What’s the secret behind the growth and success of Islamic finance?

Liza Mydin

 

On May 25, 2018 the International Monetary of Finance (IMF) announced that by 2019 it will incorporate Islamic Finance into its financial sector assessments of select countries and that they will adopt the International Financial Services Board (IFSB) assessment methodology for the review. The endorsement by the IMF is an overdue recognition of an industry that has grown to become present in over 60 countries.

The potential of Islamic Finance have received much attention in the past decade, an observation one would typically accord a new star player.  Since then, the industry continued to mature year on year and today analysts are predicting that the market size could reach USD 3.4 trillion by the end of 2018. 

The key Islamic Finance markets are Malaysia, the United Arab Emirates (UAE) and Bahrain, countries that have come to be known as Islamic Finance hubs. Malaysia is a forefront runner in product innovation and its Islamic banks’ growth rate continuously surpasses its conventional counterpart.  The UAE is about to establish the world’s first Islamic trade finance bank in Dubai and Bahrain is known to have a  well-defined infrastructure and strong legal system as its prudential and regulatory frameworks are often internationally accepted by the global Islamic Finance industry.

Whilst many factors often come into play to achieve such success for these countries, the main determinants can be narrowed down to two –the equitable growth that Islamic Finance product offers and the government’s will to push the industry.

 

Equitable growth through Islamic Finance Products

Firstly, Islamic Finance products have a profound ability to render equitable growth. Risk sharing, a defining principle in Islamic Finance ensures economic growth with financial stability[1].  Credit risk transfers and speculative activities that commonly lead to creating opaque financial instruments under conventional finance are strongly prohibited. Many studies found that most, if not all factors that caused the 2008 sub-prime crisis contravened the Shariah.

Adopters of Islamic Finance products found a fairer alternative in product features such as the imposition of profit ceiling rates and prohibition of both interest or any compound versions of it. More importantly risk sharing contracts are designed to allow financier and receiver of funds to share risks and rewards when there can be no guarantee of a particular outcome. In contrast, debt financing requires payment of principal and interest, irrespective of whether the borrower succeeds or experiences losses. Entering into risk sharing activities is encouraged for a stronger linkage between the financial sector and the real economy. Financial stability is a precursor to economic growth and this cannot be achieved in systems entrenched in debt as it triggers recurring financial crises whenever there is a rise in debt default events.

Islamic Finance gained traction after the financial crises not only because it was the only alternative to conventional finance, but also the business and overall economic case to take up the product were too great to ignore – it restricts any party from obtaining undue or unjust gains, at the expense of others.

 

The government has to push the agenda

Secondly, the government needs to actively pave the way for the advancement of the industry through establishing the required legislation and governing institutions. The success story in Malaysia can be traced back to its former Central Bank Governor who had an extensive role in the development of the industry in the country and globally. Tan Sri Dr Zeti Aziz was part of the group of Governors that established the IFSB and the International Islamic Liquidity Management Corporation.

She also headed a taskforce that identified the building blocks required to strengthen the Islamic Financial system and the development of talent for the industry. Subsequently, the International Centre for Education in Islamic Finance, the world’s first global university dedicated to Islamic Finance was established. Their Central Bank has also made commendable efforts to implement true risk sharing activities such as its backing for Islamic Financial institutions to create investment account platforms so that funds may be channelled to finance viable projects.

In Dubai, the plans to accelerate growth of the Dubai Islamic Economy is credited to the vision of Sheikh Mohammed Rashid Al Maktoum, the Vice President and Prime Minister of the UAE. Under the ruler’s directives, strategic partnerships were formed such as the recent UAE-China collaboration in the Islamic banking and finance sector. Frameworks were also developed for the country to compete with Malaysia and establish the largest platform to attract and list sukuks. In recent years, the country has made significant strides in its digital and sustainable energy sectors.

Much of the momentum that has gathered in the Islamic Finance market in Bahrain stems from the willingness of its central bank to establish a legal framework right and its governing institutions for the industry. In 1990, the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) was formed and its standards are adopted by regulators all over the world.  Bahrain also hosts other Islamic financial institutions such as the Liquidity Management Centre, International Islamic Financial Market, the Islamic International Rating Agency and the Shariah Review Bureau. To develop talent, the Central Bank established a special waqf fund to support education and training initiatives.

Islamic Finance in its modern form is no longer in its infancy and the recent nod by the IMF shows that Islamic Finance has a significant impact on global financial systems. While the industry in most countries experience sporadic growth, development in these Islamic Finance hubs are years ahead. For these Islamic Finance hubs, the industry is on its way to becoming mainstream.

 

 

[1]Maghrebi, Nabil and Mirakhor, Abbas (2015) Risk Sharing and Shared Prosperity in Islamic Finance (Islamic Economic Studies Vol. 23, No. 2, Nover 2015 (85-115)

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