Islamic Finance as a Value Oriented Proposal for Modern Economy

Dr Mehmet AsutayDurham Islamic Finance ProgrammeSchool of Government and International AffairsDurham Universitymehmet.asutay@durham.ac.uk

Presented at the 4th Biennial International Conference on Business, Banking and Finance on ‘Restoring Business Confidence and Investments in the Caribbean’ organised by the Department of Management Studies of UWI with SALIES and CCMF, June 22-24, 2011, Hilton Trinidad & Conference Centre

Financial sector acts as a catalyst to growth

• Provides platform and incentives for savings and investments− Able to mobilise and allocate national savings and change their term and structure

to finance longer term and relatively riskier investmentsMobilise savings

Real economy channelling

Productivity enabler

Global capital market link

• Integrates domestic economy into global financial system− Able to access funds from international capital markets and attract foreign direct

investments− Reduce intermediation margins and costs by being “close to the market”

• Aid local community and real economy development− Enable company formation, expansion and competition in the market− Fund SME and Microfinance opportunities to contribute to employment and

wealth generation

• Raises total factor productivity levels−Enable shift away from labour to capital intensive and higher value-add

productivity sectors

However, recent crisis in banking highlights dangers caused by failures of financial sector

Negative spiral

Bank insolvency

Lack of short-term lendingLack of short-term lending Corporate liquidity

crisisCorporate liquidity crisis

Inability to meet financial obligationsInability to meet financial obligationsDisruption of

paymentsDisruption of payments

Crisis of confidenceCrisis of confidence

Instability in the banking system can destroy otherwise healthy economies

Financial Institutions

Crisis underscores certain elements that need to be addressed

Impact points

Global Markets

Real Economy

Policy Implications

Need for savings and investment orientation to replace consumption and credit culture

Need for savings and investment orientation to replace consumption and credit culture

Dangers of opaque sale of debt now shown to be evident

Dangers of opaque sale of debt now shown to be evident

Differentiation between deposit-taking institutions and investment managers

Differentiation between deposit-taking institutions and investment managers

Stronger links needed between banking and real economy investment

Stronger links needed between banking and real economy investment

Material crisis requires moral solutions

Islamic Finance: A Value Oriented Proposition

• A financing proposition shaped by the rules (fiqh) but also moral values of Islam;

• ‘Form’ but also ‘substance’ is expected to be Islamic as well;

• Islamic moral economy, in modern sense, developed since 1970s aiming at development issues; and

• Islamic financing expected to provide an alternative solution as a financing tool and method;

• Ethicality in this value proposition in the original sense is not only prohibition of riba (interest) but relating to larger social and economic development issues;

Islamic Finance: A Value Oriented Proposition

Islamic moral economy assumes certain axioms:• Social justice and beneficence (adalah and ihsan);• Growth in harmony (tazkiyah);• Enabling individual, society and natural environment to reach its

perfection (rubibiyah);• To overcome the conflict between individual and society,

voluntary action is not perceived to be enough; and hence certain social oriented financial and economic obligations (fard);

• Individual is perceived to be vicegerent of God on earth to fulfill the expected duties in their economic and financial behaviour to make their decision through a financial filter (vicegerent individual);

• Operational dimensions of these axioms are possible with Maqasid al-Shari’ah – objective of Shari’ah: human well-being.

Islamic finance is based on socially responsible investing

Islamic finance principles reinforce the ethos of Islam

Islamic economics has an explicit value framework

– Based on justice, equity, human dignity, freedom of enterprise and moderation

– Based on developing and harnessing economic resources to satisfy spiritual, material and social needs of all members of the community

– Based on a moral obligation to serve poor and destitute from share of wealth

IslamIslamCrass materialismCrass materialism Aesthetic spiritualismAesthetic spiritualism

Removing speculation and ensuring value-enhancing activity

If something is immoral, one cannot profit from it1

Islamic finance principles consist of core basic tenets

To share reward, one must also share risk2

One cannot sell what one does not own3

In any transaction, one must clearly specify what he or she is buying or selling and what price is being paid

4

Banking and finance needs

Islamic finance is the outcome of religion in banking

Shariah filter

Islamic banking and finance solutions

• Prohibition on:

– Interest

– Speculation

– Gambling

– Quran

– Sunnah

– Ijma’ (jurist consensus)

– Qiyas (analogy)

– Ijtihad (reasoning)

– Musharaka - Partnership

– Mudaraba - Partnership

– Murabaha - Purchase-resale

– Ijara - Lease

– Istisna’ - Manufacturing contract

– Salam - Forward sale

• Asset-backed transactions with investments in real, durable assets

Fiqh al-Muamalaat contractsShariah sources

• Prohibition of certain investments:− Sectors (e.g.: alcohol, armaments,

financial services, gambling, pork, pornography, tobacco)

− Instruments (e.g. no forward transactions, limited option use, no derivatives, short-selling)

• Credit and debt products are not encouraged

Aims of Islamic Finance

Islamic banking and finance aims at:

Community banking: Serving communities, not markets;

Responsible Finance, as it builds systematic checks on financial providers; and restrains consumer indebtedness; ethical investment, and CSR Initiatives;

Alternative Paradigm in terms of stability from linking financial services to the productive, real economy; and also it provides moral compass for capitalism;

Fulfils Aspirations in the sense it widens ownership base of society, and offers ‘success with authenticity’.

A holistic approach to financing a society

Conceptually, Islamic finance is more than financial contracts

Tenet-bound

Fundamental tenants are derived from Shariah

– Absence of interest-based transactions

– Avoidance of economic activity involving speculation

– Prohibition on production of goods and services which contradict the values of Islam

Principles-based

Concept is grounded in ethics and values

– Principles akin to ethical investing

– Emphasis on risk-sharing and partnership contracts

– Credit and debt products are not encouraged

Real economy-linked

Islamic finance offers an alternative financing paradigm

– Asset-backed transactions with investments in real, durable assets

– Stability from linking financial services to the productive, real economy

– Restrains consumer indebtedness as credit is linked to real assets

Society-service

Islamic banking is community banking

– Serving communities, not markets

– Open to all-faith clients

– Instruments of poverty-reduction are inherent part of Islamic finance (zakat & qard hasan)

2 • Promoting the investment mindset rather than the banking mindset− Investing in real assets rather than promoting speculation and leverage

3 • Making meaningful real economy impact− Investing in asset-backed instruments and real economy ventures

1 • Engagement of an under-served and previously un-banked market− Providing an ethical banking solution to local communities to deepen the banking

market

4 • Attracting foreign investment and cross-border partnerships from Islamic financial institutions− Attractive source of cross-market ventures and cross-border lines from Islamic countries

A growing industry promising benefits

Islamic finance aims and positive impact

Banking with morals

Industry presents an alternative banking paradigm to create ethical profits

Corpo

rate

Gover

nanc

e

Corporate Social

Responsibility

Business Ethics

Ethical profits (rather than

“profits-at-any-costs”)

Accountability to God“More-than-profit” mentality

Shari’a

“Code of Ethics”

Several practices from the Islamic banking sector are relevant to the conventional sector following the crisis

Increased emphasis on asset-based financing Increased emphasis on asset-based financing1

Limits on the sale of debt and preference for equity financing Limits on the sale of debt and preference for equity financing2

Greater transparency in transfer of debt and linking to origin Greater transparency in transfer of debt and linking to origin3

Introduction of “Ethical Supervisory Boards” Introduction of “Ethical Supervisory Boards”4

Evolving financial architecture to be based on separation of risk-free and risk-bearing accounts

Evolving financial architecture to be based on separation of risk-free and risk-bearing accounts5

Prioritizing research and development with two-way transfer of best practices Prioritizing research and development with two-way transfer of best practices6

Source: Relevance of Islamic Finance Principles to the Global Financial Crisis, Aamir A. Rehman, March 2009

Development of Paradigm and Industry

1950s

60s

70s

80s

90s

00s

− Egypt and Malaysia pioneering institutions− Establishment of the OIC

− Development of theoretical framework− Muslim-majority nation independence

− Islamic Development Bank and DIB− One country-one bank setup

− Advancement of Islamic products− Full “Islamization” of Iran, Pakistan and Sudan

− Entry of global institutions e.g. HSBC Amanah

− Tipping point reached in some markets− Development of industry-building institutions

1970s

commercialbanking

insurance

1980s syndications

structuredand trade finance

1990s

equity

private equity

projectfinance

debtissues

2000s

structured products

1970s

1980s1990s

2000s

Evolving richness in productsDevelopment of industry

Industry has near like-for-like parity with conventional offering

Industry has advanced from niche to critical mass

Industry is fragmented and is gradually evolving and internationalising

66% growth

33% growth

Islamic banking assets as proportion

of total (%) *

40%

20%

12%

30%

Islamic finance is a 40 year old industry− Mitghamr Savings Associations (1963) – Shaikh Ahmad Al-Najjar − Tabung Hajji Malaysia (1967) – Royal Professor Tunku Abdul Aziz − Islamic Development Bank (1974) – Dr. Ahmed Mohamed Ali

& Dubai Islamic Bank (1975) – Sh. Saeed Lootah

Industry is a market-driven proposition− Retail customers historically the backbone of the industry− Tipping point in retail sector: Saudi Arabia, UAE, Bahrain and Kuwait− Self-regulating organisations, Standards bodies and Training Institutes

Market size estimated at about USD 950 billion globally− Growing at 15 to 20% per annum− Within 8-10 years, industry estimated to capture half the savings of the

1.6 billion Muslim world2

− Estimated to grow to USD 1.3 trillion by 2012

Industry has global scale− More than 500 Islamic banks worldwide operating in over 75 countries1

− GCC accounts for two-thirds of global Islamic assets4

− Malaysia leading industry maturity and sophistication− Islamic Development Bank: largest pan-OIC financial institution

Multinational banks have gradually increased their focus on Islamic finance

Mainstream institutions have embraced Islamic banking

Ad hoc participation− Correspondent banking for IFIs− Tailored Private Banking services for HNWIs

Islamic client services− Dedicated Relationship Managers for IFIs− Dedicated Private bankers for HNWIs

Islamic window model− Committed unit for Islamic financial services− Citi Islamic (1996), HSBC Amanah (1998)

Dedicated Islamic subsidiary− Islamic subsidiaries of conventional banks− Joint ventures and partnerships

Market entry strategy

Defensive strategy Proactive strategy

• Service and retain existing Muslim clients

• Refine current proposition to reflect local needs

– Particularly important as economic clout of locals increased

• Protect and embed the brand

• Acquire new customers, especially wealthy locals

• Build a sustainable community banking proposition

• Benefit from higher growth rates of emerging markets

– Crucial as developed market growth slows

Evolving commitment

Product Areas

1980s 1990s 2000+1970s

Murabaha

Ijara

Takaful

Equities

Sukuk al-Ijara

Structured Alternate Assets

Product Development Over the Years

Retail

High Net-Worth

Islamic Financials

Non-Bank Financials

Institutions

• Endowments

• Ministries

• Pension Funds

Governments

• Local Govt

• Central Banks

• Investment Agents

1980s 1990s 2000+1970s

• Retail sector has been the historic backbone to the industry’s recent development

• Increasing trend of regional corporations tapping into Islamic markets for fundraising

• Public sector and pension funds are key to next phase of industry development

Biggest industry customers still waiting in the wings

Developing nature of the client base

Equity

Real estate

Fixed income

Sophisticated client investment product depth needs Cash

management

Hedging products

Private equity

Structured products

Mature

Maturing

Emerging

Development areas and products

– Achieving depth across range would enable industry to capture NBFI, Institutional and government assets

• Achieving Shariah-compliance while building out asset range and depth

• Achieving scale and capital efficiency

• Attracting experienced and dedicated human capital

• Real estate: REIT laws in OIC countries

• Lack of Islamic private equity managers

Challenges to overcome

Industry is Reaching Mainstream Relevance in Global Financial System

Relevance to non-OIC CountriesRelevance to OIC Countries • Reaching a broader

market − Muslim-minority

populations become inclusive, economic, productive agents

• Alternative source of funding

− Debt issuance with the widest acceptance

− Attract “new-to-industry” investors with Shariah-compliant funds and transactions

• Gateway to OIC markets− Regional preference of

Islamic investors− Infrastructure investment

opportunities

• Fulfilment of financial needs of Muslims

− Islamic finance is the equilibrium choice

• Widens stakeholder base of society

− Increases bankable population of economy

− Increases economic efficiency as a result of society’s increased engagement

• Enhances stability of financial model

− Asset-based framework links financial services to real economy

Overview of the Islamic Financial Service Industry

Phases of Expansion

ME

GULFAFRICA

N. AMERICA

S. AMERICA

ASIA

EUROPE

OCEANIA

1970-1980

•Commercial Islamic Banks

BIRTH

2000-2010

•Commercial Islamic banks

•Islamic investment companies

•Islamic insurance companies

•Islamic investment banks

•Islamic asset management

•Islamic retail banks

•Islamic brokers

•Islamic internet companies

•Islamic capital and financial markets

EXPANSION

1980-2000

EMERGENCE

•Commercial Islamic Banks

•Islamic investment companies

•Islamic Insurance companies

Overview of the Islamic Financial Service Industry

Offering Evolution

AREAS

METHOD

TARGET

1970-1980BASIC CONVENTIONAL

•Trade finance

•Working capital Finance

•Replicate conventional basic banking PS

•Sharia compliant substitute

•Muslims to meet their religious obligations

1980-2000STRUCTURED

•Project finance

•Leasing

•Capital markets

•Insurance products

•Structuring Sharia compliant products and services in both Banking and Insurance

•//

•Non Muslims who subscribe to ethical investment philosophy

2000-2010FULL ADDED VALUE

•Debt capital market

•Asset management

•Funds

•Islamic Indices

•Retail products and services

•Engineering capabilities

•Wide range of P/S

•More sophisticated offering•Return to investors become comparable to conventional benchmarks

•//

•//•Non Muslims who find Risk/Return Features attractive( 90% of HSBC’s corporate customers of its Islamic banking services are not Islamic companies)

Overview of the Islamic Financial Service Industry

Worldwide Acceptability

1970-1990

A Folly System in the modern

Economy

•The challenge came from western analysts who suggested the folly of a system based on 0% interest rate on investment

•The BBC and The Wall street journal qualified Islamic finance:

• As a ‘voodoo’ economy

1990-1997

Theoretically viable in the

Modern Economy

•A system which prohibited a fixed ex-ante interest rate

• Allowing the capital rate of return to be determined ex-post (based on the return to the economic activity)

•Is theoretically viable

1997-2010

Globally accepted as a genuine

alternative of Modern Finance

•There is a clear recognition of the viability of the Islamic system and it’s firm significance in today’s finance worldwide

•Islamic finance is an efficient and productive way of financial intermediation

•Is Globally accepted

Sovereigns, MNC’s and International Companies are tapping the growing IFI

5

Mainstream Relevance

Islamic Banking and Finance - Regional and Global Growth

• Source: Maris Strategies & The Banker

Top 25 IBF Institutions by Shari’ah Compliant Assets

Top 25 Countries by Shari’ah Compliant Assets

Geographical Distribution of Reported Shari’ah Assets, GCC, 2009 (% Distribution)

Geographical Distribution of Reported Shari’ah Assets, Non-GCC MENA, 2009 (% Distribution)

Geographical Distribution of Reported Shari’ah Assets, Non-MENA Global, 2009 (% Distribution)

Institutions Registered for Shari’ah Compliant Products

Trends in the Number of Islamic Banks and Windows

Top 25 Fastest Growing IBF Institutions

New Entrants IBF Institutions

Global Islamic Fund Management Industry

As the figure indicates, there has been a shift away from traditional asset classes such as equities and real estate funds with a number of new asset classes being introduced including Shari’ah compliant ETFs and hedge funds.

Global Islamic Fund Management Industry

As the figure depicts, however, overall Islamic funds still remains concentrated in traditional asset classes such as equities and fixed income.

Assets Under Management of Islamic Funds by Categories (Q1 2010)

The Dow Jones Islamic Market 100 Index- Performance, 2005 -2010

The Dow Jones Islamic Market 100 Index- Performance, 2008-2010

Developments in Sukuk

Global Sukuk Issuance

About 20-25% of the total population worldwide are Muslims, their global wealth is estimated at $3 trillions, the penetration of the Islamic financial service industry is still embryonic (less than 10%)

Within 8 to 10 years, as much as half the savings of the world’s then 1.6 billion Muslims would be in Islamic banks

• The global Islamic insurance (Takaful) market is estimated to reach USD 14.4 billion by 2010

• Islamic finance has also gained popularity in Muslim-minority countries– Germany issued the first Islamic Eurobond (2004)– UK’s first standalone Islamic bank (2004)

• Trends of convergence and conversion– Ethical investing, community banking– Conversion of banks: e.g. National Bank of Sharjah, Bank al

Jazira, Dubai Bank

FOCUS ON ISLAMIC POTENTIAL MARKETSIslamic Financial Service Industry: A Huge Potential

Focus On Islamic Potential MarketsIslamic Financial Service Industry: A Huge Potential

CONCLUSION

Islamic consumers are a niche market; but Islamic finance is no longer a niche market;

It is a market with huge growth potential;

Established institutions with a large consumer base are in a unique position to enhance “share of wallet” through Islamic products;

Reputed financial institutions providing competitive Islamic product will experience increased market share and bottom line success.

Thank you…

“Through our scientific genius we have made this world a neighborhood; now through our moral and spiritual development, we must make it a brotherhood.”

– Martin Luther King

“Through our scientific genius we have made this world a neighborhood; now through our moral and spiritual development, we must make it a brotherhood.”

– Martin Luther King

“If there is to be a human future, we must bring ourselves into balanced relationship with one another and the earth. This requires building economies with heart.”

(David Korten, Author of “When Corporations Rule the World”)

“If there is to be a human future, we must bring ourselves into balanced relationship with one another and the earth. This requires building economies with heart.”

(David Korten, Author of “When Corporations Rule the World”)