A positive counterweight

World finance is being transformed at an unprecedented pace. Rules and standards that were once de rigueur are being re-jigged with a view to avoiding the abuses that led to the global financial crisis. Conventional banking is eschewing riskier practices in a bid to restore confidence in banking practices and, in a way, has made Islamic finance as a platform for ethical banking more alluring. This may explain the amount of debate generated around the question whether Islamic finance can become a creative balancing force, a positive counterweight in global finance to conventional finance.

The value of global Shariah-compliant assets is estimated to be US$1 trillion. Forecasts hold out the possibility of a doubling in the next three to five years, according to Zeti Akhtar Aziz, governor of Bank Negara Malaysia.

Prospects seem brightest in the Middle East, Malaysia and Indonesia. Even non-Islamic jurisdictions, such as Hong Kong and Singapore, are looking to make their mark, especially on the wholesale side of the business. The number of purely Islamic banks is growing in Malaysia, Indonesia and the Middle East but a fair share of these opt to operate Islamic windows side by side with conventional banking operations – often using the same branches and banking platform – so as to save on operating costs.

Sheer demographics work in favour of Islamic finance. As of mid 2010, an estimated 1.57 billion Muslims – representing around 22% of humanity – live predominantly in Indonesia, Pakistan, Bangladesh, India, Egypt, Nigeria, Iran and Turkey. The world’s second largest religion is growing at 2.9% per year, faster than the 2.3% rate at which the global population grows. In other words, Islam is attracting a progressively larger percentage of humanity.

As the number of Muslims increases worldwide and the business expands in scale, the banks will likely grow more confident about setting up separate and unique platforms, catering to Islamic customers. In terms of funds, Saudi Arabia with a population of over 25 million is considered the largest player in the global Islamic finance market, even if its industry faces traditional bottlenecks, in addition to a scarcity of human capital and an underdeveloped market awareness among Muslims themselves.

Conducive regulations
Islamic finance does not only target the Muslim faithful. Banks in Malaysia report that a fair proportion of their customers are ethnic Chinese who have realized the value of business based on Islamic precepts, where risks and returns are shared rather than concentrated mostly on one side of the relationship. Only a handful of jurisdictions – Iran, Malaysia, Bahrain and Saudi Arabia – have so far been able to provide the conducive and robust regulatory framework required for the growth of Islamic finance. There is the recognition that it may take time before governments in other countries succeed in doing so.

Malaysia has been one of the most successful in this regard. Granted, it took a great deal of persuasive power by the Malaysian central bank before local players started buying into the idea of undertaking full scale Islamic banking and finance activity, and there is still much work to be done.

The development of the required legal infrastructure to facilitate Islamic finance is continuing, notes Bank Negara Malaysia deputy governor Dato’ Muhammad bin Ibrahim. He says it is part of an ongoing and dynamic process where they are constantly on the look-out to remove legal impediments to Islamic finance. “What lies ahead is to harmonize existing laws such that they accommodate and facilitate Islamic finance in the most legally efficient way possible.” These laws, he explains, are not confined to those under the financial services act, but to all Malaysian laws.

“As the future of Islamic finance depends on its agility and innovativeness in developing new products, our laws have to be facilitative and contemporary. Countries that intend to promote Islamic finance must have laws that are clear and easily enforceable. In this respect, having common laws, or a reference point for laws on Islamic finance, would serve to benefit the industry worldwide.”

Upholding Islamic financial contracts
One major issue for Islamic finance is whether it will be able to move to the next stage of its development and develop products that address the needs of its customers. The industry has, for the most part, been wary of changes that are perceived to diverge from the strict interpretation of the teachings of the Koran. The industry has witnessed a number of legal disputes involving Islamic financial transactions brought to Common Law courts for settlement.

As Muhammad highlighted in a speech at a recent Islamic finance conference, these recent cases have highlighted the hesitancy on the part of the Common Law judges to deliberate on issues concerning Shariah principles in Islamic finance transactions. “This is quite understandable given the lack of expertise on the matter. While evidence on Shariah matters can be admitted from subject matter experts, such evidence or advice is not binding.”

Muhammad believes that this was in evident contrast to the scenario in Malaysia where a dedicated High Court for Islamic finance related cases operates. “The judges refer to the Shariah Advisory Council (SAC) for questions or rulings relating to the Shariah and these rulings are binding. Malaysian courts, therefore, are well equipped to uphold the sanctity of the Islamic financial contracts as they have the avenue to make references. They have the capability to preside over such cases and give firm, consistent decisions with the backing of SAC rulings.”

As part of their collaborative effort to expand human capital development initiatives, Muhammad notes that measures are being implemented to ensure that players within the industry (including judges and lawyers) are trained in Islamic finance. “With the existence of a dedicated court, competent human capital and consistent legal precedents, our courts and arbitration centre are well qualified to serve as a platform for adjudication and dispute settlement.”

While the Islamic financial system, in Zeti Akhtar Aziz’s words, “does not exist in isolation and will continue to develop as an integral part of the global financial system”, it is equally not as vulnerable to the shocks that confront the real economy and “has weathered the global financial crisis well”, thus helping to shape a more mature view of the industry. Bankers says the recent global financial crisis showed that the industry’s crucible of strength lies in the quality of its assets. Unlike a slew of conventional banks, most Islamic banks had avoided the mistakes of investing in low-quality assets that suffered from a severe lack of transparency and ultimately lack of liquidity.

The road ahead
As advocates are careful to point out, this does not mean that the industry has yet achieved a high degree of transparency where it can afford to sit back and relax. In fact, a heightened vigilance is needed. This explains the steady stream of reminders from regulators of the need among industry players to tweak practices to address the lack of transparency and weak corporate governance. The experts are of the view that the industry needs more knowledgeable regulators and tougher regulations. In the Middle East, for instance, the industry should be moving to introduce greater transparency to profit-sharing investment accounts. Savers in these accounts tend to be less aggressive than shareholders, but ought to be better aware of what is happening.

Regulators have stressed that it does not suffice to take the model of conventional finance and apply Shariah rules. The process is more complex than that. The industry has to be proactive in launching sophisticated instruments that will provide it with enough depth of liquidity. At the same time, it matters a great deal how these accounts are structured. As one Bahrain central banker warned, there is always the danger that if one gets too close to conventional financial bonds, then you are no longer Shariah-compliant.

“Just as the health warnings on investment products constantly remind us, past performance is not necessarily a guide for the future,” Rasheed M Al Maraj, governor at the central bank of Bahrain, reminded a gathering of senior bankers and regulators.

“The industry should not extrapolate growth trends of the last five or ten years and use this as a guide for the future. The industry will only realize the predicted growth trends if it can properly address some fundamental issues, central to which are the business models of Islamic financial institutions.”


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