic banking run on similar plane when bank capital isconcerned.

In western banking, shareholders put their money at risk with an expectation of earninghigher returns. On average, the return on equity (ROE) on banking stocks isapproximately 15 per cent. That is for every ringgit investment, they earned 15 cent perannum. To some extent they deserve the earnings given the higher level of risk takenrelative to fixed deposits. For example, the interest rates on a 12-months fixed deposit

ranges from 3.5 percent to 4 percent. It is substantially smaller that the ROE of bankcapital since bank deposits face no potential loss at all compared with bank capital.

The risks faced by the banking shareholders are numerous but the most notable iscredit risk. Bank managers are paid well to mobilize deposits and make loans. Thesafety of deposits rests on banks capital as well as deposit insurance while the safety ofloans depend a lot of prudence and risk management.

Risk management is the process of measuring, or assessing, risk and developingstrategies to manage it. Usually, risk management refers to managing credit risk as it isthe major risk in the banking business. When an Islamic bank uses credit instrumentssuch as murabaha,aitab, and tawaruq, it exposes bank capital to losses arising from baddebts. Here unsystematic risk or controllable risk predominates banking operation.However, if it applies partnership instruments such as musharakah and mudarabah,then bank capital exposure to market or systematic risk should be much greater.

The issue at hand is as follows. The structure of Islamic deposits is quite different fromconventional ones as the former is largely derived from profit-sharing investmentaccounts (PSIA) based on the mudarabahcontract. In 2006, PSIA constituted more than70 percent of Islamic bank deposits. Mudarabah works on similar fashion likemusharakaexcept that only one party provides the money capital while the other oneproviding knowledge and skills.

In Islamic banking application, the bank who acts as the manager injects knowledgeand skills while depositors injects money capital. No guaranty concerning the safety of

deposits is given to PSIA as the contract of mudaraba is also based on risk-sharing.Losses must be shared between the bank and PSIA depositors. Thus, deposit risk isnow new to Islamic banking. It is potential loss faced by the PSIA depositors when afinancial activity that uses the mudarabahdeposit does not do well.

For example, if a $50 million PSIA deposit is injected into Project A but fail to take offwith only $5 million remaining after 5 years, the deposits shall carry the loss while thebank losses the opportunity cost. However, if the project runs very well and increases invalue to $200 million, the profits shall be divided between the bank and PSIA

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depositors. In this way, MIA depositors stand to earn higher returns as they are puttingtheir deposits at risk.

However, the average rate of return on PSIA (RPSIA) deposits ran approximately at 3.5per cent while average ROE in Islamic banks in Malaysia is approximately 15 per cent.While the 15 percent ROE is a deserving income to the shareholders, the somewhat low

3.5 per cent returns on a risky PSIA deposits seems quite puzzling. The 11.5 % Equity-Gap between ROE and RPSIA thus deserves some explanations. Both sides bear similarrisk but only the latter gets the larger cake. It makes sense that conventional practicesgave less to interest-bearing deposits and more to shareholders capital but the sameshould not hold for Islamic banking as investment deposits are also risky in nature.

Conventional Banks Islamic Banks

ROE 15.49 per cent 15.2 per cent12-month Deposits 3.67 per cent 3.43

Source: Annual Bank Reports Malaysia 2006

In the Middle-East, the ROEs for the major players such as al-Rajhi, Kuwait FinanceHouse and Dubai Islamic Bank were even more higher at 36 percent, 47 percent and 25per cent respectively in 2006. However, return on deposits tends to show similar trends.In 2006, the cost of funds to deposit ratio was at 4.7 per cent while in Dubai IslamicBank it ran at 2.1 per cent in 2005.

The problem may lie in the structure of the Islamic banking firm. This is becausecurrent regulatory requirement provides relatively little room for Islamic banks to injectmudarabah deposits into risky but also higher yielding investments such as salam,istisna, ijaraoperation lease, joint-venture and venture capital. But recent Bank Negaraguidelines on risk-absorbent aspect of PSIA can pave way for greater innovations of

Islamic deposit products based on private equity model. The risk-absorbing PSIA isexpected to reduce stress on Islamic bank in raising additional capital to support newhigh risk-weights Islamic financing instruments such as musharakah.

It is worthy to note that risky investment in Islamic finance does not mean taking asuicidal approach to investment. It simply means that wealth creation must be basedon the principle of no pain no gainwhich the Shariah has well recognized. The legalmaxim al-ghorm bil ghonm which means that no reward can be obtained withoutrisk is a fundamental principle in Islamic law of transaction.

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