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    • The global outlook of theIslamic financial services industryAn Economist Corporate Network management briefSupported by
    • The global outlook of the Islamic financial services industry Contents Preface 2 1. Introduction 3 2. The scale of the opportunity 4 3. Stresses and strains 7 4. Regulatory requirements 9 5. Building the talent pool 12 6. Priorities for action 14© Economist Corporate Network 2010 1
    • The global outlook of the Islamic financial services industry Preface The global outlook of the Islamic financial services industry is an Economist Corporate Network (ECN) report. The ECN wrote the report based on a roundtable event staged at the Global Islamic Finance Forum held in Kuala Lumpur in October 2010. The findings and views expressed here are those of the ECN alone. Rajiv Biswas and Jane Kinninmont were the authors of the report. Gaddi Tam was responsible for design. The cover image is by Corbis. November 2010 Participants at the Economist Corporate Network roundtable on Islamic finance: Zukri Samat, managing director, Bank Islam Steven Choy, president and CEO, Cagamas Noripah Kamso, CEO, CIMB Principal Islamic Asset Management Daud Vicary, global leader of the Islamic Finance Group, Deloitte Aamir Rehman, managing director, Fajr Capital Richard Thomas, CEO, Gatehouse Bank Rafe Haneef, managing director, HSBC Amanah Agil Natt, president, INCEIF Mushtak Parker, editor, Islamic Banker Mohammed Rashdan Yusof, executive director, investments, Khazanah Nasional Mohd Safri Shahul Hamid, deputy CEO, MIDF Amanah Investment Bank Takuya Furuya, chairman, Nomura—Middle East and Africa Dr Nik Norzrul Thani, chairman, Zaid Ibrahim & Co To learn more about the roundtable, visit: www.ecn-asia.com/mifc © 2010 The Economist Corporate Network. All rights reserved. All information in this report is verified to the best of the authors’ and the publisher’s ability. However, the Economist Corporate Network does not accept responsibility for any loss arising from reliance on it. Neither this publication nor any part of it may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior permission of the Economist Corporate Network.2 © Economist Corporate Network 2010
    • The global outlook of the Islamic financial services industry1. IntroductionMore than 1,000 participants from 50 countries gathered at the Global Islamic Finance Forum (GIFF)held in Malaysia in October this year. The wide spread of delegates—from countries as varied as theGulf states, the UK, France, Switzerland, Russia and Australia—is testament to the industry’s globalspread beyond what is normally thought of as the “Muslim world”. To understand this growing appeal,as well as to debate the industry’s pressing challenges, the Economist Corporate Network staged aroundtable discussion with some of the leading figures at GIFF.I slamic finance has won increasing attention in both Muslim and non-Muslim countries in the past decade. From its small beginnings in the 1970s, the industry has expanded rapidly. Bank NegaraMalaysia, the Malaysian central bank, has estimated that the industry’s financial assets may alreadyexceed US$1trn. And the growth looks set to continue. By some forecasts, the industry’s assets are ontrack to double over the next five years. The sector’s rapid growth will inevitably bring challenges as wellas opportunities, and much of the discussion at GIFF centred on avoiding self- congratulation and pushingforward with efforts to develop the industry. Islamic finance practitioners favour an approach to investment that avoids excessive leverage andis based on real, tangible assets. Such principles are finding more resonance following the globalfinancial crisis, which was sparked by excessively complex financial instruments involving levels of riskand borrowing that investors did not understand. But perceptions that the Islamic finance industrywas immune to the global crisis are over-optimistic. Notably, some of the Gulf-based Islamic banksthat invested heavily in regional property markets made substantial losses when the real estate marketturned, and there have been defaults on a small number of sukuk (Islamic bonds). The Islamic finance industry remains closely linked to the conventional financial sector and one ofthe key questions for its future development is how it will differentiate itself more clearly. The industryalso needs to demystify itself. Many potential investors remain unclear about what Islamic finance reallymeans. Risk management and risk assessment still need to be developed further. And almost everyone inthe industry acknowledges that more investment needs to be made in human capital. Creative thinking isalso needed to push ahead with innovation without simply mimicking conventional finance.© Economist Corporate Network 2010 3
    • The global outlook of the Islamic financial services industry 2. The scale of the opportunity A t an Economist Corporate Network roundtable on Islamic finance1 held at GIFF, Aamir Rehman,1 This roundtable was heldon 28th October 2010 as partof the Global Islamic Finance managing director of Fajr Capital, a Dubai-based Islamic investment firm, and author of a book onForum in Kuala Lumpur,Malaysia. Islamic finance, identified four key factors driving the growth—and globalisation—of Islamic finance. First, he said, is the increased importance of capital from the countries that belong to the Organisation of the Islamic Conference (OIC), an association of 56 Muslim-majority countries. “The economies of the OIC are a crucial source of capital-generating surpluses, growth and wealth while many of the world’s largest economies face deficits and capital constraints,” he noted. What’s more, Mr Rehman added, OIC-based companies “with sharia sensitivities” are becoming increasingly important global players. Thirdly, the industry is becoming increasingly sophisticated and is developing new products to attract customers. Finally, there is increasing demand on the retail side, “the core of the market and the soul of the industry”. For instance, he said, there are now calls in the Gulf to set up more sharia-compliant pension funds. In some countries, Islamic finance has already reached a significant share of activity. In Malaysia, which operates a dual financial system, Islamic finance accounts for 21% of the financial sector, and is2 Bank Negara Malaysia growing rapidly. In the first seven months of 2010, Islamic banking assets grew by 21% compared to the previous year.2 Islamic banking assets have also been expanding in neighbouring Indonesia in 2009 and 2010 after years of sluggish growth. In Saudi Arabia, bottom-up demand for Islamic banking has led many of the conventional banks—which dominate the Saudi market—to switch to sharia-compliant retail operations. The potential Muslim market is huge and growing: Islam is the second largest religion worldwide, with3 Mapping the Global Muslim 1.57bn followers, or 23% of the global population3. Many of the world’s Muslims live in rapidly-growingPopulation: A Report on theSize and Distribution of the emerging markets such as Indonesia and India. However, there are some important caveats. Muslims doWorld’s Muslim Population,2009, Pew Research Centre not necessarily choose Islamic financial services—especially in cases where these are more expensive than conventional equivalents. Many are skeptical or unaware of modern Islamic finance and the industry still needs to do much more to make its case to the large pool of potential customers. Furthermore, many Muslim countries, or countries with large Muslim populations, have not put the4 © Economist Corporate Network 2010
    • The global outlook of the Islamic financial services industrylegal framework in place to develop Islamic finance, often because of political and social sensitivities.Government support is critical to the successful development of the industry in any given market. Theindustry has been slow to grow in North Africa because of an absence of political support. Moreover,India, which has the world’s largest Muslim population but is not a Muslim-majority country, does not yetlicence or regulate Islamic banks, despite attempts in 2009 by the Kerala State Industrial DevelopmentCorporation to set up the country’s first sharia-compliant financial institution. Several participants in the roundtable said that Islamic finance needs to demystify itself and toemphasise its links with other forms of alternative finance, from modern “ethical finance” which prohibitscertain forms of investment—such as in gambling companies—to traditional banking practices thatavoided excessive leverage. Some argued that the industry should even lose the label “Islamic”. Forinstance, Muslim banks in Turkey are normally called “participation banks” to avoid offending secularistsensibilities. One participant suggested the industry should adopt English terminology instead of usingthe traditional Arabic words which are unfamiliar to most people.Not just for MuslimsOn the other hand, Islamic finance has had some success in attracting non-Muslim investors andborrowers, encouraging a number of non-Muslim countries to support the industry. In Europe, the UK,France and Luxembourg have all passed laws to ensure tax neutrality for Islamic finance, both to developtheir international competitiveness as financial centres and to offer a wider range of services to EuropeanMuslims. Ireland is now pressing ahead with similar legal changes. From an issuer’s point of view, Islamic instruments represent an opportunity to reach a new pool ofinvestors. In a notable development earlier this year, Nomura, a Japanese bank, tapped the Islamicmarkets twice. In July, it raised US$70m through a murabaha facility issued in Bahrain and US$100mthrough ijara certificates issued in Kuala Lumpur. “Islamic finance represents an important alternative channel to move money and diversify our fundingsources,” said Takuya Furuya, chairman of Nomura for Middle East and Africa, speaking at the ECNroundtable. Cagamas, Malaysia’s national mortgage company and securitisation house, issued its firstsukuk al-Amanah Li al-Istithmar in August, having worked with Al-Rajhi Bank in Saudi Arabia to ensure itssharia provisions were acceptable to Middle Eastern investors. Its president and CEO, Steven Choy, saidthat 43% of investors were new investors in Cagamas—and that one-third of them were buying sukuk forthe first time. Most issuers have been cautious this year, with many companies placing expansion plans on hold.Meanwhile, “demand for sukuk is outstripping supply,” said Zukri Samat, CEO of Bank Islam in Malaysia,and many investors are non-Muslims attracted by the returns on sukuk. Mohammed Rashdan MohammedYusof, the executive director of Investments at Khazanah Nasional, the Malaysian government’sinvestment holding arm, which issued its debut Singaporean-dollar sukuk this year out of Malaysia, sees agreat appetite for alternative investments and believes that international private equity funds are readyto embrace Islamic finance.© Economist Corporate Network 2010 5
    • The global outlook of the Islamic financial services industry Liquidity boost The financial framework that underpins the industry is strengthening too. Liquidity management has proven a challenge, but an international taskforce has developed a solution. On October 25th 2010, 12 central banks and monetary authorities, and two multilateral organisations—the Islamic Development Bank (IDB) and the Islamic Corporation for the Development of the Private Sector—set up the International Islamic Liquidity Management Corporation (IILM). Based in Kuala Lumpur, and with an authorised capital of US$1bn, its aim is to add resilience to global Islamic finance by facilitating cross- border capital and investment flows. The provision of enhanced liquidity to Islamic financial instruments will generate greater confidence in the products across financial centres. Dr Zeti Akhtar Aziz, governor of Bank Negara Malaysia, said the new institution will “enable more effective liquidity management not only for Islamic financial institutions but also for the management of Islamic financial portfolios.” She added that the development is also significant because “it demonstrates an international collaboration among the central banks.” Some have called for OIC sovereign wealth funds (SWFs) to dedicate even a small part of their portfolios to sharia-compliant investments. A recent research paper by Kuwait Finance House Research asked why there are no sharia-compliant SWFs when some of the largest such funds are owned by Muslim countries. This remains a sensitive issue as many SWFs have invested heavily in areas not deemed sharia-compliant, notably conventional banks but also hotels. Perhaps a more likely next step is increased issuance of sovereign sukuk to further strengthen liquidity management.6 © Economist Corporate Network 2010
    • The global outlook of the Islamic financial services industry3. Stresses and strainsN onetheless, despite all the progress and growth of recent years, significant challenges remain for the industry. Many of these challenges were highlighted during the stresses of the recent global financialcrisis. Some observers had assumed that Islamic finance would be insulated from the types of shock thatcreate turmoil in conventional financial services. Partly that’s because Islamic finance is much moreasset-based—it is built around real-world projects and investments rather than abstract risks—andinvolves greater risk-sharing than conventional finance, since both the client and the financial institutionmust assume some of the risk. Equally, it’s because the industry is less exposed to some forms of financialinnovation, especially in the field of derivatives, given Islamic restrictions on trading in financial risk. Those perceptions were put to the test in 2009 and in some cases found to be misplaced. During thefinancial crisis, a number of issuers of sukuk, defaulted, including Investment DAR, a Kuwait-basedfinance and real estate group, and fellow Kuwaiti firm, International Investment Group. Fears alsocirculated widely of a large-scale sukuk default by Nakheel, a Dubai-based property developer. Such fearswere only allayed following a US$10bn bailout by Abu Dhabi to Dubai World, Nakheel’s parent company. In other respects, the financial crisis also demonstrated the resilience of Islamic finance. Notably,a comparison of the performance of the ten largest conventional banks with the largest Islamic banksshows a stark contrast during the crisis4. While aggregate profits of conventional banks fell from 4 Islamic Finance and Global Financial Stability, IFSB andUS$116bn in 2006 to a net loss of US$42bn in 2008, profits at Islamic banks rose by 9% from US$4.2bn to IDB, April 2010US$4.6bn. Professor Dr Abbas Mirakhor, first holder of the chair of Islamic finance at the International Centrefor Education in Islamic Finance (INCEIF) in Malaysia, believes the sukuk defaults can have a positiveeffect. “If the economy is suffering, you want that to be reflected in the balance sheets of banks. It showsthat the banking sector is tied to what is happening in the real economy and is not removed from it,” hesaid. In contrast, much of the activity of conventional finance became highly esoteric and removed fromthe real economy over the past decade. Likewise, Noripah Kamso, CEO of CIMB-Principal Islamic AssetManagement, told the roundtable that the sukuk defaults in the Gulf will force people in the industry toimprove transparency and to address legal reforms.© Economist Corporate Network 2010 7
    • The global outlook of the Islamic financial services industry Nonetheless, the unnerving experiences in Dubai, Kuwait and other places suggest that many issues need addressing. In the case of Nakheel, protracted discussions with creditors about restructuring the firm’s debt highlight the need for formalised processes and mechanisms to resolve default issues. Questions have also been asked about the valuation of underlying assets during the Gulf property boom. “Really, the issue is poor credit, not the sukuk structure,” said Rafe Haneef, managing director of HSBC Amanah, the Islamic finance arm of HSBC bank. Some of the participants argued that the defaults and near-defaults in the Gulf had more to do with weaknesses in the Gulf legal systems than with sukuk structures themselves. Among the other key issues raised were questions of regulation, risk management, and the development of human capital—all of which were the subject of heated debate.8 © Economist Corporate Network 2010
    • The global outlook of the Islamic financial services industry4. Regulatory requirementsT he rapid growth of the industry has increased the focus of regulators on appropriate regulatory standards and risk management systems. When the Bank for International Settlements (BIS) inSwitzerland released its Basel II guidelines for capital adequacy, the Islamic Financial Services Board(IFSB), the international prudential standard setting body, followed with its own guidelines for Islamicbanks. The subsequent agreement reached for a Basel III Accord in September 2010 sets higher minimumcapital standards for banks, and will trigger further changes from the IFSB too. As the key global standards setting body for regulatory capital in the global banking industry, BIS has onlyrecently widened its representation to include developing countries. In mid-2009, it invited developing countrymembers of the G-20 forum to join its standard-setting committee. Among the countries joining the committeewere Indonesia, Saudi Arabia and Turkey. In the past, Islamic countries had no voice in setting global bankingstandards. But the inclusion of these three nations has changed that. Of course, the IFSB has been developing prudential standards specifically for Islamic banking for manyyears, and promoting greater co-operation across different jurisdictions. And its activities have beengrowing. In April this year, for example, it set up the Islamic Financial Stability Forum (IFSF) to buildinternational co-operation in crisis prevention, management and resolution. In some ways, the IFSB has been path-breaking in its approach. For example, uniquely amonginternational financial regulators, it not only oversees Islamic banking, it also sets standards for Islamicinsurance (Takaful), and also the activities of capital market intermediaries. “We recognize the stronglinkages between different branches of finance and the need to have a regulatory approach that canmanage those linkages,” says Dr Zeti of Bank Negara Malaysia. However, many in the industry feel that standards have room for improvement. Earlier this year,Deloitte’s Islamic Finance Knowledge Center surveyed the industry and found that two-thirds believeIslamic banking is under-regulated. And more than 60% feel that regulations are needed to strengthensystems of risk management. (See Charts 1 and 2, overleaf.) 5 “Islamic Banks and Financial A recent IMF research paper on Islamic banks5 argued that, while small Islamic banks tend to be Stability: An Empirical Analy-financially stronger than both small and large conventional commercial banks, large Islamic banks tend sis” by Martin Cihak and Heiko Hesse, IMF Working Papernot to be as financially strong as large conventional commercial banks. The reason, the authors argued, 09/16© Economist Corporate Network 2010 9
    • The global outlook of the Islamic financial services industry Chart 1 Do you think the Islamic finance industry is properly regulated? (% of total respondents) Under-regulated 66 Appropriately regulated 31 Over-regulated 3 Source: Deloitte Consulting Islamic Finance Knowledge Center Chart 2 Which of the following areas require new regulatory measures to ensure compliance of regulation and best practice in Islamic finance? (% of total respondents) Islamic accounting standards 62 Risk management 62 Corporate governance 58 Shariah standards 55 Bank credit exposures 45 Business conduct 42 Source: Deloitte Consulting Islamic Finance Knowledge Center is that it is significantly more complex for Islamic banks to adjust their credit monitoring system as they become larger. Daud Vicary Abdullah, global leader of the Islamic Finance Group at Deloitte, noted at the roundtable that there is a particular need to focus on strengthening risk management “in operational risk control and in sharia-compliance for product structures”. The concept of “sharia risk” has become an issue, especially since early 2008, when the Auditing and Accounting Organisation for Islamic Financial Institutions (AAOIFI), an internationally recognised industry standards board based in Bahrain, ruled that many sukuk in the market were not sharia- compliant as they were structured in a way that failed to share risk between the borrower and the lender. In an attempt to address this, there is increasing dialogue between scholars from different countries. According to Dr Zeti, there is now a scholarly consensus on some 80% of issues pertaining to Islamic finance, while there are still a few product structures that are accepted only in some jurisdictions. Scholarly differences are unlikely to disappear altogether. In a religion where there is no single centralised clerical authority, such differences are a normal part of theological debate and, arguably, religious freedom. Yet, when it comes to practical application for companies, Mr Choy of Cagamas says it is simply “not that difficult” to find a structure that is acceptable globally, adding that it took Cagamas 14 months to develop its sukuk alim, but that this was “time well spent”.10 © Economist Corporate Network 2010
    • The global outlook of the Islamic financial services industry Other regulations also vary from country to country depending on the legal and political environmentof each market. Dr Nik Norzrul Thani, chairman of Zaid Ibrahim & Co, a Malaysian law firm working acrossAsia and the Middle East, argued that three things are needed for Islamic finance to flourish in any givencountry: a good enabling environment in terms of tax neutrality and the laws governing the sector; thewider enforceability of contracts within the country’s judicial system; and the availability of disputeresolution mechanisms.© Economist Corporate Network 2010 11
    • The global outlook of the Islamic financial services industry 5. Building the talent pool A nother key issue for Islamic finance is human capital. For years, industry participants have said that there is not enough investment in training the next generation of Islamic finance professionals, who need to be well-versed in a combination of Islamic principles, finance, and legal and regulatory standards. Training is needed at all levels. “We need more training, not just within the industry itself, but right across the spectrum of governance—training for the regulators, the tax authorities, and even the parliament,” argued Richard Thomas, the CEO of Gatehouse Bank, a UK-based sharia-compliant wholesale bank. Some progress has been made in developing professional qualifications for accountants, auditors and finance professionals. However, Mr Thomas identified a particular gap in training: “The industry needs to spend a lot more money in training risk professionals. Risk is a completely different model in Islamic finance; it’s more fundamental.” Mr Thomas added that, “In the past, Islamic finance has been held back because conventional banks have been underpricing risk.” To date, efforts to build up professional training certifications and higher degrees have been patchy. At present, each Islamic financial centre pursues its own path in human capital development, without internationally agreed curricula and codes of conduct. This issue will become ever more prominent as the industry becomes increasingly international, and skilled personnel move to different jurisdictions during their careers. Participants in the roundtable emphasised a need for greater coordination across the industry, involving regulatory bodies, educational institutions and financial firms in developing professional standards. “The record on quality control is mixed and there is a risk that students can spend their money wrongly,” said Mushtak Parker, editor of Islamic Banker, an industry magazine. Mr Parker suggested that the IFSB and the Islamic Development Bank (IDB) should now set up a taskforce on Islamic finance talent development, just as they set up a taskforce to deal with liquidity management, which eventually led to the creation of the IILM. One of the bodies actively developing education standards for the industry is the Malaysia-based International Centre for Education in Islamic Finance (INCEIF), a university specialising in Islamic finance12 © Economist Corporate Network 2010
    • The global outlook of the Islamic financial services industrythat was set up in 2006 by Bank Negara Malaysia. International co-operation projects are underwaywith institutions including the University of Reading in the UK, the University of Bahrain, UniversitasIndonesia and Abu Dhabi University in the UAE. Agil Natt, president and CEO of INCEIF, believes a key priority is for greater international co-operationin education and training. “There is now an urgent need for a professional association that will groupShariah scholars together and establish a code of conduct,” he says. “There is also a need for greatersharing of research and materials in a common international language, English, to ensure that alljurisdictions have access to research that may have originally been done in other languages, notablyArabic. Greater transparency of relevant fatwas [Shariah pronouncement] and research will also be anessential part of wider education and outreach efforts to help address skepticism about the industry.” Several participants also called on Islamic banks to invest more in universities. “Larger Islamicfinancial institutions should come up with graduate programmes,” said Mohamad Safri Shahul Hamid, aformer Deutsche Bank executive who is now deputy CEO of MIDF Amanah Investment Bank. “These banksdon’t yet have the same [graduate training] offering as the Goldman Sachs and Merrill Lynches of thisworld.”© Economist Corporate Network 2010 13
    • The global outlook of the Islamic financial services industry 6. Priorities for action T he global outlook of the Islamic financial services industry remains strong, driven by a combination of macroeconomic factors, Muslim population demographics and growing demand from non-Muslim institutions for Shariah-compliant products. But this rapid growth does create challenges for the industry. At a policy level, there is a need for greater engagement by governments with the industry, including representation on global decision-making bodies such as the IMF and World Bank. In some cases, governments in Islamic countries have been sluggish in promulgating legislation to allow the further development of Islamic finance. Despite progress by some governments, most have a long way to go to address legal and tax impediments. In terms of industry standards, there is still a lack of a clear regulatory framework and guidelines. Importantly, standards need to be as simple and transparent as possible. Among financial leaders in the industry, a strong consensus exists that risk management and regulatory standards need to be strengthened and that Islamic financial institutions are lagging in their implementation of risk management systems. The experience of the recent financial crisis highlights the need for improved risk management in relation to capital markets product structures, as well as greater regulatory efforts by capital markets authorities to enforce high standards of disclosure and transparency. Strengthening credit risk management systems in large Islamic entities is also an important priority. To that end, improving the development of human capital and establishing best-practice international standards for the industry, remain important priorities. Many in the industry are calling for greater international co-operation among academic institutions to establish common standards, as well as a code of conduct across financial centres. Meanwhile the industry itself needs to offer more support to up-and- coming students. More research will also be needed to promote innovation, from new risk management systems to a greater and more inclusive range of products and services, to maximise the opportunities for further growth.14 © Economist Corporate Network 2010
    • Whilst every effort has been taken to verify the accuracyof this information, neither The Economist IntelligenceUnit Ltd, nor the sponsor of this report can accept anyresponsibility or liability for reliance by any person on thiswhite paper or any of the information, opinions or conclu-sions set out in the white paper.Cover image - Corbis/Pascal Deloche
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