Islamic Finance: The Way Ahead
Islamic finance has witnessed unprecedented expansion over the last decade. Standard & Poor’s estimates that the market for Islamic financial products, which include retail banking services, mortgages, equity funds, fixed income, insurance, private equity, and derivatives, is worth $400 billion. Furthermore, the market is estimated to have grown 15 percent annually over the last three years, a rate that seems sustainable given Gulf investors’ accumulating reserves of petrodollars and Western banks’ search for high-growth markets.
However, Islamic finance is still playing catch-up to conventional finance in several areas, most notably in the development of capital markets. As the balance sheets of Islamic banks and insurance, or takaful, companies grew, they began to accumulate surplus reserves. According to the Islamic Capital Market Task Force, the lack of Shari’ah-compliant financial products meant that these surplus reserves often remained inactive.
Many of the innovations in the past three years have been aimed at addressing this lack of suitable investment opportunities. Islamic banks and the Islamic banking divisions of conventional banks have become increasingly more creative in the design of new financial products aimed at both Muslim and non-Muslim customers. Innovations in takaful, Islamic bonds (sukuks), derivatives, and equity funds have fulfilled the needs of investors by providing a range of investment opportunities, more liquidity in Islamic capital markets, and risk management tools. Moreover, innovation has significantly closed the competitive gap between conventional financial products and their Islamic analogues, placing Islamic finance at the forefront of the global financial services industry.
Bridging the gap between conventional and Islamic finance is clearly dependent upon innovation. Islamic banks have nearly caught up to Europe and the United States in equity funds and insurance, while innovation in sukuks is at the forefront of product development for both conventional and Islamic banks. One of the few areas in which Islamic banks lag significantly is derivatives, although there are signs that the more traditional views on derivatives are being reexamined.
The development of capital markets must accompany product innovation. While individual Islamic products may mimic conventional ones, a wide range of products provides investors with more choice, greater liquidity, and more effective ways to allocate risk. Demand for sukuks was driven in part by a lack of Shari’ah-compliant products in which takaful companies could invest their portfolios. The plethora of sukuks, meanwhile, has led to greater interest in Islamic derivatives so that investors can more easily quantify the various types of risk and adjust them accordingly. Without comprehensive capital markets, however, Islamic finance will continue to lag behind conventional finance. As an immediate solution, countries in the Gulf and Southeast Asia have created the Liquidity Management Center, based in Bahrain, to assist in the creation of an Islamic interbank money market to provide extra liquidity.
Regulatory agencies must develop standard accounting practice and Shari’ah interpretations. Malaysian banks, for example, tend to be more flexible in their interpretations of the Shari’ah, which has hindered Malaysian products’ acceptance in the more conservative Gulf states. Not only are different interpretations of the Shari’ah confusing to investors, but they also inhibit commoditization of Islamic financial products, a necessary step in the building of Islamic capital markets. The creation of the Islamic Financial Services Board, underwritten by the Islamic Development Bank and the International Monetary Fund, has helped facilitate more cooperation between regulatory agencies in the Gulf and Southeast Asia. Indonesia, taking note of Malaysia’s success in Islamic finance, is revising regulations to support the issuance of both sovereign and corporate sukuks.
Finally, Islamic financial products must be competitive investments in themselves. Islamic banks can no longer rely solely on the religious fervor of their clients as a stimulant for demand. Especially as European and American investors show more interest in Islamic products, banks must structure instruments so that they offer equivalent or better investment returns than their conventional rivals.