Islamic finance is seeing spectacular growth since 2008. It grew 30% last year. Islamic banking is just part of the overall Islamic finance sector, which includes asset management and increasingly more sophisticated investment products. Total Islamic assets under management reached $1 trillion in 2010. Growth is being driven by record-high oil profits, which in turn is driving Middle Eastern countries to create world-class financial centers such as Dubai, Bahrain, Abu Dhabi, Kuala Lumpur,... According to a McKinsey estimate, Middle Eastern countries will have a total of $9 trillion to invest by 2020. Further demand for Islamic banking will come from the growth in population and wealth of the world's 1.6 million Muslims. The ongoing global credit contraction provides an opportunity for Islamic financing to blossom.
Key figures (Financial Times 2010):
- Sharia-compliant financial institutions: 1,124
- Assets in Islamic finance: between $822 billion and $1 trillion
- Increase in such assets in 2009: 29%
- Worldwide Muslim population: approximately 1.6 billion
- Percent who use banks: approximately 14%
- Islamic mutual funds: 473
- Islamic money market funds in this total: 79
- Islamic real estate funds in this total: 28
- Assets in Islamic mutual funds: $35 billion
What is Sharia law?
Under Sharia Islamic law, making money from money, such as charging interest, is usury and therefore not permitted. Wealth should be generated only through legitimate trade and investment in assets. But investment in companies involved with alcohol, gambling, tobacco and pornography is strictly off limits.
How does Islamic finance work?
The overarching principle of Islamic finance is that all forms of interest are forbidden. The Islamic financial model works on the basis of risk sharing. The customer and the bank share the risk of any investment on agreed terms, and divide any profits between them. The main categories within Islamic finance are: Ijara, Ijara-wa-iqtina, Mudaraba, Murabaha and Musharaka. Ijara is a leasing agreement whereby the bank buys an item for a customer and then leases it back over a specific period. Ijara-wa-Iqtina is a similar arrangement, except that the customer is able to buy the item at the end of the contract. Mudaraba offers specialist investment by a financial expert in which the bank and the customer shares any profits. Customers risks losing their money if the investment is unsuccessful, although the bank will not charge a handling fee unless it turns a profit. Murabaha is a form of credit which enables customers to make a purchase without having to take out an interest bearing loan. The bank buys an item and then sells it on to the customer on a deferred basis. Musharaka is an investment partnership in which profit sharing terms are agreed in advance, and losses are pegged to the amount invested.
As a result of these developments Islamic financial institutions have developed a vast range of products designed to serve the growing market. These cater for housing and consumer finance, business loans and project funding. Lately, Malaysia and Bahrain have been instrumental in launching tradeable securities. These should create much needed liquidity and a secondary market for institutional investors in the Islamic finance market.
Several “Islamic equity” investment funds have also been launched, with both FTSE and Dow Jones providing indices to monitor this growing market.
Bodies have already sprung up to address issues of accounting and auditing standards, Shari’a compliance, and central bank regulation. The Islamic Financial Services Board (IFSB) has been launched in Malaysia. This initiative of D-8 countries laid the foundation of the regulation of the Islamic Finance market on a consistent basis.
Islamic finance in non muslim countries
As was to be expected the major instruments utilized by the Islamic banks are those which approximate closely to those in the conventional banking market. In particular, there is still a dearth of pure risk sharing instruments where gains and losses are shared equitably between investors and operators. With the emergence of quoted tradeable instruments this anomaly is expected to be addressed in the next generation of products.
In Western countries, much progress has been made towards launching mainstream housing and other consumer finance products compliant with the Sha’ria. Following a long period of consultation and advocacy, agreement is close to allow such products to be launched on a competitive basis in many countries. It is expected that within the next months one will see many such products being marketed from high street financial institutions in many non muslim countries. This is expected to be followed by similar initiatives amongst the twenty million Muslims in Europe and the United States.
As Islamic finance will arrive on the high streets of many countries, the challenge would be to operationalise the equity considerations of the Sha’ria and make this mode of financing widely accepted amongst a constituency which transcends Muslim communities Nearly all the traditional retail banking services expected from established High Street banks are available in a Sharia compliant format. Banks are hoping to attract business from Muslims living in their homeland.