Long-term viability and sustainability will come from increased interoperation between sharia-compliant financial institutions throughout the world, says Joe DiVanna.

Perhaps the biggest questions facing the Islamic finance industry are: can the ever-increasing rate of growth be sustained? And will all sharia-compliant institutions be viable?

Like the complex nature of Islamic finance, the answer to these questions is equally complex, as national economies fluctuate with numerous variables beyond the controls of the banking sector. However, one thing is clear: barring any significant downturn in the Middle East markets, strong growth in the industry is likely to continue. At the microeconomic level, the viability of individual institutions is also unknown as the competitive boundaries are also in the process of redefinition. The market for Islamic banking has begun to consolidate in several markets as key urban centres reach a saturation point, as seen by the recent merger between Emirates Bank and the National Bank of Dubai.

However, in most regions the demand for sharia-compliant services is still far below any saturation point. In short, the lack of access is driving the demand for sharia-compliant services, which will remain high as the overall access to services increases in communities where services have been unavailable.

The second value driver for sharia-compliant services is the presence of profit-seeking investors, as seen in the oversubscription of sukuks (bonds) throughout the Middle East. In spite of the popularity of sukuks, conservative sharia scholars have argued that this offering may not be effective in avoiding interest-like activities because the nature of sukuks requires payment for the time-value of money. As sukuks offer investors a fixed return on their investments, they also fall into contention with some sharia scholars because they are, in many cases, independent of risks in a particular venture and interpreted by some as not equally sharing risk and return, which is another fundamental tenant of sharia principles. That said, in many mixed-mode economies, asset-backed sukuks are progressively more attractive to worldwide Muslim and non-Muslim investors.

To sustain the overall growth in the Islamic finance market in the long-term, regional co-dependency between national economies will increase the ability for regional businesses to conduct activities across borders, with a minimum of encumbrances. Central banks and political figures in various Islamic regions will need to achieve increasing levels of regulatory collaboration, which will be the key to regional competitiveness. Creating a level playing field for Islamic finance is the key to sustainable growth whereby economic activity of nations with a dominant Muslim populations must seamlessly interact on par with the economic engines of the US, Europe and China. Facilitating the next level of growth in the industry will require Islamic nations to begin transnational economic and monetary collaboration on a scale without precedent. The starting point for this type of transnational collaboration may indeed be the Gulf Cooperation Council (GCC) monetary union slated for 2010.

Three future scenarios

The challenge for institutions offering sharia-compliant services is that the Islamic finance industry is poised to grow along three distinctly different competitive fronts: growth by fundamentals, growth by innovation, and growth by market redefinition.

Growth by fundamentals will be achieved by providing primary banking services to the vast numbers of unbanked Muslims and non-Muslims worldwide. Banks in saturated markets are turning to other geographies for their growth strategies by introducing services into new markets or establishing collaborations with local banks. In Saudi Arabia, HSBC and SABB have partnered to bring co-branded wealth management products to conventional banking customers; it is only a matter of time before this type of collaboration occurs across sharia-compliant competitors.

Growth by innovation is perhaps the most immediate challenge for Islamic banks and their conventional counterparts. Currently, Islamic banks offer sharia-compliant services that simply replicate their conventional counterparts. True market innovation must occur at multiple levels within the value propositions of Islamic banks across the entire spectrum of their activities. In the short-term, banks need to become best-in-class for services with ultra-efficient cost structures to compete against larger institutions that have the advantage of economies of scale. Simultaneously, Islamic banks must create new products and develop services that engage customers in a meaningful value-added dialogue that informs, educates and advises on the relativity of a customer’s actions to their financial goals within a framework of sharia compliance. In the longer term, innovation must produce new services designed specifically to facilitate the lifestyles of retail customers and the commercial activities of Muslim businesses.

Growth by redefining the market is in a very early stage, as issues such as GCC monetary union and other macroeconomic factors are converging to change the competitive landscape for sharia services in the Middle East and beyond. One scenario discussed with senior bankers, regulators and academics is the concept of regional co-opetition in the creation of a single regional market for sharia-compliant financial centres specialising on a specific aspect of Islamic finance.

The financial acumen of the financial centres in Bahrain, Kuwait, Malaysia, Qatar, Saudi Arabia and the UAE combined into one comprehensive suite of sharia-compliant services electronically linked and regulated by a basic framework of standards and collaborative monetary policies could theoretically become a contender for global banking services on a par with New York, London and Hong Kong.

In the case of long-term competitive positioning on global markets, a sharia-compliant co-opetition (not to be confused with a cartel) is a synergistic interdependence between competitors operating within Muslim nations. Fundamentally, it is a co-operative system of economic value creation based on a mutual interdependence whereby competitors in sharia-based services are concentrated into ultra-efficient electronic markets that share infrastructure resources such as clearing, settlement and a host of support services. The shared infrastructure provides a platform that facilitates or enhances the products and services offered throughout the market without compromising an individual institution’s direct perceived value to customers.

Dynamics of the market

Interviews with senior bankers, regulators, analysts and academics indicate a growing realisation that the economics of the Middle East are changing towards a higher degree of interdependence across financial markets and an increased sense of economic unity when contrasted with western financial markets. Market demand for sharia-compliant services, represented by a 29.9% growth rate between 2006 and 2007, is growing in each of the 47 nations reporting sharia-compliant activities. The annual reports of financial institutions reflect a growing optimism on the state of the economies across Muslim nations which can be validated by the increase in spending by financial institutions in their pursuit of providing a greater range of sharia-compliant services.

Initiatives such as the GCC monetary union or the fundamentals of Islamic monetary union as expressed by Pakistan’s prime minister, Shaukat Aziz, are increasingly being discussed and debated throughout the Muslim financial community. The general consensus is that the technology and know-how required for such market redefining actions exist today and are within the financial reach of most participating nations. The missing ingredient is an overarching political will to reinvent the dynamics of the markets on a truly global scale. This is not surprising due to the relative immaturity of the Islamic finance industry and, as several academics have argued, change on this scale is perhaps too early given the industry’s overall development.

 Numerous institutions interviewed expressed concern over the forthcoming shortage of experienced sharia scholars. Because sharia is not a set of codified laws, but rather a set of interpretations based on the Koran, the Sunnah, the judgement of scholars and consensus agreement, it follows that rulings are affected by personal beliefs and cultural influences. The current sharia scholars have gained their experience during the past 30 years of the industry’s growth and now with the rapid expansion of sharia-compliant services these scholars are in high demand and often spread too thin to accommodate demand. Islamic banks are concerned with where the next generation of scholars will come from and the quality of their experience.

When worlds collide

In the final analysis of the Islamic finance market, long-term viability and sustainability will come from increased interoperation between sharia-compliant financial institutions throughout the world. Initiatives such as monetary unions, trade collaboration and economic policy synchronisation will influence the Islamic finance industry in three ways: increased efficiency, increased capacity, and increased access for customers worldwide. The technical mechanisms for monetary and currency union exist today; they are well known and are understood by experts in the Gulf and Europe. However, the synchronisation of political agendas, fiscal policies, economic objectives and monetary goals requires an extreme amount of political will power.

Economic co-ordination and strict budgetary discipline by each member state is essential to prevent asymmetric shocks; therefore, discussion and planning may take longer to achieve the level of consensus required to craft meaningful policy guidelines. This level of regulatory discipline will provide the Islamic finance industry with increasing levels of stability adding to the overall competitiveness of sharia-compliant institutions in the world market.

However, analysts, academics and the media have been speculating on the amount of progress towards the achievement of initiatives such as the GCC monetary union with guarded scepticism. Nevertheless, one must remember that this is the Middle East, not Wall Street; building consensus is an art form which takes time and patience, and once achieved things move very quickly. There is an old Arab proverb that says: “A tent cannot be put up with one peg.”

 Joe DiVanna is the author of numerous books on banking including Understanding Islamic Banking: The Value Proposition that Transcends Cultures, and is the managing director of Maris Strategies, a Cambridge-based strategy think tank for financial services and applied economics.


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