The Islamic finance industry may have been slow to find its feet since the arrival in 1975 of Dubai Islamic Bank, now viewed as the first modern commercial Islamic bank, but it has nonetheless continued to evolve. Today it encompasses retail and commercial banking, equities, syndicated transactions, debt issuance and structured products in a number of Muslim and non-Muslim countries.
“In countries with a strong Islamic banking sector, such as the UAE and Malaysia, we see a whole range of businesses across a number of industries opting either wholly or partially for Islamic finance, from large corporates down to SMEs,” says Tom Guest, Associate Director of independent investment management and advisory firm, Eiger Trading Advisors. The drivers tend to be diversification of their funding base and the option of tapping into an alternative pool of liquidity, but often the driver is investor demand, especially in Saudi Arabia for example where the majority of retail investors on the tadawul (the domestic stock market) may restrict their portfolios to Shariah-compliant companies. “If a company sees a larger potential market for their debt or equity issuance on a Shariah-compliant basis then it makes sense at least to explore the option.”
Because Islamic finance has traditionally been focused on financing the production and trade of physical assets, it was much easier for these types of businesses, such as palm oil producers or cement manufacturers, to access Islamic finance. In recent years, however, as Islamic finance has developed and become increasingly sophisticated, we are seeing less obvious underlying businesses, such as telecoms companies, coming to market, and this trend looks set to continue as original and innovative deal structures become more commonplace.
It was historically perceived that Islamic finance is more expensive than its conventional counterpart. “It is now possible to secure cost of funding that is either equivalent or cheaper than conventional capital. The view from Vicky Jones, Of-Counsel, Norton Rose Fulbright (an international law firm that has handled many sukuk issues through its Singapore office) is that although the depth of liquidity in the Islamic market is good, “I would not say it was so great that companies not using it for principled reasons would do so for the sake of it”. She adds that, although the Islamic finance market represents an alternative pool of liquidity, the extra costs involved in executing Islamic finance transactions mean that some corporates will not be interested, or will not consider it worth their while, to tap that pool of liquidity. For example, a Hong Kong corporate is unlikely to look into entering an Islamic finance transaction unless it has another reason for doing so, such as diversifying its funding base.
Requirements
Although open to Muslims and non-Muslims alike, all Islamic finance products are subject to the interpretation of Islamic law, or Shariah, by Muslim scholars. All products must, for example, adhere to restrictions on investments in companies involved in gambling, pornography, alcoholic beverages or porcine food products. The application of interest is prohibited which means providers and consumers of Islamic finance must find a different route to reimbursement. Islamic finance also demands tighter integration between the sources and application of funds which almost inevitably introduces extra (but not insurmountable) complexity at both an administrative and legal level.
Each Islamic financial services provider will have its own Shariah board of scholars which will issue guidance on the suitability of specific products. This is often cited as presenting issues around product standardisation as each scholar may hold a different view. Bodies such as the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) in Bahrain and the Malaysia-based Islamic Financial Services Board (IFSB) are making headway on this matter but to date, their proposals are neither mandatory nor universally accepted. However, the different interpretation of Shariah is “more talked about as an issue than it is an issue in practical terms”, notes Noel Lourdes, Executive Director at independent global Islamic finance advisory firm, Amanie Advisors.
Indeed, many of the large Middle Eastern banks are active in Malaysia; if their home regulators had an issue with the difference they would simply not allow them to trade overseas. “Even on home territory, if these banks find a difference they will find a way of converging; they are not waiting for AAOIFI to find a solution.”
The level of standardisation of products and governance is the main limiting factor to greater uptake, Guest believes, particularly in cross-border transactions. “National Shariah boards can help in this regard, and the UAE has recently announced a move in this direction, following Malaysia’s example.” The logical extension to this, he continues, is greater collaboration between these national boards, in concert with the international Islamic Financial bodies, such as IIFM and IFSB, to create a product set that is acceptable to Islamic banks across the world, or at least within each region.
The recent collaboration with ISDA in this regard, which led to the Tahawwut (Hedging) Master Agreement was a very positive step in the right direction. “Strangely, there has been a real lag in the market uptake of tools based on this document,” notes Guest. “To a large extent I believe this is due to top tier banks, whose Islamic windows still typically lead the market in product development and execution, struggling to adapt the contract to the international legal, compliance and risk frameworks that they are required to follow internally.” As a result, he feels that what started as a standard agreement, emerges as a heavily redrafted version suited to each institution. “It will probably be some years before we see a deep, liquid market in cross border Islamic hedging and derivative contracts.
Product development
The sukuk market has been a real success story for Islamic finance, notes Guest. Both issuers and arrangers have brought a huge number to market in recent years. “These range from plain vanilla structures to more complex offerings that, in most cases, are many times over-subscribed by investors in the primary market.”
However, there is a shortage of high quality sukuk issuance, notes Jones, not helped by the fact that many investors hold their investments to maturity even though there is a secondary market. Expectation is also a drag on market growth; much of the current demand lies in the Middle East but, notes Jones, there is “a pricing gap” between what issuers have been able to pay in the domestic Malaysian market and what many Middle Eastern investors expect to receive in return.
What Guest sees though is a good pipeline of future issuance which has helped to free up secondary markets. This, he suggests, is because investors can feel confident that there will be enough supply of ongoing issues to meet future demand, slowly eliminating the ‘buy to hold’ mentality that has been prevalent in the market to date. An active secondary market helps borrowers to price their credit, and ensures a more accurate mark to market for investors. “In some ways, Islamic finance has suffered from an over emphasis on sukuk I believe, to the detriment of developing other products, especially for smaller companies, or un-rated corporates to raise financing.”
Commodity murabaha financing is by far the most common structure, because of the pre-defined profit rate and the ease of execution, as well as clearly defined obligations of each party, in both Shariah and Commercial legal terms. Specialist brokers such as Eiger are usually involved because there is a need to source the underlying assets traded. A commodity murabaha wouldn’t really be classified as an investment product per se; it is more a transactional contract that has been institutionalised by banks to serve the needs of corporate and individual clients. “It forms the basis of most of the innovative new hedging and derivative tools that we are starting to see in the market, profit rate swaps for example, or collateralised financing, such as the Islamic repo,” explains Guest. “I think these products will be one of the next big growth areas in Islamic finance, as we are gradually seeing standardisation in the documentation used, within and across jurisdictions, and there is a huge appetite amongst both corporate and bank treasurers to use these instruments.”
Islamic finance is a relatively young industry, and so the complete suite of products required by sophisticated corporates is still not there yet. The pace of development has gathered momentum in the past few years, “but there will always be a gap between the conventional and Islamic capital markets,” Lourdes comments. “I do not see it ever compromising its principles to facilitate a certain class of borrower or investor who may need synthetic asset classes or instruments to enhance their return or hedge their risk.” Indeed, new structures are typically built according to the needs of the investor or borrower rather than modelled for the sake of it. “A product has to be relevant and practical and Islamic finance has to innovate to meet those demands,” he explains.
Certain solutions have a natural fit for business needs. According to statistics from the World Trade Organisation’s Annual Report in 2012, about 90% of global trade is supported by trade financing. Given the strong trade links between Asia and the GCC (more than 35% of its total imports are from Asia), the Malaysia International Financial Centre (MIFC, part of Bank Negara Malaysia) said in its March 2014 Insights report that Islamic trade financing possesses “a strong potential for significant expansion in the region”.
Indeed, Guest notes that the majority of Islamic financial instruments are trade-based contracts that have been adapted to accommodate the requirements of modern banking. The sector is still dominated by conventional and European banks, even for trade flows between countries with strong Islamic banking sectors. “We should see improvements in this area in the coming years, led by the excellent work of the Islamic Development Bank and its trade finance subsidiary, the ITFC.” However, one of the mains barriers to uptake is lack of education amongst traders and importers/exporters. “Islamic bankers and market players need to do more to promulgate Islamic trade finance as an alternative and complementary source of funding and banking services.”
Corporate understanding
The Islamic finance market is not necessarily well-understood amongst non-Islamic corporates says Jones, and in order to encourage Islamic finance among such non-Islamic market participants a process of education will need to be undertaken with respect to Islamic principles as well as the extra documentation involved. “But non-Islamic corporates are willing to explore it and make the effort to understand it,” she says. “A lack of education in this space is not a barrier.”
For Guest, education is the key. But in certain markets, Malaysia being the leading example, Islamic finance has really penetrated the greater economy, partly because of the investment in education at school and university level. “In other countries, where this holistic approach isn’t practical, more engagement is required, and relationship managers at Islamic banks, or the Islamic windows of global and regional conventional banks, should be at the forefront of this push.”
The different schools of Islamic thought can lead to differing approaches to structures and documentation in different jurisdictions, although the fundamentals remain the same internationally. It is more the requirements and the asset base of the issuer which dictate the Islamic structures used and as such requirements become more complicated to cater for particular issuers and as the Islamic finance market becomes more sophisticated so structures become more complex. For example, Jones observes, corporates with diverse asset bases are able to use more than one Islamic finance structure within one sukuk issuance. This obviously adds to the complexity of the documentation and adds to the cost. But at the same time, it is more appealing and allows greater flexibility to companies that have diverse portfolios of assets. The question of Shariah interpretation usually boils down to a case of negotiation. “In the end,” she notes, “deals get done”.
Contribution
According to the MIFC, the key Islamic finance marketplaces in Asia include Malaysia, Indonesia, Pakistan, and Bangladesh. Other Asian countries with a growing or niche presence include Singapore, Brunei, Philippines, Hong Kong, Kazakhstan, Azerbaijan and Thailand. In general banking terms, Malaysia is the leading Islamic banking hub in Asia, followed by Indonesia, Bangladesh and Pakistan.
MIFC reports that emerging markets in Asia experienced “robust real GDP growth rates” of 6.2% in 2013. These markets are expected to sustain real GDP growth of 6.3% into 2014. It further believes that Islamic finance will “contribute significantly” to the growing economies in emerging Asia, with the trade finance, infrastructure investment and wealth management sectors playing a key role.
In terms of growth potential, Indonesia could be a major player. It has the world’s largest Muslim population (205 million or 88% of the country), which is starting to benefit from the country’s growing economic strength. Indeed, Indonesia’s economy is South East Asia’s largest and is amongst the world’s top ten says the IMF. However, Jones notes it will have to make up a lot of ground to compete with its neighbour Malaysia.
Jones notes there is growing interest in Islamic finance generally, helped by certain non-Islamic countries trying to position themselves as centres of Islamic finance, for example, Japan, Hong Kong and the UK recently drafting legislation to encourage Islamic finance and some speculation regarding countries such as the UK and Hong Kong investigating the possibility of issuing sovereign sukuk. She also notes a trend in non-Islamic institutions investigating the use of Islamic finance; accessing new pools of liquidity may appeal to certain corporates, whereas for others it will be the publicity value of conducting a more unusual debt issue.
Ultimately growth of Islamic finance will be sustained by the retail client base, especially in Indonesia. This base layer will provide a huge capital base with which to extend Shariah-compliant funding to corporations and entrepreneurs, says Guest. “As these investors become more sophisticated, and wealthier, we should see increased participation in stock markets, and indeed debt markets through pension funds and Takaful funds.” This will in turn bring more issuers to market, and more companies exploring Islamic finance as a viable alternative or complementary option.
Clearly, it is instructive to differentiate between those companies who are fully Shariah-compliant because of their domestic market and their ethical religious choice, and for whom Islamic finance will be their only financial solution, and those at the other end of the spectrum – large regional or multinational corporates – for whom Islamic financing options will only ever be a small subset of their banking and capital raising needs. “In between those two poles are entities domiciled in markets with a strong Islamic financial sector that tend to view Islamic finance as complementary,” comments Guest. “What will tip the balance is further development of the Islamic product set, as well as cost and level of service. Islamic finance is in a competitive market for this business, and for the most part the gap is closing as Islamic banks and windows invest in improving their infrastructure and human resources.”
