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| 04 April, 2018

Islamic finance at a crossroads

Muslim-majority countries face the challenge of devising strong yet flexible regulatory environments for Shariah-compliant financial instruments if Islamic finance is to compete with conventional systems and prosper

Image used for illustrative purpose.
Young Arab investor monitoring his investments.

Image used for illustrative purpose. Young Arab investor monitoring his investments.

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Islamic finance stands at a crossroads. After several decades of exponential growth since the introduction of modern Islamic finance in the 1970s, the industry faced headwinds following the oil price crash of 2014 as the oil-rich states of the GUlf Cooperation Council remain the industry’s biggest players. The industry began to recover in 2016 and by the end of that year its global assets had picked up to $2.2 trillion from $2.1 trillion the year before, according to the ICD-Thomson Reuters Islamic Finance Development Report 2017.

That same report predicted continued growth in the industry, and forecast global Islamic finance assets at $3.8 trillion by 2022, but for this growth to happen the industry will need address a number of important challenges and turn those into opportunities.

First among these challenges is the regulatory environment. The implementation of financial regulations in Muslim-majority emerging markets lags behind that of developed markets, and in the aftermath of the global financial crisis of 2008, with regulatory regimes becoming increasingly stringent, that gap is widening. Developed markets are also ahead in integrating practical solutions to such problems as environmental management within the financial system, whereas Islamic principles have to date offered only a broad framework for addressing these problems.

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Need for strong regulatory environments

Yet Muslim-majority countries also face the challenge of devising strong yet flexible regulatory environments for Shariah-compliant financial instruments if Islamic finance is to compete with conventional systems and prosper. And one question for authorities now in those countries is should they try to close the gap in standards with the regulatory regimes of more developed markets or should they concentrate first on developing a more comprehensive Shariah-compliant regime? It is particularly important that different Islamic finance markets work more closely together to increase efficiency and trust in the system while preventing opportunities for arbitrage.

In light of these issues, the Islamic Financial Services Board (IFSB) was founded in Kuala Lumpur in 2002 to assist in setting international standards for regulatory and supervisory agencies consistent with Shariah principles and to recommend their adoption.

Another major development affecting the modern financial world is the unprecedented disruption being caused by financial technology, or fintech. Conventional finance within developed markets is being rapidly transformed by such technology, while Islamic financial technology has so far made relatively few inroads.

Yet both these challenges present huge opportunities for Islamic finance if they can be suitably addressed. With fintech, Islamic financial institutions could improve transparency, cut costs, grow scale and attract new customers if secure, efficient, and cost-effective solutions can be developed in line with Shariah principles. One area where Islamic fintech is making a difference is in online Shariah crowdfunding, which is having a big impact on getting funds to SMEs and MSMEs in Indonesia in particular.

Addressing challenges could allow Islamic finance to grow faster than before

So too the challenge of industry regulation and governance, which if properly addressed could allow Islamic finance to grow faster even than it did before the oil crisis. After all, Islamic finance offers a number of advantages. In a world still reeling from the global financial crisis, Islamic finance offers an alternative, kinder financial universe that operates solely within the real economy, prohibits uncertainty and speculation, and avoids industries that work against the social good. Islamic finance works more as financial intermediation, where funds are raised through asset-based methods and partnerships instead of interest-based lending and borrowing.

One particular benefit it is hoped Islamic finance can bring is greater financial inclusion. Not only would addressing the outlined challenges encourage greater financial inclusion in countries already with large amounts of Islamic financial assets such as the GCC states and Malaysia, it could increase engagement in other countries like Pakistan, Bangladesh, Indonesia, Egypt and Turkey. Another hoped-for beneficiary of a more developed Islamic finance industry would be SMEs, who as yet are underserved by the industry. However, as mentioned, fintech is beginning to provide much-needed funds for SMEs in Indonesia through Shariah-compliant online crowdfunding, presenting a model that could be replicated in other Muslim-majority countries.

Other potential benefits of developing the Islamic finance industry within Muslim-majority countries such as those of the GCC would be to help diversify their economies in the wake of the oil price shock, and to allow financial systems to better withstand such shocks and volatility in oil prices. Countries in the GCC are beginning to diversify their economies away from reliance on oil. The most notable example is Saudi Arabia since Mohammed bin Salman was appointed Crown Prince last June. Bin Salman has introduced a series of measures under his Vision 2030 to transform the conservative kingdom by ending its “addiction to oil” and diversifying its economy through such measures as increasing female participation in the workforce and greatly expanding the country’s entertainment sector.

Attraction of alignment with responsible finance

Possibly the biggest draw for Islamic finance, and one that is attracting interest even from the non-Muslim world, is its alignment with the values of responsible finance which have become increasingly popular in the developed world after the global financial crisis. Islamic finance through its adherence to strict ethical guidelines offers more than just guidelines for the Islamic world but also a universal value proposition that can light the way forward for non-Islamic finance, working in tandem with wider initiatives such as the United Nations’ Sustainable Development Goals and integrating Environmental, Social and Governance (ESG) values to further the aims of a more equitable, inclusive and sustainable financial world. Businesses with superior ESG performance can gain wider public acceptance and a boosted reputation, can satisfy stakeholder demands, and are more compliant with national and international guidelines and laws.

The Malaysian central bank, Bank Negara, has taken a lead in this by issuing the Value-Based intermediation guidelines, and to a similar end the Central Bank of Kuwait and the Islamic Financial Services Board will hold a high-level conference on May 2, 2018 in Kuwait on Islamic finance as a universal value proposition. This conference will discuss this and other key issues facing the industry such as fintech and governance.

There does of course remain the challenge which perhaps overrides them all, and that is no matter what initiatives are undertaken, the results need to demonstrate a financial performance at least on a par with conventional finance, otherwise take-up will be limited and industry growth curtailed. However, several studies into the adoption of ESG-related measures have shown that this generally boosts financial performance and it remains at least possible that Shariah-compliant finance can be equally financially viable.

In a world which, according to data from the Global Islamic Finance Report 2017, more than 80 percent of Muslims worldwide still have no access to Shariah-compliant banking, there remains huge opportunities to vastly increase the size and scope of the Islamic finance industry.

The event is organised by the Central Bank of Kuwait and the Islamic Financial Services Board (IFSB), in collaboration with Thomson Reuters. For more information on the IFSB Annual Meetings 2018 & CBK-IFSB Conference on Islamic Finance, please click here

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