HBL and the Barrier of the Conscience

Ali Asghar Nek

Contents
Introduction to HBL....................................................................................................................................... 2 A Humongous Market Waiting to be Tapped ............................................................................................... 2 The Dynamics of the SME Sector .................................................................................................................. 2 The Banking Preferences of the Small businessman .................................................................................... 3 The Barrier of the Conscience ....................................................................................................................... 3 Popularity of Islamic banking in Pakistan ..................................................................................................... 4 Difference between Islamic and Conventional Banking ............................................................................... 5 The Problem .................................................................................................................................................. 5 What should be done? .................................................................................................................................. 6 Questions ...................................................................................................................................................... 7 Appendix ....................................................................................................................................................... 8

In the chilly December of 2009, Mr. Mujtaba Naqvi sat on his table, perplexed and confused. As the Head of Product Development at HBL, he was responsible for developing services that could generate big profits for the company, but the rise of Islamic banking was taking its toll on him. It was a threat to an industry that ran solely on higher and higher spreads (the difference between deposit and lending rates). Sood haram hai bhai!!, he would often hear from his customers, who would then get all their funds transferred to a PLS account, the least profitable product for a bank. He had considered focusing more on the Islamic banking segment, but that would be tantamount to changing the banks image as a conventional bank. In the midst of rising religiosity among the masses, Mr. Naqvi had to come up with a solution that could not only convince customers to maintain their deposits with HBL but also somehow boosted these deposits. But the million dollar question was: what would this solution be?

Introduction to HBL
HBL started its operations in 1947 with head office in Karachi. It is currently present in 25 countries with subsidiaries in Hong Kong and the U.K. This makes HBL the largest domestic multinational. HBL was nationalized in 1974 and continued to dominate the commercial banking sector with a major market share in inward foreign direct investment. The government of Pakistan privatized HBL in 2004 and formally granted 51% of its ownership to the Agha Khan Fund for Economic Development (AKFED). The remaining ownership is with GOP and general public. The key areas for operations encompass product offerings and services in retail and consumer banking. HBL has the largest corporate banking portfolio with an active investment banking arm. In order to cater the needs of a diverse clientele, HBL also offers Islamic banking for customers looking for Shariah Compliant products. Corporate and Commercial customers can choose from Shariah compliant banking solutions to meet their business needs. Shariah compliant products include Ijarah, diminishing Musharaka, Murabaha and many others.

A Humongous Market Waiting to be Tapped

HBL had always been conservative when it comes to product development. In particular, it had been unsuccessful in catering to potentially the most profitable market, i.e. the small and medium enterprise (SME) sector. According to the State Bank of Pakistan, as of 2012, no less than 63% of the market that is open to a banks services is the SME sector. So when Mr. Mujtaba Naqvi took the reins of the product development department of HBL, he took up the challenge of somehow tapping on this uncatered market. But he had to face far more than what he had bargained for.

The Dynamics of the SME Sector

Most of the SME sector largely operates in clusters of similar businesses or shops, like the Electronic Market, Light House, Empress Market and Preedy Street in Karachi. These shops are seemingly small but have exceptionally high turnovers. The businessmen operating these shops have high daily transactions

costs which seriously cut down their profit margins. Since most of the shops sell almost similar products, the only way they can differentiate themselves is by lower prices. Because these shops are closely located, there is fierce competition in terms of prices. Even a Rs. 1 difference can mean a shift in store loyalty as the cost of shifting loyalty for the customer is negligible. So these businessmen have a general abhorrence for transaction costs as these costs can eat away the little profits per unit that they make.

The Banking Preferences of the Small businessman

The branch manager of Jodia Bazar Branch, HBL, once visited a famous and sizeable grocery store in the Bazar. Despite having a small business, the owner also dealt in imported products. When the branch manager visited the store, he was surprised to know that the owner did not want to do business with the bank at all. When asked about the reason, he emphatically said that most of his transactions are carried out through pay order and the bank charges Rs. 90 per pay order. Given the relatively large number of transactions per day, the cost of bank charges had become unbearable for him and he had started to do transactions in cash only. Bank charges constitute a sizeable percentage of a small businessmans costs. A typical small businessman regularly transacts with a bank and due to resource constraints, will quickly shift to a bank which provides lower charges. None of the big banks at the time had developed any specific product targeted towards this sector. HBL had the basic current account that was meant for people with very low withdrawal requirement. The Super Value and Business Value accounts were (and still are) profit bearing and had a lot of value added features like bank overdraft. The problem was that the SME owners arent literate enough to understand these features and so these accounts were only meant for the high yield customers. All the small business owners want is: safety of their funds and low transactions cost. Both of these concerns could be dealt with. But as Mr. Mujtaba later discovered, there was one more barrier left to be conquered, and it was the most challenging one as yet.

The Barrier of the Conscience

Pakistanis are driven more by religion than any other aspect of their culture. The average Pakistani is an inveterate Muslim. He might be negligent towards his daily religious duties and the rights of his fellow human beings, but he has a fair idea of what Islam prohibits and what it allows. That is, he is well aware of halal and haraam and would not compromise when given a choice between them. Therefore, selling a product that is contrary to the beliefs of the average Muslim is becoming more and more difficult. Statistics say that Pakistan has one of the lowest savings in the region. According to World Banks report, savings in proportion to the countrys Gross Domestic Product stand at around 22 per cent in Pakistan compared to 38 per cent in Bangladesh, 34 per cent in India and 25 per cent in Sri Lanka1. Moreover, Pakistans savings ratio has actually plummeted from 26 per cent in 2002, while the rest of the

http://tribune.com.pk/story/366129/analysis-how-pakistanis-are-discouraged-from-savings/

comparable nations in the region have shown a consistent increasing trend in savings during the same period. The aversion to saving can partly be attributed to the dismal interest rates in Pakistan which do not compensate investors for the double digit inflation in Pakistan. But more importantly, this trend substantiates the religious reluctance of people to save. In capitalism, interest is an incentive to save. But Islam indirectly discourages savings by levying a tax on them, called Zakat. In the West, on the other hand, lending to and borrowing from banks is a usual practice. People consider their checking accounts as a separate option for investment rather than solely as a source of keeping their money secure. In sharp contrast, Pakistanis generally hold accounts solely for the security of their liquid cash. Despite the mushrooming interest bearing investment options available to the average consumer in Pakistan, he still has an unconscious abhorrence for interest, and hence most use current accounts only.

Popularity of Islamic banking in Pakistan

The religious dynamics in Pakistan are quite different from the rest of the world. Religion is a force that unites Pakistanis, and Muslims at large. If a marketer can appeal to this preference and capitalize on it, the chances of success are huge. This phenomenon catapulted Islamic banking into growth since its introduction in Pakistan ten year ago. Exhibit 1 identifies the principles that underlie Islamic Banking. Islamic banking has registered double digit annual growth over the last decade and this trend continued with 17.5 percent growth in total assets during the period under review With Rs. 560 billion of assets by June-11, IBIs have 7.3 percent share in total assets of the banking sector, which is more than the total assets of the 5th largest bank in Pakistan and over four times of the total assets managed by all DFIs in the country2. This is a significant achievement compared to a country like Malaysia which has only managed a 12% share in 25 years and the growth rate is only half percent. This high deposit growth rate [in Islamic banks] is sustainable also because of the religious bias of the people and deeper penetration of Islamic banking into smaller cities and towns and also because Shariah-compliant products ensures a fairer distribution of profits, said Mr. Mujtaba. Islamic banks have used advertisements and have tried to inculcate the religious implications of conventional banking in the masses (Exhibit 2). Research to gauge popularity of Islamic banking was conducted by Burj Bank. Focus groups were conducted among small businessmen from SEC A, B, and C in Karachi and Lahore. Results revealed that when people switch from conventional banking to Islamic banking, their wealth becomes purified and is blessed by God3. The results were worrying as they were solely based on belief and not rationality. No one can empirically prove if your wealth is actually blessed or not. And the catch was, if you sell something which defies the religious beliefs of people in a market like Pakistan, you are not only bent to lose but also instigate reprisal. Burj Bank capitalized on this sentiment and launched its campaign

Financial Stability Review-State Bank of Pakistan (www.sbp.org.pk/fsr/2011/pdf/Chap-04.pdf)

http://auroramagazine.blogspot.com/2011/09/selling-blessings.html

Shariat Me Barkat. It is unclear, however, if Burj Banks campaign will strike a chord with its audience or not. Pervaiz Said, the CEO of Burj Bank, told Aurora Magazine that only 20% of the population is not open to Islamic banking; some because they believe there is no concept of banking in Islam, others because they are satisfied with conventional banking services. However, the remaining 80% of the population is open to banking that offers Islamic finance. Pervaiz also says that while the bank is Shariah Compliant, it is not traditional. In fact, there is no reason Shariah cannot be adopted to modern life. Burj Banks recent campaign has made an effort to change the traditional image of Islamic banking.

Difference between Islamic and Conventional Banking

The basic differentiating factor of Islamic banking is the absence of interest. As all Muslims know, interest , or Riba, is Haram (strictly prohibited) in Islam and is considered one of seven heinous sins. But scholars of finance say that the interest charged on loans is not Riba but time value of money. Time Value of Money is the value money loses when it is lent for a specific period of time, i.e. a dollar received today is more valuable than a dollar received in the future. Therefore, the farther the maturity (the time when the lender receives his money back along with the interest) of a loan, the less valuable the money is to the lender and so the higher interest charged on it. In Islamic banking, however, there is no concept of time value of money. The conventional bankings taking interest may be logical and justified but it is extremely difficult to change beliefs with reason. This is what Mr. Mujtaba learnt when he sent his RBOs (Retail Business Officers) to various cluster markets. These markets have a large number of shops selling similar goods. While identifying the various characteristics of this target market, they realized that most, if not all, people were pretty reluctant to do business with HBL. The primary reason was that they had to pay a lot of transaction cost through pay orders and demand drafts through which they would receive their bigger payments. A second, and more troubling, reason was that they did not want interest to make their wealth impure.

The Problem
Two characteristics that underlie Islamic banking are: all exchanges are based on profit and loss sharing and all investment activities are conducted in shariah-compliant institutions. The growing popularity of Islamic banking meant more people shifting to shariah-compliant products. But why should HBL worry about this shift when it has its own Islamic banking segment? The reason is that Islamic banking is downright unprofitable. The conventional banking system works in manner shown in Exhibit 3. It proves that the higher the spreads, the more the profits. Islamic banking, however, works on a profit sharing basis. This means that the profits arising out of the investments are shared but the losses are not. And the higher the profits, the more the sharing. This is the reason why banks usually keep an 80-20 ratio of conventional to Islamic banking deposit targets. For HBL, these ratios were gradually shifting towards Islamic banking. But as Mr. Mujtaba realized, the SME sector may be best catered with Islamic banking because of its characteristics already mentioned above. Furthermore, the SBP plans to increase the

share of Islamic banking from the current 7.3% to 12%. Being a big bank, HBL would be expected to increase its focus on Islamic banking. So HBL was facing regulatory pressure as well.

What should be done?

Mr. Mujtaba considered the growing religious sentiment too strong to overcome. He considered the idea of launching a product that would somehow bring the flavor of Islamic banking into the umbrella of conventional banking. It made sense to focus on the current account as it was non-interest bearing. But the unlimited withdrawals provided through the debit card made it unprofitable for the bank as the bank could not invest it anywhere. He also considered launching a separate product to cater to this growing category of religiously aware customers, but he was unsure if it would be successful. Mr. Mujtaba was aware of the success of Islamic banking globally. He thought that catering to the small business sector with Islamic banking might just prove successful, as it had banks like the Al-Rajhi Banking and Investment, a Saudi Islamic bank, and the Kuwait Finance House. By concentrating mainly on retail and small-business customers, these banks have performed better, on average, than those that target only corporate banking. This has also reflected in their above-average return on assets. After a long deliberation with his subordinate, Mr. Jawwad, Mr. Mujtaba hopelessly said, The religious sentiment among the consumers is too great to overcome. The problem we face today is less about increasing deposits and more about creating customer loyalty. HBL already has the highest deposit base in Pakistan but we are going to lose deposits as we lose customers. He paused for a while and said, I think its time to yield to the customer sentiment and focus more on promoting the Islamic banking segment. We should introduce new products and attract deposits through strong campaigning so that the traditional outlook of Islamic banking can be mitigated. This will help attract the liberal customers as well. The campaign should highlight the Halal aspect of the income earned from Shariah compliant investments. I think we are missing the point here, said Jawwad. If we can somehow offer a conventional banking product to this market which is non-interest bearing, we can easily deal with the customer sentiment. Furthermore, we may keep a minimum balance requirement, say Rs. 20000 and if that is met, they may have pay orders and demand drafts made for free. You dont understand prompted Mr. Mujtaba, we are playing the perception game here, not the feature game. Most of this market does not understand the features. And nobody would want to keep deposits with us if we give them no return. All they want is that their profits are Halal, and we can only sell this idea through Islamic banking. But you, of all people, should know that Islamic banking is not profitable at all replied Jawwad. We are sharing the profits but not the losses. Plus, we maintain an 80-20 ratio of conventional to Islamic banking deposits solely because of the unprofitability of the latter. Promoting Islamic banking now would mean an internal cannibalization that would hurt us big time in the long run. Moreover, there are transactional costs involved in Islamic banking as well, which our target market is reluctant to incur.

Well, you are right about the possible internal cannibalization, but that would be favorable, corrected Mr. Mujtaba. We are already losing customers from our conventional banking unit, and if we can catch the same customers through another channel, Islamic banking in this case, we would be better off. Moreover, the features any bank provides in conventional banking can be easily copied, but an Islamic banking product can survive for a very long period. One banks Sharia committee can reject a product offered by another bank. And with the mushrooming Islamic banking products in the market, only a handful are producing products that truly comply with Sharia. That is a great opportunity for us. We can create a product and then get it endorsed by religious scholars. Sir, promoting Islamic banking through endorsements and strong campaign will incur a lot of costs. We cannot afford that much. On the other hand, launching a product similar to the current account would be far more profitable. We would not be paying any interest to the account holder, which is what he wants, and we will be able to lend the money at as a high a rate as 39%. Can it be any better? The endless discussions went on for days but a decision was still pending. Jawwad was afraid that if he failed to convince Mr. Mujtaba about his stance, Mr. Mujtaba decision would prevail. They had just 3 day to go till the annual budget would be decided, in which the product development department would have to present the product designed for the SME sector.

Questions
In light of the case, analyze the issue that HBL faces. Identify any alternatives to overcome the problem. Give their pros and cons. Which of the alternatives you identified from the case should Mr. Mujtaba go ahead with? Give reasons for your answer.

Appendix Exhibit 1

Exhibit 2

Exhibit 3

Exhibit 4

Rs. 1000 in hand Invests in bank at 10% per year.

Bank
Borrows Rs. 1000 from Company A and lends to Company B Earns 5% per year.

Rs. 1000 required Borrows from bank at 15% per year

Company A

Company B

An illustration of how a bank earns profit

Exhibit 5 Declining ratio of Conventional versus Islamic banking deposits (in billions, approx) Year Conventional Islamic banking Ratio (%, conventional banking to Islamic) 2006 481 0 100-0 2008 547 4 99-1 2010 644 76 88-12 2012 (est.) 805 175 82-18

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