Although still small in comparison to the conventional global banking sector, Islamic Banking (IB) has nevertheless grown so impressively in recent years that it now seems more like a critical driver for the industry as a whole than a niche market reserved only for a small slice of the map.
Indeed, as the General Council for Islamic Banks and Financial Institutions reported in early 2007, world-wide assets for IBs and Islamic Financial Institutions (IFI) now stand at over $260 billion, with financial investments totaling more than $400 billion. Year on year growth rates for the sector over the past seven years have averaged almost 15% helping to bring the total number of IBs and IFIs (IBFIs) to 267 in 2006, up from 176 in 1997. Islamic equity funds also now exceed $300 billion in value (growing an average of 25% annually over the past seven years), while Islamic sovereign and corporate sukuks (instruments similar to conventional bonds) have reached $50 billion.
One recent Standard & Poor’s (S&P) review, though, has provided particular fodder for market watchers eager to claim new markets: the overall sector could be worth as much as $4 trillion if it were fully exploited. In fact, according to one prominent IB, Al Baraka Bank, the Islamic share of banking activities specifically in the next decade is expected to rise to half of all bank activities in the Arab world. That’s largely because, according to one recent conference presentation by Nasser Saidi, chief economist of the Dubai International Financial Center, only about 20% of the Muslim population in the oil-rich Gulf Cooperation Council (GCC) countries buy shariah-compliant financial products currently.
According to S&P, the figure is even less, just 10%, if one includes the banking practices of the entire worldwide Muslim population. Which is to say nothing of the percentage of companies and wealthy individuals in the Middle East and Southeast Asia who rely on conventional banking and finance instruments. Or the fact that two-thirds of all IB users in Malaysia, the main hub of the sector, are not even Muslim.
Islamic Trade Finance
As far as Islamic Trade Finance (ITF) is concerned, its share of global Trade Finance activity and IBFI activity overall is of an even smaller order, although no consensus estimate exists.
In fact, partially because the major Western players have seen the boundary-pushing Islamic Project Finance (IPF) arena as both more profitable and higher-profile (involving the use of options and derivatives in several recent cases), some institutions which nevertheless engage in substantial ITF activity tend not to want to highlight such activities.
As one major German-based financial institution put it,“We only take a reactive approach to such [trade-based] transactions as opposed to a proactive one.”
In other words, if a trade deal comes, then we might just take it. But we don’t go out looking for them.
Do such responses mean that some of the majors might be missing the boat when it comes to the ITF market?
Perhaps. But for IBFIs that are through-and-through shariah-compliant—i.e., not just with an Islamic window or a segregated branch—ITF is critically important, and should be even more so in the future.
“There is a massive amount of short term liquidity in Islamic institutions that needs to be invested in something,” explained Michael Gassner, managing director of Michael Gassner Consultancy. “It is either trade or [project finance] in companies. Trade finance, by its short terms nature, meets this need perfectly. It involves real assets not nominal ones [one key for being shariah-compliant] so this can really be done well.”
ITF Instruments
Doing shariah-compliant trade finance well, however,
generally involves costs and operations above and beyond
traditional trade finance, which means that ITF is both more
complicated and potentially less profitable.
Thus, although many of the risk mitigation tools used in
both structured trade and project finance have strong
similarities with various tools that have evolved in Islamic
finance, the supply side, or the instruments made available
by IBFIs, tend to be supported more by a desire on the part
of institutions to propose Islamic financing to
clients—a move that can then translate into a
competitive edge overall.
On the demand side, according to one 2006 UN Trade and
Development report, “those that are able to tap into
Islamic financing markets can obtain relatively low-cost
capital.” Of course, this is not always true. But more
than a relative cost saving, a growing number of clients
simply want to ensure a shariah-compliant transaction.
In that case, several instruments are available for
structuring trade deals. All must, however, fall in line
with a number of basic Islamic precepts that fundamentally
revolve around the necessity of taking and sharing risk
through the possession of real assets.
Although interest taking is therefore prohibited first and
foremost in favor of asset-backed, partnership arrangements,
this particular element is not the only one that makes a
deal shariah-compliant.
Islam also prohibits trading excessive financial risk
(gharar), with such activities regarded as gambling.
Additionally shariah prohibits investing in businesses that
are considered haram—those that sell alcohol or pork,
or businesses that are engaged in gambling or produce
un-Islamic media.
As a result, it is generally accepted (generally, because
there is no single interpretation of what is permitted, and,
in any case, each IBFI has its own shariah board), that
deals are only undertaken with a business whose interest
income is less than 9% of total income and/or who holds a
ratio of debt to total assets lower than 33% of total
assets.
With these prohibitions and benchmarks as a basic
foundation, four instruments for financing trade are
employed in the Islamic market: murabaha, bai al salaam,
musharaka and istisna. According to the recent book,
“An Introduction to Islamic Finance: Theory and
Practice” by World Bank official Zamir Iqbal and IMF
Executive Director Abbas Mirakhor, close to 90% of all
Islamic trade financing is currently based on murabaha, with
more than half of the assets of some Islamic banks invested
in murabaha transactions.
Challenges and Horizons
All four instruments pose unique challenges to both IBFIs
as well as conventional BFIs who wish to enter the Islamic
Trade Finance marketplace. As Sayyed Alwi bin Mohamed
Sultan, senior financial analyst at the Accounting &
Auditing Organization for Islamic Financial Institutions,
said: “There are lots of risks. Market risks, credit
risks, operational risks. The same risks any conventional
bank or financial institution may face and over and above
that [you also face] shariah compliance which is another
risk that Islamic banks have to address.”
One particular problem native to all four instruments is
that the mere presence of sufficient collateral is not
sufficient for a transaction. In contrast, an extensive
evaluation of a borrower’s business is required,
which, as the UN report points out, “can slow down
financing decisions, and disqualify borrowers without much
of a track record, thereby stifling economic growth.”
Added to this is the problem of how to give the
flexibility of variable interest rates, since financing is
generally made on a basis equivalent to fixed interest
rates. As one industry report recently said: “It is
not clear whether borrowers can swap out of such a position,
but if not, fixed interest rates (in an environment where
most companies have the possibility to actively influence
the rates they are paying) may seem at times somewhat
unattractive.”
Nevertheless, “Islamic trade finance is our bread
and butter,” said Yakub Bobat, global head of
commercial banking at HSBC Amanah. “It is an efficient
contributor to our overall Islamic finance activities and it
is a key driver of the Islamic banking pie as a
whole.”
While that appears to be the general sentiment among those
involved in ITF, the truth is that the sector will only
become an indispensable driver of growth if it is matched up
with the far more ambitious tools now being pioneered by
Islamic project finance.
“Frankly, the industry needs to move away from
commodity murabaha,” added Bobat. “Historically
there has been a lack of a comprehensive product suite, but
this is fast developing [and now] you have rollouts across
markets.
“You will see,” he predicted, with apparent
enthusiasm. “The industry gaining critical
mass.”
