The Islamic finance industry is set for an exponential expansion over the next few years. It's thought to be worth between £150bn and £250bn compared with £100bn two years ago, and it's current annual growth rate is estimated at between 15% and 20%. The most rapid growth in Islamic finance has been in banking – both in Islamic banks and in conventional banks with "Islamic windows". The Islamic capital market has also seen a surge in activity, with a variety of multi-million-pound bonds (
sukuks) hitting the headlines.
Sukuks are seen as an important way for the Islamic finance market to meet the funding requirements of both the Middle East and South East Asia, which are estimated at £250bn and £500bn respectively over the next five years.
The growth in demand from these two regions has resulted from two factors:
- The massive accumulation of assets in banks operating in the predominately Islamic countries that have benefited from the extraction of energy reserves. The most obvious examples are the Gulf States, along with Brunei, Malaysia and Indonesia.
- A reaction to western financial practices throughout the Muslim world and a move towards comparative practices that adhere to Islamic law (sharia)
It's estimated that there are between 1.5 billion and 1.8 billion Muslims worldwide, of whom a quarter live in countries with a Muslim majority. While most of them currently subscribe to western financial principles, the new developments in Islamic finance may appeal to this group. It's also believed that the socioeconomic ethos underpinning Islamic finance may prove attractive to non-Muslims.
Investment and trade are central to the Islamic view of wealth creation. Practising Muslims believe that profits should not be earned simply because they have money to lend and someone is prepared to pay them to borrow it. They believe that a lender should profit only as a result of their interaction with an investment. As such, surplus funds held by an individual should be invested only in projects where they will play an active role in sharing the risk if they want to benefit. As a result, individuals or businesses wishing to borrow from those with surplus funds need to be able to trade with the financier who can then profit from a real trade investment.
With conventional finance, if X needs funds he borrows from Y who charges X interest based on the amount, the duration of the loan and the perceived risk. With Islamic finance, X and Y need to become trading partners for Y to benefit from the deal. The necessity for both parties to interact in a trading enterprise means that contracts play a key role in the process. They ensure that the participants benefit from trading but not from merely transferring or holding cash balances. The nature of these contracts is central to all aspects of Islamic finance.
Trading contracts may be the hardest thing for the uninitiated to understand. The problem is not that each contract is derived from practices that have existed for centuries, but that they are expressed in Arabic terms. Contracts that are at the core of Islamic financial products include mudarabah (profit sharing), musharakah (a form of equity partnership investment)
murabahah (cost plus mark-up),
ijarah (operating lease) and
ijarah muntahia bi tamleek (an alternative to hire purchase and finance lease). A range of bolt-on agreements can be included to adjust each deal in order to meet a customer's particular requirements while still complying with sharia principles.
A company must offer products and services that are
sharia compliant in order to trade as an Islamic financial institution (IFI). Such compliance must permeate throughout the organisation and its activities. An IFI's customers should use its funding for
sharia compliant purposes only.
The issue of consistency is a big challenge for the industry. Each IFI has its own
sharia advisory board, which is an independent panel comprising experts in interpreting the
sharia principles governing product terms and conditions. These boards provide integrity by ensuring that IFI's policies and instruments don't contravene the principles set under
sharia. They are seen as the most important body governing Islamic banking and finance. All of them have the common goal of ensuring compliance, but they will differ over details such as methods of appointment, the legal status of rulings, internal supervision and so on.
The standardisation of products and services in Islamic finance is further challenged by the fact that boards differ in how they interpret the sharia principles. In the case of finance, South East Asia generally takes a more liberal approach than the Middle East. For example, most Gulf states allow only operating leases and not finance leases. This requires the lessor to assume responsibilities as in an operating lease until the transfer of title is executed. It also means that products deemed acceptable in South East Asia may not be adopted in the Middle East. Such differences of opinion are accepted by the Muslim community so long as the scholars involved have used a rigorous method of interpretation (
ijtihad) that can be traced back to the primary sources of the
Koran, the practices of the Prophet Muhammad and juristic views in the past.
A notable development in the market is that an increasing number of non-Muslims are seeking out Islamic financial products. The attraction for them seems to be the ethical basis on which financial decisions are made. When an IFI makes a trading agreement with a customer, it creates a stronger link than that of the normal lender-borrower relationship. If the venture fails, the institution suffers the loss while the customer loses only the time and effort they have spent. An IFI will, therefore, conduct strict due diligence before entering a deal and also work closely with a customer to ensure the success of their enterprise. Also, an IFI wouldn't wish to invest in a deal that could result in the exploitation of any party to it. Business activities should be based on mutual consent and goodwill. All participants should feel that they are benefiting from the arrangement. In addition, ventures involving alcohol, tobacco, gambling, entertainment, weaponry and pork products are excluded.
Another indication of social responsibility is the religious levy of
zakat, which Muslims pay on all wealth that's capable of generating a return (excluding their home, furniture, tools of trade and personal jewellery).
Zakat payments are distributed to designated beneficiaries, primarily the poor and needy. Such features are proving increasingly attractive to the socially responsible investor, Muslim or otherwise.
Despite the increasing importance of Islamic finance, few institutions offer courses in it and there is no global qualification. This is why The Chartered Institute of Management Accountants has developed the CIMA Certificate in Islamic Finance and it will be launched in Kuala Lumpur on 8 April. For more information, please contact 03-77 230 348 / 333 (Edward or Siew Lian).
John Willsdon is a practice manager in the CIMA Centre of Excellence. This article is contributed by CIMA and it first appeared in Financial Management, CIMA's monthly magazine for its members.
