Islamic finance is an industry that has enjoyed headline-grabbing growth in recent years, but now pressures are beginning to mount. Unquestionably, sharia-compliant institutions in most markets are looking at a rosy future while Islamic banks continue to outgrow their conventional peers, and frontier markets from Indonesia to Pakistan remain relatively untouched.
However, the challenges ahead are common to any young but maturing market, including the need to establish a globally coherent set of rules and guidelines to encourage sustainable future growth.
This is particularly important to the Islamic finance industry because, according to research by Standard & Poor’s, its development arc has created several independent core markets and minor fractures along the lines of sharia compliance. Meanwhile, legal documentation is not yet sufficiently standardised across borders for the likes of sukuk issuance. S&P has identified issues around standardisation as a key impediment to future growth.
“Standardisation will allow for the industry to be more integrated. Right now it is a collection of small industries rather than a globalised market. All stakeholders need to work together to achieve this,” says Mohamed Damak, senior director and global head of Islamic finance at S&P Global Ratings.
Effort to standardise
Arguably, it has been the lack of centralised sharia authorities that has fragmented the industry’s development. This absence of oversight has left responsibility for rulings on sharia compliance in the hands of scholars at the institutional level. These have therefore varied between entities over time, even if differences have been relatively minor. On a global level, this has contributed to a lack of integration between markets.
“Sharia compliance has been interpreted in a different manner across the globe and scholars have been given some leeway in their interpretation. This has resulted in a limited interaction between different jurisdictions,” says Mr Damak.
Introducing higher sharia authorities into core markets would be helpful in establishing greater internal market coherence, and could act as a first step towards establishing common norms in core markets, which in turn will ease the process of establishing cross-border standards. Encouragingly, progress is being made. Malaysia has had a central sharia authority for many years, Bahrain and Oman have recently followed suit, and the United Arab Emirates cabinet approved the launch of such a mechanism in 2016.
“The growth of centralised sharia boards appears to be a step in the right direction. The Accounting and Auditing Organisation for Islamic Financial Institutions [AAOIFI] has issued recommendations that clearly lay out what central sharia boards should and should not do. We think that will help with issues around standardisation,” says Mr Damak.
Global co-operation
AAOIFI will play a crucial role in forging global standards of sharia compliance. Thanks to the inclusion of sharia scholars from across the world, much progress has already been made in setting standards that have been adopted either on a mandatory basis or as a point of reference by central banks and financial authorities around the world.
According to S&P, in 2017 this has included the production of exposure drafts on the conduct of central sharia boards and accounting rules related to sukuk transactions.
“AAOIFI has been the international body to which the Islamic finance industry has turned in recent years. Rules and standards are set by a group of global scholars within the organisation, and this is helping to establish cross-border norms,” says Farmida Bi, head of Islamic finance for Europe at law firm Norton Rose Fulbright.
Meanwhile, in a further sign of the industry’s strengthening oversight, there has been a greater push for the introduction of external sharia audits of Islamic banks in recent years. This involves external checks of sharia compliance of financial institutions, alongside the internal boards that govern Islamic rulings on products, services and transactions. In late 2016, the Central Bank of Bahrain proposed new governance rules requiring the country’s Islamic lenders to execute external audits.
This follows similar action taken by Oman in 2012 and Pakistan in 2014, according to a report from Reuters. Such audits are intended to boost consumer confidence in Islamic institutions.
Differences in structure
Nevertheless, obstacles to the harmonisation of sharia standards remain. In Malaysia, for instance, employing a murabaha structure on sukuk is a popular way of structuring a transaction. Under this cost-plus-profit format, one party will purchase goods for another and sell it back at a pre-agreed mark-up. Such instruments are not tradable and are only employed in the primary market. But elsewhere in the Islamic world other formats for structuring deals are preferred.
In addition, some sharia scholars in the Middle East have deemed murabaha sukuk as non-compliant with religious principles, arguing that they are not sufficiently based on real economic activity and insufficiently share risk between the two parties. “Some sukuk issued in Asia, for example, would not be seen as sharia compliant in the Gulf
Co-operation Council. Reportedly, this includes the commodity-based murabaha sukuk,” says Mr Damak.
Bridging this kind of gap in sharia compliance and interpretation will be a necessary obstacle to overcome, even if the points of contention, on a global scale, are relatively small. Most observers indicate that on the majority of transactions, products and services, scholars from all markets share a consensus view on sharia compliance.
“I think the differences in sharia compliance between Islamic finance markets have been overplayed. Most of the industry’s biggest deals are tailored to the needs of the global market. If you consider Islamic finance as a form of structured finance, you will see that most deals are developed along similar lines. The market has effectively decided how these transactions should look, even if they aren’t identical,” says Norton Rose Fulbright’s Ms Bi.
Nevertheless, the need for standardisation remains. Looking ahead, if today’s industry leaders can establish a strong foundation of coherent guidelines and standards the Islamic finance marketplace has every chance of realising its full potential.
This will require vision, innovation, international co-operation and ongoing dialogue around complex issues relating to jurisprudence and law. The goal for the industry is to make conducting business in accordance with sharia law as easy as it is along conventional lines.
Malaysia’s lead
Encouragingly, one market has, to some extent, already achieved this. In Malaysia, the bridge between conventional and Islamic finance has effectively narrowed thanks to the strong lead taken by the authorities. As the International Monetary Fund notes in its Article IV April 2017 consultation, the outstanding stock of government Islamic securities is now approaching that of conventional government debt. Indeed, taking the sukuk market alone, S&P now believes that the process of issuing this instrument is as easy as issuing a conventional bond in Malaysia.
The industry’s newer markets stand to gain from the experience of Malaysia, and other mature jurisdictions, as the popularity of Islamic finance grows within their borders. And for many markets participants, this development represents the industry’s exciting future. Large populations of Muslims with little or no access to sharia-compliant financial services exist across the globe and tapping into those pools will help to propel the market to the next stage of its growth. But doing this with globally recognised rules and standards will make the task significantly easier.
“The future of Islamic finance will be driven from the ground up,” says Ms Bi. “Islamic banks in frontier markets, including south Asia, Indonesia and Africa, are driving the growth of the retail market by serving unbanked populations.”
