Islamic finance and Islamic banking principles are set for strong growth within mainstream conventional banking in the coming years, as the advantages of this form of banking have become even more evident in the aftermath of the economic crisis. It is clear that one of the key lessons learned from the crisis is that the financial industry can no longer function or rely on initiating debt instruments or financing transactions whereby greed and profit maximisation are the prime considerations, regardless of the purpose and of the consequences of such instruments or transactions.
The most important aspect of Islamic finance is based purely around that; it provides more sustainability to the financial industry, as it avoids interest rate-based lending. Conventional debt has certain characteristics that may place debtors in difficulty if circumstances do not allow them to repay in time. Interest is compounded and debtors are often subjected to all sorts of financial penalties. Debt incurred through Islamic instruments is less likely to put the debtor under excessive financial pressure. On the contrary, relief and debt payment rescheduling would be considered. Evidently, such a characteristic of Islamic finance would leave very little room for a credit crunch to occur.
Islamic finance can also have a stabilising affect on the banking system, since both assets and liabilities are subject to almost the same amount of risk sharing. In certain Islamic countries, however, under-developed credit laws affect profit margins, necessitating alternative risk management strategies. Therefore, risk management capabilities will be an issue that Islamic banks will need to address in order to cope with additional challenges dictated by the current status of the global financial crisis. Islamic banks are therefore set to implement more sophisticated risk management systems.
Islamic banking controls excessive credit creation and speculation as it never provides present money in return for future money. It reduces moral hazard and adverse selection problems, and is always used to finance real assets and projects thus removing the dichotomy between finance and real development activities. This obviously leaves very little room for excessive credit expansion.
Islamic banks are expected to be big players in the asset management arena. As asset management is expected to boom following the credit crunch, Islamic banks are striving to attract wealth under management from both individuals and institutions – this will therefore dictate the need for asset management systems and expertise in this arena.
Investment in the Right Place
Across Islamic entrant types, the initial focus of IT investment to support Islamic banking will focus on core systems, particularly around product processing, accounting and reporting. Enhancing or developing core systems to support Islamic products is something of a prerequisite for banks to be able to launch an Islamic banking proposition, although development strategies will vary by entrant type. Conventional banks are likely to try to enhance existing systems initially in order to minimise capital expenditure outlay. In contrast, standalone banks are more likely to deploy new Islamic-specific core systems as part of their market entry strategies, offering a wider range of products, a greater focus on product innovation and time-to-market.
After establishing core system and compliance capability, IT investment priority tends to shift to distribution. With Islamic windows – whereby a conventional bank offers Islamic banking to a group of customers who are willing to bank under Islamic Shariah laws – this focus is largely centered on supporting the roll-out of products across the branch network, establishing sales training and origination processes. With standalone banks, branch expansion strategies tend to be relatively limited (with the focus concentrated on metropolitan areas with high Muslim population densities). Online banking and supporting broker distribution therefore tends to be at the top of next stage IT investment priorities.
Vendors need to demonstrate that an incorporated Islamic banking functionality has moved beyond simply offering an Islamic banking module. Shariah law requirements have implications across core banking systems, even if much of the underlying process and modules can be shared. Additionally, vendors need to demonstrate a long-term commitment to Islamic finance, as it is still a relatively young sector, albeit with product innovation across the Islamic world driving the demand from vendors to support this growth. Similarly, vendors need to ensure that sufficient Islamic expertise and understanding can be demonstrated and provided for implementation and support on Islamic banking projects.
Overall IT spend to support Islamic banking growth ambitions is set for significant growth, increasing from just under US$30m in 2009 to over US$60m in 2013. Spend will be focused on core systems for most of this period, given that much of this growth will result from expansion by new entrants into Islamic banking provision.
East in the West
To create a ‘level playing field’ between the conventional banking market and the rapidly developing Islamic market, the UK government passed legislation specifically aimed at accommodating Islamic instruments and introduced attractive tax concessions. In the March 2007 Budget, the Chancellor announced changes to accommodate ‘alternative finance investment bonds’ specifically intended for sukuk, otherwise known as Islamic bonds – a fixed income debt instrument used to finance large infrastructure projects and considered one of the more popular Islamic financial instruments. Currently, there are 25-30 regulated firms in the UK that are authorised to offer Islamic products, with many more applications from banks in the pipeline. Having a UK base enables firms to operate in any EU country.
UK Islamic banks continue to grow steadily despite the worst financial crisis in almost 80 years, amid growing demand for financial products that avoided paying interest. The financial woes have prompted the UK central bank policymakers to decide to cut interest rates unexpectedly amid fears of recession, and toxic assets and derivatives have seen losses mount above US$650bn (£415bn) at the latest count among the conventional banks. However, Islamic banks have not been affected to the same extent.
UK banking giant Lloyds TSB’s corporate markets division has provided a murabaha facility “in excess of £100m” to refinance the purchase of the Grosvenor House Apartments by Park Lane Properties, co-owned by Kuwait-based ADEEM Investment Company (ADEEM) and The Investment Dar (TID). Lloyds TSB said this is the second-largest Islamic finance deal to date in the UK. It is structured in accordance with Shariah principles using a series of sequential murabaha transactions.
In April 2009, the UK’s first Islamic fixed rate mortgage was launched with the aim of offering ethical property finance. The new product from the Islamic Bank of Britain was a direct bid to win a bigger share of the UK’s mainstream mortgage markets.
“We have not been affected to the same extent that the conventional banks have, although we have been indirectly impacted by the general lack of liquidity,” says Humphrey Percy, chief executive of the Bank of London and Middle East.
Islamic banking as a proposition is on the increase, particularly evidenced by the number of commercial banks moving into the market. Banks are witnessing increased customer demand for purely Islamic finance products, all of which need to be Shariah-compliant. Banks appear to finally be waking up to the fact that, as the benefits of Islamic banking seek to outweigh the costs, it is fast becoming a more effective option than those instruments which caused the credit crunch in the first place. This will hold particularly true if the new regulatory regime is conducive to Islamic banking.
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