In seeking to tap into the burgeoning Islamic market, Western banks are learning to accommodate laws such as the one that prohibits interest payments.
By Giles Parkinson
Islamic finance was virtually unheard of in the West just a decade ago, when its activities were limited to a group of specialist institutions servicing members of the Islamic community.
But over the past four years its assets have more than quadrupled, by some estimates to more than AUD$1 trillion worldwide, making it one of the fastest-growing sectors of the international banking industry.
The Kuala Lumpur-based Islamic Financial Services Board has predicted that assets managed under Islamic rules will almost triple by 2015 to AU$2.8 trillion.
The growth has become so dramatic that leading Western banks have created specialist Islamic divisions to service this growing market. The target is not just the enormous wealth of the Middle Eastern countries, but also capturing the increasing demand from the growing Islamic communities within their own borders.
Countries such as the United Arab Emirates and Malaysia are creating their own Islamic finance sectors, which they expect may one day rival the traditional finance centres of the Western world.
Geert Bossuyt, the head of Middle East Structuring at Deutsche Bank, one of many European banks to create an 'Islamic window' in the past few years, says there are 1.6 billion Muslims in the world today. 'No investment bank has the luxury to stay out of this business.'
Islamic finance is different from the Western concept of finance in many areas, and the most fundamental of these is the prohibition of interest payments, or riba. Under Sharia law (the code of law based on the Koran used in some Muslim countries), the goal of trade and enterprise must be the sharing of wealth within the community under morally acceptable business practices. Risk must also be shared.
The payment and receipt of interest is prohibited because it is deemed to be effortless profit. 'Money cannot yield additional money,' Bossuyt says. 'You must have an underlying asset or business.'
Bossuyt says that for the Muslim world, money is a way of expressing value, not a tool for making more money. In concept, it is similar to the beginnings of conventional finance, when gold, a solid and touchable asset, was the standard.
The way it works in practice is like this. If a customer wishes to borrow AU$100,000 for a business or a home, under Western financing practices they would expect to pay interest, possibly AU$10,000 a year. In Islamic finance, there are several methods used that eliminate the need for interest and allow the customer and the finance provider to share both the profit and the risk of the transaction.
Musharaka is regarded as one of the purest forms of Islamic contracts. A bank will provide the funds to enable a customer to buy an asset, but will set an agreement to share the profits or indeed the losses from that asset.
A contract known as murabaha has become the most popular form of financing. Here, a bank will finance the purchase of an asset such as a house, or a car, and agree to sell the asset back to the customer at a higher price.
The advance is repaid in instalments. A variation of this method is known as ijara, where the repayments are effectively in the form of a lease over an agreed period.
Murabaha is commonly used in supply chain and trade financing, while another tool, known as mudharabah, is used in the financing of new business ventures. One party provides the funding, and another party the effort and labour. Profit is shared at an agreed ratio.
The concept is extended to insurance (takaful) and to other forms of financing such as bonds (sukuk), which have been developed to allow Islamic investors access to international bond markets.
The major difference between a sukuk and a conventional bond is that the sukuk is backed by an asset. According to Bloomberg data, sales of sukuk grew nine times faster than international corporate bonds in 2006.
Importantly, investments in certain business activities are also forbidden on ethical and moral grounds. These include alcohol, tobacco, pornography, arms, pork products, and gambling.
In Australia, despite a growing Islamic population, it has nearly doubled in the past decade to more than 350,000, there is little activity in the Islamic finance arena. Two small ventures, the Muslim Community Co-operative (Australia), or MCAA, and Iskan Finance, are offering services to their members, although both organisations declined to be interviewed for this article.
The MCCA, founded in 1989, describes itself as a 'living example' of Islamic principles in practice. 'We provide innovative products for individuals and businesses, enabling them to participate fully in economic life without compromising the tenets of their faith,' reads the spiel on its website. Iskan was created in 2001 and offers a range of Sharia-compliant products.
The growth of Islamic finance in Australia may be constrained by legislation. In the murabaha for instance, where ownership of the asset is first transferred to the financier and then to the customer after repayments have been completed, stamp duty is payable on both occasions.
Some legislative amendments have been made, notably in Victoria, but Australia has yet to follow the UK, which in 2001 passed legislation facilitating Islamic finance as the then chancellor of the exchequer (now prime minister), Gordon Brown, moved to ensure London would emerge as a centre for Islamic banking and investment.
That policy appears to have worked. London has become a favoured centre for Sharia funds, which have invested billions of dollars in real estate and other investments.
Brown introduced further legislation in 2006 to facilitate the activities of Sharia-compliant funds and financiers in London, and this year HSBC became the first major British bank to offer Sharia-compliant mortgages, seeking to tap the market of some of the two million Muslims who have chosen not to take out conventional mortgages or open bank accounts. But while Australia remains a spectator for the moment, its expertise is in demand.
David Knott, the former chairman of the Australian Securities and Investments Commission, is right at the heart of growth in Islamic banking in his new position as head of the Dubai Financial Services Authority. 'Islamic banking is starting to make itself felt,' he says.
'Its an exciting thing to see, and I think Dubai is well positioned to participate in that growth.' Indeed, Knott is at the centre of an extraordinary plan to build in Dubai a new financial centre that will rival those of London, New York and Tokyo/Hong Kong.
The Dubai International Financial Centre is a unique carve-out, both geographically and jurisdictionally, of 110 acres in the centre of Dubai. Launched in 2004, it consists of a new city in the style of Londons Canary Wharf, but with residential, commercial and retail activities, its own laws, and new stock and commodity futures exchanges. The project is expected to be completed in 2010.
'We believe it will become a very major financial centre,' Knott says.
'Its a long way from being the size of London and New York, but it does fill a time gap between Asia and Europe, and taps into one of the fastest growing regions in the world. The Middle East and North Africa are experiencing huge growth, and not just from oil. Dubais GDP is less than 5 per cent related to oil. Its strategy is very much to prepare for life after oil.'
As the economy grows, so does the need for a fully fledged financial services industry and capital markets. Opportunities for investment banks and fund managers have become more attractive.
Knott believes Islamic finance is in some ways analogous to the old cooperative style of lending and the principles of the former building societies. 'They look for a partnership, they look to share risk in relationship to their proposals, be it a persons house or a business,' Knott says. 'This is fundamental to the transactions, and to underpin that relationship there has to be real assets.'
Knott is also in a pivotal position in the development of the regulatory framework for Islamic finance and how it interacts with mainstream financial markets.
Crucial to the growth of Islamic finance is the presence of supervisory boards of Sharia scholars, who can certify that any products meet religious requirements. 'We do require the (financing) firm to have a specialist Sharia board to sign off before it makes any representations to the public,' he says.
'Then we require it to have processes in place to monitor those products and ensure they continue to be managed in accordance with Sharia.'
In Malaysia, there is a single board, but this is not possible in the Middle East where there are noticeable differences of interpretation in some aspects of Islamic law. 'In a very conservative country like Saudi Arabia you might get a different interpretation than in Malaysia, where they are a bit more liberal,' Knott says.
Knott says that in the UAE, of which Dubai is the second biggest of seven emirates, the share of total bank assets held by Islamic banks has nearly doubled to more than 13 per cent in the past five years. 'The change is very dramatic and very noticeable,' he says.
'I wouldnt be surprised to see it reach 25 per cent in the next five years. In some markets, it could be more. Its very interesting that Brown wants London to be a major Islamic finance sector. It gives you an idea of how important it is seen to be.'
Little wonder that major western banks are moving quickly into the sector. UBS, HSBC, Barclays, Deutsche Bank, Paribas, Citigroup, Prudential Asset Management and Standard Chartered all have created Islamic units or become heavily involved in activities such as the underwriting of sukuk in recent years.
Western customers are tapping into this market. The German state of Saxony has issued Islamic bonds, and the British government is considering doing the same. A Texas oil company, East Cameron Gas, and a Japanese financier, Aeon Credit Services, have also issued Islamic bonds.
Islamic financing accounted for 15 per cent, or AUD458 million, of the refinancing taken out by the Emirates Group for its orders of A330 airbuses.
Deutsche Banks Bossuyt says the bank has sought to integrate its Islamic financing activities as much as it can into its conventional business. 'We have an approach that anything that is possible in conventional finance is possible in Islamic finance,' he says. 'Everything is run on the same processes, although the structuring is slightly different. Trading is the same, the risk processes are the same.'
Bossuyt believes that in many Muslim countries, the Sharia market will become the standard, and the conventional market will become the exception. 'Commercial issuers and supra-nationals will want to tap into that market,' he says. 'A conventional client can buy Sharia-compliant products, but not the other way around. That will drive the market.'
