The document summarizes Islamic finance, its relevance and growth. It discusses how Islamic finance prohibits interest and certain investments based on religious principles. It has grown significantly in recent decades to become a mainstream part of the global financial system, with an estimated market size of $750 billion. The future of Islamic finance looks promising as the industry develops new products and reaches new markets and populations around the world.

1. Islamic Finance: Relevance and Growth in the Modern Financial Age London School of Economics 1 February 2007 Iqbal Khan Founding ex-CEO, HSBC Amanah

2. Agenda What is Islamic finance? What relevance does it have in the modern financial system? What are the areas of current growth and initiatives? What does the future hold?

3. Banking and finance needs Islamic finance is the outcome of religion in banking 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 contracts Shariah 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 Shariah filter

4. Synthesis of Islamic law and contemporary finance Community banking : serving communities, not markets Islamic finance is embedded within values Islamic finance is more than financial contracts Client affinity Fulfils aspirations Widens ownership base of society Offers “success with authenticity” Alternative paradigm Stability from linking financial services to the productive, real economy Moral compass for capitalism Responsible finance Builds systematic checks on financial providers Restrains consumer indebtedness Inclusive proposition Open to all-faith clients Available to Islamic and conventional issuers Parallel trends Ethical investment CSR initiatives

5. Values of good governance are central to Islam Accountability to God raises level of awareness Quranic code of ethics Best practices of corporate governance Accountability and obligation to shareholders Integrity and ethical behaviour Fiduciary role and responsibility of board Vicegerent concept of accountability (2:30) Honest fulfilment of contracts (5:1) Prohibition against betraying any trusts (8:27) Prohibition against deriving income from cheating, dishonesty or fraud (4:29) Prohibition against bribery (2:188) Prohibition against concealing evidence (2:283) Disclosure and transparency “ O ye who believe! Be ye staunch in justice, witnesses for Allah, even though it be against yourselves or (your) parents or (your) kindred…” (4:135)

6. prohibited sectors ECONOMIC IMPERATIVE Market-driven yet values-based Gradualist and evolutionary nature Symbiotic and synergistic relationship with mainstream finance Islamic Financial Institutions are positioned in a “zone of sustainability” Islamic finance characteristics: NGOs not-for-profits SOCIAL IMPERATIVE ZONE OF SUSTAINABILITY Islamic businesses

7. Growing at 15 to 20% per annum 1 Within 8-10 years, industry estimated to capture half the savings of the 1.6 billion Muslim world 2 Industry has advanced from niche to critical mass Market size estimated at USD 750 billion globally 1 Young industry Mitghamr Savings Associations (1963) & Tabung Hajji Malaysia (1967) Islamic Development Bank (1974) & Dubai Islamic Bank (1975) 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 Research and Training Institutes Global scale More than 250 Islamic banks worldwide operating in over 75 countries 3 GCC accounts for two-thirds of global Islamic assets * Malaysia leading industry maturity and sophistication Islamic Development Bank: largest pan-OIC financial institution Industry is fragmented, with slowly internationalising players Source:1: S&P Report ( 31 Aug 2006); 2: IIR Middle East (Apr 2006); 3 Bursa Malaysia “The Islamic Capital Market” 2005; * HSBC analysis Islamic banking assets as proportion of total (%) * 40% 20% 12% 30% 66% growth 33% growth

8. Industry has developed a comprehensive product offering over its young history 1950s 60s 70s 80s 90s 00s Egypt and Malaysia pioneering institutions Establishment of OIC (1969) Development of theoretical framework Muslim-majority nation independence Islamic Development Bank (1974) and DIB One country-one bank setup Advancement of Islamic products Full “Islamization” of Pakistan, Sudan and Iran Entry of global institutions, e.g. HSBC Tipping point reached in some markets Development of industry-building institutions syndications structured and trade finance Evolving richness in products Development of industry Industry has near like-for-like parity with conventional offering 1970s commercial banking insurance 1980s 1990s equity private equity project finance debt issues 2000s structured products 1970s 1980s 1990s 2000s

9. Source: HSBC Amanah Islamic finance industry is developing a global reach…

10. … with worldwide momentum from retail to regulator involvement . Singapore: Active in developing Islamic finance UK: New legislation for Islamic mortgages (2003) UAE: 30% of retail banking is Islamic (2005) Several institutions have converted from conventional to Islamic Malaysia: Islamic product and industry, development and sophistication leader USA: Harvard workshop with six regulators (1995) China: Active member of Islamic Financial Services Board (2004) Bahrain: Leading Islamic financial centre, and housing regulatory bodies Saudi Arabia: 95%+ of new consumer lending is Islamic (2006) Retail market rapidly converting to Islamic (2006) Source: HSBC Amanah, Press Reviews Each region is contributing in a unique way Japan: JBIC exploring Islamic financing opportunities (Dec. 2006) Germany: Saxony issues E100m Sukuk (2004)

11. Self-regulatory organizations bring credibility through standardization of practices GCIBFI (2001) Bahrain Promoting industry in theory and practice Disseminating Shariah concepts & multilateral understanding between IFIs and public Improving IFI practices, cooperation, professionalism and transparency IIFM (2001) Bahrain Development of global Islamic capital and money market Promoting active and regulated trading and capital flows Catalyzing trading infrastructure, product innovation and information flows AAO-IFI (1991) Bahrain Benchmark of Islamic accounting standards 56 accounting, auditing, governance and Shariah standards Enhancing clarity, transparency and harmonisation IIRA (2005) Bahrain Reference point for IFI ratings Issuing sovereign, credit, Shariah quality and corporate governance ratings Providing effective tool for informed investment decision-making IFSB (2002) Malaysia Standard-setting body of regulatory and supervisory agencies Complementing Basel II Capital Accord Key standards: risk management, capital adequacy & corporate governance LMC (2002) Bahrain Creation of active Islamic inter-bank market Creating secondary market for short-term Shariah-compliant treasury products Enabling IFI management of liquidity mismatch

12. Strong growth of OIC economies Retail customer commitment Institutional capital Liberalisation of capital markets Innovative product development Resurgence of Muslim cultural values EXPLOSIVE GROWTH OF ISLAMIC FINANCE Industry is driven by fundamental factors Why Islamic financing is flourishing

13. Multinational banks have gradually increased their focus on Islamic finance Mainstream institutions are embracing 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 and 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

14. Industry is reaching mainstream relevance in global financial system Relevance to non-OIC countries Relevance 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 Islamic finance benefits are not exclusive to Muslims

15. 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 1 The global Islamic insurance ( Takaful ) market is estimated to reach USD 14.4 billion by 2010 1 Most Islamic financial institutions are highly liquid , and seek new asset classes and markets to diversify Project finance requirements of USD 500 billion in 5 years 2 Capital markets developments: Malaysia – Sukuks account for 71% of 1H06 debt issues 3 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 The industry has not yet reached its potential Source: 1: IIR Middle East (Apr 2006); 2 Banker ME (June 2006); 3 RAM Islamic Ratings Services (2006)

16. Islamic framework provides solutions for key limitations of conventional banking system An ethical grounding prevents a wide set of problems IFI solutions Conventional banking issues Growing consumer indebtedness TSV maximisation ultimate goal Systemic conflict between shareholders and credit-financed customers Speculation-fuelled crises 1997 East Asia Crisis 1998 Russia 1999 Argentina Shariah-based IFI is Taqwa-based Regulation is reactive to corporate innovation Shariah-based system prioritises God over regulators – (SRO) Check on profit-seeking alone as sole business motive Investment channels towards ethical activities Prevention of speculation Ownership is prerequisite of sale Excessive risks are prohibited The case for “Narrow Banking” Equitable distribution of risk and reward Asset/need-based approach to financing Regulation often reactive and lagging corporate misbehaviour Collusion between research and M&A teams Enron, WorldCom, Arthur Anderson, Tyco and other collapses

17. An alternative banking model in development Liabilities Assets Investments Deposits Profit, not interest, becomes the basis for financial intermediation Suppliers of capital Productive economic actors with capital needs Equity financing mudaraba & musharaka Debt financing ijarah, murabaha, salam, istisna‘ Reducing debt-based products Islam permits commercial debt for productive ends Debt-based consumer products permitted on basis of need More the exception than the desired norm Building income-sharing products Musharaka is true form of financing Develop with “fixed” income payment profile Removing bias towards debt Current tax, accounting and regulatory systems and risk-weighting promote debt instruments Key internal issues that need addressing…

18. Shariah-based mindset is crucial direction for product development Shariah-based industry is the new vision Shariah-compliant products Shariah-based solutions Savings & Investments Indebtedness x Income-sharing products Shift from debt-based product offering Letter of the law Replicating conventional credit service offering

19. A number of factors need to be engaged to bring success Need for co-ordination to enable further development Key enablers Dedicated people Greatest intangible to enable Islamic finance and build its future Human capital development: bankers and Shariah scholars Committed sponsorship Academic input to formulate visionary framework and development Capital sponsorship to bring plans to life Change in mindset From Shariah-compliant to Shariah-driven products and services Education of all key stakeholders To build understanding and awareness Proactive engagement Regulators, practitioners and Shariah scholars to set a common agenda

20. We must preserve what is distinctive about Islamic finance Industry regulations and governance heading towards mainstream globalization Balancing different elements of Shariah credibility Concluding remarks Current expanding reach and richness of Islamic finance Despite the absence of an enabling framework But at a cost: culture of exceptions, Shariah credibility, competitive disadvantages To build an enabling framework requires concerted efforts Collaboration between IFIs, endowed industry institutions and regulators Exploration of narrow banking principles Imperative is for moving to Shariah-based services Japanese proverb: “ Vision without action is a daydream. Action without vision is a nightmare.”

21. Thank you Iqbal Khan Founding ex-CEO, HSBC Amanah