Introduction

The Islamic finance phenomenon

Why does Islamic finance exist?

Why is Islamic finance a sizeable and growing market?

Key challenges facing the industry

Conclusion

INTRODUCTION

Islamic finance is estimated to be an industry worth over a staggering $1.7 trillion¹ in terms of global banking assets and is growing globally at more than 15 per cent per year. For some, it represents an opportunity to tap into a lucrative new market, while for others it is now necessary to provide services or products in this sector so that current or potential customers are not lost. This book seeks to equip practitioners with an understanding of the key concepts underpinning Islamic finance and the prevalent and developing market practices. It will also explain the main product and service types and, where applicable, how they differ from comparable conventional finance instruments.

The book assumes the reader to have no previous knowledge of the subject. Islamic finance is a faith-based proposition and thus to understand the finance, one must understand key features of the faith. Therefore the first part of the book focuses on understanding more about the beliefs, values and principles that underpin the practice. The second part of the book looks at the application of Islamic finance by discussing the key transaction types and market practices and products.

Whether you are a banker, lawyer, asset manager, wealth manager, accountant or any person with an interest in Islamic finance, this text aims to give you a solid knowledge foundation of the area, a tool kit and frame of reference to understand and apply yourself to the sector. People may perceive Islamic finance to be mysterious, specialised and accessible only to Muslims, made worse by the use of jargon and foreign terminology. This book seeks to explain the guiding principles and practices with a clear, jargon-free narrative that defines any reference to foreign terminology. The book will also demonstrate that while Islamic finance is a faith-based proposition, it is underpinned by a few core principles which need not exclude any section of society from involvement, whether as a practitioner, supplier or consumer.

THE ISLAMIC FINANCE PHENOMENON

While Islamic assets represent only about 1 per cent of the global financial market,² it has been the remarkable growth and the potential of the Islamic finance industry that have really captured the attention of governments, the financial services sector and other stakeholders such as regulators and central banks globally.

Figure 1.1 Global assets of Islamic finance

Figure 1.1 shows this impressive growth in global Islamic banking assets.³

This growth has spurred interest in Islamic finance across the world and not just in predominantly Muslim countries. Institutions specialising in this sector, such as Islamic banks and Islamic insurance providers, have emerged. Islamic finance has also become significant for many mainstream institutions and service providers, especially large international law firms and investment banks. The Islamic finance industry is estimated to comprise 716⁴ firms offering services to the sector, spanning 61 countries in the East and West, and an estimated 38 million customers globally with Islamic banks.⁵ Banks account for the bulk of Islamic assets globally, with Islamic insurance and investment funds making up the rest. There are now more than 1,000 sharia-compliant funds around the globe with assets under management of more than $60 billion.⁶

Although three-quarters of Islamic finance assets worldwide are in Muslim countries, the UK (at 2.3 per cent) and ‘others’ (countries with less than 1 per cent of the market – see Figure 1.2) are notable exceptions.

Figure 1.2 Share of global Islamic finance industry

Source: ‘Global Islamic Finance Report 2013’, Edbiz Consulting.

WHY DOES ISLAMIC FINANCE EXIST?

In a world where there is no obvious link between faith and finance, what is it about the Islamic faith that motivates Muslims to demand financial products and services that accord with their faith?

The teachings of Islam permeate all aspects of life, from family, social and business dealings to worship, morals and even areas such as private hygiene. Islam does not subscribe to a secular model whereby religion plays little or no role in public affairs; there is no separation of ‘church’ and ‘state’ as such. Islam is an Arabic term and means ‘submission to God’s will’. A believer endeavours to live his/her life in a way that is consistent with the values and teachings of the Islamic faith, with the ultimate aim of pleasing God and gaining God’s favour and acceptance.

The Islamic faith lays down some clear principles and guidelines for business and financial dealings. For practising believers it is therefore very important to follow these teachings. Not only do they believe there is benefit to be gained from following the guidance but they are wary of the consequences of not following the teachings.

This can be demonstrated by reference to the rulings around interest. A key feature of Islamic finance is that paying or receiving interest is forbidden. The Qur’an, the Muslim holy book and the primary source of guidance for Muslims, warns against this in the strongest terms:

Those who take interest will not stand on the Day of Judgement except as he who has been driven mad by the touch of the devil. That is because they have said, ‘trading is like interest’, but God has permitted trading and prohibited interest. Whosoever receives an advice from his Lord and stops, he is allowed what has passed and his matter is up to God. And those who revert back are the people of the Hellfire. O you who believe! Fear God and give up what remains due to you from interest if you are really believers; and if you do not, then take notice of war from God and his Messenger, but if you repent you shall have your capital sums. Deal not unjustly and you shall not be dealt with unjustly.

(Qur’an, Chapter 2, verses 278–279)

Based on the above passage from the Qur’an alone, the seriousness of the issue of interest is obvious. Much of conventional finance is underpinned by interest; theoretically it is very difficult for Muslims to engage with the industry at all. Of course, Muslims have the same need for financial services as any other group in societies across the world, whether that is in relation to business, purchasing properties, investing or protection. It is no surprise, therefore, that increasing numbers of Muslims seek to fulfil this need in compliance with their religious duties.

WHY IS ISLAMIC FINANCE A SIZEABLE AND GROWING MARKET?

Islam is an ancient religion and yet it seems that Islamic finance has only relatively recently emerged as a significant industry. The reality is that Islamic finance is as old as the religion itself. However, a number of developments in the second half of the twentieth century have driven the importance and growth of the industry. Broadly, these can be summarised as:

• growth of the Muslim population worldwide leading to rising prominence of the Islamic faith in the world;
• the economic development of countries with large Muslim populations leading to rising affluence among Muslims;
• the greater integration of Muslim and non-Muslim economies (which may be considered to be a function of globalisation) leading to institutions tapping the liquidity of Muslim nations.

Key growth factors

Rising prominence of the Islamic faith in the world

It is estimated that Muslims around the world total in the region of 1.6 billion people, accounting for approximately 23 per cent of the world’s population. This makes Islam the second biggest religion in the world after Christianity. Islam has been the fastest-growing religion in the world for some time and it is estimated that it will continue to be so, such that by 2030 Muslims will total a projected 2.2 billion people – 26.4 per cent of the world’s population (see Figure 1.3).⁷

Figure 1.3 Muslim population by region, 2010 and 2030

Source: Pew Research Center Forum on Religion & Public Life, ‘The future of the global Muslim population’, January 2011.

Several factors account for the faster projected growth among Muslims than non-Muslims worldwide. Generally, Muslim populations tend to have higher fertility rates than non-Muslim populations. In addition, a larger share of the Muslim population is in, or soon will enter, the prime reproductive years (ages 15–29). Improved health and economic conditions in Muslim-majority countries have led to greater-than-average declines in infant and child mortality rates and life expectancy is rising even faster in Muslim-majority countries than in other, less developed countries.⁸ Figure 1.4 shows the top 10 countries with the largest Muslim populations. Clearly, as the number of Muslims globally increases, so does the potential demand for products that accord with the Islamic faith.

Figure 1.4 Top 10 Muslim countries by population

Rising affluence among Muslims

The oil boom in the 1970s and 1980s and continuing wealth derived from oil in the Middle East have prompted the beneficiaries of this wealth to demand more financial products that are compliant with Islam. Indeed, in a report entitled ‘Addressing the Muslim market’, published in 2007, global management consulting firm AT Kearney estimated that the OPEC (Organization of the Petroleum Exporting Countries) nations had more than $500 billion in current account surpluses annually, which they were increasingly channelling through Islamic financial institutions.

As the industry has matured in terms of scale, market practices and regulation, and there has been greater demand and awareness among the masses, the provision of products has broadened and become more mainstream. The first commercial Islamic bank was Dubai Islamic Bank, formed in 1975, soon to be followed by Islamic banks in Egypt, Sudan, Bahrain and Kuwait.

Ten of the world’s 24 rapid growth markets as categorised by professional services firm Ernst & Young in a recent report have large Muslim populations and offer strong growth prospects for the Islamic finance sector (retail, finance for small and medium-sized enterprises, trade finance, wealth management) (see Table 1.1).⁹

Table 1.1 Rapid growth markets

Rapid growth markets	GDP compound annual growth rate (CAGR) 2000–10
Qatar	12.8%
China	10.3%
Kazakhstan	8.5%
India	7.4%
Vietnam	7.2%
Nigeria	6.4%
Ghana	5.6%
Russian Federation	5.3%
Indonesia	5.2%
Malaysia	5.0%
UAE	4.9%
Egypt	4.9%
Ukraine	4.7%
Republic of Korea	4.6%
Thailand	4.4%
Turkey	4.2%
Colombia	4.1%
Argentina	4.1%
Poland	3.9%
Chile	3.8%
Brazil	3.7%
South Africa	3.6%
Saudi Arabia	3.4%
Mexico	2.3%

The Ernst & Young ‘World Islamic banking competitiveness report 2013–14’ went on to highlight six of these 10 markets in particular. The credentials for growth in these six markets are very strong, as shown in Table 1.2.

As Table 1.2 on the next page indicates, despite the size and growth of the industry in recent years, the level of penetration of Islamic finance in many Muslim countries is still relatively low. Penetration in a number of Muslim-majority countries is limited, with Islamic banking accounting for only 4–6 per cent of total banking assets in Turkey, Egypt and Indonesia.¹⁰ Hence there is plenty of room for growth.

Table 1.2 Potential for growth

	CAGR % of Islamic finance – 5 years (2008–12)	Growth rate vs. conventional finance	Size of Islamic assets $bn	% market share of Islamic finance
Qatar!	31%	1.8× faster	$54bn	24%
Indonesia	42%	3.1× faster	$20bn	4.6%
Saudi Arabia	11%	3.6× faster	$245bn	53%
Malaysia	20%	2.1× faster	$125bn	20%
UAE	14%	3× faster	$83bn	17%
Turkey	29%	1.6× faster	$39bn	5.6%

Tapping the liquidity of Muslim nations

As the wealth of Muslims and majority-Muslim nations has risen, so too has the ability of companies, banks and governments to tap into this liquidity to help finance large-scale projects and initiatives.

An instrument known as a sukuk has been at the forefront of raising such finance. (Given the prominence of sukuk in the Islamic finance industry, a whole chapter of this book – Chapter 6 – will examine this instrument in detail.) A sukuk is often referred to as an Islamic bond because from a returns perspective it shares many of the features of a bond: that is, the returns are often expressed as a specific yield on the amount invested. In reality, a sukuk is quite different to a bond. While a bond is a debt instrument, a sukuk is an investment in an underlying asset, and it is the economic return on that asset that dictates the returns to an investor. Many sukuk are based on the underlying asset being leased subject to a contract. The returns tend to be predictable and known, which leads to similarities with the return profile of conventional bonds.

Figures 1.5 and 1.6 show how both the number of sukuk issues and the amount raised through sukuk issuance have soared in recent years.

The success of the sukuk market has attracted the attention of many non-Muslim governments, banks and corporates. The liquidity and availability of capital have been curtailed in many western countries in particular due to the financial crisis that began in 2008. In this context, tapping the liquidity of Muslim nations has emerged as a credible option to raise capital – for example, the UK government raised £200 million through the issue of a sovereign sukuk in June 2014.

Figure 1.5 Global aggregate sukuk historical trend, 1996−2013

Source: ‘Islamic finance gateway’, Thomson Reuters Zawya.

Figure 1.6 Sukuk issuance: breakdown by country ($m, 2013 YTD)

Source: ‘Islamic finance gateway’, Thomson Reuters Zawya.

KEY CHALLENGES FACING THE INDUSTRY

While the Islamic finance market credentials are relatively strong, being a fairly new industry it faces a number of challenges if it is to achieve its full potential. Some of the key issues are outlined below.

Regulatory environment

As any industry matures, the infrastructure around it needs to develop. One of the key parts of this infrastructure is regulation. The financial services industry in particular is highly regulated throughout the world and it is important that regulation for the Islamic finance industry develops to:

• give it a level playing field versus conventional finance in terms of taxes and other areas;
• make products and services more portable across borders;
• standardise, as much as practically possible, sharia rulings, documentation and accounting treatment.

Sharia authenticity

A key success factor in the development of Islamic finance is for the industry to remain true to the spirit and objectives of the Islamic teachings. After all, the industry is a faith-based proposition; the faith is centred on certain social and ethical values. If these are hijacked or diluted at the expense of commercial ends, the industry will lose credibility in the medium to long term and will not fulfil its potential. Practices such as commodity murabaha (described in detail in Chapter 5), a synthetic transaction designed to overcome the prohibition of interest by using a metal trade, have probably damaged the credibility of the industry. Product providers need to innovate and bring products to the market that the consumers want but are true to the spirit and objectives of the sharia.

Another dimension to this issue of sharia authenticity is for product providers to be bold enough to bring new products to the market that do not simply seek to mimic the economic effect of conventional products, but are potentially very different and present a real alternative to conventional products. For example, instead of using commodity murabaha, industry players need to be bold enough to practise other techniques in which there is a genuine trade and/or profit and loss sharing.

Scale

As mentioned earlier, Islamic finance represents about 1 per cent of the global financial market. In the short time frame of the modern Islamic finance industry (around 40 years), it is clear from empirical research that the overwhelming majority of Muslim consumers want sharia-compliant products that come with a competitive price and service compared to similar products in the conventional space. Two good examples of where scale is required to achieve competitive pricing are retail banking and protection/insurance. In both of these areas, sharia-compliant providers have struggled to compete effectively with conventional players. The Islamic finance industry needs to build scale and achieve world-class operational efficiency and service standards.

Islamic finance for all

Naturally, adherence to Islamic teachings and principles appeals to Muslims. However, the objectives of the sharia (called maqasid al sharia) are very much rooted in protecting and promoting the welfare of individuals and society as a whole. Indeed, a well-known Islamic scholar, Imam Abu Hamid Al-Ghazali (died 1111 CE), summarised the objective of the sharia as follows:

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 this context, Islamic finance can be presented to Muslim and non-Muslims as an ethical form of finance, the principles of which aim to promote the well-being of society. Hence there is a real opportunity to make Islamic finance more appealing and inclusive to all and present it as a real, viable alternative to conventional finance. Indeed, in the wake of the recent global financial crisis, many around the world have questioned conventional financial products and systems and there has been something of a resurgence in looking at alternative products and systems.

The human capital challenge

For an industry growing at more than 15 per cent a year, it is widely recognised that a key enabler for this growth to continue is to have the right amount and quality of human capital coming through. In an article by Nazneen Halim, editor of Islamic Finance News, she says it is anticipated by 2015 that more than 50,000 individuals will be needed in the Islamic finance industry globally.¹¹ This will require the training and education of professionals serving this industry and attracting and retaining the best possible talent to the industry. Professionals from outside of Islamic finance have a lot to offer the industry – they can bring valuable professional experience to the table and help Islamic finance players achieve best commercial practice, operational efficiency and world-class service standards.

One aspect to the human capital challenge facing the Islamic finance industry is to ensure there are enough new sharia scholars coming through who understand the financial system and regulatory environment enough to provide sharia advice that is rooted in the realities of the legal, regulatory and commercial environments.

All of the above issues are recognised in the industry and there is much debate and discourse on these. We will revisit several of these areas in the last chapter of the book, ‘Chapter 9,’ The future of Islamic finance’.

CONCLUSION

In summary, the religious imperative for Muslims to follow the teachings of their faith, coupled with demographic and other changes in the Muslim world rooted in wealth and population growth, has made Islamic finance an attractive market segment. A quote from information provider Thomson Reuters in the marketing for its event entitled ‘The Global Islamic Economy Summit 2013’, which took place in Dubai in November 2013, sums it up well:

The Islamic economies of the world represent more than $8 trillion in GDP, and a 1.6 billion population growing at double the rate of the global population. Disposable income for the Islamic economy is estimated at $4.8 trillion – and with 62% of the population under the age of 30, the next generation of Muslims are increasingly asserting their Islamic sensitivities with everything from food preferences to banking and finance, to fashion, cosmetics, travel and healthcare.

The Islamic finance industry is young, developing and full of promise and opportunity. It has gone through and will continue to go through a number of growing pains, and needs to rise and overcome a number of challenges if it is to fulfil its potential. This book aims to take the reader on a journey in which the first step is to gain some appreciation of the faith from which this industry stems, then to appreciate the conceptual principles, values and economic framework pertinent to Islamic finance, and finally to look at the practice, application and key market segments of this industry. We finish with several opinion pieces on the future of the industry. By the end of this journey, my hope is that the reader will have a good grasp of the subject, feel empowered to engage with the industry, and is enlightened as to some of the key challenges, opportunities and imperatives the industry faces as it strives to forge ahead.

¹ Ernst & Young, ‘World Islamic Banking Competitiveness Report 2013−14’.

² UKIF, ‘Islamic Finance Report – March 2012’.

³ ‘Islamic Finance Report’, City UK, October 2013. Figure for 2013 from Ernst & Young, ‘World Islamic Banking Competitiveness Report, 2013−14’.

⁴ ‘Opportunities for Islamic finance in the UK’ (www.gov.uk/government/news/opportunities-for-islamic-finance-in-the-uk).

⁵ Ernst & Young, ‘World Islamic Banking Competitiveness Report 2013−14’.

⁶ Ernst & Young, ‘Islamic Funds & Investment Report 2011’.

⁷ Pew Research Forum (www.pewforum.org).

⁸ All these facts around the Muslim population and its growth have been sourced from the Pew Research Center.

⁹ Ernst & Young, ‘World Islamic Banking Competitiveness Report 2012–13’.

¹⁰ UKIF, ‘Islamic Finance Report – March 2012’.

¹¹ Halim, N. (2013) ‘Transforming Islamic finance – the human capital challenge 2013’, Islamic Finance News.