Islamic finance represents one of the world’s fastest-growing asset classes. Modern Islamic banking has its origins in Egypt, where in 1963 the first mutual savings bank following interest-free principles was established with German support. Today, there are approximately 500 Islamic banks, operating across 75 countries, whose sharia-compliant banking and finance assets now total approximately US$1 trillion. The latest economic forecasts continue to point towards exponential growth. Deloitte & Touche, for example, anticipates that the sector is likely to grow at more than four times the rate of conventional finance.
This growth heralds opportunities for Islamic and non-Islamic corporates and financial institutions alike. In order to gain access to the necessary capital and liquidity to meet the growing demand of their clients, Islamic banks need to be able to access funding from banks and the global capital markets in a manner that is compliant with Islamic law; in particular the prohibitions on charging interest and trading debt. Likewise, for non-Islamic companies looking to work with financial institutions in the Islamic world, Islamic finance provides a means to access a rapidly expanding source of capital.
However, Islamic finance has yet to become fully established alongside conventional global banking instruments. In order to become more widely used internationally there are a number of challenges the sector needs to overcome, particularly in adopting a more standardised financial infrastructure. The current lack of standardisation derives from a complex web of diverse interpretations of religious law, different national laws, and competition between standards boards, and represents a serious impediment to the sector’s continued growth.
Overcoming these problems is possible, but will require a change of mind-set from practitioners, and continued product and services innovation from financial institutions.
The Initial Challenge: Understanding Islamic Finance
Based on Islamic (sharia) law, Islamic banking aims to be socially and ethically responsible, and embraces high transparency and shared risk. Core features of the law as it pertains to finance include the prohibition of interest, speculation, gambling, and investment in products such as alcohol and pork to cite just a few examples. Money cannot be used as to generate income in itself and trading in debt is prohibited.
Instead, Islamic finance utilises a number of distinct products and services. Of these the primary kinds are:
- Murabaha: a kind of Islamic loan involving the selling and buying of an asset.
- Sukuk: sharia-compliant bonds.
Murabahas (selling and buying transactions) are by far the most popular Islamic products available, accounting for a majority of the total Islamic finance market. A reverse murabaha, known as tawarruq, facilitates Sharia-compliant funding for clients requiring liquidity to be advanced. When conducting a murabaha the bank, acting as a supplier and in agreement with its Islamic client, purchases a commodity from a broker (see stages 2-3 in Figure 1). Sharia law forbids this from being gold or silver (considered as substitute money), so a different precious commodity, such as copper or palladium, is usually purchased instead. This commodity is then sold to the Islamic bank (stage 4), which agrees to pay the bank (in this example Commerzbank) for the commodity at cost plus an agreed margin, on deferred terms usually of 60, 90, or 120 days.
The Islamic bank then immediately asks Commerzbank to sell the commodity on their behalf (stage 5). Acting in its role as agent Commerzbank then sells this commodity on to a willing broker (stages 6,7), and transfers the money raised to the client. Finally (stages 10-11), the Islamic bank completes payment to Commerzbank for the commodity originally sold to the Islamic bank at stage 4 on the diagram. In this manner the client is able to raise liquidity without breaking the religious prescriptions in trading in debt or charging interest.
Figure 1: Workflow of Murabaha Financing in Commerzbank
The Problem of Standardisation
A key challenge in catering to the Islamic finance sector is being able to negotiate the complex web of legal requirements needed to ensure sharia compliance.
Islamic banking transactions have to follow Islamic rules, as well as being subject to secular national laws. However, there is no generally binding international law regulating Islamic banking transactions. Instead, different Islamic schools of thought generate different interpretations of sharia compliance, and demand different legal requirements. As a further complication, non-Islamic corporations dealing in sharia-compliant products and services must also ensure that their contracts are valid and enforceable within their own jurisdictions.
The national laws governing Islamic banks can differ widely. In the Gulf Co-operation Council (GCC) countries, for example, there is no special supervision of Islamic banking (one rule for all), while Malaysia has a supervised conventional system alongside an Islamic banking system. By contrast, in countries like Sudan all of the banks have to comply with sharia. In Europe, countries such as the UK and France have a conventional banking system allowing special rules for Islamic banks to a limited extent.
All contracts concluded by western banks such as Commerzbank with Islamic international banks are required to be governed by English law. This is necessary because the Islamic principles and jurisprudence that constitute sharia law derive from a number of sources, are subject to varying interpretations and do not, therefore, represent a codified system of law.
Whether a planned transaction or contract is in accordance with the national law is decided by the bank’s legal department, often in conjunction with specialist law firms in the relevant countries. However, whether the transaction is in accordance with sharia law is the decision of the client´s own sharia board. These boards´ decisions may vary, so that while there have been some movements toward standardisation, it is still a common occurrence to find that, for example, a contract acceptable to one Middle Eastern bank is not viewed as sharia compliant by a different bank in the area.
Satisfying these various sets of conditions requires experience, flexibility, and the ability to build and maintain long-lasting relationships with clients. Commerzbank’s own involvement in Islamic markets goes back several decades. Initially, it involved catering to the needs of customers for services such as letters of credit (L/Cs), foreign exchange (FX) and trade finance. However, the evolving requirements of Islamic clients, driven by continued economic growth in the sector, has necessitated international banks’ service offering moving in step with the demand for a more all-inclusive range of Sharia-compliant products and services, including payroll management and fund-raising transactions.
In turn this has required an on-the-ground presence, with a number of western banks including Commerzbank represented in the Gulf area and other Muslim countries for many years. Experience of the sector and knowledge of clients has become even more vital in order to develop products that mitigate the difficulties arising from a lack of standardised regulations for Islamic banking.
Designing the Product to the Market
Indeed, developing a standardised set of rules and regulations for sharia-compliant banking is proving a difficult challenge. Alongside different religious interpretations and the proclivities of individual clients, various standard boards such as the Accounting and Auditing for Islamic Financial Institutions (AAOFI), the International Islamic Financial Markets (IIFM) and the Islamic Financial Services Board (IFSB) are to a certain extent competing organisations. As a result, their rules do not tend to function as standards but only as recommendations.
Given the impediments, gaining universal acceptance of all the current rules and products is probably unrealistic. Instead it is perhaps more realistic, at least in the short-to-medium term, for non-Islamic banks to focus on innovating generic products that can subsequently be customised to meet the particular Sharia demands of customers in different jurisdictions.
In an attempt to meet this need, Commerzbank has developed its own master agreements in conjunction with its own legal team, sharia advisory boards, and global law firms, with alternate versions considering the AAOIFI and IIFM recommendations. These agreements can then be used as a basis for talks with clients and their supervisory boards, and further tailored to their specific needs, interpretations and points of view if required.
Taking Islamic Finance International
Even with these innovations, in order to go truly international the mind-set of the practitioners and supervisors of Islamic finance must change. Currently the tendency is towards focusing on differences in views. The result is a changeable and opaque regulatory environment that generates inefficiencies and creates higher barriers of entry to Islamic and non-Islamic institutions alike.
Instead, in order to promote the global growth of the Islamic finance sector it is important that interested parties concentrate on seeking out the similarities and common denominators between various competing interpretations of Islamic law. In this respect organisations such as AAOIFI and IIFM have provided a useful first step by drawing up initial frameworks and guidelines. Hopefully these will be built on, rather than used as ends in themselves.
Failure to overcome these challenges could severely curtail the Islamic financial sector’s potential for growth. There is growing concern that if these differences remain unresolved Islamic finance may never become popular, even among Muslims. While currently a rapidly expanding part of the market, it is not yet utilised by a majority of Muslims, and currently remains largely concentrated in the GCC region and the Islamic countries of south-east Asia, particularly Malaysia and Indonesia.
Despite these difficulties, there is optimism that ultimately they will be overcome and that Islamic capital markets will increase in the future and become a source of funding for corporate, governmental and public sectors the world over.
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