Islamic Finance expected to grow to 3 trillion by 2018

13 August 2015 Consultancy.uk

Islamic finance has been growing rapidly over the past decades, reaching $1.8 trillion in 2014 and is expected to exceed $3 trillion by 2018. In a recent article by BearingPoint Institute, the consulting firm considers the differences between the partnership practice of Islamic banking and the practice of interest. The firm also explores the wider challenges faced by both Islamic and western banking institutions as the practice of Islamic banking further expands to meet the needs of up to 1.6 billion potential participants in Islamic financial products and services.

How finance works is somewhat rigidly understood within much of the Western financial world, and while companies are developing potentially disruptive new financial products, as well as creating new platforms on which to access funding, the fundamentals remain relatively similar. Islamic states, such as Saudi Arabia, Qatar and Malaysia, also practice a form of finance, called Islamic finance, which eschews one of Western finances fundamental concepts: interest.

Islamic finance
Interest has the potential to be leveraged punitively, where the need of the beneficiary is taken advantage of by those with means. To prohibit less than ethical practices within finance, Islamic finance seeks to share risk/reward as a key tenet. Banks are required to build a clear understanding of what is being financed, with the agreement between parties more akin to a partnership. The principles of Islamic banking come from the Sharia law that prohibits usury, uncertainty and speculation; rather it requires transparency and necessitates physical presence for money transfers.

The rise of Islamic Finance

As its practices are firmly rooted in ethical constraints on practices, with profit not an above all but state imposition, Islamic banking has quietly enjoyed a growing market share in Saudi Arabia, Qatar and Malaysia, recently reaching 50%. Some of the region’s most powerful banking institutions are engaged in the practice, including Al Rahji Bank and Bank Al Jazira in Saudi Arabia, as well as the Kuwait Finance House.

Today Islamic banking is a $1.8 trillion dollar financial structure, with a large number of different segments being served by Islamic banking institutions. The banking practice is growing rapidly, with double digits, and is expected to be worth up to $3 trillion by 2018.

One of the main financial instruments in Islamic banking is sukuk, which is roughly equivalent to bonds. Through entering into partnerships with small players, Islamic banks provide a different funding source than government finances, which accounts for 62% of some markets. Furthermore, unlike conventional bonds, sukuk grants the investor a share of an asset, along with cash and risk. The largest part of the total bonds issued in the market has been provided to financial services at 26%, followed by energy & utilities at 25%. Transport comes in at 19% followed by real estate at 8%.

Sectors engaging Islamic finance

Ethical partnerships
According to BearingPoint, a number of challenges face the form of banking. The main challenge relates to staying within international and national regulations while at the same time making sure that providers keep their reputations and remain within the spirit and the letter of the practice. Finding relevant skills also is an issue for institutions, at both the level of principles and operational practice required in meeting face to face and upholding strong bonds.

Western financial institutions seeking to enter the Islamic financial market face considerable hurdles. According to the researchers, a lack of cultural awareness and a fundamentally wrong intention behind the practice are possible barriers. One way to enter the relevant markets is to create subsidiaries that are their own brands, like ‘Amanah’ created by the HSBC group. As the practice is expanding into new areas, the risk of Western business not fully understanding the way of engaging with partners makes it considerably more difficult to reach out to the Middle East, Africa and Far Eastern countries, such as Malaysia and Indonesia. Banks in these regions are increasingly likely to come across organisations for whom it has a place – customers, partners, suppliers, and governmental and non-governmental organisations.

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The business and operating models of digital-only banks

04 April 2019 Consultancy.uk

In recent years, several digital-only banks have successfully managed to nestle themselves in the banking landscape, with their popularity continuing to increase. Looking at it from the customer’s point-of-view, there is little difference between these FinTech unicorns; looking at the bigger picture, however, reveals significant variation in their business models. Matyas Fekete, a consultant at KAE, explores some of the main similarities and differences in digi-bank business and operating models. 

What about the profit?

Unlike in the UK, in most of continental Europe, bank accounts and corresponding banking services are historically paid-for services. The fact that digital banks offer most of their services free of charge has undoubtedly helped them build a large customer base. On the other hand, despite comparatively low set-up and minimised operational costs compared to that of traditional banks, and given the lack of revenue stemming from the typically no-fee model, profitability has proved difficult to achieve. Monzo, for instance, recorded a net loss of £30+ per customer in its most recent financial year. 

In the start-up world, it is customary to focus on expansion rather than profit – see the case of Uber, for instance. Still, while profitability might not be their number one priority in their early stages of development, it must be a long-term goal of any business. With their ever-growing customer base, digital banks are increasingly under pressure to turn their business from loss- to profit-making. 

Credit where credit is due

Digital banks pride themselves on their fair (often meaning “free”) proposition and have so far stayed clear of offering loans (including credit cards & overdrafts), traditionally amongst the most lucrative products for traditional providers. Though somewhat reluctantly, newcomers are also realising that offering lending products is one of the most straightforward ways to offset losses made on their free, often high-cost services (e.g. overseas ATM withdrawals). Monzo, N26 and Starling have recently started offering credit products to their customers, with their loan offering expected to be extended to a wide range of services, from mortgages to overdrafts. Correspondingly, creating a lending portfolio can also pave the way for launching an interest-paying savings offering – a proposition seen as a basic banking product that is yet to feature in most digital banks’ portfolios. 

The business and operating models of digital-only banks

The premium customer

While most digital banks offer most of their products for free, some have extended their offering by paid-for premium services in order to create a revenue stream. As these premium features – including different types of insurance, unlimited free transfers/withdrawals, faster payment settlement or concierge services – are often offered in a subscription format, customers are typically prompted to pay for the full package rather than just the desired service(s), providing a significant revenue stream for the bank. Revolut, for instance, was amongst the first digital banks in Europe to break even earlier this year, a feat largely due to revenue from its premium subscription.

SMEs like digital too

Traditional banks typically service small and medium sized businesses under their retail rather than corporate banking arm. Having their product offering tested with consumers, and consequently gaining a reasonable customer base, digital banks have also identified SMEs as an ideal segment to extend their target audience to. The five FinTechs profiled have already gone, or plan to go, down this path by following up their consumer solution with a business account. While both propositions are typically built on similar features, some providers charge businesses a monthly subscription (e.g. Revolut), while others apply additional fees to specific services (e.g. TransferWise), banking on the expectation that businesses are more likely to be willing to pay for banking – something they are already used to doing. 

The marketplace model

While most digital banks offer a wide range of banking services, some of these tend to come from partnering with third-party providers. For instance, Starling Bank’s only proprietary product is its current account, which serves as a basis for the provision of ancillary services, ranging from loans to insurance, to investment opportunities. Instead of developing these services in-house, Starling enables a select group of partnering financial service providers access to its platform in exchange for a fee. In effect, Starling is using its customer base to create a market for its partners, charging a commission for each acquired customer. 

In such cases of digital banks applying this marketplace model, the majority of their income often comes from partners rather than customers. Naturally, only banks with a large enough customer base can be successful in this set-up, underlining the current intensity of competition amongst digital banks.

Banking as a Service

While customer-centricity is heralded amongst the main USPs of digital banks, some are looking beyond offering consumer-facing services to diversify their revenue streams. Starling, which is among the few digital banks built on its own proprietary platform, has recently leapt into the Banking as a Service (BaaS) industry, making its technology available to other start-ups looking to launch a digital bank. Naturally, this raises the question whether the two offerings could threaten each other’s success. Generally, as long as such partners operate in different markets, the two business lines should be able to thrive alongside each other. Further along the line, however, such partners could easily end up expanding their banking solution into the same market(s) as they aim for global success, and by doing so, becoming direct competitors. 

Different approach, same result?

It is fair to say that consumers in Europe looking to bank with a digital-only provider would have a difficult time finding relative advantages/disadvantages amongst the leading players in the industry. Still, despite the limited surface-level variety, exploring the business models of leading digital banks reveals different approaches to the challenge of making money. Alongside the more straightforward method of offering paid-for premium features/subscriptions, some are banking on the value that access to their customer base offers to third-parties, while others outsource their technology to neobanks wanting to focus on the Fin rather than the Tech. With competition amongst digital banks heating up, it will be interesting to see which business model(s) prove to be the winning formula in the long term.