Money and religion do not mix easily – on that both bankers and Islamic scholars tend to agree. But when the concept of Islamic finance can be made to work, the results can be spectacular. No area of banking has seen such rapid growth in the past 50 years, and the Middle East is well placed to capitalise on this sudden interest in the decades to come.
In March 2007, the first billion-dollar Islamic bonds were listed on the London Stock Exchange. The listing of the Aldar Properties and Dubai Islamic Bank sukuks was a clear indication of how far the Islamic finance industry has come in the past 30 years. The two new bond issues will send the value of global outstanding sukuks in excess of $70,000 million.
Fuelled by the phenomenal growth of the economies of the Gulf, modern Islamic finance has evolved into an industry that today represents a credible alternative to conventional methods of finance. Though born in the Middle East, the influence of sharia-compliant finance now extends far beyond the geographical boundaries of the region.
Sharia principles were first applied to financial practices in the 1960s. Mitghamr Saving Association was established in Egypt in 1963 and Tabung Hajj Malaysia came into being a year later. However, Mitghamr soon went out of business.
It seemed like a fad that had passed. It is no coincidence that the establishment of the first fully-fledged Islamic banks corresponded with the oil boom in the Gulf. An abundance of petrodollars has helped foster the development of Islamic financial services in two main phases. Both Dubai Islamic Bank and the Islamic Development Bank were set up in 1975. The first Islamic insurance (takaful) company was established in Sudan in 1979.
In the 1980s, Pakistan, Sudan and Iran announced the full Islamisation of their financial systems. Attempts to consolidate and regulate the industry followed. The Accounting & Auditing Organisation for Islamic Financial Institutions was established in 1990 and the increasing influence of sharia-compliant finance led Dow Jones and the Financial Times to launch the first Islamic indexes.
However, a true explosion in Islamic financial asset classes and institutions has only taken place in the past decade. Global Islamic assets are now estimated to be worth up to $400,000 million. But ratings agency Standard & Poor’s (S&P) says the potential market for Islamic finance is nearer $4 trillion. Judging by the growth rate of the industry, which has exceeded 20 per cent a year over the past 10 years, the opportunities are tremendous.
“The restrictive image of Islamic finance as limited to a particular religion and largely deployed in a certain geographical region is a thing of the past,” says Esam Janahi, chief executive officer and board member of Gulf Finance House (GFH). “The advantages and benefits of Islamic finance have spread far and wide to ensure its continued growth and acceptance.”
The factors driving the growth of the industry have changed over the years. “In the 1970s, the whole business was driven by supply,” says Anouar Hassoune, primary credit analyst at S&P. “The objective was to create an Islamic banking market. The banks had the mandate to reveal potential hidden demand. Now the picture has completely changed. The business model is driven by demand.”
This demand is largely a product of high liquidity in oil-exporting countries. Shifting cultural values have also played an important role, with sharia-compliant financial products seen as an ethical alternative to conventional finance.
“It is easier – for the same risk return characteristics – to sell investment vehicles in the Gulf if they are sharia-compliant,” says Hassoune.
Those seeking to tap liquidity in the Gulf are now using sharia-compliant structures to do so. In 2004, the German state of Saxony- Anhalt issued the first Islamic Eurobond. Japan and the UK are both now hoping to launch the first sovereign sukuk issued by a G7 member country.
Consolidation will be a dominant theme of the next decade. It is estimated there are more than 250 Islamic banks operating worldwide, but according to ratings agency Fitch only a few of these have more than $100 million in equity.
“There are too many small players,” says Wafik Grais, senior adviser at the World Bank’s financial sector network. “The industry needs a few bigger ones. These will have the resources to compete and develop products.”
The continued expansion of Islamic finance is contingent upon several factors.
A long-term decline in oil prices, for example, would make Islamic finance less attractive.
A lack of standardisation is another challenge facing Islamic finance. The Far East is generally more liberal in its interpretation of sharia than the Gulf. “What is sharia-compliant in Malaysia is not so in Saudi Arabia,” says Raymond Hill, corporate analyst at Fitch. “In order to create a single market, defining standards is fundamental.”
Without clear rules, product innovation also becomes tricky. New asset classes need to be developed to meet rising demand. “Islamic securitisation will most probably be the next step,” says Hassoune. “But there are so many technological constraints. For example, subordinated debt is not accepted.”
But there is also room to grow within existing frameworks. The bulk of the $60,000 million-70,000 million in global outstanding sukuks are over-the-counter instruments. Of those, only 20-25 per cent are listed and a secondary market is almost non-existent.
These developments will have far-reaching consequences. “It is indeed not a short-term change,” says GFH’s Janahi. “The reforms that are taking place and are being talked about in Islamic finance – like a broader standardisation of accounting and auditing practices, or the call to have a unified mechanism for interpreting sharia – do have a long-term and far-reaching character. In that sense, these reforms will herald a paradigm shift.”
Numerous financial centres are competing to become the hub for the expanding sharia-compliant industry. Dubai, Kuala Lumpur and Bahrain are all worthy candidates. “If Kuala Lumpur wants to become a financial centre beyond its borders, it needs to get in line with the Gulf,” says Hassoune. “Dubai has geography in its favour as well as the first-mover advantage.”
But London is making quick progress and is well-positioned to become a European hub for Islamic finance. The UK is expected to launch a sovereign sukuk soon. “London balances stability and market vibrancy,” says Grais. “It has an open-minded regulator and will not stifle development.”
The task for Gulf banking centres such as Dubai and Bahrain is to wrest this business back, and quickly. Islamic finance is just one of many areas in which regional banks are dabbling for the first time. However, its novelty is proving a huge draw for investors, and a huge test of banking systems in the Gulf.
If Middle East states are unable to secure a hold on sharia-compliant banking – a product so readily identified with the Muslim world – then it will not bode well for their status as international banking hubs in the decades to come.