Islamic Finance, Today and Tomorrow

With the modern Islamic financial services industry enhancing its sophistication, an increasingly affluent Muslim-investor population has started to express its desire for more investment products that adhere to Islamic principles. Coinciding with this surge in demand is the progressively more significant role that Islamic finance plays in the global financial community. Indeed, with respect to the breadth and range of products and services offered, the distinct line that once separated Islamic financial institutions from their conventional counterparts is blurring.

Islamic Banking – Is it a Different Form of Banking?

The basic principle of Islamic banking is the prohibition of riba (usury, or interest). Islam not only prohibits dealing in interest but also in liquor, pork, gambling, pornography and anything else that Shari’a (Islamic law) deems haram (unlawful). Islamic banking is an instrument for the development of an Islamic economic order. Some of the salient features of this order include:

• While permitting the individual the right to seek his economic well being, Islam makes a clear distinction between what is halal (lawful) and what is haram (forbidden) in pursuit of such economic activity. In broad terms, Islam forbids all forms of economic activity that are morally or socially injurious.
• While acknowledging the individual’s right to ownership of legitimately acquired wealth, Islam makes it obligatory for the individual to spend his wealth judiciously and not to hoard it, keep it idle or to squander it.
• While allowing an individual to retain any surplus wealth, Islam seeks to reduce the margin of the surplus for the well being of the community as a whole, in particular the destitute and deprived sections of society by participation in the process of zakat.
• While making allowance for the ways of human nature and yet not yielding to the consequences of its worst propensities, Islam seeks to prevent the accumulation of wealth in a few hands to the detriment of society as a whole, by its laws of inheritance.
• Viewed as a whole, the economic system envisaged by Islam aims at social justice without inhibiting individual enterprise beyond the point where it becomes not only collectively injurious but also individually self-destructive.

The Islamic financial system employs the concept of participation in the enterprise, utilizing the funds at risk on a profit and loss sharing basis. This by no means implies that investments with financial institutions are necessarily speculative. This can be excluded by careful investment policy, diversification of risk and prudent management by Islamic financial institutions.

Islamic banks are structured to retain a clearly differentiated status between shareholders’ capital and clients’ deposits in order to ensure correct profit sharing according to Islamic law.

Recent Trends

The recent phenomenal growth of Islamic banking underpinned the need for greater innovation and flexibility to facilitate wider acceptance of Islamic products and services. An estimate of the global Islamic industry is:

Islamic banking customers are not only confined to limited areas such as the Middle East but are spreading across Europe, the US and Asia Pacific. The global Muslim population is approximately 1.6 billion and Islam is considered to be the fastest-growing religion in the world. Under these circumstances, it is hardly surprising that global financial institutions are creating a range of Islamic investment instruments.

The industry has embraced a wide range of institutions and products, including commercial Islamic banks, Islamic investment companies, Islamic investment banks, insurance companies, asset management companies, e-commerce, brokers and dealers. Products include commercial Islamic banking products, insurance products, mutual funds and unit trusts, Islamic bonds and Shari’a compliant stocks. It has been over two decades since Islamic banks first appeared as active players and today Islamic banking and finance has become a force to be reckoned with. The provision of banking services adhering to Shari’a rules has grown to such an extent that many conventional banks, both in the Middle East and in the US and Europe, have realised that it is a segment that demands their attention.

In September 2003, the General Council of Islamic Banks reported that assets in the global Islamic banking and finance (IBF) industry exceeded US$250bn and were growing at an annual rate of about 23.5%. Over the previous decade, annual IBF growth averaged about 10%. At US$280bn, the market is still small, but the addressable market is huge.

Although the Middle East is still home to most of the world’s 275-plus Islamic banks, a growing number of banks operating in the marketplace are domiciled elsewhere. Local players such as Malaysia’s Bank Islam Malaysia and the UK’s Islamic Bank of Britain are being joined by Citi, HSBC’s Amanah and UBS’s Noriba subsidiary.

Additionally, there is a spread of Islamic banking outside the Middle East and the Gulf countries. Singapore, for example, already manages around US$2bn of Shari’a compliant capital market funds and is seeking to grow rapidly over the next few years, particularly in the fields of wealth management, capital markets and reinsurance within the Islamic banking sector. Malaysia is also a strong player. Islamic banking has figured here for 23 years. Its share of the total market for Shari’a products has now reached around 12%. With strong support from its government, it is slowly creeping up year on year and is currently worth in the region of £10.7bn. And by sheer force of numbers, the Republic of Indonesia is still the most populous Muslim-majority nation in the world, with almost 86% of Indonesians declared Muslim according to the country’s 2000 census. Its total population in July 2006 was more than 245 million.¹

Future Challenges

This phenomenal rate of growth is likely to be affected by a number of challenges:

• Shortage of experts in Islamic banking: The supply of trained or experienced bankers has lagged behind the expansion of Islamic banking. The training needs affect not only Arab domestic banks, both Islamic and non-Islamic, but foreign banks as well.
• Absence of accounting (and auditing) standards pertinent to Islamic banks: Uncertainty in accounting principles involves revenue realization, disclosures of accounting information, accounting bases, valuation, revenue and expense matching, among others. Thus, the results of Islamic banking schemes may not be adequately defined, particularly profit and loss shares attributed to depositors. The need is to satisfy local generally accepted accounting principles (GAAPs), IFRS, and financial and prudential regulations, etc.
• Lack of uniform standards of credit analysis: Islamic banks have no appropriate standard of credit analysis. Similarly, there is a widespread training need involving related aspects such as financial feasibility studies, monitoring of ventures and portfolio evaluation.
• Differences with central banks: Islamic banks have been established as separate legal entities; therefore, their relationships with central banks and/or other commercial banks are uncertain. Problems may be further aggregated when an Islamic bank is established in a non-Muslim nation, and is subject to that nation’s rules and requirements.

• Differences within domestic banks, foreign banks, and Islamic banks: It appears that domestic banks and foreign banks will experience continuing difficulty in adopting Islamic banking practices until they can become more confident of the results of investing ventures.
• Instruments that meet the demand of specific investment requirements: One of the biggest challenges facing institutions is the provision of short-term investment instruments. Several institutions have tried to develop high quality short-term instruments, but have been hampered by their ability to generate assets, by their credit ratings, and by liquidity.
• The product development needs to be enhanced and moreover consistency is required in product structure.
• Improvement of corporate governance and risk management practice.
• Revision of usual tax regimes to meet the needs of Islamic products and create a level playing field with conventional products.

To fulfill this potential, the pressure remains on Islamic financial institutions to move toward additional and more sophisticated offerings for consumers who demand Shari’a-compliant products. These consumers are making it increasingly clear that returns, service, and convenience of these offerings are just as critical as Shari’a compliance.

Indeed, this is a clear measure of the progress the industry has made in a matter of years – no longer is there a perception that you should be prepared ‘to pay extra’ for Shari’a-compliant products.

Historically, Shari’a compliance was the primary issue among investors. The debate now encompasses additional issues such as quality of return, transparency of disclosure and excellence of customer service.

Growth and Business Development

The Muslim population accounts for nearly one quarter of the world’s population, and it is expected to grow at a faster rate. With demand for Islamic products rising, the availability of Shari’a-compliant banking, investment, and insurance products continues to grow.

The industry faces competition from a number of angles, not least from the conventional financial sector. Well established, western-based global financial players continue to open and expand operations in Muslim regions of the world and have built infrastructures to enter markets, particularly in the Islamic financial centres of Dubai, Bahrain, and Kuala Lumpur. They are using their considerable operational, marketing, and technology skills to produce and distribute Islamic financial products in direct competition with indigenous financial institutions.

Today, more than 250 Islamic banks (90 institutions of them are in the Middle East) are operating from China to the US. Western banks, through their Islamic units in the UK, Germany, Switzerland, Luxembourg, and others countries also practice Islamic banking.

Pure-play Islamic banks and financial institutions manage over US$280bn in assets and a further US$200-300bn is managed by the Islamic windows and subsidiaries of international banks. The Gulf Cooperation Council (GCC) region has been a hotbed of activity as far as the Islamic banking industry is concerned, where 41 Islamic financial institutions are currently operating in the GCC countries (of which 18 are banks). Qatar and Bahrain are the leaders and hold a 70% share of the assets, while the UAE accounts for 19% of assets. The growth in assets is estimated at 15% and expected to remain so, for several reasons:

• Growth in overall wealth in the Middle East.
• Growing awareness about the Islamic products.
• The fact that Islamic products are becoming more competitive compared to conventional products.
• Wider availability and variety of Islamic financial products.
• Equity/asset ratio of Islamic banks stands at 13.1% compared to 11.3% for conventional banks in the GCC region. This indicates under-utilization of capital and provides a lot of scope for taking on additional risk on the balance sheet.