ISLAMIC BANKING, COSTLY RELIGIOSITY, AND COMPETITION

• DOI: http://doi.org/10.1111/jfir.12207
• Author: M. Ishaq Bhatti,A. S. M. Sohel Azad,Hamza Ghaffar,Saad Azmat
• Published date: 01 May 2020
• Date: 01 May 2020

The Journal of Financial Research Vol. XLIII, No. 2 Pages 263–303 Summer 2020

DOI: 10.1111/jfir.12207

ISLAMIC BANKING, COSTLY RELIGIOSITY, AND COMPETITION

Saad Azmat

Lahore University of Management Sciences

A. S. M. Sohel Azad

Deakin University

M. Ishaq Bhatti

La Trobe University

Hamza Ghaffar

Manchester University and Barclays Bank PLC

Abstract

In this article we explain how Islamic banks (IBs) maximize profitability in the

presence of costly religiosity. Because of strong competition between IBs and

conventional banks (CBs), a unique equilibrium emerges that affects the IB

pricing structure. We propose a new model that identifies the optimal rate on the

asset and liability sides of IBs. It shows that the financial products offered by IBs

are not an exogenous function of religiosity; instead, they are endogenously

determined by the nature of market forces in which IBs are operating. We show

that in the presence of costly religiosity and competition, the rates of both

converge. Moreover, the competitive pricing mechanism induces IBs to structure

their asset‐and liability‐side financial products (particularly Murabaha)witha

risk profile similar to that of the CB loan system. This article empirically supports

the theoretical propositions by using data from 17 Muslim majority countries

where both IBs and CBs coexist from 2000 to 2015. We find that, holding other

factors of bank returns constant, competition significantly affects IB asset‐and

liability‐side returns. The analysis also reveals that because of increasing

competition between IBs and CBs, the market power of IBs has significantly

declined over time.

JEL Classification: G14, G21, G24

We thank the editor and two anonymous referees for their constructive comments that have improved the

final version of the paper. The paper has also benefited from the constructive comments of Andrei Shleifer,

Nadia Masood, Frankel Allan, and the seminar/conference participants at Deakin University, the American

University of Sharjah, and the 2015 Asia Pacific Derivatives Association conference. We acknowledge research

funding support from Deakin University and La Trobe University, Melbourne, Australia. We take full

responsibility for any errors.

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© 2020 The Southern Finance Association and the Southwestern Finance Association

I. Introduction

At the core of Islamic banking is the idea that there is something wrong with

conventional banking. In its numerous forms, Islamic banking has tried to ascertain its

identity as the “other,”a better alternative where profitability and religiosity may

coexist. The growth experienced by the Islamic finance industry hinges on the

uniqueness of this value proposition. It offers its customers a competitive return, like a

conventional financial institution, while claiming to offer an additional benefit of

fulfilling their religious needs. In the presence of costly religiosity, Islamic banking

does, however, contain a paradox, that is, the continuous struggle between the lure of

profitability and manifestation of religiosity. The industry offers an interesting setting

to test how costly religious practices may interact with other market behaviors

including profit maximization to create a unique equilibrium.

1

A large literature has tackled the question of religiosity in the marketplace

from a demand‐side perspective, focusing on how it may affect consumer preferences

including risk aversion (Elnahas, Hassan, and Ismail 2017; Benjamin, Choi, and

Fisher 2016; Akerlof and Kranton 2000; Jiang et al. 2015). These studies examine the

impact of religiosity as an added feature of the utility function, like the utility

experienced from the consumption perspective. Applying these demand‐side explana-

tions does not explain some anomalies in the Islamic finance industry. A demand‐side

perspective suggests that Islamic banks should maximize the religious salience of their

financial products, which may allow them to charge a premium on their returns. This

implies that the industry should have uniquely differentiated financial products with

strong religious features.

The equilibrium rate that should emerge in the market should also be distinct

from conventional financial institutions. Both these implications are at odds with the

empirical evidence pertaining to the industry, which suggest that the industry offers

financial products that are in fact similar to those in the conventional finance industry,

with limited religious salience. Also, there is no evidence of a religious premium

existing in the industry (Abedifar, Molyneux, and Tarazi 2013).

2

We explain these

anomalies adopting a supply‐side perspective, highlighting the roles of competition and

1

In this article we make distinctions among religiosity, religious identity, and religious affiliation.

Religiosity in our model is defined as a preference that may increase the utility of the individual in case of

religious consumption such that the religious individual may even be willing to bear the cost of the religious

consumption. Religiosity is more of a permanent feature of an individual’s utility function and preferences.

Religious identity is a phenomenon that is closest to the concept of group identity (Akerlof and Kranton 2010). It

implies that a person may experience additional utility from religious consumption or disutility from lack of it

only once the religious identity of the person is salient. Religious affiliation implies that the person may associate

herself with a religious group but may or may not experience additional utility upon consumption of the religious

goods.

2

The crux of our article revolves around the idea of convergence between Islamic and conventional banks’

rates and products, which is driven by the absence of market segmentation. This means that in the presence of

competition, any unique feature of Islamic financial instruments may be crowded out. The absence of market

segmentation may also be driven by the fact that Islamic banks cater to a pool of customers with risk and return

profiles similar to conventional banks. In effect, it means that the many unique Islamic structures, particularly

involving risk sharing, are not suitable for the customer base.

264 The Journal of Financial Research

market power. We show that in the presence of costly religiosity and strong

competition from conventional banks, homogenous products and a return comparable

to a conventional bank emerge in equilibrium.

We argue that Islamic banks use trade‐based modes of financing on the asset

side. The essence of the trade‐based mode is the ownership of the underlying asset,

which must reside with the Islamic bank even though for a brief (or negligible) period.

As this ownership risk is costly, Islamic banks prefer to minimize it. Moreover, as the

ownership risk does not add any additional value to the customer in terms of returns,

the customer may not be willing to pay a premium for the ownership risk borne by the

bank. We show that in such a setting the rates and products of both Islamic and

conventional banks are likely to converge.

We build a theoretical model and offer empirical evidence to support our case.

Our results suggest that the sociological impact of religiosity becomes less salient in

Islamic financial markets. The literature has examined different aspects of Islamic

banking, including Islamic product features, functions, religious compliance,

efficiency, productivity, performance, risk, asset quality, stability, and so on (see,

e.g., Abedifar, Molyneux, and Tarazi 2013; Baele, Farooq, and Ongena 2014; Abedifar

et al. 2015). One aspect that is generally ignored in the literature is the role of the

market forces, such as competition, in explaining the pricing and product features of

Islamic financial institutions. Also less emphasized is the role played by regulators. In

this article we focus on these supply‐side factors.

With reference to market forces, we argue that Islamic banks operate in an

environment dominated by conventional banks, in which the latter act as price

setters and the former are price takers. To remain competitive and attractive to

firms and depositors driven by profit maximization, Islamic banks price their

financial products similar to conventional banks. The phenomenon is illustrated

theoretically and empirically in this article. To illustrate our case, we take

conventional banks’lending rate, which is comparable to that of Islamic banks’

asset‐side rate, and then the conventional banks’deposit rate, which is comparable

to that of Islamic banks’deposit rate. We show that under competition, the asset‐

(liability‐) side rate of Islamic banks converges with lending (deposit) rates of

conventional banks. Our model further illustrates that the competitive pricing

mechanism induces Islamic banks to structure their financial products with risk

similar to that of conventional banks’loans. Our model also explains the conflict

between profit maximization and religiosity. We show that competition in the

Islamic financial industry results in a situation where religious features of Islamic

instruments exist only on the periphery, just enough to declare that the product is in

fact Shariah compliant. We find that competitive pricing affects the structure of the

financial product, such that the costly religious features are reduced to the bare

minimum. This scenario results in an instrument with risk–return characteristics

similar to that of a conventional loan.

To empirically test the implications of our model, we first look at some

preliminary statistics to understand the relation between conventional and Islamic

markets using the most widely used benchmark offer/lending rates: London

Interbank Offer Rate (LIBOR) for conventional banks and Islamic Interbank

265Islamic Banking, Costly Religiosity