Islamic fintech for financial inclusion

LAST year, Bank Negara announced five successful applicants for the digital banking licenses under the respective Financial Services Act 2013 and Islamic Financial Services Act 2013. This followed the release of the policy document on Licensing Framework for Digital Banks in 2020. Three of the five applicants are majority-owned by locals .

The applicants must “undergo a period of operational readiness that will be validated by Bank Negara through an audit before they can start operations. This process can take between 12 and 24 months’ (Bank Negara press release, 29 April 2022).

As part of the terms of the license application, digital banks will have to “offer banking products and services to the underserved or unserved markets, and address the gaps in financial inclusion in the country” (“Fostering Financial Inclusion Through Digital Banking in Malaysia”, The Edge Markets , 8 August 2022).

The presence of digital banking is in line with the country’s broader digitization vision to transform the economy and industry, of which the banking and finance sector is encompassed.

Digital banking, driven by fintech (financial technology), is thus on the rise in Malaysia, driven by an enabling and supportive regulatory, institutional and policy environment and with an eye on a potentially untapped domestic market.

As Malaysia is a Muslim-majority country, Islamic fintech represents a promising platform that will provide financing solutions that are not only cost-effective, convenient and Sharia-compliant (in terms of lenders), but also support financial inclusion and economic empowerment (in terms of the borrowers).

Financing/financial access has been a major issue for many Malaysians, whether on the retail side (for the individual and household consumer) or the business side (MSMEs – Micro, Small and Medium Enterprises).

Although accessibility (ie in terms of location) is not a big problem for a country like ours, fintech has trumped when it comes to ease of use and convenience, that is from the consumer’s point of view and experience.

With the domestic banking industry downsizing and cutting costs by downsizing operations (transferring employees from front-end to back-end roles and vice versa) or completely shutting down operations via branch closures, including closures, the issue of accessibility is also fast approaching becoming a problem. practical problem that digital banking can exploit.

According to global consultancy Roland Berger, “there will be an 18% net reduction in retail bank branches across Southeast Asia by 2030 as lenders increasingly move away from branch-based services”.

The firm also estimated that “there will be 567 closures in Malaysia over the decade, with the number of brick-and-mortar branches projected to fall by 23% to around 1,900 in 2030 from 2,467 in 2020” (“Nearly 600 bank branches in Malaysia to close by 2030 “, The Edge Markets, 17 May 2021).

Foreign-based HSBC, which already lacks a significant presence in Malaysia, announced in 2021 that it will close 13 branches across the country. And recently CIMB closed 13 branches (to be merged or relocated) due to the growth of online banking.

Islamic fintech can be the best contender to leverage innovative solutions to address issues of access and accessibility, and tap into the total market (which includes both Muslims and non-Muslims).

Industry findings estimate that 55% of the country’s adult population is unbanked (unserved) or underbanked (underserved), and only 39% of Malaysians are able to get loans from their banks (“Taping into the potential of digital banking”, The Star , 6 June 2022). Furthermore, 77% of small and medium-sized enterprises (SMEs) remain only at a basic stage of digitization (“Challenges in Digital Adoption”, SME Corp, 20 October 2021).

Similarly, Indonesia has an unbanked population of 51% and has only 30% of MSMEs in the digital market (“Indonesia strives to expand coverage of digitization of MSMEs”, Antara News, 16 September 2022).

The lack of digital adoption in MSMEs can significantly hold back the economic potential in both countries. Digitization and digital tools help companies reduce costs, standardize and automate business processes and reduce dependence on labour.

Digitization is also a prerequisite for remaining competitive in a world constantly transformed by technology, from the way one can now enjoy the entire shopping (eg retail automation) or dining experience (eg robot restaurants) without a single human employee, to the way one can now instantly communicate with another despite the distance (including topographical barriers).

Digitization enables businesses to innovate solutions and achieve efficiency. One of the biggest obstacles standing in the way of widespread digital adoption among business owners in Malaysia is the financing costs associated with all the hardware and software.

With a majority of the population also unbanked or underbanked, this means that important financial services that provide access to credit are largely unavailable to those who need it most. Thus, digitization for financial empowerment is also an issue of financial inclusion.

Islamic fintech can drive solutions for SMEs and unbanked private customers, as well as reduce the cost of services, and innovate payment solutions to improve market expansion (“Leveraging Islamic Fintech to Improve Financial Inclusion”, World Bank, 18 November 2020).

The untapped potential of Islamic fintech is also partially reflected in the projected 21% CAGR (compound annual growth rate) by 2025 (compared to only 15% for conventional fintech), exponential growth in the Muslim birth rate, and also the increased global demand for socially responsible investing and business practices, or ESG, that align well with Islamic finance principles (“Islamic FinTechs Rise in Southeast Asia”, FinTech News Malaysia, 18 October 2022).

Islamic fintech is based on four main principles of Islamic finance, which are:

i) sharing of profits and losses (musharakah/mudarabah);

ii) all wealth must be backed by assets and have a real economic purpose;

iii) investments should also have a social and ethical benefit beyond pure monetary returns; and

iv) harmful (haram) activities and industries should be avoided. It is also characterized by the prohibition of interest (riba), excessive uncertainty (gharar) and gambling (maysir).

The principle of profit and loss sharing protects the borrower from bearing a disproportionate burden of risk in a business venture, and the principle of asset support has historically made Islamic investments less volatile.

Zakat, sadaqah, waqf, Islamic microfinance and micro takaful models also reduce the number of unbanked by giving them financial access, thus contributing to financial inclusion.

Examples of Islamic fintech in Malaysia include HelloGold, an award-winning Malaysian-grown Islamic fintech app that enables individuals to protect their savings via gold in a Shariah-compliant manner. Other notable examples include MicroLEAP, Malaysia’s first Shariah-compliant P2P (peer-to-peer) financing platform for MSMEs, and also PayHalal, the world’s first Shariah-compliant payment gateway/digital payment solution.

Indonesian success stories include PayTren, a payment gateway service that facilitates daily money transactions together with Alami, an award-winning and world’s first Shariah challenger bank, as well as Kapital Boost, an Islamic-based P2P platform that offers short-term, ethical investment opportunities for global investors. However, the Islamic fintech industry in both Malaysia and Indonesia is still nascent.

We still lag behind in the proportion of equity-based financing products, i.e. based on the contractual principles of Musharakah (profit and loss sharing) and Mudarabah (profit sharing) and also the lack of a distinct and specialized institutional structure to judge Islam. -based financial disputes, which still have to rely on civil courts (“A Comparison between Malaysia and Indonesia in Islamic Banking Industry”, Research Journal of Business and Management, Atikullah A., 2017).

Meanwhile, a report by a global news platform shows that Indonesia has the fifth largest share (US$2.9 billion/RM12.33 billion) of the Islamic fintech market in the world. Reports also noted that millennials dominate the borrower category. First in line is Saudi Arabia with USD 17.9 billion, followed by Iran with USD 9.2 billion, the United Arab Emirates, USD 3.7 billion and Malaysia USD 3 billion” (“Indonesian Shariah Fintech market fifth largest in the world”, OpenGov, 11 May , 2021).

According to an article published on F1000Research (“Business trends and challenges in Islamic FinTech: A systematic literature review”, 2022), current issues holding back further Islamic fintech development in Malaysia are as follows:

-> lack of specialist talent (in both Islamic finance and fintech);

-> lack of regulatory guidance; and

-> lack of a standardized Shariah benchmark for Islamic fintech

However, bilateral cooperation between Malaysia and Indonesia can address these shortcomings via strategic synergies.

Beyond the cultural and religious commonalities (ties between family and kinship) as well as geographical proximity, which enables economies of scale and market integration, Malaysia and Indonesia share, among other things, a common vision of using Islamic fintech to achieve greater financial inclusion and economic empowerment.

In 2020, the Securities Commission (SC) of Malaysia and Indonesia’s OJK (Financial Services Authority) entered into a fintech cooperation agreement to facilitate information sharing and referrals for businesses wishing to operate in the other’s jurisdictions (“SC inks fintech cooperation agreement with OJK, expanding cooperation between Malaysia – Indonesia”, SC Malaysia, 24 August 2020). This is no surprise as these two countries bring distinct and complementary strengths and contributions to the table.

Malaysia has been ranked first among 81 countries for nine consecutive years as a global leader in Islamic finance (“Islamic FinTechs Rise in Southeast Asia”, FinTech News Malaysia, 18 October 2022). Indonesia is among one of the fastest growing countries in Southeast Asia with the world’s largest Muslim population (“Economy of Indonesia”, Indonesia Investments, 2022).

To fully unlock the wealth of opportunities in Islamic fintech, Emir Research wishes to propose the following guidelines:

1. SC and OJK should implement a framework to provide bilateral accreditation for Islamic fintech courses

This will take the existing cooperation agreement a step further by encouraging and paving the way for convergence and an emerging solid consensus on Islamic fintech standards, at least in the wider Southeast Asia region. Such convergence and consensus can then serve as a model and template that can be replicated and duplicated in other parts of the world with significant Muslim populations (eg in South Asia).

2.SC and OJK should implement a framework to co-develop Islamic fintech consumer protection guidelines and regulations

At the same time, both countries can also step up the existing cooperation agreement through maximum co-integrations of Islamic fintech principles and practices by developing guidelines and regulations for consumer protection.

Together, both Malaysia and Indonesia can be the leading players in the global Islamic fintech industry, incubating creative and innovative solutions where social and ethical benefits are at the core of an Islamic financial ecosystem (4.0 and beyond).

Jason Loh and Jennifer Ley Ho Ying are part of the research team at EMIR Research, an independent think tank that focuses on strategic policy recommendations based on rigorous research.

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