Traditional Islamic Banking Causes Debt Crisis

Sweden eliminated cash transactions in two-thirds of its bank, Kenya shed light on developing nations through the introduction of M-Pesa—and the U.A.E. just announced it will begin the first phase of installing the country’s first credit bureau. 

The U.A.E.’s progression in the financial industry is noticeably rudimentary. Several other Gulf countries have similar issues, and many lack mature credit bureaus, collateral registries and the ability to enforce legal action to collect debt. However, that various Middle Eastern banks are struggling to catch up with technology and regulation cannot be blamed on apathy or negligence. The cause for the Middle East’s underdeveloped financial infrastructure can be traced back to the 1970s when Islamic banking was first created in the Persian Gulf States. 

In the Gulf countries, most of the bank’s customers were practicing Muslims who desired a banking system that aligned with their religious ethics, AT Kearney reported. These values condemned banks from lending with interest because followers believed this was a form of exploitation and stealing. Additionally, the act of making business investments was thought to be morally corrupting, and was compared to drinking alcohol and engaging in pornography.

In recent years, Islamic banking has received greater attention. This was largely due to the notion that the financial crisis that echoed around the world seemed to have missed the Islamic banks in the Middle East. Islamic banks stood their ground during the economic fallout. They remained fully intact and there were no desperate cries for substantial bailout plans.

However, credit ratios in some Middle Eastern banks contribute very little to the country’s GDP. Low credit ratios often indicate a lack of funding capacity, however it is clear that this is not the case for most Gulf countries.

Despite previous successes, Islamic banking has emerging problems just as conventional banking does. According to the research, titled “Credit Risk Management: A Case Differentiating Islamic and Non-Islamic banks in the U.A.E.” published by the Emerald Group, traditional Islamic banks often used personal experience and judgment to determine creditworthiness. Once a loan application was submitted for review, commercial banks appointed a board of members they deemed experts to take control. These members formulated their decision based on qualitative data. In other words, they primarily used subjective opinions to determine which customers were deserving of such liabilities.

A new survey from Arabian Business reported that more than a third of U.A.E. consumers claimed they own more than three credit cards, and half of them admitted their cards were maxed out. Forty-two percent said they fail to pay more than the minimum payment each month, while 45 percent said they repayment fees were not financially feasible. Additionally, one-in-five said they took out a loan to help payback credit card debt. All of these figures underscore the country’s growing debt issues.

Islamic banks’ propensity to fall into debt is largely due to the lack of formal limits that guide the lending process. Credit risk is an integral part of banking that must have strong structure and close management. The Emerald Group results suggest that Islamic banks need to reform legislation to help protect lenders and ensure borrowers are meeting agreed obligations. 

A few months back, Arabian Business reported that U.A.E. banks were still using the local police to retrieve past-due debt from customers. Lobbyists complained for years that it was immoral and unjust to throw residents in prison because their check bounced.

Finally, the U.A.E.is taking the initiative to change old, ineffective ways and will soon have a credit bureau in place. Other countries have come to understand that former banking structures include management styles that are highly susceptible to several types of risk.

An AT Kearney report also indicated there remains an unmet need to mend the operational efficiency in banks. Several banks in the Gulf still manage documents and data manually, which is time-consuming and also leaves room for error. Bank systems need to work towards automation and building a better communication network to decrease costs and increase productivity, as stated in the report.

While there are holes in the banking process, banks in the Middle East are showing rapid improvement with attempting to regain control. In the last year more Islamic banks have introduced more innovation and leadership the financial sector.

To read the full article at Arabian Business click here, to read the full report from AT Kearney click here, or to access the SSRN journal click here.