C F A M A G A Z I N E M A Y – J U N E 2 0 0 9
KEY POINTS
• Islamic banks were largely spared the effects of the toxic assets at the heart of the global credit crunch.
• To take advantage of opportunities, Islamic financial institutions need to improve governance practices.
• Lack of standardization poses a challenge for practitioners, regulators, and investors.
Islamic banks, which shy away from leverage, have been largely buffered from the toxic debts of the credit crunch, now estimated by the International Monetary Fund to reach as high as US$4 trillion. Unlike mainstream houses, Islamic institutions are still growing. Their financial assets are estimated to be worth US$750–US$800 billion, having grown at a compound
annual rate of 20–30 percent over the past decade, according to a September 2008 research report by Morgan Stanley. This figure is widely expected to exceed US$1 trillion by 2010, and some consultants believe it could go as high as $2 trillion.
“Because of the global credit crunch, the potential for Islamic banking is now brighter than the potential of the conventional system,” explains Wohid Islam, legal counsel for the Qatar Investment Authority, the sovereign wealth fund of the state of Qatar.
Islamic finance is governed by Shariah law, which prohibits usury, making it difficult to offer debt, interest, or leveraged products to the market. Shariah-compliant institutions are also prohibited from making investments in companies involved in tobacco, weapons, gambling, alcohol, or porkrelated products. Shariah-compliant supervisory boards must approve each product, adding an extra layer of governance to the mix.
Growth in the industry has come largely from debt-based products. Sukuks are Islamic bonds that offer coupon profits instead of compound interest. They are the fastest growing area of the market.
Challenges to Growth
And yet, for the industry to reach its potential, there are growing pains to resolve. In 2007, Sheikh Muhammad Taqi Usmani, chairman of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOFI) said that 85 percent of all Gulf Islamic bonds do not fully comply with Islamic laws. Hedge funds and structured products have also caused controversy, with critics saying that some Shariah scholars, who sit on the boards of multiple financial institutions because of rising demand, are often too well paid or too unfamiliar with products to make fair decisions. Very few of the Shariah scholars have financial backgrounds, and most have had to learn about the industry as they went along.
“Islamic financial products are subject to the same regulation as any other financial product, whether they are offered in Europe, Asia, Africa, or anywhere else.”
One hedge fund of funds manager, after being given approval to develop a product by his own Shariah board, was startled to discover that other scholars at different institutions would not allow the product to be distributed. “It’s ridiculous to go ahead with something which takes up time, energy, and money only to then find out that there’s no consensus and you can’t launch the thing anyway,” he complains. “There needs to be some sort of coherent approach, we have to be able to trust our advice.”
Regulators are trying to deal with the issue. “Islamic financial products are subject to the same regulation as any other financial product, whether they are offered in Europe, Asia, Africa, or anywhere else,” says Shaykh Yusuf Talal DeLorenzo, a leading Islamic scholar and adviser to the Dow Jones Islamic Market Indices. “Owing to the special nature of Islamic finance products, however, some jurisdictions have established an extra level of supervision. Such measures are welcomed by the industry.”
But even this is proving tricky. Malaysia has tackled the issue by developing its own Shariah board at a regulatory level to provide centralized oversight. But the Gulf Cooperation Council (GCC) and stricter Muslim nations feel Malaysia’s approach to Shariah compliance is far too liberal and relaxed.
“Investors here are not willing to invest in the products that are approved by Shariah boards in Malaysia,” explains Mohammad Shoaib, CFA, chief executive of Al Meezan Investment Management in Pakistan.
In most of the GCC, Shariah governance is devolved to the bank level. “It is almost privatized, and as a result there is quite a lot of variation in systems of governance. You don’t get standardization, and there are issues about the appointment of Shariah scholars and what qualifications they have and how many boards they sit on,” explains Rodney Wilson, professor of Islamic finance at Durham University and visiting professor at Qatar University. Wilson is also chair of the academic committee of the Institute of Islamic Banking and Insurance in the United Kingdom. “There is one scholar who sits on the boards of 55 institutions,” he points out. “We have published guidelines that highlight some of these issues, not least of which is confidential access to information.”
Unlike Malaysia, Dubai does not believe in a centralized approach to governance and regulation. “We don’t think we are qualified to be Shariah arbitrators,” insists Nik Thani, executive director of Islamic finance at the Dubai International Finance Centre (DIFC). He believes that Malaysia has limited its options by centralizing. “They have an excellent Islamic finance market, and it’s very efficient. But the backbone of their structure is not something that is recognised outside of Malaysia. Shariah law is like common law. It is dynamic, and it evolves. It’s difficult for a government to shift its position. We leave it to market players to develop products that will appeal to their clients.” Thani also points out that unlike other religions, Islam has no central authority. “We need a more collaborative approach between the various regulators,” he says.
Standardization
For some observers, standardization is a difficult concept. “From my perspective, you stifle development by having total standardization. If you had a universal Shariah committee, there would be more certainty to the market, but the downside would be a lack of innovation,” says Richard Thomas, managing director of GSH UK, the UK investment arm of a Kuwaiti-based real estate firm. He believes that a large amount of standardization has already been put in place. “What is universally agreed upon is far greater than areas where there is some conflict. A lot of the controversy has come up from the way that different organizations have exploited the industry and encouraged inappropriate uses for instruments like sukuks.” Others argue that standardization wouldn’t be necessary if international banks hadn’t jumped on the bandwagon and come into Muslim countries with the idea of paying lip service to Islamic
banking by pushing every esoteric structured product through the system. They believe that Islamic banks should continue to do what they are good at— follow classic banking models, with
financing to come from deposits. Then there are those who favor practical standards. “You don’t have to standardize products, but there’s nothing wrong with standardizing procedures,”
says Wilson. “There are different principles of Islamic jurisprudence, but there’s no reason why principles can’t be done in a way that gives confidence to the market.”
ISLAMIC BANKINGCONVENTIONAL BANKING
1. Money is not a commodity, good, or service. It has no price of its own and cannot be used in lending or borrowing for a price (i.e., interest).
2. Money is priced based on the concept of time value of money/opportunity cost, in
addition to the level of risk inherent in a given transaction.
1. Financing activities must be backed by tangible assets.
2. Financing activities are mostly carried out back to back without being asset backed.
1. Money (a stream of cash flow) cannot be exchanged against money (another stream of cash flow) for a price.Exchanging different streams of cash flow in terms of interest paid/received or timing of payment/collection is a common practice.
2. Transactions and activities that involve an element of uncertainty (speculation) regarding outcome and/or timing of execution or delivery are not allowed.Uncertainty and risk management are part and parcel of conventional banking activities
1. Penalties on late payments are prohibited. If penalties are levied, they must be re-channelled to charities.
2. Fees are typically charged for late payments.
1. Transactions and activities that involve engagement with unlawful business sectors, such as gambling and alcohol, are not allowed.
2. Besides money laundering and the financing of criminal activities, how customers use borrowed funds is typically unrestricted.
Source: Al Meezan Guide to Islamic Finance, Morgan Stanley Research.
Challenges to Development
Standardization is one of many challenges to future development. Morgan Stanley has identified four other areas of concern. First, the scarcity of Shariah scholars who are well versed in both Islam and finance leads to overburdened Shariah boards and slow approval processes. Second, Shariah compliance leads to greater product complexity, higher skills requirements, and more onerous documentation. Third, because of the unique aspects of Islamic finance and lack of hedging instruments, liquidity makes risk management that much more challenging. Finally, says Morgan Stanley, there is competition from conventional banking. Industry leaders are unfazed. “At the moment, Islamic finance only accounts for 1 percent of the global financial market,” says DIFC’s Thani. “We have done a lot of growing up in the past few years, and we’re conscious of the weaknesses in the system. We’re always addressing those. It’s difficult to set a time for the development of a level playing field [with conventional banking], but I think it will be relatively fast.”
Maha Khan Phillips is a financial journalist based in London.
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