With world markets suffering extreme turbulence in the wake of the credit crunch and subsequent banking crisis, it is an opportune time to examine the merits of an alternative banking model which adopts a different attitude to risk and finance, based on the principles of Sharia-law. Islamic Banking had grown substantially in the decade or so until the start of the present global economic turmoil; arguably, the events of the past few months will provide a spur to even further growth in the sector as non-Muslim bank customers opt for the relative safety of institutions based on the principles of Islam.
The impact of economic and demographic changes
In the past decade, the world’s economic centre of gravity has begun to increasingly tip in favour of developing economies such as China, India and the Gulf States, to the extent that leading multinationals such as GE and P&G expect more than half of their future growth to come from these emerging markets. Experts such as the leading fund manager, Antoine van Agtmael, have predicted that the combined Gross National Product of emerging markets will overtake that of developed economies within 30 years. Already these emergent economies hold 75% of the world’s foreign exchange reserves.
At the same time, there has been a demographic change, with an increase in the population in Muslim countries at the expense of developed markets where populations are stagnating or falling. There are now approximately 1.6 bn. Muslims worldwide, comprising 24% of the total world’s population.
These Muslim populations are increasingly looking for financing tools which comply with the tenets of Islamic (Sharia) law, while offering the flexibility and range of traditional banking products. Choosing Sharia-compliant products has become a means for many Muslims of asserting their Islamic identity.
Islamic Banking is not, however, necessarily confined only to Muslims. It has been recently argued that the tenets of Islamic Banking are applicable to a wider population, and that the principles offer safeguards that may counter the excesses which caused the sub-prime crisis and frauds perpetuated by rogue traders.
Islamic Finance is governed by Sharia (Islamic law), which is sourced from the Qur’an and Sunnah. The key tenet of Islamic financing is the prohibition of interest, Riba, the principle being that it is unacceptable to increase the value of any commodity merely by lending it to another person. Sharia law also prohibits Masir, which is involvement in speculation and gambling transactions, Gharar, which is uncertainty about the terms of contract or subject matter (prohibiting, for example, selling something which you do not own), and investing in businesses which are considered unlawful or undesirable e.g. alcohol, drugs, gambling, arms.
The dynamics of Islamic Finance
The recent rise of Islamic Finance has coincided with the record revenue generated from 5 years of high oil prices which has attracted funds into the Gulf States, prompting Muslim investors to pull money out of the US and developed markets and invest it within the region. At the same time, even for Muslims who are not particularly devout, using Sharia-compliant products has become a means of asserting their Islamic identity, and of enhancing their status in the local community.
Islamic Financing, however, is not confined to Islamic banks – non-Islamic banks can produce Islamic products, provided a Fatwa, a decree, is issued by a Sharia qualified scholar or board deeming that they are compliant. Western banks have thus enlisted respected Sharia scholars to review banking products, and issues Fatwas legitimising them. As a consequence, qualified Sharia scholars are in high demand, charging a substantial premium for their services.
This reliance on a few, highly-qualified Sharia scholars, is giving rise to concern at several levels. The paucity of qualified scholars means that they may divide their time among several banks, which may compromise their independence. The UK’s Financial Services Authority, for example, in November 2007, highlighted possible “significant” conflicts of interest in such concentration of expertise. At the same time, the lack of scholars is slowing down development of the industry, and raises questions about the ability of Sharia supervisory boards to provide enough challenge and supervision of banking products and services.
At a wider level there are issues of consistency and transparency, as there are differing interpretations of Sharia law and whether products and services are compliant. Malaysia has attempted to resolve this issue by adopting one set of rules for all Islamic banking products and services, but their lead has not yet been followed by other Muslim markets. More broadly, two international organisations, AAOIFI (Accounting and Auditing Organisation for Islamic Financial Institutions) and IFSB (Islamic Finance Standards Board) have been created to promote and enhance the soundness and stability of the Islamic financial services industry. However, at this stage, the regulatory environment for Islamic Finance remains relatively fragmented.
Islamic banking is now one of the world’s fastest-growing economic activities, comprising over 300 institutions in more than 75 countries. Currently a $400 bn. market, it is expected that it will grow to $4 tn. over the next 5 years (Torsten Hinrichs, Standard & Poor’s). While Islamic banking is concentrated in the Middle East and South-East Asia (with Bahrain and Malaysia representing the largest hubs), it is also starting to appear in Europe and the United States, in countries where there are large Muslim minority populations.
In all dimensions of financial services, Islamic financing is now prevalent, from debt and capital markets and insurance, to asset management and structured and project financing. Since its early evolution, the complexity of products offered has increased dramatically, starting with commercial banking in the 1970 through to the present day where a full range of banking and financial products is available.
There is considerable room for growth as well, particularly in Asia, where there are very large Muslim populations and low coverage by Islamic banks. In Indonesia, with a Muslim population of 195 million, only 1.2% of total banking assets are under Islamic Finance. India, Pakistan and Bangladesh have 439 million potential customers but less than 10% of the market in each case has been tapped into by the banks offering Sharia-compliant products. Even in the Middle East and North Africa, which may be regarded as the natural home for Islamic banking, the penetration by Islamic banking is still relatively small. The potential for development of the sector, is, therefore, very large, especially given the relative population growth of the Muslim world versus the global population.
To serve the growing market, financial institutions have developed a range of products catering for housing and consumer finance, business loans and infrastructure project funding. “Islamic equity” investment funds have been launched and both the Dow Jones and FTSE provide indices to monitor these funds. However, the major instruments utilised by Islamic banks still closely resemble conventional banking products. There is currently a relative lack of pure risk sharing instruments where gains and losses are shared equitably between investors and providers. This gap is expected to be addressed in the next generation of Sharia-compliant products.
For the past 30 years or more, financiers in the Muslim world have been trying to find ways of mixing Islamic laws with modern finance. These efforts started with the creation of so-called Islamic banks in countries such as Malaysia, Pakistan and Dubai, but have gradually expanded to include the creation of more complex and sophisticated products. These include Murabaha, where a financier buys a commodity and sells it to a purchaser at a higher price; Mudarabah which involves a bank providing funds to entrepreneurs who share the profits of any venture, without the entrepreneur being required to provide any capital; and Musharakah where a bank provides funding to entrepreneurs who contribute capital, with the profits from the venture shared.
The most common Islamic Finance products and their characteristics are outlined in Appendix A.
Islamic Banking and the Credit Crunch
The Islamic Banking model has developed on principles which, theoretically at least, are inherently less risky than the prevailing western alternatives. The current global economic crisis stemming from subprime mortgage debt write-downs is attributable to two main factors. The first was the relaxation of mortgage credit criteria in developed economies, such as the US, on the assumption that rising house prices would offer sufficient collateral against the lending risk. The second was the use of securisation to repackage these mortgage-based obligations into tradable financial products which diluted the underlying asset-backing. Once house prices began to stall, these financial securities became “toxic”, dragging down in their wake the banks with the greatest exposure to them. Banking instability and failure, in turn, led to a failure in confidence and a reluctance of banks to lend to each other, causing money markets to dry-up.
An Islamic Bank, theoretically at least, is less exposed to the type of lending and financing practices which are at the root of the present crisis. Because of the principle of Riba, Islamic banks do not borrow or lend on international money markets because interest is not allowed; traditionally they have a larger proportion of their assets in reserve accounts with central banks. Islamic banking is based on the principles of risk-sharing between depositor and investor – in theory, meaning that customers practice greater oversight of an Islamic bank’s lending performance than their Western banking counterparts. Sharia-law stipulates that Islamic securities should be asset-based, which means that a trader must own the asset being traded as opposed to the complex derivative products which have had such an adverse impact on Western banks. This, in turn, proscribes most forms of futures trading, as goods that the seller does not own or will not deliver cannot be the subject of an Islamic contract. Practices such as short-selling, consequently, are not a feature of Islamic Banking.
A note of caution, however, may be introduced at this point. Whilst the underlying precepts of Islamic Banking prohibit many of the practices which have imperiled Western banks, the efforts to offer an expanded range of Sharia-compliant offerings have led to the development of financial products which closely resemble more conventional financial instruments, such as Tawarruq and Sukuk, with exposure to the same type of risks, albeit not to the same degree. News may yet emerge in the coming months of an Islamic Bank suffering losses because of these new products.
The Saudi market
The Saudi banking system is by far the largest in the Middle East, with Saudi banks accounting for nearly 50% of all private sector deposits held by GCC, and 25% of all private sector deposits in Middle Eastern banks. Traditionally, the Saudi market was dominated by local banks offering the traditional range of Consumer and Investment banking products. However, the market for Islamic finance has taken off to the extent that now 64% of Saudi banking transactions are Islamic in nature.
In a parallel development, the Saudi government was forced to open up the banking and insurance sectors to foreign investors as a condition of WTO (World Trade Organisation) membership. Traditional Islamic banks, which had historically prospered due to the highly protected local market, now find themselves having to compete with new market entrants, hybrid banks offering a mixture of Islamic and conventional products. Generally more nimble, these banks tend to offer superior marketing and customer service skills. At the same time, banks such as HSBC and NCB (National Commercial Bank) have created Islamic-branded subsidiaries and networks in response to customer needs. As a result, customers no longer have to choose between Sharia-compliant banks and western levels of service. Faced with increasingly knowledgeable and demanding customers, a generic positioning as an Islamic bank is no longer sufficient.
Islamic Banking is increasingly starting to dominate the industry. Al Rajhi Bank, headquartered in Riyadh, for example, is not only vying with NCB to be the largest bank in the Saudi Arabia and the Middle East, but is the biggest Islamic bank in the world, with 100% of its products totally Sharia-compliant. It consciously promotes itself as an Islamic bank and, for the majority of its customers, this is a strong component of their loyalty and attachment to the bank. Not to be outdone, most of the other banks in Saudi Arabia now emphasise the Islamic nature of much of their products, even when conventional services are offered alongside the Sharia-compliant ones.
From a research perspective, financial institutions need to conduct the appropriate studies to evaluate the appeal of existing and new Islamic products in comparison with conventional products, and how best to communicate the functional as well as more emotive and intangible benefits of such products. This is emerging as one of the key research topics in the Gulf region, and is likely to become even stronger in the future.
For the research to be at its most effective, the researcher-consultant needs to combine in-depth knowledge of appropriate methodologies with a fundamental understanding of both the conventional banking sector and its Islamic variants.