July 04, 2007

ISLAMIC BANKING: AN EMERGING FINANCIAL MARKET

Over the past decade, the growth of the global Islamic finance industry has been impressive. At an estimated growth rate of 15%per annum, the industry currently owns assets of between US$200 billion and US$300 billion, which represent a small but growing share of the global banking industry. Islamic finance involves the provision of financial products and services that comply with Islamic laws, which are collectively referred to as Shariah. The underlying premise of this rapidly growing financial system is the absolute prohibition of payment or receipt of any predetermined, guaranteed interest or riba. Instead, the system is based on a profit and loss structure rather than a lender borrower arrangement. With a profit and loss structure, a financial institution enters into a joint venture with a client in order to provide capital. The risk associated with the joint venture entitles the financial institution to profit from the transaction. In this way, principles of Islamic doctrine regarding risk sharing, individual’s rights and duties, property rights and the sanctity of contracts are observed. Only those business activities that do not violate the rules of Shariah qualify for investment. For example any investment in businesses dealing with alcohol, gaming or pork products would be prohibited.

The system of Islamic finance is not limited to banking, but extends to capital formation, capital markets, and all types of financial intermediation. In practice, this form of finance is offered through two channels: Specialized Islamic banks and Islamic windows. Specialized Islamic banks are commercial and investment banks structured wholly on Islamic principles, dealing only in Islamic instruments. However, Islamic windows are unique facilities designed and offered by traditional banks to provide services to Muslims who wish to engage in Islamic banking.

Products & Services

The dominant instruments of Islamic finance include mark-up financing (murabaha), profit-sharing (mudaraba), leasing (ijara), and partnership or equity participation (musharaka). The Mudaraba and Musharaka modes are the main conduits for investment. The former has a maturity structure that ranges from short to medium term and is more suitable for trade activity, while the latter has been used for financing fixed assets and working capital of medium to long term duration. In practice however, Islamic banks tend to prefer less risky modes such as the ‘mark-up’ device (Murabaha). In a Murabaha transaction, the bank finances the purchase of a good or asset by buying it on behalf of its client and adding a mark-up before re-selling it to the client on a cost-plus basis, to be paid in monthly installments after a period of time. Islamic banks also frequently practice Leasing or ijara. With this mode of financing the banks would buy the equipment or machinery and lease it out to their clients who may opt to buy the items at some time in the future.

At the deposit end, Islamic banks normally operate three broad categories of accounts, mainly current, savings, and investment accounts. The current account, as in the case of conventional banks gives no return to the depositors. It is essentially a safe keeping arrangement between the depositors and the bank, which allows the depositors to withdraw their money at any time and permits the bank to use the depositors’ money.

The savings account is also operated on a safe keeping basis, but the bank may at its absolute discretion pay the depositor a positive return periodically, depending on its own profitability.

Current Global Trends

Apart from countries such as Iran, Pakistan, Egypt and Malaysia that are predominantly Muslim states, Islamic finance is becoming a growing phenomenon in the US and Europe. The burgeoning of Islamic finance in the latter regions is partly due to immigration, and Islam being one of the fastest growing religions in the world. In the US, using religious affiliation as a gauge for estimating demand, experts identify three levels of observance in the Muslim community. The first level represents the most observant, who do not use conventional financing. This group represents the core market for Islamic financing arrangements. The second third of Muslims consists of those who currently use conventional financing, but might switch to Islamic financing if it became more widely available. The final third consists of those who currently use conventional financing and may continue to do so even if religiously compliant alternatives were readily available.

A global market for Islamic bonds (Sukuks), which was only in its infancy a few years ago, has grown to the value of almost US$8 billion today. According to a survey released by the Islamic Finance Information Service, the Islamic bond market has more than tripled from US$1.9 billion in 2003 to US$6.7 billion in 2004. One of the significant catalysts driving the Islamic Bond market is the surplus earned from record high oil prices. Issues by both sovereigns and corporates have already reached $1.08 billion at the end of the first quarter of 2005.

It is estimated that the Shariah-compliant market, including sales of Islamic bonds and other financial instruments could provide interest free returns between $1.3 billion and $1.8 billion for 2005.

Challenges

The key challenge facing the future growth of Islamic finance is the structuring of products that not only conform to Islamic doctrine but also traditional banking regulations. The key issue for regulators is understanding the risks associated with Islamic banking products. Another significant issue is the lack of a secondary market for Islamic products, which often places liquidity constraints on the providers. This latter issue is being addressed through the securitization of assets, particularly real estate, leasing and trade receivables owing to the collateralized nature of their cash flows. A third important issue is the need for sound accounting procedures and standards for information disclosure, monitoring and building investor confidence. Finally, given the differences in interpretation of Islamic principles by different schools of thought, providers of Islamic finance have to form their own religious boards – “Shariah advisors” - for guidance, and consult them to seek approval for each new instrument and investment. This problem may result in the same instrument not being acceptable in all countries, or even by all Islamic groups within a country.

Outlook

Islamic financial products are fast becoming the darlings of the global banking industry, attracting Muslims and Non-Muslims due to risk sharing, ethical provisions and no-interest policies. Even if one does not subscribe to the Islamic injunction against the institution of interest, one may find in Islamic Banking some innovative ideas that could add value to the existing financial network and by extension one's portfolio.

The main selling point of Islamic Banking at least in theory, is unlike conventional banking, Islamic Banking is concerned about the viability of a project as opposed to the size of collateral. It is especially in this sense that Islamic Banks play a catalyst role in stimulating economic development.

Using the very rough gauge for projecting demand outlined above and estimates from the local Central Statistical Office, the potential core demand for Islamic finance in the local economy is approximately 0.2% of the population or roughly 25,000 clients. Institutions offering Islamic finance locally include Clico Investment Bank Limited (CIB) through its Islamic Banking Service (IBS) and the Muslim Credit Union. CIB has taken the lead among the conventional financial institutions in offering an array of Shariah-compliant innovative financing products and services to the local market. Also, as an alternative investment vehicle, the fund has been generating an annualized return of over 6% to its investors, a return that is on par with locally managed funds. Further growth of Islamic finance in the local market is anticipated as more Muslims and Non-Muslims are attracted to this alternative financing and investment vehicle.