Islamic Finance: Relevance and Growth
in the Modern Financial Age
Iqbal Khan
Founding ex-CEO, HSBC Amanah
London School of Economics
1 February 2007
Agenda
1. What is Islamic finance?
2. What relevance does it have in the modern financial system?
3. What are the areas of current growth and initiatives?
4. What does the future hold?
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Islamic finance is the outcome of religion in banking
Banking and finance needs
Fiqh al-Muamalaat contracts
Shariah sources
– Musharaka - Partnership
– Quran
– Sunnah
– Ijma’ (jurist consensus)
Shariah filter
– Qiyas (analogy)
– Ijtihad (reasoning)
– Mudaraba
- Partnership
– Murabaha
- Purchase-resale
– Ijara
- Lease
– Istisna’
- Manufacturing contract
– Salam
- Forward sale
Islamic banking and finance solutions
•
Prohibition on:
– Interest
– Speculation
– Gambling
•
Prohibition of certain investments:
− Sectors (e.g.: alcohol, armaments,
financial services, gambling, pork,
pornography, tobacco)
− Instruments (e.g. no forward
transactions, limited option use, no
derivatives, short-selling)
Islamic Finance: Relevance and Growth in the Modern Financial Age | 3
•
Asset-backed
transactions with
investments in
real, durable
assets
•
Credit and debt
products are not
encouraged
Islamic finance is embedded within values
– Synthesis of Islamic law
and contemporary finance
– Widens ownership
base of society
– Community banking:
serving communities, not
markets
– Offers “success with
authenticity”
– Ethical
investment
Client
affinity
Parallel
trends
– CSR
initiatives
Inclusive
propositio
n
Fulfils
aspirations
– Builds
systematic
checks on
financial
providers
Responsible
finance
Alternative
paradigm
– Restrains
consumer
indebtedness
– Open to all-faith clients
– Stability from linking
financial services to the
productive, real economy
– Available to Islamic and
conventional issuers
– Moral compass for
capitalism
Islamic finance is more than financial contracts
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Values of good governance are central to Islam
Best practices of
corporate governance
−
Accountability and obligation to
shareholders
−
Integrity and ethical behaviour
−
Fiduciary role and responsibility
of board
−
Disclosure and transparency
Quranic code of ethics
−
Vicegerent concept of accountability (2:30)
−
Honest fulfilment of contracts (5:1)
−
Prohibition against betraying any trusts (8:27)
−
Prohibition against deriving income from
cheating, dishonesty or fraud (4:29)
−
Prohibition against bribery (2:188)
−
Prohibition against concealing evidence (2:283)
“O ye who believe! Be ye staunch in justice, witnesses for Allah, even though
it be against yourselves or (your) parents or (your) kindred…” (4:135)
Accountability to God raises level of awareness
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Islamic Financial Institutions are positioned in a “zone
of sustainability”
ECONOMIC
IMPERATIVE
SOCIAL
IMPERATIVE
ZONE OF
SUSTAINABILITY
prohibited
sectors
Islamic
businesses
NGOs
not-for-profits
Islamic finance characteristics:
• Market-driven yet values-based
• Gradualist and evolutionary nature
• Symbiotic and synergistic relationship with mainstream finance
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Industry has advanced from niche to critical mass

Young industry
−
−
Mitghamr Savings Associations (1963) & Tabung Hajji Malaysia (1967)
Islamic Development Bank (1974) & Dubai Islamic Bank (1975)

Market-driven proposition
−
−
−
Retail customers historically the backbone of the industry
Tipping point in retail sector: Saudi Arabia, UAE, Bahrain and Kuwait
Self-regulating organisations, Standards bodies and Research and
Training Institutes
Islamic banking assets as
proportion of total (%) *
45%
40%

Market size estimated at USD 750 billion globally1
−
−
Growing at 15 to 20% per annum1
Within 8-10 years, industry estimated to capture half the savings of the
1.6 billion Muslim world2

Global scale
−
−
−
−
More than 250 Islamic banks worldwide operating in over 75 countries 3
GCC accounts for two-thirds of global Islamic assets*
Malaysia leading industry maturity and sophistication
Islamic Development Bank: largest pan-OIC financial institution
40%
33%
growth
35%
30%
30%
25%
20%
66%
growth
20%
15%
12%
10%
5%
0%
2005
2010e
GCC
Malaysia
Industry is fragmented, with slowly internationalising players
Source:1: S&P Report ( 31 Aug 2006); 2: IIR Middle East (Apr 2006); 3 Bursa Malaysia “The Islamic Capital
Market” 2005; * HSBC analysis
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Industry has developed a comprehensive product
offering over its young history
Development of industry
1950s
−
−
Development of theoretical framework
Muslim-majority nation independence
60s
−
−
Egypt and Malaysia pioneering institutions
Establishment of OIC (1969)
70s
−
−
Islamic Development Bank (1974) and DIB
One country-one bank setup
80s
−
−
Advancement of Islamic products
Full “Islamization” of Pakistan, Sudan and Iran
−
Entry of global institutions, e.g. HSBC
−
−
Tipping point reached in some markets
Development of industry-building institutions
90s
00s
Evolving richness in products
structured
products
debt
issues
private
equity
2000s
1970s
1990s
1980s
insurance
syndications
project
finance
equity
Industry has near like-for-like parity with conventional offering
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Islamic finance industry is developing a global reach…
Reach and richness
Mainstream relevance
Niche presence
Engaging with regulators
Conceptual exploration
Islamic Finance: Relevance and Growth in the Modern Financial Age | 9
Source: HSBC Amanah
…with worldwide momentum from retail to regulator
involvement
UK:
New legislation for
Islamic mortgages (2003)
USA:
Harvard workshop
with six regulators
(1995)
Germany:
Saxony issues
E100m Sukuk (2004)
Saudi Arabia:
95%+ of new consumer
lending is Islamic (2006)
• Retail market rapidly
converting to Islamic
(2006)
China:
Active member
of Islamic
Financial
Services Board
(2004)
Bahrain:
Leading Islamic
financial centre, and
housing regulatory
bodies
UAE:
30% of retail banking
is Islamic (2005)
• Several institutions have
converted from
conventional to Islamic
Japan:
JBIC exploring
Islamic financing
opportunities
(Dec. 2006)
Singapore:
Active in
developing
Islamic finance
Malaysia:
Islamic product and
industry, development and
sophistication leader
Source: HSBC Amanah, Press Reviews
Each region is contributing in a unique way
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Self-regulatory organizations bring credibility through
standardization of practices

Benchmark of Islamic accounting standards
Bahrain
−
−
56 accounting, auditing, governance and Shariah standards
Enhancing clarity, transparency and harmonisation
IIFM

Development of global Islamic capital and money market
Bahrain
−
−
Promoting active and regulated trading and capital flows
Catalyzing trading infrastructure, product innovation and information flows
GCIBFI

Promoting industry in theory and practice
Bahrain
−
−
Disseminating Shariah concepts & multilateral understanding between IFIs and public
Improving IFI practices, cooperation, professionalism and transparency
IFSB

Standard-setting body of regulatory and supervisory agencies
Malaysia
−
−
Complementing Basel II Capital Accord
Key standards: risk management, capital adequacy & corporate governance
LMC

Creation of active Islamic inter-bank market
Bahrain
−
−
Creating secondary market for short-term Shariah-compliant treasury products
Enabling IFI management of liquidity mismatch
IIRA

Reference point for IFI ratings
−
−
Issuing sovereign, credit, Shariah quality and corporate governance ratings
Providing effective tool for informed investment decision-making
AAO-IFI
(1991)
(2001)
(2001)
(2002)
(2002)
(2005)
Bahrain
Islamic Finance: Relevance and Growth in the Modern Financial Age | 11
Why Islamic financing is flourishing
Strong growth of
OIC economies
Institutional capital
EXPLOSIVE GROWTH
OF ISLAMIC FINANCE
Innovative product
development
Resurgence of
Muslim cultural values
Liberalisation of
capital markets
Retail customer
commitment
Industry is driven by fundamental factors
Islamic Finance: Relevance and Growth in the Modern Financial Age | 12
Multinational banks have gradually increased their focus
on Islamic finance
Market entry strategy
Evolving commitment
Ad hoc participation
Defensive strategy
Proactive strategy
• Service and retain
existing Muslim clients
• Acquire new customers,
especially wealthy locals
• Refine current
proposition to reflect
local needs
• Build a sustainable
community banking
proposition
– Particularly
important and
economic clout of
locals increased
• Protect and embed the
brand
• Benefit from higher
growth rates of
emerging markets
– Crucial as
developed market
growth slows
−
−
Correspondent banking for IFIs
Tailored Private Banking services for HNWIs
Islamic client services
−
−
Dedicated Relationship Managers for IFIs
Dedicated Private bankers for HNWIs
Islamic window model
−
−
Committed unit for Islamic financial services
Citi Islamic (1996), HSBC Amanah (1998)
Dedicated Islamic subsidiary
−
−
Islamic subsidiaries of conventional banks
Joint ventures and partnerships
Mainstream institutions are embracing Islamic banking
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Industry is reaching mainstream relevance in global
financial system
Relevance to OIC countries
•
Fulfilment of financial needs of Muslims
−
•
•
Increases bankable population of economy
Increases economic efficiency as a result of
society’s increased engagement
Enhances stability of financial model
−
•
Asset-based framework links financial services
to real economy
Reaching a broader market
−
Islamic finance is the equilibrium choice
Widens stakeholder base of society
−
−
Relevance to non-OIC countries
•
Muslim-minority populations become inclusive,
economic, productive agents
Alternative source of funding
−
−
•
Debt issuance with the widest acceptance
Attract “new-to-industry” investors with Shariahcompliant funds and transactions
Gateway to OIC markets
−
−
Regional preference of Islamic investors
Infrastructure investment opportunities
Islamic finance benefits are not exclusive to Muslims
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The industry has not yet reached its potential
 Within 8 to 10 years, as much as half the savings of the world’s then 1.6 billion
Muslims would be in Islamic banks1
 The global Islamic insurance (Takaful) market is estimated to reach USD 14.4
billion by 20101
 Most Islamic financial institutions are highly liquid, and seek new asset classes
and markets to diversify
– Project finance requirements of USD 500 billion in 5 years2
– Capital markets developments: Malaysia – Sukuks account for 71% of 1H06 debt issues3
 Islamic finance has also gained popularity in Muslim-minority countries
– Germany issued the first Islamic Eurobond (2004)
– UK’s first standalone Islamic bank (2004)
 Trends of convergence and conversion
– Ethical investing, community banking
– Conversion of banks: e.g. National Bank of Sharjah, Bank al Jazira, Dubai Bank
Source: 1: IIR Middle East (Apr 2006); 2 Banker ME (June 2006); 3 RAM Islamic Ratings Services (2006)
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Islamic framework provides solutions for key limitations
of conventional banking system
Conventional banking issues
•
Growing consumer indebtedness
−
−
•
TSV maximisation ultimate goal
Systemic conflict between shareholders and
credit-financed customers
Speculation-fuelled crises
−
−
−
•
•
Asset/need-based approach to financing
•
Check on profit-seeking alone as sole
business motive
−
Collusion between research and M&A teams
Enron, WorldCom, Arthur Anderson, Tyco and
other collapses
Investment channels towards ethical activities
•
Equitable distribution of risk and reward
•
Prevention of speculation
−
−
−
1997 East Asia Crisis
1998 Russia
1999 Argentina
Regulation often reactive and lagging
corporate misbehaviour
−
−
IFI solutions
•
Ownership is prerequisite of sale
Excessive risks are prohibited
The case for “Narrow Banking”
Shariah-based IFI is Taqwa-based
−
−
Regulation is reactive to corporate innovation
Shariah-based system prioritises God over
regulators – (SRO)
An ethical grounding prevents a wide set of problems
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Suppliers of capital
An alternative banking model in development
Deposits
Profit, not interest,
becomes the basis for
financial intermediation
Debt financing
ijarah, murabaha,
salam, istisna‘
Liabilities
Assets
Investments
Equity financing
mudaraba & musharaka
Key internal issues that need addressing…
•
Reducing debt-based products
−
−
Islam permits commercial debt for productive ends
Debt-based consumer products permitted on basis of need
−
•
More the exception than the desired norm
Building income-sharing products
−
−
•
Musharaka is true form of financing
Develop with “fixed” income payment profile
Removing bias towards debt
−
Current tax, accounting and regulatory systems and risk-weighting
promote debt instruments
Islamic Finance: Relevance and Growth in the Modern Financial Age | 17
Productive
economic actors
with capital
needs
Shariah-based mindset is crucial direction for product
development
Shariah-based solutions
−
−
Income-sharing
products
Shift from debt-based
product offering
Savings &
Indebtedness
Investments
x
Shariah-compliant products
−
−
Letter of the law
Replicating
conventional credit
service offering
Shariah-based industry is the new vision
Islamic Finance: Relevance and Growth in the Modern Financial Age | 18
A number of factors need to be engaged to bring success
Key
enablers
•
Dedicated people
−
−
•
Greatest intangible to enable Islamic finance and build its future
Human capital development: bankers and Shariah scholars
Committed sponsorship
−
−
•
Academic input to formulate visionary framework and development
Capital sponsorship to bring plans to life
Change in mindset
−
•
From Shariah-compliant to Shariah-driven products and services
Education of all key stakeholders
−
•
To build understanding and awareness
Proactive engagement
−
Regulators, practitioners and Shariah scholars to set a common agenda
Need for co-ordination to enable further development
Islamic Finance: Relevance and Growth in the Modern Financial Age | 19
Concluding remarks
 Current
expanding reach and richness of Islamic finance
–
Despite the absence of an enabling framework
–
But at a cost: culture of exceptions, Shariah credibility, competitive disadvantages
 To
build an enabling framework requires concerted efforts
–
Collaboration between IFIs, endowed industry institutions and regulators
–
Exploration of narrow banking principles
 We
must preserve what is distinctive about Islamic finance
–
Industry regulations and governance heading towards mainstream globalization
–
Balancing different elements of Shariah credibility
Japanese proverb:
“Vision without action is a daydream.
Action without vision is a nightmare.”
Imperative is for moving to Shariah-based services
Islamic Finance: Relevance and Growth in the Modern Financial Age | 20
Thank you
Iqbal Khan
Founding ex-CEO, HSBC Amanah