From a commercial point of view, the effective returns on Islamic accounts, both deposit and financing, need to be of the same scale as the conventional ones. In reality, the disparity in real returns may potentially represent a threat to the Islamic banking industry, at least in the short-term. As base rates in the conventional banking world have begun to approach zero, the interbank rates, although slow to respond, have now also begun to fall. At present, over 75 % of Islamic financial transactions are based on murabaha and ijara, and others may be wakala, salam or istisna, with a maximum of 5 % for PLS-based structures. Although the majority of Islamic banking is conducted through murabaha and ijara, the rates of return on mudarabah and musharakah are not immediately similarly impacted. The real returns on those products are reflected in the profits made by those enterprises that are financed in the Islamic profit-and-loss sharing (PLS) concept.
So, the dilemma Islamic banks that have financed through mudarabah or musharakah may face is that their returns may be significantly above the rates achieved by conventional banking. They may now face the commercial risk of being overwhelmed by an influx of funds for which there is no short-term liquid market; or alternatively, they may face the ethical dilemma of reducing the real return on their PLS investments to bring them in line with the low interest rates of the conventional world. Sukuk issuers, that have benchmarked their returns from ijara or mudarabah investment pools against LIBOR or other interbank investment rates, may have to deal with this problem soon, as their steady investment returns will be much higher than international rate benchmarks.
When the balance sheets of conventional banks have been decimated by derivatives and other questionable trading strategies, could the real, asset-backed investments of PLS be of genuine interest to conventional bankers anxious to gain some sort of return in a world where their interest-rate based investments are almost worthless? Is it conceivable that it is the conventional banks that lead the way into Islamic banking?
Conventional banks’ lending rates will stay positive even if the base rate goes down to zero and the same will apply to Islamic banks; the impact will be felt by depositors (savers), irrespective whether they are banking with Islamic or conventional institutions.
If Islamic banks use equity-based structures, like mudarabah and musharakah, on asset and liability sides ‘in substance’, their operations will be riskier. While this may provide some comfort in the present economic scenario, in the long term the real rate of return to depositors at Islamic banks will be low, due to compliance with regulatory and taxation rules. Capital adequacy requirements for equity-based products are higher than debt-based ones. Also, taxation treatment of debt makes it more attractive than equity.
In a nutshell, due to the above-mentioned issues, Islamic banking products are not very different from conventional ones. Is it not time to re-think and change the strategy for moving to equity-based structures at least in the markets that are more supportive of Islamic finance, such as Malaysia and Bahrain? Surely, once there is a success story in one market, it will become easier to emulate it in other places.
