In This Chapter
Meeting existing Islamic financial institutions
Seeing the impact of global credit crises on the industry
Predicting future growth
Anticipating industry challenges
In this chapter, I take you on a quick tour of the Islamic finance industry as it exists today. I first introduce you to the key participants in the industry: the institutions that offer financial products to businesses and individuals. Then I share some thoughts about how a changing global financial landscape — epitomized by a seemingly never-ending string of credit crises — is influencing the Islamic finance industry.
I firmly believe that this industry is poised for substantial growth in the near future, and I explain why I feel that way in this chapter. I also list some challenges that inevitably accompany growth as Islamic financial institutions search for new products, employees, and clients — all while upholding a commitment to the principles that define the industry (see Chapter 1).
Looking at Current Islamic Financial Institutions
Many types of Islamic financial institutions exist, which isn’t surprising if you consider how many types of financial institutions you depend on to manage the business of your life. For example, chances are you have a bank account with an institution that has both a headquarters (which you never visit) and local branches (which you may visit frequently, even if only to coax some cash out of an ATM). And you may carry a variety of insurances, such as home or rental, health, life, disability, and car insurance, each of which is issued by a financial institution. If you have a 401(k) or other retirement plan through your workplace, you probably invest the funds in stocks and/or bonds, which are also issued and managed by financial institutions.
In this section, I introduce the variety that exists within the Islamic finance industry as well. Each of the types of products I mention in the previous paragraph has a cousin in the world of Islamic finance, and lots of institutions exist to issue and manage those products. In fact, the number of Islamic finance institutions is growing virtually every day — a topic I delve into in the later section “Gazing into the Crystal Ball of Islamic Finance.”
Islamic banks are the cornerstones of the Islamic financial system and were the first financial institutions established under sharia principles. The very basic difference between a conventional bank and Islamic bank is this: Islamic banks are based on interest-free operations. As I discuss in Chapter 1, interest (called riba in Arabic) is prohibited under Islamic law. You may wonder how a bank can operate without interest. That’s a great question, which I begin to answer in this section and then explore in detail in Part III.
Despite the key differences in operations, Islamic banks offer many products similar to conventional banks’ offerings, including the following:
Current (checking) accounts
Profit-sharing savings accounts
Profit-sharing investment accounts
Lockers (safe-deposit boxes)
Online banking services
Money transfer facilities
Think of how your favorite commercial bank operates. When you want to deposit money or have the ability to pay with checks, you open a checking account or savings account. For a savings account, the bank gives you a predetermined interest rate return. When you want to take out a student loan or a mortgage or to finance your car, the bank charges you a higher interest rate. Banks make some money through activities such as safeguarding money and issuing commercial papers (think: letters of credit and so forth), but conventional banks operate (and make profits) primarily based on interest.
So how can Islamic banks survive without charging interest? Does an interest-free operation mean that the capital has no value? In a word, no. Islamic principles recognize the value of capital but don’t allow the owner to make a predetermined profit in the form of interest. Instead, Islam allows the owner of the capital to share a profit from the surplus of an economic activity by taking risk.
Islamic banks operate by collecting money from customers (the sources of funds) and utilizing those funds in economic activities that result in surpluses, which are distributed among the depositors and banks. (I discuss the sources and uses of funds in Islamic finance in detail in Chapter 9.) If you intend to make deposits in an Islamic bank with your excess money, the bank gives you a profit- and loss-sharing ratio based on the product you select. The money you deposit is invested in an economic activity, such as a business project or an asset purchase. If the activity results in a surplus, you get your profit share. If the activity results in a loss, you share the loss according to the agreed-upon ratio.
What if you want to get a loan from an Islamic bank? Strictly speaking, taking out a loan isn’t possible. Instead, the bank comes up with a partnership agreement with you for your investment activities or, if you want to get a loan to buy a house or a car, creates a rental agreement to help you accomplish that goal. I cover this subject in detail in Chapter 10, where I outline the variety of banking products available to businesses and individuals — from construction and retail loans to mortgages and advance payments for goods and services.
Adopting appropriate operating structures
Islamic banks are generally stand-alone organizations because of their mandate to operate interest-free and according to sharia principles. However, Islamic banks have adapted a variety of structures based on the countries in which they operate. These structures accommodate the financial laws they must follow and the economic and monetary policies of the presiding government.
Following are some of the most common bank operating structures followed in the Islamic finance industry:
Full-fledged banks: These banks operate as independent organizations whose sole purpose is to provide sharia-compliant products. (I introduce the role of sharia — religious laws or codes of conduct that govern Islamic finance — in Chapter 2.) The Islamic Bank of Britain and the Dubai Islamic Bank are examples of full-fledged banks.
Subsidiary banks: Subsidiary banks are generally formed by existing conventional financial institutions as separate legal entities. They’re managed independently from the parent company but adhere to the parent company’s strategies. The best examples are HSBC Amanah, which is a subsidiary of the HSBC Group, and Standard Chartered Saadiq, which is a subsidiary of Standard Chartered. (Both parent companies are headquartered in London.)
Branches: Some conventional financial institutions offer sharia-compliant products through branches, which are separate and dedicated storefronts. For example, ABN Amro offers Islamic banking through its branches in the Middle East.
Window models: In this case, the Islamic financial activities are simultaneously carried out by a conventional financial institution that assures its clients that Islamic operations are segregated from the conventional services occurring within the same building. This very basic model is used by conventional banks that haven’t converted themselves to Islamic financial services. One example is UBS Islamic Finance in Switzerland.
Islamic banks interact with and have good relationships with international financial organizations such as the World Bank, International Monetary Funds, government central banks, and conventional commercial banks. (I devote Chapter 8 to discussing the relationships between Islamic banks and conventional commercial banks.)
Supporting their customers and communities
Islamic banks aren’t created only to make money or to serve as alternatives to conventional banks. They also serve their customers and communities by playing the following critical roles:
Investment manager: The foundation of Islamic banking is investment. Islamic banks are involved in making investments according to sharia principles. Those investments can be crucial both at a personal level (for an individual seeking to open a business, for example) and at a community level (to facilitate economic development and support public projects that benefit all residents).
Social services organization: Islamic banks increase their ties to the communities where they operate by offering social and humanitarian services. For example, many banks are involved in collecting and distributing zakat, which is a financial religious obligation that requires wealthy Muslims to give a share of their riches to the needy (see Chapter 2). Islamic banks also are involved in micro financing projects based on sharia principles.
Islamic investment fund operators
Islamic fund operators bring sharia-compliant equity and commodity investment options to the capital market, including mutual funds, exchange-traded funds, and unit trusts. The very first Islamic fund to hit the market was created in 1986 in Indiana — go figure! (I share the story of the Amana Income Fund in Chapter 11.)
Growing by leaps and bounds
As of this writing, Islamic banking services are growing at a rate of 10 to 15 percent per year. Around 300 Islamic banks are operating in 51 countries (both Muslim and non-Muslim countries). In Muslim countries, many Islamic banks have been operating for the last two decades, and now the West has started to adopt Islamic banking as well. In the United States, for example, Michigan-based University Bank provides Islamic financial services. The United Kingdom has incorporated Islamic banking services under its financial law. Countries such as France, Russia, Switzerland, and Germany have already opened their doors to Islamic banks. And a few Asian, non-Muslim countries have also started to adopt Islamic banking practices, including Sri Lanka, India, and Thailand.
To achieve sharia compliance, fund managers structure their equity and commodity investment products based on Islamic contracts (a topic I cover in Chapter 6). All Islamic equity funds are based on mudaraba contracts, which create financial partnerships in which an investor gives money to a fund manager for the purpose of investing it in a business or a specific economic activity. Both parties share the profits, which are achieved by buying and selling stocks to make capital gains and by receiving corporate dividends.
Islamic equity funds apply a strict two-step screening process that filters out stocks from companies whose transactions aren’t sharia-compliant and/or whose financial ratios indicate too much leveraging. A company engaged in prohibited transactions may conduct business that involves interest-bearing products, for example, or that relates to the production of alcohol, pork, pornography, or another product forbidden by Islam. A company that is filtered out because of its financial ratios likely carries too much debt and is involved in speculative transactions, which are also prohibited. I explain the two-step screening process in depth in Chapter 12.
Likewise, Islamic commodity funds cannot invest in any commodities that are prohibited by Islam. And Islamic commodity funds differ in other crucial ways from their conventional counterparts: They cannot participate in short selling because the commodities in question must be in the actual possession of the seller, and they generally cannot participate in forward sales (although exceptions exist). See Chapter 12 for the scoop on commodity funds as well.
Islamic indexes for benchmarking the industry
Anyone who invests in the U.S. stock market has heard of the Dow Jones Industrial Average (DJIA) and the S&P 500. Just as U.S. investors need benchmarks that they can use to measure the performance of their investments, investors in Islamic equities also need indexes.
In Chapter 11, I introduce you to Islamic capital markets, which allow for investment in equity products (similar to stocks), derivatives, exchange-traded funds, and more. (If you aren’t sure what these terms mean, never fear; I explain these products in Chapter 11.) The point here is that in order for investors and potential investors to make educated decisions about what capital market products to buy and when, Islamic indexes are quite helpful. These indexes serve the same function as the DJIA or S&P 500: They give equity owners (or potential owners) something against which to compare the performance of a company or group of companies.
Many Islamic indexes exist, both domestic (covering only companies operating with a certain country’s borders) and international. The Dow Jones Islamic Market Index was the first successful Islamic index developed, and it has been joined by others with names such as IIRA (Islamic International Rating Agency), FTSE Global, MSCI Barra, HK Islamic Index, EW India Islamic Index, and Jakarta Islamic Index.
Without trustworthy indexes, investment in Islamic capital markets would have died on the vine. But because these indexes exist, investors have confidence that they know how to judge their portfolio performance. Solid indexes build trust between investors and equity markets. Without them, those markets can’t thrive because investors will take their money elsewhere. I cover indexes and Islamic capital markets in general in Part IV.
Islamic bond (sukuk) issuers
Islamic bonds, or sukuk, are an increasingly popular mode of non-equity investment worldwide. As I write these words, the value of the sukuk market is at least $182 billion and is increasing 30 percent annually.
Sukuk are an Islamic alternative to conventional bonds; they’re sharia- compliant Islamic bonds that exist because conventional bonds are prohibited in Islam (because they’re subject to interest payments and can be sold above or below their nominal value). Generally, a sukuk certificate describes ownership of interest in an asset or pool of assets. The sukuk give the holder the proportionate beneficial ownership of that asset or pool of assets, along with the associated risk and potential return of cash flow from the underlying asset or assets.
The importance of being indexed
If you’re not sure what the Dow Jones Industrial Average (DJIA) and the S&P 500 actually refer to — maybe you just know they somehow relate to the value of the stock market as a whole — here’s a quick primer on indexes: An index generally consists of a group of companies that serve as a benchmark for judging the performance of the rest of the equity market in a country or a region of the world. For example, the DJIA, which was first created in 1896, reflects the stock market performance of 30 major U.S. companies. (The list of 30 companies has changed quite a few times since 1896.) When you hear on the news that the Dow Jones went up that day, you can rest assured that the value of your retirement plan (assuming you’re at least partly invested in the U.S. stock market) probably got a boost.
Not all indexes reflect the performance of just a select list of major companies. Some indexes are designed to reflect the performance of most companies in an entire nation. The S&P 500 gets closer than the DJIA to serving this role for the United States because it tracks the performance of 500 companies. The Wilshire 5000 (which, of course, tracks 5,000 companies) gets even closer. The Japanese Nikkei 225 and the British FTSE 100 are other examples of national indexes.
In truth, you can’t really call sukuk an exact equivalent to conventional bonds, stocks, or even some combination of these products. The very basic difference is that conventional bonds are represented by pure debt, while sukuk give the holder ownership of an asset or project and clearly disclose the risk and the credit worthiness of the issuer.
Sukuk are used as a channel to transfer money (in a sharia-compliant way) between an investor and a government or company that needs money for projects and asset acquisitions. Sukuk enable smaller investors to benefit from larger investments. Many types of sukuk are on the market. In Chapter 13, I explain in detail about the different types of sukuk and how they work.
Governments are often looking for alternative methods for financing projects, and sukuk have proved resilient during the global credit crises in recent years. Because of these credit crises (which I discuss later in this chapter), Western investors are more interested than ever in investing in Gulf sukuk because of their strong value and lower risk. Gulf sukuk are issued by Gulf Cooperation Council countries, which include United Arab Emirates (UAE), Saudi Arabia, Qatar, Oman, and Bahrain. The reason for growth in Gulf sukuk is the strong economic development taking place in these countries.
Capital markets are divided into primary and secondary markets. The primary market deals with new issues of financial instruments such as stocks, bonds, and options. The term secondary market refers to the aftermarket where the previously issued financial instruments are traded. Sukuk are traded in both markets, including on the London Stock Exchange.
Islamic insurance (takaful) providers
Takaful are often defined to Western audiences as “Islamic insurance,” but in reality they’re slightly different products than the insurance you’re familiar with. Islamic principles prohibit conventional insurance because it involves interest, gambling, and uncertainty (see Chapter 1). Takaful products, therefore, are an alternative to conventional insurance; they involve a kind of mutual risk-sharing arrangement among multiple parties.
The takaful concept isn’t new; it has been practiced in Islamic society since the ninth century by Muslim merchants who were trading in Asia. They formed a fund by mutually agreeing to make contributions to cover losses incurred because of pirates or unpredictable natural events. Then and now, takaful are based on the principles of cooperative risk sharing, mutual responsibility, mutual protection, and solidarity among participants. The word takaful is an Arabic term that means “guaranteeing each other.” In takaful, a group of people agree to share the risk of any potential loss, such as a house fire, vehicle accident, or health crisis, by making contributions to the fund. Then the takaful fund helps members when they suffer a loss.
Takaful companies differ from conventional insurance companies in how they invest their funds. Conventional insurance companies can invest their funds without any restrictions, but takaful companies are required to make investments in sharia-compliant ways. In addition, any profits from the takaful investments are shared with contributors in an agreed-upon ratio. In other words, takaful companies share any surplus moneys in the insurance pool with the contributors.
For example, suppose you buy a motor takaful from a takaful company. You contribute a sum of money to the general takaful fund as your premium. You also sign a contract that states that you mutually agree with other participants to use your fund premiums to help each other in case of any loss due to a motor vehicle accident. As your takaful matures, you have the right to share in any surplus funds if you haven’t made any claims. You share the potential surplus with the company and other participants based on a pre-agreed ratio.
Many types of takaful products are on the market. The current takaful market includes approximately $5 billion of premium contributions and involves more than 110 institutions worldwide, and it’s growing fast. Part VI offers all the details about takaful, including the most commonly used products.
Islamic finance is regulated and monitored by various governmental, nongovernmental, and regulatory bodies to make sure it meets certain criteria that also apply to conventional financial institutions. Two self-regulatory institutions that are considered the most important are the Islamic Financial Services Board (IFSB) and the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI). Both ensure that the financial statements of Islamic financial institutions meet quality and international standards comparable to those adhered to by conventional institutions.
IFSB: This international organization for the Islamic financial industry began operations in 2002 with its headquarters in Malaysia. The IFSB aims to develop a transparent and regulated Islamic finance services industry by introducing new sharia-compliant prudential standards. The IFSB issues principles and standards in corporate governance, risk management, and capital adequacy.
AAOIFI: The AAOIFI was established in 1990 with headquarters in Bahrain. This independent, not-for-profit organization is supported by governments, central banks, and financial institutions. The organization ensures that all the participants in the Islamic finance industry conform to certain rules and regulations. Additionally, it’s involved in setting the compliance standards according to sharia for accounting, auditing, ethics, and corporate governance. It aims to harmonize Islamic financial practice around the globe and ensure uniformity in financial reporting.
Both of these organizations have helped the Islamic finance industry more effectively mesh with mainstream finance and meet the needs of investors. Because of the IFSB and the AAOIFI, investors know they can rely on the financial statements issued by Islamic financial institutions.
The AAOIFI interacts with the London-based International Accounting Standards Board (IASB), which is one of the most recognized international accounting standards organizations. This interaction has given the AAOIFI good credentials and international recognition for its standards. The IFSB interacts with the Bank of International Settlements (BIS), which is an association of various government central banks. This connection has helped raise the international visibility of the Islamic finance industry.
Considering the Impact of the Global Credit Crises
Starting in late 2007 and intensifying in 2008, global credit crises shook the whole world. As I write, these crises have not abated; instead, they seem to be spreading from one nation to another, infecting investor confidence and creating ongoing stock market volatility. The severity of the credit crises challenges the world’s seemingly stagnant economic philosophies, including the granddaddy of them all (at least to many Westerners): capitalism. It’s forcing financial professionals to look for new ideas and solutions.
Recent bank performance
Here are some statistics regarding the performance of conventional and Islamic banks during the global credit crises based on a study of the top ten conventional and Islamic banks:
Between 2006 and 2008, the market capitalization (total value of all stocks) of conventional banks declined by 42.85 percent, while the market cap of Islamic banks declined only by 8.5 percent. Additionally, the total assets of the conventional banks in the study grew 36 percent, while the Islamic banks’ total assets grew 55 percent.
The net profits of conventional banks dropped from a $116 billion profit in 2006 to a $42 billion loss in 2008, while Islamic banks experienced a net profit increase of 9 percent in the same period.
Five of the top ten conventional banks received government assistance totaling up to 26 percent of their combined equity during the years 2006 through 2009, while only one Islamic bank received government assistance to restructure its suspended share trading.
Conventional financial institutions have taken the hardest blows from the crises. Here are a few facts to consider about where financial markets stand:
In the summer of 2011, the U.S. and many European countries faced yet another financial downturn (including a downgrade to the U.S. credit rating by Standard & Poor’s) fueled by setbacks and defaults in the banking sector.
A stagnant U.S. economy, with an unemployment rate hovering around 10 percent, led the Federal Reserve to make an unusual commitment in 2011: to hold short-term interest rates near zero at least through the middle of 2013.
Fears of failure in the European banking system sent markets tumbling in mid-2011 and required substantial commitments from the European Central Bank to purchase bonds from Italy and Spain.
Since 2008, the credit crises have led to the failure of many banks throughout the U.S. In that year, 25 banks failed, and the number jumped to 140 in 2009. The year 2010 was even worse; 157 banks went under.
One reason for the instability in the conventional financial sector is that its financial institutions have proven to have weak risk-management practices, meaning they haven’t properly managed their risks through the years. (Chapter 17 offers a description of the risks that financial institutions must manage and the potential repercussions if they don’t do so effectively.)
But as conventional institutions were losing ground between 2007 and 2009, the assets managed by Islamic banks doubled. (Keep in mind that not all Islamic banks performed the same in this time period; banks in some countries in the Persian Gulf region, for example, actually saw their assets decline.) That growth was motivated by several factors: increasing numbers of customers were turned away from conventional banks and toward Islamic banks both in Muslim and non-Muslim countries; the banking industry in the Middle East region grew; and many banking authorities and regulators changed their legislation to better support Islamic banking (including in Europe, India, and China). The ratings by major rating agencies have also been more favorable for many Islamic banks than for conventional banks.
Gazing into the Crystal Ball of Islamic Finance
Predicting how any industry will perform in the future is difficult because so many factors are at play. After all, if I could tell you with absolutely certainty that Industry X (whether it be utilities, superconductors, or Islamic finance) is going to grow threefold over the next ten years, you and I would know exactly where to invest and hold our equity dollars, right?
So it’s with a humble keyboard that I type this section. I’ve gathered a great deal of data from what I consider to be reliable sources, and I’ve based my predictions on my interpretation of that data. Just don’t go betting your paycheck that I’m right because predictions are always subject to change.
Studying recent growth
In the past two decades, the Islamic finance industry has had an average growth of 14 percent per year. That’s enormous! For comparison, consider that the global bond industry has averaged 5-percent growth per year during the same period.
As I write these words, the Islamic finance industry is worth an estimated $1 trillion. Approximately 60 percent of the total assets belong to the Middle East region, 20 percent are in Asian countries, and 20 percent are spread among the rest of the world. In just one recent year — from 2008 to 2009 — assets of the 500 top Islamic financial institutions grew from $639 billion to $820 billion.
Here are some additional statistics about the industry as it looks today:
The Islamic banking segment of the industry has current assets that are estimated to total around $500 billion.
More than 250 sharia-compliant mutual funds are available to investors.
Globally, sukuk issues in 2011 exceeded $65 billion.
The float-adjusted market capitalization (the total value of all stocks available) of the Dow Jones Islamic Market Index is more than $14 trillion.
The estimated current captive market for Islamic finance (meaning people who’d likely seek out sharia-compliant products because of their religion and culture) is 1.6 billion Muslims, 62 percent of whom live in Asia.
Approximately 500 Islamic financial institutions provide Islamic financial services globally. Islamic financial institutions are operating in 75 Muslim and non-Muslim countries; the following sections give you the highlights of the activity in several major regions.
In the Middle East
Iran is the largest player in Islamic financial services in the Middle East; it has a fully Islamicized financial system. Iran boasts the biggest Islamic bank — Bank Melli Iran — as well as six more of the ten largest Islamic banks in the world. Saudi Arabia is considered the second-largest player in the Middle East for Islamic finance, with four Islamic banks and 30 percent of its total financial assets in Islamic finance products.
Bahrain is one of the world’s leaders in Islamic financial services with a dual banking system, which means it operates both conventional and Islamic financial systems. Bahrain was the first country to implement an Islamic financial system in the Gulf region.
United Arab Emirates and Qatar are also important players in Islamic finance in the Middle East, and Oman has recently joined that list as well.
In Southeast Asia
Malaysia is a key player in the global Islamic finance industry and is also famous for Islamic finance education. Like Bahrain, Malaysia has a dual banking system. Approximately 18 Islamic banks (both local and foreign) operate in Malaysia. Singapore, Indonesia, Hong Kong, and Brunei are also practicing Islamic financial services.
In the Commonwealth of Independent States (CIS) region
Central Asia is becoming another booming area for the Islamic finance industry. After the collapse of the Soviet Union, the Muslim-majority countries of central Asia, which are known for their substantial energy resources, have become more economically independent.
At the beginning of 2009, Kazakhstan introduced laws to facilitate the operation of Islamic finance firms. Kazakhstan is home to 13 million Muslims and a wealthy oil industry. Many international Islamic financial institutions are targeting Kazakhstan to tap the potential market.
Kyrgyzstan introduced Islamic finance legislation in 2010 after a three-year pilot study. Azerbaijan introduced Islamic banking at the beginning of 2012 and has expressed the desire to become a hub for Islamic finance in central Asia. Tajikistan is another Muslim majority country considering adapting Islamic finance.
In other parts of Asia
Sixty-two percent of Muslims live in the Asia-Pacific region, so it’s no surprise that many Asian countries are incorporating the Islamic financial system. For example
At the end of 2011, Japan initiated reform of its taxation policies and regulations to facilitate local sukuk issuances and sharia-compliant investing.
South Korea has proposed tax exemptions for local sukuk issuance.
Pakistan is following both conventional and Islamic financial systems and has five full-fledged Islamic banks. Many educational institutions in Pakistan specialize in Islamic finance.
Bangladesh adopted Islamic banking activities beginning in the 1980s.
Sri Lanka is the first non-Muslim country to adopt Islamic finance in South Asia. It has one full-fledged Islamic bank, as well as three conventional banks that operate Islamic windows.
In the West
The United Kingdom was the first Western nation to adopt the Islamic banking system. In 2004, the Islamic Bank of Britain became the first wholly licensed sharia-compliant bank in the West. In 2006, the European Islamic Investment Bank, headquartered in London, became the first Islamic investment bank in the West. The United Kingdom is also the most preferred place for Islamic finance education in the West; numerous British universities offer Islamic finance education for local and international students.
In the United States and Canada, the Islamic finance industry has developed much differently: Islamic financial products have been developed to respond to demand from small Muslim communities rather than from the broader financial market. In the past 30 years, the industry in the United States and Canada has grown by offering sharia-compliant investment products such as mutual funds and home purchase agreements. With 4 million Muslims in the United States alone, the demand for retail Islamic banking opportunities will continue to grow.
Many European countries, such as France, are considering incorporating Islamic banking into their mainstream banking systems. Germany has already partially amended its laws to incorporate Islamic banking, and the German state of Saxony-Anhalt has issued sukuk. Luxembourg and Switzerland are already enjoying Islamic financial transactions.
Australia, which has one of the world’s most sophisticated financial systems, has recently joined the growing list of eager participants in the Islamic finance industry. One of its largest banks, Westpac, is offering short-term wholesale investment products for overseas Islamic financial institutions. Also, Islamic investment companies have been established in Australia, and some of its universities are offering Islamic finance education. And in early 2012, Thomson Reuters and Australia’s Crescent Wealth (an Islamic investment manager) developed the Islamic Australia Index to help investors make sharia-compliant equity investment decisions in the Australian market.
Anticipating worldwide expansion
Based on the information I’ve seen, I estimate that the Islamic finance industry will grow between 10 and 15 percent annually in the next decade. The global asset value of the Islamic finance industry was estimated to be $1 trillion in 2011, and some people project it to be as high as $5 trillion in 2016. (That would be huge growth, indeed!)
Why am I so bullish? The Islamic finance industry is still very young when you compare it with the conventional finance industry. Although the Islamic finance industry has ancient roots (which I discuss in Chapter 3), the industry as it stands today began relatively recently — in the 1970s. (The conventional finance industry, in contrast, began developing in the 17th century.) I see the Islamic finance industry poised for great things, ready to make the move from adolescence to adulthood.
Of course, the age of the industry isn’t the only factor influencing my expectations. Two other key factors are the increase in wealth among Persian Gulf nations and the growth of the Muslim population globally.
Gulf wealth: The potential for expansion in Gulf countries is immense for both consumer banking and corporate banking. The Gulf countries have 45 percent of the world’s oil and gas reserves and are planning to invest $2 trillion in the next decade to diversify their economies. Many of these wealthy countries are looking for investments in sharia-compliant products, which means that Islamic financial institutions are their best investment sources.
Population growth: The growing Muslim population throughout the world creates demand that drives the Islamic finance industry. Consider these population statistics just from Europe:
• Russia (officially known as the Russian Federation): 18 million Muslims
• France: 5 million Muslims
• United Kingdom: 1.6 million Muslims
• Spain: 1 million Muslims
These populations, which will continue to grow, seek out sharia-compliant products.
As I note earlier in the chapter, many banks in Muslim countries are already converting to Islamic finance to meet the growing demand. The world’s largest financial institutions, such as the World Bank, the International Monetary Fund (IMF), and the treasuries of developed countries, have likewise engaged with the Islamic finance industry. Islamic finance practices are being accepted and embraced across the globe.
Also, many non-Muslim countries have already changed their monetary policies to accommodate Islamic financial practices. The United Kingdom, for example, wants to be the Islamic financial hub for Europe, and many other European countries (such as France, Germany, Luxembourg, and Russia) have just entered the market.
In the near future, Islamic financial institutions around the world will be globalized, meaning they’ll have an international presence and become involved in mergers and acquisitions, much like what occurs within the modern conventional finance industry.
Eyeing Industry Challenges
The Islamic and conventional finance industries face many of the same challenges, including financial crises, innovative product development, competition, and management of risk. However, the Islamic finance industry also has several unique challenges, which I spell out in this section.
Dealing with regulatory and tax issues
Islamic financial institutions must deal with government regulations and tax issues in the countries in which they operate — rules that may not fully recognize their business structure. The difficulty is that in countries where Islamic finance isn’t practiced as major business, government regulations and taxation rules specifically address conventional finance. Creating a bridge between such regulations and the Islamic finance industry is a major challenge, especially as the industry grows. The following sections cover a couple of the main issues.
Ignoring the unique bank-customer relationship on tax day
Customers of Islamic finance institutions are different from conventional customers for the purposes of government regulations and tax codes. People who deposit money into Islamic banks are partners of the business, and they share the profit and losses. Their deposits aren’t guaranteed; they have no promise that they’ll get back their initial investment in the case of a loss. This structure is a stark contrast to that of conventional banks, where depositors are creditors to the bank and their deposits are guaranteed.
Because of the special relationship between depositors and Islamic banks, depositors need to be given special consideration as business partners; they should receive tax credits or incentives. These tax incentives already occur in countries with significant Islamic finance industries, such as Malaysia. In other words, the government of Malaysia recognizes the distinct differences between the structures of conventional and Islamic institutions and tries to encourage development of the Islamic finance industry by giving tax incentives to Islamic banking customers.
Conversely, in countries where Islamic finance is practiced on a smaller scale, government authorities often apply the same policies to both types of institutions and don’t offer credits/incentives for Islamic products — thus hindering the potential growth of the Islamic finance industry — because these authorities simply don’t (yet) understand the nature of the industry.
Mandating minimum reserves
The central bank of any given country, state, or region requires commercial banks operating within that geography to hold a minimum amount of money from customers’ deposits either as cash physically stored in the bank’s vault or as a deposit at the central bank. This requirement safeguards customer deposits and helps to regulate the liquidity in that country, state, or region.
The minimum reserve requirement differs from place to place. In the United States, the minimum is set by the Board of Governors of the Federal Reserve System, with the reserve amount depending on the bank’s deposits. Many developing countries have minimum requirements ranging from 2 to 20 percent of the commercial bank’s total deposits.
Here’s where the problem occurs: Islamic banks are also required, by law, to meet these minimum reserve requirements. But deposits made into an Islamic bank are different from deposits made to conventional banks; the deposited money is immediately funneled into business activities and doesn’t sit in a vault or get invested in conventional financial products. So meeting the reserve requirements can really strain the Islamic bank’s liquidity management. One suggestion for leveling the playing field is to offer Islamic banks tax incentives for maintaining reserves.
Help wanted: Finding trained and skilled Islamic bankers
The Islamic finance industry is in need of qualified, skilled, and trained personnel. That statement was true when the modern industry began, and it’s even truer today because of the industry’s phenomenal recent growth. Current forecasts suggest that the global Islamic financial industry will employ a total of 55,000 trained professionals by 2020.
In early 2012, only a few universities and institutions were providing recognized courses in Islamic finance at the international level. However, I expect the numbers to increase as more people become aware of the industry’s growth and potential.
To work in the Islamic financial industry, you must be skilled in both conventional and Islamic finance because so many conventional banks are opening Islamic branches or windows or are converting their conventional operations to Islamic banks. At minimum, you need a certification in Islamic finance, banking, or economics along with your basic bachelor’s degree. As in the conventional banking world, some positions require a master’s degree.
If you have a bachelor’s degree in any business field and you plan to go to grad school, I recommend focusing your master’s program or your professional certified courses on Islamic finance. If you’re just stepping into higher education and know that Islamic finance is for you, you’re better off starting with an Islamic finance major if it’s available (or seeking out certified professional Islamic banking courses).
One thing you don’t need to know is the Arabic language. (I can hear your sigh of relief!) Although studying Arabic can certainly boost your career options, most internationally recognized Islamic finance degree and professional certificate programs are offered in English, and employment options exist that don’t require knowledge of Arabic.
Satisfying sharia scholars: The search for compliant products
Islamic financial institutions differ significantly from conventional financial institutions because they require approval for their product development. As I explain in Chapters 2 and 16, Islamic financial institutions are guided and governed by sharia boards: religious boards steeped in knowledge of Islam that use such knowledge to determine whether the products offered by financial institutions comply with Islamic principles. If a sharia board doesn’t approve a product that an Islamic bank or other institution wants to introduce, that product doesn’t go on the market — period.
Different schools of thought exist regarding Islamic law. (The same can be said of the laws governing every religion; not every Christian interprets the Bible the exact same way, right?) Satisfying all the sharia scholars, whose opinions inevitably differ, is difficult. The result of differences in opinion is that a scholar from one region may approve a new, innovative product, but a scholar in another region may not. This fact makes product development in the Islamic finance industry quite a challenge!
Consider an example: The sale of debt (bay’ al dayn) is one of the most controversial Islamic financial products. Basically, it’s a process in which a creditor sells a debt to a third party, and it’s practiced in the secondary market for sukuk. Sharia jurists in the Middle East don’t allow this product, but Malaysian jurists do.
As the industry blooms and more Islamic financial institutions become multinational entities, these kinds of challenges related to product development will emerge again and again.
Educating clients and crossing the language barrier
Sometimes, Arabic financial terminology is challenging for me — both in terms of the concepts and the pronunciation. And I’ve known Arabic my entire life! Certainly, people who are raised speaking languages other than Arabic may be so intimidated by the language barrier that they shy away from investing in the Islamic finance industry.
Helping customers understand the Arabic terminology that is commonplace in the Islamic finance industry is a challenge. For starters, people working in the industry need to help potential customers realize that the Arabic terms aren’t intended to exclude non-Muslims from participating. Instead, these terms help industry professionals differentiate their products from conventional financial products. (Sukuk differ from conventional bonds, for example, so using the same word for both products isn’t helpful. Flip to the earlier section “Looking at Current Islamic Financial Institutions” for details on how sukuk and other Islamic finance products differ from their conventional finance cousins.)
Many Islamic finance institutions recognize the language barrier and make overt efforts to reach out to non-Arabic-speaking people. They do so by defining their products in brochures or on their websites so that customers can fully understand and consider certain investment products. I expect that as more Westerners select Islamic finance as a topic of study and as a career goal, you’ll see greater public relations efforts to help potential investors get familiar with Islamic investment products.