Professionals in the Islamic banking sector are often asked whether the current strategies adopted by Islamic financial institutions will prove effective at competing at the global level in the long run. Since a strategy is a plan of action designed to achieve certain goals, its effectiveness can be assessed only in relation to these well-defined goals.
Strategies that improve franchise value
Franchise value is about the solidity of a bank’s market standing in a given geographical market or business niche. A solid and defensible franchise is a key element underpinning a bank’s ability to generate and sustain recurring earnings, to create economic value and, thus, to preserve or improve risk protection in its chosen markets.
The Islamic brand is economically valuable; in many instances Muslim depositors will happily pay a small premium for conducting their finances in what they perceive to be an ethical way. With a large addressable population and relative immaturity there is still scope for solid long-term growth.
It is believed that strategies leading to sustainable entrenched market position, improved geographical and earnings diversification, and increased earnings stability can enhance a bank’s long-term franchise value.
Size is important because diversification is harder to achieve when an institution is small. It should be noted, however, that a bank dominant in smaller but more favourable markets may have a higher franchise value (which could translate into greater earnings stability) than a bigger bank with a highly price-sensitive customer base in a competitive market.
It follows that it is better for Islamic banks to have a strategy that helps achieve a stronger position in a few selective markets than one which results in marginal positions in many competitive markets.
Strategies that improve risk positioning
A bank’s risk positioning is a fundamental qualitative factor in a credit analysis; the current credit woes apparent in the global market once again highlight its importance. In this regard, strategies that improve corporate governance, controls and risk management, financial reporting transparency, credit risk concentration, liquidity management and strategies that set a conservative market risk appetite are considered favourably.
Improving risk positioning is particularly relevant. Although Islamic banks are able to pass through a negative shock on the assets side to the investment depositors, displaced commercial risk is at stake.
Islamic banks have a number of buffers to manage displaced commercial risks. These are profit equalisation reserves which contribute to smooth earnings across the cycle; investment risk reserves which absorb negative shocks on asset values; Mudarib fees which can always be decreased in a discretionary manner to avoid penalising the depositing Rab al Maal; and shareholders who can always provide Qardh Hasan to profit-sharing depositors. In a stress situation, those IFIs sufficiently equipped with such mitigating instruments would be considered more resilient to downturns.
Nonetheless, to date few, if any, Islamic banks have passed on losses to their depositors. If the buffers mentioned above are inadequate, the IFIs could experience funding pressure as deposits are moved to other financial institutions.
Additionally, Islamic banks tend to have greater concentration in assets and liabilities compared with conventional banks. They also face challenges in managing liquidity and risk due to the limited range of instruments available.
Moreover, Islamic products are less commoditized and require more tailoring and oversight, and this leads to substantial overheads and operation risk.
Strategies that improve financial fundamentals
Normal analysis of a bank’s financial fundamentals can be broken up into five sub-factors, namely profitability, liquidity, capital adequacy, efficiency and asset quality. Some financial metrics necessarily reflect a bank’s franchise value and risk positioning, but a prudent financial policy also plays an important role in shaping these numbers.
For instance, a bank with a strategy to maintain a conservative financial policy is likely to keep its capital and liquidity ratios higher than most of its peers. The result is a stronger balance sheet and which can better withstand adverse economic cycles. For Islamic banks with significant exposures to equities and properties, conservative financial leverage is particularly important in view of the volatility in the values of these investments.
Most of the strategies of Islamic banks try to achieve profitable asset growth. The differences in their strategies mainly reflect the state of development of Islamic banking and their positions in their respective home markets, their aspirations for the medium and long term, and the resources they have.
