Islamic Finance: Expansion Brings Challenges
Between 1992 and 2002, the growth of Islamic banking services has been far higher than that of conventional banking. In this period, the growth in Islamic financial institutions has been estimated at 10% in the Gulf States and almost 15% worldwide. Since then this trend has continued. In the UK alone, Islamic banks have opened their doors in retail as well as investment banking. In addition, conventional banks are picking up part of the market share via, among others, Islamic subsidiaries and as arrangers of large funding transactions.
Increased regulation via self-regulating bodies, such as the Islamic Financial Services Board (IFSB) and the Accounting and Auditing Organisation of Islamic Financial Institutions (AAOIFI), are further indications that the market for Islamic financial services is maturing. However, this increased globalisation does not come without risk. The types of risk Islamic banks face are not the same as conventional banks. The prohibition of riba, translated as usury or interest, means that Islamic banks do not have any interest rate risk. They do, however, face a rate of return risk that is similar. Other dangers common to the financial services industry, such as liquidity and credit risk, occur in Islamic banks as well, although in some cases in a slightly different form. The level of risk an Islamic bank runs as part of its day-to-day operation is, however, not significantly different from those of conventional banks. Like conventional banks, Islamic banks are typically not risk takers, and can on average be considered reasonably risk neutral.
Over the past few years, the supply of Islamic financial services has increased significantly:
Islamic finance started mainly with retail operations. The majority of wholesale type operations were focused on placements of funds with other financial institutions and commodity transactions. Since the end of the last century, however, the focus has shifted towards investment banking products. Islamic finance is providing an increasingly popular vehicle for large transactions. Over the past two years, a number of large, highly publicised transactions have been executed. Besides the normal banking risks, these transactions have something else in common: each has one or more characteristics that have the potential to significantly affect the credibility of the Islamic financial industry.
The case studies in the box below are not uncommon for the type of transactions offered in the market. The possibility of raising significant amounts of Shari’a compliant funds is proven by the recent sukuk issues. The potential to invest in Shari’a compliant projects or companies, however, is limited, which is in part caused by the relatively small and illiquid Islamic capital market.
The issues that emerge are two-fold. First, the structures often appear to mimic conventional, interest-based instruments, and are often perceived by non-Muslims as fundamentally un-Islamic. Second, as a result of increased globalisation and the limited availability of pure Islamic investment opportunities, Islamic banks often offer their products to clients who also use conventional funding. This is unlikely to be appreciated by some of the more devout clients of the Islamic banks.
The main risk that emerges for Islamic banks is associated with perception and reputation in the market. How seriously will they be taken by other financial institutions and investors if the products on offer appear to have similar structures to conventional financial instruments? How do account holders view the fact that although their funds are being raised in an Islamically correct fashion, the investments made with these funds are potentially not Shari’a compliant? Will account holders and investors alike maintain confidence in the banks, or will they revert to less formal means and less protected means of financing? More importantly, if the perception is that Islamic banks offer services that are similar to conventional services but are only in name different, how credible will the banks be?
Islamic finance is a growing player and is no longer restricted to local and regional banks in the Middle East and Asia. Islamic banks are integrating into the global financial markets, and a number of large, highly publicised transactions have shown that it is possible to raise substantial amounts of money in an Islamically accepted way. The risk, however, is that the credibility of the Islamic banking sector is undermined by transactions that appear to be interest-bearing, and investments in non-Shari’a compliant companies and projects. The Islamic financial sector will have to address these issues and determine how to circumvent them.
One way to mitigate the dangers could be to change from the current product-based Shari’a board to a central, preferably international, Shari’a board with a single set of approved transactions that apply across all banks. In combination with full transparency of the structures this would enhance the understanding and confidence of account holders, investors, and the general public. The number of investments in non-Shari’a projects and companies will reduce only when the Islamic capital market becomes more developed. The increasing globalisation and integration of Islamic financial institutions in the conventional banking industry cannot prevent money initially raised as Shari’a compliant eventually ending up in a company or project that is quite happily applying different modes of finance based on the best available deal.
Finally, it remains a possibility that similar to other major religions which have gone through a period of prohibition of usury, Islamic scholars will come to the conclusion that riba should be interpreted as excess interest, and that the charge of market rates of interest is acceptable. If that happens, Islamic banks will still adhere to other ethical principles that will appeal to their client base. It is, however, a scenario that the banks should keep in mind when determining their strategy.
In April 2005, MTC acquired an 85% stake in Dutch Celtel International BV, which was initially part financed by a US$2.4bn (£1.3bn) bridge loan facility. At the end of 2005, MTC entered into a US$750m (£405m) commodity-based murabaha transaction to pay off part of the bridge loan. MTC uses a mixture of financial instruments to fund its operations, which is in line with its strategy to diversify sources of funding. In addition to the murabaha facility, MTC reports a total outstanding interest bearing debt of KW$219.5m (£421.8m) in its 2005 annual report. The use of conventional and Islamic funds shows the potential of Islamic finance to be integrated in the global market. There is, however, a danger that Islamic investors who place their money with a bank for ethical reasons may not appreciate that their money is being invested in companies such as MTC, which also uses conventional debt. This may result in account holders and investors withdrawing their funds.
The largest sukuk to date is the US$3.5bn raised on behalf of DP World to fund the acquisition of P&O. The transaction is structured along the principles of a zero-coupon convertible bond with a maturity of two years. The structure allows for up to 30% of the bond to be converted into shares in subsidiaries of the Ports, Customs and Free Zone Corporation (PCFC). In addition, on the converted portion of the bond a return of 7.125% per annum is payable at maturity of the bond. For any certificates outstanding at maturity that are not converted investors are compensated with a higher yield of 10.125% per annum, again payable on maturity. This transaction does not only have a fixed return that could be perceived as interest, but also invests in a company that uses conventional funding. Over the six months to 30 June 2005, P&O had net borrowings of £660.6m and paid a total of £37.6m in interest payments.
In October 2004, the Department of Civil Aviation (DCA) in Dubai issued a US$1bn sukuk al-ijara, an Islamic bond with a lease construction. The Special Purpose Vehicle (SPV) set-up for this transaction bought Dubai International Airport assets from the DCA and leased them back under a master lease agreement. The lease rental payments were determined based on a margin over LIBOR, which are payable to the SPV, and subsequently flow through to the bond holders. The payout structure of the sukuk mimics floating rate interest payments, which potentially undermines the credibility of the transaction as Islamically correct.