Shamshad Akhtar: Islamic finance - its sustainability and challenges
Closing keynote address by Dr Shamshad Akhtar, Governor of the State Bank of Pakistan, at
Georgetown University, Washington DC, 18 October 2007.
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Introduction
In the closing session for this event on Islamic Finance, I propose to reflect on the growth
and trends in Islamic Finance, its size and dimensions and prospects which are now evolving
from regional to global scale and impacting the private capital flows. The renewed interest
and hype in Islamic Finance is unprecedented. Since it coincides with commercial interest of
Western financial institutions to attract flows generated from oil revenues and other savings,
there is a degree of skepticism regarding sustainability of interest and trends in Islamic
Finance industry within and outside Muslim jurisdictions? Also there are concerns echoed on
whether the industry will persevere the competition from the global financial world nurtured
by the conventional system backed by strong legal, policy, regulatory and institutional
framework.
In my assessment, the Islamic Finance now seems to be a reality and is on its way to be
institutionalized, albeit at different levels in different countries, and the Western world is also
now selectively and cautiously positioning to invest in this system. There are promising signs
that Islamic Finance trends are sustainable. It is entrenched in a well conceptualized Islamic
economic system whose mysteries are being unfolded with renewed academic interest in the
subject. While undeniably faith driven, the Islamic finance system has great potential to meet
the financial gaps and requirements of development and society at large and as such its
demand would be robust going beyond religious grounds.
Islamic Finance has to be recognized as a parallel system which will augment and be
augmented by the deeper knowledge and experience of the conventional financial system.
As such, the key challenge going forward to its growth and sustainability would lie in how it
interfaces and benefits from complementing and supplementing the conventional system and
how it adapts and conforms to the international regulations and supervision adequately
refined in line with the technicalities and nuisances of the Islamic financial instruments and
their associated risks. Exploiting properly the unique features of Islamic finance with
appropriate adaptability, without compromising Shariah principles, will be critical to the
growth and promising future of Islamic industry.
Touching on some of these debates, I propose to first discuss the trends in Islamic Finance,
lay the case for sustainability of Islamic Finance and finally discuss some of the key
challenges facing the industry which the Islamic financial community at large is now trying to
address.
Global and regional growth and trends
Spread across 70 countries, Islamic Finance has grown to almost a $ trillion industry. Despite
its growth, given its current size and composition it is still a niche market in the overall global
financial industry. Prospect for the industry are quite bright given strong demand for financial
services from a large segment of about 1.4 billion Muslim populations and need to channel
effectively rising foreign savings and high net worth individuals.
The growth, level, interest and motivation to promote this industry vary across the globe. The
growth in Gulf Cooperation Council has been exceptional with Bahrian emerging as a main
centre adopting and implementing Islamic banking regulation, being the first central bank to
issue Sukuk and establishing centre for Islamic finance education, etc. Iran and Sudan
declared sometime back 100% conversion to Islamic banking. Within South East Asia,
Malaysia stands out with $31 billion Islamic banking assets, $1.7 billion Takaful industry and
has the largest Islamic private debt market which constitutes 45.5% of its total debt market.1
Other countries in South East Asia have smaller Islamic financial markets and Singapore has
positioned itself to offer strong wealth management potential. Within South Asia, Pakistan
stands out for its proactive and systematic stance to evolve Islamic finance industry. In all
these countries, assets of Islamic banking have grown faster than the overall banking assets
and scope and coverage of financial services has been extended to retail and consumer
finance, private equity, structured products, insurance and project finance etc.
Distinct from Islamic countries, is the interest of few global financial centers such as London
that now provide policy and tax incentives to promote Islamic finance industry to attract funds
from high net worth clients. Same motivation seems to have driven global banks such as
HSBC, Standard Chartered, Deutsche Bank, Citibank etc. to set up special hubs to structure
Islamic finance products.
In reality, while current hype in industry may be partially driven by availability of surpluses
generated by oil revenues, Islamic banking is emerging as an alternate financing option that
coexists alongside the conventional financial industry. Moving from traditional Islamic
products, now the industry is offering consumer financing for residential purposes and
structuring financing vehicles for supporting infrastructure and housing finance projects etc.
Product innovation is emerging with several different types of hybrid Sukuks and other
combination of structures which involve different forms of Musharikas with other products.
Notwithstanding these developments, increasing share of equity based credit products, such
as Murabaha and Ijara, remain the dominant form of Islamic financing across the Islamic
financing institution.
These trends are expected to persist and the industry is set to grow. Standard & Poor
Services Rating Agency estimates that industry has potential to grow to $4 trillion over
medium term.2 As highlighted above, the exceptional growth in Islamic Finance, particularly
since 2000, which has coincided with growth in oil revenues, has raised questions whether
interest in Islamic Finance is one time phenomena? And what the future prospects and
sustainability of the industry are?
While motivations and driving factors for this industry vary across the world, this round of
wave in Islamic finance industry is there to stay there. What lends one confidence is the large
investments by financial industry across main hubs in GCC/Middle East/South East and
South Asia, within countries and growing foreign ownership and joint ventures across
borders, in infrastructure development in this industry through:
(i) issuance of holistic banking licenses or opening of special windows or creation of
hubs/dedicated Islamic asset management funds, private equity funds and hedge
funds etc. accompanied by Dow Islamic Index to which all such transactions
subscribe too are large;
(ii) development of Shariah knowledge and understanding and engagement of Shariah
advisors and scholars which together are providing required consensus, guidance
and legitimacy to Islamic industry, products and structures; and
(iii) development of Islamic standard setters such as the Islamic Financial Supervisory
Board and Accounting and Auditing Organization for Islamic Financial Institutions
(AAOIFI) and International Islamic Financial Market (IIFM) etc. by the central banks
as well as a range of Multilateral Development Agencies including the Islamic Bank
Development. The combined efforts have helped develop and initiate
implementation of Islamic prudential regulatory, accounting and auditing
frameworks, and inspection and supervision of financial institutions;
All these regional and global efforts are serious long term initiatives which are irreversible
though maintaining and building momentum on these fronts would be critical to address the
questions of sustainability and challenges facing this industry.
Sustainability and challenges of Islamic finance
Prospects for sustainability of Islamic finance appear promising, but there are associated
challenges which need to be concurrently addressed while one exploits and maximizes the
opportunities created by this discipline.
First, the sustainability of Islamic finance stems from recognition that Islamic economic and
financial architecture has a lot of appeal and depth going beyond Muslim countries. While
initially conceived to be solely anchored on Riba free interest rate regime, there is now
appreciation that advocacy to move to Islamic business and finance structure - whether on
religious or social grounds - is not a "slogan" or mere religious pronunciation or
condemnation of Riba but is supported by a complete and deep Islamic ideology. When
studied carefully, it has its logic and basis in a comprehensive Islamic economic system
which deals with allocation of resources, production and exchange of goods and services
and distribution of wealth - all too familiar debates in conventional economic textbooks.
Second, the confidence in sustainability of Islamic economic system emerges from the better
understanding that this economic system is a well conceptualized, consistent and integrated
framework. More interestingly, it is accompanied by a rich and an elaborate set of tenets
which, among others, recognize the right to property supported by elaborate obligations for
stakeholders, principles and rules of conduct, a contract system and institutional framework
and procedures for enforcement of rules which all together lay the foundation for Islamic
business and financial architecture. It is this substantive Islamic ideological and legal
framework, governed by Shariah injunctions and principles that have translated into defining
the public and private economic and social affairs that eventually help frame the business
and financial relations. The core of these relationships is backed by solid principles of
contracts, rights and obligations of parties to the contractual arrangements.
Third, the sustainability of this system is reinforced by the business and financial relations
that are guided by the logically defined emphasis on the preferred modes of transaction
which advocates profit sharing and as such relies on "ex-post" variability rather "than ex ante"
fixity in returns and consequently has built in risk sharing as a central element of
transactions. Relevance of contracts is at the core of Islamic transactions which define the
rules of game for sale and purchase/trade/exchange of goods and services. Financing
contracts are than structured around the nature of transaction which could be either in the
form of trade financing; asset based financing or different forms of partnerships. Under
Islamic finance preference is given to trading of physical assets as well as trading of rights.
Fourth, the confidence in sustainability emerges from the framework of enforcement implicit
in Islamic system. The main driver of enforcement of contracts and rules-compliance in
Islamic system is ideology and faith which is in turn influenced by Islam's emphasis on
establishing an equitable, ethical, just, and fair socio-economic system. It is this feature
which shapes up Islamic finance and also distinguishes it from the conventional finance.
Although one can argue that sustainability of interest in Islamic Finance is tied solely to the
response of Muslim population to their religious values and beliefs, but it has to be
recognized that attraction in this discipline is now widely emerging as there is better
understanding of Islamic economics and finance and mechanisms are being found to
juxtapose the knowledge of conventional economics and financial engineering.
Fifth, flexibility and innovation to structure different types of financial products which augur
well for Islamic Finance's sustainability. What distinguishes Islamic finance is its emphasis on
trading of goods and services and its advocacy for profit and risk sharing in businesses
supported by a variety of partnership arrangements - this is in sharp contrast to loan based
financing in conventional banks. By virtue of these characteristics Islamic finance offers
prudent financing options being asset backed or equity based; particularly linkage of assets
with financing ensures that transaction is less prone to debt crisis and funds are used for
their prescribed purpose minimizing defaults resulting from improper use of borrowed funds.
Concurrently it offers promising potential for offering alternate avenues for saving and
investment for all segments of population.
Sixth, market surveys confirm that the potential for retail, housing and project finance3 and
innovation emerging in these markets is significant and augurs well for economic and
financial services development. Islamic banks have registered double digit growth in retail
markets. Penetration has occurred faster where personal banking solutions have been
structured well and where information technology is used to offer online, ATMs and
telephone banking services. By and large products are structured on murabaha principles
where funds are allocated for particular projects or finance an asset (such as home
ownership and automobiles) in which depositor shares in the project rather than bank profits
and to structure ijara (leasing) with appropriate asset backing and legal structures.
Islamic housing finance for acquisition and other purposes has evolved to be a natural and
promising market to cater for huge home financing demand in Muslim countries. This market
is gaining momentum following some interesting facilitation/incentives offered by some
countries: for instance US has facilitated Islamic lease-to-own relationship by allowing bank
to take title to property and in the UK Bank of England abolished double stamp duty on
Islamic mortgages, ijarah and murabaha transactions, and rationalized of legal service fees
and risk weightage etc. and Australia and Canada allowed adoption of declining balance
partnership concepts to facilitate structuring Diminishing Musharaka contract etc.
In some jurisdictions momentum for tapping retail market has been accelerated by partial or
full conversion of conventional to Islamic banks such as Saudi Arabia - challenges of which
cannot be underestimated as it involves converting the loan book to Shariah compliant
modes of product. Stand alone Islamic banks have a challenging task of competing with the
conventional players who have an edge of longevity and customer loyalty and economies of
scale. High level of customer service, offering full product range, introducing a level of
transparency in transactions, devising unsecured personal loan products (a wave emerging
with adoption of tawarruq product), introducing Shariah compliant credit cards, handling
properly the unfunded businesses and improving efficiencies are some of responses to
challenge of competition.
Large scale business opportunities however lie in exploiting project finance. Successful
application and integration of Islamic instruments with the conventional financing has helped
in this area while facilitating closure of large and complex multisource financing deals.
Project financing, backed by asset and equity and structured using combination of Ijara,
Istisna,, Sukuk and Musharika etc. has offered opportunities for risk diversification, avenues
for resource mobilization and revenue sharing and performance of services between
contractual parties. These deals have illustrated how conventional and Islamic financing can
blend and coexist under common legal and regulatory arrangements.
Finally, more than conventional finance, Islamic finance emphasizes just and equitable
financial system. Among others, Islamic finance offers a financial inclusive option to Muslim
who have excluded themselves from financial services in absence of riba free services.4
Since a number of Muslim countries suffer from low financial services penetration, bringing in
the appeal of Shariah compliant financing mechanism could turn out to be a powerful tool for
enhancing access to development finance and empowering the poor and vulnerable groups.
It is important to recognize that Islamic finance confines itself to largely socially and
development projects and institutions are not permitted to invest in prohibited or socially
undesirable investments. Emphasis on ethical issues and rigorous self-regulation in terms of
Shariah supervision ensures fair play and justice and offers superior consumer protection
model. Furthermore it induces higher financial discipline and places stringent ethical
standards for all stakeholders that offers a strong and unique model of governance.
Conclusion
In conclusion, encouraging developments and trends in Islamic Finance lend confidence that
this industry has taken off. However, there are varying motivation and driving factors for the
development of this industry ranging from religious fervor to the opportunities that exist in
Islamic finance for broadening and deepening the process of financial intermediation which
augurs well for financial innovation and engineering, enhancing the financial services
penetration in national jurisdictions and for cross border capital flows. While the size of
Islamic financial industry is still quite small as a proportion of the total world's financial
assets, the current growth trends and the investments in infrastructure in development of its
Islamic Finance networks and its regulatory and supervisory systems, lend confidence that
this industry has promising potential.
Prospects for this industry appear comforting because of variety of factors - most significant
being the strengths of Islamic ideology and economic system which offer a complete
framework for the Islamic finance industry. Islamic financial system lays down rules of
conduct and contractual arrangements, and offers feasible financing structure which
emphasize trade and equity financing that together will help the much needed financial
diversification in Islamic countries.
Islamic finance also has potential to blend economic and social objectives and address the
ethical aspects of financing effectively. As such it is generally more acceptable in populations
with moderate to strong inclinations toward managing their financial relationships in line with
their beliefs. This can thus help in poverty alleviation through inclusion of a larger proportion
of population into the banking system giving them access to credit and mobilizing their
savings effectively.
The emerging solutions and application to structure Islamic finance innovatively have helped
cater for all types of markets and financing requirements ranging from retail to project and
home financing to equity funds and products and insurance. Industry effort to benchmark
pricing and apply legal, regulatory service standards at par with conventional products and
standards has also helped encouraged confidence in the system.
Going forward, the sustainability of Islamic Finance would rest in how the international
community builds on the momentum achieved thus far. This would require
(i) Further deepening the efforts to enhance the legal and regulatory framework of
Islamic finance consistent with the international practices.
(ii) Continued strive to conform and align the structures and products in line with the
Shariah principles would help Muslim population's motivation to turn to this
alternative mechanism of financing, while attracting others to product and risk
management and mitigation innovation and additional option that this window offers.
(iii) Recognizing that Islamic finance has perpetuated and changed the dynamics of
cross border private capital flow, this industry has great potential to augment the
process of globalization and financial integration, but this requires more cooperation
and vigilance on the part of home and host regulators.
(iv) Launching aggressive efforts to implement the evolving Islamic financial regulatory
and supervisory standards and capturing the different types of risks associated with
Islamic finance, while launching consumer protection frameworks.
(v) Promoting more financial diversification by encouraging financial innovation and
Islamic capital market development.