Friday, April 03, 2009

Case Study: Pioneering Islamic Banking in the US

Chicago-based Devon Bank is a true pioneer when it comes to Shari’ah finance but it has had to overcome plenty of hurdles along the way, with others still to be crossed.

The bank in the US that has a solid case for claiming pioneer status in Shari’ah finance in that country is to be found in Chicago, Illinois. Perhaps, at first glance, not the obvious place to look for such innovation. However, Devon Bank resides in one of the most ethnically diverse neighbourhoods in the country. The move into Shari’ah financing basically stemmed from customer demand, explains the bank’s corporate counsel, David Loundy. There have been plenty of challenges along the way, as is always the case with pioneers in any walk of life, and there are a fair few still outstanding. But what is clear, as the story unfolds, is that Devon Bank has been pretty good at finding ways around issues or, as Loundy puts it, forcing square pegs into round holes.

This ethnic diversity is reflected in the fact that the bank’s employees are conversant in some 33 languages. The neighbourhood is often a first staging post for immigrants, many of whom ultimately move on. There are large Indian and Pakistani communities, with others from Africa, central Europe and elsewhere.

The first approach to the bank regarding Shari’ah finance came six or seven years ago. This was from a customer who wanted to buy a store front up the street but did not want to pay interest. The customer wanted to know if the bank could help. At that point, the answer was ‘no’. In fact, the only bank in the US that could help at that time was United Bank of Kuwait.

After United Bank of Kuwait was bought out, the customer came back to Devon Bank and asked the same question again. There were beginning to be other enquiries along the same lines as well, so it was felt that this was something the bank should look into. There had been early moves towards developing a solution for these customers but it wasn’t going very quickly, says Loundy.

He was a lawyer and joined the bank at about this time; the bank is family-owned and David is a family member. Given his legal background, the Shari’ah finance challenge was handed over to him. Early and subsequent assistance has come from the Shari’ah Supervisory Board of America, which is conveniently placed just two blocks up the road from the bank. One of its founders helped Devon Bank to get started and also took a keen personal interest as he has a real estate business. At that stage, the Supervisory Board was going to banks to try to attract interest. ‘We were already interested,’ says Loundy.

As the initial products began to take shape, so the enquiries started to multiply. People began asking whether the bank could provide finance for houses and cars, could help with lines of credit, could ‘help their sister in Connecticut’, says Loundy. At first, Devon Bank’s emphasis was on its own neighbourhood, with this having been its sole area of activity prior to the Islamic Finance initiative, but it was quickly pulled into other states and now provides Shari’ah products across more than 35 US states finding itself one of the top providers in the country.

So what have been the challenges? The bank was trying to ‘mesh two legal systems and two financial systems together in a way that made sense’, says Loundy. Other dimensions to the complexity involved were ensuring that the products were correct from a religious perspective while also, of course, commercially attractive. There has been a lot of education required – of the regulators, title companies, attorneys, tax authorities and other relevant parties. With obvious exasperation, he admits that practically everything about every transaction requires explanation.

The banking regulators have been very supportive,’ says Loundy. In part, this is because they see the initiative as helping to bring unbanked individuals into the banking system. ‘They see it as a valuable community service.’ Less positive has been the response at the individual state level. ‘The Secretaries of State are the bane of my existence,’ he sighs. It is hugely difficult to register to do business in each state. This is often nothing to do with Islamic banking per se but rather that the request does not ‘tick any box’, by virtue of being unfamiliar.

'The banking regulators have been very supportive, In part, this is because they see the initiative as helping to bring unbanked individuals into the banking system. ‘They see it as a valuable community service.’

Despite these issues, the bank has been able to develop a wide range of home finance products, with these including the equivalent of fixed rate, bridge financing and so on. However, tax continues to be an issue. It has been an ongoing battle to persuade the IRS (Internal Revenue Service) to respond to the questions being posed, says Loundy. ‘Essentially, they are refusing to answer.’ He says: ‘They know there is an issue, there is probably $1 billion of Islamic paper in the market’. However, for the time being at least, there is no sign of resolution. He feels there is a logical regulatory fix waiting to happen but there currently appears to be insufficient public outcry to bring about the change.

The situation is not as bad at the local tax level. There is the equivalent of the UK’s stamp duty (which needed adapting to pave the way for viable Shari’ah mortgages in the UK; see the interview with Lord Eddie George, 'NewHorizon, April–June 2007' issue) to contend with. ‘Fortunately, in many states, there are ways around it,’ says Loundy. However, where this is not the case, it just adds the basic expense of incurring the duty twice (this stems from the nature of the transaction under Shari’ah principles, which involves initial ownership by a financier).

Education is also needed on the customer side. This encompasses a broad spectrum: some customers have already had conventional mortgages but many have not. ‘A lot have never thought they would be buying a house so have never learnt about the process or about mortgage financing,’ says Loundy. The bank finds that, unlike with many mortgage applicants, the prospective customers will often come in, spend a considerable time talking to the bank, and then disappear for six months. The first point of contact comes not because they have a property in mind to buy but rather because they are exploring whether or not such a thing is feasible. Even on the commercial side, which constitutes a good part of the bank’s Shari’ah business, while the customers are typically ‘savvy business people’, Shari’ah finance still usually falls outside the reach of their expertise.

There has also been the challenge of how to reach a much wider geographical customer base. If a customer is in Chicago and wants a conventional mortgage, they may well turn to Devon Bank. If they are in Texas, they will turn to a bank there. But if they are in Texas and want a Shari’ah mortgage, then they are likely to turn to Devon Bank, explains Loundy. ‘The telephone is a wonderful device,’ he says. The bank has not made its Shari’ah products available via online banking largely because of technical reasons, particularly an inability to make the displays Shari’ah-compliant. Indeed, the bank has had an issue with technology as a whole, so there is more manual effort here than in the rest of its activities. It has developed some software itself but has struggled to find Shari’ah-compliant applications.

Of course, the competition has increased. In some ways, this is good for Devon Bank, because it builds the awareness and maturity of the market. Some areas have become highly competitive, some less so, says Loundy. Residential financing is in the former category, which is one reason for Devon Bank’s broader product set. The ‘800-pound gorilla’ is Fannie Mae, the shareholder-owned entity with a Federal remit to ensure that mortgage bankers and other lenders have enough funds to lend to home buyers at low rates in support of home ownership and rental housing. Fannie Mae has decided to make this a focus area as part of its commitment to minority home ownership and is seeking to roll out a uniform product. When this has happened and such finance is available to everyone, then Devon Bank’s differentiators will need to be breadth of product, backed up by quality of service, as the mover benefits will be no more.

One challenge that Devon Bank is particularly trying to overcome at present besets everyone in this space – lack of liquidity. The bank is trying to launch an offshore investment company but this is an uphill task, exacerbated by the subprime meltdown. Any potential investor, says Loundy, can ‘pick up a newspaper and read the headlines’. In reality though, in four and a half years, Devon Bank has had no foreclosures and no write-offs. ‘We have an exceptional portfolio performance.’ The plan is to set up an independent entity called Devon Islamic Ventures Offshore (DIVO) to try to expand the bank’s Islamic financing programme through the creation of a Shari’ah-compliant investment vehicle and the provision of an investment conduit for other Islamic financing ventures.

‘We have got pretty much everything set up and ready except the money,’ he says. DIVO has close ties with the bank but is an independent entity so will have a wider remit, beyond the reach of an Illinois bank. The vision is for a portfolio of Shari’ah-compliant businesses, provided either directly by DIVO or an affiliate, but mostly through equity investments in other providers of such services or in funds operated by such providers. There is already a Devon Real Estate Asset Management company which will eventually have DIVO as a parent and which is focused on real estate-only finance business.

There is a final interesting twist to the story: the Loundys are a prominent Jewish family. The bank itself has been operating since 1945, set up by local merchants, and owned by the Loundy family since 1953. While it might seem a huge leap from the bank’s origins to today’s faith-based banking activities, the latter are in keeping with the caring community bank envisaged by its founders. As the bank says itself within its marketing: ‘There’s no one size fits all when it comes to banking services from Devon Bank.’ Nowhere can that ethos be seen more clearly than in its pioneering Shari’ah finance activities.

Source: New Horison - Global Perspective on Islamic Banking and Insurance

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