ISLAMIC FINANCE-OPPORTUNITIES WITHIN CHALLENGES
MUHAMMAD ASHFAQ (firstname.lastname@example.org)
June 29 - July 5, 2009
Islamic finance is one of the fastest-growing segments of today's banking industry. Formerly deemed as a marginal industry, Islamic finance is now recognized as a vital and thriving industry. While the size of Islamic finance and banking activities, estimated to range from $500bn to $1,000bn, is still a fraction of conventional banking, the impressive growth rates of 10ñ15% seen in recent years emphasize the potential market for such activities. From the late 70s onwards, Pakistan has had a protracted history of Islamic banking. On 1st July, 1985 all commercial banking in Pakistani rupees became interest free. The sudden conversion and lack of preparedness posed difficulties for the implementation of this practice.
A growth of 40% per annum is expected and 15% market share is targeted. Conventional banks are allowed to operate Islamic bank subsidiaries or even standalone Islamic banking branches along-side full-fledged Islamic bank. A vast concentration of Islamic banking in the cities Karachi and Lahore is evident. There are government and corporate Sukuk on the market. In 2007, ABN AMRO opened an Islamic branch. Emirates Global Islamic Bank has started a dedicated Islamic commercial bank and Qatar Islamic bank confirmed plans to setup a Shari'ah compliant banking unit soon. Citibank was another big foreign entry.
However, from 2001 an evolutionary process was in place in order to nurture acceptability and development in a more structural approach. The first "Islamic bank license" was awarded to Meezan Bank back in 2002 (founded 1997). Most noteworthy is the present Islamic Banking Policy December 2001, under which Islamic banking is promoted parallel to conventional banking. Implementation of set by the Accounting and Auditing Organization of Islamic Financial Institutions (AAOIFI) and Islamic Financial Services Board (IFSB) is underway.
DESCRIPTION DEC-08 DEC-07 DEC-06 DEC-05 DEC-04 DEC-03 Total Assets 276 206 119 72 44 13 % of banking Industry 4.9% 4.0% 2.8% 20.% 1.5% 0.5% Deposits 202 147 84 50 30 8 % of banking Industry 4.8% 3.8% 2.6% 1.8% 1.3% 0.4% Financing and Investment 187 138 73 48 30 10 % of banking Industry 4.4% 3.5% 2.3% 1.7% 1.3% 0.5% No of Full Fledge Islamic Banks 6 6 4 2 2 1 No. of conventional banks with Islamic banking divisions 12 12 12 9 9 3 No. of Branches 514 289 150 70 48 17 Source: Islamic Banking Department SBP
FINANCING BY ISLAMIC BANKS DESCRIPTION SEPT-08 DEC-08 %CHANGE Murbaha 59067 59640 1% Ijarah 30656 30173 -2% Musharaka 2421 2469 2% Mudarbah 453 308 -32% Diminishing Musharak 43434 44812 3% Salam 2104 2649 26% Istisna 3566 4268 20% Qarz-e-Hasna - - 0% Others 2535 2650 5% Total 144236 146969 2% Amount for Non performing Financing 3122 3420 10% Provision Against NPFs 2057 2311 12% Net NPF 1065 1109 4% Source: Islamic Banking Department SBP
CAN ISLAMIC FINANCE INFLUENCE CONVENTIONAL FINANCE?
"Deposits in Islamic Accounts have been growing 10 per cent per annum over the past 10 years, and now total USD175bn."
"Islamic finance has become a major global industry with over 500 institutions involved in both Muslim and non-Muslim countries and international financial markets. Assets managed in accordance with Islamic law are worth over USD200bn."
As these quotes show, Islamic finance is becoming increasingly important in the world economy. Some financial experts are suggesting that no Islamic financial institution has failed in the credit crisis, while unprecedented bailout packages have been put together to deal with the systemic threat posed by the falling conventional financial institutions.
Not that Islamic financial institutions have been unaffected by grim market conditions ñ after all, they are subject to the same economic environment as conventional financial institutions. Still, years of double-digit growth and lack of a bankruptcy in the current market conditions have produced optimism in Islamic finance circles and Islamic economists highlight this optimism.
But, does this survival mean that the younger Islamic finance is now ready to shine and influence the thinking in the established conventional finance? Perhaps not. There are three simple arguments to suggest that in order to influence the thinking in conventional finance, Islamic finance needs to do a lot more than surviving the crisis.
First, despite the havoc wreaked by the credit crisis, conventional finance has not been pushed to the point of re-thinking its fundamentals. While experts are identifying a wide range of causes behind the credit crisis, they are not saying that there is something inherently wrong with either money lending or trading risk through derivatives. In fact, mainstream thought in conventional finance is perhaps more concerned with the possibility of over regulation of markets.
In contrast to conventional finance, Islamic finance prohibits money lending and trading of risk, requires all trading to be based on real goods and services, and prefers risk-reward sharing contracts. These prohibitions and requirements are an important reason why Islamic financial institutions do not invest in the products that have hurt their conventional counterparts. That does not mean that conventional finance is now going to be more favourably disposed to such prohibitions nor should the need for excess liquidity in the oil-rich Arab countries be confused with a desire to learn from Islamic finance.
To influence the thinking in conventional finance, Islamic finance cannot rely on a favourable setting produced by the current crisis. It needs to come up with empirical evidence to prove that the costs of money lending and derivatives outweigh their benefits. While some empirical evidence against money lending is perhaps already there for debt and poverty in developing countries, the challenge is to put it in the Islamic finance context and also come up with evidence in corporate and consumer lending. Unless modern research methods are used to back up the arguments, it is unlikely that conventional finance would be willing to consider learning from Islamic finance.
Second, the Islamic finance industry needs to establish a track record that it can employ to influence the thinking in conventional finance. Modern Islamic finance is less than forty years old and estimates of its global total assets tend not to exceed $1 trillion, whereas the asset of a large conventional bank could be even more. While the share of Islamic finance varies significantly across countries, so far in no country is Islamic finance being associated with a positive impact on economic development, which was not achieved by conventional finance. On the other hand, Islamic finance remains subject to fierce criticism for putting form over substance.
Third, many underlying causes for the credit crisis are problems of governance which are not unique to conventional finance. Decision-makers-whether mortgage brokers, credit rating agencies, the US legislature, regulators, or others ñ are either unable or unwilling to exercise independent judgment due to conflicts of interest. These governance challenges are clearly relevant for Islamic finance. Take the case of Shari'ah supervisory Boards that rule whether a product or service is permissible or not. Ordinary Muslims have high, and at times unmet, expectations of wisdom and piety from the scholars serving on these boards. Given the potentially large compensation of scholars, the Shari'ah Supervisory Boards is subject to conflicts of interest and critics have been hitting them hard.
In sum, despite the credit crisis, conventional finance remains unlikely to reconsider its fundamentals and Islamic finance needs research, genuine risk-reward sharing, and a track record of success to be able to influence the thinking in conventional finance.
WHAT DIFFERENTIATES ISLAMIC FROM CONVENTIONAL FINANCE?
The evolution of Islamic banking and finance has come about from two main objectives, namely the elimination of interest-based (riba) finance and the development of low-risk products, which would give confidence to regulators, shareholders, and depositors alike. This latter aim was even more necessary given the failure of some of the earlier Islamic banking models in Egypt, Pakistan, and Malaysia in the 1950s.
One of the most notable features of the current Islamic finance market is the development of a comprehensive range of product offerings, with the industry now having almost like-for-like parity with conventional banking, whether it is investment banking, commercial banking, or personal financial services. Many of the primary products developed in Islamic banking were debt based in order to be more akin to the anatomy of conventional banking products. The use of these products, clearly similar to conventional instruments certainly appeased many of the stakeholders, including the financial services industry itself. However, those same resemblances did and continued to receive criticism from those wishing to see Islamic finance based on the core principles of Shari'ah. Nonetheless, there are quite distinct aspects of Islamic finance, which differentiates it from conventional modes of finance. Describing the Islamic financial system simply as 'interest-free' does not do justice to the system. Its essence stretches to the promotion of entrepreneurship, preservation of property rights, and the transparency of contractual obligations. These and the other pivotal and underlying principles are formed through a thorough consideration of Shari'ah. The nature of capital as solely being a medium of exchange (i.e. no intrinsic value) is central to the prohibition of interest, and forms the central tenet of Islamic banking and finance. However, other important principles include:
- the prohibition of contractual risk,
- advocating sharing of risk and return,
- asset-banked finance (as banks cannot rely on issuing against collateral alone).
OPPORTUNITIES AND CHALLENGES
The opportunity for growth in the Islamic finance market is dependent upon two interlinked criteria: demand, and the ability of practitioners to develop new products, which fall within what is permissible under Islamic law. Islamic finance, in order to grow and challenge so called 'conventional finance', must develop through the innovation of new products. This is however Islamic finance's greatest challenge. The staggering growth of this market has, largely, been consumer led. The last couple of decades, despite the obvious difficulties Muslim communities have faced, have also seen a growing desire among many Muslims to return to the fundamentals of their faith along with growing economic empowerment. Such a trend is evident across the Muslim world, particularly in the oil-rich Middle East, and also among wealthy, young, professional Muslims living in Europe and the United States, many of whom have become key players driving the Islamic finance market.
Islamic finance must grow and innovate in order to meet the demand of consumers and clients, while bearing in mind that it is the fact that it is Islamic in nature, which is the motivating factor behind both the sources of Islamic capital and the consumers of such capital. The development of Islamic finance depends not just upon avoiding what has been prohibited by Islamic law but also in promoting Islamic values. In particular, an Islamic system of financing, and therefore Islamic financial products, should promote the values of fairness, justice, and equality. Islamic finance prohibits the idea of making money just by having money because it is fair that with reward also goes risk and partnership. Islam does not view as just a system where the debt of others is traded when the Quran calls for it to be forgiven as an act of charity.
The 'Islamic' financial products we have today are, for the most part, Shari'ah-compliant. The challenge now is to build on this and develop Shari'ah-based financial solutions to meet the needs of Muslims, and wider society. This means not just reworking conventional products but developing new products and solutions from a blank sheet based on Shari'ah principles. In some cases, Islamic finance may have to say that some conventional products are simply not possible in an Islamic context. However, Islamic finance should be able to offer better thought-out alternatives. The reasons are due to the facts that conventional banks in Pakistan have longer history and experience in doing banking business and hold dominating position in the financial sector with its large share in the overall financial assets of Pakistan, as compared to Islamic banks, which in true sense, started only a few years back with all letter and spirit.