While Islamic finance grows at a marked clip in the GCC and Asia, what is its prognosis in Europe?
As we’ll see in this article, a considerable demand exists for Islamic banking products in Europe but to date, for a number of reasons including risk-aversion and conservatism, this need has gone largely unfulfilled.
The Islamic banking market continues to flourish around the world with current estimates suggesting that assets managed by Islamic banks are in excess of $700 billion – predominately concentrated in the Middle East.
It is a fact that there are sufficient Muslim investors and borrowers in both Islamic and non-Islamic countries to warrant the attention of traditional banks that seek to serve such clients and capture a potentially profitable slice of a still relatively untapped market. This is corroborated by the growth of Islamic finance in the US, which has a population of over 7 million Muslims.
The challenge for European financial institutions is how to leverage their banking knowledge and expertise in developing sufficient products and services that fulfill the requirements of their Islamic customer base while being compliant with Islamic finance principles.
Key Islamic financial Instruments
Islam is not only concerned with the relationship between man and God but it is also a system of beliefs, justice, equity, fairness and morality which are the values that underpin the entire Islamic way of life. These beliefs are governed by the body of Islamic principles generally referred to as Shariah, which is used to develop and create Islamic financial products.
The European market size and scope
There are more than 14.74 million Muslims in Europe, of which 1.8 million are resident in the UK plus an additional 72 million in Turkey. There are 360,000 Muslim households in the UK.
The following table illustrates the potential market size in mainland Europe for an Islamic bank, as well as highlights the potential for extra-European expansion in countries such as Turkey.
Population (millions) Muslim Population (millions) Percentage
France 61.00 6.10 10%
UK 60.00 1.8 3%
Germany 83.6 3.25 3.89%
Italy 56.00 1.39 2.5%
Spain 42.10 0.60 1.43%
Belgium 10.70 0.39 3.65%
Sweden 9.30 0.31 3.33%
Austria 8.50 0.22 2.6%
Denmark 5.60 0.19 3.4%
Cyprus 0.95 0.24 25.26%
Turkey 72.10 72.00 99.89%
Switzerland 7.80 0.25 3.2%
Source: OECD World Fact Book 2005
The UK is the first country in Europe to promote and encourage retail Islamic banking and it is in the process of embracing Islamic financial techniques by introducing new laws to facilitate further market entry and practice of Islamic finance in the UK.
According to the Office of National Statistics the UK Muslims by country of origin are in the following proportion:
In a research carried out by The Runnymede Trust, “Islamophobia – a challenge for us all,” the Muslims from Middle East and Africa represent 24% of the total Muslim population in the UK. Islamic banking in Europe will inevitably focus on both the retail and institutional customers as these are the two major dominant players in the market. As the table clearly illustrates there is a significant retail market opportunity in Europe for new retail banks, but in terms of sheer volume of transactions the institutional market provides the more lucrative opportunity for the Islamic banks.
Trends in Islamic Banking in Europe
The UK has taken a major lead in Europe in promoting and encouraging Islamic banking activities but this has mainly focused on retail banking and only more recently on investment banking.
The Financial Services Authorities (FSA) in the UK has only authorized one Islamic retail bank which is the Islamic Bank of Britain (IBB). Although other investors have looked into the retail banking arena, no other dedicated competitors have entered the retail market, mainly due to the level of investment required to acquire the critical mass customers that are needed to ensure the retail bank is profitable. There is potentially one Islamic retail bank in France called Tayseer Bank with is going through the authorization process from regulators and should be operational in the near future.
The major hurdle for IBB and any new Islamic retail bank in the UK and Europe is having banking products that are competitive with conventional products offered by other retail banks. Also, competitive product development provides opportunities for potential new entrants into the market to differentiate themselves and add competitive advantage against existing banks in the market.
More recently in the UK, there have been new Islamic investment banks authorized by the FSA including the European Islamic Investment Bank and the most recent entry, Gatehouse Bank. In total, there are five Islamic investments banks in the UK focusing on institutional investors in Europe and also looking to gain institutional funding from organizations in the Middle East. The Islamic investment banking sector in the UK has flourished enormously with other potential new entrants in the pipeline.
The trend in the UK seems to be that bankers believe it will be more difficult to make profitable businesses from the retail customer base while the institutional market is seen as an area where Islamic banks can make significant inroads into the European market. Further supporting the rise of Islamic banking activities is the fact that the UK government is making a concerted effort to turn London into a global hub for the industry.
Customer Segmentation in Retail Islamic Banking
Developing Shariah compliant retail financial products can be complex, with a multitude of options available. Before embarking on such a route, it is paramount that the target customer base for the product is clearly defined and their needs and priorities are understood. As in European banking, where there is no ‘one size fits all’ approach to product development, the same can be said of Islamic banking, with an array of customer segments each with different product and service requirements as well as brand criteria.
In terms of product, a key differentiator between Islamic banking customer segments is the interpretation of what constitutes acceptable levels of Shariah compliance. The scale is divided between the more traditional and conservative customers on the one side, and those who seek higher levels of Islamic assurance on the other. Certain customer segments are willing to pay a premium for the most compliant Shariah products, whereas others will be more attracted to products that are only part Shariah compliant but offer a more competitive rate. Prior to designing a Shariah compliant product concept, the requirements of the target customer segment should be clearly understood, and the resulting costs and benefits weighed.
In addition to the product, service requirement is another area that will differ between customer segments. Characteristics such as a customer’s age, education, lifestyle and desired relationship with the bank will determine these criteria. Delivering against these is a key element in the proposition and will differentiate banks, which otherwise might offer similar Shariah compliant products.
The community spirit and culture has been lost from banking in the UK and these adjustments in the delivery services have marginalized the small trader and sole proprietor who no longer has a local branch of his/her bank for cash deposits and withdrawals, and the collection/exchange of coins. The Cruikshank Report published in 2000 highlighted the poor service provided by the traditional banking community in the UK. More importantly, the report focused on the high level of charges being imposed by traditional banks on their clients due to cartel structures and difficulties for clients changing banks. The recently published financial results of the major banks show that this position has not changed. The ethos and values offered by retail Islamic banks go against these trends and thus provide a unique selling point against conventional retail banks.
Brand recognition is also a key factor that will differ between customer segments. Certain customer segments will only bank with brands that have a strong history and presence in Islamic countries, whereas other customer segments will be more willing to accept European brands with the right product and service propositions.
As with any new product development, prior to taking a Shariah compliant product to market, the customer segments which form that market must be understood, their product, service and brand criteria defined, and the economic, technical and regulatory feasibility of delivering against them assessed. Only by doing this will banks be able to develop compelling propositions that provide the desired level of return.
The way forward
In the wider context, Islamic finance faces the perpetual challenge that it operates as a subset of conventional finance which is based on fundamentally different premises. While this may be a limiting facet (in that Islamic financial institutions must model their products after conventional models) Islamic financial institutions (IFIs) also have the capacity to innovate within this space. In a sense, the constraints can become boundaries that Islamic finance pushes. Certainly, in the current context of financial intuitions failing the world over, IFIs might be able to showcase their own equitable forms of financing and risk sharing. This in turn may allow IFIs to influence the development of financial systems the world over.
In Europe, the UK is leading the charge to enact laws that embrace Islamic banking. It abolished double stamp duties that until recently hindered the purchase of a property under Islamic principles. The UK Government is reviewing other laws in order to soften the establishment and offering of Islamic banking products and naturally this has opened the doors for European banks to further their focus in this market.
In 2005, Lloyds TSB launched services that provided Shariah compliant banking products to its existing retail customer base, but these products were merely white labeling an existing limited product range, and thus not competitive compared to conventional retail banking offerings in the UK. This was the first major activity from a European bank in this market and has encouraged other banks to evaluate their strategy and to take a closer look at this market.
As the market for Islamic banking grows, there is also a need for IT systems that can accommodate an innovative mix of products and provide an efficient cost effective pricing for banks to offer Shariah compliant products. Currently there is no recognized universal IT system for Islamic banks thus resulting in bespoke systems being implemented which are not necessarily providing the services required by banks, hence limiting their product development capabilities.
A European bank using effective IT systems and developing Shariah compliant products will have the key competitive advantage over their rivals and as a result will, without a doubt, ensure that the bank makes great inroads into this prosperous and growing market.
European banks need to incorporate various aspects of traditional banking with Islamic banking concepts in order to fully capture the Islamic market in Europe. While being compliant with Islamic principles may initially be seen as a hurdle, the potential return and increase in customer base will inevitably outweigh any financial investments and commitments made by the bank.
The main principles of Shariah are:
Interest – the charging of interest or riba is strictly prohibited as it is deemed to be terms of unfair exploitation
Speculation – Shariah does not permit speculation or gambling, thus many institutions are unable to enter into derivative transactions such as swaps, futures and options
Prohibited investments – investments in certain products such as alcohol, pork and gambling activities are deemed inappropriate Profit – profit cannot be assured and the Islamic financial institution must assume at least part of the investment risk, thus a guaranteed return is not applicable in Islamic finance
Uncertainty – there is no concept of uncertainty, thus uncertain investment returns are not permitted.
Islamic institutions raise money mainly through the main banking services, the current accounts and savings accounts that generally comes under the strict law of Shariah, thus being fully compliant.
Following are the main Islamic techniques used in finance:
Mudaraba (Trust Financing): This is a form of partnership in which one partner provides the capital required for funding a project while the other party manages the investments using his expertise.
Ijara (Leasing): The ijara contract is very similar to the conventional lease. Ijara is a contract under which the bank buys and leases out the asset or equipment required by its client for a rental fee. This is commonly used for Islamic mortgages.
Salam (Advance Purchase): This is defined as forward purchase of specified goods for full forward payment. This contract is regularly used for financing agricultural production.
Murabahah (Cost-plus Financing): This technique is used extensively to facilitate the trade finance activities of Islamic financial institutions. The bank will purchase the necessary goods/equipments and then sell on to its clients at cost plus a reasonable profit.
Sukuk (Bond Issue): This essentially amounts to commercial paper that provides the subscribers with ownership in the underlying assets.
There are various types of Islamic finance and all in some form or another are limited by the following observations:
In terms of mortgage, a large deposit is sometimes required then the conventional mortgages
Most observers believe that Islamic mortgages are more expensive than the conventional ones
Monthly payments are high in murabahah, but volatile in ijara
Each transaction can be complex and difficult to convey as there are combination of contracts involved in a single transaction
There is a possibility for “negative equity” in the ijarah mortgage
Absent or underdeveloped international capital market
No market maker mechanism
Article written by Nurul Islam, Founder & Executive Director of the European Bangladesh Federation of Commerce & Industry (EBF) and Director of the Nerissa Group.