Shariah Fintech - Emerging

Sep 30, 2021 9:26 AM

Durian’s quote to ponder: “What other core building blocks of finance are worth reimagining?”

Quick disclaimer: this is a speculative piece in an area I’m not an expert but find interesting. I’m sure many readers have more familiarity, and I welcome the feedback. I will be sure to post corrections next week if needed - many thanks to the always engaged readers at Emerging.

This week, we explore:

  • The rise of “values-based” finance exemplified in the reflexive loop between a new generation of consumers, allocators and CEOs to push beyond profits
  • Why those values aren’t universal; reimagining the financial system without one of its core building blocks
  • Linking the rapidly growing halal economy in Indonesia to the future of fintech in the Indonesia - Bangladesh - India - Pakistan corridor
  • How Sharia-compliance may throw a wrinkle into tech champions’ attempt to “swallow the financial value-chain from the point-of-sale”
  • The massive opportunities and challenges facing the revival of Islamic finance

The 21st century is under-going a massive paradigm shift in capital allocation. The Chicago School’s focus on shareholder capitalism which held sway for much of the late 20th century to ~2008 is rapidly losing mindshare to a softer “stakeholder” capitalism. A consensus that businesses should not focus solely on returns to shareholders but also their impact to employees, communities, and future generations. Behind this shift is a new generation of consumers who are adamant in aligning their consumption with their values and holding businesses accountable to those same values.

This grass roots movement is trickling up.

Larry Fink - the CEO of the world’s largest asset manager BlackRock with ~US$7.3 under management - wrote an open letter to CEOs which closed:

As we approach a period of significant capital reallocation, companies have a responsibility - and an economic imperative - to give shareholders a clear picture of their preparedness. And in the future, greater transparency on questions of sustainability will be a persistently important component of every company’s ability to attract capital. It will help investors assess which companies are serving their stakeholders effectively, reshaping the flow of capital accordingly. But the goal cannot be transparency for transparency’s sake. Disclosure should be a means to achieving a more sustainable and inclusive capitalism. Companies must be deliberate and committed to embracing purpose and serving all stakeholders - your shareholders, customers, employees, and the communities where you operate. In doing so, your company will enjoy greater long-term prosperity, as will investors, and society as a whole.

The reflexive loop between consumers, capital allocators, and CEOs is taking shape - a flywheel accelerating consumer $, investment $, and company strategies towards not simply profit - but marrying profit with impact in a sustainable way; shifting the allocation of resources to what we as a society collectively value.

In the west, these values reflect a secular progressive shift. However, there is no rule mandating those values universal. In other parts of the world, different ideologies, national-pride, or faith will likely form different reflexive loops and push economies in different directions. They may even rethink the tools with which they rebuild.

Building with New Blocks

Finance is not known for its first principles thinking. Creativity? Sure, often to a problematic degree. However, the praise lauded on Elon Musk & co.’s questioning of the most basic assumptions - to break products or systems down into their most fundamental components and reconstruct them from the ground up - rarely graces the halls of high finance. The building blocks are often stacked in novel ways, but the blocks themselves don’t change much.

That is one reason I find the rise of Islamic finance intriguing.

One of the cornerstones of conventional finance is interest. From central banks to commercial banking to credit cards to mortgages to corporate balance sheets, it’s not an exaggeration to say the modern economy runs on debt. Debt is a fundamental block.

But how would you construct a modern economy without interest?

This is the question posed to economists, policy makers, religious scholars, and entrepreneurs throughout the Muslim world. A daunting challenge. While there are many deviations, the most consequential difference between conventional and Islamic finance is the prohibition of interest under Sharia Law. By eliminating interest, Sharia Law forces out of the box thinking; reconstructing a 21st century economy from the ground up without perhaps its most essential building block.

Marrying Islamic Finance and Modernity

While the founding texts date back to the 7th century, the modern Islamic banking movement is relatively young. Amidst an Islamic revival in the mid-20th century, activists pushed to create modern financial institutions more closely aligned with the teachings of Islam. The core tenets of Islamic finance include institutions / contracts built on:

  1. Profit-and-loss sharing agreements instead of interest (riba) - which is deemed as usury
  2. Limited speculation on uncertain events (gharar)
  3. Forbidding investments in certain industries (alcohol, pork, gambling, porn, etc) and
  4. Generally promoting fair, ethical finance focused on the good of the community in line with the teachings of Islam

The first experimental Islamic bank was established in rural Pakistan in the 1950s and charged no interest on its loans. This inspired the opening of the first modern bank in Egypt in 1963 and later the Islamic Development Bank in 1975 to provide funding to member countries catalyzing a movement. By 1995, there were 144 Islamic financial institutions worldwide including 33 government-run banks, 40 private banks, and 71 investment companies. Today, Islamic finance has institutions operating in 105 countries, manages ~US$2t in assets, boasts global indices like the MSCI World Islamic or the DJIMW indices, and enjoys some of the industry’s highest growth rates at ~15 - 20% yoy.

Examining global demographics and the current ~1% penetration of the industry today, Islamic banking is still in its very early innings.

The Opportunity

There are ~1.9 billion Muslims today - almost 25% of the world’s population. While fragmented by language, nationality, denomination and much more, the market potential is massive. A massive market based on shared values.

Similar to the shift in Western economies, as the world’s sizable Islamic community progressively accesses the modern economy, many will demand services in alignment with their most central values. Their faith.

On the ground in Indonesia, the rise of halal-certified products is undeniable. Restaurants race for certification. Fashion-lines and shampoos heavily market compliance. Local cosmetics brands like Wardah have taken 30% of the market in just a couple years pioneering halal-beauty through localized, social channels. The growing “hijrah” movement on social media is gaining followers and the Shariah economy now makes up as much as ~40% of Indonesia’s GDP according to the Deputy Governor of the Indonesian Central Bank.

Indonesia is the world’s most-populous Muslim majority nation accounting for 87% of the country’s 263m citizens. The faith is deeply integrated into daily life and by extension purchasing decisions.

Financial services will be no different.

Today, ~87% of international Islamic banking assets are held in Saudi Arabia, Malaysia, UAE, Kuwait, Qatar and Turkey (fn 1). Despite today’s overweighting of assets in the Middle East, demographics point to the Indonesia - Bangladesh - India - Pakistan corridor as the clearest growth vector. The four countries combined account for ~44% of the world’s Muslim population - a staggering ~800m.

Most of these individuals have yet to access to the modern financial system. When they do, Sharia-compliance is likely to be a consideration. With just ~1% penetration of the world’s assets but ~25% of it’s population, the growth potential for Islamic banking is tremendous.

However, traditional banks are unlikely to capture much of it.

A New Wrinkle in the Digital Financial Services Value-Chain

According to Google-Temasek-Bain’s Digital Financial Services report, ~75% of the adult population in Indonesia is under-served by existing financial institutions.


Considering the GDP per capita of India, Pakistan, and Bangladesh are ~2x+ smaller than Indonesia, the financial inclusion metrics are likely worse. Fortunately, the smart phone is changing this. Indonesia’s internet penetration is now ~65%, well above the ~25% mark for properly banked consumers. While the usual suspects - entertainment, ads, eCommerce, and travel - formed the first wave of internet consumption, we are now seeing a second wave of companies rise focused on access and inclusion - in education, healthcare, SME digitization, and fintech.

In all these economies, the opportunity to “bank the unbanked” is now cliché. The unfortunate reality is many of the “unbanked” remain unbanked for a reason. Even through lower-cost digital channels, the unit economics still don’t pan out today. However, riding high rates of development, the winners of the raging urban payment battles between OVO, Gojek, SEA, and Linkaja in Indonesia and PayTM, PhonePe, and Jio etc in India will slowly seep out to tier II and III cities to welcome the rural swell coming online. These customers are not likely to open an offline bank account but will be met with variations of the Ant Playbook. The old adage : “every tech company wants to be a bank” is alive and well in Emerging Asia.

However, despite my thesis of payment leaders swallowing the financial value-chain, I wonder if future demands for a Sharia-compliant financial value-chain will throw a wrinkle in that forecast?

It seems likely Indonesia’s Islamic banking sector (currently at just ~5 - 6% penetration) will rapidly approach that of Malaysia’s (~25% penetration) in the coming years - just looking at the rise of halal in other categories.

If so, how strict will compliance become? Will it be possible for leading payment companies to own the digital financial services value-chain for both the conventional and Islamic financial system simultaneously?

If not, which pieces of the fintech value-chain will need to be reengineered for compliance? Will tech incumbents ultimately forfeit sizable chunks of the digital financial services value-chain to pure-plays with a trusted Islamic brand?

Could such institutions go international? Can different countries agree on standards given high variance in interpretation by different scholars?

If so, could the next decade witness the “Revolut” of Islamic banking based on different building blocks, attracting a potential 1.9 billion digital-first consumers based on shared belief?

Clearly, I have a lot of unanswered questions. But despite the early days, the opportunity is big enough to keep an eye on. However, in order to reach the land of thriving Islamic neo-banks, there are quite a few hurdles to overcome.

Speedbumps to a World without Interest

The Islamic financial system promotes fairness. All parties having “skin in the game” is essential to ensure an even distribution of risk and reward. Interest - receiving low-risk, fixed payments through lending - goes against this principle.

Given these constraints, many contracts under Islamic finance take the form of profit-and-loss sharing. As opposed to providing the bank deposits, which will collect interest as the bank lends out to alternative parties, deposits at an Islamic bank entitle a depositor to the profits (and losses) of the bank. The bank uses the deposits to invest in projects - typically weighted towards harder asset industries like industrials or real estate - and then shares the proceeds back with the depositors.

Similarly, “Sukuk” or Sharia-compliant bond offerings do not provide an investor with “interest payments” but award partial ownership status entitling the investor to profit distributions or a portion of underlying lease payments.

A similar co-operative principle of mutual gain / loss sharing guides insurance (takaful) as well.

In this sense, many of the guiding principles of Islamic finance resemble equity securities. While it promotes “skin-in-the-game” principles, the clear downside of strict adherence is the lack of nuance in the capital structure. By not allowing fixed interest payments and segmented claims on cash flows by seniority, it becomes more difficult to match risk preferences with investment appetites. Everything begins to look more like a lower-risk equity investment in a hard-asset industry which is not necessarily bad but does limit the universe of opportunities substantially - on both the safe & high-risk ends.

These asset-intensive portfolios tend to be more cyclical in nature - providing less downside protection than a more diversified portfolio. Incrementally, in the event of a down-turn, an “interest-free” financial system will clearly be restricted in its monetary policy tools - with an inability to “flood the market” with liquidity at the exact moment it is most needed. A severe credit crunch would seem inevitable.

Given these limitations (along with evolving governance), the guidelines above are adhered to based on varying levels of strictness with high deviations depending on country, religious scholar, or financial body. While striving for pure “profit-and-loss” based financial systems, the ideal of an “end-to-end” national Sharia-compliant banking system is still out of reach given how essential interest is in managing a modern economy. In practice, many day-to-day contracts within Islamic banking are based on “cost-plus” models which, while not explicit, have implied interest rates. For instance, agreeing to pay more for the ability to pay over time in installments. In the end, Islamic finance is still a young industry and finding the right balance between strict religious fidelity and economic realities will be an iterative process.

While reimagining an industry as core as finance is bound to run into challenges, the wave is coming. Newly-armed with smart-phones, the world’s 1.9 billion Muslims will progressively reengineer their respective financial systems to reflect a different value system than what they have inherited from the west. A value-system based on shared faith. A faith that mandates reimagining not only how capital is allocated, but the very building blocks with which they do it.

Economic systems are evolving to better reflect the values of their constituents. One fourth of the world’s population is bound to have an increasingly large voice.

Sharia fintech is coming.

1) Calculation excludes Shia-majority Iran which is also a sizable contributor with ~US$250b+ in assets

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