From Collateral to Collaboration

How Interest Free Banking Fosters Transparency, Strengthens the Economy

In Ethiopia, following the legal framework for interest-free banking products established a decade ago, the banking industry has introduced a range of Sharia-compliant saving and investment products under window services. The revised banking proclamation passed in 2019 ushered in a new era of full-fledged interest-free banking services. Currently, we have four full-fledged interest-free banks and more than a dozen conventional banks that provide interest-free banking services under window arrangements.

Islamic banking operates primarily based on a risk-sharing model. Although the commercial banks operating in Ethiopia, both conventional and full-fledged, claim that they provide various kinds of financing, the product is significantly dominated by Murabaha (cost plus markup) financing.

Of course, there are financing products designed based on the principle of risk-sharing. Mudaraba is a profit-sharing arrangement whereby the investor provides money, and the entrepreneur manages the business. While both parties share the profit according to a pre-set proportion, the investor absorbs the loss.

The most interesting Sharia-compliant financial arrangement is Musharaka, which resembles Mudarabah but has significant differences. Musharaka is an Arabic word that means sharing. In the context of business, this arrangement means a joint venture. It also has an Amharic equivalent word, ሽርክና or partnership. In this financing arrangement, both the investor and the entrepreneur share risks and returns.

The principle of risk sharing is the cornerstone of Islamic finance. This principle has broader implications for how banking institutions interact with borrowers and the real economy. In such a financing arrangement, there is no predetermined interest. The reward to the bank is based on the profit earned by the joint venture. This brings both upside and downside risks to the banker.

Usually, when conventional banks provide credits, they require security and the interest rate they charge is predetermined. As long as the borrower pays the principal and the interest, the rest is none of their business. In this case, the borrowers shoulder the risk of failure and repossession of their assets. This arrangement is at odds with Islamic principles of financing.

Unlike conventional lending, Sharia-compliant financing, which incorporates the principle of risk sharing, increases the bank’s stake in the joint venture on which it puts its money. If the venture succeeds, the bank will be rewarded; if it fails, it will bear its share of the loss. The presence of high skill in the game encourages banks to work to make the venture actively successful. The contribution of expertise, continuous monitoring and follow-up, and the injection of more capital in times of difficulty make IFB beneficial to both parties. This approach calls for transparency between the bank and the investor and, as a result, helps build trust even more between them.

The continued interactions between the bank and the investor enhance the bank’s understanding of the investor’s business. This information would significantly help the bank in its financing decisions of a similar nature. Furthermore, the experience gained working with investors would allow the bank to launch new financial products.

Conventional financing heavily relies on security. This hinders entrepreneurs with ideas but without securities from accessing financing. Islamic finance based on risk sharing can be tapped to unlock the entrepreneurial potential of startups without securities.

In a financial system based on risk sharing, the banking system has a supportive role in the real economy. As the famous economist Joan Robinson stated in 1952, “Where enterprise leads, finance follows”. This means that the banking system serves the needs of the real economy- a notion fundamental to Islamic finance. However, a section of the modern-day financial system is detached from the real economy with significant negative repercussions. A finance system based on risk sharing encourages innovation and entrepreneurship and, as a result, fosters economic growth.

Despite the wide-ranging benefits of a financing system based on risk sharing, caveats should be added.

Conventional bank lending is riddled with information asymmetry. The borrower has more information about the venture than the lender. It exposes the bank to an adverse selection market situation where it provides credit to a high-risk borrower. Similarly, although Islamic financial contracts are fraught with information asymmetry, their degree depends on the type of the contract. That is why Islamic financial agreements such as those in Musharaka are less attractive to banks, as significant information asymmetry is attached to them.

Similarly, the cost of monitoring arising from agency problems is significant in finance contracts based on risk sharing. Increased involvement in the affairs of the joint venture entails substantial costs to the bank in terms of expertise, time, and resources. The trouble is that if the investor leaves the joint venture unchecked, it could expose the bank to losses due to dishonesty, poor ethics, and poor management. This means the banks need to keep substantial capital aside as a cushion.

The Sharia-compliant products, which are based on the principle of risk-sharing, require unique regulatory rules as they are entirely different from conventional lending. This covers at least areas such as valuation of assets, provision for assets impairment, and capital adequacy. If the size of these assets is substantial, incorporating the regulation within macro-prudential regulation is essential.

Transparency is one of the benefits of Islamic banking. Compared to traditional interest-based banking, IFB entails a better degree of transparency for everyone. This offers several benefits for depositors, investors, and the overall financial system.

Islamic or Interest-Free Banking gives options for a clearer understanding of the risks and rewards of any business. This is because the model operates on profit-sharing principles instead of a fixed interest rate, which is the case in conventional banking.

In the IFB, depositors become investment account holders, sharing profits (and losses) generated by the bank’s activities. In this case, transparency is crucial because depositors must understand the underlying investments and the associated risks. Clear disclosure of investment types, risk profiles, and profit distribution mechanisms allows depositors to make informed financial decisions. That’s why IFB offers enhanced trust and confidence among stakeholders. Traditional banking can sometimes feel like a black box.

Depositors entrust their money but may need to grasp how it is used. Detailed information about the bank’s Sharia-compliant activities (investments that adhere to Islamic law) allows depositors to see how their funds are used; they can decide where they will be used or rejected based on their values and considerations. This transparency builds confidence in the system and encourages broader participation, further boasting deposit mobilization and investment.

Islamic Banking also creates a more vital market discipline. Transparency empowers depositors to act as informed participants in the market. By understanding the bank’s performance and risk profile, depositors can make better choices about where to invest their money. This market discipline incentivizes Islamic banks to be more efficient with their operations and investments, ultimately leading to a more robust financial system.

IFB also reduced information asymmetry. In traditional banking, more information is often needed between banks and depositors. Banks possess superior knowledge about the financial products and the risks involved. Transparency in Islamic banking helps bridge this gap. Detailed disclosures about fees, profit distribution models, and underlying assets ensure depositors are well-informed about the terms and conditions of their investments.

Greater transparency facilitates effective regulatory oversight by central banks and Sharia compliance boards. Detailed financial information allows regulators to monitor Islamic banks’ activities and ensure adherence to Sharia principles and financial regulations. This promotes a stable and well-functioning banking sector.

However, achieving complete transparency in Islamic banking can be challenging because of the complexity of Islamic Financial products.

Indeed, Islamic financial products can be intricate, and explaining them in a clear, concise and accessible manner can be difficult. Banks need to find the right balance between providing adequate detail and avoiding overwhelming users with technical jargon. Finding employees who understand the sophistications of each financial product and can explain with precise terms so that customers can understand them well is a challenge, especially in countries such as Ethiopia, where human resource development in the financial sector has a long way to go.

Another challenge is the need for standardized Sharia interpretations. Sharia interpretations can vary between scholars. This lack of complete standardization can lead to ambiguity in how certain financial instruments are classified as Sharia-compliant. While efforts are underway to create a more unified approach to Sharia interpretations, much remains to that effect. The absence of standardized interpretations will continue to challenge providing IFB services.

Overall, transparency is a cornerstone of Islamic banking. By providing clear and comprehensive information about financial products, risks, and profit-sharing mechanisms, Islamic banks can build trust with depositors, promote market discipline, and contribute to a more stable and ethical financial system.

Unlike traditional banking, where profits are guaranteed, Islamic banking exposes banks and depositors to shared profits and losses. This transparency discourages excessive risk-taking by the banks. A loan will not depend only on the presence of worthy collateral. A sound business plan, prudent management capabilities, and other financial considerations are considered. Knowing depositors will withdraw funds if they perceive ventures as too risky, banks are incentivized to make sound investment decisions, promoting overall financial stability.

Indeed, market discipline, driven by transparency, fosters a financial system that discourages risky lending behaviour. It rewards ethical practices and promotes overall efficiency. This helps to strengthen regulatory oversight, leading to a more stable and prudent financial environment for everyone.

12th Year • April 2024 • No. 128