Islamic finance taking shape
Merkato, once proclaimed to be the single largest open-market place in Africa, seemed to be evolving overtime. In the past decade alone, Merkato has undergone a significant level of transformation. For one, a better part of this old market establishment can no more be called an open market with new high-rise buildings housing most of the shops and storage facilities, these days. And together with that, a number of new coffee shops and other service giving entities are now popping up in Merkato targeting the tens and hundreds of thousands that rumble through the market every day.
Nevertheless, Merkato is still the nerve center of Ethiopia’s trade and commerce activities. They say, easily,goods and services worth millions of birr changes hands every day. Arguably, Merkato could also be unparalleled in the country in terms of the volume of transaction it handles in a single business day. The bulk of the daily transaction in Merkato is also not based on formal contractual interactions and standard bank payment mechanisms.
In fact, Merkato might as well be the single largest market place in Ethiopia in terms of the volume of cash-based transacting activities. Although notorious for its street-smarts and illusive traders and businessmen, Merkato is also a place where huge amounts of financial dealings are made solely based on trust and social networks.
Yes, this aspect of Merkato is definitely another constant in the rapidly shifting business environment of this Italian-era market place. Every day, a staggering amount of short term business-to-business loans and financing decisions are made in Merkato; and most of it is truly based on trust and social networks, posing a serious challenge to tax administration and trade regulation. Some of the traditional, social saving-credit collectives aka equbes are said to be as large as hard-to- come- by bank financing facilities (credits). However, such non-conventional business interactions are not always a matter of choice for those involved (business people).
In fact, Muslim members of the business community are and had been severely underserved by the nation’s financial industry. For there are no financing instruments that can cater to the needs of the Muslim community both in Merkato and the rest of Ethiopia, resorting to informal financing mechanisms is indeed no surprise. The conventional banking sector is one of the major players in the Ethiopian financial system to have failed this significant portion of the business community.
A service as simple as opening a checking account or access saving or loan instruments was difficult for Muslim members of the business community for the entire banking industry in Ethiopia and was limited to offering a conventional interest-based banking products to clients; whereas interest and other speculative financial instruments are basically in contradiction with the basic Islamic laws and principles. This, in turn, had massive consequences to the business environment as it distorts the level playing-field and eventually the market. On the other hand, the banking sector, as a lucrative investment area, also stayed closed-off to Muslim investors.
This however, seemed to be changing in 2011 with the enactment of the nation’s first interest-free banking directive by the National Bank of Ethiopia. The directive that authorized the business of interest free banking in Ethiopia was highly shrouded with controversy back when it was enacted.
The months leading to the enactment of the directive saw the emergence of the first financial institution in Ethiopia that seeks to operate on the basis of an interest-free banking scheme which is also consistent with the Islamic principles: Zemzem bank. Although still under formation, Zemzem dominated debate platforms, discussing the importance of an Islamic financial institution in Ethiopia and how it operates. However, it was a short-lived party to say the least. Soon, the most anticipated national bank directive sealed the fate of the first interest-free bank in Ethiopia. Yes, it was not to be. The directive only authorizes interest-free banking window in the setup of a conventional banking system and not a full-fledged Islamic bank.
The news hit the bank (under formation) and it’s pledged shareholders pretty hard. Accordingly, the existing private and state-owned banking institutions were not quick to the capitalize on the window that opened up by the directive; not until Oromia International Bank, which was only 5 years into the banking business at the time, took the step to pioneer the first interest-free banking window in Ethiopia, in October 2013. Including the state-owned Commercial Bank of Ethiopia (CBE) a number of banks from the local finance sector followed suit.
And exactly six years later, the once frustrated Zemzem returned to the finance scene. But this time around with two more potential full-fledged Islamic banks namely Zad and Hijra. The three have officially started selling shares while un officially at least two more banks are said to be in the pipeline to take part in the interest-free banking game. This will bring the total number of new entrants to five.
Taking a step back, the whole concept of an Islamic financial institution is said to be a relatively newer phenomenon in the global financial order. The first banking establishment solely based on Islamic principles appears on the global scene as late as 1963 in the form of the Mit-Ghamr Islamic Saving Bank of Egypt. Although not a banking institution in its fullest sense, a year earlier in 1962, the Malaysian government has initiated the establishment of the “LembagaTabung Haji” the first pilgrim’s fund management company to assist Malaysian religious travelers to save money while making beneficial investments of their funds in the process. Although not exactly an Islamic bank, the Fund gave rise to the first Malaysian interest-free bank and later in the mid-70s to other Islamic banks in middle east and North Africa namely the Dubai Islamic bank, the Faisal Islamic Bank in Egypt and Sudan and Kuwait Finance House.
Islamic law scholars and Shari’ah experts allude that the emergence of an Islamic financial system is important since Islam by its very nature is a religious framework that encompasses all aspects of the life of the observant. This is where financial instruments that are completely consistent with the Islamic belief and principles become a necessity.
According to an IMF working paper on Islamic finance published in 2015, Islam does not endorse every human wish, and it prohibits on moral grounds activities related to tobacco and other drugs, alcohol, pork products, gambling involving money and non-money assets (maysir), speculation, pornography, and armaments and destructive weapons. Hence, it argues that Islamic finance is generally governed by three principles: equity, participation and ownership.
“Scholars generally invoke the principle of equity as the rationale for the prohibition of predetermined payments (riba) [charged interest], with a view to protecting the weaker contracting party in a financial transaction,” the paper reads. This goes with the other two principles of participation (where reward (profit) is linked with risk taking and real and productive activities) and ownership (underscoring the sanctity of property right and ownership) to fully form the principle behind Islamic financing.
These very principles set Islamic banking apart from the conventional one, according to Jamal Muzeyin, Banking business professional and organizer/promoter of Zemzam bank.
“To truly understand what sets Islamic (interest-free) banking institutions apart from conventional banking,” Jemal says, “first we need to clearly define what banking services really mean in this modern business environment. “Banking services can really be summarized in three broad categories, according to Jamal, which are payment facilitation; service charge and fee based services like Letter of credit, foreign exchange trade, money transfer and the like; and the third and last one which has to do with mobilizing deposits and channeling funds to borrowers.
“With regard to the first two services, both the Islamic and conventional banking systems are the same; but the departure point is with channeling funds,” he explains. Interest-free banking is truly different from the conventional banking system first and for most by not charging interest both on deposits and funds advanced to borrowers.
True to form, interest and other speculative financial instruments together with prohibited (haram) businesses like alcohol, cigarettes, adult entertainment, products related with pork and the like are completely excluded from the Islamic finance system. “This makes Islamic banking different form a conventional one, but it is not the only one,” Jamal told The Reporter via a phone interview.
In fact, according to scholars. Financing in the context of Islamic banking has two attributes which cannot be found in a conventional banking scheme; The first one is the fact that it is asset-based (instead of cash advances, Islamic banks heavily rely on actual asset financing on behalf of the borrower). While the other is a risk distributing characteristic that financing products offered by the Islamic banking industry have.
“Uniquely, the Islamic banking or the products offered under Islamic principles share the risk that is faced by borrowers. Not only the banks but depositors and account holders also share overall risk that comes with financing a certain ventures,” Jamal says. “If you ask me, this could be by far the most risk mitigating scheme among the range of financial products offered in the market; and from a macroeconomic stand point this ensures the overall stability of the banking and the financial system,” he argued.
"On the other hand, these two attributes make Islamic banks different in a sense that the banks can play a role of a commodity trader (buying and selling goods and services) and a business partner, Jamal illustrated further, adding “And this is something that could not be found in a conventional banking system.”
With regard to project financing under the Islamic financing scheme there appears to be two possible contractual arrangements between the bank and its clients. According to the scholars, it could either be “profit and loss sharing arrangement (Musharakah) or ‘profit sharing and loos-bearing arrangement’ (Mudarabah).
And hence, in Musharakahn contracts, banks and clients (or any other two or more business entities) can enter into a joint partnership (either limited to specific project or not; but in the context of banking for specific project) with a full right to participate in managerial decisions and also bearing the highest risks from all modes of Islamic financing. Even though profit is shared agreed up-on proportion, losses are usually born according to capital contribution of the partners.
Nevertheless, Mudarabah is about forging partnerships (bank and client in this case) as financier and agent, the latter providing the managerial and entrepreneurial expertise towards generating a profit. The financier obviously bears all losses while profit is shared according to the agreed up on proportion.
As far as banks acting as commodity traders, the standard financing products dubbed Murabahah entails Islamic banks buying commodities and services to be resold by their clients at a payment deferred for a latter period.
Apparently, there are variants of the specific contractual agreement to be concluded between the bank and client. In this regard, the bank and the client can agree on a price markup or profit sharing arrangement from the proceeds of the sales of goods and services by the client as compensation for financing services.
In fact, data shows that about 80 percent of the entire global Islamic financing portfolio, at this point in time, involves Murabahah in one way or the other. This is especially true for the nascent Interest free window operated by local banks in Ethiopia. “In Ethiopia, Murabahah’share could be as high as 90 percent of the overall Islamic financing activities,” says senior banking professionals working with private banks operating an interest free window.
So far, the local interest free windows are reported to have done well in terms of mobilizing deposits. In fact, some reports put the level of deposit mobilization by eleven banks (operating interest free windows) at 40 billion birr, which is unprecedented in the space of 5 years since they launched their operation.
In the overall Islamic financing framework, depositors and the banks relationships as well are quite different from the conventional one. Since there is no interest payments, depositors in interest free banks deposit their money either for the sole purpose of safekeeping or facilitating their payments or wanting to reap the benefits of profit sharing from the operation of the bank. According to pundits, depositors have options either to share the benefit form specific projects or from the general operation of the Islamic bank. The proportion of the profit sharing the bank offers to depositors depends on,of course, the type of the deposit (time or demand) or the level of risk they are willing to stomach (either from the specific or general operation of the bank).
The only way depositors differ from actual shareholders of an Islamic bank is in light of the latter’s voting right in the matters of the banks and protecting its interest.
Nevertheless, Jamal as well admits that the existing Islamic banking windows in the market are yet to realize the full potential of the Islamic financing system. “I say this since, as they currently operate the Islamic banking window in Ethiopia, almost 90 percent of their activities are limited to offering the services of sellers of goods and services,” he argues.
Yes, they have mobilized an impressive amount of deposit in a space of a few years, Jamal says. However, they have not advanced well in offering actual project financing banking services. Jamal admits that the legal and administrative regulatory frameworks facing the interest-free banking windows in Ethiopia are yet to improve.
In fact, he says that, this is one of the external challenges that the new entrants are expected to face, when they do finally join the sector. “To be honest the legal limit placed on the investment participation of banks has proven to be quite an impediment since Islamic banks main line of business involves investing on third parties based on a specific profit sharing agreement,” he explained further.
Jamal questions the logic of placing a limit on the mainline of business of an industry. “You see Islamic banks are like investment banks, they can’t survive if they can’t invest,” he argues, adding that double taxation problem regarding financing of goods and services and ownership transfer are also other areas that needs to be looked at by the regulatory body.
As far as the bank professional is concerned, the new entrants do face a host of challenges to make it in the business. “For one, these new banks navigate through the various legal and regulatory restrictions placed on their way,” he explained to The Reporter. Even then, he continued, "they need to work hard to squeeze in a small market share by competing against established banks their Islamic banking windows."
Since Murabahah takes the overwhelming share in the business of interest free banking in Ethiopia, the banking professional said that, the newer banks need to secure a sustainable source of foreign exchange by building their clientele in the export business, which, given the current business environment in Ethiopia could prove to be a very daunting task. “Apart from foreign trade activities do require to secure a strong correspondent bank from the developed world. The correspondents-African banks relationship at this time is at a very precarious level,” he continued to explain, since most of the biggest correspondent banks have recently chosen to abandon their working relationships with banks from the Sub Saharan region to reduce the risk they face if this relationship resultes in a potential fine to them. “Some of these correspondent banks are so big that the fine they face from their regulatory authorities could be in billions of dollars at a time and the overall business volume with Sub Saharan region is nowhere near to cover the fines,” he underscored.
Notwithstanding the huge capacity gap in project analysis and management in the industry, the customary business practices in Ethiopia could also prove to be another daunting challenge for Islamic banks, according to Jemal. “We know most of our businesses lack in the area of proper financial bookkeeping and ethical business practices; this is a big problem for Islamic banks since the nature of the business they are in requires them to be actual partners to projects they wish finance,” he explained to The Reporter.
He asks how many of the local companies in Ethiopia have properly audited financial reports; and how many of them discharge their tax obligations properly and on time? Furthermore, Jemal is also concerned about the overall business culture. “Islamic banks will enter into business partnerships with companies trusting that they will have an ethical business conduct. How many of these companies have trust worthy financial statements?” he asks.
Banks under Islamic financing system offer products where they not only have profit sharing arrangements but bear the losses of these projects they finance. That, according to Jemal, puts the banks in a difficult situation if the business practice is not ethical and lacks trustworthiness.