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Pondering the future is not an easy task. It’s like looking into a crystal ball. Is it hazy or clear, full of light or darkness? By most accounts, Islamic finance is now in its fourth decade of steady progress and development.
But what do its horizons look like? Will it continue to follow its current course or will it define itself on its own foundations? Will it serve the interests of the many or the few? Charting a defined course for the future must be based on a rigorous approach to these questions.
Despite the much touted $250 billion or so in assets under management at Islamic financial institutions the industry as a whole is undergoing a considerable amount of soul searching. While its origins lie in the work of those who sought to establish full fledged Islamic economies in various parts of the world, Islamic finance as a discipline has entered the field of mainstream finance. Today, its instruments commingle with conventional instruments in the international markets and among the measures of its success are the acceptance it has gained in the global capital markets (see our previous article on Securitization) as well as a level of constant, though somewhat restricted, innovation for new products and services. Still, the questions seem to linger.
At the recent International Islamic Finance Forum in Istanbul, Turkey the debate to answer these questions resulted in a generous level of soul searching in discussions on themes relating to the moral basis of Islamic finance, the deficit of human talent in Islamic finance, and perceptions of Islamic finance were all addressed. In the panel on Market Perceptions of Islamic Finance, presentations were made by leading commentators and practitioners – one of whom was Rafe Haneef of ABN Amro Bank.
Mr. Haneef’s presentation on the “Practice and Perceptions of Islamic Finance” was given from a practitioner’s point of view – in other words, it was from the real world of money which gave his views a seasoned, pragmatic approach. At the same time Mr. Haneef’s comments were laced with an idealism that stems from a belief that Islamic finance has a larger role to play in building societies. As such, this combination made his insights practical while they retained a vision for Islamic finance beyond managing costs, liquidity and risk for corporate or sovereign entities; an ideal that moved Islamic finance toward building communities and societies.
Mr. Haneef’s remarks began with a simple statement – People who read about the lofty, moral goals of Islamic finance in the books of Usmani and others are often disappointed when they realize that these are not the drivers for its development in the City of London or on Wall Street and even in Bahrain or Kuala Lumpur. The theoretical emphasis on profit and risk sharing through mutual cooperation is discarded in the market because these structures are not yet well-understood in the capital markets.
Those of us who are familiar with the developments of Islamic finance know that contracts forms such as Murabaha and Ijarah allow Islamic bankers to create products that closely mimic conventional products such as leases or conventional loans. Indeed, the fundamental structures and the basis for exchange are inherently different but the end economic result conforms to the prevailing product mix in the market.
The issue at hand, according to Mr. Haneef, is that Islamic finance still finds itself at an early stage in its development. In order to gain a foothold in the global financial markets and due to the overwhelming magnitude and momentum of the conventional capital markets, Islamic finance is mainly adopting an approach which mimics the credit risk profile of conventional products. This phenomenon is illustrated in the accompanying diagram which shows how a counterpart has been created in the Islamic finance market for each product in the conventional market. The Islamic finance products have familiar risk and return profiles based on structures that are similar to the conventional instrument and are priced according the same conventional benchmark i.e. LIBOR, US Treasuries, Swaps, etc.
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Figure 1 |
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Conventional and Islamic Product Analogues |
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Credit risk is the element which governs investment choices in the conventional markets. At the end of the day people use this credit risk to price assets/securities with a conventional benchmark – mimicking conventional instruments. Islamic finance faces challenges because it is in a minority, it is a niche market and therefore judged by the conventional sector.
This minority position puts the discipline of Islamic finance in what Mr. Haneef calls the conforming stage (see the accompanying illustration). At this stage the prime directive for practitioners is to gain market share. The best way to do this is by structuring Islamic products according to Shari’ah dictates and mirroring the risk and return profiles of conventional structures. After almost 30 years of activity this is where the industry finds itself.
As the industry gains market share it will move into the next stage which would be the improvement stage in which bankers and financiers have gained enough of the market to widen the field of innovation within the industry and better compete with conventional instruments through more attractive risk/return profiles.
Following this course will culminate in what Mr. Haneef refers to as the innovation stage in which a dominant market share will allow a new type of Islamic banking to evolve which will create products and practices that serve the higher ideals of Islamic economics. These successive stages would probably take another 30 years or more to culminate in a dominant position for Islamic finance in the global capital markets.
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Figure 2 |
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Stages of Industry development |
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The tragedy of 9/11 caused a massive shift of perception of Islamic finance. As a result, in the post 9/11 era the conforming stage may stay with us for quite a long time; at least until its practitioners can effectively separate the discipline from suspicions of money laundering and funding for religious zealots. With the support of Western governments Islamic finance will likely gain a stronger foothold in the market.
Practitioners must create contracts and structures which serve the needs of small and midsize corporates. The real test will be to see governments in the Muslim world push the envelope with greater acceptance, rigorous regulatory regimes, and the will to utilize Islamic finance to fund development projects for the state and corporates.
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