Islamic finance moves to centre-stage
Funds invested in Islamic finance products at banks in the Gulf now amount to $70 billion – a fifth of the total asset base, and a clear signal of the extent to which a onetime niche activity is moving centre-stage, particularly in the Middle East and parts of Southeast Asia.
What was once seen as marginal is becoming mainstream. Islamic bankers will come to Dubai this week for the International Islamic Finance Conference – timed to coincide with the IMF/World Bank annual meetings – not as practitioners of a marginal sideline but as mainstream players in the financial community.
Dubai’s Bank Street. ©Gulf News
Some of the top global banking names are now in the field. Citibank and HSBC have incorporated Islamic financing businesses. BNP Paribas recently set up a special unit in Bahrain.
And the rationale is clear: Islamic financial assets are now estimated at about $239 billion worldwide. The sector is growing by 15 per cent a year. That is a lot of investment clout.
For a bank that is seeking to maximise its deposit base and access to investment capital, especially in the Gulf, the region’s fast-growing pool of Islamic assets is clearly attractive. “It is a source of finance that one can no longer ignore,” says Amin Raad, deputy head of Islamic banking at BNP Paribas.
Meanwhile, client demand for Islamic financing is also on the rise, both in the Middle East and further afield, in western markets such as Britain and Germany, and in south-east Asian countries. In Pakistan, the entire financial system is being transformed to make it compliant with Islamic principles.
The Malaysian government’s masterplan for the financial sector envisages that Islamic services will account for 20 per cent of the banking system by 2010. The current figure is 9.4 per cent.
“Malaysia’s Islamic baking sector has achieved the critical mass needed to further develop the Islamic financial system. Islamic financial institutions must take this opportunity to aggressively market their products and services to put them ahead of competitors,” deputy finance minister Shafie Mohammed Salleh argued recently.
Bank Islam Malaysia, a local pioneer, is now 20 years old and it offers a wide range of products, ranging from everyday personal bank accounts through to corporate finance and securitisation. Initially, the sector developed to meet demand from committed Muslims who had chosen to conduct both their personal life and their business activities in full accordance with the precepts of Sharia law.
Malaysia introduced framework legislation for the emerging Islamic finance industry in 1983, with the Islamic Banking Act.
But today, the industry’s appeal stretches far beyond the faithful. Many clients in Malaysia are from the local Chinese community, while the established Islamic banks now face competition from conventional institutions that offer Islamic funding and investment windows.
Altogether, more than 40 different products are marketed. It is important to stress that modern Islamic banks, investment houses or insurers are quite distinct from traditional charitable structures.
The US-led international crackdown on terrorism finance has not specially targeted Islamic finance institutions. A huge range of banks and institutions of both Islamic and conventional types have come under increased scrutiny, as have charities and the hawala money transfer system used by migrant workers in the Gulf to send their savings home.
In predominantly Muslim countries such as the Gulf states or Malaysia, many services are tailored to the needs of mass market personal consumers. But Islamic financing is also making itself felt as a force in the big business field. This is what BNP Paribas is concentrating on.
Amin Raad explains that, since the 1980s, different specialist units in the bank had gradually developed Sharia-compliant versions of their products to meet the needs of key Islamic customers. But these were not actively promoted as a coherent range of services. That is now changing with the establishment of the new operation in Bahrain.
“We set up the Islamic banking unit to develop our marketing,” he explains. The Bahrain office works with the various teams of product experts in Paris and London to promote the services that these specialists have devised for Islamic customers.
“We feel there is an ever-growing demand for products, both from sovereign [government] clients and from private sector clients,” says Raad.
In business terms, he maintains, Islamic finance is competitive. But it is also worthwhile for the banks providing the services. “We try to create Islamic products which have the same characteristics as conventional products – both for the client and, in terms of revenue, for us.”
However, the development of the Islamic finance sector does pose new management and regulatory challenges. Islamic financing replaces conventional interest rates with the principle of profit and loss sharing by investors depositors. They gain a share of the profit or loss incurred through the bank’s use of their money.
But a working paper published by the IMF in November 2002 argued that, while this shifted credit risk from the bank to the depositor, it also added to the overall level of risk to which the bank’s balance sheet was exposed.
Another complication is posed by the drawn out nature of profit or loss. There is no exact timetable for repayment – and thus for deciding when default has occurred. A bank that provides funds to an entrepreneur on a profit-sharing basis must wait until the business client generates the profits or losses.
The Fund paper also pointed out that the vast growth of Islamic financing products was making it hard to standardise them. Implicitly, this adds to the workload facing supervisors.
Moreover, the bank has no legal control over the business management decisions taken by the entrepreneur.
The paper highlighted particular risks relating to Islamic “ijara” structures – equivalent to leasing – and purchase-with-deferred-delivery arrangements and noted that the development of hedging and inter-bank money markets had not evolved as far as that of the conventional financing equivalents.
Of course, many of these shortfalls in the depth of the Islamic financing market are likely to be filled as the global banking and investment groups strengthen their presence.
But the Fund paper also pointed out that regulation of Islamic finance varied from country to country and it argued that there was a “lack of an efficient and reliable Shariah litigation system to enforce financial contracts”.
In light of all these factors, the paper stressed the importance of Islamic banks developing their capital and reserves base to offset the risks.
It proposed the development of a new framework for Islamic banks’ management of risk and disclosure of information, based on the CAMELS (capital, assets, management, earnings, liquidity and sensitivity) model.
But governments of Middle Eastern and Asian countries where Islamic banking is now a major force had already begun to take action. In talks at the April 2002 IMF/World Bank spring meetings they decided to establish an Islamic Financial Services Board, based in Kuala Lumpur, to promote good regulation and uniform prudential standards.
The new Basel Capital Accord – when it is finally agreed – is also likely to incorporate risk measures better suited to the Islamic finance sector than existing regulatory standards.
Meanwhile, the credibility of Islamic finance as a tool for major business structures is steadily rising, and this has been particularly noticeable in the Gulf, where it has been used in infrastructure deals.
Kuwait Finance House and the Islamic Development Bank led a $55 million Islamic finance tranche for the $255 million Hidd power project in Bahrain. In the UAE, Islamic groups stepped into the breach when the 11 September confidence slump in 2001 threatened to leave funding for the $1.6 billion Shuweihat power project some $350 million short of target.
Islamic institutions, which felt more comfortable with Gulf political risk than some of the more nervous western banks, quickly agreed to provide the necessary resources.
Industry experts believe that in future, international power developers will routinely seek to include a substantial slice of Islamic funding in arrangements for new Middle Eastern projects.