Table of Contents
The present study aims to bring an analytical perspective of applying the key notions of Islamic banking and economics to a case study involving an Islamic bank and a conventional banking entity operating under an Islamic jurisdiction. Based on a comparison of Dubai Islamic Bank and HSBC Emirates, the perceived similarity in performance and moderate compliance could be traced to varying incentive structures with regard to targets and strategies alike.
Despite a dominant share of natural gas and oil in its exports and GDP structure, the Emirati economy could be referred to as the most heavily diversified of the Gulf models (World Bank 2014). This could be seen as one way of tackling the issue of gharar, or excessive risk, that has to be avoided by all reasonable means. However, that pertains to ends or opportunities, whereas a less diversified core has been regarded as ultimate means, i.e. the source of financing or startup capital. Whilst it may not be feasible to strike a perfect balance across a variety of compliance hurdles, one could be naturally led to prioritize ranking of potential abuses or excesses so as to avoid the most critical or haram type.
To begin with, a weak cut-off stance whereby whatever is not haram is halal or adab could be used as a last resort. The fact that the UAE is renowned for its very conservative legacy, with Sharia law, might ironically come in handy in dealing with hands-on implications as well as applications based on the core maxims, without having to eke out the disparate body of fatwa rulings that are by and large just solutions or fixes aimed at satisficing ad hoc. By contrast, one could be interested in a possibly generalized vision as a starting point of distinguishing as well as reconciling alternate strategies. At any rate, commercial disputes, and corporate negotiations in particular, are far more plausibly to belong to a tort type, readily falling under the jurisdiction of Sharia law rather than civil or criminal.
On second thought, the recent episodes of forex rigging (najash), in which HSBC’s EU and US subsidiaries were implicated (Treanor 2014), can be clearly qualified as criminal offense and major corrupt practices. In this case, currency manipulations and derivative options are a source of excessive risk in their own right rather than mitigating means. It remains to be seen whether reputation loss amounted to adverse externality or global spill-over are enough for marring its UAE presence while coming under critical scrutiny vis-à-vis its portfolio and capital structure. In a sense, Basel II stipulated general capital adequacy or legal reserve norms as part of due diligence or internal control and prudential management at large could serve as the lower-bound not likely to remove the restraints of Islamic law. Although the fines, incurred as part and parcel of the plea bargains, could reach the Sharia settlement pay whenever the immediate plaintiffs or stakeholders have been identified, collective interest at threat may have been compromised to an extent that urges heftier outlays short of shutdown. This raises the stakes with regard to risky or morally hazardous strategies or business models compared to non-Muslim operational legacies.
The fact that the UAE features no more than 17% of the Emirati citizens' shares in its population breakdown (World Bank 2014) could suggest its sharing and public-interest as the compliant paradigm of Sharia has worked properly on at least some levels. The flipside of it would be extra expectations that might complicate matters with any subsequent solutions being tailored to fit in squarely. Although GDP per capita between USD 45K and 65K (nominal versus adjusted purchasing power) would suggest low risk versus ex ante, the fact that the populace has exploded in size over the past five decades should make one cautious of careless or poorly designed models that regard collective interest or social cohesion. On the other hand, an ever larger network of interaction may posit some oversimplified institutional models as less than feasible. One paradoxical implication could arise because umma or ijma accommodative solutions might fail as these small- or medium scale forms effectively dominate in mounting complexity.
In fact, the same would be typical of the asset portfolio and capital structures of banks, whether Dubai Islamic or HSBC, which are challenged to address community relevance despite their market power or shares befitting large-scale, long-term public projects on which market driven solutions or private incentives alone might either be efficient or fail altogether. In any event, the UAE’s implied minority governance as pivotal player’s leverage might come in line with the preponderant part that small- and mid-scale projects play amid the fragmented demographics as stated by a high Human Development Index (World Bank 2014). The ratio of population to land area, which is 35%/5%=7 for Dubai as compared to, for example, 31%/87%=.36 of Abu Dhabi, could point to any model, as maintained by Dubai operating banks, being representative for all practical and precedence setting purposes.
Islamic versus Hybrid Models of Financing
Well-developed infrastructure, as boasted by the Emirates, appears in line with social cohesion and capital (asabiyyah) as well as protection of public interest, particularly in the way of attracting tourism and proposing superior business opportunities. The latter would, first and foremost, involve agglomeration effects stemming from large scale and the scope pertaining to capital concentration rather than to competition or individual market shares . The bulk of synergy and complementarity-based growth is garnered from agglomeration.
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However, infrastructure amounts to long-term outlays, which are inevitably built on low rollover or cost of capital, if only because solid investment projects are supposed to offer high IRR (internal rate of return) or low RRR (required rate of return), acting as a discount or hurdle. In other words, this hybrid model could best work as a matter of aligning Muslim and Western constituents and state-market partnership alike in this area. Regarding the relevance or demand side, the hybrid model or a mixed strategy is indeed most sought after, in light of the demographics laden with cultural diversity. An appropriate toss-up should be opted for anywhere in between tawhid or taawon versus ‘diminishing musharakah’, i.e. good harmonization as opposed to weak or asymptotic convergence or progressively lesser opportunism on the part of either new entrants with respect to the incumbent and host legacy or allies vis-à-vis each other and the common cause.
Whereas banking entities have long been restricted from engaging in some fairly risky activities or all-out network expansion out West, the restraints could be even more exacting, yet systemic and coherent in Islamic settings. Among other things, Western banks, whether under common law or continental jurisdictions, have not by and large been permitted to tap into securitization vehicles, derivatives, or equity trading. Although they may technically participate in vertically integrated schemes catering for the real sector, this is routinely frowned upon as non-core activities by the markets. For that matter, the so-called ‘investment banking’, or confined to underwriting bond issuance, does not pertain to banking per se and is perhaps the single most feasible fixed-income segment; apart from insurance and pension funds that regular banks end up tapping amid bubble bursts in real-estate crediting and related bond trading.
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In a sense, the Islamic bank is a complete about-face in the aforementioned context, with fixed income positing a controversial profile of prohibited riba or pure interest income versus reasonably avoided risk. Along these lines, optimization could be centered on the Sharpe ratio, capturing excessive returns net of risk-free rate and uncertain or standard deviation. On second thought, bank performance is more routinely gauged according to CAMEL analysis or support levels, prudential capital adequacy, gap management, and financial ratios to name but a few. Investments of both direct and portfolio types, or real-sector and equity as alternatives to interest, are most encouraged as long as they involve sound reasoning and risk-mitigating scrutiny.
Evidently, this has nothing to do with narrowing of investment banking described above. For that matter, gap management may pertain to duration that is based immunization much the way it is done with portfolios of bonds, yet in ways that match capital maturities against ultimate investment horizons or project paybacks. Finally, involvement in securitization vehicles such as futures and hedging options might or might not be encouraged, depending on whether risk mitigation or insurance goals dominate income targeting that could alternatively be secured in less questionable and more trade-related opportunities. Dau-Schmidt (2012) has proposed a motivation that is based on dichotomy distinguishing between hedging versus speculative forward positions, even though it remains to be seen how this basic analysis may be applicable to the more involved strategies based on arcane derivatives.
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Reserves are rather aimed at fostering liquidity and working capital management than at the immunity against deposit runs which are far less critical. The latter agenda arises as a response to holding inventory or receivables insofar as exposure to real investment projects warrants is involved. More importantly, the public good as traced all the way back to national and community stakeholders should count more in comparison with conventional maximization of shareholder value, or stock price. To put it simply, valuation multiples such as the P/E, P/S, or EPS (price to equity, price to sales, and earnings per share) are nearly inapplicable back in the East.
Case Study Involving BS & IS: HSBC versus Dubai Bank
At this stage, comparison can be done in terms of ex post, contrasting between the prior expectations or incentives compatibility. As a starting point, one should not be surprised at the stunning gap between money creating capacity, or deposit driven lending for the two polar types of banking, as these are determined by very different multipliers: marginal propensity distinguished from the reserve ratio for the Islamic versus conventional cases. It has yet to be seen whether the general equilibrium does indeed reveal converging ROI or marginal profitability between the financial versus real sectors, which is subject to the productivity residual or money velocity gap. In other words, in Islamic setup, compressed money velocity and higher GDP-to-debt coverage would be obtained, thus pointing to sustainability convergence; whereas under conventional models, expansion is backed with excess exposure that is driven by lower reserve coverage. As a result, a mixed model building could usher in some unexpected or multiple equilibria for both. Chapra (2007) is a relatively early study hinting at how, in line with an alternative design embedding some more stability into the world’s finance, the sharing of risks and return could be done beyond conventional securitization without aggravating the structural uncertainty.
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By referring to Table 1 in the appendix, one can make sure that the two banks have turned out to be comparable on many levels, e.g. capital adequacy and financial leverage or gearing, return on equity and assets, net profit margin, or even interest coverage (DIB 2015; HSBC 2015). Moreover, somewhat paradoxically, the non-Islamic HSBC model may appear to have either outperformed DIB or even outmatched it in the inherently adab battlefield. However, save for the differential conventions on measuring some of the underlying aggregates (e.g. interest expense and reported reserves), that would be a rather superficial perception. For instance, Shaikh (2011) has pointed to similar benchmarking issues with reference to riba avoidance that is based on performance comparison.
For starters, capital adequacy has been defined as the unity residual of leverage, meaning that they add up to one identically. Although a 14.29% equity cushion clearly looks better than 11.47% along with lower leverage or debt-to-equity ratio, still it might appear strange that the latter values are at all commensurate with the two in the first place (85.7% versus 88.5% for DIB and HSBC respectively). Actually, this has mapped to similar ROEs at 15.84% versus 14.64%, despite somewhat more divergent ROAs at 2.26% versus 1.68%. The fact that their assets have revealed a gap in their earning power has also shined through superior net profit margin for DIB at 50% as opposed to 41% for HSBC, which is still enviable. However, an even higher interest coverage that the latter has enjoyed at 4.43 as compared to DIB’s 3.50 could be rationalized in terms of the excess riba or share in the net interest income that DIB was willing to forgo in line with the requirements and recommendations of Sharia.
In fact, this agrees with Lodhi, Kalim, and Iqbal (2005), arguing that Islamic banking need not be interest free as an end in itself. Alternatively, Khan (2011) has demonstrated that bypassing type solutions such as murabahah might compromise the nature of incentive compatible values. Not least, Mansoori (2011) has questioned the very premises of looking into the strategic compliance trade-offs, sometimes with the meta-criteria , addressing the issue of manipulative consideration with due diligence albeit not necessarily corrupt. By contrast, Khan (2013) has suggested that talfiq could be justified on meta-gounds of a different order in terms of how aptly it promotes public good.
Overall, the lower interest coverage amid better ROA measures up to the international surveys positing lower cost efficiency yet greater scale returns for Islamic banks (Abdul-Majid, Saal & Battisti 2010). Srairi (2010) has arrived at a alternative perspective, which can be reconciled with the previous breakdown regarding the divergent motivation that the two models pursue when stressing cost efficiency over profitability, stemming from scale and possibly accruing to public stakeholders rather than private decision makers.
Moreover, the share of receivables in the current assets as well as those in the total assets appear to be consistent with DIB at about 20%. Although this share would seem even larger for HSBC at 92% and 59% respectively, this outlier is due to the excessive exposure to customer operations, which, if offset, would yield a negative contribution to net working capital. Insofar as this set of metrics could capture just how closely the bank qualifies as Islamic with an eye on trade relevance, DIB reveals sustainability along these lines as well. Moreover, the negligibly low reserves ratio for HSBC amid its reserves shrinking and turning negative, only reinforces the big picture along with the coverage or solvency outlook that is based on the current and quick ratios being juxtaposed for the two.
In Islamic banking system, sustainability results from the ultimate driving rationale almost by design or due to the very nature of collective interest , whether it is maintained statically or inter-generationally. Although the restrictions and inflated expectation might be hard to meet, their apparent consistency suggests some natural ways of reconciling public agency, private deliverables, and interim means. Whereas some of the grand solutions have at times been reported as either second best or involving guesswork only, they have been presented in the literature as the ultimate way to public good as the ultimate cause and target, regardless of how close a scrutiny has been applied to each standalone fatwa. Based on the 10K reports for the two banking entities, the competing rationales have been illustrated in all materials, while lending themselves rather well to the empirical literature. Arguably, cost and risk sharing naturally result in sustainability.
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