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Best-performing banksNovember 5 2007

From niche to mainstream

The Islamic finance industry is rapidly evolving and expanding, with growth of banking assets estimated at $750bn and growing at a rate of 15% to 20% a year. Nabeel Shoaib explains.
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The growth of Islamic finance is outpacing almost every other business segment of the global banking system. Sharia-compliant banking for Islamic retail clients was introduced only a decade ago (corporate banking has been around a lot longer), yet the past four years have seen exponential growth of the business, particularly in Saudi Arabia, where 95% of all retail banking transactions are now done through Islamic banking institutions. Other markets with a vast potential, such as Malaysia and Indonesia, are moving dynamically through a development stage. The Malaysian and east Asian markets show a great deal of promise, as they tend to be highly sophisticated with a more developed infrastructure than the Middle East and a more liberal sharia interpretation.

At the retail end, there is already a flourishing array of products available to Muslim customers. The offering includes sharia-compliant home and auto finance, current and savings accounts, debit and credit cards and investment products such as equity funds, property funds and capital-protected funds.

Islamic finance is not a new phenomenon. It has been practised since the Middle Ages, but has risen in prominence over the past 30 years or so. This is largely due to the growing financial resources of oil-producing countries in which Islam is the main religion, increasing wealth and financial sophistication, as well as increasing demand for financial services. In recent times, just as there is an increasing interest in the western world in ethical finance, the emerging Islamic banking sector has achieved acceptance and funds managed by Islamic institutions continue to grow and flourish.

Fundamental principles

Islamic finance has been adopted to meet the needs of specific countries and societies, but the overarching principle is that all forms of interest are forbidden. The Islamic financial model works on the basis of risk sharing. The customer and the bank share the risk of any investment on agreed terms, and divide any profits between them. The main categories within Islamic finance are: ijara, ijara-wa-iqtina, mudaraba, murabaha and musharaka. Ijara is a leasing agreement whereby the bank buys an item for a customer and then leases it back over a specific period. Ijara-wa-iqtina is a similar arrangement, except that the customer is able to buy the item at the end of the contract. Mudaraba offers specialist investment by a financial expert in which the bank and the customer shares any profits. Customers risk losing their money if the investment is unsuccessful, although the bank will not charge a handling fee unless it turns in a profit. Murabaha is a form of credit that enables customers to make a purchase without having to take out an interest-bearing loan. The bank buys an item and then sells it on to the customer on a deferred basis. Musharaka is an investment partnership in which profit-sharing terms are agreed in advance, and losses are pegged to the amount invested.

Today’s Islamic finance industry is rapidly evolving from niche to mainstream, with growth of Islamic banking assets now estimated at $750bn and growing at a rate of 15% to 20% a year. The Gulf Co-operation Council (GCC) proportion of total Islamic banking assets has reached 30% and is projected to rise to 40% in the next three years. In Malaysia, the Islamic share is currently 12% and the government is committed to boosting this to 20% by 2010. In Islamic countries such as the United Arab Emirates (UAE), where less than 30% of the local population are Arabs, sharia-compliant banks are gaining market share at the expense of conventional banks.

The spectacular acceptance and demand for Islamic finance means that within the next decade, the industry is likely to capture half the savings of the 1.6 billion-strong Muslim world. It is tempting to assume that the growth is being fuelled by an older generation of Muslims keen to take advantage of an offering that complies with their traditional way of life. Not so: the vast majority of the uptake comes from the under-30 segment of the Islamic world, and it is this segment that holds the key to success for the more than 250 Islamic banks that now operate in more than 75 countries worldwide. The popularity of Islamic finance among these young Muslims responds to a resurgence of interest in their cultural and religious identity. This ‘baby boom’ of customers makes up the backbone of the industry.

The Islamic finance industry infrastructure is supported by several international bodies. One is the Islamic Financial Services Board (IFSB). This is an international standard-setting organisation that promotes and enhances the soundness and stability of the Islamic financial services industry by issuing global prudential standards and guiding principles for the industry, broadly defined to include banking, capital markets and insurance sectors. The IFSB also conducts research and co-ordinates initiatives on industry-related issues, as well as organises round tables, seminars and conferences for regulators and industry stakeholders. The Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) is an Islamic international autonomous not-for-profit corporate body that prepares accounting, auditing, governance, ethics and sharia standards for Islamic financial institutions and the industry.

Professional qualification programmes are presented by AAOIFI in its efforts to enhance the industry’s human resources base and governance structures. As an independent international organisation, AAOIFI is supported by more than 155 institutional members from 40 countries, including central banks, Islamic financial institutions, and other participants from the international Islamic banking and finance industry, worldwide. AAOIFI has gained support for the implementation of its standards, which are now adopted in Bahrain, Dubai International Financial Centre, Jordan, Lebanon, Qatar, Sudan and Syria.

The Islamic International Rating Agency (IIRA) was established to provide capital markets and the banking sector in predominantly Islamic countries with a rating spectrum that encompasses the full array of capital instruments and speciality Islamic financial products, and to enhance the level of analytical expertise in those markets. IIRA’s rating system recognises and incorporates the unique features of Islamic finance in a way that broadens the quality perspective that is a rating agency’s ultimate goal. This will facilitate development of the company’s markets. The business model employed, focused on the needs of institutional investors, predicates value creation for ratings on the premise that investors will ultimately demand the company’s ratings and research.

IIRA has received formal recognition from one multi-lateral development bank. This business model defines the prerequisites for establishment of the agency: independence of rating judgement, objective and impartial rating committees, highly-trained professional analytical staff and business objectives determined by the market.

Islamic finance in the UK

The global momentum of Islamic finance is not limited to the Arab world. The UK, home to some two million Muslims, is making a bid to compete with Islamic finance centres such as Bahrain, Dubai and Riyadh. The British government’s stated aim is to make London a global centre for financial markets in the Middle East, north Africa and other Muslim countries around the world. It has recognised the vast potential of this market and in 2003 it began shaping the tax and regulatory framework to allow for the development of Islamic finance products. One of the first initiatives was to remove the double stamp duty land tax charge on Islamic mortgages, while in 2005 it legislated to bring these products within the existing mortgage regime.

London has also emerged as the centre for secondary market trading in Islamic instruments. The City is home to many of the originating banks, as well as the hedge fund and real money investors that have recently bought into Islamic bonds. Sukuk (bonds) are structured such that investors have a beneficial interest in the cash flows generated by the underlying assets. Assets are sold by the original to a special purpose vehicle (SPV) in the form of a trust. The size of the sukuk market, encompassing domestic and international issues, is estimated at about $60bn. The market is expanding at a rapid pace, with last year’s $20bn issuance representing a rise of almost 50% over 2005. Hence the past few years have seen a rapid expansion in the issuance of sukuk securities across Asia and the Middle East. Although the global market at present remains relatively small, the issuance potential in the Gulf region is high. This market is forecast to grow as part of the systemic Middle East expansion in long-term conventional debt financing, combined with a drive to tap the deep pool of Islamic liquidity. Malaysia, where some 75% of corporate issuance has been Islamic in the past two years, provides a clear indication of future demand.

The Islamic finance market is also expanding in the area of investment banking, with significant growth in sharia-compliant transactions in project finance, corporate and structured finance, financial advisory, underwriting and syndication. Trade finance is another growth area not to be underestimated. Islamic trade financing techniques are readily embraced by many major western corporations in their business with the Muslim world and increasingly as a competitive advantage in their day-to-day activities.

Corporate treasury market operations comprise liquidity and yield management, and structured solutions. Corporates need to be aware of the parameters within which it is acceptable for a counterparty to operate, and feel comfortable with what is not a conventional financing arrangement. The need to marry secular tax, legal and accounting requirements with sharia adds an additional layer of complexity. Moving outside the realm of pure financial contracts, it is important to watch out for non-sharia-compliant elements in normal commercial contracts. An obvious example is provisions imposing interest charges on late payments, which would be unacceptable for a sharia-compliant counterparty. Alternative penalty arrangements need to be considered in such cases.

Innovation priorities

The Islamic finance industry has developed a comprehensive product offering across the entire range of investment banking, capital markets and retail segments of the business. Competition is fierce and the customer base is becoming more sophisticated and demanding. Innovation is now a major priority for shifting from sharia-compliant products to sharia-based solutions, with the introduction of new methods, ideas and products. Innovation has to take into account the multiple dimensions surrounding the world of Islamic finance, from technology and distribution channels to product development and the regulatory framework. The universe of assets that has been used to create sharia-compliant profit is still limited and there is great scope to expand it.

Private banking for high net worth individuals (HNWI) is attracting an increasing number of Muslim customers and represents one area in which innovation becomes a top priority for highly demanding customers. Global institutions with private banking arms, such as HSBC, have rolled out products specifically designed for this market segment, which is a growing segment of the world’s wealthy individuals. The bank has a sharia-compliant offering focused on asset-backed leasing and liquidity management products.

One such product is the Alpha Currency Fund targeted at generating sharia-compatible returns for customers while providing them with liquidity. This is an unleveraged cash fund that generates returns by trading spot foreign exchange currencies on an intra-day basis. The returns of the fund are unrelated to other asset classes such as equities and the product has become popular with institutional and private banking clients.

The business model is another important area in which innovation is required to ensure sustainability. The window model in use up to now has enabled the growth of Islamic finance, however there is a longer term need for dedicated Islamic entities, along with a dedicated regulatory framework and licensing flexibility. More specialist firms will have to enter the field, including brokerages, Islamic investment banks, consultancy practices and venture capital firms. The current business models that dominate the Islamic finance business are aimed mainly at the educated and affluent population, in particular the huge segment of young Muslim professionals. But there is a tendency to neglect underprivileged customers, a problem that could be addressed by rolling out microfinance-type institutions to service microentrepreneurs and promote job creation.

The concentration of interest in developing investment and financing instruments for Islamic investors has resulted in a wealth of recent innovations. Aside from a surge in sukuk issues, there have been sharia-compliant hedge funds debuts, and prime brokerage and managed account units. Over the past year or so, sharia structuring techniques have become much more sophisticated and have opened up new asset classes and pay-offs which, in turn, have resulted in a notable jump in issuance. Banks have been working on equity-linked structured baskets, in which the stocks are specifically selected to be sharia-compliant. But they have also looked at developing some similar commodity-based products which allow for a lot more flexibility in product development.

As the Islamic market evolves, product innovation is spreading beyond the vanilla bond market. There have already been sharia-compliant real estate funds and secured equity funds, and this year saw the launch of the first sharia-compliant hedge funds in the US and UK. Bankers realise that investors who wish to comply with Islamic law are interested in investing in hedge funds because returns generated are a bond-plus type of return.

The successful roll-out and application of these products and services will depend to a large extent on the ability to provide dedicated technology platforms for Islamic finance institutions. At present, conventional banking systems with the introduction of selective modifications have been used to account and process Islamic transactions. Generally speaking, the outcome has resulted in a poor customer experience. This in turn has hit the credibility of sharia and raises the issue of inadequate disclosure. Implementation of appropriate accounting standards and practices is vital for a sound governance structure for Islamic financial institutions. Except for those that have adopted AAOIFI standards, transparency remains relatively poor.

So far only Bahrain, Sudan and Jordan have fully embraced these standards, though they are given some positive recognition elsewhere, most notably in Qatar and Saudi Arabia.

There is an urgent need to invest in dedicated and specialised accounting and processing systems to deal with Islamic transactions, and this includes technology platforms to facilitate sharia-based solutions. A similar situation exists in Islamic distribution channels, which are essentially replicas of conventional channels and will have to evolve to meet the requirements of Islamic customers.

Product development

A sharia-based mindset is critical to achieve product innovation. This applies, for instance, to the field of securitisation in order to create instruments with predictable yields and a full spectrum of maturities. A lot of sukuk securitisations have been put into place, but these have so far been relatively basic. Also included in this category are venture capital and private equity vehicles, as well as instruments to enable a ‘real economy’ play. There is a need to develop hedging instruments for risk management, for instance by using risk pooling concepts of takaful (insurance). Other innovative concepts being developed are savings schemes using infrastructure projects as sources of investment return, and substitute commodity-based financing products with specific asset-backed or linked products.

So far the market has been working on equity-linked structured baskets, in which the stocks are specifically selected to be sharia-compliant. Structuring techniques are now sufficiently developed to be applied to develop almost any sort of product.

The greatest intangible to enable Islamic finance and build its future is the ability to create a qualified and dedicated workforce to deal with the complex issues of Islamic finance. The Islamic finance sector may be booming but it is struggling to establish a common education standard as qualifications are developed to meet the growing demand for specialised professionals. Regional differences in how banks prepare and communicate accounts as well as how they interpret sharia are confusing investors and holding back the sector’s rate of growth.

Accounting standardisation

Islamic banks in the UK differ in their accounting operations from banks in Bahrain, which in turn differ from banks in Malaysia and Indonesia. Standardisation in Islamic finance is necessary to avoid fragmentation and to ultimately create a new asset class that can fully compete with conventional finance. The UK, which wants London to become the global centre of Islamic finance, has introduced an Islamic Finance Qualification (IFQ), which it hopes will become a global benchmark. Global giants such as HSBC, along with the International Monetary Fund and the Financial Services Authority, have already enrolled their employees onto the course.

In Malaysia, a different qualification is being offered by the International Centre for Education in Islamic Finance. The AAOIFI, as one of the Islamic finance industry’s main standard-setting organisations, has issued several standards on Islamic accounting, auditing, governance, ethics and sharia. The AAOIFI offers its own qualification and has launched its Certified Islamic Public Accounting (CIPA) programme, which is now being used by accounting organisations and central banks, including the Central Bank of Egypt, KPMG and Deloitte & Touche. With different countries offering different Islamic finance qualifications the next stage will be to standardise professional qualifications on a global level.

The academic world needs to get involved in helping to promote the growth and professionalism of Islamic finance. Input is required from institutions of higher learning to formulate a visionary framework. This will help to develop a change in mindset from sharia-compliant to sharia-driven products and services. A crucial element of this process involves a proactive engagement of regulators, practitioners and sharia scholars to set a common agenda aimed at achieving these goals.

 Nabeel Shoaib is global head of HSBC Amanah and is based in Dubai.

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