Shamshad Akhtar: Islamic finance - growth, competitiveness and
sustainability
Speech by Dr Shamshad Akhtar, Governor of the State Bank of Pakistan, at the 14th: World
Islamic Banking Conference, Bahrain, 9-10 December 2007.
* * *
1. Islamic finance has received overwhelming response from across the world as one
discovers its ideological and practical richness and relevance. Growth in Islamic finance
industry has however triggered a number of debates regarding the challenges this industry
faces. These debates essentially revolve around whether Islamic finance is progressing well
and is it there to stay? Is Islamic finance going to be a niche market or does it have global
appeal? What are key drivers for enhancing the efficiency and competitiveness of Islamic
finance industry which would in turn help broaden its appeal and in turn enhance its
sustainability? In my brief remarks I will touch on these debates.
2. Despite transitory challenges - typical of a new and emerging industry, my view is that
prospects for growth of Islamic finance are promising but rests on building an effective
system for Islamic finance.1 Growing interest has led to rising investments in Islamic finance
and resulted in phenomenal growth in Islamic finance businesses. Interest in this discipline
has already extended beyond Muslim and Islamic countries to non-Muslim population and
jurisdictions and non-Islamic financial institutions. The avoidance of forbidden investments
("haram" products) and interest rates and speculative structures prohibited in Islamic
jurisprudence and Islamic finance's emphasis on just and equitable financial system offers
distinct appeal for Muslims to be attracted to this option. Appeal of Shariah compliant
financing mechanism is also likely to be a powerful tool for enhancing access to development
finance and empowering the poor and vulnerable groups, particularly if Islamic banks extend
their reach in rural areas which are currently not effectively served by conventional system.
3. Irrespective of religious appeal and affiliations, consumers would be eventually
attracted to Islamic finance if it positions itself to offer an efficient and competitive alternate
avenue of financial intermediation which caters to all segments of population and economy
and services retail and personal banking and project finance. This can happen only if key
messages and principles of Islamic finance are flexibly, constructively and innovatively
interpreted, its conceptual framework further developed, nurtured and translated effectively
into practical applications, and work is launched to better develop interface and linkages
between Islamic and conventional finance and unleash the synergies to advantage of global
financial development.
Drivers for enhancing efficiency and competitiveness
4. Few key drivers for enhancing efficiency and competitiveness of Islamic Finance
include:
(i) Financial engineering and innovation.
(ii) Global financial centers and their regulators support for Islamic finance industry.
(iii) Standard governance and prudential regulation and supervisory guidance which
require tweaking regulations to properly identify and assign proper weights for new
and different types of risks associated with the special and unique characteristic of
Islamic finance business.
(iv) Development and adoption of simple and standard and cost effective legal
frameworks for contracts associated with the new and hybrid products.
(v) Flexible and practical application and enforcement of Shariah principles and
injunctions and its acceptability by public.
5. Taking up these items, first it has to be emphasized that financial engineering and
innovation is one of the most potent tools of Islamic finance and will be the key driver
to attracting global economic and financial player's interest which will be critical for
competitiveness and sustainability of Islamic finance. Increasingly Scholars, academics
and practitioners have worked with global banks to offer wide range of wholesale, retail and
trade financing banking solutions. For instance:
(i) Vanilla Sukuks are now being compliment by range of hybrid Sukuks: Sukuk -Ijara,
Sukuk-Musharaka, Sukuk-Moharba and so and so forth - as per IMF recent study
there are today over twenty odd different variants of Sukuk.
(ii) Islamic derivative market now offers Islamic equivalent of interest rate swap/option
called profit rate swap/option and Islamic cross currency and FX swap and options.
This is appreciable development given that Shariah compliant transaction has to
fulfill existence of underlying real assets and generally it does not approve of
uncertainty (jahala) and speculation or undue risk taking (Gharar).
(iii) Private equity has already structural compatibility with Islamic financing, although it
has to be deployed for Shariah eligible uses.
(iv) Personal banking solutions are now being floated saving and investment account
and information technology is used to offer online, ATMs and telephone banking
services.
(v) 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.
(vi) In some cases there is move into bancassurance through establishment of
associated Takaful institution and appending insurance sweetener is also a wave,
though slow to take off.
6. There is scope for deepening financial engineering and innovation and exploiting its
edge to promote equity based financing or structure hybrid debt: equity instruments. This will
allow Islamic banks to offer richer and multiple options to customer, while allowing banks
opportunities for proper fund mobilization and asset diversification. It will allow avenues for
proper diversification and integration of financial services and pooling of risks through
blending of Islamic and conventional financing to epitomize risk sharing between
stakeholders and align rewards to be consistent with the risks.
7. Second driving factor would be global financial centers and their regulators
support for Islamic finance industry. Currently wave of interest in Islamic finance is
fascinating and has helped attract global banks in Asia and Europe to use their skills to
augment the application of Islamic finance principles. As expected the approach and level of
enthusiasm and pro-activism has varied in Western world. I would like to highlight the
emerging approach of United Kingdom which has set on course a conducive and practical
approach for development of Islamic finance which I would advocate other developed
jurisdictions can pursue. U.K aims to strike a balance whereby FSA's recent paper2
highlighted that it has adopted "no obstacle and no favors" policy for Islamic finance.
Recognizing its secular framework, U.K has been upfront, practical and candid requiring
financial institutions to find mechanisms for conforming to FSA basic regulatory framework,
while being open to be accommodative in interpretation of its rules and regulations. To
conform to FSA requirements, Islamic financial institutions have to ensure structures evolved
are in compliance with FSA requirements. Meanwhile, U.K provides the necessary flexibility
and the required relief to its regulation on case to case basis. Equally supportive has been
U.K rationalization of multiple taxes applicable in purchase and sale of properties to facilitate
Sukuks and Islamic mortgages.
8. Third critical driver of Islamic finance is the efforts being launched by central
banks to reach understanding on banking regulation and supervision. Broad
understanding has now evolved that financial institution have to conform to standard financial
regulation and supervision requirements applicable to conventional banks. There has been
steady progress to improvise and modify regulatory framework to recognize the safeguards
required for risks associated with Islamic banking solution and the required capital treatment
for special and unique characteristics of Islamic finance business. The differences in the
assets and liability structure in Islamic finance and the complexities associated with different
Islamic products, however, tend to alter the risk perception associated with this financial
system.
9. As such, work of IFSB and industry continues to be critical to evolve better
understanding of different risks and how to cushion for such risks. Ensuring harmonization
and consistent adoption, application and implementation of these evolving standards for
Islamic finance and products will be a challenge but absolutely required to avoid regulatory
arbitrage by industry and certain Islamic jurisdictions. Potential for such distortions will be
inevitable as Islamic prudential regulatory and capital adequacy standards require more
guidance and awareness. Furthermore, in line with the spirit of Bank International Settlement
subscribed regulatory standards, IFSB standards are also for voluntary, rather than
compulsory compliance. While this would result in differences in timing of adoption of such
standards by Islamic industry, it is expected that with growing awareness market and
investors will be factoring in differences in compliance in their choice of institutions.
10.
Fourth critical driver of Islamic finance would be development and adoption of
simple and standard legal frameworks. Contracts are at the core of Islamic transactions
which define the rules for sale and purchase/trade/exchange of goods and services.
Contracts are 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 and with
the growing hybrid products the demands for legal documentation has multiplied and is
adding to the cost of transaction. Certainty of contract is another important element under
Islamic contract law. The body of Islamic Contract Law while rich and supportive of
participant's right in transaction is onerous, complex and prone to different interpretations
and rulings. Equally challenging are questions of enforceability of terms and conditions and
lack of ability of courts to arbitrate litigation in case of dispute on contracts.
11. Fifth, it has to be recognized that Islamic finance is in its evolutionary stage and
its sustainability would depend critically on regulators work with Islamic Scholars to
reach flexible and shared, if not unified, understandings on principle elements at
international level, despite differences in faiths and disciplines. There are number of
faiths and disciplines across Muslim jurisdictions (for e.g. Syria and Pakistan are
predominantly Hanafi school, Bahrain, Dubai and Abu Dhabi pursues Maliki school, Saudi
Arabia and Qatar relies on Hanbali school). Rather than pursue harmonized views, each faith
developing its own applications adds to the cost of transaction, introduces doubts on viability
of Islamic finance given the split opinions, and confuses the public that basically relies on
Scholars endorsement of products and business. These differences along with different
interpretations of Shariah Scholars at the Boards or as advisors within the banks, if
significant, further carry the risk of Sharia arbitrage which carries complications for
regulators. Reaching consensus and shared/harmonized guidance among Scholars of
different beliefs and faiths and evolving more unified institutional mechanism for adoption of
common Shariah standards and ensuring proper enforcement through effective internal
controls for their compliance would let the industry grow and compete on level playing field.
Flexible and simpler interpretation of the basic tenets at the level of Scholars would enhance
public acceptability.
12. Finally, keeping these macro considerations aside, Islamic banks being late starters do
face a real challenge of competing with a well established conventional industry.
Furthermore, full-fledged Islamic banks as per their licensing requirements have to confine
themselves to Islamic businesses and products, while conventional banks with Islamic
windows have inherent advantage as they can compete more aggressively offering both
conventional and Islamic businesses. Different approaches to licensing are debated to have
implications for competitiveness of industry whereby there is an argument put forward that in
interest of fostering healthier competitions banks should be allowed to choose what they offer
without imposition of licensing policy constraints.3 To propel Islamic industry allowing
dedicated Islamic banks is a well accepted course as long as regulators do not shield or
provide preferential treatment to these institutions but creates a level playing field in
regulatory and supervisory oversight.
Next stage of development
13. Competitiveness of Islamic finance in future would depend on how Government and
regulators perceive and nurture future development of Islamic finance and address the
issues highlighted above and develop institutional, regulatory and supervisory frameworks
and their effective enforcement. In the next stage of Islamic finance development, there is
need for more substantive work on Islamic finance in the areas of:
(i) Standardization of contracts and documentation which would reduce transaction
costs and risks of litigation.
(ii) Development of dispute resolution mechanism for Sharia compliance matters as
regulators will not be in a position to resolve these.
(iii) Proper implementation of evolving guidance of regulatory standards for special
features of Islamic without comprising international standards to which both Islamic
and conventional banks are to be subject too.
(iv) Development of more interfaces between regulators - so far there seems to have
been more systematic alliance between central banks to coordinate standard setting
and its compliance. There is however need for better coordination between bank
and non bank regulators and also for later to launch more initiatives to nurture
nonbank Islamic sector.