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Dr. Nasser Saidi: Does Islamic Finance Matter?

Dr. Nasser Saidi: Does Islamic Finance Matter?

Much needs to be done for it to truly reach its potential, writes the founder and president of Nasser Saidi & Associates.

There is much hype about Islamic finance and it’s potential. However, the truth is that it remains a niche player.

Global Islamic finance assets were estimated at $1.66 trillion in 2013 by the recently issued “State of the Global Islamic Economy 2014-15” report – which also forecasts the potential universe of Islamic finance assets in its core market to touch $4.2 trillion in 2014.

However, despite the surge and purported popularity of Islamic finance, the industry is inconsequential in comparison to conventional finance. Islamic finance assets are heavily concentrated in the Middle East and Asia, and overwhelmingly in the Islamic banking sector.

Islamic banking assets ($1.0 trillion plus) are less than one per cent of global banking assets and even the optimistic potential levels for 2014 would be about 3 per cent of global commercial banking assets.

There is a long road ahead for Islamic finance to achieve mainstream status. It does distinguish itself from conventional finance with its strong ethical foundations.

Islamic finance is based on four guiding principles and building blocks: (a) risk sharing; (b) social justice; (c) ethical principles; (d) poverty alleviation.

It expresses an intent to meet the financial needs of participants with integrity and in a manner that is just, fair, trustworthy and honest, while ensuring more equitable wealth distribution.

These Islamic principles uphold the principles of integrity, transparency, fairness and good corporate governance, helping curtail excessive risk taking. These ring true in a global context of growing inequality and lack of social justice.

The Great Financial Crisis has caused a fundamental loss of trust by the general public in the financial system.

Reduced trust in the financial system has increased the cost and lowered the availability of capital for non-financial firms.

Surveys show that the public now has the least trust in bankers, regulators and politicians. The 2014 Edelman Trust Barometer shows that banks and financial services continue to be the least trusted industry globally, more deeply mistrusted than the media.

Islamic finance should capitalise on this opportunity by highlighting its ethical standards and risk sharing principles.

THE POTENTIAL FOR ISLAMIC FINANCE

Why could Islamic finance become important? The world’s Muslim population is expected to rise from 1.7 billion in 2014 to 2.2 billion by 2030, according to the Pew Research Centre.

Additionally, by 2030, the median age in Muslim-majority countries is expected to be 30 while about 29 per cent of the global young population (15-29) is projected to be Muslim, promising a burgeoning middle class.

The economies that comprise the OIC region had a combined nominal GDP of $6.7 trillion last year and are estimated to grow at an average pace of 5.4 per cent during the 2015-19 period.

With the demand for financial services typically growing faster than income as countries develop from low-income status, there is scope for fast growth of Islamic finance.

But this merely an opportunity.

MAINSTREAMING ISLAMIC FINANCE: AN AGENDA FOR POLICY-MAKERS

For Islamic finance to go mainstream, the focus needs to be on: (a) increasing Access to finance and financial inclusion; (b) integrating Islamic finance instruments into public finance; (c) developing Islamic finance markets and (d) building institutions and overcoming legal and regulatory hurdles.

Access to Finance: The MENA region has the lowest global account penetration rate and least use of accounts to receive payments. According to the World Bank’s Global Financial Inclusion database, 51 per cent of adults globally report having an account at a formal financial institution.

In OIC countries, however, this rate is as low as 28 per cent, compared to 47 per cent in other developing and 91 per cent in developed countries. When it comes to credit, 33 per cent of adults in OIC countries report family or friends as one of their most important sources for new loans in the past year.

Home construction and purchase in addition to emergencies form the main reasons for borrowing. The signal is for OIC banks to focus on access to finance, housing finance and developing an Islamic finance mortgage backed Sukuk market.

Public finance: Countries of the MENA region – especially the GCC – need to develop public finance Sukuk markets to allow governments to smoothen volatile energy revenues in addition to enabling the conduct of counter-cyclical policies, including deficit financing.

This would also provide banks, Islamic finance institutions and corporations with instruments to manage risk and liquidity while helping to finance infrastructure, public works and development projects.

Given falling oil prices, the time is right for governments to introduce Sukuk as an integral part of public finance. Malaysia and Indonesia are successful examples. Importantly, the development of government Sukuk markets would provide the benchmark for corporate Sukuk markets.

Development finance & Islamic financial markets: Young, fast growing populations in the OIC countries underscores the need for infrastructure and development projects. These are highly suitable for funding through Islamic finance instruments and securities being asset based.

The basis for an Islamic finance market should be development finance and financial inclusion. It should ideally include three building blocks – (a) housing finance and mortgage market; (b) sukuk for infrastructure and development projects (asset backed securities); and (c) Sukuk issued by sovereigns & Islamic finance institutions.

There is also immense opportunity for Islamic structured products to support project finance needs and for structuring leasing transactions relating to energy (including ‘Green Sukuk’), aviation, and transportation among others. The principle of risk sharing underlying Islamic finance offers scope for Public-Private Partnerships (PPP) using Islamic finance instruments but requires the enabling regulatory and risk management framework.

Despite this potential, the Islamic finance market is severely underdeveloped. There are only a few Islamic investment banks and they lack the capability in structuring, originating or arranging capital market transactions.

The lack of standardisation of Islamic finance instruments such as Sukuk and underdeveloped financial infrastructure required for secondary markets has also discouraged institutional investors from entering Islamic capital markets, leading to a dearth of liquidity.

Currently, the top lead arrangers are mostly non-Islamic banks, including the likes of Standard Chartered, HSBC and Citi to name a few. With international banks setting up Sukuk programs with the aim of tapping the pool of cash-rich Sharia-compliant investors, Islamic banks are missing the opportunity of becoming Islamic finance market builders in their privileged access markets.

To compound the competition, developed markets including Britain, South Africa, Luxembourg and Hong Kong entered the Sukuk market this year. This could eventually mean that established financial hubs like London, Hong Kong and Singapore could become strong competitors to the current Islamic finance capitals of Kuala Lumpur and Dubai and potentially succeed in using the emerging market OIC savings to invest outside these countries.

Institutions, legal and regulatory hurdles: Standardisation is one of the biggest barriers throttling Islamic finance growth. While the IFSB, AAOIFI, IIFM are standard setters promoting increased standardisation and harmonisation of Shari’a products, it is imperative that central banks and regulators adopt and impose these standards and guidelines in addition to ensuring compliance. This has not happened.

THE WAY FORWARD

GCC governments –starting with Dubai given its Islamic economy ambitions – need to take the lead to mainstream Islamic finance by building financial capacity & literacy, creating the enabling legal & regulatory framework (notably by agreeing standard documentation for Sukuk and other Islamic finance instruments), establishing a central Sharia board and setting up a GCC Islamic finance Passport, supplemented by Mutual Recognition Agreements between regulators to support Islamic finance.

GCC governments should prime the Sukuk market by issuing sovereign Sukuk to finance infrastructure and development projects. As Chinese philosopher Lao-tzu reminds us “A journey of a thousand miles starts with a single step”.

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