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How Islamic finance can reach its full potential

How Islamic finance can reach its full potential

Mohamed Damak explains the importance of standardisation in boosting the impact of Islamic finance

The value of the Islamic finance industry’s assets reached $2 trillion at the end of 2016 but it still makes up a small portion of the global financial system.

Given the fact that Islamic finance remains concentrated in oil-exporting countries, with the GCC, Malaysia and Iran accounting for more than 80 per cent of the industry’s assets, the drop in oil prices and the pursuing cutbacks in government spending did not help industry growth. While sukuk issuance accelerated in the first nine months of 2017, up 54.2 per cent compared with the same period in 2016, we are less certain about the market performance in 2018.

The industry continues to expand – albeit at a slower rate – and we believe a paradigm shift is required to further support the growth of Islamic finance. This will require participants, including regulators, to work together to reduce complexity and achieve greater standardisation with the ultimate goal of creating an internationally agreed standard that transcends individual markets standards. This harmonisation is required to transform Islamic markets into a truly global industry.

Islamic finance instruments can help companies and sovereigns to diversify their investor base. In addition, the contribution of the Islamic finance industry to sustainable development cannot be ignored. There is a natural connection between the principles of Islamic finance, responsible finance and impact investing, which all aim to create more equitable financial systems that have a positive, tangible impact on the economy and population.

So why is the industry not growing more quickly? Numerous institutions consider the Islamic finance and sukuk market when assessing their options but when faced with the time-consuming and complex steps required, revert to conventional financial instruments. The time and cost gap has, however, been reduced over time and the industry is progressing towards greater standardisation. For example, in Malaysia, we understand the process of issuing sukuk is as smooth as it is for conventional bonds.

Indeed, some steps have already been taken to help the market grow to its full potential. For example, the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) issued standards on Central Sharia Boards and sukuk accounting in the first half of the year for industry comment. The official publication of these standards is marked step away from a self-regulating industry and a step towards a more unified framework.

Standard-setting bodies have identified four clear areas to improve the Islamic finance sector: Sharia compliance, legal documentation, market education and using government issuance as an example for the market.

Many countries with developing Islamic finance sectors are harmonising national principles and structures with 17 now adopting a centralised Sharia board structure. Not only does this elevate corporate governance and enhance the quality of national supervision, it reduces the cost of executing transactions. Some countries are even implementing external Sharia auditing, which would further increase the transparency of the industry when it comes to compliance.

Much progress has also been made to standardise the legal documentation of the Islamic finance sector, particularly sukuk, however, documents are still not streamlined enough to entice issuers. We are conscious that the industry cannot achieve full standardisation because some transactions still need to comply with local laws. Industry bodies are aware of the requirement for increased market education to inform investors about the risks particularly to Islamic finance including residual asset risk, Sharia interpretation risk and the difference sukuk structures combining Mudaraba and Murabaha in Saudi Arabia from those used elsewhere.

Standardisation does not have to negatively impact innovation. In fact, S&P Global Ratings believes that standardisation could relieve the market of time-consuming tasks, leaving more time to focus on innovation. Standardisation is therefore a contributor, rather than a deterrent, to ensuring the industry reaches its potential.

Supporting the progress of the Islamic Finance industry is not the sole responsibility of regulators. While they would create a more supportive regulatory environment, scholars and lawyers could help in achieving greater harmonisation. Universities and other education institutions are also key to the development of the Islamic finance sector as they could provide the necessary training and knowledge to create the next generation of Islamic finance professionals.

After all, it is the integration of all of these groups that will help the industry reaching its full potential.

Mohamed Damak is head of Islamic finance at S&P Global Ratings

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