Has Islamic finance taken its opportunity?

Institutional Investor, June 2008

One could argue that the sub-prime crisis, and the ructions in global banking that have followed it, present a perfect opportunity for Islamic finance to prove its worth. No Islamic banks have foundered in the last 12 months;  the principles of equal sharing of risk, of building trade on real assets rather than synthetics, and of avoiding speculative activity, have served the industry well.  “The Islamic finance industry has generally remained insulated,” says Shamshad Akhtar, governor of the State Bank of Pakistan. “Islamic bank transactions are backed by real economic transactions… banks and investors have to share the profit and losses in accordance with the risks taken.”

There’s no question that Islamic finance is flourishing. Some impressive numbers are frequently touted for the industry, although they are tricky to source; Hamad Al-Sayari, governor of the Saudi Arabian Monetary Agency, estimates the Islamic finance industry worldwide is worth between $500 and $600 billion (some say as much as $1 trillion), with 500 financial institutions active in the field, and with $200 to $300 billion in off-balance sheet accounts in mutual funds and portfolio accounts. That is, though, only the start of what the industry could be worth: Al-Sayari says it represents barely 1% of global financial assets. As one billion Muslims grow in wealth and sophistication, the market is underpinned by unquestionable demand.

But there are problems, too:  the industry is hugely fragmented (that figure of 500 institutions isn’t necessarily a positive, since so many of them are small), while there are many areas where interpretation of Shariah – the rules that govern Islam, including its financial markets – varies from place to place, particularly between Malaysia and the Gulf.

At the heart of efforts to redress these challenges is the Islamic Financial Services Board, a Kuala Lumpur-based agency inaugurated in 2002 with a mandate to set international standards for regulatory and supervisory agencies for the Islamic financial services industry. It s 164 members include 41 regulatory and supervisory authorities worldwide and it has issued seven standards so far, on risk management, capital adequacy, corporate governance, supervisory review processes, transparency and market discipline. It is working on plenty more (among them governance of investment funds; corporate governance in takaful, or Islamic insurance; business conduct; Shariah governance; and more specialist issues in capital adequacy) and is also the author, with the Islamic Development Bank, of a 10-year blueprint aimed at harmonising Islamic finance practice and getting it to fit in with the conventional finance world.

It’s a big job, as Professor Rifaat Ahmed Abdel Karim, the IFSB’s secretary-general, explains to Institutional Investor. “To implement banking standards takes some time: you have to prepare the whole industry for it,” he says. “Some countries have started taking serious measures [in implementing the IFSB’s standards, which are not mandatory]: Bahrain, Malaysia, Pakistan. You have to go to member countries and work with the relevant regulatory authorities there to enhance understanding of these standards.”

They are grounded in pragmatism: that to be respected, Islamic finance has to live up to the same standards as conventional finance. “In developing these standards we have attempted not to reinvent the wheel,” he says. “We complement Basel 2. The idea is to view these standards, when they are implemented, as a means of integrating Islamic finance into the global financial system.”

Different countries have approached the Islamic finance opportunity and challenge in different ways, and it is fair to say that Malaysia and Bahrain are considered leaders. Malaysia has worked hardest to build a strong regulatory framework governing all areas of Islamic finance, and has been helped in its swift progress by the common vision shared by the government and the central bank. The results are already starting to show. Malaysia’s sukuk market (a sukuk is the Islamic equivalent of a bond) is the world’s largest Islamic bond market: at the end of 2007, it accounted for 60% of the US$100 billion global sukuk market. Since the global market quadrupled in size between 2004 and 2006 alone, this is a useful area to be a leader.

Apart from the impressive breadth of the regulatory framework Malaysia has developed, there are two other elements about it that are striking. One is its position on human resources. This is, without question, one of the biggest challenges facing the industry today: developing the personnel with the skills to keep pace with this rapidly expanding sector.

The problem is most acute when it comes to Shariah scholars. Basically, since the compliance of products with Shariah law is largely a self-regulated matter, an investor in any Shariah product has to trust that the product they are buying complies with their religious conviction. The people they trust to make this call are the Shariah advisory committee of the bank or fund manager in question – people who are independent of those groups, but are retained by them in the same way as one might retain a lawyer. The problem is that, particularly for international institutions, there is a tiny handful of these scholars who can combine knowledge of Islamic law, an understanding of the financial markets, and acuity in English and Arabic (at least), so that a group of less than 10 names appear on almost every Shariah board of these multinationals. Examples of this elite are Bahrain’s Nizam Yaquby, Saudi Arabia’s Mohamed Elgari, and Malaysia’s Mohd Daud Bakar.

Recognising this shortfall and the troubling appearance of a cartel, Malaysia insists that scholars can serve on no more than one Shariah board in the country – the idea being that this forces the development of a broader range of people who can provide the necessary advice. Coupled with this, Malaysia has built leading educational institutions such as the International Centre for Education in Islamic Finance, established in 2006, which already has 1000 registered students in its professional Islamic finance certification programme, as well as a number of PhD students. Another group is the Islamic Banking and Finance Institute Malaysia.

Others have watched Malaysia’s efforts with interest. “Everybody knows there is a shortage of qualified scholars,” says Rasheed Al-Maraj, governor of the Central Bank of Bahrain. “It’s not an easy task.” Bahrain does not put the same restrictions on scholars as Malaysia does – indeed, the policy raises eyebrows in the Gulf, where some see it as a restraint on trade – but has established a fund to train academics and practitioners to become scholars in future.

The other reason Malaysia stands out is in trying to embrace the differences of Shariah interpretation and see them as an opportunity rather than a problem. It has effectively opened its doors to Islamic finance no matter what the interpretation. “Malaysia has taken a three-pronged strategic initiative to promote greater mutual respect of Shariah views,” explains Dr Zeti Akhtar Aziz, governor of Bank Negara Malaysia, the country’s central bank. “The first is to recognise the principle of mutual respect in Shariah opinions issued in other jurisdictions by a recognised Shariah committee for transactions undertaken in Malaysia.” The second prong is the human resources initiative, and the third, to promote dialogue among leading Shariah figures.

Malaysia is also home to the Malaysia International Islamic Financial Centre, which offers a variety of tax breaks and other incentives in order to encourage non-Malaysians to transact Islamic business out of the country. A similar theme can be seen in the welcoming of three Middle Eastern Islamic institutions – Kuwait Finance House, Saudi Arabia’s Al Rajhi Bank and Asian Finance Bank, which has a variety of backers but chiefly Qatar Islamic Bank – to set up in Kuala Lumpur and transact freely.

The issue of harmonisation is a thorny subject in Islamic finance: during an Institutional Investor roundtable in Kuala Lumpur recently, when the subject was raised, the opinion universally expressed was that it did not really matter, yet discussing it took half of the roundtable’s duration. It is true that as much as 80% of Shariah standards are common across the Islamic world: the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI), based in Bahrain, has been at the vanguard of developing a basic rulebook common to the Islamic world. But many people feel that the differences, although they can foster innovation, can be problematic.

“Diversity is a fact of life. Diversity is a fact in Islam,” says Nor Rejina Abdul Rahim, managing director of Nomura Asset Management Malaysia – a Japanese enterprise increasingly active in Islamic finance that has opted to base its operations in this field in Malaysia. She argues diversity has helped to spur growth, “but without standardisation this growth will not be sustainable. Convergence is crucial.” She argues that Malaysia’s approach, building a regulatory environment that has helped to ensure uniformity, proves the point: “It has facilitated an orderly development of a strong and competitive market. It creates confidence, which spurs product development and creates stability in the market.”

She adds: “Divergence of interpretation has not in the past impeded product development, and can in fact encourage innovation, but the fact remains an operating environment needs standardisation.” She believes the gap can be bridged by more Islamic nations adopting IFSB’s standards.

For IFSB’s part, Rifaat would like to see more of a common approach. “On one hand I have heard the argument that you shouldn’t have too much harmonisation at this stage: it would kill innovation,” he says. “On the other hand, markets cannot function with all these differences. The last thing we would like to see is shariah arbitrage from one jurisdiction to another.” Cross-border flows are beginning to thrive in Islamic finance, but they could arguably be greater with more standardisation.

In the Gulf, Bahrain is the traditional leader in Islamic finance. It has been at the forefront of development for decades and can boast the numbers today. Islamic banks in Bahrain, combining domestic and international institutions, had $16.4 billion in assets at the end of 2007, according to the Central Bank of Bahrain. On the funds management side Bahrain hosted 87 Islamic funds with US$1.3 billion invested in them by the end of 2007 – a figure that represents a 78.5% increase in 2006, and more have since opened.

“There is a clear upward trend,” says Abdul Rahman Al Baker, executive director of financial institutions supervision at the Central Bank of Bahrain. There’s also an increase in diversity and innovation. “These funds invest in various types of securities [besides mainstream equities]: GCC Islamic Index funds, MENA [Middle East and North Africa] funds, real estate funds; the latest one we have is a leasing fund, investing in the leasing of aeroplanes.”

Assets apart, much like Malaysia, Bahrain’s progress can be seen in the fact that it hosts so many of the institutions that matter in the sector’s development globally. AAOIFI is one example; it also hosts the International Islamic Financial Market, mandated to develop the capital market and money market for Islamic banks. Bahrain has been involved in efforts to develop a trading platform for sukuk, to create master documentation for Islamic derivatives, and to develop qualifications for the industry, among other things. Consequently it is also home to some of the most powerful Islamic institutions, among them Global Banking Corporation, Gulf Finance House, and the innovative and interesting investment bank Unicorn.

Other countries are getting in on the act. In Saudi Arabia, for example, Islamic finance is increasingly the dominant form. Again, asset management provides a useful illustration: according to data from Tadawul, the Saudi Arabian stock exchange, 53% of funds and 72% of assets are Shariah compliant. At the end of 2007 there were 103 Shariah-compliant funds there, and it also hosts many of the biggest Islamic banks, including Al Rajhi, by many measures the largest Islamic bank in the world.  Al Rajhi has historically been a strictly domestic institution, but its development of a major presence in Malaysia – including retail – is illustrative of the growing willingness of bigger Gulf institutions to export their expertise overseas and into Asia.

Kuwait Finance House is another of the largest and most innovative Islamic institutions in the world, also present in Malaysia, as well as owning a major subsidiary in Turkey, among other places. An increasing number of Kuwait’s investment companies are entirely Islamic. And Dubai, apart from boasting one of the biggest and most sophisticated names in the industry in Dubai Islamic Bank, has also worked hard to create a niche in this area. The volume of listed sukuks on the Dubai International Financial Exchange (DIFX) topped US$10 billion in 2007 and the exchange remains the biggest venue by volume; Dubai institutions, particularly those linked to the government like the Ports Customs and Free Zone Corporation (PCFC) routinely break the record for the largest ever Shariah debt transactions, and have been responsible for the growth of exchangeable structures in particular.

While other countries have been slower to develop their Shariah industries, they are making up for lost time. Pakistan, for example, only recently put together a regulatory environment allowing Islamic finance to grow, but there’s no stopping it now. “It’s been growing at 40% plus and is positioned to grow at that level,” governor Akhtar tells Institutional Investor. “Pakistan’s biggest trend of Islamic finance will come from the masses themselves. There is a huge need to enhance the penetration of the banking system and I see Islamic banking playing a key role in trying to enhance that financial penetration. We have, in-house, the demand of 160 million people.”

The world’s most populous Islamic nation, Indonesia, has been slower still, but passed landmark legislation this year which should enable the sovereign to issue a sukuk within months – considered a vital part of a country’s development in Islamic finance, since it provides a benchmark for others to price against. Indonesia does have three Islamic banks – Bank Muamalat Indonesia, Bank Syariah Mandiri and Bank Syaria Mega Indonesia, plus about 20 mainstream banks offering Islamic services through separate divisions. And banks from sophisticated Islamic finance markets see great opportunity in Indonesia: CIMB, one of the leaders in Islamic banking in Malaysia, owns Bank Niaga in Indonesia and has a licence to practice Islamic banking through it, an opportunity it intends to exploit. Multinationals, too, see the opportunity: Standard Chartered owns Bank Permata, and sees the bank’s Shariah licence as a key attribute.

Perhaps a more telling trend is the decision of many non-Islamic countries, and foreign multinationals, to get involved. Both Singapore and Hong Kong sent high level delegations to the IFSB’s annual conference in Jordan in May, seeking to position the city states as hubs for Islamic finance in Asia. The theory for both of them – and for London besides – is that any place that aspires to be a global financial centre must cater for Islamic finance as part of the mix. And the growth of interest from foreign houses has been sharp: groups like Citi, HSBC (through its HSBC Amanah brand), Deutsche, BNP Paribas and UBS have built strong cross-border presences ranging from structured product development to capital markets and corporate finance.

In sum, the Islamic finance industry is one of the most vibrant and fast-growing anywhere in world financial services. The opportunity is great, but so are the challenges still to come.