Equity-Gap in Islamic Banking

Prof. Saiful Azhar Rosly,Head, Islamic Banking Faculty, saiful@inceif.org
International Center for Education of Islamic Finance (INCEIF)
31st March 2008. Malaysian Reserve

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 volatile market movement renders it
sensitive to depreciation and appreciation in value. Islamic banking
stockholders are not an exception. Low revenues from financing
activities, inefficient use of resources and increasing write-offs from bad
murabaha and al-bai bithaman ajil may erode bank’s capital. To some
extent, the “no pain no gain” rule is a universal one. Western and Islamic
banking run on similar plane when bank capital is concerned.

In western banking, shareholders put their money at risk with an

expectation of earning higher returns. On average, the return on equity
(ROE) is approximately 15 per cent. That is for every ringgit investment,
they earned 15 cent per annum. To some extent they deserve the
earnings given the higher level of risk taken relative 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 bank
capital 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 is credit risk. Bank managers are paid well to mobilize deposits
and make loans. The safety of deposits rests on bank’s capital as well as
deposit insurance while the safety of loans depend a lot of prudence and
risk management.

Risk management is the process of measuring, or assessing, risk and

developing strategies to manage it. Usually, risk management refers to
managing credit risk as it is the major risk in the banking business.
When an Islamic bank uses credit instruments such as murabaha,aitab,
and tawaruq, it exposes bank capital to losses arising from bad debts.
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 from conventional ones as the former is largely derived from
profit-sharing investment accounts (PSIA) based on the mudarabah

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contract. In 2006, PSIA constituted more than 70 percent of Islamic bank
deposits. Mudarabah works on similar fashion like musharaka except
that only one party provides the money capital while the other one
providing knowledge and skills.

In Islamic banking application, the bank who acts as the manager injects
knowledge and 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 is now new to Islamic
banking. It is potential loss faced by the PSIA depositors when a financial
activity that uses the mudarabah deposit does not do well.

For example, if a RM50 million PSIA deposit is injected into Project A but
fail to take off with only RM5 million remaining after 5 years, the
deposits shall carry the loss while the bank losses the opportunity cost.
However, if the project runs very well and increases in value to RM200
million, the profits shall be divided between the bank and PSIA
depositors. In this way, MIA depositors stand to earn higher returns as
they are putting their deposits at risk.

However, the average rate of return on PSIA (RPSIA) deposits ran

approximately at 3.5 per 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 similar risk but only the latter gets the larger cake. It
makes sense that conventional practices gave less to interest-bearing
deposits and more to shareholders’ capital but the same should 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 cent

12-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 Finance House and Dubai Islamic Bank were even more higher at
36 percent, 47 percent and 25 per cent respectively in 2006. However,
return on deposits tends to show similar trends. In 2006, the cost of

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funds to deposit ratio was at 4.7 per cent while in Dubai Islamic Bank it
ran at 2.1 per cent in 2005.

The problem may lie in the structure of the Islamic banking firm. This is
because current regulatory requirement provides relatively little room for
Islamic banks to inject mudarabah deposits into risky but also higher
yielding investments such as salam, istisna, ijara operation lease, joint-
venture and venture capital. But recent Bank Negara guidelines 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
is expected to reduce stress on Islamic bank in raising additional capital
to support new high risk-weights Islamic financing instruments such as
musharakah.

It is worthy to note that risky investment in Islamic finance does not

mean taking a suicidal approach to investment. It simply means that
wealth creation must be based on the principle of no pain no gain which
the Shariah has well recognized. The legal maxim “al-ghorm bil ghonm”
which means that “no reward can be obtained without risk” is a
fundamental principle in Islamic law of transaction.

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