Islamic Finance: A Longer-term Option for Corporates

The advantages of Islamic finance, which strictly forbids the charging of interest known as riba and the trading of highly-leveraged stock and excess risk, were first highlighted in the aftermath of the 2008 global financial crisis. While many conventional financial institutions (FIs) struggled with liquidity constraints, Islamic banks emerged relatively unscathed. Indeed, many Islamic banks found themselves struggling with the reverse – a surplus of liquidity they were hard pushed to invest and manage in a sharia-compliant manner.

Given this, some conventional banks and FIs sought to apply the principles of sharia – meaning greater transparency, enhanced risk mitigation and profit-sharing – to their own cash and trade operations in the bid to boost cash resources and decrease risk. Indeed, the tenets of Islamic finance lend themselves well to trade finance and modern treasury management, even for western institutions. Trade finance is goods-based rather than paper-based and therefore more transparent and less risky than some other arms of finance, while best practice in treasury advocates the convergence of the historically-siloed cash and trade functions to increase visibility and improve risk management.

In this respect, there is much common ground between sharia- compliant and conventional finance methods. This has reignited the debate as to how Islamic finance could possibly be more widely used to aid corporate liquidity management. The question may be of particular relevance to western corporates, many of which now find themselves in a similar position to that of the Islamic banks post-crisis.

Corporate Cash Management

Growing concerns over the security of banks and ongoing market turbulence in the eurozone means that, four years into the crisis, many European corporates are sitting on large cash balances. This trend for stockpiling cash is likely to continue as debt becomes increasingly expensive and will be further fuelled by concerns over the effects of regulatory change. The Basel III Accord is expected to ramp up the cost of borrowing, while Solvency II is likely to reduce the insurance industry’s appetite for long-dated corporate debt. The corporate rationale behind hoarding cash is therefore clear, but it is not a problem-free solution.

Corporate cash balances are becoming an increasingly important way for companies to fund themselves, which means that treasury departments will need sophisticated, not to mention safe ways to invest them. As a result, there is a slow-burning trend for so-called ‘ethical investment’ that meets the need for security. 

The Development of Islamic finance

Whether viewed from an intentionally Islamic perspective or from a purely commercial standpoint, demand for sharia compliance is increasing and the number of Islamic FIs is rising. Since the advent of the Arab Spring, there has been sharp increase in the number of Islamic FIs, particularly throughout the Middle East and north Africa (MENA) region. Egypt, for example, now has 14 Islamic banking licences in accordance with the ruling political party’s plans to increase the Islamic banking market share from 5% to 35% in five years’ time. Meanwhile, the spread of Islamic finance continues throughout Europe and conventional banks in Europe and the US are increasingly seeking to open Islamic windows.

Despite this, and perhaps unsurprisingly, the bulk of the demand for sharia-compliant products and instruments remains concentrated in MENA and southeast Asia. Saudi Arabia is fast becoming the largest Islamic financial centre in the Middle East, with 100% of new banks launched in recent years being Islamic, while Malaysia boasts the world’s largest Islamic capital market. Indeed, Malaysia is a prime example of how Islamic finance can be successfully integrated into the broader financial system, with a deep market for institutions and intermediaries in sharia- compliant equities, sukuk (sharia-compliant bonds), exchange-traded funds (ETFs), real estate investment trusts (REITs) and derivatives. With this in mind perhaps Malaysia is the model that Europe may one day emulate, although there are many barriers that must first be overcome.

Overcoming Challenges

While European interest in Islamic finance may be growing, real demand lags significantly behind. And there are good reasons for this.

Islamic finance is certainly not without its challenges. The first is the lack of uniform regulations. As with any law sharia is subject to interpretation, meaning that what is compliant according to one market and/or sharia board will not be so for another. Saudi Arabia and Malaysia are examples of the extent to which attitudes can differ in this respect, with the former being notably conservative and the latter taking a more liberal approach.

Of course Islamic finance, even at the relaxed end of the spectrum, is restrictive by nature. With interest-based financial instruments out of the question, most Islamic alternatives are based on the crucial concept of profit-sharing, termed murabaha. While this demonstrates that the Islamic financiers in question have assumed some responsibility for the commercial risk inherent in the underlying venture – vital for sharia compliance –  it acts as something of a barrier to innovation. In recognition of this, corporates looking to explore the Islamic space express particular interest in the sukuk market, which has served to release much pent-up demand from the Islamic banking sector over the past few years.

Sukuk is similar to the bonds used in conventional finance, except that money is invested in sharia-compliant projects, and a profit share is distributed among clients in place of interest payments. This burgeoning sector is the principal area of focus for companies, and indeed conventional banks are seeking to expand into this space. But there is no denying that the sukuk market still has a long way to go. As most sukuk are medium-to-long term, even if traded and liquid, they are not price stable – and therefore fail to address the lack of flexible and compliant short-term liquidity management tools. Until there is a truly global-sized, liquid market for sharia-compliant instruments, the sukuk market is likely to remain a talking point rather than action point for the majority of corporates looking to explore the Islamic finance sector. 

Looking to the Future

Islamic finance has been a topic of interest for some time now, and is set to grow further as interest in ethical investment intensifies. However the complexity of this space, and the education process that is required, mean that it will be some time before western corporates drive demand for sharia-compliant products. And until that happens conventional banks and FIs will be slow to develop their own Islamic offerings, especially as they will always be followers, rather than leaders, in this sector.
Yet this does not mean western banks can turn a blind eye to developments in the Islamic space. If corporates are expressing interest in Islamic finance, so should they, and they can keep abreast of developments by partnering with a global provider that has made headway in the sector. The choice of partner, however, is crucial if conventional banks are to approach the Islamic space in the right way.

Providing sharia-compliant cash and liquidity management services is not about helping corporates chase returns, as important as they are. The true aim, rather, is to establish and nurture long-lasting relationships by encouraging transparency and enhanced risk management and by providing the balance between risk and return that corporates require. Banks that bear this in mind will be those best placed to address corporate demand for compliant solutions as the Islamic finance market develops.

To read more from BNY Mellon, please visit the company’s gtnews microsite.

 

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