CAN ISLAMIC BANK INCREASE FINANCIAL INCLUSION?

Can Islamic Banking Increase Financial Inclusion? In a recent IMF working paper published in February 2015, shows that there is "a possible link between the presence and activity of Islamic banking and financial inclusion" despite of a mixed picture due to number of reasons such as weaknesses on the financial infrastructure of those countries studied, lack of conducive regulatory environment, lack of qualified Islamic banking talent among others.

What is the global situation on financial self-exlusion due to religious reasons? Researchers observed that "Worldwide financial exclusion for religious reasons seems relatively small, but the share varies notably across countries and can be particularly high in certain Muslim countries. For example, the share of adults citing religious reasons for not having an account is 34 percent in Afghanistan, 26–27 percent in Iraq and Tunisia, and 23–24 percent in Djibouti and Saudi Arabia. However, other Muslim countries exhibit relatively low levels of religious self exclusion: virtually zero in Malaysia, 2½–3 percent in Kuwait and the United Arab Emirates, and 4½ percent in Sudan."

Why lower rate in Malaysia, Kuwait, UAE and Sudan? Reaserchers could not attempt to shed light on this question. I would argue that may be due to the fact that Islamic banking has been in those countries since 1960's and others 1980's. North Sudan for example have no conventional bank since 1970's. Therefore, self-exclusion because of religion is irrelevant in this country so can be said of Malaysia, Kuwait and UAE which have significant number of Islamic Banks.

Is there any previous evidence of a link between Islamic banking and Financial inclusion? Researchers observed that "The World Bank 2014 GFDR presents some encouraging results: Islamic banking is found to be positively related to financial inclusion; while Muslim countries in general tend to exhibit lower levels of financial inclusion, Islamic banking is associated with a lower incidence of religious self-exclusion and with a lower share of firms citing access to finance as a significant obstacle. However, there is also reason for caution. Using micro-level data, Demirguc-Kunt, Klapper, and Randall (2013) find that, once relevant individual characteristics are accounted for, although Muslims are less likely to have an account or save in a formal financial institution, they are no less likely to borrow from one, and the greater observed religious self-exclusion of Muslims seems to arise solely in sub-Saharan African countries."

Why the greater religious self-exclusion of Muslim seems to arise solely in Sub-Saharan Africa? I would argue, one amongs many reasons could be linked to increased awareness of Islamic teachings in financial matters as well as awareness of the erroneous operations of conventional banking system. However, an indept research is required to shed more light on the subject.


Policies for enhancing financial inclusions.

Reaserchers offer the following recommendations to enhance financial inclusion through Islamic Finance:

1. Improvement of the current operating model of Islamic banks. "Islamic banks may need to improve their current operating model so as to attract depositors and serve SMEs, which have so far been excluded from the formal financial sector for religious considerations.One option is to create separate SME business units within Islamic financial institutions, to understand the market dynamics of these firms, and to tailor Islamic financial instruments to their specific needs." This can be achieved by:
A. Providing better training to bank personnel in Shari’ah-compliant instruments and to streamline the execution of Islamic transactions, especially those related to financing applications for SMEs.
B. Introduce credit evaluation techniques such as behavioral scoring and an early warning system to better price and reduce risk exposure to SMEs, which will help develop equity related instruments (musharaka and mudaraba ) and ijara for SMEs.
C. Explore the potential of private equity (PE) and venture capital (VC), both of which seem well suited to Islamic models of finance. In this regard, Bahrain provides an example of the successful introduction of an Islamic VC bank focused on financing SMEs.
D. Establishing Islamic equity funds for SMEs could also be a possibly beneficial source of finance, especially for high-risk SMEs that lack access to conventional bank finance and cannot afford the compliance costs associated with listing in capital markets. "Developing a Shar’iah-compliant financial market (equity and sukuk), where both the instruments and trading process would be in line with the Shari’ah requirement for transactions (Bacha and Mirakhor, 2013), could help alleviate the finance constraints on SMEs."

2. Private and public sector initiatives to strengthen the role of Islamic finance in broadening financial access. "The development of Islamic microfinance could offer more effective tools for improving financial inclusion than conventional microfinance. On the funding side, Islamic microfinance companies can mobilize additional resources such as zakat and waqf, and on the lending side they mainly use financial instruments that are based on Profit and Loss Sharing (PLS) schemes such as mudarabah and musharaka rather than loans, avoiding the imposition of oppressively high interest rates on poor households and small entrepreneurs." This can be achieved by:
A. Allowing Islamic banks to open microfinance branches or to developa Shar’iah-compliant finance model for microfinance.
B. Qard-al-Hassan40 resources ( normally Islamic banks offer current accounts using Qardh Hassan contract) should be made available to Islamic microfinance institutions to reduce the burden of high interest charges on their borrowers (Iqbal and Mirakhor, 2013).
C. Zakat funds could be used to cover the default risk of microenterprises and to build capacity and skills of micro-entreprenuers.
D. Use sukuk to securitize credit facilities granted to microenterprises and SMEs and provide additional funding for this excluded segment of the economy.

3. Institutionalization of Islamic redistributive mechanisms such as zakat, sadaqat, qard-al-Hassan and waqf(Mohieldien and others, 2011). The aim of institutionalization is to formalize and standardize operations and to enhance the effectiveness of these instruments for addressing the lack of financial inclusion in Muslim countries and Muslim communities. This can be achieved by:
A. Setting up a nonprofit financial institution funded by waqf that would provide Qard-al-Hassan to poor consumers (Elgari (2004)).
B. Establishment of an awqaf fund to provide investment and working capital financing to microenterprises (Mohieldien and others (2011)).

4. Establishment of an Islamic partial credit guarantee scheme (IPCG) or extension of the existing PCG to Islamic banks with the aim of reaching underserved groups such as SMEs and startups, especially at a time when governments are improving credit information and creditor rights (see the experience of Jordan, which recently established a Shari’ah-compliant loan guarantee). Successful IPCGs may consider a coverage ratio closer to international standards (around 30–40 percent), fees could be closely tied to risks, and systematic assessments should be conducted regularly to ensure cost-effectiveness and customer satisfaction (Saadani and others, 2010).

5. Improvement of financial infrastructure. This can be achieved by:
A. Introducing private credit bureaus, the enlarging of credit reporting of utilities and retailers, and the coverage of both personal and commercial credit information.
B. There is also a need to improve credit protection, because, as shown earlier, the region ranks low in the area of credit rights as
measured by the legal rights index. This may require enlarging the pool of assets acceptable as collateral,adopting collateral regimes, and developing out-of-court enforcement mechanisms.
C. Increase bank competition due to its positive link with financial inclusion. "Increased competition could help to push Islamic and conventional banks to develop business lines beyond large corporations and expand the SME segments of the market. This could be done by easing entry into banking, developing the capital market, and reducing loan concentration though prudential measures."

Finally, consumer protection, financial education, and a sound regulatory and supervisory framework for Islamic finance could be helpful in encouraging households and enterprises to use Shari’ah-compliant instruments. Government and regulators also need to support improvements in access, especially through Shari’ah-compliant financial instruments, and consider better access a goal as important as financial stability (Mohieldien and others 2011).