A couple of decades ago, Islamic finance was a relatively unknown term but has become the buzzword in today's financial world. Qatar Today takes a peek into the latest developments - its growth, challenges and opportunities in Qatar and elsewhere.

Islamic finance, which includes Islamic banking, sukuk, Islamic funds and takaful, was popular only in the Muslim countries but became an integral part of the global financial architecture in the last few years after gaining credence in other countries where Muslims are in the minority.

The UK issued its first sovereign Islamic bond for $298.08 million (QR1.08 billion) in June last year which was subscribed more than 10 times. Other countries like Morocco, Japan, Senegal, China and South Africa too have evinced keen interest in Islamic finance products and Germany launched its first Islamic bank two months ago.

China is a potential market for the development of Islamic finance as its Muslim population is around 20 million. At present, the industry has a nominal presence and, realising this, two Qatari banks - Qatar National Bank and Qatar International Islamic Bank - have signed a memorandum of understanding with Chinese brokerage Southwest Securities to set up a company for Islamic deals in that country. Through this agreement, Southwest Securities will be able to access the markets in the region.

"The growth has largely been driven by the increase in deposits, with retail and institutional customers becoming more familiar with Islamic finance. I also expect to see increasing appetite for Shariah-compliant funds from investors from within and outside the GCC region." - Hani Ibrahim, Head of Debt Capital Markets, QInvest

Central Asia's largest economy, Kazakhstan, became the latest country on the Islamic finance radar with the lower House in its Parliament approving the new Islamic finance laws on April 8th. The oil-rich nation plans to launch its first sovereign sukuk early in January 2016. However, the state-owned Development Bank of Kazakhstan already issued the first Islamic bond, a five-year sukuk, for $73 million (QR265.72 million) in 2012.

Russia, which is in the throes of a financial crisis due to the low oil prices and also Western sanctions for its role in Ukraine's unrest, introduced a draft bill in Parliament in March this year to develop the Islamic finance industry in the country and also bring in much-needed capital inflows to boost Russia's market liquidity.

With Islamic finance popularity growing each year, its assets were estimated to be around $2.1 trillion (QR7.64 trillion) at the end of 2014 (see graph), growing at a compounded annual growth rate (CAGR) of 17.3% between 2009 and 2014. While Islamic banking formed 80% of the total assets, sukuk came next with 15%. It is expected to be around $3.4 trillion (QR12.37 trillion) in the next five years.

The reason for this stupendous growth is that the Islamic finance products are more attractive and also an alternative to those being offered by conventional banks. Besides, people are becomingly interested in Socially Responsible Investments (SRI) among people.

The Islamic finance industry recorded double-digit growth in all Muslim countries last year except Pakistan, Indonesia and Turkey, which are yet to capture a majority of the available clientele like retail consumers. At present, the Islamic financial assets account for 4.5% of the total banking assets and are expected to be 10% by 2018.

While Saudi Arabia tops the list as far as Islamic banking assets are concerned (18%) in the world, Malaysia, with 16 Islamic banks, is ranked second (13%) followed by the UAE (7%), Kuwait (6%) and Qatar (4%).

"There is a significant undersupply of Sharia-compliant products services and Islamic finance should outgrow conventional finance not only in Qatar, but all over the world in the coming decades. Islamic finance is approximately 2% of global finance as of today whereas Muslims constitute 20% of the world population." - Akber Khan, Director of Asset Management, Al Rayan Investment

According to the Kuala Lumpur-based Islamic Financial Services Board, a growing interest and awareness of Islamic finance supported by supply-side dynamics by private financial institutions, aggressive postures adopted by governments in spending on infrastructure and an increasingly active role played by government, regulatory agencies and multilateral bodies are the main drivers for the growth of the industry.
Deputy Director in the Department of Monetary and Capital Markets at the International Monetary Fund, Christopher Towe, feels that Islamic finance offers considerable promise as it has the potential to foster more inclusive growth by increasing access to banking services to Muslim populations that may not be willing or able to use conventional banks.

"Islamic finance has the potential to foster growth-enhancing investments by enabling easier access to financing for SMEs in public infrastructure. It has the potential to improve financial stability because, as it is asset-backed, it reduces leverage and requires risk sharing between borrowers and lenders," Towe says.

Head of Debt Capital Markets at QInvest, Hani Ibrahim, says that Islamic finance has became increasingly mainstream as investors have been looking to diversify for secure returns.

"Across the industry, we have seen a marked increase in investors who are not Sharia-sensitive across a range of financial products and investments, attracted to Islamic finance due to its ethical and social characteristics as well as a means of diversifying portfolios away from certain assets," he says.

This was evidenced by the fact that in 2014, there were several non-Muslim sovereign nations that issued their maiden sukuk. This included Hong Kong and Luxembourg (both of whom were advised by QInvest on their maiden issues) as well as the UK and South Africa.

"We are also seeing more international issuers issuing sukuk, for example the recent issuance by Goldman Sachs and the companies and projects in the UK and Europe, that have raised Islamic finance from Qatari and GCC investors and used this as an alternative to bank funding that would be available to them locally," Ibrahim says.

GCC and Islamic finance
In the GCC region, all six countries have been at the forefront in supporting the Islamic finance industry and all of them are listed in the top 10 countries in the world's Islamic Economy ecosystem, according to the latest Global Islamic Economy report released recently by Thomson Reuters along with Dinar Standard.

Qatar barred the conventional banks from offering Sharia-compliant products to customers nearly four years ago to reaffirm its commitment to promote Islamic financial institutions and markets and included them among the critical goals under the Strategic Plan for Financial Regulation.

At present, the assets of Qatar's Islamic banks are around 25% of the total assets of the banking system.
Dubai is making all efforts to emerge as the world capital of Islamic finance by implementing new regulations and plans to set up a Federal Sharia Board, comprising scholars who pass religious decrees on whether a financial product conforms with the Islamic tenets such as a ban on interest payments. The Board is expected to meet the huge need to unify standards and contracts in the industry.

"Akin to the $100 billion Asian Infrastructure Investment Bank (Qatar is one of the founding members) launched a few months ago, there is clearly a need to create large, thematic, impact-driven financial institutions in the Islamic finance space." - Muzammil Kasbati, Director, Islamic Banking Centre, Ernst & Young

The demand for Islamic products is on the rise in Bahrain while Kuwait, Saudi Arabia and Oman have the potential to emerge as the main Islamic financial centres in the Middle East region.

While opportunities are aplenty for the industry's growth, what is tempering the growth of Islamic finance is the fluctuating oil price in the last eight months which can slow down spending on infrastructure projects; social and political unrest in the Middle East which may impact Islamic banks' expansion plans in the region; increasing competition between the GCC and Malaysia for supremacy resulting in stress on profit margins; shortage of trained staff engaged in the Islamic finance industry; lack of Sharia-compliant insurance schemes which can undermine confidence in the industry; poor public awareness and market education about the principles and products of Islamic finance; low financial literacy in these markets and the lack of standardisation of structures, contracts and Sharia interpretations. The opportunities for the industry's growth include the growing halal economy, corporates which are looking to fund their operations through Sharia-compliant means, and Islamic pensions which could add around $200 billion (QR728 billion) to the sector.

Director of Islamic Banking Centre at Ernst & Young, Muzammil Kasbati, says that the GCC currently holds high business prospects with growth charts in Saudi Arabia and Qatar expected to move up in the next five years. "Given our experience with previous GCC markets, the common challenge faced by Islamic financial institutions is the lack of awareness of Islamic products amongst entrepreneurs who would otherwise be inclined towards Islamic finance," he says.

Once such a challenge is taken care of and the right people in the industry are given business-specific insights on how Islamic finance can help them do business in a Sharia-compliant way without compromising on profitability, it does lead to a shift in financing strategy. Currently, the market that is displaying profusely is Oman.

"One fourth of the banking system in Qatar has transitioned to be Sharia-compliant and it is anticipated that there will be a 15-20% sustainable growth for the banking industry. This has been made possible due to immense sovereign support," he says.

Similar growth trends are a highlight of the Saudi Arabian market as demand for Sharia-compliant banking has emerged from the retail and corporate markets and the size of its structure has almost doubled in the last five years with total assets touching $258 billion (QR939.12 billion), Kasbati says.

With respect to Qatar, Kasbati feels that the government should think boldly and put in place two to three flagship initiatives that have a game-changer impact. Currently, industry has a "more of the same" syndrome, so jurisdictions that are able to put a bold vision into action will be a decisive winner over the next decade.

He says that the Islamic finance industry's infrastructure in Qatar may not be able to support the expected growth for the next ten years. It requires a comprehensive overhaul in terms of aligning with new product and business model innovations we have seen over recent years, as well as agreeing a more effective working protocol with the mainstream conventional global financial system. This is across regulatory, brand and communication, capital markets, supervisory, and talent initiatives.

"Akin to the $100 billion Asian Infrastructure Investment Bank (Qatar is one of the founding members) launched a few months ago, there is clearly a need to create large, thematic, impact-driven financial institutions in the Islamic finance space," Kasbati says.

Hani Ibrahim says that the outlook for the Islamic finance sector in the region is positive and he expects it to grow further as a result of the wider growth of the economy and from taking market share from the conventional banks.

"The growth has largely been driven by the increase in deposits, with retail and institutional customers becoming more familiar with Islamic finance. I also expect to see increasing appetite for the Sharia-compliant funds from investors from within and outside the GCC region," he says, adding that Qatar's Islamic finance sector will continue to mature and the initiatives from the authorities and Qatar Stock Exchange to promote a domestic fixed income market are a positive first step.

"I believe that the sector would receive a significant boost from the development of an active sukuk market by allowing banks and other institutional investors to participate in the development of the country by investing in the financing of projects. In addition to opening up the investor base, an active local currency market would enable the stakeholders to price credit transparently and efficiently and give investors an opportunity to trade the paper on a regulated exchange," Ibrahim says.

Undersupply
"There is a significant undersupply of Sharia-compliant products services and Islamic finance should outgrow conventional finance not only in Qatar, but all over the world in the coming decades. Islamic finance is approximately 2% of global finance as of today whereas Muslims constitute 20% of the world population," says Akber Khan, Director of Asset Management at Al Rayan Investment.

He says that Qatar has implemented a distinct separation between Islamic and conventional banks, meaning that Islamic windows were no longer possible by the latter. A key benefit of this is that Islamic deposits cannot be used for conventional loans and vice versa.

He says that Islamic finance has great potential in India, South Africa, North America and Western Europe where significant Muslim populations have very few Sharia-compliant products and services to choose from.
"Turning to sukuk for their funding needs will certainly be on the cards for Qatari banks, particularly given the fall in the oil price which has put pressure on government deposits. Demand for bank borrowings will be considerable in the coming years as spending on infrastructure and new projects continue," Khan adds.

Funding SMEs
Like the conventional banks, the space for SME funding is limited and underserved in the scheme of things as far as Islamic finance is concerned.

Ibrahim says that this is a challenge not just for Qatar but has been a theme of the recent global financial crisis. SMEs in Europe, for example, have also struggled to raise finance. Within Qatar, the relatively small size of SME businesses and the SME sector as a whole has meant that there has been less focus on it from banks. In addition, the pace of growth in the rest of the economy has meant that banks have preferred to extend financing to the larger businesses that the SMEs are competing with for financing.

"There are some initiatives that have looked to address this challenge, particularly with the Qatar Development Bank (QDB). Qatar Islamic Bank in particular has been working on extending financing to SMEs with the support of the QDB. Similar initiatives will be key for the SME sector to access financing from banks in general and Islamic financing in particular," Ibrahim says.

Kasbati too says that the funding ecosystem for small finance, unfortunately, is severely restricted though the SME segment is the backbone of the Middle East countries' economies. The skills sets required are very different and need a more comprehensive understanding of business risks, and hence different skill-sets, which is more than just collateralised-lending or credit risk assessment performed by banks today.

"This demands a shift in mindset on how banks operate today. The game changer would be setting up specialised SME funds with a combination of sector-focused and banking skills, and a bottom-up approach to building geographic or sector-specific portfolios. Anything short will fail to actualise the full potential," he says.

However, Khan feels that as far as access to Sharia-compliant funding to small and medium-sized companies is concerned, Islamic banks seek to lend to sustainable businesses, whether large or small. "Islamic banks are well suited to lending to the SME sector and are very keen to do so," he adds.

Global Head of Islamic Finance at Standard & Poor's, Mohamed Damak, says that funding for SMEs depends on the credit quality of the SME. "Islamic banks are profit-seeking entities and will probably not finance SMEs if they come to the conclusion that the project or the business model is not viable," Damak points out.

"The global regulatory framework might not be applicable due to the specifics of each country. However, core principles of Islamic finance regulation such as those adopted by the Islamic Financial Service Board (IFSB) in April 2015 could help further integration of Islamic finance with the international architecture for financial stability." - Mohamed Damak, Global Head of Islamic Finance, Standard & Poor's

Sukuk
Sukuk, which is part of the Islamic finance sector around the world, is making inroads in all five continents and the global Islamic bond issuance is expected to be around $175 billion (QR637 billion) in 2015, up from $110 billion (QR400 billion) in 2014 in 19 countries.

Sukuk issuance is projected to be around $250 billion (QR910 billion) by 2020, according to the Thomson Reuters report entitled "Sukuk Perceptions and Forecast," which was released at the 21st annual World Islamic Banking Conference last year. The report also predicts that the total global outstanding sukuk, which is currently at $241 billion (QR877.24 billion), is also expected to grow to $907 billion (QR3.3 trillion) by 2020.

Sukuk is the most popular Islamic finance product going by its success and the GCC governments can look at this to fund the ongoing infrastructure projects if need be.

"Every contract and product has its own merits and it is difficult to pinpoint the success story of only one type of contract. However, recently sukuk has been very popular from both the issuer and investor perspective as it provides a secured means of investment to the investor and at the same time is preferred by issuers as they are able to securitize their assets and raise liquidity at reasonable rates," Kasbati says.

"Sukuk has been a fantastic innovation of the decade. The missing link is the absence of quality assets and Qatar, with its infrastructure spending, is ideally positioned to help bridge this gap. A pre requisite is to facilitate through regulatory reforms and plugg in the missing pieces of the debt capital market ecosystem like diversifying sukuk by currency, tenor, risk and structures," he says.

Hani Ibrahim says that the quantum of financing is large and though the local and international bank markets are expected to provide the largest share of this financing requirement, they are unlikely to provide all of the financing.

"Sukuk financing is a viable alternative source and will be key in meeting Qatar's financing needs. The ability of companies and project sponsors to access sukuk financing will be enhanced significantly by the promotion of an active QR sukuk market, allowing companies that typically cannot access the international sukuk markets to raise sukuk funding," Ibrahim says.

Sharing the same views, Mohamed Damak feels that sukuk could contribute to the financing of project finance in Qatar and globally due to the asset backing principle of Islamic finance that makes it a natural partner for infrastructure and project financing.

Global regulatory mechanism
Though multiple interpretations of the law by sharia scholars can leave the industry as well as investors unclear about certain aspects of Islamic banking, most of the experts feel that a global regulatory framework cannot be put in place as each country has a different set of rules and regulations for conducting financial operations.

"The global regulatory framework might not be applicable due to the specifics of each country. However, core principles of Islamic finance regulation such as those adopted by the Islamic Financial Service Board (IFSB) in April 2015 could help further integration of Islamic finance with the international architecture for financial stability," Damak says.

Kasbati says that this may sound simple but has to be researched well as Islamic finance will always be prone to varying interpretations with respect to different fiqh and schools of thought. A practical approach would be for Organisation of Islamic Conference jurisdictions to agree on a minimum set of standards to be made consistently applicable across markets.

Christopher Towe says that though Islamic finance could prove safer than conventional finance, the Islamic bankers must tighten rules and follow them more consistently. "Our analysis suggests that these standards are not being applied consistently, and this could either stifle the development of Islamic finance or encourage its growth in a manner that creates systemic vulnerabilities," he says.

Towe also warns that some issues, such as the need to tailor regulations to specifics of Islamic banks and for greater consistency of regulation and supervision, fill the gaps in the instruments that central banks have to manage liquidity for Islamic banks, improve the poor design of financial safety nets to meet the specificities of Islamic finance and ensure an enabling environment for sukuk markets which still remain relatively shallow and illiquid. There is also the need for consumer and investor protection frameworks that take into account the specifics of the Islamic finance industry to be addressed so as not to unduly handicap its growth but also to ensure that the potential risks they pose are avoided.

Hani Ibrahim says that the organised Islamic finance industry is relatively young when compared to conventional finance and the regulations are therefore still growing and evolving. However, there are already efforts within the industry to standardise some aspects of Islamic finance with organisations such as AAOIFI, IFSB and IIFM setting standards, guidelines and best practices.

As with any industry, it is very challenging to prescribe regulations and standards on a global basis that would be relevant and applicable to the industry as a whole. This applies more so to Islamic finance given the differing legal and regulatory requirements in each of the local markets where Islamic finance is and will be present, combined with the differing Sharia interpretations of scholars. "Whilst the differing interpretations of scholars may be seen as a challenge, it is also the factor that helps Islamic finance evolve and come up with new solutions as it stimulates debate within the industry. Having said that, the industry would benefit from an element of standardisation and regulation that would prescribe certain products or areas where there is wide consensus amongst scholars and practitioners," Ibrahim says.

"Islamic finance has the potential to foster growth-enhancing investments by enabling easier access to financing for SMEs in public infrastructure. It has the potential to improve financial stability because it is asset-backed, reduces leverage and requires risk sharing between borrowers and lenders." - Christopher Towe, Deputy Director, Department of Monetary and Capital Markets, International Monetary Fund

Human capital
While the growth of the Islamic finance industry is phenomenal, the demand to develop human capital is also on the rise. It is estimated that Malaysia, which is leading the industry, needs as many as 200,000 professionals by 2020 and the situation is no different in other Islamic countries.

Kasbati says that the industry should re- think its strategy to attract the best brains though there is a glut of young professionals with great conceptual knowledge and certifications in Islamic finance principles. However, that falls short of what the industry needs today.

He says that the demand is for specialised talent that can put concepts into practice and the missing links are the innovation labs that provide the linkage between industry and academia.

"For example, exploring how Islamic trade finance could be made to work across new trade corridors being formed between high-growth emerging markets or how to connect the dots between financial and real economic sectors of the halal economy. Or how to embed impact financing in the way Islamic banks build their investment portfolio. So industry and academia need to come closer to fund and incubate these talent innovation labs and transform their focus to the broader Islamic economy," Kasbati says. "We need to ensure that the industry continues to be promoted so that top-tier financial services professionals are attracted to work in the country. Organisations like QInvest have a responsibility to inspire the next generation of Qatar's business leaders. We are committed to developing the talent needed to support the growth of Islamic finance in Qatar and the region and have in place a number of internal programmes and collaborations with academic institutions to support this. There are a number of academic and training institutions that are operating in Qatar who provide Islamic finance training and qualifications which I believe is a good way to introduce professionals to the industry," Ibrahim says.

Outlook
In its outlook for the Islamic finance industry till 2018, Bank Negara Malaysia predicts that the industry will reach new heights amid global uncertainties. The growth of Islamic finance will be supported by the on-going recovery in the global economy, with firmer global growth forecasted at 3.8% next year, an uptrend compared to 3.3% growth in the 2013 and 2014 estimates.

"Underpinning this growth is the robust domestic demand in emerging economies, including in Asia Pacific and the Middle East, amid stronger global trade activity (2014 estimate 3.7%; 2015 forecast 5%).

Nevertheless, financial market sentiment remains vulnerable to exogenous events such as geopolitical crises, especially in the Middle East and Russia; as well as shocks to oil prices," the report says.

Another key concern for investors will be the timing of the unwinding of easy monetary policies in the advanced economies, especially the Federal Reserve's quantitative easing programme. In the past, announcements on the Fed taper had led to volatility in financial market yields, especially in emerging economies, the report adds.

© Qatar Today 2015