Derivatives are highly disputed in Islamic finance. Some industry officials condemn them as inherently incompatible with the principles of Shari'ah. They believe two parties' deferment of obligations to a future date is tantamount to a debt exchange without an underlying asset transfer, implying the possibility of gharar - prohibited transactions associated with speculation. This is a main reason why derivatives have not yet gained universal appeal in the Islamic world, particularly in the Gulf states.
Some leaders within the Islamic financial services industry, however, recognize the need for managing risks and the potential benefits of derivatives for hedging purposes. For example, Bank Negara Malaysia has long advocated introducing derivatives in Islamic banking, saying that with an adequate legal, regulatory, and corporate governance framework they could improve the Islamic fi ancial system. The bank launched the first global Islamic derivative master agreement to document Islamic derivative transactions in 2007.
A Malaysian bank also created the world's first Islamic derivative product (an Islamic profit-rate swap) in 2005.
Another major milestone for Islamic derivatives was the Tahawwut Master Agreement, launched in early 2010 by the International Islamic Financial Market, a Bahrain-based global standardization body for the Islamic capital and money markets, and the International Swaps and Derivatives Association. The multiproduct agreement, including murabaha (cost plus financing with known cost of underlying asset at the time of entering arrangement), musawama (cost plus financing with unknown cost of underlying asset at the time of entering arrangement), and wa'ad (unilateral pledge) products set terms upon which parties can enter risk management arrangements for hedging transactions, standardizing structures, and documentation. If widely adopted, the new standards could boost the Islamic derivatives market. Currently, Malaysian banks and major international banks are driving Islamic derivative offerings. The most widespread are profit-rate swaps, cross-currency swaps, cross-currency profi t-rate swaps, forward-rate agreements, and equity-linked structured products. Contrary to conventional derivatives, Islamic derivatives cannot be traded, as they are intended for hedging purposes only, and not as specu-lative investments.
A MARKET OVERVIEW
Islamic banking--financial activity consistent with Shari'ah, or Islamic law--has become a material part of the global financial services industry, growing rapidly in both size and stature. Total Islamic assets are estimated around $1,200 billion in 2010. Islamic banking assets make up around 90 percent of this, while outstanding Islamic sukuk and Islamic investment funds comprise the rest.
The major geographic markets are Iran, the Kingdom of Saudi Arabia, the United Arab Emirates, Malaysia, Kuwait, Qatar and Turkey. Over the past several years, Islamic banking has seen double-digit growth rates. For example, the compound annual growth rate between 2006 and 2010 has been 21 percent in the Kingdom of Saudi Arabia and 24 percent in Malaysia.
In terms of Islamic banking penetration (that is, Islamic banking assets as percent of total banking assets), markets can be broadly categorized into three clusters: established, emerging and untapped . The established cluster of Islamic banking activity is the Middle East and South East Asia, with some of the world's most active markets such as Kuwait, the Kingdom of Saudi Arabia, the United Arab Emirates and Malaysia. Emerging markets such as Pakistan and Indonesia have vast Muslim populations and offer significant growth prospects. Large yet untapped markets such as India offer great potential to daring investors. To date, there are no major initiatives undertaken to promote Islamic banking, and if tackled strategically, markets such as India present a vast opportunity for expansion.
There are three main types of players in the Islamic banking industry: fulfill edged Islamic banks, Islamic windows of conventional banks, and Islamic finance companies. Full-fl edged Islamic banks are either fully independent entities or subsidiaries of conventional banks, holding banking licenses. Islamic windows are secluded Islamic banking departments within conventional banks.
Islamic finance companies focus on supplying Shari'ah-compliant financing products such as auto and home finance, and are not allowed to take deposits.
CHALLENGES IN ISLAMIC BANKING
Given the slowing growth and decreasing profitability of Islamic banking, we looked at some of the main challenges facing the industry.
• SIZE.
Many Islamic banks are considerably smaller than their conventional competitors in their domestic markets.
Moreover, even the biggest Islamic banks are typically small compared to international conventional competitors.
There is no Islamic Citibank or Islamic Goldman Sachs--that is, no global pureplay Islamic banking leader with a broad or specialized business model.
• COMPETITION.
The number of Islamic banks and financial services firms is growing even as market growth slows down. For example, the only new banking licenses in the United Arab Emirates issued in recent years were for Islamic banks; meanwhile, conventional banks continue to launch Islamic windows. As a result, merely being Shari'ah compliant is not a major differentiator.
• STANDARDIZATION AND REGULATION.
Standardization and regulation present ongoing challenges for Islamic banks. Different interpretations of the acceptability of various products from a Shari'ah perspective makes standardization diffi cult. For example, the same Islamic financial instrument can be rejected by one Shari'ah board and approved by another, as the Shari'ah rulings of these boards are based on their understanding of the underlying Shari'ah principles. Moreover, historically, there have been marked differences in product acceptance between Southeast Asia and the Middle East. There is a converging trend now, as Bank Negara, Malaysia's central bank, discourages the sale of Islamic banking products that are deemed unacceptable in the GCC to increase industry standardization.
Regulation issues also stem from some countries' lack of specific Islamic banking rules.
• COST STRUCTURE.
Despite strong growth, most Islamic banks have not been consistently profitable, particularly since the global financial crisis. Structural factors are partly to blame as Islamic products are typically more complex than conventional products, which add development and manufacturing costs. Bank-specific weaknesses, such as risk management and operational effectiveness, also play a role.
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© Business Islamica 2013
