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Islamic finance

Date 29/10/2008

Duncan McKenzie, Director of Economics, International Financial Services London (IFSL)

Islamic finance has been developed in its modern form over the past three decades, although its key principles remain unchanged. A number of countries including Malaysia, Iran, Saudi Arabia and the Gulf states have led the way in these developments. More recently, London has been keen to establish itself as the key Western centre for Islamic finance. This has involved roles for both government and the private sector.

Sir Stephen Wright, Chief Executive of IFSL, highlights IFSL’s role in Islamic finance:

“IFSL is keen to work with its private sector members and partners in government to ensure that London’s potential is fulfilled. To this end, the publication of IFSL’s first report on Islamic Finance represents an important start. More widely, the process of establishing London as the Western centre of choice in the growing market for Islamic finance is central to IFSL’s remit of promoting expertise of UK financial services around the world.”

The size of the market

As measured by Sharia compliant assets, the global market for Islamic financial services is estimated to have reached USD531bn at end-2006, having grown by over 10% a year from about USD150bn in the mid-1990s. Islamic commercial banks accounted for 75% of the assets (USD397bn), and investment banks 13%, (USD66bn). The balance is made up by Sukuk issues (USD44bn); assets of equity funds and other off-balance sheet investments USD14bn; and assets of Takaful providers (USD10bn). Standard & Poor’s has estimated that the potential market for Islamic finance could be USD4tr, over seven times its current size.

Assets that can be allocated to individual countries from The Banker’s survey of 500 organisations reveal that the leading countries for Sharia compliant assets are Iran with USD154bn, Saudi Arabia along with other Gulf states and Malaysia. The UK, in 9th place, is the leading Western country with USD10bn of reported assets, largely based on HSBC Amanah.

The market for Islamic financial services has developed in a number of key ways, with respect to emerging centres of expertise; a broadening geographical spread of customers; and the growing range of Sharia compliant financial services being marketed.

Emerging centres of expertise

Bahrain, Dubai/UAE and Kuala Lumpur have strong historical positions and future ambitions as centres for Islamic financial services. Riyadh, Qatar, and Singapore also have aspirations to become centres for Islamic finance. London is positioning itself as the gateway to Islamic finance in western Europe. Providers in London are likely to focus on services that complement those available in other centres.

Broadening geographical customer base for Islamic services

The market is currently most developed in Malaysia, Iran and the majority of countries that form the Gulf Co-operation Council (GCC). However, Islamic finance is moving beyond its historic boundaries in these countries into new territories both within and outside the Arab world. Key future markets include other Arab countries such as Egypt, Turkey, Lebanon and Syria, as well as Asian countries such as Indonesia, which has the largest indigenous Muslim population in the world, and China.

There are also opportunities in the Western countries of Europe and North America. Countries such as the US, France, Germany and the UK each have indigenous Muslim populations of between one and five million. Moreover, the customer base in Western countries is not necessarily restricted to Moslems: other customers may be attracted by the ethical and environmental basis of Islamic finance. Historic providers of Islamic finance are facing competition from newly established providers and from conversion of conventional institutions.

Sharia compliant financial services

Banking and Sukuk– the issue of Islamic notes – represent the forms of Islamic finance that are most well established, although Takaful (insurance) and equity funds are evolving. Products that may be the subject of innovation include private equity, hedge funds and derivatives. Significant challenges, outlined below, need to be addressed if the potential of these markets is to be fulfilled.

Existing Islamic banks have started to build on their natural competitive advantages including customer loyalty, sensitivity to religious practices and stable base of deposits. Conventional banks also have moved to open Islamic ‘windows’ through setting up branches, creating Sharia compliant subsidiaries or converting to become fully Sharia compliant banks. In a survey by the Banker, balance sheet assets of Sharia compliant banks totalled USD463bn in 2006, of which USD397bn were in commercial banks and USD66bn in investment banks. It is estimated that about 55% of the total bank assets were in Islamic banks and 45% in Islamic windows of conventional banks.

Malaysia and Pakistan have over 20 banks supplying Islamic financial services; Kuwait and Bahrain each have 17; and Iran, Saudi Arabia and Bangladesh each have around 10. Three UK banks reported to the Banker’s survey, although there are estimated to be over 20 in total. Market share of Islamic banks in Malaysia and the Gulf Cooperation Council (GCC) has been rising. In Malaysia between 2003 and 2006 the share of Islamic banks increased from 9% to 12% while in the GCC it rose from 13% to 17%. Within the GCC, Kuwait and Saudi Arabia are the countries in which Islamic banks’ market share is highest and has grown the fastest.

Sukuk are issues of Islamic notes that represent an alternative to conventional bonds. Issuance of Sukuk has grown rapidly from USD1bn a year in 2001 and 2002 to USD12bn in 2005, USD27bn in 2006 and USD36bn in the first nine months of 2007. The market was dominated by Malaysian issues in the early years but GCC issuance has been rising. Pakistan has also entered the market with about a fifth of its issuance in the first half of 2007 being Sukuk, up from no issues at all in the same period of 2006. Only a quarter of Sukuk are listed with the remainder being over the counter. Dubai is the main centre for listings followed by London, where at least eight Sukuk have been listed. Turnover in the secondary market in London was estimated at USD2bn a month in 2007. The largest sukuk to date were those issued by Dubai-based Nakheel Group for USD3.5bn early in 2007: they were listed in both Dubai and London. In the first nine months of 2007 the major underwriters of Sukuk were Citibank, HSBC and BNP Paribas.

While sovereign Sukuk issues by Bahrain and Malaysia played an initial role in establishing the market, over three quarters of issues between 2001 and 2006 have been by corporates. The most important market for Sukuk corporate issues totalling USD44bn over this period has been infrastructure followed by financial services and energy. The commitment to a substantial programme of infrastructure investment totalling up to USD1,000bn over the next ten years in the GCC should provide considerable potential for further expansion of Sukuk.

The market for Islamic funds has expanded significantly over the past decade, with the total number of Sharia compliant funds having risen from around 150 in 2000 to over 350 in 2006. The market for equity funds alone has grown from 9 funds with an aggregate value of USD0.8bn in 1994 to over 120 funds with a value of USD16bn in 2006. Out of 71 managers of equity funds identified by Failaka International, 29 are located in the Middle East, 18 in Asia, and 24 elsewhere, including 9 in the UK and 7 in the US.

Investment in equity funds should receive additional impetus following the construction by Standard & Poor’s of three equity indices that track the stocks of companies that are judged to be Sharia compliant in the US and Japan. These have been designed as an alternative to conventional indices. Over the past five years they have shown a high degree of correlation with conventional indices, particularly those based on US securities. In the UK iShares has launched three tracker funds – World Islamic, Emerging Markets Islamic and USA Islamic – on the London Stock Exchange. These Exchange Traded Funds (ETFs) will allow Muslim investors to track markets in accordance with Islamic law.

Takaful, similar to mutual insurance, is a risk sharing entity that allows for the transparent sharing of risk by pooling individual contributions for the benefit of all subscribers. Estimated assets of Takaful firms are USD10bn. Premiums are estimated to have reached USD3bn in 2006 has grown from USD0.8bn in 2000. The Takaful market is concentrated in Malaysia, Saudi Arabia, Iran and Kuwait. Penetration of Takaful is low being only 6% in Malaysia and 1% in Saudi Arabia. GCC and other countries with Islamic majorities are under-insured so should represent a strong growth opportunity, particularly with regard to life insurance, as Sharia compliant products are developed. Prudential was given approval in 2006 to launch a Takaful business in Malaysia in partnership with Bank Negara Malaysia.

Development of Islamic finance in the UK

London has been providing Islamic financial services for 30 years, although it is only in recent years that this service has begun to receive greater profile. A key feature of the development of London and the UK as the Western centre for Islamic finance has been supportive government policies intended to broaden the market for Islamic products for both Sharia compliant institutions and firms with ‘Islamic windows’. Central to this has been the establishment of an enabling fiscal, legal and regulatory framework:

Supportive government policies

Government policy has been increasingly supportive of the development of Islamic financial services in recent years because it has been seen to contribute to broader government objectives such as combating social exclusion and promoting London and the wider UK as a global financial centre. A key aspect of supportive government policy has been the establishment since 2003 of an enabling fiscal and regulatory framework in the UK for Islamic finance. There have been a number of initiatives which are intended to form part of a continuing process. In 2003 double tax on Islamic mortgages was removed and tax relief on Islamic mortgages was extended to companies, as well as individuals. Reforms were made to the arrangements for issues of bonds so that returns and income payments can be treated ‘as if’ interest, which has made London a more attractive location for issuing and trading Sukuk. The Financial Service Authority has also sought to ensure that regulatory treatment of Islamic finance is consistent with its statutory objectives and principles.

Establishment of fully Sharia compliant institutions

The four fully Sharia compliant banks established in the UK puts it in the lead in Western Europe. The Islamic Bank of Britain became the first stand-alone retail Islamic bank in the country. European Islamic Investment Bank, AIM-listed in 2006, was created with the aim of recycling surplus institutional and private liquidity from the Gulf into Sharia compliant asset classes in Western markets. Opening in 2007, The Bank of London and The Middle East offers Sharia compliant investment banking to businesses and high net-worth individuals globally. European Finance House, a unit of Qatar Islamic Bank, is the most recent entity to have received a banking licence in February 2008.

Establishment of an ‘Islamic window’ by major Western banks

Around 20 conventional banks have set up units to provide Islamic financial services. These include Arab Banking Corporation, Barclays Bank, BNP Paribas, Deutsche Bank, HSBC Amanah, Lloyds TSB and UBS. Including the four fully Sharia compliant Islamic banks, there are around 23 banks in the UK supplying Islamic financial services. This is more than four times that of any other country in western Europe. Switzerland has five and France and Luxembourg each have four.

A number of major law firms in the UK including Allen & Overy, Clifford Chance, Eversheds, Denton Wilde Sapte, Norton Rose, and Trowers and Hamlin are active in Islamic finance. The UK has a successful record as a trading centre for Islamic products as commodity-based Murabaha agreements, based on contracts at the London Metal Exchange are traded daily off-exchange. This has for years been a key mechanism for Islamic financial institutions to manage their assets and liabilities.

Providers in the UK are looking to build on mortgage products with new savings and commercial property finance products also under development. IBB headquartered in Birmingham is taking the opportunity to spread the market for services in the Midlands, Manchester and Wales. Albaruq approved mortgage business totalling over GBP100m in the first half of 2007. Lloyds TSB in 2006 became the first UK bank to launch a student account for undergraduates.

The Government is continuing to play a key role with, for example, a review being undertaken by National Savings & Investment, the state-owned savings bank, into the possibility of the Government issuing retail Islamic products. The Government is also reviewing the possibility of issuing Sharia compliant government bonds.

The outcome of both government initiatives and private sector responses to market opportunities is reflected in the establishment of various aspects of Islamic finance in the UK. In addition to the 23 banks in the UK supply Islamic financial services – more than the rest of western Europe combined – there are also nine fund managers providing the opportunity to invest in 10 funds, exceeded only in number by Saudi Arabia and Malaysia. The secondary market in Sukuk in London is estimated at USD2bn a month in 2007. There is a growing market for retail mortgage and insurance business and development of legal expertise. A variety of educational and training products in Islamic finance have been launched by professional institutions, universities, business schools and other training providers. For example, The Securities and Investment Institute, The Chartered Institute of Management Accountants and the Cass Business School have each partnered with other organisations to offer Islamic qualifications. Ongoing initiatives are intended to build on London’s existing competitive advantage with regard to its large size and international reach; deep and efficient markets, liquid secondary markets; and cluster of expertise.

Key challenges in the development of Islamic finance

Despite the considerable advances in Islamic finance in parts of the world, a number of key challenges remain.

Many countries with Muslim majorities still do not have an enabling legislation covering the authorisation of Islamic banks. In this respect the UK is well ahead of such countries in facilitating Islamic finance. At the international level, the issuance in 2006 of Capital Adequacy Standards and the Guiding Principles of Risk Management for Institutions offering Islamic Financial Services should facilitate appropriate assessment of regulatory capital.

The quality and transparency of financial reporting and disclosure in Islamic financial industry differs significantly across jurisdictions. The UK, Malaysia and Bahrain provide examples of best practice. Inadequate financial reporting is linked in part to the lack of a global framework which would provide international standardisation of rules and principles governing accounting practices. The Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI), based in Bahrain, has been working with its 160 members in 40 countries to enhance accounting and auditing standards for the industry since its establishment in 1990.

While diversity in Sharia opinions is enshrined in Islamic law, there nevertheless needs to be harmonisation of products, operations and systems in order to ensure compliance. There has been some convergence between GCC and Malaysian models. The UK has tended to adopt the GCC model due to strong links between the UK and the Gulf and also because, in aggregate, the Gulf forms the largest market. Convergence is hindered by differences of opinion between scholars. There is a shortage of scholars with expertise in the application of Sharia law to financial products.

While the market for Islamic finance has made large strides there is a shortage of people with suitable qualifications. This applies not only at the scholarly level, indicated above, but also in the wider industry. In this context the UK therefore has a major opportunity to become the leading Western centre for education and training.

The secondary market for Sukuk, although growing, remains sparse. This reflects the limited secondary markets in emerging financial centres such as Dubai where most Sukuk have so far been issued. London’s competitive advantages as a financial centre include its size and reach, sophisticated markets and expertise.

The specialist nature of Islamic finance means that customised IT systems may be required. Banks and other providers are therefore looking to develop IT systems that can handle not only the specific characteristics of Islamic finance but also cope with growing demand and the increased diversity of products.

The proactive role of UK institutions and authorities in attempting to address these challenges, together with the broadening footprint of providers in the UK, means that London is well positioned to take advantage of the developing market for Islamic finance.