The Likely Impact of Interest Free Banking on the Financial Sector
In 2010, there were few Islamic banks under establishment in Ethiopia. However, they failed to open their doors because the government prohibited the provision of full-fledged interest free banking in 2011. Until now, interest free banking services are provided by conventional banks at a single window level. However, things have started changing after Prime Minister Abiy Ahmed (PhD) gave a green light to the formation of the much awaited banks recently. Consequently, five Islamic banks are preparing to float shares, while few more are under establishment. Will the entrance of these new financial institutions change the banking industry? EBR’s Ashenafi Endale & Kiya Ali report.
In December 2010, promoters of Zamzam Bank, a financial institution that is still under establishment, floated shares to realize their dream of opening the first Islamic bank in Ethiopia. A year later, the promoters of the bank were able to sell shares worth of ETB330 million, which was far more than the seventy five million birr minimum paid up capital required to establish a bank at the time.
But shortly, the National Bank of Ethiopia (NBE) introduced a new directive that prohibits the establishment of full-fledged Islamic banks. Instead, the central bank allowed Islamic (interest-free) banking services to be provided by the existing banks at a window level.
Since no official explanation was given by the government, the promoters of Zamzam had no choice but to abandon their quest.
But this changes when the NBE gave a green light for Zamzam a day after Prime Minister Abiy Ahmed (PhD) promised to undertake reforms and allow the provision of full-fledged Islamic banking services during Iftar (fast-breaking) dinner held at Millennium Hall on May 22, 2019. “I promise that we will work together to establish an Islamic Bank which was long awaited by Muslims,” the premier vowed.
Soon after the pledge made by the Prime Minister, the central bank begin amending the 2011 directive that governs the business of interest free banking. According to insiders, the NBE is currently finalizing the preparation of additional legal frameworks that will enable it to regulate the provision of full-fledged Islamic financial service.
Capitalizing on this opportunity, other Islamic financial institutions are organizing themselves to join the industry. Hijra, Nejashi, Zad, Kush and Huda banks are already in the process to get the green light from the central bank to start floating shares, while several others, which have not yet picked a name for their would be bank, are organizing themselves. “We have finalized everything and waiting for the go ahead from NBE to start floating shares,” says Ahbabu Abdela, head of the establishing committee of Hijra Bank and manager of Explore More Consultancy. Hijra plans to kick off with a minimum of one billion birr paid up capital.
Islamic banking (interest free banking) is a finance system based on the principles of Sharia law. It is known for reducing risk and creating space for greater investment stability. It avoids financing of prohibited economic activities such as riba (usury-interest), gharar (uncertainty), haram (forbidden) trades and businesses like alcoholic beverages, pornography as well as gambling, among others.
While the introduction of modern Islamic Banking dates back to 1963, the present-day practice began in 1975, after banks flourished and were given mandates to operate in accordance with Sharia rules. Driven by awareness and growing demand, the practice of Islamic banking has since shown drastic growth globally. Even western countries have followed strategies that allow dual banking system, whereby Islamic banking co-exists with conventional banking.
Besides its vast geographical coverage, Islamic banking is witnessing rapid expansion across the whole range of financial activities including personal banking and capital market investments. Some of the products of Islamic bank include Mudharabah (profit sharing and loss-bearing), Wadiah (safekeeping), Musharakah (joint venture), Murabahah (cost plus finance), Ijara (leasing), Hawala (international fund transfer system) Takaful (Islamic insurance) and Sukuk (Islamic bonds). Investments under Islamic banking financing system are also evaluated based on what they contribute to the society and the country, not only depending on the profit they can bring. Because of its focus on financing of businesses that largely contribute for healthy social development, Islamic banking is alternatively referred to as ethical banking, according to some literature.
Many agree that Islamic banking is ideal for project financing, hence contributing to growth of manufacturing, real estate and property development, and other sectors. However, some argues that Islamic banking does not take the dynamic nature of trade activities into account. “Conventional banks provide lump sum of money for projects when they loan. However, the nature of Islamic banking is not suitable for traders,” stress a coffee exporter with two decades of experience.
Putting aside its likely effect on trade activities, there is a mixed feeling when it comes to the likely impact of Islamic banking on the existing banking industry.
“When we launched interest-free banking (IFB) at window level, many predicted that Muslim clients’ deposit at conventional banks will shift to OIB. But that was not what happened,” explains Abie Sano, President of Oromia International Bank (OIB), the first private financial institution that embarked on IFB in Ethiopia in 2015. “No doubt, many big investors and traders, who were seeking for IFB products, have been working with us ever since. But many are still working with conventional banks because they cannot rely only on one bank.”
Since 2013, ten commercial banks mobilized over ETB30 billion deposits through IFB window. OIB is the leading bank by mobilizing three billion birr deposits from 248,614 customers just in the past fiscal year, showing a 48Pct growth from the previous year. This constitutes 15.12Pct of OIB’s consolidated corporate deposit portfolio. In the same financial year, the Bank also provided ETB1.59 billion loan IFB customers, which showed 50Pct from previous year. The figure constitutes 13.6Pct of its total loan portfolio. Such financial activities help OIB to register the highest profit from IFB services in the years. During 2017/18 financial year, IFB window generated ETB194.7 million profits, which constituted 20.8Pct to total profit.
But Abie doesn’t hide the fact that it will be highly challenging for the upcoming Islamic banks, if not impossible, to survive and stay competitive in the existing industry, particularly in urban areas where the presence of conventional banks is strong. “The upcoming banks will have strong base and high survival chance [only] if they come up with large asset property in addition to providing some conventional banking products and services.”
Citing three reasons, Ahbabu, however, argues that there is still unsatisfied demand that his proposed bank will serve even in urban areas. “First, only few banks are very active in providing IFB. Second, the commercial banks tend to mix money mobilized through conventional banking with interest free banking schemes, despite having a separate window. Third, most of the banks are holding IFB deposit for over three years without reinvestment and sharing profit with IFB customers. Large amount of IFB money is still idle at these banks,” Ahbabu stress. “We will definitely fill these gaps.”
Be it as it may, Abie argues that the impact of interest free banking services on the performance of existing conventional banks depends on the type of law introduced by the regulatory body. “The existing laws do not support services like musharaka (partnership), investment deposit, and sharing loss, which are iconic products of Islamic banking. Unless such products are introduced, the impact will be less significant since other interest-free banking products are not totally new to the industry.”
Of course, studies conducted on the issue indicate that among the challenges Islamic banks faces especially in developing countries like Ethiopia, the lack of appropriate legal and policy framework is the major one. Even in some advanced nations, interest free banking service providers are governed by a regulatory and supervisory framework developed for conventional financial industry. As a result, the industry still remains nascent worldwide compared with conventional banking industry.
Despite this fact, Addisu Haba, outgoing president of Ethiopian Bankers Association and former president of Debub Global Bank, stresses the fact that many private banks have embarked on IFB shows that there is a huge demand for such kind of products. However, he argues, “the new banks are not going to have [major] impact on the existing conventional banking system.
Addisu cite the case of Kenya to support his argument. “In Kenya, there are 47 banks for a population of 52 million. “Bearing such experiences in mind, the entrance of new banks will have a positive impact on the economy,” he says. Ethiopia has 19 banks for its more than 100 million people. A bulk of the population, more than 60Pct of the adult population according to some statistics, however, remains still unbanked. Additionally, most of the banks, except the state owned Commercial Bank of Ethiopia, which serves more than 60Pct of the banking industry, are small in their capital base, asset and technology use.
Aschalew Tamiru, Marketing Communication and Operation Manager of Bank of Abyssinia, agrees. “The advent of Islamic banks will help to expand financial inclusion,” he says. “Moreover, since huge sum of money is outside of the formal economy, Islamic banking will pave the way to bring the resource to the banks, which will have positive spillover effect on expansion of investment, job creation and increasing productivity.”
Yet, some are worried because there is lack of skilled human resource that could manage Islamic banks. “In addition to having the knowledge of the banking system, additional skill and experience is required to manage Islamic banks,” explains Andualem Hailu, advisor to the president of Dashen Bank. “The other challenge could be resource mobilization. If there is no sufficient human resource, they cannot expand their branches in short time.”
But Ahbabu says otherwise. “Ethiopian Bankers Association has been training professionals who handles interest free banking services at window level for the past five years by collaborating with foreign organizations such as Turkish Airline,” he says. “Soon, we will start issuing certificate for trained professionals. Thus, the availability of skilled labour will not be an issue.”
8th Year • July.16 – Aug.15 2019 • No. 76