Islamic financial services have experienced rapid growth over the last decade, managing a rate of over 30% per annum since 2000. Assets under Islamic financial services were estimated to have reach US$1.3 trillion in 2011, a 150% increase from 2006. Buoyed by this rapid growth, Islamic finance has moved from a niche offering a decade ago to a mainstream phenomenon.
This is particularly true for Islamic countries, which account for around 98% of global Islamic financial assets. Among the Islamic countries the Gulf Co-operation Council (GCC) nations and Iran collectively account for 80% of all assets, even though only 6% of world’s Muslim population resides in these regions. Southeast Asia, north Africa, Turkey and the subcontinent also have sizeable Muslim populations and interest in Islamic financial services, offering good prospects for the industry.
The aftermath of the global financial crisis has been an important period in the evolution of Islamic finance. The industry has shown resilience, while conventional banking in the West has suffered greatly in the post-crisis period. However, it needs to be said that Islamic finance is still very small, representing less than 1% of global assets, and even then it was affected by its exposure to real estate markets, especially in the Middle East. Going forward, the industry is likely to expand beyond the Islamic countries and gain traction in other regions, especially those with large Muslim minorities. France is one such example, while London is already making serious efforts to position itself as a hub of Islamic financial activities.
Five Decades of Change
In its early stages of evolution, Islamic banking was mostly retail oriented. However, things started to change in the 1970s, when newer services such as commercial banking and project finance were offered. In the last decade the industry has seen the emergence of advanced treasury services, balance sheet management and asset management-related activities. Driven by high demand, many conventional banks started offering Islamic products and services.
At present wholesale banking is the biggest market for Islamic finance. The industry’s universe of offerings is mostly limited to simple and more conventional products that use structures such as murabaha, or a Shariah-compliant sale based on an honest declaration of cost, and ijara, a transaction where a known benefit from a specified asset is made available in return for payment. In these areas ‘vanilla’ products and real estate offerings dominate. These provide more predictable returns and do not address issues such as governance, profit calculation or advanced features as found, for example, in private equity.
However this has been changing in recent years, mostly driven by increased and varied demands from corporates and Islamic financial institutions. Islamic banks, led by their peers in Malaysia, have developed new derivatives, risk and balance sheet management services. Some of these include Islamic profit rate swaps (IPRS), Islamic cross-currency swaps (ICCS), and Islamic forward rate agreements (IFRA).
IPRS allows exchange of profit streams from fixed to floating rate (or vice versa) much like interest rate swaps (IRS). It was first developed by Malaysia’s CIMB Group around five years ago; recently, international regulators launched a standard contract template to promote the growth of this instrument. ICCS is another recent phenomenon, first executed by Standard Chartered Bank for Bank Mumamalat Malaysia in 2006. It is an agreement to exchange profit and principal payment dominated in different currencies, and allows investors to manage both foreign currency and interest rate risks. These products can also find use in other domains such as project and trade finance. However, use of Islamic finance in trade finance-related activities has been very limited to date, due to lack of operational expertise and aversion toward complexities. Instead banks prefer relatively straightforward activities such as direct landing and debt financing.
Attempts to further develop the product offerings have been controversial for many reasons. Compliance of many instruments and their underlying assets with Shariah laws is a primary contention. Proper management of credit risk and counterparty risk is another problem as there is no lender of last resort. These issues need to be addressed adequately for further development of the industry.
Islamic products can also be used to adjust for asset liability management (ALM) through securitisation and balance sheet management tools. Islamic securitisation is at its early stages of development at present, but has good long term prospects. Sukuk and Islamic real estate investment trusts (REITs) are important products in this regard. Sukuk, commonly referred to as Islamic bonds, are Islamic investment certificates. The sukuk market experienced a strong resurgence post-global financial crisis and the 2009 Dubai debt crisis, and is expected to exceed US$100bn in issuance this year, with Malaysia playing a dominant role in the market. Many companies in these countries fulfil their financing needs through issuance of sukuk. Islamic REITs, which allow for funding of real estate for builders and diversification for financiers, are popular in Malaysia and Dubai.
In addition to these, other services are gaining traction in the market. For example treasury murabaha, which involves money transfer and commodity trade, typically involving banks and brokers, is a tool for liquidity management. Islamic microfinance is another area that has good prospects in the long run, as the small to medium-sized enterprise (SME) markets in the emerging countries have good potential but remain largely untapped. The financing needs of the SME sectors in these countries have traditionally been catered to by governments. With the development of Islamic finance, banks can play significant role by offering newer products and efficient distribution channels, creating sound regulatory framework and providing easier access to funds for this sector.
It must be said that there is still not sufficient awareness or understanding about the different aspects and potential benefits of Islamic finance among many of the market participants. This is partly due to a lack of infrastructure and standardised framework of operations in many countries. As a result, lack of breadth, depth and liquidity afflict the industry in many countries. Banks in these countries should take an active role to mitigate the concerns by broadening their portfolio of services beyond vanilla offerings. They should specifically target local corporate customers and local financial institutions, as both have an interest in Islamic offerings but lack the understanding or skills to embrace this opportunity. Regulators need to provide standardised frameworks and appropriate guidelines to mitigate operational challenges.
High economic growth prospects, coupled with strong underlying demand for Shariah-compliant financing needs by corporates and financial institutions in the GCC and southeast Asian countries, make Islamic finance a significant economic opportunity. However, the market is at a very early stage of development with technical, operational and regulatory challenges hindering advancement of the industry. Concerted efforts by all market participants including banks, regulators, financial institutions, corporates, religious scholars and governments can make this a viable alternative to conventional finance.
Europe’s opening banking regulation is finally here. After months of preparation across the continent, the Revised Payment Services Directive comes into effect on January 13.
The revised Payment Services Directive regulation, regarded as one of the most disruptive in Europe’s financial services sector, will begin to make an impact on January 13, 2018.
The cost of compliance efforts for banks has increased exponentially in recent years. This is especially true for those banks that are active in the global trade finance domain, where the overwhelming expectation is for compliance requirements to become even more complex, strict and challenging over time.
This year promises to further the regulatory compliance burden imposed on financial institutions. How are firms in the sector responding to the challenge?