Trends and Challenges in Islamic Finance: January 2008
Trends and Challenges in Islamic Finance: January 2008
Trends and Challenges in Islamic Finance: January 2008
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Andreas Jobst
International Monetary Fund
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I. Introduction
The Islamic finance industry is in the midst of a phenomenal expansionary phase, exhibiting average annual grown rates of about 15 percent in
recent years. This rapid growth has been fueled not only by surging
demand for shariah compliant products from financiers from the Middle
East and other Muslim countries, but also by investors around the world,
thus rendering the expansion of Islamic finance a global phenomenon.
In fact, there is currently more than US$800 billion worth of deposits
and investments lodged in Islamic banks, mutual funds, insurance
schemes (known as takaful), and Islamic branches of conventional banks.1
According to a recent study by McKinsey (2007), the value of Islamic
banking assets and assets under management is expected to reach US$1
trillion by 2010 with Islamic banks growing more rapidly than the average
banking sector in most countries.
Besides its wide geographical scope, the rapid expansion of Islamic
finance is also taking place across the whole spectrum of financial activities, ranging from retail banking to insurance and capital market investments. But perhaps the most striking has been the fast growth of sukuk or
Islamic bonds, the most popular form of securitized credit finance within
Islamic finance. Islamic bond issuance has soared over the last three years
in response to growing demand for alternative investments (Jobst et al.,
Heiko Hesse, Andreas Jobst and Juan Sol are Economists in the Monetary and Capital Markets
Department of the International Monetary Fund in Washington, D.C. The views expressed in this
article are those of the authors and should not be attributed to the IMF, its Executive Board, or its
management. Any errors and omissions are the sole responsibility of the authors.
1
There are currently more than 300 Islamic financial institutions spread across 51 countries, apart from
250 mutual funds that comply with Islamic principles. For a discussion of the ways in which Islamic banks
are becoming increasingly involved in conventional financial systems and of the associated challenges, see
Sol (2007).
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2008). At the end of 2007, outstanding sukuk globally exceeded US$90 billion (Moodys, 2007 and 2008). Gross issuance of sukuk has quadrupled
over the past two years, rising from US$7.2 billion in 2004 to close to
US$39 billion by the end of 2007. Although the current level of sukuk
issuance by corporates and public sector entities remains a fraction of the
global fixed income markets, total issuance in 2007 accounted for roughly
a quarter of conventional securitization in emerging markets.
Sukuk have largely escaped the retrenchment of investment in structured finance on the heels of the global financial crisis triggered by the collapse of the US sub-prime mortgage market. Although the issuance of
sukuk has slowed to US$4 billion in the first quarter of 2008 (down by
almost half from the first quarter in 2007), the number of deals brought to
market has remained steady. That said, the prevailing market uncertainty
and the retrenchment of real estate exposures worldwide has created a significant backlog of planned sukuk issues, which could see a restoration over
the course of this year. On the assumption of a stable rate of growth, the
volume of sukuk issued by governments and corporates will surpass the
US$150 billion mark by 2010, spurred by buoyant demand especially from
banks, insurance companies and pension funds in both Islamic and nonIslamic countries.
The rapid evolution of Islamic finance activities points to the enormous
profit opportunities that beckon. This in turn has prompted a vetting
process among a number of jurisdictions around the world to establish
themselves as leading Islamic financial centers. In this regard, the case of
London is perhaps the most remarkable insofar as it has managed to
extend its leading position in world financial markets to become a center
for Islamic finance. Similarly, Hong Kong, New York, and Singapore are
also making important advances to accommodate Islamic finance within
their jurisdictions and aspire to join the ranks of the more established
Islamic centers such as Bahrain, Dubai, Kuala Lumpur, and Labuan.
Islamic finance rests on the general idea of extending the tenets of
Islamic religious beliefs to economic activity in a way that enhances social
welfare. As one of the key features of Islamic finance, Islamic contracts are
asset-based and transactions have to comply with shariah law, which prohibits (i) the trading of debt contracts to earn a profit (riba), (ii) profit taking without a real underlying economic activity, and (iii) activities that are
not considered halal (shariah compliant). Moreover, the contractual
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relationships between financiers and borrowers are governed not by capital-based investment gains arising from the time value of money but by
shared business risk (and returns) from entrepreneurial investment in lawful activities.
In the authors opinion, all these developments underscore the fact that
Islamic finance has established itself as a permanent element within the
global financial landscape. Nevertheless, despite the recent advances,
important challenges lie ahead. This paper first provides a brief overview
of the main Islamic finance principles, before discussing some of the challenges faced by Islamic finance and suggesting potential solutions. For
expository purposes, we have adopted a two-pronged approach in considering these challenges through a discussion of key banking issues and then
some capital market issues.
See Iqbal and Mirakhor (2007) and Wilson (2008) for an introduction to Islamic finance.
The trading of debt is allowed in some jurisdictions under the concept of Bai al Dayn.
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investment and trade: (i) synthetic loans (debt-based) through a salerepurchase agreement or back-to-back sale of borrower- or third party-held
assets, (ii) lease contracts (asset-based) through a saleleaseback agreement
(operating lease) or the lease of third-party acquired assets with a purchase
obligation (financing lease), and (iii) profit-sharing contracts (equity-based)
of future assets. The appendix provides a short overview of these Islamic
finance principles, which govern financial relationships and contracts in
Islamic law jurisdictions.
These principles are best illustrated in Islamic banking, probably the
oldest area of Islamic finance. For instance, Islamic banks determine the
rate of return on deposits differently from commercial banks. In conventional banking, the rate of return is set contractually (fixed in advance or
tied to a reference rate) and does not depend on the banks lending performance. In an Islamic bank, the rate of return on a deposit is directly
dependent on the performance of the banks investments. If the bank
records losses as a result of poor investments, depositors may lose some (or
all) of their deposits. Thus, the contractual agreement between depositors
and Islamic banks does not pre-determine any rates of return; it only sets
the ratio according to which profits and losses are distributed between the
parties to the deposit contract.
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See the IFSBs guidelines Capital Adequacy Standards for Institutions (Other than Insurance Institutions)
Offering Only Islamic Financial Services and Guiding Principles of Risk Management for Institutions (Other
than Insurance Institutions) Offering Only Islamic Financial Services.
6
See the FSAs Briefing Note BN016/06, Islamic Banking in the UK, available at www.fsa.gov.uk
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See the FSAs PN041/2006, Home reversions and Islamic mortgages get new consumer protections, available
at www.fsa.gov.uk
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different legal regimes can lead to the same outcome (substance), the legal
process (and possibly the associated rights and obligations of the contractual parties) (form) might vary considerably.
If shariah compliance is treated (only) as a matter of substance and
upholds in spirit what was created in form, such as the issuance of assetbacked securities (ABSs), (defined by commercial law), the violation of
the shariah would probably temper investor interest in a transaction, but
would not preclude legal enforceability of investor claims. However, if the
transaction is governed solely by shariah law as a matter of form, the opinion of shariah courts could override commercial legal concepts and requalify the legal nature of a securitization transaction. For instance, the
legal separation of securitized assets from the bankruptcy estate of the
originator in a true sale securitization carries the possibility of bankruptcy
courts or insolvency officials in Islamic jurisdictions to invalidate the substantive non-consolidation and re-characterize an asset sale as an unsecured loan.
Regulatory consolidation and market harmonization
Recent efforts to achieve regulatory consolidation and standard setting
have addressed economic constraints and the legal uncertainty imposed
by Islamic jurisprudence and poorly developed uniformity of market practices. Therefore, market inefficiencies caused by heterogeneous prudential norms and diverse interpretations of shariah compliance are expected
to wane in the near future. Leading international organizations in Islamic
finance, such as the Accounting and Auditing Organization of Islamic
Finance Institutions (AAOIFI), have been working on aligning shariah
principles on a consistent basis. In this regard, a fine balance is required
between collective initiatives and regulatory revisions, so as to ensure that
standardization is achieved without staving off financial innovation. In
2008, a Task Force of the IFSB is due to publish recommendations for
standard sukuk structures in response to efforts by professional organizations towards greater uniformity of such structures.
Outlook
Since conventional securitization is virtually absent in Islamic countries,
considerable demand for shariah-compliant investment assets provides an
untapped market for structured finance. Islamic securitization also
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V. General challenges
What are the current challenges for Islamic finance and its continued
above-average growth rates in the different regions, across banks and products? Below, we list a few key challenges that were partly touched upon in
the above discussion.
Recent regulatory changes concerning the structure of sukuk warrant
careful consideration and might mute some of the recent enthusiasm for
Islamic capital market products. In February 2008, the shariah committee
of AAOIFI issued new recommendations regarding the role of asset ownership, investment guarantees, and the shariah advisory and approval
process in sukuk origination and trading. These proposed rules attracted
significant attention prior to their release, following a statement by the
chairman of the shariah committee in November 2007 indicating that 85
percent of sukuk issues in the GCC do not concur with shariah principles.
Most sukuk issued in the GCC have explicit repurchase agreements that
guarantee the repayment of principal but violate the profitloss sharing
(PLS) features of shariah law. There are currently discussions underway
between the various stakeholders and some market participants to gauge
the potential of these recommendations to cause permanent damage to
the sukuk market.
The sukuk market is also still plagued by illiquidity due to limited depth
and breadth, mainly because Middle Eastern banks, which are the most
likely securitizers/sellers of risk, are flush with liquidity and capital, so
there is no strong funding or balance sheet rationale for sukuk. Although
the commoditization of illiquid asset exposures through securitization
facilitates the disciplining effect of capital markets, the lack of information
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from private sources about securitized assets in many sukuk and the prevalence of buy-and-hold investments inhibit efficient price discovery and
information dissemination. Moreover, sukuk are available at maturities of 3,
5, and 10 years but not for short-term maturities, which significantly limits their application for money markets. Although Islamic banks are currently one of the largest buyers of shariah-compliant products (at long
maturities), they would benefit most from issues at shorter tenors. There
is some hope that the launch of different sukuk funds in the near future
might potentially unlock liquidity constraints, but this might only create
new demand without sufficiently alleviating supply constraints. It is currently also difficult to set up sukuk funds with sufficient diversification.
Notwithstanding the compelling value proposition of sukuk, without efficient and transparent capital markets and appropriate legal frameworks to
operate within, Islamic capital markets will not continue to grow meaningfully in the near future.
Liquidity risk management of Islamic banks is an important challenge
and is constrained due to limited availability of tradable Islamic money
market instruments and weak systemic liquidity infrastructure. At the
moment, there is no shariah-compliant short-term Islamic money market
(less than one week maturity) in local currency or in US dollars, and
Islamic repo markets have not yet developed. Islamic money markets with
longer maturities, which are based on commodity murabaha transactions
(mark-up financing), sometimes suffer from unreliable brokers with low
credit-worthiness. Islamic banks also have a competitive disadvantage
with conventional banks, as they deposit their overnight money with their
domestic central bank interest free. The lack of liquidity and viable alternatives, combined with the competitive disadvantage, hamper the local
Islamic banks and can even create a liquidity crisis. Many investment
banks are currently designing new complex products, compliant with shariah law, that attempt to overcome the shortcomings of the Islamic money
market. It remains to be seen whether these new solutions will obtain
widespread shariah compliance in the Islamic finance community and
generate enough demand for a functional Islamic money market to
develop.
Business models and products of Islamic banks are still rather homogenous, while shariah compliance amplifies risks stemming from product
configuration and process implementation. The success of Islamic banking
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in recent years has produced too many Islamic banks with the same business models. There is a lack of bread and butter lending, and the current excess liquidity has led to too much complacency among the Islamic
banks. In addition, there is a large and diverse set of accounting standard
differences across the different jurisdictions. The development and setting of simple standard legal contracts is necessary in order to overcome
the complexity and heterogeneity of current contracts. Furthermore, the
deployment of IT systems that help monitor the fulfillment and visibility
of processes on an end-to-end basis are crucial to facilitate the continuous
monitoring of activities by shariah scholars while eliminating the possibilities of non-compliance, which in some cases might render transactions
invalid.
Financial innovation in Islamic finance is still hampered by the need for
harmonized financial regulation. As discussed before, governance issues,
especially the shariah compliance of products and activities, constitute a
major challenge for the Islamic finance industry. Although shariah rulings
(fatwas) by legal scholars are disclosed, there are currently no unified principles on which shariah scholars decide on the shariah compliance of new
products. Fatwas are not consolidated, which inhibits the dissemination,
adoption, and cross-fertilization of jurisprudence across different countries
and schools of thought. Moreover, there is still considerable heterogeneity
of scholastic opinion about shariah compliance, which undermines the
creation of a consistent regulatory framework and corporate governance
principles. The fragmented opinion of shariah boards, which act as quasiregulatory bodies, remains a source of continued divergence of legal opinion. Since Islamic law itself is divided between different juristic schools of
thought (madhahib), which provide guidance on the analytical reasoning
(ijtihaad) or interpretative analogy (qiyas) of the general principles of the
shariah, there is no consensus (ijma) on the religious compliance of certain
products and transaction structures. Given the rising global integration of
the Islamic financial services industry, greater supervisory harmonization
across national boundaries is essential.
There is also regulatory disparity among national supervisors, with each
regulator working independently and refusing to recognize the validity of
judgments made by foreign counterparts. A greater role for the AAOIFI,
the General Council for Islamic Banking and Finance Institutions (GCIBFI),
and the Islamic International Rating Agency (IIRA) in this regard has added
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VI. Conclusion
Despite a number of challenges that we outlined in the previous sections,
the future looks bright for Islamic finance. Financial institutions in countries such as Bahrain, the UAE, and Malaysia have been gearing up for
more shariah-compliant financial instruments and structured finance
both on the asset and liability side. In addition, financial innovation will
contribute to further development and refinement of shariah compliant
derivative contracts. For instance, the development of Islamic derivatives
bodes well for the Islamic insurance (takaful) industry, whose shariah compliance has traditionally resulted in overdependence on equity and realestate investment, restricting the potential of risk diversification from a
wider spectrum of available assets.
At the same time, the leading financial centers, e.g. Hong Kong,
London, New York and Singapore, are making significant progress in
establishing the legal and prudential foundations to accommodate Islamic
finance side-by-side with the conventional financial system. Many of the
largest western banks through their Islamic windows have become active
and sometimes leading players in financial innovation and new shariahcompliant financial instruments that attempt to alleviate many of the current constraints such as a weak systemic liquidity infrastructure. More
conventional banks are expected to offer Islamic products, enticed by
enormous profit opportunities and also ample liquidity especially across
the Middle East.
New product innovation is also driven by domestic banks interest in
risk diversification. With a large number of new Islamic banks across the
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APPENDIX
Islamic BankingBasic Terminology
Term
Explanation
Amana
(Demand deposits)
Deposits held at the bank for safekeeping purpose. They are guaranteed in
capital value, and earn no return.
The seller can sell a product on the basis of a deferred payment, in installments or in a lump sum. The price of the product is agreed upon between
the buyer and the seller at the time of the sale, and cannot include any
charges for deferring payment. In a BBA contract, the lender is not compelled to disclose the profit margin.
Salam
(Pre-payment, deferred delivery)
The buyer pays the seller the full negotiated price of a product that the seller
promises to deliver at a future date.
Ijara
(Lease, lease purchase)
A party leases a particular product for a specific sum and a specific time
period. In the case of a lease purchase, each payment includes a portion
that goes toward the final purchase and transfer of ownership of the product.
Istisna
(Deferred payment and delivery)
A manufacturer (contractor) agrees to produce (build) and to deliver a certain good (or premise) at a given price on a given date in the future. The
price does not have to be paid in advance (in contrast to bay salam). It may
be paid in installments or part may be paid in advance with the balance to
be paid later on, based on the preferences of the parties.
Juala
(Service charge)
Kifala
It is a pledge given to a creditor that the debtor will pay the debt, fine or liability. A third party becomes surety for the payment of the debt if unpaid by
the person originally liable.
Mudaraba
(Trust-based contract)
Rabb -ul- mal (capital s owner) provides the entire capital needed to
finance a project while the entrepreneur offers his labor and expertise.
Profits are shared between them at a certain fixed ratio, whereas financial
losses are exclusively borne by rabb -ul- mal. The liability of the entrepreneur
is limited only to his time and effort.
Murabaha
(Mark-up financing)
The seller informs the buyer of his cost of acquiring or producing a specified
product. The profit margin is then negotiated between them. The total cost is
usually paid in installments.
Musharaka
(Equity participation or sweat
capital finance)
The bank enters into an equity partnership agreement with one or more partners to jointly finance an investment project. Profits (and losses) are shared
strictly in relation to the respective capital contributions.
Qard Hassana
(Beneficence loans)
These are zero-return loans that the Quran encourages Muslims to make to
the needy. Banks are allowed to charge borrowers a service fee to cover the
administrative expenses of handling the loan. The fee should not be related
to the loan amount or maturity.
Sources: Errico and Farrahbaksh (1998) and El-Hawary, Grais, and Iqbal (2004).
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