ISLAMIC BANKING A STEP IN THE RIGHT DIRECTION

Last week parliament passed the Financial Institutions (Amendment) Bill that establishes Islamic banking services in Uganda.

"Islamic banking is among other things, based on the principle that earning interest from lending is haram (taboo). Banks operating under this law finance businesses by becoming their partners and sharing the profit that may result from the transaction financed...

This is welcome as an alternative financing model that our market sorely needs.

The challenge for our banking industry is that is dominated by commercial banks. Commercial banks tend to finance going concerns as opposed to startups for example. A company that is beginning needs another kind of financing than the type of bank lending that dominates our market. Similarly, an agricultural enterprise or a real estate developer or an industrial concern.

What we have now is largely short-term financing at high interest rates, with little differentiation to cater for unique categories. This has a lot to do with the dominant source of funds, largely short-term deposits.

The banks have dipped their toes in various products, but clearly more specialization is needed, to cater for the different stages of the business cycle, as well as the different sectors of the economy.

One of the major reasons for business failure in Uganda is undercapitalization, that businesses are set up with too little money to survive the vagaries of business. In Uganda businesses are set up with individual savings, which is as it should be, and then the business owners hope to survive off sales. So, when sales don’t happen quickly, as in the case in increasingly competitive business environments, our businesses fold.

In other places where their financial sectors are deeper small businesses have access to government support, angel investors – rich people organized to help small business, venture capitalists all before or as alternatives to commercial bank lending.

And this maybe a major reason why our businesses remain largely informal. To qualify for all these “lower” levels of financing in those economies businesses need to be formalized – registered, have books and some rudimentary structures that suggest the business has a chance of survival if a bus runs over the founder. The more organized you are the more funding you can get.

While it is important for government to enact laws to regulate these various levels of funding what often happens is that the industry is set up and then policy and law follow.

Government is on the right track trying to create these markets with its various funds for small businessmen. A case can be made for government to develop laws and regulations to incentivize the private sector to join these markets. Government by their nature cannot do such things efficiently, patronage leading to corruption are bound to doom government efforts. That is why they need the private sector to join them and supersede them. The sooner the better.

Which brings around nicely to the excitement about the passing of the Islamic banking law and why we should manage our expectations around this product.

So the excitement seems to be around the understanding those banks offering this service will not charge interest. Banks make money by playing the middle man between those with excess funds and those with need for funds. They charge interest, fees or whatever for delivering this service.

The model we are used to is that we deposit our money with the banks and they take that money and lend it. They have managed the model in such a way that even if you go back for your deposits they will give them back without upsetting the cart.

Under this model the bank often times doesn’t care what you do with the money as long as you pay them back.

If you have a working business model the trick then is to cover the down side, mitigate against risk.  Banks do that now by ensuring you have a steady income from which they can draw their dues and/or have collateral they can flog in case of default. They are biased more towards ensuring you have the revenues to pay them which is why people say that banks lend you money when you do not need it.

In the case of Islamic banking the way they cover their risk is becoming a partner in your business. That is something people are glossing over. What does that mean? To cover his risk the banker will now have to become intimately involved in your business he can refuse to fund you for example if you are not up todate with your tax obligations, a situation which may prove a real risk to you realizing profit. He may require some managerial changes coz your brother who is the CFO just does not cut it. He may have a say on the business he is financing, you want to import 100 tons of starch but for it to make sense to him, he may require you import less or more...

While it may prove uncomfortable for our businesses to switch to Islamic financing, it has long term benefits, for them and the economy, if it allows our businessmen to move more and more towards formalization. On the other hand it will improve our bankers’ business acumen, because now beyond just assessing whether the business is good for the money they will have to have a better understanding of the business, its drivers and risk. If for nothing else I am a fan of Islamic banking because of these.

It is not unlike other financial services for early-stage businesses in the western world.

With the increase in capital requirements, banks will have to be more innovative, cater to more businesses to remain viable. It is hard to see the downside in these new developments.