NEWSLETTER

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In this period of great uncertainty, in which the tra-ditional banking system has been brought down to its knees and the world’s media have turned against ‘greedy’ bankers and their ‘risky’ products, financial in-stitutions, driven by Islamic rules and regulations, are looking increasingly attractive.

Islam-inspired financial institutions that offer Shariah-compliant products represent a system of ethical investing that is becoming increasingly popular worldwide, in the midst of the present global economic crisis. This is down to a number of factors. Firstly, due to the prohibition of payment as well as the collection of interest (riba) and the investment or participation in non-Shariah-compliant activities (such as gambling, weapons and alcohol) according to Islamic law, highly complex instruments such as derivatives and other original accounting practices are not employed by Islamic financial institutions. In addition, transactions of such institutions are required to be backed by real assets (excluding subprime mortgages) and the risk must be shared between the bank and the depositor, providing a real incentive for institutions to ensure that the deal is sound. Fur-thermore, investors also have the right to know how their funds are being used and the sector is overseen by a dedicated supervisory board. Finally, it is more difficult for Islamic financial institutions to use leverage (since debt to total assets should not exceed 33 percent), a further characteristic that is representative of a lower risk profile.

Since the establishment of the Islamic Development Bank and Dubai Islamic Bank in 1975, the ideas of interest-free banking and Islamic financial services have become in-creasingly attractive to the 1.6 billion Muslims across the world. In the past decade, in particular, we have seen the rapid expansion of Islamic finance into the multi-billion-dollar industry it is today – not only with a presence in traditional Muslim countries, but also stretching well beyond. Worldwide, there are more than 300 banks that offer Islamic banking (including conventional banks), with over US$1 trillion in assets (~5 percent of worldwide assets under management). Furthermore, despite years of rapid growth (15-20 percent per annum), Islamic finance is still only a fraction of its development poten-tial. It is already gaining market share at the expense of the conventional market in most Muslim-dominated countries.

The captive market is huge and demographics are also favourable: the global Muslim population makes up some ~20 percent of the world, is relatively young and enjoys high birth-rates. Prudent investment principles and the type of products offered by Islamic Financial Institutions are also very attractive to a wide range of customers and investors – not only Muslims – who are interested in a fairer and more secure alternative to the conventional banking system. For instance, many retail customers and SMEs appreci-ate the clarity of the Islamic lending liability structure when compared alongside the complexities of a compound interest employed by conventional institutions. The appeal of such fixed-profit products resonates strongly in environments in which high interest-rates are charged, such as in Turkey, where banks like the Islamic player Bank Asya have grown rapidly. In Malaysia, more than two-thirds of Islamic financing is taken up by non-Muslims (primarily the Chinese) due to the appeal of fixed-profit rates.

Likely the continued growth in the GCC also drives other segments, such as the develop-ment of the Islamic bond or sukuk (the certification or trust of ownership for an asset or usufruct, with returns tied to the underlying asset) and Islamic insurance. In the case of the former, the market size is estimated at US$82 billion as of 2007 year-end, representing an annual growth of 40 percent since 2000. Islamic insurance (takaful), for its part, is already enjoying an annual growth of 20 percent, a figure that is only expected to increase over the next ten years. The strong growth trend – 15 percent on average – will also involve the Islamic mutual funds by 2010. As of the end of the first quarter of 2008, there were over 500 Shariah-compliant funds in the world (a significant portion of which are concentrated in Saudi Arabia and Malaysia) aside from the international capital markets.

Islamic banking: a safe-haven in global turmoil

Roland Topic, senior manager, Dubai office, and Cristina Zunino, manager, Milan office

Financial services: charting a new course

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Despite this strong position, Islamic banking has begun to be negatively affected by the global turmoil, proving that even Shariah compliant investors are not to be totally im-mune to the financial crisis. Islamic banks, especially in the Middle East, invested heavily in private equity and real estate and many loans may be backed by property. However, even if the expected slowdown in the GCC area over the next few years affects the over-all growth of the Islamic banking industry, Middle Eastern markets are still expected to outperform Western markets by a significant margin.

Irrespective of the economic climate, GCC governments will continue to insist on the pro-motion of Islamic tranches to finance mega projects. As a result, European countries are also taking a closer look at Islamic banking than they ever did before. In France, Germany and Britain, Islamic finance has already been successfully integrated into the banking system. French banking executives have done much to publicise their efforts to allow Muslims in France to bank and invest under the Islamic code. Deutsche Bank is about to launch a Shariah-compliant hedge fund. London, for its part, aspires to become the global centre of Islamic finance (around 20 major banks operating in the UK have set up units to provide Islamic Financial Services) and has reformed its tax and regulatory framework to accelerate the development of the industry. Indeed, as a result of the market turmoil, the number of stand-alone Islamic financial institutions in the UK is expected to double over the next three years.

Another spur for Islamic finance will be given by Middle-Eastern-based banks and sover-eign funds interested in investing in other countries at a time when Western companies are anxious to find fresh sources of financing. Libya’s sovereign fund has recently become the second biggest shareholder in Unicredit, increasing its stake in the Italian institu-tion up to a total of 5 percent. In the last month, Middle Eastern and Asian investors have given an “encouraging response” to Deutsche Bahn in their search to sell shares to sovereign wealth funds. Elsewhere, Islamic banks interested in investing in an envi-ronmentally-friendly company focused on helping poor people in developing countries, launched a cooperative venture with Velcan Energy, a Paris-based company developing hydropower plants in Brazil and India.

Thus, conventional banks will continue to establish Islamic windows in both whole-sale and retail areas with the aim of both strengthening the positioning of existing franchises as well as tapping an increasing lucrative customer base in the wake of the successful pioneering efforts of banks like HSBC and Citigroup. Likewise, Islamic banks will increase their presence in Western countries in order to meet the needs of the growing community of Muslim immigrants who are keen to put their money in institutions that are Shariah-compliant. The real challenge in the coming years will be to find the best way of seizing the opportunities offered by this growing market, and following Islamic banks in their effort to find new business opportunities, in-creasing their presence abroad with the establishment of a greater number of local branches and helping the conventional banking system to widen its customer base and to find alternative revenue streams.