Rise of Islamic Banking Assets, Coverage and Sophistication

The scope of Islamic banking has grown beyond all recognition since the establishment of the first Islamic Development Bank in the 1970s. This article discusses how the Islamic finance sector has been able to increase its profile around the world through increasingly sophisticated products.

Islamic banking is designed around the prohibition of usury and unearned profits, and is born out of strong religious views. As such, it outlaws any services based around the charging of interest, as well as activities such as gambling and trading in forbidden goods such as alcohol.

The origins of a uniform approach to Islamic banking can be traced back to localised activities in the 1960s and 1970s, with experimental projects such as informal profit-sharing savings institutions in Egypt, and Hajj savings programmes in Malaysia. Subsequently, a model for modern financing was first formed in 1973, when the Conference of Finance Ministers of Muslim Countries issued a Declaration of Intent to establish the first Islamic Development Bank (IDB), which was opened in 1975. The purpose of the IDB is to foster the economic development and social progress of member countries and Muslim communities individually, as well as jointly in accordance with the principles of Islamic law. The 1980s saw the increasing adoption of more formal approaches and transitions to a Sharia-compliant model. Pakistan was one leader of this, adopting a policy in 1979 to transform the country's banking operations over a three year period. Iran was another leader, passing a law for usury-free banking in 1983 that required banks to convert all deposits and operations in line with Sharia.

Striving for Global Convergence

At the Islamic Banking and Finance Conference in Washington DC in 2002, it was estimated that there are some US$300bn assets in Islamic banking, and it is largely accepted that this market is set to grow. In addition to this dollar amount, there are additional assets in conventional banking that will be transferred to Islamic banking as well as an indefinable amount of assets that are yet to be banked. This, along with the appearance of an increasing number of small, dedicated Islamic banking institutions has attracted global conventional banks to also offer Sharia-compliant products.

As a result, a key theme in today's Islamic banking market is the challenge to continue to transform the industry so that it can synthesise Islamic products and banking processes with some of the more recent innovations in Western banking in an appropriate way.

Filling the Regulatory Void in the Middle East

Regulation has played an important role in defining the current Islamic banking landscape. Today, there is still no structured regulatory view for the market. While the market is founded upon strong religious principles and some theoretical texts exist to guide financial activities, there is no governing body, which limits the growth of the market, particularly in the Middle East where it originated.

Instead of a governing body, each Islamic bank in the Middle East has its own Sharia Board. This board oversees the development and implementation of Sharia-compliant banking services and ensures that they are carried out in strict compliance with Islamic banking principles. It also has the authority to issue opinions and rulings on the bank's proposed activities. This model has led to the issue of non-standardisation between banks in relation to various common banking services. For example, if a bank wished to invest monies in the stock market, it could do so only by investing in Islamic companies and in compliance with Sharia-law, as regulated by the Sharia Board. The lack of a standard, detailed definition of permitted companies means that it is hard to compare one bank's offering in this area with another's. This lack of commonly understood permitted activities and investment definitions means there is less transparency of products and services to actual and prospective customers.

While the number of Sharia Boards continues to grow in line with the market, they are unlikely to appear at a central banking level and therefore will continue to offer only a fragmented and micro-level solution to the regulation issue. However, there have been some moves to adopt a national approach. In Pakistan, the State Bank has an Islamic Banking Department that aims to make Islamic Banking the first choice for providers and users of banking services. This department was founded in 2003, and is working to improve Sharia compliance, risk management and prudential management. This approach brings Pakistani Islamic Banking regulation more in line with conventional banking, and draws some parallels with other regulatory issues such as Basel II.

The Westernised Approach

While this addresses the landscape in predominantly Muslim regions, developments in predominantly non-Muslim countries have differed. In the UK, for example, there have been some early experiments, such as Al-Barakah, a London-based deposit-taking institution and, more recently, the Islamic Bank of Great Britain. The history of Dallah Al-Barakah is instructive in that its operations were found to be incompatible with the then existing Bank of England's regulations. Due to the inherent nature of its Sharia-compliant operations, it could not guarantee the return of deposits. This was a pre-requisite for the licensed deposit taking regulatory status at that time. This highlighted the fact that Western regulatory regimes would need to adapt their view of banking.

Also in the UK, the Chancellor of the Exchequer, Gordon Brown, acknowledged the significance of this important market by changing legislation to enable future growth. In Islamic banking, instead of loaning the money on an interest-based repayment scheme, the bank buys the property and then re-sells it to the purchaser. Instead of repaying a loan or mortgage, the purchaser pays a form of rent to the bank and at the end of the agreed term makes a final payment and takes over the ownership of the property. As the bank is forbidden to charge interest, it instead charges a management fee so is still able to make profit. As this includes two changes of ownership, under UK law this requires the two separate payments of stamp duty. In September 2002, Gordon Brown introduced new legislation that waived stamp duty on a second change of ownership, accommodating the Sharia-compliant approach to mortgages.

So while Islamic banking in the West might be constrained by Western banking practices, there are clear signs that the market is beginning to address the requirements and create a clearer path for growth. Today there are a number of examples of firms that are addressing the needs of Muslim communities in predominantly non-Muslim countries. These include the Islamic Bank International of Denmark, founded in 1982, and Islamic Banking System International Holding, founded in 1978 in Luxembourg.

As a result of national changes in regulation and the success of the smaller institutions, the path is clear for the larger conventional banks to also join the market. Global Westernised banks, such as HSBC, now also offer Islamic banking activities.

As more banks offer the services, the approach has become in some ways more distant from its religious foundation and more akin to conventional banking, with established Western firms offering Sharia-compliant products. And as the market, along with the number of players, grows, the approach becomes more product-orientated, with services such as trade finance and property finance becoming particularly prominent. This also extends to particular regions such as Asia, where there is a trend for greater product innovation, with the arrival of new services and twists on old ones.

Future Challenges

A future challenge from a business perspective is the inherent lack of flexibility and liquidity in the Islamic banking market as it currently operates. This results largely from the prohibition of usury-based activities stemming from the lending and borrowing of monies on the capital markets. Western style banks use the capital markets not just for speculative trading purposes, but also to allow them to cover funding and liquidity gaps. These markets give a degree of flexibility and financial agility to their participants that do not currently exist in the Islamic banking sector. This not only creates potential economic inefficiencies in the sector, but also raises the possibility of the failure of an institution for liquidity reasons. This is a challenge that the industry is keen to overcome in order for the market to truly flourish, both at a local level and in relation to the global banks.

There are now interest-free debt instruments known as Sukooks, but the market in them is not yet sufficiently liquid or deep for them to fully realise this role. An alternative solution to liquidity constraints would involve the creation of Islamic versions of the lender of last resort role often operated by central banks or other monetary authorities. Although this would reassure potential depositors in Islamic banks as to the likelihood of the bank continuing to operate, this only forms a safety net in the case of failure rather than as a mechanism to stop the failure from occurring in the first place. More attractive is the creation of an Islamic banking equivalent to the capital markets, by allowing banks to trade between each other to cover operational liquidity and other constraints in the short term. According to the Financial Times on 2 October 2006, Swiss investment bank UBS will launch an instrument that claims to be the world's first Sharia-compliant investment product linked to commodity prices, demonstrating the growing levels of product innovation in the industry. This is just one example of the growing innovation of products in the sector; which is of particular note in South East Asian countries.

The Islamic Development Bank could step in to either or both of these roles. It has helped the market from time to time by financing projects in less well-developed states and acted as an inter-governmental bank, so is potentially well-positioned to help to shoulder this responsibility.

While customers feel religiously compelled to use Islamic banking, their confidence in particular institutions is likely to dictate some of the growth patterns. Most dedicated Islamic banking institutions are small, so do not really mirror a typical, conventional Western bank. There are exceptions, such as the Dubai Islamic Bank, the world's first fully-fledged Islamic bank that has assets of US$15bn, as well as assets under management in funds and other collective investment and financing scheme considerably exceeding this. The bank now possesses A and A1 ratings from Standard and Poor's. And while it is unlikely that institutions in the Middle East will be allowed to fail, in predominantly non-Muslim countries it is less certain. As such, consumer confidence could well favour the more established firms, leaving the smaller dedicated banks behind.

As the market seems set for substantial growth, the industry now has to step up to the challenge of ensuring the products can meet the demand, while adhering to the laws of Islam. There will inevitably be risks along the way, such as the possibility of large-scale failures. However, once these are avoided and firms, along with national governments, demonstrate a coherent, stable and innovative approach, the path will be clear for the market to reach its true potential.

By: Nicholas Brewer, Temenos