Islamic Banks and Risk
Numerous are the impediments to Islamic banking’s growth in many countries, let alone inadequate regulation, but one major impediment is the deep-rooted risk aversion mindset, both on the bank side and the customers side.
On one hand, Islamic banks’ officials want to generate risk-free revenue streams, which can only be implemented through debt-like instruments, in particular murabaha and ijara. In fact, most of Islamic banks’ officials and many of the employees come from conventional banks. They hence systematically avoid equity-like instruments, especially mudaraba and musharaka, because of their risk nature. Besides, risk-free instruments are much easier to manage. Yet, another reason that makes banks keep away from equity-like instruments is to meet the expectations of customers.
Customers, even the most loyal ones to Islamic banking principles, have long been used to conventional banking instruments. In most of the times, they talk about their capital and their returns as guaranteed and at pre-determined rates. Rare are those customers who would accept to incur a loss in their capital. A customer base with a conventional culture enforces Islamic banks’ officials to act as described.
However, the customers’ problem is also in part due to the lack of awareness about the nature of the contract between them and the bank, which is a mudaraba contract in principle. When they ask the bank’s front desk employee about the rate of return, they always ask about it as rate of the capital. They almost never ask about the share of profits between them and the bank, which is the basis of the contract between them and the bank. This lack of understanding also goes to the banks’ employees. I remember when I once wanted to open an investment account in an Islamic bank, I asked the employee: “What is the share of profits?” He said: “It’s variable, but around 1.5% per quarter” Again, he was talking about my return as an approximate ratio of the capital. I said “No, I mean the share between me and the bank…” He surprisingly said: “I don’t know”.
This risk aversion and lack of understanding of the core of Islamic banking has caused debt-like instruments to prevail in Islamic banks at the detriment of equity-like instruments, reaching around 75% of Islamic banks assets, making Islamic banking no more than a mere adaptation of conventional banking. Consequently, this has strongly affected the growth of Islamic banks in many countries, and more importantly, their impact on investment and economic growth. This signals the urgent need for awareness campaigns to promote societal understanding of Islamic banking and to spread the mindset of profit and loss sharing to shift gradually from the old guarantee-based mindset. By the same token, Islamic banks’ officials, managers and employees should be intensively trained and educated on understanding the essence, value added and specifics of Islamic banking instruments.