Regulatory uncertainty fails to cripple Bangladesh's Islamic banks

Islamic financing accounted for more than 24% of total financing in Bangladesh.

Demand for Islamic banking in Bangladesh will receive a boost from the country’s robust economic growth and rising population, according to Moody’s Investors Service.

The country’s GDP is expected to rise between 7-7.5% in the next two years, the fastest pace amongst Muslim-majority countries, driven largely by private consumption. The rising population and expanding middle-class also presents a bigger untapped customer base for Islamic banks, the report added.

"Bangladesh has an advanced Islamic banking industry relative to other Muslim-majority countries, with Islamic financing accounting for more than 24% of total financing in Bangladesh at the end of 2018, and exhibits strong fundamentals for further growth," said Moody’s Analyst Tengfu Li.

“Islamic banks stand to benefit from increasing private consumption, especially given that they have larger exposures to the manufacturing, wholesale and retail trading sectors than their conventional peers,” the report noted.

Strong growth in the ready-made garment (RMG) sector, in particular, is expected to spur demand for Islamic financing. The RMG industry is one of the key drivers behind the country's economic growth and contributed more than 70% of the Bangladesh’s goods exports in 2019, said Moody’s.

Demand for Shariah-compliant banking amongst Muslims and early government efforts to facilitate the sector’s development has fueled Islamic banking’s expansion in Bangladesh. Compound annual growth rate (CAGR) of Islamic financing between 2008 and 2018 hit more than 20%, growing faster than the conventional private-sector banks (around 18%) and state-owned banks (<15%).

But a lack of an all-inclusive legal and regulatory infrastructure for Islamic banking, coupled with deteriorating asset quality, will limit the sector's expansion, noted Li.

“To ensure compliance with Shariah principles, Islamic banking contracts have to be structured differently from those for conventional, interest-based financing. Also, Islamic banks are prohibited from financing certain businesses, such as those engaged in pork products, entertainment or speculative activity,” the report stated.

Bangladesh has yet to establish a separate law that comprehensively covers these principles. Currently, Islamic banks in the country operate under the same laws as conventional banks with some basic Islamic provisions added.

The country also lacks an authority that supervises Islamic banks' adherence to Shariah principles and ensures consistency in implementing them. Compliance is largely the responsibility of each banks’ board of directors, who depend on their respective Shariah supervisory boards and secretariats.

Whilst the central bank issues Islamic banking guidelines, it is not involved in approving Islamic products. Nor do they inspect banks.The industry-led body, Central Shariah Board for Islamic Banks of Bangladesh, provides only advisory and training and does not have any enforcement power.

This means that there are no legal deterrents to Shariah noncompliance. Furthermore, the decentralised model of Shariah governance that Bangladesh currently has could lead to conflicts of interest, given that members of the supervisory committee at a bank are hired by its board of directors.

Additionally, the central bank has not issued any new license for a full-fledged Islamic bank since 2013—which Moody’s says has resulted in the industry’s growth slowing.

These legal deficiencies could impede public confidence and hinder new customers and “highlights the difficulty of accommodating a rapid expansion of Islamic banking for a regulator that does not have resources devoted to Shariah governance,” added Moody’s.

Growing asset risks—the result of structural weaknesses such as the prevalence of poor corporate governance and risk management—further pose an obstacle for the sector to unlock its full potential.

“Liquidity risks are higher for Islamic banks than for conventional banks because Islamic banks operate with tighter liquidity, given that they are subject to lower regulatory liquidity requirements. This makes them more susceptible to liquidity stress amid tightening liquidity conditions,” the report stressed out.

Islamic banks also lack access to liquidity through broader secondary and repo markets because they cannot hold conventional government securities. Instead, they obtain liquidity through the BGIIB, which has a much shallower market.

“This is a common issue for Islamic banks operating with smaller market shares than conventional banks in dual banking systems, although there are other forms of liquidity that Islamic banks can utilize when needed, such as Shariah-compliant short-notice deposits from the interbank market and the central bank,” Moody’s added.

Photo courtesy of Wikimedia Commons.