Islamic finance in numbers
$10m: Amount raised by IIT in the UK’s first sukuk
£1bn: Rumoured size of a planned sukuk issue by the UK government
$2.8 trillion: Projected asset value of the Islamic finance industry by 2015
Sources: MEED; Islamic Financial Services Board
A small technology company in the northeast of England is an unusual place for a finance revolution to start. Particularly one related to the complex world of Islamic banking.
The deal to raise $10m for International Innovative Technologies (IIT) in August through a sukuk (Islamic bond) was a landmark transaction, despite its small size. It was the first ever sukuk raised by a company in the UK.
Regulatory environment for sukuk
Its significance stretches well beyond its value and serves as the real beginning of the battle to attract Islamic finance business away from its traditional heartlands of the Gulf and Malaysia. The transaction serves as proof that sukuk can be done in London, and that regulatory changes over the past few years have opened the door for further issuance.
The GCC remains the engine room for Islamic finance, and I don’t expect that to change
Nadim Khan, Herbert Smith
The path to this particular deal has been a long one, with many disappointments along the way. The UK government has been looking at the possibility of issuing a sovereign sukuk for the past five years, gradually tweaking regulations and tax rules, only to establish the regulatory environment that allowed IIT to get there first.
In 2008, the UK Treasury published the results of a consultation paper on sovereign issuance of sharia-compliant debt. It was expected to be followed by a government issuance that was rumoured to be more than £1bn ($1.58bn). That has never occurred, in part because attentions have instead had to focus on the financial crisis and the change in the UK leadership in mid-2010. The new government, in place since May, is expected to look again at the sovereign sukuk, but has so far been concentrating on more pressing issues.
There is probably only room for one really strong Islamic centre serving Europe
UK-based Islamic finance lawyer
France has also noticed the opportunities in attracting Islamic banking to its financial centre in Paris. Politicians, regulators and the promoters of the Paris financial district have spent the past few years trying to set the framework for Islamic finance in the country. Finance Minister Christine Lagarde has talked about making Paris “the capital for Islamic finance”.
|Geographic breakdown of Islamic finance*|
|Banking, takaful & fund assets, end-2008|
Bankers and lawyers in Paris say that although the government has often talked of becoming a European centre for Islamic finance, and several have had discussions with regulators and policymakers about the issue, little action has been seen on the ground so far.
It is no surprise that Western politicians are keen to explore the potential for Islamic finance. It is already a $1 trillion industry and US ratings agency Moody’s Investors Service estimates it has the potential to become a $5 trillion market. By 2015, Kuala Lumpur-based Islamic Financial Services Board expects the number to be about $2.8 trillion.
|Global Assets of Islamic Finance ($bn)|
Problems in the global financial system have also helped shift attention towards Islamic banking, which is designed to eschew interest and speculative behaviour, focusing instead on profit and loss sharing and investing in real assets. Advocates say the recent problems in the global banking sector could be avoided through sharia structures.
Participation banks or Islamic banks
Beyond Paris and London, Turkey has also spotted an opportunity in Islamic finance. Turkey’s secular constitution limits sharia banking activities. Islamic banks there are instead called “participation banks”. Semantics has not prevented the growth of the industry, however.
Several participation banks have been established in Turkey and there has been a few sharia-complaint financings already this year. These include a $100m sukuk issued by Kuveyt Turk Katilim Bankasi, part of Kuwait Finance House. It was the first Islamic bond to be issued in Turkey.
|Western & offshore Islamic Banks|
|Sources: The Banker; IFSL|
So far, the UK is widely considered to be in the lead in creating the legal environment to foster the development of Islamic finance. If a sovereign sukuk were to be issued by the UK government, it would be a clear statement of commitment to the promotion of Islamic finance. It would also prove to be a vital tool for other parts of the Islamic finance industry.
The lack of highly rated, liquid assets to invest in presents the takaful (Islamic insurance) market with a serious problem. Sukuk issues from the UK, or other AAA-rated sovereigns, are vital for the proper management of assets in the insurance industry.
Key to enabling Islamic finance to develop in new places is addressing taxation regulations, which often end up taxing Islamic finance deals twice.
The UK has already tackled the issue, Paris is lagging behind. Plans for a French sukuk are also languishing.
Whoever manages to issue the first European sovereign sukuk will have a significant lead on becoming the hub for the region. “There has always been a lot of Middle East investment activity into Europe,” says an Islamic finance lawyer in the UK.
“But there is probably only room for one really strong Islamic centre serving Europe, so being first to establish a legal framework and to prove it works by issuing a sovereign sukuk will be really important.”
Western hubs for Islamic finance
London and Paris are unlikely to be able to wrestle Islamic finance away from the Gulf or Malaysia, but they are in competition to be the main hub in the mature financial markets of the West.
The US has so far shown little interest in vying for Islamic finance, although Canada has shown some interest in issuing a sovereign sukuk.
It is not just Europe and North America that are looking at Islamic finance. African nations are also eyeing the market, and given its 490 million Muslim population, it has the potential to be a significant one.
Egypt, Algeria, Tunisia, Sengal, Gambia and Djibouti have already set up Islamic financial institutions, and several countries are looking at issuing sukuk. Nonetheless, Africa’s importance in Islamic finance beyond its own borders is likely to be limited as its population is largely poor and under-banked.
The strong regulatory environment of London and Paris may help them emerge as hubs of wider importance to the global Islamic finance industry by attracting international firms that want to tap Islamic investors, but are nervous about financial centres of which they have little experience.
“Centres like London have a vibrant debt capital market and proven legal infrastructure, which places like Dubai struggle to compete with,” says the UK-based lawyer. “So for an international corporate, that wants to get access to an emerging market investor base, that is an attractive option.”
Getting a new investor base is also attractive for the UK and France, both of which have racked up large government debts during the financial crisis and could use sukuk issues as a way of raising new cash from a different set of investors.
Although a UK sovereign sukuk would attract a lot of investment from the established Islamic finance centres, it would be difficult to change the industry’s centre of gravity.
“The GCC remains the engine room for Islamic finance, and I don’t expect that to change,” says Nadim Khan, partner at UK law firm Herbert Smith in Dubai. “There is still a tremendous demand for investment in infrastructure in the GCC and Far East and a lot of that will be Islamically structured.”
At present, Malaysia is the global hub by asset values. Islamic banks in the UAE hold assets worth around $65.8bn, while in Bahrain their assets total about $26bn. The two countries respectively represent 16 per cent and 11 per cent of global Islamic banking assets.
Several international issuers are also choosing the Gulf as the place to launch sukuk deals. General Electric, Nomura and the International Finance Corporation, part of the Washington-headquartered World Bank, have issued sukuk that were based in the GCC. Those deals were intended to help the companies again access to a different investor base.
Growth drivers for Islamic finance
For Islamic finance to develop in new regions, the main drivers of growth will be domestic firms looking to attract Muslim investors, or Middle East investors looking to buy Western assets in a sharia-compliant way.
Regulatory arbitrage, with issuers looking for either the best regulatory environment, or easiest to comply with, is expected to be limited.
That does not mean the growth prospects are limited. With more than 14 million Muslims in Europe, not including the potential 72 million in Turkey, there is plenty of room for growth, especially in the retail market, where penetration is so far low.
With a large and growing Muslim population spread across the world, it seems likely that in time several Islamic finance hubs will develop. The GCC and Malaysia will probably remain the largest centres of the industry, but the development of new hubs in Europe, North America and Africa is almost certain. First mover advantage will be key for each of those cities trying to capture the Islamic finance market.
Fortunately, the growing number of countries looking at Islamic finance are not wrestling over a shrinking industry.
“If you look at the growth in the past 10 years, and the demand for different types of products, there is room for several centres focused on different types of Islamic finance products,” says Khan.
As competition intensifies in regions such as Europe, North Africa, and even the Gulf, finding particular areas of expertise will be essential.