Saturday, October 23, 2010

Islamic finance in the global financial system

A commenter on The Review Middle East to an earlier blog post asked me to discuss how Islamic finance can make a name for itself within the global financial system. I have covered many aspects of what I think Islamic finance needs in order to be a significant part of the global financial system. It was on the verge of breaking out and becoming more significant following the financial crisis when markets in the GCC were continuing to grow even as the financial system in the West faltered.

However, the Islamic finance industry became part of the financial crisis with the debt crisis in Dubai after the real estate market peaked and began a sharp decline. Although I suggested that the idea that Islamic finance was not immune from crisis, despite that being a popular narrative during and after the crisis, it was not until after the Dubai debt debacle that the narrative disappeared. As with conventional finance in the US where real estate woes translated into a significant drop in financial service activity, the Dubai real estate crash (and also lingering effects of the Western financial crisis) led to the issuance of sukuk falling sharply in Asia and particularly the GCC.

The decline was sharper first in Asia and the GCC benefiting from rising oil prices in the summer of 2008 that buffered early symptoms of the credi crisis. However, after the Dubai debt crisis, the primary sukuk market within that region saw very few issuers, most of them sovereign. At the same time, the sukuk issuance out of Asia rebounded quickly and until the last month or so, Asian issuers have led the resurgence of sukuk.

Now, not all Islamic finance is sukuk. There are many other players from asset managers to Islamic banks (both commercial and investment) to takaful providers. These have fared better (with the exception of investment banks dependent upon new sukuk and other large investment deals) through the crisis. However, they also face challenges coming out of the crisis to define their place in the global financial system.

Getting to the issue of the question posed by the commenter, the first point that the Islamic finance industry should be willing to accept is that it is not immune from a future crisis that looks very much like the last one (in the conventional industry). Islamic finance may be based on more tangible assets, but it is still a financial system structured in a similar way as the conventional industry. It acts as an intermediary between people with excess capital and those needing access to capital. It is structured differently, to receive approval as being Shari'ah-compliant, but it performs the same role as the conventional financial industry.

Therefore, it must do that in a different way in order to establish its place in the global financial system. The easiest (although not most effective, in my opinion) way would be to focus narrowly on providing financial services to Muslims. This would place its focus on the people who will not deal with the conventional financial system. However, this would be ineffective particularly if it wants to shed the 'niche' label because it would limit its market. Despite the growth of Islamic finance in the West, this is the logical end of its current focus on replicating conventional products with Shari'ah-compliant alternatives. If Islamic finance continues on its current track and even if it becomes price competitive with conventional finance, it will be limited in its size within non-Muslim markets to providing a way for non-Muslim borrowers to access the wealth held by Muslims.

If the current track of 'replication' is not effective, then is there another way to move forward that will make it able to compete with conventional banks for non-Muslim markets? There is in my opinion, but it will take a shift in direction for the industry. First, while the replication of conventional products has its place, the news should not be filled with stories of the 'first Islamic [insert conventional product]'. These products are necessary in many cases in making the industry stronger (for example money markets) and in providing financial products that consumers understand (for example Islamic mortgages). The limit of replication is that it does not create a competitive advantage for Islamic finance among any groups except devout Muslims who would otherwise be un-banked if there were not a Shari'ah-compliant alternative available.

Second, the industry should borrow from other 'ethical' financial trends. For example, socially responsible investing has been growing rapidly, particularly in the West. This is a market where many consumers are non-Muslim and are looking for alternatives to the 'business as usual' approach in investing. There are few barriers for Islamic finance to adopt the screening criteria and combine it with the back-to-basics banking approach that is adopted by many Islamic banks. Currently, the issue of social responsibility is limited to investing (the screening-based methodology used by SRI funds is similar to what Islamic funds are using) and to putting pressure on financial institutions (e.g., the Equator Principles for project finance, which is voluntary and has no Islamic banks as participants).

Third, Islamic financial institutions should use their basis as 'ethical' financial institutions to pursue greater focus on poverty alleviation and use their experience with innovative products to further that focus. Islamic banks, while not commonly, do use mudaraba and musharaka, which are financing methods that more closely resemble equity than debt. If they used these (and other) products within a sustained effort to promote Islamic microfinance, it could represent a significant innovation within microfinance. Microfinance institutions around the world have branched out to offer micro-insurance and deposit services, as well as their main debt-based lending programs. Islamic financial institutions could step in and provide equity financing to microbusinesses. They could also provide takaful to microfinance clients, which fits in well with the microfinance ethos of 'group-based lending'.

Fourth, Islamic financial institutions could integrate their profit-and-loss sharing products more into their businesses. This would provide them with a 'unique' product (especially for commercial banks) that would create differentiation from conventional banks, which focus on debt financing. Within this move, the Islamic financial institutions could align themselves more closely with institutions like credit unions which are member owned (rather than being owned by external shareholders). The member ownership of credit unions fits in well with the back-to-back mudaraba concept that was initially devised as a model for an Islamic bank.

These ideas are very general and do lack specificity needed to actually turn them into a reality, but they should serve as a basis by which new developments in Islamic finance can be viewed. Is the new development furthering the status quo of 'replication' of conventional products? Are new products filling the essential gaps where replication is neutral? Is a new product providing the industry with a model for a way to attract a broader market towards Islamic finance? Only time will tell regarding the direction Islamic finance (through the financial institutions that mak it up) will take.