Growth and Diversification in Islamic Finance

Islamic finance (IF) is one of the fastest growing areas of banking – in terms of both the availability of new products and in geographical spread. Financial instruments in IF must comply strictly with Islamic Shari’a law, which as well as attracting Muslim investors around the world is also gaining greater numbers of non-Muslims who believe this is a more ethical way of operating compared with traditional western banks. Recent figures from the International Monetary Fund show that approximately US$400bn is invested in IF products globally, and that there are 275 IF institutions with a presence in 75 countries. These figures show that, while IF is now making a mark on the global stage, there is still a lot of room for growth going forward.

As well as creating opportunities, this growth is also posing a challenge to the sector. For example, IF institutions rely on Shari’a committees of elders for advice and instruction on their services – as the number of institutions increase, the relatively small number of elders is being stretched, and there is pressure to ensure that a new generation is being groomed to handle the increasing demand. Islamic banks in the Middle East and Asia are also facing competition from western banks that are setting up their own Islamic products to compete in the growing marketplace.

Sukuk Issuance Growing

In IF, the sukuk provides a good example of how the market has grown in recent times. As concepts such as interest (riba) and the trading of debt are prohibited in IF, conventional bonds that are offered by western banks are unacceptable. Sukuk is the closest thing to a bond in IF, the difference being that its returns are strictly linked to the asset that has been purchased. In this way it has some similarities to an asset-backed security.

The global sukuk market today is thought to be around US$70bn, with the largest sukuk issuance so far coming from Dubai’s Nakheel Group at US$3.52bn earlier this year. Despite most sukuk issuance coming from the Middle East and Asia, London is also staking a claim to be a major sukuk centre, as Anouar Hassoune and Emmanuel Volland of Standard and Poor’s state in their article, The UK’s Development as a Major Marketplace for Islamic Finance. They cite the market strength of London, giving investors the ability to switch in and out of sukuk when they wish, and the rigorous legal standards as two examples of London’s suitability as a centre to trade and issue sukuk. “The tax regime applicable to sukuk coupons will make them deductible – no longer viewing them as rental payments but equivalent to interest,” explain Hassoune and Volland. This is a clear example of how a new marketplace for IF has adapted its existing legal environment to best encourage growth.

Sukuk issuance in Malaysia is also growing strongly, measured at US$11.7bn in 2006 as Abhishek Kumar of Financial Insights notes in his article, How Malaysia Leads Asia in Islamic Banking. “With the continued growth of the sukuk market, it is only a matter of time before other Malaysian and foreign financial institutions actively seek to take a bigger piece of the sukuk pie,” comments Kumar. CIMB Group leads Malaysia’s sukuk market at the moment but, with Bank Islam issuing two separate sukuk with a combined value of US$294m, competition is clearly increasing, which is a good sign for the Malaysian IF market going forward.

Risk Management

Risk management in IF can be looked at as a challenge, as standards such as Basel II were prepared without much thought about how to interpret Islamic financial instruments, according to Phil Cantor, of Misys, in his article Islamic Banking: Better Banking?. There are challenges presented by Islamic banking that have an effect on slowing down Basel II implementation, such as availability of data and the unique risks of IF. Vishal Dugar, of Cognizant, highlights these challenges in his article, Islamic Banking’s Quest to Adopt Basel II, “Profit and loss sharing shifts the risks in the institution to investment depositors,” notes Dugar. He adds that Islamic banks, by their nature, take on a lot of risks that are usually borne by equity investors.

The risk responsibility of IF institutions is also picked up by Afaq Khan of Standard Chartered Bank, in his article, Risk Management – Islamic Hedging Solutions. Looking at hedging, Khan describes how Islamic institutions have had to assume risks for which financial solutions are required to ensure sound investment decisions. Western banking has tried and trusted solutions for risk exposure, but hedging in IF is at a nascent stage of development. “The availability of even basic hedging instruments will open new avenues for investors and customers in areas such as debt-capital markets, structured trade and project finance and overall balance-sheet management for Islamic financial institutions,” argues Khan.

In his article, Cognizant’s Dugar looks at IF’s approach to various types of risk. In regards to market risk he shows that, unlike interest, some forms of gains in capital are permitted under Shari’a law. In Mudaraba contracts, the holder of the investment account shares the profit and also bears, at the same, all the market risk as well as the credit risk of that position. “The investor provides capital and therefore is eligible to share the profit, rather than receiving interest that is initiated from the banking activities and products,” notes Dugar. Of course the potential downside of this for the investor is that they also share the risk exposure and so could make a loss. In terms of credit risk, most Islamic banks favour the standardised approach, one of two approaches suggested by the Basel II committee. This is an area where Islamic banks will need to be on top of the historical data challenges, as they need to be accurate when estimating the probability of default and loss given default. Dugar recommends a multinational data system to help meet these challenges. And with operational risk, Dugar presents the case that Islamic banks are meeting fraud and breach of contract challenges, but need to remain vigilant and also ensure that solid measures are in place in the case of a catastrophic event, which is an area for improvement.

Growing Global Presence

Those with little or no knowledge of IF may be tempted to say that it is only active in the Middle East, but it is gaining popularity in several territories around the world. Even in the Middle East, there are differences on a national level in terms of IF framework and Shari’a compliant instruments available. Looking at Basel II implementation, different countries are at different stages. Bahrain and Saudi Arabia have set a target of 2008 for their banks to be Basel II compliant, while the Qatar National Bank is already reporting the monthly capital adequacy ratio to its central bank. It is this sort of rich diversity that means that both corporates wishing to invest in IF instruments and western banks wanting to set up IF subsidiaries or take IF products to existing foreign markets need to pay a great deal of attention to every last detail.

Malaysia is heralded as an example of IF success outside of the Middle East. Examining this claim, Financial Insight’s Kumar finds several reasons that have contributed to this overall success. The Malaysian government offers a lot of support to the IF market through its advanced regulatory conditions, which began back in 1983 with the Islamic Banking Act. The central bank, Bank Negara Malaysia, has also had a key role to play, through the introduction of non-interest-bearing paper (NIBP). Previously, Islamic banks would have been unable to hold government securities due to the interest they paid. Islamic banks can now see the issuance of NIBP as a loan to the government, which frees their hand considerably. 1994 saw another step forward, with the founding of the Islamic interbank money market, which allowed one Islamic bank to issue profit-sharing certificates to another for a fixed investment period of up to one year. This is important in allowing Islamic banks to raise funds when necessary. Finally, Islamic banks from abroad are being actively encouraged to set up operations in Malaysia, through tax breaks and a cap on the stake they can purchase in Malaysian Islamic banks. This has had the effect of drawing foreign banks into the Malaysian market and increasing competition, which in itself helps boost efficiencies. Investment in Malaysian IF products has not just come from Muslims, it is estimated that nearly 25% of all Islamic business in the country is carried out by non-Muslims.

In comparison to Malaysia, Indonesia has a far higher Muslim population, and yet its IF market has been slower to develop, as Eko Pratomo of Fortis Investments highlights in his article, Indonesian Experiences of Islamic Finance. The country has a Muslim population of over 200 million, but assets gathered by Islamic banks are only 1.5% of those held by non-Islamic banks. Pratamo explains how the early years of IF in Indonesia were severely hit by a number of negative economic events, which have stunted the growth of the market. But moves are underway to boost the IF market – the central bank has set up an acceleration programme to boost the market in ways similar to that seen in Malaysia. At the end of 2006 the assets of Indonesian Islamic banks totalled US$2.96bn, but the target of the acceleration programme is to raise this to approximately US$10.14bn by 2008. The potential for IF in Indonesia is huge, when you think of the population that could become market participants together with the favourable measures that are improving the infrastructure for IF in the country. This potential has already begun to be realised, as foreign banks are starting to move in and offer products. Pratomo gives the example of Fortis Investments and HSBC Amanah collaborating on an equity-based Shari’a compliant fund for the country, and it is surely only a matter of time before more of the large western banks come to compete in this market.

As previously mentioned, London is making a play to become a major sukuk hub, but this is just one way that the UK is becoming the European centre of IF. The UK’s Financial Services Authority has recently licensed the European Islamic Investment Bank. “This wholesale financial institution has been created expressly to recycle the massive amounts of institutional and private liquidity in the Gulf into Shari’a-compliant asset classes originated in mature, stable and transparent western markets,” note Hassoune and Volland from Standard & Poor’s. The FSA is playing a key role in furthering IF in the UK, on both the corporate and retail sides.

What the Future Holds

The global Islamic banking and finance sector is growing year on year. Banks are being able to offer new and innovative products and the appetite for ‘ethical’ financing options has helped IF to break out beyond its traditional borders. But there are still challenges to be met, and Amit Khandelwal of i-flex Consulting identifies a number of these in his article, Islamic Finance, Today and Tomorrow. These include:

  • Shortage of experts in Islamic banking.
  • Absence of relevant accounting and auditing standards for Islamic banks.
  • Lack of uniformity in credit analysis.
  • Differences from central banks, local banks and foreign banks.
  • Having instruments to meet the demands of specific investment requirements.
  • Enhancement of product development required.
  • Improvement of corporate governance and risk management.
  • Tax regimes not meeting the needs of Islamic products.

There are a number of issues that will require a lot of work before the global IF market can claim to be anywhere near mature, this is clear. But with the involvement of nearly all of the major western banks in this field (to one extent or another), the growth in Asia and a willingness to evolve practices and products in the Middle East, IF will continue to have a global presence going forward.

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