Will mergers fix governance issues in the Islamic banks?

In Bangladesh, the Islamic banking sector has grown significantly, with 10 fully fledged Islamic banks operating in the country. Some of these banks were established as Islamic banks, while others transitioned from conventional banking. Additionally, many conventional banks offer Islamic banking services through dedicated windows or branches. This sector has been instrumental in channelling funds, generating employment, and investing in real economic sectors, making it systemically important to the Bangladesh economy.

However, recent years have seen severe governance challenges within Islamic banks, particularly in Shariah compliance and overall governance. The situation became critical when the Bangladesh Bank, the country's central bank, reported that 8 out of the 10 Islamic banks are financially weak and experiencing a severe liquidity crisis. These banks have also struggled with weak Shariah governance and inadequate corporate governance, especially in their investment decisions. 

In response, the Bangladesh Bank has taken several initiatives to support these banks, such as providing liquidity facilities and reforming their boards of directors. Despite these efforts, the banks continue to face financial challenges and a lack of public trust, although there has been slow progress.

In light of these developments, the governor of the central bank has announced plans to merge all 10 Islamic banks into just two. This proposal raises a critical question: will this merger effectively address the existing governance issues within the industry? 

Several key points must be considered before proceeding with such a decision:

Systemic risk and market concentration: Merging 10 banks into two would result in a highly concentrated banking industry. These two new banks would hold significant market share, making them "too big to fail." This consolidation could increase systemic risk unless governance measures are strengthened alongside the growth in size.

Shariah compliance and market competition: The concentration of Islamic banks may stifle market competition, po10tially compromising Shariah compliance. Depositors and investors who engage in Islamic banking with a sense of faith would have fewer options if governance issues arise.

Employment and economic impact: The 10 existing Islamic banks contribute to employment generation in various capacities, both directly and indirectly. A merger could limit future job creation in the banking sector and pose a risk of layoffs among current employees.

Governance Standards: Weaker Islamic banks of10 have poor governance cultures that could undermine the stronger banks' governance standards. This dilution of standards is a significant concern.

Complex shariah governance issues: Merging different banks could create complex Shariah governance issues, as there are variations in Islamic banking products and interpretations of Shariah laws across banks. Combining all these products would exacerbate this challenge.

Public trust and sector growth: Over the past 40 years, the Islamic banking sector has built a solid foundation of public trust. Reducing the number of players to just two banks may send a negative signal regarding public trust and the overall efficiency of the industry.

While mergers can offer advantages such as economies of scale, enhanced oversight, and better expertise, the po10tial downsides of merging 10 banks into two may outweigh the benefits. Therefore, this merger is unlikely to resolve the existing governance issues within the Islamic banking sector. Instead, the focus should be on improving Shariah governance by ensuring dedicated supervision from the central bank, mandating external Shariah audits, and creating provisions for expert Shariah scholars to join the Shariah boards of Islamic banks.

Dr Md Safiullah is a Senior Lecturer in Finance, RMIT University, Australia. 

Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinions and views of The Business Standard.