Sustainability AndChallenges

In the closing session for this eventon Islamic Finance, I propose to reflecton the growth and trends in IslamicFinance, its size and dimensions andprospects which are now evolvingfrom regional to global scale andimpacting the private capital flows.The renewed interest and hype inIslamic Finance is unprecedented.Since it coincides with commercialinterest of Western financialinstitutions to attractflows generatedfrom oil revenues and other savings,there is a degree of skepticismregarding sustainability of interestand trends in Islamic Financeindustry within and outside Muslimjurisdictions? Also there are concernsechoed on whether the industry willpersevere the competition from theglobal financial world nurtured bythe conventional system backed bystrong legal, policy, regulatory andinstitutional framework.In my assessment, the Islamic Financenow seems to be a reality and is on itsway to be institutionalized, albeit atdifferentlevels in different countries,and tbe Western world is also nowselectively and cautiouslypositioning to invest in this system.There are promising signs that IslamicFinance trends are sustainable. It isentrenched in a well conceptualizedIslamic economic system whosemysteries are being unfolded withrenewed academic interest in thesubject. While undeniably faithdriven, the Islamic finance system hasgreat potential to meet the financial

gaps and requirements ofdevelopment and society at large andas such its demand would be robustgoing beyond religious grounds.

Islamic Finance has to be recog-nized as a parallel system which willaugment and be augmented by thedeeper knowledge and experience ofthe conventional financial system. Assuch, the key challenge going forwardto its growth and sustainability wouldlie in how it interfaces and benefitsfrom complementing and sup-plementing the conventional systemand how it adapts and conforms tothe international regulations andsupervision adequitely refined in linewith the technicalities and nuisanceof the Islamic financial instrumentsand their associated risks. Exploitingproperly theunique features of Islamicfinance with appropriate adapt-ability, without compromisingShariah principals, will be critical tothe growth and promising future ofIslamic industry.

Touching on some of these debates,I propose to firstdiscuss the trends inIslamic Finance, lay the case forsustainability of Islamic Finance andfinally discuss some of the keychallenges facing the industry whichthe Islamic financial community atlarge is now addressing.

Global and Regional Growthand Trends

Spread across 70 countries,Islamic Finance has grown to almosta $ trillion industry. Despite its

- Dr. Sliamslmd Aklitar

growth, given its current size ai.Jcomposition it is still a niche marketin the overall global financialindustry. Prospect for the industryare quite bright given strong demandfor financial ser-ISS3 vices from alarge segment of about 1.4 billionMuslim populations and need tochannel effectively rising foreignsavings and high net worthindividuals.

The growth, level, interest andmotivation to promote this industryvary across the globe. The growth inGulf Cooperation Council has beenexceptional with Bahrain emergingas a main centre adopting andimplementing Islamic bankingregulation, being the firstcentral bai\Kto issue Sukuk and establishing centrefor Islamic finance education, etc. Iranand Sudan declared sometime back100% conversion to Islamic banking.Within South East Asia, Malaysiastands out with $31 billion Islamicbanking assets, $1.7 billion Takafulindustry and has the largest Islamicdedt market which constitutes 45.5%of total Malaysia debt market. Othercountries in South East Asia havesmaller Islamic financial markets andSingapore has positioned to offerstrong wealth management potential.Within South Asia, Pakistan standsout for its proactive and systematicstance to evolve Islamic financeindustry. In all these countries, asstcjof Islamic banking grew faster thanthe overall banking assets and scopeand coverage of financial services

ECONOMICREVlEW-9/lO, 200743

extended to retail and consumerfinance, private equity, structuredproducts, insurance and projectfinance etc.

Distinct from Islamic countries, isthe interest of few global financialcenters such as London that nowprovide policy and tax incentives topromote Islamic finance industry toattract funds from high net worthclients. Same motivation seems to havedriven global banks such as HSBC,Standard Chartered, Deutsche Bank,Citibank etc. to set up special hubs tostructure Islamic finance products.

In reality, while current hype inindustry may be partially driven byavailability of surpluses generatedby oil revenues, Islamic banking isemerging as an alternate financingoption that coexists alongside theconventional financial industry.Moving from traditional Islamicproducts, now the industry is offeringconsumer financing for residentialpurposes and structuring financingvehicles for supporting infrastructureand housing finance projects etc.Product innovation is emerging withseveral different types of hybridSukuks and other combination ofstructures which involve differentforms of Musharikas with otherproducts. Notwithstanding thesedevelopments, increasing share ofequity based credit products, such asMurabaha and Ijara, remain thedominant form of Islamic financingacross the Islamic financinginstitution.

These trends are expected topersist and the industry is set to grow.Standard & Poor Services RatingAgency estimates that industry haspotential to grow to $4 trillion overmedium term. As highlighted above,the exceptional growth in IslamicFinance, particularly since 2000,which has coincided with growth inoil revenues, has raised questionswhether interest in Islamic Finance isone time phenomena? And what thefuture prospects and sustainabilityof the industry are?

While motivations and drivingfactors for this industry vary acrossthe world, this round of wave inIslamic finance industry is there tostay there. What lends one confidenceis the large investments by financialindustry across main hubs in GCC/Middle East/South East and SouthAsia, both within countries andgrowing foreign ownership and jointventures across borders, in infrastruc-ture development in this industry beit by way of

(i) Issuance of holistic bankinglicenses or opening of special win-dows or creation of hubs/dedicatedIslamic asset management funds,private equity funds and hedge fundsetc. accompanied by Dow IslamicIndex to which all such transactionssubscribe too are large;

(ii)Development of Shariahknowledge and understanding andengagement of Shariah advisors andscholars which together areproviding required consensus, guid-ance and legitimacy to Islamicindustry, products and structures;and

(iii) Development of Islamicstandard setters such as the IslamicFinancial Supervisory Board andAccounting and AuditingOrganization for Islamic FinancialInstitutions (AAOIFI) andInternationa] Islamic FinancialMarket (IIFM) etc. by the central banksas well as a range of MultilateralDevelopment Agencies including theIslamic Bank Development. Thecombined efforts have helped developand initiate implementation of Islamicprudential regulatory, accountingand auditing frameworks, andinspection and supervision offinancial institutions;

All these regional and globalefforts are serious long term initia-tives which are irreversible thoughmaintaining and building momen-tum on these fronts would be criticalto address the questions of sus-tainability and challenges facing thisindustry.

Sustainability and Challengesof Islamic Finance

Prospects for sustainability ofIslamicfinance appear promising, butthere are associated challenges whichneed to be concurrently addressedwhile one exploits and maximizesthe opportunities created by thisdiscipline.

First, the sustainability of Islamicfinance stems from recognitionl thatIslamic economic and financialarchitecture has a lot of appeal anddepth going beyond Muslim coun-tries. While initially conceived to besolely anchored on Riba free interestrate regime, there is now appreciationthat advocacy to move to Islamicbusiness and finance structure whilebe on religious or social grounds isnot a "slogan" or mere religiouspronunciation or condemnation ofRiba but is supported by a completeand deep Islamic ideology. Whenstudied carefully it has its logic andbasis in a comprehensive Islamiceconomic system which deals withallocation of resources, productionand exchange of goods and servicesand distribution of wealth - all toofamiliar debates in conventionaleconomic textbooks.

Second, the confidence in sus-tainability of Islamic economic sys-tem emerges from the better under-standing that this economic system isa well conceptualized, consistent andintegrated framework. Moreinterestingly, it is accompanied by arich and an elaborate set of tenetswhich, among others, recognize theright to property supported by elab-orate obligations for stakeholders,principles and rules of conduct, acontract system and institutionalframework and procedures forenforcement of rules which al!together lay the foundation for Islamicbusiness and financial architecture.It is this substantive Islamicideological and legal framework,governed by Shariah injunctions andprinciples that have translated into

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defining the public and privateeconomic and social affairs thateventually help frame the businessand financial relations. The core ofthese relationships is backed by solidprinciples of contracts, rights andobligations of parties to thecontractual arrangements.

Third, the sustainability of thissystem is reinforced by the businessand financial relations that are guid-ed by the logically defined emphasison the preferred modes of transactionwhich advocates profit sharing andas such relies on "ex-post" variabilityrather " than ex ante" fixity in returnsand consequently has built in risksharing as a central element oftransactions. Relevance of contractsis at the core of Islamic transactionswhich define the rules of game forsale and purchase/trade/exchangeof goods and services. Financingcontracts are then structured aroundthe nature of transaction which couldbe either in the form of trade financ-ing; asset based financing or differentforms of partnerships. Under Islamicfinance preference is given to tradingof physical assets as well as tradingof rights.

Fourth, the confidence in sus-tainability emerges from the frame-work of enforcement implicit inIslamic system. The main driver ofenforcement of contracts and rules-compliance in Islamic system isideology and faith which is in turninfluenced by Islam's emphasis onestablishing a equitable, ethical, just,and fair socio-economic system. It isthis feature which shapes up Islamicfinance and also distinguishes it fromthe conventional finance. Althoughone can argue that sustainability ofinterest in Islannic Finance is tiedsolely to the response of Muslimpopulation to their religious valuesand beliefs, but it has to be recognizedthat attraction in this discipline isnow widely emerging as there is betterunderstanding of Islamic economicsand finance and mechanisms arebeing found to juxtapose the knowl-

edge of conventional economics andfinancial engineering and learn toapply this to the Islamic economicsand finance discipline withoutdiluting its ideological underpin-nings.

Fifth, flexibility and innovation tostructure different types of financialproducts which augur well for IslamicFinance's sustainability. Whatdistinguishes Islamic finance is itsemphasis on trading of goods andservices and its advocacy for profitand risk sharing in businessessupported by a variety of partnershiparrangements - this is in sharpcontrast to loan based financing inconventional banks. By virtue of thesecharacteristics Islamic finance offersprudent financing options being assetbacked or equity based; particularlylinkage of assets with financingensures that transaction is less proneto debt crisis and funds are used fortheir prescribed purpose minimizingdefaults resulting from improper useof borrowed funds.Concurrently it offers promisingpotential for offering alternateavenues for saving and investmentfor all segments of population.

Sixth, market surveys confirm thatthe potential for retail, housing andproject finance and innovationemerging in these markets is signif-icant and augurs well for economicand financial services development.Islamic banks have registered doubledigit growth in retail markets.Penetration has occurred faster wherepersonal banking solutions have beenstructured well for saving andinvestment account offering range ofproducts and where informationtechnology is used to offer online,ATMs and telephone bankingservices. By and large products arestructured on Murabaha principleswhere funds are allocated forparticular projects or finance an, asset(such as home ownership and 'automobiles) in which depositorshares in the project rather than bankprofits and to structure Ijara (leasing)

with appropriate asset backing andlegal structures. Diversifying intobank assurance throughestablishment of associated Takafulinstitution and appending insurancesweetener is also a wave, though slowto take off. Islamic housing financefor acquisition and other purposeshas evolved to be a natural andpromising market to cater for hugehome financing demand in Muslimcountries. This market is gainingmomentum following someinteresting facilitation/ incentivesoffered by some countries: for instanceUS has facilitated Islamic lease-to-own relationship by allowing bank totake title to property and in the UKBank of England abolished doublestamp duty on Islamic mortgages,Ijarah I and Murabaha transactions,and rationalized of legal service feesand risk weightage etc. and Australiaand Canada allowed adoption ofdeclining balance partnershipconcepts to facilitate structuringDiminishing Musharaka contractetc.In some jurisdictions momentum fortapping retail market has beenaccelerated by partial or full conversionof conventional to Islamic banks suchas Saudi Arabia - challenges of whichcannot be underestimated as it involvesconverting the loan book to Shariahcompliant modes of product. Standalone Islamic banks have a challengingtask of competing with the conventionalplayers who have an edge of longevityand customer loyalty and economies ofscale. High level of customer service,offeringfullproductrange, introducinga level of transparency in transactions,devising unsecured personal loanproducts (a wave emerging withadoption of Tawarruq product),in troducingShariah compliant creditcards, handling properly theunfunded businesses and improvingefficiencies are some of responses tochallenge of competition. Large scalebusiness opportunities however liein exploiting project finance.Successful application andintegration of Islamic instruments

ECONOMlCREVlEW-yiO, 2007 45

with the conventional financing hashelped in this area while facilitatingclosure of large and complex multisource financing deals. Projectfinancing, backed by asset and equityand structured using combination ofIjara, Istisna, Sukuk and Musharika etc.has offered opportunities for riskdiversification, avenues for resourcemobilization and revenue sharing andperformance of services betweencontractual parties. These deals haveillustrated how conventional andIslamic financing can blend and coexistunder common legal and regulatoryarrangements.

Finally, more than conventionalfinance, Islamic finance emphasize justand equitable financial system. Amongothers, Islamic finance offers a financialinclusive option to Muslim who haveexcluded themselves from financialservices inabsenceofRiba free service.Since a number of Muslim countriessuffer from low financial servicespenetration, bringing in the appeal ofShariah complaint financingmechanism could turn out to be apowerful tool for er\hancing access todevelopment finance and empoweringthe poor and vulnerable groups.

It is important to recognize thatIslamic finance confines itself to largelysocially and development projects andinstitutioris are not permitted to investin prohibited or socially undesirableinvestments. Emphasis on ethicalissues and rigorous self-regulationin terms of Shariah supervisionensures fair play and justice and offerssuperior consumer protection model.Furthermore it induces higherfinancial discipline and places strin-gent ethical standards for all stake-holders that offers a strong and uniquemodel of governance.

ConclusionIn conclusion, encouraging

developments and trends in IslamicFinance lend confidence that thisindustry has taken off. However, thereare varying motivation and drivingfactors for the development of this

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industry ranging from religious fervorto the opportunities that exist in Islamicfinance for broadening and deepeningthe process of financial intermediationwhich augurs well for financialinnovation and engineering, enhancingthe financial services penetration innational jurisdictions and for crossborder capital flows. While the size ofIslamic financial industry is still quitesmall as a proportion of the total world'sfinancial assets, the current growthtrends and the investments ininfrastructure in development of itsIslamic Finance networks and itsregulatory and supervisory systems,lend confidence that this industry haspromising potential.

Prospects for this industry appearcomforting because of variety of factors- most significant being the strengthsof Islamic ideology and economicsystem which offer a completeframework for the Islamic financeindustry laying down rules ofconduct and contractual arrange-ments and feasible financing struc-ture which emphasize trade andequity financing that together willhelp the much needed financialdiversification in Islamic countries.

Islamic finance further has poten-tial to blend economic and socialobjectives and address the ethicalaspects of financing effectively. As suchit is generally more acceptable inpopulations with moderate to stronginclinations toward managing theirfinancial relationships in line with theirbeliefs. This can thus help in povertyalleviation through inclusion of a largerproportion of population into thebanking system giving them access tocredit and mobilizing their savingseffectively.

The emerging solutions andapplication to structure Islamic financeinnovatively have helped cater for alltypes of markets and financingrequirements ranging from retail toproject and home financing to equityfunds and products and insuranceoffers a full array of financial options.Industry effort to benchmark pricing

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ECONOMlCREVlEW-9/10,2007

and apply legal, regulatory servicestandards at par with conventionalproducts and standards has alsohelped encourage confidence in thesystem.Going forward, the sustainability ofIslamic Finance would rest in howthe international community buildson the momentum achieved thus far.This would require

(i) Further deepening the effortsto enhance the legal andregulatory framework ofIslamic finance consistentwith the international prac-tices.

(ii) Continued strive to conformand align the structures andproducts in line with theShariah principles wouldhelp Muslim population'smotivation to turn to this

' alternative mechanism offinancing, while attractingothers to product and riskmanagement and mitigationinnovation and additionallythat this window offers,

(iii) Recognizing that Islamicfinance has perpetuated andchanged the dynamics ofcross border private capitalflow this industry has greatpotential to augment theprocess of globalization andfinancial integration, but thisrequires more cooperationand vigilance on the part ofhome and host regulators,

(iv) Launching aggressive effortto implement the evolvingIslamic financial regulatoryand supervisory standardsand capturing the differenttypes of risks associated withIslamic finance, whilelaunching consumer

protection frameworks,(v) Promoting more financial

diversification byencouraging financialinnovation and Islamiccapital market development.