How trade finance could enhance Islamic banking

How trade finance could enhance Islamic banking

By Darryl Yu

It’s no secret that trade finance has been experiencing a rough patch over the last few years. With slowing global trade demand and an abundance of liquidity in the marketplace, trade finance banks have had to deal with lower margins and potential credit losses.

However, trade finance could find its footing in the growing niche Islamic banking space, despite the industry difficulties. Unlike traditional trade finance that typically deals with financing exclusively through credit, Islamic trade finance prohibits the use of interest (riba). As a result, trade finance instruments leveraging profit and loss techniques evolved to circumvent the need for interest.

Within the realm of Islamic trade finance there are three trade finance instruments a company can use. Under a musyarakah arrangement the bank enters into a partnership agreement with the client for the sale and purchase of goods. The cost of the goods is divided between the parties and then the subsequent profit (or loss) is then distributed based on the pre-agreed parameters.

In a murabahah structure the bank imports goods at the request of the client and sells the requested goods to the client. The selling price includes a mark-up or profit, and repayment terms are established. The bank utilizes its own funds to open a letter of credit under the murabahah structure.

The wakalah setup involves the arrangement of shariah-compliant letters of credit where a bank acts as an agent on behalf of the client. The bank is paid fees and commissions in the place of interest for its services.

Islamic trade finance volumes have grown significantly over the past few years. The Islamic Development Bank’s International Islamic Trade Finance Corporation (ITFC), which tracks Islamic trade finance activity, has approved trade transactions worth US$6.05 billion in 2015 compared to US$5.2 billion in 2014, representing a 16% growth in activity. In terms of regional breakdown, ITFC data shows that 53% of Islamic trade financing activities emerged from Asia/CIS followed by MENA (36%) and Sub-Saharan Africa (9%).

Looking to expand their Islamic banking capabilities several banks within the Asia-Pacific region have begun implementing and updating their trade finance systems in order to stimulate additional Islamic business.

“What we are making the Islamic bank do right now is concentrate on CASA [current account savings account], that means going for retail deposits which is more stable for funding. Previously Islamic banks didn’t really care too much about having funding because they would always think that if funding was short they could always rely on the parent bank’s support,” explains a banker from an Asian-based Islamic bank.

“Trade finance will increase the balance sheet velocity and won’t really use the balance sheet at the same time. I think in terms of priority we are looking at a stable form of funding so that we can have sustainable growth.” -The Asset

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