Introduction

Recommendations for success by IFSB and IDB/IRTI

Opinion pieces

The Christian view of usury by Robert Van de Weyer

The future of Islamic finance by Dr Sayd Farook

The secret to long-term success: get the direction of travel right by Faizal Karbani

INTRODUCTION

In coming to this last chapter of the book, it is my hope that the reader has grasped the key principles, concepts and practices underpinning the Islamic finance industry. Furthermore, that it is clear that the industry in its modern form is at a very exciting stage – the growth potential is impressive, with plenty of opportunity for expansion and progress across the world. Indeed, penetration levels are fairly low in Muslim-majority countries. However, many challenges remain for an industry that is barely 40 years old if it is to compete effectively against a conventional financial system that is mature, well established and enjoys the benefits of scale.

As a practitioner myself and having been actively involved in the industry for the past decade, it feels as though we are no more than 10–15 per cent of the way through the journey that the industry needs to go through to establish itself as a viable and credible alternative to conventional finance.

The purpose of this chapter is to give the reader some powerful insights and perspectives on where the industry is and what are some of the key challenges, opportunities and imperatives for the future if it is to achieve its potential.

RECOMMENDATIONS FOR SUCCESS BY IFSB AND IDB/IRTI

To start with I want to cite a credible report published in May 2014 which seeks to provide a blue print for the development of the Islamic finance industry. The report was produced by two important organisations in the Islamic finance industry – the Islamic Financial Services Board (IFSB) and the Islamic Research and Training Institute (IRTI).

1. IFSB: in addition to AAOIFI, the IFSB is the other most recognised regulatory body in the Islamic finance industry. The IFSB serves as an international standard-setting body which has the objective of ensuring the soundness and stability of the Islamic financial services industry. The work of the IFSB complements that of the Basel Committee on Banking Supervision, the International Organization of Securities Commissions and the International Association of Insurance Supervisors.¹
2. IRTI: the institute was established by the Islamic Development Bank (IDB – a supranational bank committed to the economic and social development of Muslim member countries) as the research and training arm of the bank.

In March 2007, the IDB and the IFSB published a document on the state and future of the Islamic finance industry. The report, entitled ‘Islamic Financial Services Industry Development: Ten-Year Framework and Strategies’ (Ten-Year Framework), sought to lay out a roadmap for the development of the industry.

The Ten-Year Framework provided an overview of the industry, highlighting key opportunities and challenges. The document also offered 13 core recommendations for the development of the industry. In May 2014, the IFSB and the IRTI published a mid-term review of the Ten-Year Framework (Mid-Term Review)² as more than half of the period had passed. The report assessed the impact of macroeconomic events, monitored progress in implementing the original recommendations, and proposed additions or modifications to the recommendations to guide the industry.

The Mid-Term Review presented 16 recommendations (3 additional recommendations to the original set), classified into 3 themes, as a blueprint for the industry to develop:

1. Enablement: fostering conditions for the industry to thrive.
2. Performance: enhancing the effectiveness of institutions active in the industry.
3. Reach: expanding the set of potential beneficiaries of the industry.

The recommendations are summarised and categorised according to these themes in Table 9.1.

These 16 recommendations are an excellent reflection of the challenges facing the industry and what it needs to do to successfully progress. A number of the areas mentioned in the recommendations were highlighted in Chapter 1, namely the need for:

• a regulatory environment that allows the industry to develop and flourish;
• scale to compete effectively with conventional finance;
• human capital – if Islamic finance is to reach its growth potential, it needs significant human capital – appropriately educated and trained – to facilitate and drive this growth;
• sharia authenticity – remaining true to the spirit and objectives of the sharia;
• making Islamic finance more inclusive – as a value proposition it can and should appeal to more than just Muslims.

Table 9.1 The 16 Mid-Term Review recommendations

Enablement

Facilitate and encourage the operation of free, fair and transparent markets in the Islamic financial services sector.

Develop the required pool of specialised, competent and high-calibre human capital.

Promote the development of standardised products through research and innovation.

Develop an appropriate legal, regulatory and supervisory framework, as well as an IT infrastructure that would effectively cater for the special characteristics of the Islamic financial services industry (IFSI) and ensure tax neutrality.

Develop comprehensive and sophisticated inter-bank, capital and hedging market infrastructures for the IFSI.

Foster collaboration among countries that offer Islamic financial services.

Develop an understanding of the linkages and dependencies between different components of Islamic financial services to enable more informed strategic planning to be undertaken.

Performance

Enhance the capitalisation and efficiency of institutions offering Islamic financial services to ensure that they are adequately capitalised, well performing and resilient, and on par with international standards and best practices.

Enhance sharia compliance, effectiveness of corporate governance and transparency.

Enhance the implementation of the international prudential, accounting and auditing standards applicable to the IFSI.

Strengthen and enhance collaboration among the international Islamic financial infrastructure institutions.

Foster and embrace innovative business models, including new technologies and delivery channels, in offering Islamic financial services.

Reach

Enhance access by the large majority of the population to financial services and enhance access to funding for SMEs and entrepreneurs.

Promote public awareness of the range of Islamic financial services.

Conduct initiatives and enhance financial linkages to integrate domestic IFSI with regional and international financial markets.

Strengthen contributions to the global dialogue on financial services, offering principles and perspectives to enhance the global financial system.

These recommendations are aimed at influencing key stakeholders in the industry, particularly policy makers, regulators and industry bodies/players. With the IFSB and IDB’s membership of central banks, governments and regulators and prominence in the industry, the report has a good chance of positively influencing the way forward. As part of this Mid-Term Review, the IFSB and IDB/IRTI have set down some more specific and detailed criteria with which to assess progress against the recommendations made and it will be interesting to review these results post-2017, once the overall 10-year period has elapsed.

OPINION PIECES

I now want to share some insightful and interesting opinion pieces on the relevance and future of the Islamic finance industry. These contributions are from Robert Van de Weyer and Dr Sayd Farook.

Robert Van de Weyer – Robert is an economist and was previously a lecturer at Cambridge University. He is a practising Christian priest and has written a book called Against Usury. It is interesting to get Robert’s perspective as someone outside of the Islamic finance industry – an insight into how Christianity has viewed interest over time and how he believes an interest-free economy could produce more equitable and stable economic outcomes. This feeds into the aspiration that the values and principles underpinning Islamic finance can appeal to an audience wider than just Muslims.

Dr Sayd Farook – Dr Sayd is the Global Head of Islamic Capital Markets at Thomson Reuters. Previously he was a consultant for a leading Islamic finance consultancy, Dar Al Istithmar, and gained his doctorate in Islamic finance from the University of Technology in Sydney. Dr Sayd, by virtue of his experience, his global role and the fact that Thomson Reuters is continually conducting world class research and analysis of the Islamic finance industry, is in an excellent position to offer an insightful perspective on the progress, opportunities and challenges facing the Islamic finance industry. Dr Sayd shares his views on how the industry has developed to date and offers his wisdom as to what the industry needs to do going forward to achieve its potential.

I finish the chapter with an opinion piece from myself: what I regard as the ingredients critical to the long-term success of the Islamic finance industry.

THE CHRISTIAN VIEW OF USURY BY ROBERT VAN DE WEYER

Modern Christianity has no distinctive message about financial and economic matters. Occasionally Christian leaders condemn particular financial practices. Thus, for example, Rt. Rev. Justin Welby, the Archbishop of Canterbury, has strongly criticised the high interest rates charged by ‘pay-day’ lenders, and he has indicated his preference for credit unions as a means of providing loans to the poor. But, like all Christian pronouncements on finance, this is merely an ad hoc view on an issue that has received widespread publicity; it does not derive from any specific Christian teaching.

Yet for the first 15 centuries of the Christian history, the Christian church promulgated two particular economic principles, and the church regarded breaking those principles as criminal, to be severely punished. The Christian writer who expounded these principles most clearly was Thomas Aquinas. But they were reiterated time and again at meetings of Christian bishops.

The first principle was the ‘just price’. This stated that the price charged for any good or service should reflect the labour expended in producing it. In normal circumstances market forces will ensure the just price. If, for example, people can earn more money from producing X rather than Y, then some of those producing Y will shift to X in pursuit of a higher reward, and this will continue until earnings are roughly equal.

But the ancient Christian leaders were concerned with circumstances where market forces fail and hence where moral force must ensure compliance. One such circumstance is a temporary shortage of a good, perhaps owing to a poor harvest or warfare. Dealers in that good will be tempted to raise their price to exploit the shortage, but Christian leaders taught dealers to resist this temptation, instead leaving the price unchanged. Another circumstance is where a particular producer has some local monopoly power, giving them the ability to push up their price; again the Christian leaders taught such producers to charge a price based only on labour costs.

The second principle was the prohibition on usury, defined broadly as the charging of interest on loans. The basis for this prohibition came from various verses in the Old Testament (for example, Leviticus 25:35–7). The kind of lending envisaged in these verses is to families who have fallen into poverty, so charging of interest was seen as taking advantage of other people’s misfortune.

As the European economies became more sophisticated in the medieval period, merchants needed money from others in order to finance trade, and one way of raising money was to borrow at interest. Since the lenders and the merchants alike were typically quite wealthy, there was no question of exploitation. Nonetheless the Christian church continued to condemn interest. Those providing finance for trade should have a share of the profits rather than an amount fixed in advance.

The argument centred on the allocation of risk. If a passive investor lends money to a merchant at interest, in order to finance a trading expedition, then the financier has first call on any returns from the expedition. Thus the merchant carries a disproportionate share of the risk. If the expedition is disappointing, the investor will receive their interest, while the merchant may receive little or nothing. Conversely, if the expedition is very successful, the merchant will enjoy high returns, while the investor’s returns are unchanged.

The Christian leaders said this was inequitable. They recognised that every industrial and trading enterprise involves a degree of risk. So they taught that everyone providing funds for an enterprise should share the risk by means of sharing both the profits and the losses.

By the sixteenth century the Christian condemnation of usury was becoming more muted and a century later all the mainstream churches had accepted usury as an inevitable element of successful commercial activity. The main reason for this doctrinal retreat was the rise of banks. As banks rapidly came to occupy a central place in European economies, Christian leaders felt they had little choice but to bless them – and since banks depend on lending at interest, Christian leaders in effect also had to bless usury.

Of course, in condemning usury prior to the seventeenth century, Christianity was firmly allied to Islam, and if Christianity is again to engage in financial matters, it must renew that alliance. Yet in focusing on the allocation of risk, Christianity has a distinctive contribution, and an analysis of the nature of banking reveals this.

The essence of banking, from the sixteenth century onwards, is ‘maturity transformation’. Banks receive money from the public in the form of deposits, and depositors have the right to take out their money at any time, or at short notice. Depositors may receive a small amount of interest or, more often, the banks reward them by administering their deposits for little or no charge. The banks in turn lend out those deposits to businesses and private individuals, for periods that may vary from a few weeks or months to 25 or 30 years, and they charge substantial interest. The banks’ profits come from the difference between the high interest they charge borrowers and the low interest they pay depositors.

Banks undoubtedly serve two important functions vital to modern economies. First, bank deposits, accessed through debit cards, bank transfers and the like, comprise the main form of money, and they are far more secure than cash. Secondly, banks are the main channel through which people’s savings find their way to productive investment.

Yet banks are prone to periodic crises, of which the credit crunch of 2007–8 is the most recent, and possibly the worst – and the reason for these crises is the inequitable allocation of risk.

In principle, depositors carry no risk whatever. They are lending their money to the banks at low interest, with the right of immediate withdrawal. Conversely, businesses borrowing money from the banks carry all the risk. Regardless of how well or badly a business performs, it must pay the interest to the bank. Of course, some businesses fail altogether, so the bank receives little or nothing. But in normal times it can predict the rate of such failures and it sustains the losses through the high interest it is charging others.

A crisis comes when lots of borrowers fail at the same time and then suddenly the allocation of risk shifts. Banks find themselves unable to pay depositors when they wish to withdraw funds. As rumours of this start to circulate, depositors rush to the banks in order to withdraw funds, making the crisis worse. Thus banks are no longer able to perform their primary social function of providing money, so the entire economy is in danger of seizing up. At this point the government has no choice but to intervene, effectively guaranteeing bank deposits. So the risk ends up in the lap of the taxpayer, and the knowledge of this ultimate outcome may have prompted banks in the previous few years to make unduly risky loans – the problem of ‘moral hazard’.

This prompts the question of whether it would be possible to have an efficient banking system without usury, in which risks were allocated equitably. What would such a banking system look like? Would it perform the dual functions of providing money and channelling funds to productive investment? Moreover, would it be free of periodic crises?

A non-usurious banking system would have two sorts of banks. The first would be deposit banks, in which people deposited their money for the banks to administer. The banks would hold their deposits either as cash or in some other safe form, such as a government bond that held its real value. By their nature deposit banks would be perfectly safe, in that people could be certain, even in the direst economic circumstances, of being able to withdraw their money on demand.

The second would be investment banks. People would entrust their savings to investment banks, which would use the savings to acquire equity in businesses or buildings. Thus the banks would help businesses to expand and the banks would then receive returns depending on the success of the businesses. Those entrusting funds to the investment banks would receive an annual return, depending on how well the various investments performed. The investment banks would also retain some liquidity to enable people to withdraw on a first-come-first-served basis.

Thus the social functions of banks would be split. The deposit banks would uphold the system of money, while the investment banks would marry savings with investment. Of course, investment banks would not be the only channel for savings. Different types of investment banks would spring up, with different specialities. But the important point is that risks would be transparent and fair. Deposit banks would be totally safe, while investment banks would provide the means whereby savers and investors shared risk equitably.

While this model for non-usurious banking accords with traditional Christian teaching, it may appeal to those without faith. Indeed, since the credit crunch several commentators, with minor variations, have advocated it, the most prominent being John Kay of the Financial Times. The idea of ‘ring-fencing’, advocated by the Independent Commission on Banking appointed by the government (known as the Vickers Commission), is a weak version of the separation of banks. It would be unlikely to work successfully because it retains important elements of usury, but it perhaps indicates the way the tide of opinion is moving.

The prohibition of usury would have other important implications beyond the sphere of banking, of which two are especially prominent. First, companies would not be able to finance their operations through issuing debentures (bonds); the only form of finance would be ordinary shares, where investors receive a share of profits. High ‘gearing’ or ‘leverage’, where businesses depend heavily on bonds, is a major cause of commercial failure, even where the businesses are basically sound. All businesses go through difficult patches and if they are so highly geared that they cannot pay the bond interest, they go under. So requiring all business finance to be in the form of equity would create a more stable commercial environment.

Secondly, families would no longer buy their homes through mortgages but instead would share the purchase with an investment bank or other specialist provider. If the investment bank provided, say, 60 per cent of the funds, the family would pay to the bank an amount equal to 60 per cent of the market rent. When the family sold the house, the bank would receive 60 per cent of the proceeds. Thus the bank would share with the family the risks attaching to home ownership. One major consequence would be the end of housing bubbles, which are caused by people borrowing at interest to buy homes in the belief that the rising value will more than cover the interest.

The present writer, as a Christian, would not presume to comment on the underlying theology of Islamic finance. But undoubtedly most people regard the principles of Islamic finance as applicable only to Muslims. The present writer, by contrast, believes that if God has taught that a particular financial principle is righteous, it is universally applicable. The prohibition of usury in all its forms is a righteous financial principle, divinely ordained – and Muslims and Christians alike should preach that message to the world. Without doubt the world would be a fairer and happier place if the message were heeded.

Rev. Van de Weyer is an economist and a priest in the Church of England. The ideas expressed in this article are explored more thoroughly in his book Against Usury (SPCK, 2010).

THE FUTURE OF ISLAMIC FINANCE BY DR SAYD FAROOK

You should learn from your competitor, but never copy. Copy and you die.

Jack Ma, Founder of the Alibaba Group

Three-quarters of the world’s adult population, or 2.5 billion people, are unbanked and Muslims are more likely to be financially excluded because a significant proportion avoid interest-based financial services.³ While Islamic finance continues to grow in leaps and bounds it has the potential to gain even more traction if it can reach those left behind by conventional finance. However, Islamic financial institutions (IFIs) are facing serious challenges with respect to satisfying customers and reaching the unbanked demographic across both their native markets such as the GCC and new markets such as North Africa and Central Asia.

Customers are no longer happy to accept Islamic financial services as a sub-par alternative to conventional finance and the Islamic banking model has not proven to be inclusive. With an aggressive and competitive landscape where IFIs have to compete head on with conventional financial institutions for market share, IFIs now have to come up with a differentiated approach that increases barriers of entry and enhances stickiness of customers. The question is, how? In this opinion piece we explore the evolution of the strategic direction of IFIs in the last couple of decades, to assess what needs to be done to ensure they can compete effectively to retain and grow market share in an increasingly inclusive way.

Potential universe of Islamic finance customers

Studies during the late 1990s and early 2000s identified three broad segments that make up the potential universe of Islamic finance customers. The first are the religiously strict ‘sharia loyalist’ customers who can occupy anywhere between 10 per cent and 30 per cent of the potential customer base of IFIs. These customers demand and prefer sharia compliance above all else and are willing to pay a premium price or sacrifice profits in order to align their financial dealings with Islamic principles. This customer segment is the most inelastic and is considered a captive customer base of IFIs, in the absence of competition. The second customer segment is defined as ‘floaters’ and they occupy anywhere between 40 per cent and 70 per cent of the market for Islamic financial services. These customers are characterised by a preference towards Islamic financial products only when they are deemed to be competitive with conventional products. Finally, the last broad customer segment is termed ‘secular’ and occupies anywhere between 15 per cent and 30 per cent of the customer universe. These customers do not have any preference for Islamic financial products and care only about the relative value of the offering.

Phases of Islamic finance growth

Appealing to Muslims with sub-par products: 1990–2010

From the early days of modern Islamic finance into the post-financial crisis era, IFIs were struggling just to offer basic services – from banking and insurance to asset management and capital market products – to their captive customer base, the strict sharia-sensitive customer segment. With sparse product offerings, diverse practices and little consumer understanding of Islamic products, IFIs were insulated from competitive pressures by the strict Muslim consumer segment’s demand for sharia-compliant products; this was the case even where Islamic banks offered similar economic outcomes at higher cost than conventional banking products.

Appealing to all with competitive products: 2010 onwards

More recently, IFIs have realised that appealing just to the sharia-sensitive customer segment will result in a very limited market. To expand the pie, IFIs needed to look farther afield to all customers of financial services, and try to appeal to them with equivalent services at equal costs with conventional financial institutions, which share relatively price-elastic customers unwilling to accept higher cost for what they consider equivalent products.

This phase is likely to enable IFIs to grab a bigger slice of the financial services pie by appealing to floaters, but it is not likely to yield a significant jump in market share. In these instances, multinational and regional banks with a strong product offering and strong brand loyalty will continue to command an ever-increasing share of the customer’s pocket.

Standalone Islamic banks and sharia-compliant windows or subsidiaries of conventional banks that have developed a full product suite and a highly competitive offering can compete with other banks, and in many instances, win over customers. In many mature markets such as UAE, Bahrain, Malaysia, Kuwait and Saudi Arabia, this is where Islamic banks are gradually gaining market share.

Local banks that do not have Islamic products will continue to see their market shares decline, and Islamic banks will be the beneficiaries, but only up to a certain level as there will always be a user base for conventional products so long as there is a part of the population that is secular in character or agnostic to the type of bank that is offering the services.

The success of Islamic banks in this phase is based on an assumption that they can compete head-to-head on technology solutions (branchless banking, online), product breadth and depth (wealth, trade and financial markets) and quality service.

Appealing to all with a differentiated set of products: 2015 onwards

Most IFIs will come to realise that banking on ethics is not so much of a differentiator when conventional institutions with a strong franchise, loyal customer base and wider breadth of products are marketing themselves on the same premise. In this phase, the real game changer will be when IFIs can craft new, differentiated products that can appeal to everyone, while offering at the same time a best-in-class product suite that can win customers over to switch from their existing financial institutions. This step necessitates that the previous step of competing with conventional financial institutions on their own game is completed successfully.

To this day, there are no markets that have really reached this phase of evolution. With the exception of Grameen microfinance, the reality is that very little innovation actually originates out of the Muslim world.

That is not to say that the Muslim world will not innovate but that chances are very unlikely in the near future, given the brain drain that has occurred in the Muslim world over the past century. While Muslim societies wait for their brain gain, they have little left of an ecosystem necessary for innovation to occur.

However, there are many products that the Islamic finance industry could champion from the developed world, take as their own and run with: these products need to have a strategic fit with IFIs’ core ethos and operating model. Right now, nothing else from the developed financial markets fits with the underlying ethos and strategic perspective of Islamic finance, other than products that are ethical, increase access to banking and finance services for those who have limited access and/or aim to provide a purposeful reallocation of capital from those who have it to those who need it.

New and differentiated product offerings for Islamic finance

As such, if one were to look at what could be adopted wholesale with minor adjustments for local preferences and regulatory issues, the products are:

• crowdfunding for SMEs (small and medium-sized enterprises);
• socially responsible investments;
• community banking services.

All of these lend themselves to the Islamic financial services’ core ethos. The question is whether or not IFIs – which would include banking and non-banking institutions – can move the needle and really champion these causes in a scalable manner that enables them to grow their market share profitably.

Crowdfunding for SMEs

Many bankers in the Muslim world dismiss crowdfunding as a fringe movement or a phenomenon to be ignored. They do so at their peril. In the space of five years, crowdfunding has grown from a mere handful of sites to nearly 1,000 platforms operating on every continent except Antarctica. Experts predict that crowdfunding grew between 60 per cent and 80 per cent in 2012 and was likely to have grown more than 100 per cent in 2013.⁴

Crowdfunding breaks away from the normal banking model by enabling individuals through social networks to decide which businesses deserve funding – and these individuals do not think like bankers. They fund the smallest businesses, they expect success but not massive profits, and they view creativity and innovation as positive signs rather than warning flags. This inclusive, social justice-based innovation ethos aligns very well with Islamic finance, which emphasises access to finance for those who need it.

Experts such as Richard Swart from the University of California, Berkeley, suggest that the crowdfunding market will likely hit $95 billion by 2025, and that too without considering institutional investors.⁵ That would represent a similar growth trajectory to Islamic financing itself, which hit $150 billion in assets (75 per cent of which were banking assets) in the mid-1990s, 20 years after the Islamic Development Bank and Dubai Islamic Bank began operations.⁶

Socially responsible investments

A much-touted wedding of the $1.6 trillion Islamic financial services industry and the $3.74 trillion socially responsible investment sector has been in the making for years, yet has not seen the light of day. With the exception of a few fund managers such as SEDCO Capital, which uses dual Islamic and environmental, social and governance (ESG) screening strategies for some of its funds, the two have yet to meet on common ground and agree upon strategies to consolidate their approach to the market to capture the largest market share. Islamic asset and fund management lag behind the scale of conventional socially responsible investment (SRI) funds and hence in most cases cannot justify the higher costs to include SRI or ESG screening. The potential for this marriage is tremendous and inevitable, yet its occurrence will depend on concerted efforts by sharia-compliant fund managers to court SRI fund managers and ask them to consider offering their services to customers, and vice versa. We are already seeing trends of this occurring, with some sharia-compliant fund managers shifting their strategies to appeal to SRI investors also.

It is only a matter of time before IFIs figure out this might be the magic wand to gain critical mass in the wealth segment and start courting SRI fund managers aggressively.

Community services banking

A niche trend arising in some of the more community-oriented regions of the United States is the advent of community service-based banking. This approach goes against the conventional wisdom that branches need to be scaled down in a bid to move towards more cost-effective and technology-intensive branchless banking. Instead, community service-based banking emphasises the role of the modern bank branch as a centre of community rather than just banking services.

Customers are able to use the bank’s branches for a variety of community activities, which repositions the bank as a key stakeholder in the overall well-being of the community, akin to the role of the masjid in the early days of Islam. These banks are not just modern versions of Bailey Building & Loan, serving just a marginal role in the financial system. Some of the banks embracing this approach include those with multi-billion-dollar asset portfolios and are aggressively expanding (organically and through mergers and acquisitions).

Instead of adopting the conventional wisdom, Islamic banks that attempt to differentiate themselves through values of community service, something indigenous to the Islamic conception of business, may do better in retaining and attracting new customers.

Conclusion

Within the next few years, IFIs will be reaching a point of saturation in their home markets. With customers becoming savvier and more demanding, it will no longer be sufficient just to offer an ‘Islamic’ alternative, even if it is competitive with the conventional financial industry’s offerings. IFIs need to offer a value proposition that is fundamentally distinguished. This may mean returning to the roots of empowering entrepreneurs, increasing access to finance and serving as a real stakeholder in the community. However, this time it needs to be with a fresh twenty-first-century twist.

THE SECRET TO LONG-TERM SUCCESS: GET THE DIRECTION OF TRAVEL RIGHT BY FAIZAL KARBANI

You may have heard people using the analogy: it is useless running fast if you are running in the wrong direction. I passionately believe that the Islamic finance industry will achieve long-term success only if it is sincere to its faith-based and ethical roots. Only then will it bring a distinctive, value-based alternative to conventional finance. Otherwise, despite the hype, the impressive growth potential and the lure of billions of pounds of business from the Muslim world, the substance behind the offering will be weak and the industry, in my view, will fail to gain credibility and ultimately will not succeed.

The industry thus far can be likened to a child going into high school. It has learned to talk, write, look after itself, but has been very much copying the adults around it, namely the conventional financial institutions, in how it conducts itself. As it transitions into high school and adulthood, it will increasingly want to assert its own personality – it will discover its true self and what it stands for. This emerging adult will command respect and credibility if it is seen to be sincere to the faith and values it represents, it is honest and transparent with those it engages with, it is seen to be benefiting society (the overall objective of sharia), if it serves people with professionalism and it charges people fairly for what it offers.

Central to achieving this vision of a successful ‘adult’ and ensuring the industry is running in the right direction are, in my view, two critical issues.

Focus on achieving the objectives of sharia

As I have mentioned already in this book, the rules and principles of the sharia are designed to protect and enhance the interests of individuals and society at large, as articulated by a renowned Islamic scholar, Imam Ghazali:

The very objective of the sharia is to promote the well-being of the people, which lies in safeguarding their faith (deen), their lives (nafs), their intellect (ñaql), their posterity (nasl), and their wealth (mal). Whatever ensures the safeguarding of these five serves public interest and is desirable, and whatever hurts them is against public interest and its removal is desirable.

In my view, focusing on the objectives of sharia instead of a narrow, dogmatic perspective of just looking at the detailed rules has a number of advantages:

• For Muslims – it helps them engage with and buy into the industry and its practices; currently a lot of scepticism exists in the Muslim world about the practices of the Islamic finance industry fuelled by practices such as commodity murabaha that are very synthetic in nature. An approach grounded in expounding the objectives of the sharia such as investing in socially responsible investments and providing protection through true mutuality and cooperation inspires credibility and confidence in the industry.
• For non-Muslims – in the absence of a religious imperative to follow the injunctions of the Qur’an and the Prophetic teachings, the narrative of protecting and enhancing the interests of society is something that resonates from an ethical perspective. This in turn opens up the Islamic finance industry to a much larger audience. As the piece by Robert Van de Weyer advocates, there is a case to be made for equity finance as opposed to interest-based finance purely on rational grounds.
• Substance over form – surely ensuring the substance of transactions is sound from an ethical point of view and meeting the noble objectives of the sharia is more important than structuring transactions to meet the letter of sharia law. Focusing on the objectives of sharia when coming up with new products will ensure substance is given precedence over legal form.

Being true and bold enough to be different

As Dr Sayd Farook’s piece has highlighted, it is fair to say many of the products to date in the Islamic finance industry have sought to mimic the economic effect of conventional financial instruments – examples include commodity murabaha mimicking the economic effect of interest-bearing loans and Islamic home purchase plans mimicking closely the economic effect of conventional mortgages. This is understandable to some extent, as the industry has been in its infancy, copying the ‘adults’ around it.

Furthermore, there is nothing wrong with looking to see whether there is a sharia-compliant means of providing financial products in a way that gives the same or similar benefits as conventional products; the problem arises when it is done in an artificial way (as in the case of commodity murabaha) or the transaction is so closely controlled that while in theory the transaction exhibits certain characteristics required by the sharia, in reality these characteristics are practically non-existent because of the way the transaction is structured. For example, as described in Chapter 5, the diminishing musharakah technique is widely used for home financing. In a musharakah, both parties share in the profit and loss. Typically, in a diminishing musharakah home finance plan, the bank protects itself from the property falling in value by requiring the buyer to sign a legally enforceable promise that the buyer will buy the property from the bank at the original cost price. Hence, the bank ends up not sharing in any upside of the property price going up but it also does not share in the downside of the property price going down. Many have criticised this on the basis that it is not faithful to the true spirit of musharakah.

In the above example, it is clear that the diminishing musharakah and other sharia-compliant home purchase plans that have been in the market to date have been designed to compete head-to-head with conventional mortgages. Indeed, partly driven by banking legislation, the pricing of these sharia-compliant products has been with reference to LIBOR (London Interbank Offered Rate) and compared directly to conventional mortgages.

My recommendation is for product providers to come up with products that are faithful to the sharia principles and be bold enough to bring products that are different to the conventional space. For example, in terms of sharia-compliant home financing, to bring a scheme that means both parties share in the upside and the downside, the pricing in terms of rent is not in reference to LIBOR but real rental rates, the buying of shares in the property is not pre-ordained or forced on either party, and further shares are sold to either party at the market price at the time of selling. Yes, this is a very different proposition to the way the diminishing musharakah financing scheme from Islamic banks currently works – but it is more authentic and gives consumers a real, more flexible alternative to conventional finance. Faced with this alternative, I can see bankers retorting that my suggestion would contravene banking legislation in that the bank is taking on property price risk and crossing the line of merely providing finance. But that is exactly the point: the whole Islamic finance philosophy is anti-debt and wants financiers to take on real asset and commercial risk in the way they deploy their capital.

This brings me on to a related point, namely that I am an advocate of Islamic finance expanding as much as possible outside of the banking model. This is for two reasons:

1. The banking framework is built around the fractional reserve system. As discussed in Chapter 3, the fractional reserve system is inextricably linked to interest. Hence it is difficult for Islamic banks, and more so for Islamic windows in conventional banks, to completely extricate themselves from this system.
2. Banking regulation is biased towards interest-bearing debt-based transactions (as was alluded to in the diminishing musharakah example), while Islamic finance is biased towards equity finance and financiers taking on real asset risk. Hence banking regulation does not naturally lend itself to the ethos and philosophy of Islamic finance.

Instead of banks, investment houses, funds, private equity firms, venture capital firms and cooperatives are some of the vehicles that might be more suitable.

Concluding comments

I am a firm believer that if the Islamic finance industry can achieve the above two objectives, it will set the foundation for a long-term successful future. The industry will then present a fresh and authentic value proposition to the world: Muslims fuelled by the religious imperative to follow their faith will more readily buy into what the industry offers; and all human beings, Muslims and non-Muslims, will potentially be attracted by the ethics and values. At the very least, the industry will command respect and credibility.

All the other issues cited for the industry to develop, such as an accommodating regulatory framework, attracting the right amount and quality of human capital, etc., are very important but secondary, in my view, to the above two issues. I would compare the two issues I have highlighted to setting the industry in the right direction – the infrastructure around this direction will naturally build and flourish as the market expands. Yet if the industry does not get these fundamentals right, it may fail to provide a convincing and compelling proposition to Muslims at large and to bringing anything new to the non-Muslim market. Indeed, the worst-case scenario, in my view, is that Islamic finance is seen as little more than a system that copies the economic effect of conventional transactions underpinned by complex structures that keep to the letter of sharia law with little ethical substance to them. If this kind of situation develops, the current hope and buoyancy about the future of the industry will undoubtedly be replaced by a lacklustre and disappointing performance over the next few decades.

Therefore, the challenge to product providers, regulators, sharia scholars, academics and educators of Islamic finance and those working in the industry is to create an environment, a culture, a mindset where the objectives of sharia and building a distinctive, authentic value proposition are put at the forefront. This requires vision, bravery and a commitment to the long-term success of the industry. If this can be achieved, there is little doubt in my mind that the Islamic finance industry can enjoy substantial, sustainable growth for many years to come, and can occupy a credible and sustainable long-term place within the global financial system as a real alternative to the conventional, interest-based financial system.

¹ At April 2014, the 184 members of the IFSB comprised 59 regulatory and supervisory authorities, 8 international inter-governmental organisations, 111 financial institutions and professional firms as well as 6 self-regulatory organisations (industry associations and stock exchanges) operating in 45 jurisdictions. Malaysia, the host country of the IFSB, has enacted a law known as the Islamic Financial Services Board Act of 2002, which gives the IFSB the immunities and privileges that are usually granted to international organisations and diplomatic missions.

² IFSB and IRTI (May 2014), ‘Islamic Financial Services Industry Development: Ten Year Framework & Strategies – A Mid Term Review’.

³ World Bank (2012) ‘Three quarters of the world’s poor are “unbanked”’, http://econ.worldbank.org/WBSITE/EXTERNAL/EXTDEC/0,,contentMDK:23173842~pagePK:64165401~piPK:64165026~theSitePK:469372~isCURL:Y,00.html

⁴ Swart, R. (2013) World Bank: Crowdfunding investment market to hit $93 billion by 2025. MediaShift, 10 December [online]. Available at: www.pbs.org/mediashift/2013/12/world-bank-crowdfunding-investment-market-to-hit-93-billion-by-2025/

⁵ Ibid.

⁶ Islamic Financial Services London (2008) Islamic Finance 2008.