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
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.
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.”
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.
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