Fri, Feb 27, 2015

Growing Demand for Islamic Finance

The Islamic finance industry is attracting increasing global attention from investors. The size of the industry reached $2.1 trillion of Shari’ah (Islamic ethical framework) compliant assets in 2014, compared to just over $1 trillion in 2011, and is projected to exceed $2.5 trillion in 2015 according to AlHuda Centre of Islamic Banking and Economics (CIBE).

This remarkable growth is attributable to various factors, such as strong growth in the Gulf Cooperation Council countries and emerging markets in Asia, as well as an expansion into new markets in Europe, Australia, Brazil and China, amongst others.

Shari’ah-compliant financing and investment products are open to all, Islamic or non-Islamic investors. In addition to the steady growth, investors are attracted to Islamic finance products for various reasons such as: diversification, ethical investments and asset-based investments.

Basic principles of Islamic finance

One of the basic premises in Islamic finance is that money is not a commodity in itself but rather a medium of exchange for commercial activities, therefore, riba (all sorts of interest) is prohibited. In order to be lawful under Shari’ah, any profit is required to be linked to asset performance and its risk. Maysir (speculation), gharar (unnecessary uncertainty) and investment in haram (forbidden) businesses are also prohibited under Shari’ah. For those reasons, conventional banking and insurance are not Shari’ah-compliant and the industry has developed financial products that replicate conventional products in a Shari’ah-compliant way.

Islamic banking

Islamic financial services are offered by both fully-fledged Islamic banks (e.g. Islamic Bank of Britain) and conventional banks. The latter offer Islamic financial services via one of the three organizational models:

  1. The windows model – the same delivery channels are used for Islamic finance and conventional services
  2. Dedicated branches
  3. Subsidiaries

One of the fundamental differences between conventional and Islamic banking is that in the former the regulators consider a deposit to be a loan from a customer, whereas in the latter it is considered to be entrusted to the bank for safekeeping.

Islamic asset and fund management

Islamic funds are managed on the basis of a Mudaraba (profit/loss sharing) or Wakala (agency) contract. There are various fund structures that are also used in conventional asset management, for example:

  • Fixed-income funds typically invest in Sukuk (Islamic debt type instrument) and Ijarah (lease) and use cash
  • Ijarah funds typically invest in finance leases with some of the funds invested in liquid assets
  • Equity funds are compatible with Shari’ah or track an Islamic index
  • In real estate funds, the properties must be used for Shari’ah-compliant activities

It is important to note that there are two stages in Islamic stock selection process

  1. The industry screen where the underlying business activity of the company is evaluated
  2. The financial screen to ensure that the company complies with the financial ratios prescribed by its Shari’ah Supervisory Board

When considering the first stage, the business activity of subsidiaries is sometimes overlooked which can result in a non-Shari’ah compliant investment.

Regulatory issues

The majority of regulators regulate providers of Shari’ah-compliant products and services as part of their general regulatory regimes requiring them to obtain a license or authorization. Others, for example the Dubai International Financial Centre and the Central Bank of Bahrain, have adopted special regimes. There is also an “Islamic window” approach to regulation where providers conduct part of their business in accordance with Shari’ah.

The regulation of Shari’ah compliant products and services poses specific challenges to regulators, for example the role of regulators and the extent of powers they should assume, and classification of Shari’ah-compliant products. As the industry continues to grow and more innovative techniques are developed, this is set to present new challenges for regulators and legislators.

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