We have heard all too often, especially in the recent past, that local banks are not lending. This is largely attributed by many to apprehensions of the effects of the global financial crisis on the local economy and local commercial enterprises.
Of course, many local banks have been quite hesitant to lend given the uncertainties, especially after the defaults of a couple of large conglomerates. While the situation is changing a little now, it is generally understandable that in an economic downturn prudent bankers would normally reduce lending, or be more selective in lending. Nonetheless, it is quite a surprise to hear that many local banks, including Islamic ones, reduced lending significantly despite ample liquidity, relying more on placing their cash in safe and mostly short-term investments that also provide lower returns. In fact, some of the lending activities have been at relatively higher margins.
If the impact of the financial crisis on the local economy was significant, a sizable across-the-board reduction in lending by banks may make it even worse. If we become overly cautious in lending and also charge high margins for lending, we may exacerbate the effects of recession. We would be making a self-fulfilling prophecy!
To make it difficult to borrow at high margins while liquidity is ample and inter-bank borrowing rates are low, may make otherwise relatively healthy firms that depend on bank borrowings more prone to bankruptcy. This causes more unemployment and less consumer spending and thus affects even more firms.
That is why we see many developed countries of the world trying to spend their way out of the recession by pumping as much money as they can into financial institutions, by encouraging direct lending and by trying to maintain government spending programs. The reduction in interest rates was one of the first tools employed as usual to encourage lending and spending.
In fact, with all the bailout funds being pumped into various companies in some countries, which make them stronger, a liquidity squeeze for local companies may actually impair local companies’ ability to compete and therefore expose them to bankruptcy through their inability to compete.
There are commercial incentives for local financial institutions to lend. For one, although less applicable to Islamic financial institutions, the local interbank rate (SIBOR) is quite low, between 1 to 2 percent, so even if banks increase their spreads, overall lending rates should not be necessarily higher than what they were a few years ago, before the crisis set in, but allowing banks to make higher profits. Another, not so well known, program of the government is the SME guarantee program. This is a program run by the government’s Saudi Industrial Development Fund (SIDF) in which most local banks are participating and which guarantees repayments from certain small and medium size enterprises.
These are in fact a more important part of the economy in terms of employment. In this environment, lending to SME’s is no doubt an important aspect for spurring economic growth.
For local Islamic banks and financial institutions, there is another incentive to lend and this should make a difference. One of the intrinsic objectives of Islamic finance and financial institutions, derived from the maqasid Shariah, is to contribute to the economic growth and development of society. This obviously also improves the growth and performance of the financial institution itself. This growth can be maintained and achieved when the institution judiciously follows its objectives and can efficiently transfer savings into a diversified portfolio of finance and investments even in a recessionary environment — and since there is ample liquidity also. In a recessionary environment, the Islamic bank has additional motivation to lend, in order to do its part in alleviating the economic downturn besides ensuring reasonable profitability. Besides, money market instruments to place short-term liquid funds only hurt profitability. Incidentally, it is interesting to note that money market funds are losing volumes and investors as returns dwindle due to low interest rates.
The role of the Islamic financial institution in light of the maqasid Shariah is illustrated in one of the recent recommendations of the International Council of Fiqh Academy made in Sharjah in April 2009. Although the recommendation was in reference to a product, Tawarruq, it can apply in every sense to all activities of Islamic banks and financial institutions.
The recommendation stated that “...Islamic banking and financial institutions adopt investment and financing techniques that are Shariah compliant ... and so that the techniques will ensure the actualization of the Shariah objectives (maqasid Shariah).
Furthermore, it will also ensure the progress and actualization of the socioeconomic objectives of the Muslim world.” Of course the socioeconomic objectives of the Muslim world include the economic welfare of all humankind since the global economy is very much interrelated.
If financial institutions, especially Islamic financial institutions, do not play their role of spurring economic activity, then almost all other initiatives for rectifying the financial crisis and recessionary pressures will have a limited effect.
(Saeed Jawed Ahmad is an Islamic banker and investment analyst based in Jeddah. The views or opinions expressed in the article are solely his own and do not necessarily reflect the views of any institution.)