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Islamic finance debate: Prospects and problems of Shariah-compliant finance

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The market is growing fast in Muslim countries and among Muslim communities. Its fuller development, Euromoney’s roundtable of experts suggests, depends on clearer views on objectives, further development of regulation and standardization of products and approaches.

Delegate biographies: Learn more about the panelists

Executive summary

• The Shariah-compliant finance sector is growing fast but remains a niche market

• Putting in place a financing system that is both Shariah compliant and produces a return for investors is a challenge

• Regulators in a Shariah-compliant system require more transparency from banks than in a non-Shariah system as investors bear relatively more risk

• The Shariah-compliant system readily attracts those for whom it is a vital component of their faith but much of the growth in the market is coming from neutrals who find that the system can deal with the majority of their banking needs

• Shariah-compliant finance has proved immune to the direct impact of the sub-prime-induced credit crisis but cannot escape entirely the broader macroeconomic effects

• A secondary market in sukuk is emerging only slowly

• Standardization is a crucial but highly challenging issue in Shariah-compliant markets

MNA, AAOIFIIslamic finance – meaning instruments deemed sufficiently Shariah-compliant by some group of Shariah scholars – has been around for quite a while now. How successfully is it developing – are we talking about a niche market or a mainstream market?

KH, CBBA mainstream market has established practice, diversity of product, defined laws and regulations and a critical mass of players. Defined like this, Islamic finance is still a niche market. There are too many loopholes in terms of the practice, in terms of the laws and regulations and in terms of critical mass – so far the largest tickets have been through Islamic windows, not Islamic banks. We are not yet a mainstream market.

AAK, GBCorpI would say that Islamic banking is evolving at a very steady pace, and as in any evolutionary process it is also subject to great challenges. Due to its interest rate neutral characteristic, the current stressed market has catalysed this growth process so it will have a much bigger global presence and we will see Islamic finance tapping into newer sectors in the industry. But the greatest challenge to Islamic banking comes not from outside market influences but from within.

MNA, AAOIFINik, how do your investors react to Islamic instruments or Shariah-compliant instruments?

NNT, DIFCThe key things that I come across in meeting various investors – especially those who are new to Islamic finance or Islamic financial institutions – are simply the elements that are unfamiliar in non-Islamic transactions. So the avoidance of usury, avoidance of gharar (excessive speculative risk), avoidance of unbundled risk such as gambling (maysir), and the illegal sectors (haraam) activities. The mixing of moral issues, social justice and financing creates the structures and these structures are complex and unfamiliar to new investors. For example, there must be underlying assets for transactions, an idea primarily driven by the rationale in Islamic law that borrowers do not over-borrow.

These principles are the kinds of things that tend to be discussed more when I talk to various investors who are interested in Islamic finance, and it is important because of what it basically does – it links finance with the productive flows of the economy. That message has gone across very well but the source of unfamiliarity is how products are structured to meet these objectives.

MNA, AAOIFISo do you feel that one attraction of Islamic financing is this notion of more ethical financing structures?

I would say that ethical financing in relation to Islamic finance is not just notional but fundamental. The ethical financial structure is what differentiates Islamic banking from conventional banking. Ethical banking does not just mean that we do not participate in transactions that are deemed ‘non-Sharia compliant’, such as dealing in alcohol, gambling, drugs, etc, but it goes beyond that to encompass a structure that is fair in its transparency, risk mitigation and asset-backed transactions. This is evident in Islamic banking’s approach towards profit sharing, taking into account the client, the market and the sector.

The challenge

ND, Trowers & HamlinsI think one of the questions we probably ought to be asking is whether we think that goal or that principle is genuinely being pursued through the Islamic finance market, or the Shariah-compliance market, whichever terminology we wish to use.

The challenge is to put in place a system of financing that is in compliance with the Shariah and in compliance with relevant laws and regulatory constraints but which also produces a return. Islamic banks have shareholders and while, in theory, those shareholders accept the notion that their capital should be more at risk than the capital of the investors and shareholders in their conventional counterparts, I am not sure if that is genuinely the case if you look at how the market has developed.

People are beginning to scrutinize Shariah compliance more carefully. Obviously the AAOIFI pronouncements in January and the discussions that took place in January and other more general continuing debates are trying to bring people back to what is at the core of this industry. Yes, it is to provide movement of capital, it is to provide finance, but should it be providing finance for homes, for hospitals, for schools, for universities, or should it be providing finance for institutional funds that are free then to do whatever they like with the funds.