Which way forward for Islamic finance?

[ILLUSTRATION OMITTED]

Showing spectacular growth alongside increasing diversity and depth, Islamic finance has undoubtedly been one of the great economic success stories of recent times. Starting in its modern form back in the early 1960s with a small, experimental savings bank in Lower Egypt, the sector is now a global industry with around $1.3 trillion under management.

Averaging 20% annual growth over the last few years, the sector has also weathered many global and regional economic meltdowns, from the Asian crisis of 1998 to the global crisis starting 10 years later.

Nowadays, too, Islamic financial institutions (IFIs) are a key part of financial markets not only in the Islamic world, but also in London, Singapore and beyond.

During this rapid evolution, two broad pillars of Islamic finance have also emerged. Firstly, there is the Gulf, with major Islamic finance sectors in Bahrain, Saudi Arabia, Qatar and Dubai.

Secondly, there is Southeast Asia, where Malaysia has become the world's largest issuer of Islamic bonds, known as sukuk. Meanwhile, Malaysia's neighbour, Indonesia--the world's largest Islamic country--is also now increasingly waking up to the benefits of interest-free banking, while Singapore vies with Kuala Lumpur to establish itself as the region's Islamic financial hub.

These factors have also underpinned a recent surge in interest in Southeast Asia amongst the Gulf's Islamic financial institutions, as Southeast Asian governments and financial authorities unveil increasingly attractive packages of incentives to entice them over. In tandem with this, while in the past, the two pillars were also known for differing approaches to Islamic finance--with the Gulf broadly seen as offering a stricter definition of shariah compliance--nowadays, there are signs of growing convergence between the two spheres. This phenomenon has left many Islamic finance experts in both regions now asking, where to next for the industry?

Roll up

For some years now, Malaysia has been making a major push into the world of Islamic finance, a move backed to the hilt by the Malaysian government. The sector has been a key part of national development plans for some years, a status boosted by the Financial Sector Blueprint of 2011-2020 and the Economic Transformation Programme.

Thanks in large part to this state nurturing, the Malaysian Islamic banking sector grew from just 6% of the country's total banking sector assets in 2001 to 22% ten years later. The new Blueprint seeks to consolidate this share, while also opening the sector to a series of mega-Islamic banks, with licenses now available for those willing to offer paid up capital 0f$1 billion or more. Three banks are reportedly applying for these, with all of them widely rumoured to be from the Gulf. According to the Malaysian central bank, this year should also see these licences finally issued.

These Gulf banks would not be alone, however. Kuwait Finance House, Bahrain's Bank Alkhair and Elaf Bank and Saudi Arabia's Al Rahji Bank are already amongst GCC outfits operating successfully in the Malaysian market. At the same time, Malaysia has also become the world's largest sukuk issuer, a status it looks likely to maintain for some time to come. Indeed, according to Zawya Sukuk Monitor data, the first quarter of 2012 saw a record $43 billion of sukuk issued worldwide, with around $30 billion of this launched in Malaysia. In 2011, the data showed 72% of global sukuk issued in the Southeast Asian state, compared to 22.5% in the Middle East and 2.9% in Indonesia. Behind this dominant position is a raft of tax incentives for those issuing sukuk in Malaysia, alongside a well-regulated shariah-compliant framework. GCC companies issuing sukuk are thus often to be found launching their bonds in Kuala Lumpur, rather than the Gulf or London.

Different strokes

One traditional barrier to many Islamic investors when looking at this Southeast Asian country, however, was the long-standing perception that the Malaysians had a more liberal view of shariah compliance than some were comfortable with.

Nowadays though, many are keen to play down these differences, while some Malaysian Islamic scholars suggest that in certain areas, Malaysia is in fact stricter than the Gulf.

One of the key differences is that Malaysia allows bai'inah, or sale followed by immediate repurchase of an asset. In Gulf countries, this is not permissible, as the intention of the sale is seen basically as a loan, the profit from repurchase as interest. Malaysian shariah compliance experts counter that the intention is immaterial, and thus bai'inah is lawful. A similar practice, bai' bithaman ajil, is also similarly viewed and disputed.

These days though, these types of contracts have largely been replaced by more sophisticated tawarruq, or commodity muhabara, contracts. These introduce a third party to the transaction, while also removing the repurchase obligation--changes introduced specifically to appeal to Gulf investors.

Malaysian scholars also counter that in terms of placements, they are much stricter than Middle Eastern Islamic financial institutions.

While most Gulf shariah compliance boards allow the placement of halal financial instruments with conventional banks, this is forbidden in Malaysia. The argument runs that such a placement risks contamination and comingling of halal and haram assets.

At the same time, historically, there have also been differences in approach and a general lack of standardisation between GCC countries, as well as between the Gulf and Southeast Asia.

This has been easing, however. The Gulf Bond and Sukuk Association agreed a set of standards for regional issuances in 2011, while the Thomson Reuters Islamic Interbank Benchmark Rate (IIBR) also launched that year, set a global shariah-compliant counterpart to LIBOR.

There is also the work of the Islamic Financial Services Board (IFSB), which issues guidelines for the banking, capital markets and takaful, or Islamic insurance, sectors. The Bahrain-based International Islamic Financial Markets (IIFM) is also working to develop global standards.

[ILLUSTRATION OMITTED]

The international tahawwut, or hedging, agreement of 2010 also moved Islamic and conventional financial products towards a common standard of contracts and shariah compliance.

The convergence illustrated by this agreement has also been advocated by Singapore in particular, with the FTSE SGX Asia 100 Shariah Index and the world's first shariah compliant Industrial Real Estate Investment Trust launched there in recent months.

[ILLUSTRATION OMITTED]

This integration proposes common standards across shariah-compliant and conventional financial products, a move welcomed by many financial sector institutions, as it makes for an easier cross-over between the two varieties of instruments, bringing Islamic products more into the mainstream.

Indeed, many Islamic finance sector players are anxious to stress that their products are not just for Muslims, with the majority of Malaysian-issued sukuk, for example, snapped up by non-Muslim traders in Hong Kong, Singapore and elsewhere.

Integration or divergence?

This development, however, also puts the spotlight on some long-standing issues in the sector. Central to this is what the relationship between Islamic finance and conventional finance should be. While some support further integration and convergence between the two, others back greater diversity and difference.

Indicative of the first approach, Ravi Menon, the Managing Director of the Monetary Authority of Singapore (MAS), said in his keynote speech at the World Islamic Banking Conference Asia in the Lion State in early June that, "Islamic finance must become more integrated with the global financial system ... As Islamic finance gains prominence, conventional financial institutions increasingly want to be involved to tap these opportunities."

Yet this integration poses significant concerns, as Islamic Development Bank President Ahmed Mohammed Ali Al Madani also said at the same conference. He warned that diversity must not be jeopardised in the pursuit of greater connectivity, "a challenge that needs responsible and ethical commitment".

Indeed, many Islamic scholars see great potential pitfalls in Islamic finance attempting merely to reproduce the same effects as conventional finance, except via more shariah-compliant methods.

"Do we want to just rework conventional financial products by finding a way that fits them in with Islamic contract law, or do we want Islamic finance to be something different and better?" as one senior Malaysian Islamic scholar put it to The Middle East magazine recently.

There are also concerns that attempts, in the wake of the global financial crisis, to create standards applicable to both conventional and Islamic financial institutions may be increasingly unworkable.

The current efforts to implement the Basel III banking regulations are a case in point. These apply to both Islamic and conventional banks and are aimed at boosting both the capital adequacy banks are obliged to keep, and their liquidity. Islamic banks have long held high capital adequacy ratios, so should have no problem with the first of these requirements. Yet the nature of Islamic banking--liquidity can only be transferred to and from shariah-compliant areas--can, in a crisis, pose additional strains on their liquidity.

It may therefore be that efforts to impose one-size-fits-all standards for conventional and Islamic products become increasingly difficult as the Islamic sector develops. This may not even be desirable for many Islamic scholars either, who see the goals of Islamic finance in quite different terms from conventional bankers.

Indeed, when the first modern Islamic bank set up in the Egyptian town of Mit Ghamr, back in the 1960s, it was a cooperative project designed to help local farmers fund development projects. Some now suggest that this developmental function should be the focus again, with Islamic finance becoming more concerned with the overall enhancement of Muslim countries, rather than of global financial product markets.

"Many of us want to move to the next level," the Malaysian Islamic scholar continued. "Though the question is, what is the next level?"

The debate looks set to continue for some time to come, as an increasingly mature Islamic finance sector asks itself some increasingly searching questions, both in Southeast Asia and the Gulf.

By Jon Gorvett in Kuala Lumpur