The global Islamic finance and banking industry has been growing at twice the rate of conventional markets, driven largely by expansions in Malaysia and the Middle East. Assets in the sector are estimated to reach $2trn by 2015, up from $1.6trn in 2012. With Muslims representing a quarter of the world’s population, and an increasing number of conventional finance investors seeking ethical and uncomplicated instruments following the 2008 financial crisis, the potential for growth is widely regarded to be immense.
Still, despite the positive prospects, HSBC announced last year it will stop offering Islamic products in many of its markets while in 2011, Goldman Sachs was caught in a debate on the level of Shariah-compliance of its $2bn Islamic bond. Limited market intermediaries and the requirement for the input of a small number of academics and religious scholars further complicates product offerings and adds to issuance costs, leading to the criticism that investors in Shariah products pay “more for less.”
‘Irrationality’ hurts growth
Badlisyah Abdul Ghani, the chief executive officer of Malaysia’s CIMB Islamic Bank, says “irrationality” in Shariah beliefs has curtailed growth. While the industry remained plagued by a lack of uniform standards and regulations, a dearth of talents and limited product offerings, it has gained greater acceptance internationally. As the asset class moved beyond the traditional markets of the Gulf Cooperation Council (GCC) States and Southeast Asia, the issues confronting the sector have become more intricate as stakes rise, potentially adding to trading risks.
“Islamic finance has expanded to become significantly more globalised. This has resulted in the domestic Islamic financial systems becoming more inter-connected, with the consequence that integrated risks are more rapidly transmitted across the financial system,” Zeti Akhtar Aziz, Governor of Bank Negara, Malaysia’s central bank, says at the second edition book launch of “Islamic Finance: The New Regulatory Challenge.”
She adds: “Of priority will be efforts to strengthen the cross-border regulatory and supervisory cooperation arrangements in the relevant jurisdictions and to strengthen further the international financial infrastructure for Islamic finance.”
Further complicating efforts on standardisation and regulation is a lack of consensus regarding the interpretation and application of Shariah principles, resulting in products and transactions that are valid in one country or region but not another.
The standard-setting bodies of the Islamic Financial Services Board (IFSB) and the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) have so far played key roles in the growth of the industry. However, at the conferences held this year in Malaysia and Singapore, participants and speakers say more needs to be done.
“It does need to be recognised though, when you look at the international financial architecture sitting under the Financial Stability Board (FSB), neither the ISFB nor AAOIFO are yet members of the FSB, which is acting as the agent of the G20 and driving the international regulatory agenda,” says Ian Johnston, the chief executive of the Dubai Financial Services Authority. “The standard-setters which do sit in the FSB are not specifically addressing Islamic finance.”
“Although the involvement of the IMF and Basel committees under the recent IFSB welcome group, looking at the core standards and principles is most welcomed, I do think that more needs to be done to try to help us integrate this work and for the standards to be complementary between the conventional and the Islamic finance standard-setting body,” says Johnston.
He urged IFSB to take a more active role because standards originating from the FSB could force “Islamic finance into a more conventional mould.”
“There is a point that as the markets open up that as an industry we could do a far better job embracing our governments and regulators,” says Shayne Nelson, the chairman of Standard Chartered Saadiq Islamic Banking. “I don’t think as an industry we do a great job getting together, approaching governments and regulators, as they open up Islamic business, to make sure that we get them onto a level playing field that we are all happy with.”
The $25bn debt restructuring of Dubai World, the sovereign investment fund of the Dubai royal family, that shook investor confidence in 2009, underscores the importance of structure and legal clarity. The main concern was the delay in the repayment of a $4bn sukuk, or Islamic bond, of Dubai World’s property developer Nakheel. The issuance of the Nakheel sukuk was based on the ijarah contract, which is comparable to a conventional lease-and-lease-back transaction between the party who is in need of financing (the originator) and a special purpose vehicle (SPV), according to reports.
Sukuk investors are paid the cashflows generated by specific assets, which are put into a SPV as part of the deal. Many assumed that the bonds were “asset-backed,” giving them a claim on the assets in the event of a default. However, the majority of sukuk structures are cashflow-based, which hands sukuk holders ownership of the cashflow not the assets. While the Dubai debt crisis stemmed from crashing property prices, it raised concerns about the Ijarah structure and the lack of legal clarity as to the ownership of the underlying asset.
The emirate, which was on the brink of a default that year, was rescued by a $20bn loan from the United Arab Emirates central bank and the Abu Dhabi government and two years later Dubai World agreed with about 80 lenders to delay repayments.
Imaginative solutions needed
Following the introduction of Basel III, Islamic as well as conventional banks will be required to meet higher standards of liquidity, both short term and long term. There are two main issues for Islamic firms in managing their own liquidity, especially in the short term. One is a lack of a developed money market, and especially an interbank market that is similar to those in conventional finance; the other is a shortage of short term, or highly tradable, investment instruments with limited capital risk. Conventional banking instruments for liquidity management are interest based and therefore are not Shariah compliant. Bank Negara’s Aziz too acknowledges that a “significant regulatory challenge” remains in terms of having efficient cross-border liquidity risk management in the Islamic financial system, due to the lack of short-term Shariah compliant instruments in international currencies.
In 2010, the industry set up the Islamic Liquidity Management Corporation that has put in place a mechanism that will facilitate effective liquidity through the periodic issuance of short-term Shariah compliant financial instruments. However, new products and solutions are needed for the development of the Islamic inter-bank market. As one expert says, “This is an area in which imaginative solutions are needed.”
As the industry taps experts from conventional markets to help with product development, structure and guidelines, there are also growing concerns that in practice, Islamic financial instruments are increasingly deviating from religious principles.
“Sukuk is the most prominent instrument and it is already subject to some kind of distortion and deviation from its true nature,” says one conference participant “It has become a fixed income instrument rather than a risk-sharing instrument.”
A case well-known in the market is Goldman Sachs’ controversial $2bn sukuk programme after several Islamic scholars said it was not Shariah-compliant. Reportedly, at least three of the eight scholars quoted in Goldman’s provisional prospectus as endorsing the transaction said they had never seen the document.
For a product to be Shariah-compliant, it has to be approved by religious scholars, preferably those well-known in the industry. As a result, banks compete to appoint the most famous and established Shariah scholars to their boards to increase their Islamic credibility and reduce the chances that their boards’ verdicts will be challenged. According to research, the top 10 scholars in the world make up 40% of all board memberships, sharing 450 board positions between them.
The IFSB recognised the industry’s reliance on a limited number of scholars. “With the top 50 scholars in the boards of more than 70% of Islamic financial institutions, it is clear that there is a serious concentration risk,” Sheikh Abdulla Saoud Al-Thani, Governor of Qatar Central Bank and the Chairman of the IFSB, told a conference.
Another issue confronting the industry is the cost of finance. The cost of running sukuk is as much as 60% higher than conventional bonds, which is curtailing the industry’s growth. The reasons cited for the higher costs include a lack of liquidity, additional legal and structuring charges. The higher costs mean that Islamic banks haven’t been consistently profitable.
Future global growth of the sukuk market, in our opinion, depends directly on greater liquidity and better price formation, says Standard and Poors. “Liquidity is tight because the market is still small and viewed as an alternative asset class.”
This situation is improving as larger and more frequent issues come to market, and as sukuk gain greater acceptance as a mainstream debt instrument, it adds. Global sukuk issuance expanded for the fourth year in a row in 2012, growing 64% to about $138bn, according to the rating agency. New sukuk issuance worldwide could exceed $100bn this year, according to Standard and Poors’ base-case scenario.
Largely dominating issuance are sovereign and sovereign-related issuers from Malaysia, and, to a lesser extent, from the countries of the GCC, comprising Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates.
“From a sovereign perspective, Islamic bonds can give governments access to a new investor class by diversifying sources of fiscal funding,” says the rating agency. “They can also help to cover external financing needs and support reserve building.”
Another emerging trend is the emergence of the Malaysian ringgit as the currency of choice as the number of cross border transactions pick up and the Asian and GCC sukuk markets becoming more interdependent. The ringgit is becoming a growing, credible alternative to the U.S. dollar for non-Malaysian issuers. Interestingly, issuance in the Malaysian currency by all issuers–domestic and foreign combined–actually exceeded those by Malaysian entities for the first time in 2012.
As Islamic finance gained prominence and market share, competition intensifies. Annual growth of the sector’s AUM in Malaysia and the Middle East has exceeded 20% in the last five years. Dubai in January unveiled its plan to become the “global capital” of the Islamic economy. The wide-ranging initiative will include a Shariah council to oversee standards in Islamic finance, an arbitration centre to resolve disputes in Islamic contracts, and a drive to boost production of halal food within Dubai.
To further develop its Islamic finance industry, the Malaysian government introduced the Islamic Financial Services Act 2013 (IFSA) which came into force on 30 June 2013. The new law provides for greater clarity on the legal and prudential requirements underpinned by Shariah principles which enable Islamic financial industry players to align their practices and expertise accordingly when undertaking Islamic financial business and transactions, according to a government statement.
Bank Negara has also introduced the Financial Sector Blueprint, which runs up until 2020, by which time it envisions greater participation from the Malaysian financial sector to further expand the internationalisation of Islamic finance.
According to the Global Islamic Finance Forum’s Islamic Finance Centres Competitive Review 2012 - a survey on the competiveness of different countries within the Islamic finance space - Malaysia takes a clear lead in all areas, including regulation, products, services and infrastructure. The survey also showed that some of the niche markets of Hong Kong, Australia, China and Japan have shown promising interest in Islamic finance, indicating future growth momentum. By 2050, it is expected that about 30% of the world population will be Muslim.
Besides corporate finance, the growing pool of pilgrims’ fund and Zakat will require Shariah-compliant products. The Hajj (the pilgrimage to Mecca at least once in a lifetime) and Zakat (alms or charitable giving) are two of the five pillars of Islam, or the five basic acts of Islam.