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islamicbanking

   Interview with Stephen Ulph from Jane's Islamic Affairs Analyst (IAA)

The interview is to be reprinted in Emirates Investor

Trends in Islamic Banking  

18th April 2002


Just as Takaful is an acceptable Islamic form of insurance, options for delivery of commodities by a producer of such a commodity should be acceptable. So also should options or forward derivative contracts on any of the Islamic financial instruments be permissible. Let's talk about Financial Takaful instead of Islamic derivatives.
 
Given a choice between a pure Islamic bank and a highly rated reputable international bank providing the same service, a client would rather go to the one that has a brand name than the one that provides Islamic-only services, without the brand name.
 
Replacing Arabic terminology, such as "Ijara" with "leasing" or "Musharakah" with "equity participation", will lead to a greater understanding of the Islamic banking system.
 
There is always a flight to quality in times of uncertainty. But even before Sep 11, globally branded and rated financial institutions were increasingly providing Islamic finance directly or in partnership with regional distributors. Just as Internet-only banks soon faced competition from conventional banks, so also will Islamic banks.
 
Aside from the internal dynamic of the sector, Edwardes also sees evidence of a political weighting influencing the current development of Islamic finance: “I see a rapid development of euro denominated Islamic funds, a trend away from the heavy concentration of Islamic money in US dollar assets and a growing demand for gold and euro denominated equity funds, on grounds related to the events in Palestine.”  
 
The trading of debt is controversial and whilst it is acceptable in pragmatic Malaysia a number of Middle East based Shari'ah scholars believe it to be Haram. Perhaps a solution would be to follow the practice in the currency swaps market and adopt a process of Novation.
 
byline:
 
Warren Edwardes <note  spelling of edwardes> is ceo of Delphi Risk Management a London based banking innovation and risk consulting firm. He is author of best seller "Key financial instruments: understanding and innovating in the world of derivatives" which includes an appendix on Islamic Banking.

Islamic finance chafing at the bit 

Stephen Ulph focuses in on the logjam in Islamic finance posed by the Shari’ah boards, but also discovers a vibrant new generation that is fast working to shrug off the sector’s reputation for innovative torpor. 

Size and Potential 

No one denies the growth potential of Islamic finance, and its ability to tap into a huge potential source of funds. Although the figure $200 billion would appear to be little more than a handy mantra which keeps getting repeated, for the lack to date of any measuring method such as deal flow on a centralised market, it is unlikely to be excessively wide of the mark. 

There is no doubt of the potential of Islamic finance to unlock funds, and forge par excellence a niche market. The point was made recently by Islamic banker Atif Abdulmalik: “If we structure a product in an Islamically acceptable manner, not only are we conducting our business in accordance with Islam but also, from a business point of view, differentiating ourselves and carving out a niche in the wider, extremely competitive financial services industry.” Beyond that, considering that the 10 largest Muslim states have a combined GDP of $1.2 trillion, and there are 150 million Muslims resident in non-Islamic countries, it is obvious that the sector is likely to develop a sizeable clout. 

Its thirty-five year growth from zero has been impressive enough. Beginning with commercial banking in the 1970s (clandestinely at first, for fear of associations with political Islam), the Islamic finance sector saw its first project finance and syndications deals in the 1980s, equity deals picked up pace in the 1990s and by the new millennium leasing and private equity had taken off. At the present day we are at the stage of global equity funds, regional equity funds, funds themed by sector and geography and principal protected funds. 

Yet with retail banking products, especially in the West, still negligible, and all deals having to be structured, and with limited liquid funding for corporate and government financing, deal flow in the Islamic finance sector as a whole remains on a slow tickover.  

“The need of the hour” Atif Abdulmalik warns, “if our industry is to grow, is to diversify and develop new sources of revenue rather than all of us competing in a narrow range of products on the basis of price.”  

Limitations 

A common explanation for the persistently modest size of Islamic financial sector points the finger at its youth and the difficulties any new industry would have in learning to walk among a crowd of sprinters. 

But there are obstacles put in its way which owe more to a lack of dynamism and innovation. “Apart from Malaysia, most of the Islamic market is limited to two main products”, according to Ismail Dadabhoy, Executive Director of Islamic Finance, UBS Warburg, London: “murabaha (cost-plus financing) and equities. This means you have either the very short end, or the long end – there is nothing in between”. 

And he laments that to date “the banks and investors have contented themselves with moderately satisfactory returns from the equity market and from short term murabaha investments”.  

An aversion to risk which baffles academics such as Professor of Economics at Durham University Rodney Wilson, “given that it is the Islamic bank which determines the profit share, facilitating their management of liability exposure. This means that Islamic banks usually enjoy greater freedom of manoeuvre than their conventional counterparts, as their niche market is less crowded, and competitive pressure less, as long as market segmentation can be preserved. There is generally greater client loyalty too, and a lower turnover of deposits. Given the stable deposit base, Islamic banks could afford to be more venturesome in their financing activities”. 

Yet without a significant capital market to operate in, Ismail Dadabhoy feels, Islamic finance “will only be on the surface without deep roots and without much needed liquidity and transparency to foster a secondary market. You need to facilitate exit as well as entry, and for that you must free up liquidity”. And, chicken and egg, it is in turn the inability to hold liquid assets that yield a return that has prompted excessive reliance on short-term murabaha as a substitute. 

As it is, with the lack of an Islamic capital market, and the absence of any benchmarks forged for future issues, the development of a credit market, Islamic bonds and the expansion of takaful insurance (as characteristically principal holders of bonds) or the development of capital management services will remain a pipedream.  

New clientèle and new money will be forever slow in materializing. There is little point in waiting for the Islamic traffic to develop: “What is needed” says Dadabhoy, “is a high profile conventional player to import the necessary prestige and form a benchmark for others”. 

Warren Edwardes, CEO of Delphi Risk Management, a London based banking innovation and risk consulting firm, who follows the sector closely, concurs: “Given a choice between a pure Islamic bank and a highly rated reputable international bank providing the same service, a client would rather go to the one that has a brand name than the one that provides Islamic-only services, without the brand name – so special purpose Islamic Banks will just have to keep innovating to stay in business just like the old British Merchant Banks” 

What’s in the way? 

Of the list of woes Islamic bankers adduce the issues of standardization and training feature near the top. In a system where both parties to a contract have to have their Shari’ah compliance status verified, and where a fault at any subsequent stage of the deal can void it entirely, having a standardized set of Shari’ah rulings and therefore knowing where you stand is all the more pressing. 

The process is uneven so far. Equity funds are already well into a standardization process, and the tightening up of Islamic auditing has been a success, but the banks are proving a difficult nut to crack. There is no doubt that the learning curve for the Shari’ah scholars on the board is somewhat sharp - very few of them come from an economics based educational training - but there are actually only about twelve of them in any case. That’s twelve for the entire Islamic finance industry. And they are not getting any younger while they jet around the world in First Class from one Islamic finance department boardroom to another. 

“At such a ratio” says Rushdi Siddiqui, Director (and innovator) of the Dow Jones Islamic Index in the United States, “it is at times difficult to get their undivided attention”. For Siddiqui standardization “would allow the scholars to concentrate on product development - at its embryonic stage - rather than just signing off a bank-originated product case by case.” 

Indeed, at the International Islamic Finance Forum held in Dubai last March, under the term ‘standardisation’ the talk among the audience was of more than the sluggishness of a system that cannot march at anything other than the pace of the slowest; there were conversations on the floor that focused on the propriety of a dozen recognized scholars advising investment bankers in developing and approving new products, but which at the same time is advising investors on whether certain bank products were halal (‘permitted’). Murmurings of “cornering the market” and “acting as gatekeepers” were distinctly audible. This aside from the issue of commercial confidentiality. 

Dr. Mohamed A. Elgari, a leading Shari’ah scholar himself working boldly to free up space for new Islamic instruments, put his finger on the problem of the industry: “Manpower is the weak link. Supply is limited, and institutions of education are not producing enough quality graduates to understand both Shari’ah and conventional finance. Banks and educational bodies should create an institute to produce such people”. But there are, he noted, also some cultural constraints: “the fact is that since preference is given to the individual and not the prestige of the academy from which he graduates, this will always be a brake on development. Name recognition, unfortunately, takes precedence over knowledge”. 

Only with standardization, “will institutions be able to produce Shari’ah-compliant reports that exercise credibility and influence” and be able to take over from the imprimatur of the big names.  

Which is not itself going unchallenged. One of the younger generation of leading Shari’ah scholars, Dr. Mahmoud El-Gamal, Professor of Islamic Economics, Finance and Management at Rice University in the United States, has taken a long hard look at what he termed the ‘pseudo-economics of some contemporary jurists’, and the actual nature of the sources they purport to based their adjudications upon, which in many cases turn out to go back to the ‘customary practice’ of contemporary traders. “I have found by contemporary standards of Islamic jurisprudence”, he notes, “that the 15th century books are more sophisticated”, since they acted as a follower of the starting point of customary practice. “Therefore”, Dr El-Gamal concludes, “we need to demand that the jurists let us run something for five years and then make a judgment on its performance as an Islamic instrument.” 

New financial instruments 

A breed of more radical ‘second generation’ scholars is pushing the boundaries of Islamic finance, while preserving the core values. Dr Elgari at the Dubai forum made a spirited defence of the propriety of derivatives, as hedging instruments rather than tools for speculation, thus clearing the way for the discussions on how such an instrument should be structured. 

According to Atif Abdulmalik, one affective way of doing new things is “to leverage concepts and ideas that have been developed in conventional banking and to adapt them for Islamic banking”. 

And to counter the often unjustifiably gargoyle effect of conventional finance on traditionalist minds, it has been argued, recourse should be had to re-branding the instruments. A point which Warren Edwardes puts candidly: “Just as takaful is an acceptable Islamic form of insurance, options for delivery of commodities by a producer of such a commodity should be acceptable. So also should options or forward derivative contracts on any of the Islamic financial instruments be permissible. Let's talk about financial takaful instead of Islamic derivatives”. 

Similarly, “the trading of debt is controversial and whilst it is acceptable in pragmatic Malaysia a number of Middle East based Shari’ah scholars believe it to be haram. Perhaps a solution would be to follow the practice in the currency swaps market and adopt a process of novation” says Edwardes. 

Labels aside, “what is needed”, according to Ismail Dadabhoy, “is to initiate some form of permanent debating chamber, so that people can put up absolutely everything for discussion, and take the debate out of the hands of the scholars alone. What about preferred shares? Although this one is very unlikely to be accepted – since it violates the Islamic principle of equality – nevertheless everything deserves to be discussed and we need an open forum to do it. Only this way can proper standardization occur.” 

Radical scholars such as Nizam Yaqubi and Mohamed Elgari are making use of the accumulation of facts on the ground provided, for example, by the Dow Jones Indexes. “They are proving a motivator for development” says Rushdi Siddiqui, “simply due to their steady accumulation of statistics, our scholars - who are by nature risk averse due to fear of damage to their reputation - are discussing data and asking for more studies. This is a very positive development we are seeing”.

Jurisprudential licensing, Siddiqui notes, is starting to accelerate out of its torpor. He points by way of example to cutting edge developments such as “the Islamic version of mergers and acquisitions and leveraged buyouts, whereby a conventional company is taken whose primary business is sufficiently halal and then topped up in its Islamic compliance”.

“There is also more movement on venture capital, private equity and securitisations, all these are lining up awaiting the Shari’ah framework”.

“You can expect soon to see an Islamic exchange traded fund”, Siddiqi continues, “and Islamic index linked CDs and an Islamic money market. On this last, lots of work has been done for the institutional client, but the real benefits will be when the work is turned to the retail market, for the small Islamic investor is looking to diversify his or her portfolio away from reliance on equities in the absence of an Islamic bond.” “The dearth of Islamic Liquidity products is a major problem for banks’ asset/liability managers” says Warren Edwardes. 

Towards autonomy

Aside from the internal dynamic of the sector, Edwardes also sees evidence of a political weighting influencing the current development of Islamic finance: “I see a rapid development of euro denominated Islamic funds, a trend away from the heavy concentration of Islamic money in US dollar assets and a growing demand for gold and euro denominated equity funds, on grounds related to the events in Palestine.”

Concretising an Islamic financial autonomy in the form of an Islamic Dinar based on the currencies of 56 Muslim nations, according to Rushdi Siddiqi, still lies a long way off in the future. But there is no doubting the weight of the Islamic finance sector as it stands now. In the United Kingdom, for example, there is increasing emphasis on the development of retail Islamic products. The governor of the Bank of England Sir Eddy George has just set up a working party chaired by former Barclays and British Banking Association chairman Andrew Buxton, and the Bank of England itself is organizing a conference on Islamic Banking in early May.

Hard to find a more imposing symbol of an industry coming of age.

Stephen UIph 

Delphi Risk Management: Delphi creativity Delphi communication & Delphi control are the Innovation, Communication & Risk Management arms of Delphi Risk Management Limited 

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