Equity-Gap in Islamic Banking

Prof. 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 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) on banking stocks 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 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 $50 million PSIA deposit is injected into Project A but fail to take off
with only $5 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 $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 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 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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