DEVELOPMENTS AND INNOVATIONS
ADNAN AL BAHAR
Islamic banking is an industry that has evolved, developed and grown, and is here to stay. The industry manages approximately $60 to $80 billion dollars today, and is growing at a rate of 15 per cent per annum. Islamic banking will be responsible for managing up to 50 per cent of savings in the Islamic world in the coming 5 to 10 years.
The growth of Islamic banking is a reflection of the result of economic growth in the Islamic world, fuelled primarily by oil wealth. This growth made banking a necessary service to a large segment of the population. With banking becoming a necessary service for the majority, it became inevitable that the problems of conventional banking and its conflicts with Islamic values would come to the surface, leading to attention and research being directed to the issue.
Looking ahead, a number of developments will continue to feed this growth, the chief of these being:
• Continued economic growth in some parts of the Islamic world and the growing size and wealth of middle-income groups in Islamic countries.
• Transfer of wealth, especially in the oil producing countries, from the State to private investors, which is very much the case today with most governments running deficits and wealth becoming predominantly privately owned.
• Institutional demand for Islamic banking services, driven primarily by the underlying demand of clients; a clear example is pension funds, where there is pressure from clients for their long-term savings to be invested in an Islamically acceptable way.
• Growing support of the industry by monetary authorities, as a result of the growing realisation of the value of Islamic banking both as a competitive and growing local industry that is being attracted to base itself in these markets, and as an efficient financial intermediation system for Islamic countries, one that works much more in harmony in these markets with less friction as compared with conventional banking, and hence having higher efficiency.
As a result of the continuing growth of the Islamic banking market share, and the need to link this market with the global market, there is a growing presence of Islamic financial institutions in foreign markets while their traditional counterparts are retrenching to consolidate their operations as a result of loss of market share at home to Islamic banking, and an attack on their higher net-worth clients and corporate clients by international financial institutions.
In addition, traditional regional banks cannot respond to those requirements of the international clients that the global players can meet and exceed. On the other hand, Islamic financial institutions are gaining in market share and are not exposed to competition from global players in their home base because of their highly specialised market niche, in addition to their growing capability to deliver value to their international corporate clients by helping them tap a market that their existing bankers cannot help with.
Islamic banking started as a retail banking industry and has since grown to commercial banking, and is now on to merchant and investment banking. From being referred to as Islamic banking, it is now recognised as an Islamic market. This market has grown in size and new, longer term, more sophisticated investors have entered the market. Competition amongst a growing number of Islamic banks has intensified. All of this has resulted in improvements to the products offered and a narrowing of margins and new products and solutions are starting to emerge.
Before describing the process of product innovation in Islamic banks, a few basic issues need to be clarified, issues that, while simple, are often overlooked.
• The Islamic Sharia is a Muslim legal system or law and like every system and legal code, it addresses the broad issues and measures by comparison and precedence. The higher the authority that makes the rulings, the less likely it is that other bodies will rule against it. Islamic banks’ legal committees are their legal advisers who help them stay within the law. Successful product development requires experienced Islamic bankers and scholars with Islamic banking experience to be able to stay at the leading edge.
Therefore, success in gaining the leading edge of quality goes to those who can resourcefully apply interactions between well-learned Islamic scholars with long experience in the industry and Islamic bankers who understand the Sharia, specialists who have absorbed the accumulated wisdom and up-to-date experience of Islamic banking.
• Islamic banking, like the financial industry, is heavily dependent on credibility, not only from the financial perspective but from the Islamic perspective as well.
• Success in the Islamic banking industry, as is the case in every other industry, demands commitment and concentration.
The key to successful product development in Islamic banking, with a view not merely to competing and surviving, but with the goal of excelling in the industry, is to have an in-depth understanding of the Islamic foundations of these products and structures. This is the case because 80 per cent of new leading-edge solutions are not total breakthroughs but existing wisdom in different packages.
By looking at some basic structures with a view to understanding how these are seen by the market and by Islamic bankers, an insight into the development of some of the “later products” that have been derived from existing well-documented structures can be obtained.
The contract of bai al-salam has been around for a long time but has been rarely used until recently. Bai al-salam is a trading contract for raw materials or commodities, primarily used to finance crops. It is based on a purchase agreement with immediate payment and future delivery. Bai al-salam was not used until it was associated with the promise to purchase from a third party. Armed with a commitment to buy (promise), the bank would then purchase by paying cash today and taking delivery at a set future date. A sale agreement would then be concluded on the pre-agreed terms of the promise, which would be cash on delivery or on a deferred payment.
Ijara is a rental agreement, as in the case of renting premises or an automobile. The asset remains with the lessor at the end of the lease. As in the case of bai al-salam, the promise to purchase was introduced to add a commitment to sell, and a commitment to purchase at the end of the ijara, which brought the ijara closer to a leasing contract. Further refinements were then made, including the addition of a one-way promise for the lessor to sell at set prices at different points in the life of the ijara, with the lessee being at option. This added an early termination option.
Another feature that is now being realised is the fact that a lease can be restructured. These developments make ijara one of the most flexible financing agreements in Islamic banking.
Bai al-istisna is a totally new concept that offers a number of future structuring possibilities for trading and finance. It is a contractual agreement for processed goods and commodities. It allows for cash payment and future delivery, or a future payment and future delivery.
This instrument allows for prepayment for future delivery, or deferring both payment and delivery. The bank is then able to pre-sell to its clients for future delivery for cash on delivery, and then negotiate the purchase.
This trading contract opens the way for a number of new opportunities, including some form of futures contract trading of processed commodities, as it allows for deferring both ends of the contract – delivery as well as payment. It is also currently being used for short-term working capital finance. Istisna and wakalah, will play a key role in the short-term investment and working capital schemes in the future – replacing the murabaha as the short-term financing scheme, especially in its international application.
There are three broad areas which future developments must be directed towards:
• The need to trade assets in their current form, or after securitising them, is becoming important, especially for banks to renew their capabilities to book new business. It is also becoming even more important as central banks start to look at ways of using the discount window with Islamic banks, and ways to provide liquidity to those banks when needed. This will further encourage the development of leasing and istisna over the existing debt-based contracts, such as murabaha.
• Equity investments will remain quite restrictive and profit-and-loss-sharing agreements will see substantial growth in their use, especially in the project finance area and the financing of early-stage companies. The way to avoid company ownership, with all of its problems, from the Islamic perspective, especially for companies that will still manage their conventional finances, is to participate in the project and not the company.
• Currency hedging techniques will have to further develop along this road. The way to do this is to trade commodities in different forms and denominate these transactions in different currencies.
All of this describes how structuring works in Islamic banking and the direction of product development in the future. It is critical to closely monitor the market and the different forces shaping it, in order to detect and track trends and needs and to bring together the knowledge and wisdom of learned Sharia scholars with the skills of experienced Islamic bankers in order to achieve and maintain a leading edge.
Islamic financial techniques and solutions are growing and developing fast and are growing in complexity and competitiveness. This is the result of wisdom, the entry of more demanding clients into the market and intensifying competition.
To lead and excel in such a market, players must immerse themselves totally in the business, look at it from the technician’s point of view and live with its daily movement and change.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
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