Religiosity and Efficiency

Prof. Saiful Azhar Rosly, Ph.D

Head, Islamic Banking Department
International Center for Education in Islamic Finance (INCEIF),
MALAYSIA
22 August 2008
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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

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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 non-
complaint 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

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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.