This article first appeared in The Edge Malaysia Weekly, on October 12 - 18, 2015.

TO say that Malaysia is the global leader in the trillion-dollar Islamic finance industry is no exaggeration. A combination of state ambition and years of nurturing has led the country to chalk up a string of achievements.

From having a single flag-bearer for Islamic finance — Bank Islam — in the 1980s, Malaysia now has 16 local and foreign Islamic banks. According to the World Islamic Banking Competitiveness Report 2014-15 by Ernst & Young (EY), four Malaysian Islamic banks feature among the world’s 20 largest Islamic banks by capital base. As at end-2013, Islamic banking constituted 20.7% of domestic banking market assets and 16.7% of the global Islamic market. This makes Malaysia the second largest Islamic banking market in the world, behind Saudi Arabia.

Ironically, it is conventional lenders that have been standing at the core of this progress and should be credited for the popularisation of Islamic banking in Malaysia.

“When the government allowed conventional banks to open Islamic windows and then Islamic subsidiaries, it made Islamic banking accessible to everyone. Almost overnight, Islamic banking made a quantum leap from major cities to small towns and villages through conventional networks. It was the right thing to do at the start,” observes Professor Emeritus Datuk Mohamed Ariff of the International Centre for Education in Islamic Finance.

This is obvious because by 2013, out of the five largest Islamic banks in Malaysia by assets, three were Islamic subsidiaries of conventional banks. But, Malaysia’s Islamic banking needs to start shedding its conventional roots and empowering Islamic banks if it wants to continue leading the pack.

Industry observers say the current subsidiary operating model needs relooking into. This is because Islamic banks have found themselves competing head-on with their conventional peers to get a slice of the pie in an increasingly competitive banking landscape. This, sometimes, puts Islamic units in the awkward position of having to challenge their conventional parents for business.

“The industry is dominated by Islamic subsidiaries of conventional banks, those who entered the Islamic banking industry not because they believe in Islamic finance but for profits and to defend market share. So, it is the conventional banks that call all the shots. How can an Islamic subsidiary compete against its own parent?” asks Mohamed.

“Islamic banks need to compete among themselves to bring out the best, and not with conventional banks.”

He adds that the artificial competition between an Islamic subsidiary and its conventional parent is “ridiculous” as well as a “disservice” to Islamic banking because the lack of meaningful competition between Islamic banks is hampering their ability to innovate and develop niche shariah-based products.

One reason for that concern is that conventional banks and their profit-driven philosophy have been influencing the development of Islamic products. As a result, Islamic products often end up in the market as “Islamised” imitations of conventional ones while falling within the precept of regulators’ shariah-compliant standards.

“Islamic products tend to be just modifications of conventional banking products, as long as the products fulfil shariah contractual conditions and comply with shariah standards. Products should be Islamic from the get-go and not modelled on conventional products,” says an industry observer.

“For every conventional product from a parent bank, there will be an Islamic and shariah-compliant version from the Islamic subsidiary,” says another industry player.

Allowing conventional banks to continuously dictate product development also means that Islamic subsidiaries will not be empowered to define themselves from their parents through their products.

“Islamic banks have to come up with genuine Islamic products. That can only come through innovation and R&D. In turn, that can only happen when Islamic banks learn to compete among themselves. Otherwise, conventional banks will continue to innovate and Islamic banks will continue to imitate and throw in ‘shariah compliance’ at the same time,” says Mohamed.

Shariah compliance is not costless. Ensuring a product is shariah-compliant, whether it is from devising complex alternative arrangements, hiring shariah experts or from taking on additional risk for Islamic contracts, adds to the cost of doing business. According to EY’s report, the cost to income ratio for Islamic banks in Malaysia in 2013 was 41%, and progressively increased over the last five years. While this is lower than conventional lenders’ 48%, conventional banks have shown they are able to lower operating costs.

“Islamic banking is based on the concept of partnerships. Islamic banks offer equity capital to finance something that is connected to the real economy. So, it is not just credit risk that they have to take on. There is the legal risk, the compliance risk, the shariah risk. So, Islamic products are generally costlier than conventional products,” says Ahamed Kameel Meera, a former professor at International Islamic University Malaysia.

Higher risks should mean higher returns. But, with competition in the banking industry getting stiffer, Islamic banks are under pressure to absorb the extra cost of bearing the extra risk to keep up with conventional banks. This inevitably puts earnings growth at risk.

“If you compete with conventional banks this way, in the end, Islamic banks are the losers,” says Mohamed.

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