Gov. Mersch, one of the more proactive European central bankers as far as Islamic financial inclusion is concerned, while addressing the 5th Economic Forum of the Belgium-Luxembourg-Arab Countries held in Brussels last week, said that although banking authorities in Europe are not competent in Shariah matters relating to financial transactions, it is important that they "become more familiar with the principles and practices specific to Islamic finance in order to make appropriate supervisory and regulatory judgments".

Europe has a sizeable market for ethical investment and placement needs based on the Shariah principles of its Muslim population of over 38 million, which is about 5 percent of the total population. These needs have, so far, "not yet appropriately been addressed by the conventional banking offering", although governments and financial institutions alike are trying to cater for these needs.

Luxembourg is emerging as one of the more important domiciles for Islamic financial products such as funds and sukuk, and is poised to become the first European Union country to be an associate member of the Islamic Financial Services Board (IFSB), the Kuala Lumpur-based prudential and supervisory standard setting body for global Islamic finance industry.

Mersch confirmed that the central bank has applied to join the IFSB and the decision to accept the Banque centrale du Luxembourg as a member is a formality and will be announced in Kuala Lumpur in due course after a meeting of the IFSB council. The Banque centrale du Luxembourg will also second staff to the IFSB so that they can become familiar with Islamic finance concepts and study the various issues, notably liquidity and risk management. Luxembourg has been steadily increasing its political support to facilitate Islamic finance in its jurisdiction. As early as 2005, the Banque centrale du Luxembourg hosted an Islamic finance awareness seminar in cooperation with the IFSB. In April last year, the government set up a multi-disciplinary task force charged with identifying obstacles to the development of Islamic finance in Luxembourg and ways to support its growth. Working groups on Islamic finance were also formed by the Luxembourg Investment Fund Association (ALFI) and Luxembourg for Finance (LFF).

In May this year the government announced three new initiatives. They included a report by the ALFI Islamic Finance Working Group, which analyzed the opportunities and challenges for the development of Islamic funds in Luxembourg. The Luxembourg Banking Training Institute also launched an Islamic finance program in October 2009 in cooperation with Reading University. Similarly, the Luxembourg School of Finance is also offering a course on Islamic finance.

The government, revealed Mersch, has also instructed the tax authorities to come up with proposals to have a level playing field and ensure tax neutrality for Shariah-compliant transactions (essentially sukuk and Murabaha). Despite the relative success of Islamic financial services in Luxembourg, notably investment funds and the sukuk, not all of the regulatory challenges raised by these Islamic financial institutions have been resolved. One example is the lack of Shariah-compliant liquidity management for reserve funds at central banks, especially in Western jurisdictions.

This flexible approach for Islamic investment products and services out of Luxembourg has its origins in the late 70s when the principality licensed the Islamic Banking System Holdings Limited (Luxembourg), which was the first Islamic financial institution established in Europe. Those involved in this project include some of the pioneers of contemporary Islamic finance -- the Late Zaki Badawi; the Late Mohamed Abu Saud; Gamal Attiya; Abdul Rahman Al-Ateeqi, former minister of finance of Kuwait et al. This was followed by the establishment of Takafol (SA) in 1987, which was then part of the Dar Al-Maal Al-Islami (DMI) Group. In this respect Luxembourg served as the laboratory for Islamic finance which paved the way for its entry into other key markets in the UK and France.

Today, there are some 15 sukuk listed on the Luxembourg Stock Exchange with a combined value of 5 billion euros; and over 40 Islamic investment funds, largely equity funds domiciled in Luxembourg. In 2009, a major German bank also domiciled its new Islamic finance platform in Luxembourg called Al Mi'yar to facilitate the issuance of Shariah-compliant securities. The Bank of London & Middle East also domiciled its Islamic equity offering in Luxembourg earlier this year.

Mersch also suggested that Islamic finance may have something to offer the global financial system especially in its concentration on financing the real economy and its proscription on speculative investments such as derivatives.

Despite its traditional approach, Islamic finance is a key "innovation" in the financial area since the 70s. "While efficient reactions to the global financial and economic crisis have been taken by government and central banks worldwide to stabilize the financial conditions of banks and reduce funding pressures, this unprecedented turmoil reinforces the need to revisit our economic and financial paradigm. The crisis suggests to some to deviate from markets driven economies and behaviors and to explore more ethical and humanistic values to drive sustainable value creation.

"One stream in this context is Islamic finance promoting an alignment with the real economy. Based on its prohibition of leverage activities, its principles of justice and participation, Islamic finance is said to contribute to the reduction of the risk perception in the economy and hence its safe recovery has welcomed the approach of Islamic financial management as a banking system, and stressed that while banking authorities are committed to adapt and to accommodate Islamic finance within the European regulatory framework, it is crucial to continuously ensure a level playing field, requiring from Islamic financial institutions the same high licensing and supervision standards to those expected from conventional ones," he maintained.

As a European central banker, explained Mersch, "our purpose is to focus on the implications for safety and soundness of institutions engaging in Islamic finance and ultimately their potential risk for the banking system."

However, Islamic financial institutions are still faced with serious liquidity management challenges; risk management issues and human capital bottlenecks.

Some of the features of Shariah-compliant investment are designed to attract Western investors looking for socially responsible investment schemes and who are not only interested in the risk/reward relationship of their investment, but who are also concerned with issues of accountability and social responsibility. Islamic funds invest in ethical and non-leveraged enterprises which for those reasons have a low risk profile.

In order to facilitate the emergence of a resilient Islamic financial market in Europe, suggested Mersch, "we have to adapt and shape the infrastructure and supervisory environment to allow efficient and cost effective trading and clearing for a significant number of investment-grade Islamic financial papers across the whole maturity spectrum. In this perspective, it is worth noting that in the current turbulent period, raising finance through sukuk issuance appears to be cheaper than recurring to conventional bonds due to the burgeoning demand for Islamic instruments."

Despite the lack of detailed and scientific studies about the potential effect of Islamic finance on the price and financial stability, the resilience of Islamic banks to the recent crisis practically demonstrates the positive diversification effect they could play, contributing therewith to a systemic equilibrium. Moreover, Islamic finance acts as a natural hedging scheme restricting excessive credit boom in so far as it links the supply of financing (what would conventional banks call credit) to the growth rate of the economic activity, he concluded.

By Mushtak Parker

© Arab News 2009

 

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