May 31 2011
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Islamic finance: The Road Ahead
Even a global recession couldn't put the brakes on the rapid rise of Islamic finance, but limited products and talent within the sector still need to be addressed.
The world's first private bank to be explicitly based on Shariaáh principles opened in Dubai in 1975. Today the Islamic finance industry is worth close to $1 trillion and spans the globe. International Monetary Fund figures show that between 2007 and 2009, Islamic banks' assets grew an average of twice as fast as conventional banks' assets in major Muslim markets.
Shariaáh-compliant banking products and services account for around 38 per cent of the banking sector's assets in Saudi Arabia, the Gulf's largest economy. Moreover, the tendency of Islamic banks to avoid excessive leverage and risk-taking has attracted the interest of non-Muslims worldwide, in the wake of a credit crunch caused by off-balance-sheet loans or derivatives, among other things by conventional banks.
"If you look at what accelerated the growth in Islamic finance before the slump, the primary driver was the fact that Islamic banking could grow into lots of new areas," explains Raj Madha, banking analyst at Rasmala Investment Bank. "A key area was mortgages - the vast proportion of new mortgages were issued as Islamic lending. But [since the economic downturn] growth in mortgages has obviously been much more limited," he says.
In addition, while US-based thinktank the Pew Research Center forecast in January that the world's Muslim population will double from 1.1 billion in 1990 to 2.2 billion in 2030, new product development in the Shariaáh-compliant finance sector has been unable to keep pace. There have been some new products, such as credit cards, but the level of new product generation has dropped and so penetration growth rates have suffered.
"There is a fixed amount of conventional products, and once you provide a mimic for all of those conventional products, you're essentially done," says Madha. "You start off by mimicking the easy products, such as Ijarah, and then you begin to mimic harder products and more niche products.
"Gradually, you get declining returns on scale until you've got an Islamic equivalent of every product, at which point it becomes pretty much impossible to create new products. Dedicated products for a specific purpose, such as educational loans, will open up more of a niche, but you're not breaking fresh ground."
Razi Fakih, deputy CEO of HSBC Amanah , the international bank's Islamic financing arm, agrees that the industry must invest in research.
"[It's important] to focus on development and innovation so that we can move away from products that look like replicates of their conventional cousins and towards those that conform to the Shariaáh principles behind Islamic finance in letter and in spirit."
In addition, Fakih says that attention must be paid to growing and enhancing the Islamic finance talent pool.
"The Islamic banking industry has seen significant growth over the past decade and this has resulted in a shortage of talent. Talent continues to be a challenge and will be one of the key differentiators
in the coming years," he says.
" HSBC Amanah has continued to invest in our Islamic talent pool. We are one of the few international Islamic banks in the industry to offer a Global Islamic Finance Graduate programme where potential leaders of the industry are offered cross-country opportunities and given on-the-job training, as well as instructor-led training in Shariaáh, products and personal effectiveness courses."
Despite these concerns, if the sector does enjoy a return to high growth, then the Gulf is likely to be at the centre of that recovery. According to Deloitte & Touche, around 80 per cent of Islamic financial institutions globally are based in the GCC, and 60 per cent of assets held by Islamic financial institutions globally are concentrated in the region.
"The potential of the Gulf region is very encouraging, and a rise in Islamic finance activity is set to follow a rise in overall economic activities," says Dr Mohamad Nedal Alchaar, secretary general of the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI), the international standard-setting organisation for Islamic finance.
"Economic growth in both the Gulf and Asia is likely to be among the strongest in the world in the coming years and consequently, trading volume between the two regions is likely to increase," he continues. "This presents a compelling opportunity for the rise of trade financing through Islamic finance. Furthermore, capital flows between the Gulf and Asia are also likely to increase, and Islamic finance can play its role to facilitate them."
Dr Alchaar insists that there are exciting prospects for Islamic finance in the areas of takaful and trade financing, for which demand should increase as the Gulf economies develop their non-oil exports.
"Supply of credit will expand as liquidity gradually becomes higher, while demand for credit will grow to support increasing economic activities, including major investments in infrastructure and economic diversification efforts," he says. "This creates a perfect environment for Islamic finance as its financing mechanisms generally require real economic activities as underlying transactions."
At Rasmala, Madha is less convinced that resurgence is imminent. He insists that the Shariaáh-compliant sector needs "momentum in the key areas in which Islamic banking takes place" - and that the recovery of the region's real estate market would play a major role in re-establishing Islamic finance as a high-growth industry.
"We still have a lot of uncertainty about the property market, which is going to be a key driver of Islamic finance," he cautions. "We've not seen much in the way of salary increases in the public sector, which is a big driver of lending volume, and also the mortgage sector needs to recover."
Islamic finance glossary
Shariaáh-compliant bonds, or Sukuk, are increasingly popular in the Gulf and are recognised as an accessible and inexpensive form of Islamic finance. Sukuk, which do not pay interest, must be ratified by a Shariaáh board of scholars, to ensure that the vehicle's terms and conditions are in line with Islamic law. Islamic bonds hit the headlines in the aftermath of the Dubai World debt crisis: in January 2011 it was revealed that state-owned property firm Nakheel had received government funds to pay a $816.3 million sukuk that matured later that month. The real estate developer, which is a part of Dubai World, required the government to step in to fund the repayment of the 2.75 per cent sukuk. In happier times, meanwhile, Dubai was the location for the current world record for a single sukuk, when Dubai Islamic Bank raised $3.52 billion for the Nakheel Group in 2006.
Islamic insurance, or Takaful, is co-operative, whereby customers put money into a communal fund and take out what they need in the event of a claim. Insurance companies charge a fee for managing the operation, and any money left over at the end of the year is paid back to customers. According to Ernst & Young's World Takaful Report 2010, global contributions grew 28 per cent in 2008 to reach $5.3 billion and are expected to have surpassed $8.9 billion in 2010 -- a significant leap from just $2.5 billion in 2006. Saudi Arabia accounted for more than half of global takaful contributions in 2008 totalling $2.9 billion; Malaysia, the second top takaful market, accumulated $889 million in contributions.
Islamic leasing, known as Ijarah, is an increasingly prevalent way of allowing banks to make a profit on medium-term loans, but without using interest. Under the arrangement, the bank takes initial ownership of the asset, before the individual or company gradually redeems its possession with lease periods over a set period. Banks take ownership of the asset -- a car, for example -- and in return for a monthly payment that covers the cost of the bank's capital outlay, the institution allows the customer to use the asset for a set period, at which point the customer owns it outright. The practice is also offered as an Islamic alternative to a conventional mortgage, whereby the bank buys the house and becomes its legal owner. Over the pre-agreed period the customer pays a monthly fee, which covers a charge for rent and also a charge which purchases a small stake in the house itself. Once the final payment is made, after 25 years for example, the customer owns the property outright.
© Gulf Business 2011
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