The rapid growth of the Islamic financial market in the Gulf Cooperation Council (GCC) region and South East Asia over the past five years has created a thriving market for the suppliers of support technology to develop and enhance their offerings to meet the increasing demands of customers who operate within this specialised segment.
However, the current economic meltdown in US and European markets (which is likely to spread to other regions) will force Islamic finance players to review and redefine their focus on how to survive in a highly turbulent market place.
Many proponents of Islamic finance claim that it will not be greatly affected by this meltdown due to the underlying principles of Sharia, nevertheless, regulators will require Islamic financial institutions to enhance key processes, including risk management, to withstand the shock should another meltdown occur.
Therefore, opportunities are in the offing for suppliers of supporting technology in Islamic finance to re-architect their offerings in anticipation of the changes required by Islamic finance regulators and players as they cope with the changing landscape post the economic meltdown.
Major Events Affecting Growth of Islamic Finance
The steep rise in oil prices post 9/11 allowed many investors, especially those in GCC countries, to accumulate wealth beyond expectation. In addition, the negative investment climate in America forced many investors to look for an alternative investment haven.
The Islamic finance market, which was gaining momentum slowly, now saw rapid expansion as investors chose Islamic finance as an option. Regulators in the GCC region and South East Asia started to issue new licences to attract new investments into their countries and many Islamic banks were formed in rapid succession. Non-muslim countries such as the UK started participating in this market (the UK has five fully fledged banks).
As the Islamic finance market developed, corporations started tapping into the market by issuing Sukuk (Islamic bonds) due to the easy availability of cheap funds in this market. The growth of Sukuk reached its peak in 2007 due to take-up in Malaysia and GCC countries.
A new regulation on Sukuk issued by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) in February 2008 reduced the growth of Sukuk by more than 50%. Islamic finance players struggled with the stringent requirements imposed on the issuance of Sukuk. In particular, the transfer of tradable assets with its rights and obligations by the Sukuk issuers to the investors, proved to be extremely challenging.
Principles of Islamic Finance
The underlying foundation of Islamic finance in operation is predicated by five principles as espoused by Sharia:
In the case of the current economic meltdown in the US and Europe, two principles of Sharia are breached: the prohibition of Riba (interest) and the prohibition of Maisir.
Home loans (and mortgages) and collateralised debt obligations (CDOs), two key instruments causing the meltdown, are based on Riba. In addition, the credit default swaps (CDS) offered by insurance companies as “insurance” against defaults, are highly speculative in nature and go against the prohibition of Maisir.
The collapse of mortgages and CDOs causes the CDSs to be invoked, thus bringing down banking and insurance organisations that issued them. The actual loss (difference between the speculative value and actual value of the mortgages) is likely to be significantly higher than the interest (Riba) and income collected from the CDSs.
The strict compliance to the principles underlying Islamic finance is perhaps shielding it from adverse impact of the meltdown.
Contract-based Transactions in Islamic Finance
The application of the principles of Sharia is defined through contracts developed by Islamic jurists, using various approved sources such as the Quran and the Sayings (Hadiths) and consensus of jurists.
Over the past two decades, AAOIFI has been coding these into a set of Sharia and accounting standards that are adopted by Islamic banks worldwide. These standards are also used by technology providers to develop their offerings for the Islamic financial market (see figure 1, Key Islamic commercial contracts).
Initial development of support technology focused on trading and investment contract requirements of Islamic finance players who were actively involved in these two business areas. The investment contracts are used to build up the deposit base ie, the liability, while the trading contracts are used to build up the assets.
The Islamic Financial Services Board (IFSB), formed in 2003, issues prudential standards to be adopted by various regulators supervising the Islamic finance operators in their jurisdictions. Standards on risk management, capital adequacy and corporate governance have been issued since then, and these have become the guiding principles to both regulators and operators. Each of these standards has enabled market players to be more robust in facing future turbulence in the market.
Subsequent to the economic meltdown, Islamic banking players are likely to review their focus. It is important for technology providers to anticipate their moves and align themselves accordingly in order to remain relevant and to make the most of the opportunities that arise.
Technology impact – post economic meltdown
As Figure 1 shows, Islamic finance players have access to four classes of contracts in developing their products and services to meet the needs of their customers as they cope with the turbulent times ahead:
Of the four, the gratuitous contracts are not likely to bring in revenue as they are used by the players to discharge social responsibilities (with the exception of loan or Qard, which some players use to bring in deposits). Most players will manage these at the current level and significant process enhancement is not expected.
The trading contracts are the mainstay of these players while market growth may be flat or even negative during the next few years, stringent credit assessment in the acquisition/origination phase will ensure that only quality customers are offered and quality assets are booked. Processes relating to origination, credit rating, documentation, and asset tracking etc, are likely to come under scrutiny and will require significant enhancement and strengthening.
These players will also want to ensure that existing and future customers pay promptly, mitigating their collection risks. Processes relating to collection and handling of late or unpaid installments will come under close scrutiny..
Islamic finance players are expected to invest significantly in enhancing key processes relating to trading contracts to ensure that their most valuable assets (that is, the various financing contracts) are intact and continue to provide sufficient profit stream.
During turbulent times, customers will seek to keep their investment safe and may not be interested in sophisticated investment products (such as structured products) that the players may offer.
Therefore, Islamic banking players are not likely to invest significantly in improving processes around products and services, which use investment contracts as their drivers.
The fourth class of contracts, supporting contracts, will be the drivers of growth for Islamic finance players. These contracts generate fee-based revenues that do not require high capital allocation and risk.
The players are expected to enhance their capabilities (processes, systems, manpower) to tap into this fee-based market and offer various products and services to entice customers.
Correspondingly, significant investment will be deployed by these players as they compete with each other.
Conclusion
Islamic finance players appear not to be greatly affected by the current economic meltdown. Many proponents of Islamic finance contend that the compliance to “Prohibition of Riba” and “Prohibition of Maisir” as espoused by Sharia has helped them steer clear of this turbulence.
However, as they are effectively serving the same set of customers and with market trends looking bleak, Islamic finance players will have to review their strategies, and identify additional business areas in order to sustain their revenue stream.
Supporting technology providers in Islamic finance will have to re-architect their solution offering to move in tandem with the players in supporting their business initiatives. Providers who are able to align themselves quickly will stand to benefit as these players make investments to improve their capabilities.
Jamil Hassan is Principal Consultant, Islamic Banking, at Oracle Financial Services Software (email: jamil.hassan@ iflexsolutions.com)
