As reported on gtnews in last year’s commentary, Growth and Diversification in Islamic Finance, Islamic finance (IF) has come a long way in a relatively short space of time. Today, more than 400 Islamic financial institutions are operating worldwide, managing funds in the region of US$1.3 trillion. In his article, Growth of the Islamic Takaful Market in Malaysia, Kevin Willis, from Standard & Poor’s, predicts that gross takaful (Islamic insurance) contributions will rise by 15-20% a year in Malaysia. Not all countries have reached Malaysia’s level of sophistication, as Paul Wouters, from Bener Law Office, describes in his article, Islamic Banking in Turkey, Indonesia and Pakistan: A Comparison with Malaysia
. A success story so far, but what would happen to the global IF industry if, or when, this rapid expansion of assets and markets hits a bump in the road? By what methods can IF institutions ensure that they sustain and increase growth?
Corporate Governance and IF
It is evident through coverage from the financial news media on an almost daily basis that some of the industry’s biggest names in conventional finance are currently facing huge financial losses as a result of the sub-prime mortgage crisis in the US. As this will have a negative effect on public trust in financial services companies, it is more important than ever that institutions maintain a strong corporate governance structure. This is no different in the case of IF institutions but, as Mark Stanley from Ernst & Young explains in his article,Implementing Corporate Governance for Islamic Finance, there are extra dimensions involved in corporate governance for IF. As well as taking on board conventional governance standards, such as making sure that the actions of the institution’s management are aligned with the interests of the stakeholders, they also have to ensure that religious values and Shari’a requirements are adhered to.
On top of these obvious religious commitments, there is another difference. Due to the mudaraba contract, there are two types of owners in IF institutions – the shareholders (as in conventional institutions) and, in addition, the investment account holders (depositors). As Ernst & Young’s Stanley explains: “The relationship between the investment account holder and the IF institution can be compared to that of a collective investment scheme, in which participants (the investment account holders) have authorised their fund manager (the IF institution) to manage their investments.”
The problem with this relationship is that the investment account holders are open to the risk of the same unexpected losses as shareholders but, unlike conventional finance, there is no equity provided by shareholders to soften the blow. While some IF institutions offer a profit equalisation reserve in attempt to offer a competitive return even when their earnings are below the market rate, these are not always transparent when it comes to understanding the risk and reward they offer. Here, corporate governance needs to be tightened to ensure that the investment account holders are protected.
Corporate governance in IF can be led by Shari’a scholars who sit on the supervisory board of every institution. They provide guidance and rulings to ensure that the institution is operating within the laws of Shari’a jurisprudence. In addition, the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) recommends that every IF institution has an internal independent Shari’a compliance unit, which can ensure that management are following the rulings of the Shari’a scholars correctly. This is discussed in the article by Dr Aly Khorshid, from Elite Horizon Economic Consultancy,
For the concept of Islamic finance to be viable, IF institutions and Islamic ‘windows’ of conventional banks need to ensure that they are fully Shari’a compliant in terms of operations, products and service delivery. In their article,
Growth Model for Islamic Finance: the Collaborative Model, Venugopal PSV and Hari Krishna Prasad G from Tata Consultancy Services, explain how, on a day-to-day basis, compliance manifests across three broad dimensions: structure, process and documentation.
While these compliance categories can be presented in a fairly simple manner, matters can be complicated due to the different interpretations of what constitutes Shari’a compliant IF around the world. These inconsistencies could affect the future growth of IF and include:
- Tight coupling of practices, people and systems to institutions and operating company.
- Lack of large banks operating in all existing IF markets.
- Restriction on the movement of talent (due to tight coupling, which creates a scarcity) across IF institutions’ markets.
- Lower volumes and limited scale benefits.
To combat problems like these, organisations such as the AAOIFI and the Islamic Financial Standards Board (IFSB) have introduced standards to regulate the IF markets. Adoption of these standards is improving, but a clear set of universal and enforceable IF standards would stand the sector in good stead for future stability and expansion.
Involvement of Conventional Banks
A contentious issue in some areas of IF is the involvement of large conventional banks in this space. Can these banks ensure that there is no co-mingling of funds between their IF and conventional investments? Does that even matter? Some argue that the fact that they offer conventional banking products taints their IF operations. This is something for individual investors to make their own mind up about, but there is a difference in how Shari’a compliance is seen depending upon which institution you do business with. Natalie Schoon, from The Bank of London & The Middle East, discusses this in her article, The Difference Between Shari’a-compliant and Shari’a-based Islamic Finance Institutions. “In order for a financial product to be Shari’a compliant, it needs to satisfy, at a minimum, the criteria of Shari’a law regarding the avoidance of riba, maysir and gharar,”explains Schoon. However, she goes on to explain that this is usually as far as conventional banks go when bringing their IF products to market. In contrast, a Shari’a-based IF institution (IFI) not only ensures that its products are Shari’a compliant, but also all of its internal operations, including areas such as contracts with suppliers and employees, for example.
The Shari’a-based IFIs may have an advantage in the marketplace in this regard, but they face fierce competition in terms of pricing instruments from conventional banks. As Nick Brewer, from Temenos, points out in his article, Making the Right Moves in a Cross-over Market, “Large banks bring a global brand and can establish operations running at some loss with considerable investment.”
So what is the answer to this conundrum? On the face of it, there doesn’t necessarily need to be an answer – there will always be customers for both options. Some investors will always seek out what they consider to be the option with the most Islamic integrity, while others will always take the most competitive instrument that passes a level of Shari’a compliance. Essentially, and as Schoon from The Bank of London & The Middle East argues in her article, these two types of IF offerings are currently operating in different market niches. The next stage of development in IF should see conventional and Islamic banks learning from each other, which is promising in terms of the prospect of a unified IF industry that can compete on a global basis with conventional finance.
Geographic Expansion of IF
Finally, it is important to remember that while, in certain countries, IF is accelerating, in others it is minimal or non-existent. This is a point made by Waqar Ahmed, from Arab Banking Corporation, who gives France as an example in his article, Islamic Finance Heads to Europe
“Islamic banking services are not available in France, where the 6.12 million Muslims make up about 10% of the population,”he says. Lack of market penetration is a problem that could become an obstacle to continued buoyance in the IF market going forward.
In comparison to France, across the Channel in the UK, The Financial Services Authority (FSA) and the UK Treasury have worked closely with financial institutions to expand the range and scope of products. For example, changes made to the UK tax system last spring, to make Islamic financial products more fairly taxed, has encouraged growth and the UK government is committed to ongoing legal and regulatory changes to see Islamic finance prosper on a level playing field with more conventional financial products.
While IF is one of the big success stories in finance today, it is worth looking at the current credit crunch in conventional finance to see how easily one problem can spiral out of control. This is something that IF practitioners need to take on board and make sure they are prepared to expect the unexpected. Rigid corporate governance programmes, transparency on compliance, learning from conventional banking successes and achieving greater market penetration are all goals that will help sustain this area of finance.
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