Source: Financial Times. Special Report Islamic Finance, May 13, 2010
Islamic Finance: rich potential
Modern Islamic finance has come a long way since it started as a modest, experimental venture in the Egyptian town of Mit Ghamr in the 1960s. It encompasses a wide range of products and services that aim to reconcile conventional finance and Islamic law.
Innovation has exploded in the past five years in particular, but rather than being led by 'indigenous' Islamic banks, most products have been developed by the structured finance teams of western investment banks such as Deutsche Bank and the Islamic arms of institutions such as HSBC, Standard Chartered and Citigroup.
Many have then licensed their inventions to fully Islamic banks, particularly in the Gulf, where few have had the capacity to structure their own product range. From profit-sharing accounts and crude products, Islamic finance now spans derivatives, bonds, fund management, credit cards, car loans and even basic hedge funds – all of which use often complex structures to circumvent the Islamic ban on interest.
While the industry has a product range comparable in many areas to conventional finance, Islamic bankers say that there are still gaps in some crucial areas. The main shortfalls are in derivatives and fixed income, bankers say. Product development in these areas has been complicated by a prohibition on interest by sharia (Islamic law) and its requirement for real assets to be transferred as part of any transaction.
Some progress has been made. Longer-dated debt – in the form of Islamic bonds, or sukuk – is a staple of many sharia-compliant financial institutions' portfolio, even though maturities seldom stretch further than five years and the market has recently been rattled by several defaults.
The international Swaps and Derivatives Association (ISDA) and the Bahrain-based International Islamic Financial Market (IIFM) have recently launched a standardised master agreement for Islamic derivatives which could pave the way for the greater use of hedging in the sector.
'Given the growing nature of the Islamic finance industry, the institutions operating on sharia principles can no longer afford to leave their positions unhedged,' Khalid Hamad, chairman of the IIFM and executive director of banking supervision at the Central Bank of Bahrain, said at the time of the launch. 'Hence, some key hedging products are becoming common across jurisdictions to mitigate risk.' Shorter-term Islamic money markets also remain crude and underdeveloped, at least outside Malaysia, which stands somewhat apart from the rest of the industry due to an often more lenient sharia interpretation, experts say.
'Most [Islamic] bankers you talk to would say that liquidity management is their number one concern,' says Daud Vicary Abdullah, head of Islamic finance at Deloitte. 'There is no silver bullet. [Islamic money markets] just require time, hard work and political willingness to develop.'
Yet innovation has slowed down significantly recently. The financial crisis coincided with a backlash from some senior sharia scholars in the Middle East, who felt that the industry had strayed too far from its roots and was mimicking conventional structures too closely, particularly in the sukuk sector.
'No one wants any fancy, exotic instruments any more, so innovation has slowed down,' says Hussein Hassan, head of Islamic finance at Deutsche Bank. 'People are now structuring products and transactions in line with more conservative sharia standards.'
Because of differences in sharia interpretation in many countries and regions – and competition between banks that were keen to make names for themselves as innovators – the Islamic finance market is highly fragmented.
Divergent views on Islamic law are inevitable, given Islam's global span and different schools of thought, but bankers say the industry would benefit greatly from more homogenous documentation and structures.
'Islamic finance would also benefit from more standardisation, not only in sharia but in the documentation of products.'
Nonetheless, experts expect that innovation will continue – albeit more cautiously – and they predict that new products will adhere more closely to Islamic law.
'The industry is still on a learning curve, but I think equity-based products are going to lead the way now, as they fit better with the substance of Islamic finance,' says Mr Abdullah.
'There is a genuine concern that the industry strayed too far from its roots and mimicked conventional finance too closely.'
Which factors are decisive and most important in choosing product-market alternatives in the strategy formulation process for financial institutions?
As more of the world's 1.6bn Muslims start to use banks, many will want to do so in line with their religion
Islamic finance is taking tentative steps towards regaining its mantle as one of the fastest growing asset classes in the world. In spite of the continuing aftershocks of the financial crisis and the Dubai debt standstill, the industry is expanding in many emerging markets and introducing new standards that should help develop products and attract investors.
Assets in Islamic finance rose to $822bn by the end of 2009, an increase of 29 per cent compared with the end of 2008, according to Maris Strategies, the research and advisory group. Anecdotal evidence suggests it has continued to grow this year, as more institutions gain Islamic licences.
The driver of this growth is retail banking, which is attracting more interest not just in the world's two biggest hubs of Islamic finance in the Middle East and south-east Asia, but in China, Russia and Africa.
Joe DiVanna, managing director of Maris Strategies and one of the foremost experts in sharia-compliant finance that bans interest payments in line with Islamic law, says growth is inevitable in these emerging market countries.
This is because vast numbers of their populations do not use banks, which makes them ideal potential customers for a relatively new form of banking that started out as an experimental venture in the 1960s.
As an indicator of this potential, Mr DiVanna points to the fact that of the 1.6bn Muslims in the world, only 14 per cent use banks. By comparison, 92 per cent of US households use banks: in the UK it is 95 per cent.
Figures from the Statistical, Economic and Social Research and Training Centre for Islamic Countries (Sesric), support this thesis too. While Islamic finance represents just 1 per cent of the global financial system, the Muslim world accounts for 7.6 per cent of nominal gross domestic product. Growth among the 57 Muslim nations is also much higher than in the rest of the world, Sesric adds.
As these Muslim and emerging nations become more sophisticated, more of their citizens are bound to start using banks and financial institutions, with many wanting to do so in line with their religion.
Khalid Hamad, chairman of the International Islamic Financial Market and another leading figure in the industry, agrees with Mr DiVanna's optimism, although he emphasises that the industry is still in its early stages of development.
Very important are: demographic, economic and market factors (see above in this comment). Decisive however is 'sharia compliance' as a religious/socio-political factor in choosing products and sectors for expansion and investment. (See also 2.4.5 in 'Exhibit: The future of Islamic finance ... and sharia compliance'.)
Sections 4,1, 4,2