The pace at which Islamic finance is developing is nothing short of remarkable. Only a few years ago, it was regarded as a niche form of ethical investment. Today, Islamic financial institutions are entering the mainstream as they innovate with new products and embark on a path of internationalisation.

Estimated to have been growing at 15-20 per cent annually over the past few years, the global Islamic finance industry is today valued at $700bn. Over the next five years, the value of the industry is tipped to grow to a massive $4 trillion, according to the 2008 Notable Trends in Global Islamic Finance report from ratings agency Moody’s Investors Service.

With the Gulf awash with petrodollar-fuelled liquidity, there is sustained demand for existing sharia-compliant products as well as a growing appetite for new ones. “A booming and profitable market naturally attracts entrants because excess demand needs to meet additional supply,” says Anouar Hassoune, analyst at Moody’s.

Globally, sharia-compliant banks, takaful (Islamic insurance) companies and sharia-compliant mutual funds number 300, with new entrants arriving thick and fast, many of which have been created by governments. Established in the past few years, Saudi Arabia’s Alinma Bank, Qatar’s Masref Al-Rayan and Noor Islamic Bank in Dubai all have their governments as shareholders.

This trend hints at the concerns governments have over the dominance of the private sector, which Hassoune says are just.

“The main risk that any Islamic financial institution, and the industry at large, faces is reputational risk, he says. “If governments have an increasing share of ownership in Islamic financial institutions, the risks of consumers perceiving them as insufficiently sharia-compliant is mitigated.”

With the boom in infrastructure projects across the Middle East and North Africa (Mena) region, state support of Islamic finance makes sound economic sense as it falls in line with the principle of asset-backed project finance. The value of the project finance market has now topped $1.6 trillion in the Gulf and could represent up to 30 per cent of all major structured deals finalised in the region by 2012.

However, cashing in on the Islamic finance boom is not the exclusive preserve of Islamic banks. They are teaming up with larger, conventional institutions to manage the scale of funding required for the biggest projects, allowing mainstream banks to get a slice of the market.

UK market

Beyond the Gulf, UK government support has further helped to drive the growth of the industry. Now the main Islamic finance centre outside the Muslim world, the UK has shown considerable foresight in creating an environment in which it can flourish.

In 2003, UK laws were altered so house buyers using a sharia-compliant mortgage pay the same property tax as those using a traditional home loan. Subsequently, the value of the UK Islamic mortgage market has grown to $900m, increasing by 50 per cent between 2006 and 2007.

In 2005 and 2006, changes to UK taxation created a level playing field for savings products using mudaraba (trust financing) and wakala (agency contract) structures, as well as asset finance through murabaha (sale at pre-determined mark-up).

The 2007 budget introduced new measures enabling sukuk to be held and traded in the same way as corporate bonds.

Meanwhile, in July last year, the UK government carried out an impact assessment of sukuk (Islamic bond) legislation, setting itself the goal of issuing a debut UK sovereign sukuk in 2009.

The UK is also leading the way in other Islamic financial practices. According to a report published in May by industry group International Financial Services London (IFSL), the UK is the only Western country among the top 15 in a global ranking of sharia-compliant assets by country, ranking ninth with $10bn.

The UK now has 23 conventional banks providing Islamic products, more than the rest of Western Europe combined, and is home to Europe’s only standalone Islamic institutions.In 2004, Islamic Bank of Britain became the first sharia-compliant bank in the Western world. It is now a well-established retail bank with more than 40,000 customers and more than $250m in customer savings. Since then, the European Islamic Investment Bank and the Bank of London & the Middle East (BLME) have been established.

Since it received its banking licence from the financial services authority in July last year, BLME has completed a variety of deals resulting in total assets of £297m ($523m). “The oil-rich GCC states have foreign assets of approximately $1.6 trillion, and now that there is a credible choice of international Islamic banks, they are starting to migrate some of those assets to banks such as ours,” says Humphrey Percy, chief executive officer (CEO) of BLME.

Compared with the Gulf, Islamic banks in London offer Arab investors access to much larger and more mature equity, bond, foreign exchange and commodity markets, as well as a much deeper pool of expertise in research and delivery.

London is also pioneering in-country training for the industry. The Securities & Investment Institute now offers an Islamic finance qualification that is globally recognised and the Chartered Institute of Management Accountants’ certificate in Islamic finance is the first offered by a professional chartered accountancy body.

The US is the only other Western country that has a sizeable offering of Islamic banks, with about 20 institutions, but to date these have been focused on domestic retail operations rather than large transactions.

French finance

By contrast, France, which is home to more than 5 million Muslims, the largest Islamic com-munity in the Western world, has only four conventional banks offering Islamic products.

French financial thinktank Paris Europlace recently conducted a study to identify which tax laws and legal frameworks are holding Islamic financial institutions back from doing business in France.“French law does in fact appear to be sufficiently flexible and open - give or take a few adjustments - to accommodate Islamic financial principles and products without any major upheaval,” says Hassoune, who believes the necessary adjustments would not be dissimilar to those made by the UK for fiscal normalisation of Islamic transactions.

There is some movement on Islamic finance in France, despite the apparent need for legal reforms. Official applications for the licensing of foreign Islamic banks are about to be submitted to the French authorities, while a note from the French Financial Markets Authority (AMF) in July 2007 welcomed the marketing of Islamic funds. Meanwhile, a few months ago, a subsidiary of French bank Societe Generale launched a sharia-compliant investment fund in the French territory of Reunion.

However, critics claim that the industry will not make any real headway until the state provides visible support - most notably, by issuing sovereign sukuk. This would also send out a clear signal that France intends to compete with London as an Islamic financial centre outside the Middle East.

“This would be a salutary move in a number of ways,” says Hassoune, “It would capture some of the Arab countries’ abundant liquidity and constitute competition with the UK.”

So while these satellite Islamic financial centres are emerging, there is not yet any significant threat to the Gulf, specifically Bahrain and Dubai, as the global home for Islamic finance. Bahrain still has more Islamic finance institutions than anywhere else in the Mena region and, crucially, as home to the Accounting & Auditing Organisation for Islamic Financial Institutions (AAOIFI), is still considered the standard bearer for all Islamic rulings.

Set up in 1991, the AAOIFI has issued up to 70 standards on accounting and auditing, as well as codes of ethics and sharia standards that have been implemented across a wide geographical area - Singapore, Malaysia, the GCC, as well as Lebanon, Jordan, Syria, Sudan and South Africa.

Bahrain has led the field in pioneering the development of sharia-compliant finance. In 2001, it became the first to market prudential information and regulatory framework (Piri) regulations specific to the Islamic banking industry, and later that year became the first to develop and issue sukuk products. In 2005, Bahrain created the first regulatory framework specific to takaful and re-takaful companies.

“There is a real need for transparent and fixed standards to help provide the security and stability that has ensured the growth and continued success of the conventional banking sector,” Sheikh Mohammed bin Essa al-Khalifa, CEO of Bahrain’s Economic Development Board, told the inaugural Euro World Islamic banking conference in London in July. “We are still feeling our way in terms of global standards in regulation, documentation and corporate governance.”

Achieving global standardisation looks set to remain a key challenge in an industry where sharia law is subject to interpretation by scholars. However, it seems likely that as Islamic finance grows, there will be a greater consensus and convergence towards a set of principles, simply because operational efficiency cannot be achieved without a degree of homogeneity.

The increasing number of indices measuring the performance of sharia-compliant stocks is already helping to make the industry more structured and transparent.

There are now four key players globally offering sharia-compliant indices. Dow Jones was first in 1998 and today tracks the largest number of indices, followed by Standard & Poor’s (S&P), which in April this year introduced a sharia scorecard that reviews the performance of its indices on a quarterly basis. London’s FTSE also has a small offering and Morgan Stanley Capital International launched a few months back.

In the past few years, the commercial applications of sharia equity indices have started to become more sophisticated - for example, through the emergence of exchange-traded funds (ETFs). Although still on a relatively small scale, the Singapore stock exchange and the Dubai International Financial Exchange have been fairly aggressive in promoting the launch of some region-specific ETFs based on sharia indices. Other innovative products, such as Islamic certificates, have also been listed for trading on exchanges.

“One big area that remains untapped is the creation of futures and options based on sharia indices,” says Alka Banerjee, global product manager of S&P’s sharia indices. “Derivatives trading itself is forbidden under sharia law because you are just trading on a promise - there is no physical asset - and this immediately reduces liquidity on the exchange. Consequently, scholars are looking at creative ways of finding alternative instruments that can drive liquidity.”

Indeed, while sharia equity indices are rapidly gaining critical mass - S&P now has sharia indices for 12,000 stocks in 52 countries - their active trade levels are still considerably lower than conventional exchanges. However, given that modern Islamic banking only dates back 30 years to when the first fully-fledged Islamic financial institutions emerged, it is only natural that there is room for growth and increased sophistication.

While Islamic products and services have been proliferating at an incredible pace, increasingly following a path of international-isation, they are not yet a global phenomenon. But the number of newcomers to the sector is helping to change that. Armed with large capital bases from the outset, these newcomers are exploring uncharted territory.

Their ambitions extend beyond the borders of their domestic markets to countries where Islamic finance is still a fledgling industry. With so many new institutions emerging and the sector still in its infancy, the industry remains fragmented, with weakly co-ordinated local operations, and experts are predicting inevitable market consolidation.

“The industry is witnessing a phenomenon somewhat similar to the initial days of the dotcom boom - the existence and exuberance of too many players,” says Banerjee. “This will necessarily be followed by a period of consolidation and standardisation.”

Despite the flourishing of new establishments, a dearth of sharia-compliant products and a pressing demand for services remains a key impediment to the industry’s growth.

Promising outlook

Catering to the changing needs and increased sophistication of clients is another concern. “People are ready and waiting for the industry to innovate,” says Al-Khalifa.

Broadly speaking, the outlook for the industry remains promising. The fact that Western economies are suffering liquidity shortages as a result of irresponsible lending provides a boost to the Islamic finance industry, which forces banks to act more responsibly by forbidding them to charge interest and stipulating that all deals must be based on tangible assets.

There are now 1 billion Muslims around the world and many are showing a preference for Islamic investments. The global sukuk market alone is expected to expand to $200bn by 2010, from $120bn today. Meanwhile, the global takaful market is growing faster than the sector as a whole, at 25 per cent a year, and is forecast to reach a value of $14bn by 2010, up from $4-5bn today, according to HSBC.

Non-Muslims are also driving growth. HSBC says that up to 50 per cent of its sukuk offering has been bought by non-Muslim investors - a clear indication that the market’s potential for growth is, as yet, unquantifiable.

So long as oil remains expensive, the Islamic finance industry will keep on growing apace. The risk absorber provided by this stream of reliable and continued income gives institutions the confidence to be bullish about expanding their product offering and moving into new markets. The result of this will be the mainstreaming of Islamic finance, as the world catches on to the opportunities offered by this booming sector.

Key fact

$900m - The value of the UK Islamic mortgage market