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Islamic finance: the way forward


Themes: Finance

by Dr Kamal Munir, Reader in Strategy & Policy, Cambridge Judge Business School

Dr Kamal MunirAs the World Economic Islamic Forum kicks off in London on 29 October, the relatively nascent industry finds itself sitting at the cusp of great opportunities but also confronted with major challenges.

In the past few years, the industry has made great advances. Since 2006, the asset base has grown by 150 per cent and is forecast to reach $1.8 trillion this year. Given the stability that Islamic banks offer, and the strict constraints under which they function, this is a tremendous achievement.

More importantly, this growth is accompanied by a promise of far greater stability than the conventional financial sector provides. This is because of the stringent conditionalities that Islamic products come with. To begin with, in Islamic finance, one must work for profits, and simply lending money to someone who needs it does not count as work. Under Islamic law, money must not be allowed to create more money. Instead, a bank must provide some service to ‘earn’ its profits. Thus, instead of traditional accounts with given interest rates, Islamic banks offer accounts which offer profit/loss, with the bank purchasing assets with your money which generate returns. In particular, charging someone in need high interest rates is considered unscrupulous, leaving no space for business models like Wonga.com’s.

Secondly, high degrees of uncertainty or ‘gharar’ is not allowed. All possible risks must be identified to investors, and all relevant information disclosed. Islamic finance prohibits the selling of something one does not own, since that introduces the risk of its unavailability later on. This rules out investments in conventional derivatives, which require speculation about the future subject to excessive risks. This is also the key reason why Islamic banks survived 2007 unscathed (no exposure to derivatives).

Third, Islamic finance requires that you only invest in ethical causes or projects. Anything unethical or socially irresponsible, from weapons to gambling or adult entertainment cannot be invested in. This produces a very strong alignment between Islamic investments and socially responsible funds.

With their emphasis on equity and investment in the real economy, the principles of Islamic finance provide a stable and productive banking sector. Rather than providing a lucrative financial alternative to investing in the real economy, Islamic banking complements and strengthens the latter. It ensures that financial capital does not lead to artificially bloated prices of assets. Instead, it is made to work in the real economy on real projects.

Higher costs are the price that Islamic banks pay for this responsible version of banking. For this reason, Islamic banks have been confined to the Middle East and a few other Islamic countries for a long time. At home, they have usually been subsidised by indulgent states committed to Islamic banking.

Growth has also been limited due to the absence of well developed regulatory regimes abroad that are capable of understanding and monitoring Islamic transactions including ordinary accounts, mortgages, bonds and insurance amongst others.

Subsequent to the financial crisis, however, and partially due to the increased liquidity in the Arab world due to high oil prices, markets such as the UK have become far more interested in attracting the capital held by Islamic banks. This has meant expedited development of regulatory mechanisms for Islamic transactions thus enabling expansion of Islamic banks. It also removes some of the quirks that raise costs for Islamic transactions (for instance, Islamic mortgages that may be taxed twice because of double buying and selling of houses).

Expansion to world’s major financial markets pits Islamic banks against much bigger and established players, but the greater size also enables them to standardise products and bring costs down to a level where they can compete head on with conventional banks.

However, decades of functioning in well-cushioned home markets means Islamic banks have become more relaxed and inefficient than their conventional competitors functioning in more competitive markets. The coming five years will thus be extremely interesting. Islamic banks will be making their way into new markets where regulators are increasingly open to accommodating this financial model. In doing so, they will attract several customers from conventional banks. But in order to retain them and make the most of this opportunity they will need to develop far more robust risk management protocols than what they currently boast. They will also need to invest heavily in re-organisation and raise the level of human resource they depend on right now.

Naturally, some of them will be able to do all this better than others. But regardless of who wins these battles, their arrival on these shores will only be good for existing financial markets.