FINANCIAL PRODUCTS: PLANNING FOR THE FUTURE MARKET
RICHARD DUNCAN
I believe that Islamic banking is at cross-roads in the international market. Looking at the current position, change is necessary to ensure that Islamic banking meets the challenges ahead in the next five years and on into the twenty-first century. A failure to achieve this will lead to a lack of progress and the market will stand still against the competition – conventional finance.
We need to look at the motivations and concerns of the various parties involved in the international market and discuss the issues which arise. I am not going to try to provide answers, rather I will try to identify the major issues and pose the questions that need to be debated.
The most important and overriding concern for an investor is that the investment truly conforms with his interpretation of the Sharia. If, as bankers, we cannot ensure that the investments conform to an investor’s interpretation, we should not be doing the business. The question is, how do we ensure this without driving away genuine business with over-onerous documentary requirements?
The above issue is complicated by a lack of uniformity of interpretation on major issues, leading to a certain amount of confusion amongst prospective users of Islamic finance. All major world markets have evolved successfully because the “ground rules” are clear to both practitioners and users.
Within these markets, individual institutions have developed their own distinctive styles and niche specialisations. Nobody has the right to tell individual investors what is right or wrong in relation to Sharia interpretation, but a greater degree of standardisation in basic Sharia guide-lines will enhance understanding by, and attract greater participation of, major international corporates. An authoritative Islamic institution must take the lead in this process.
To generate a halal, return on investment, investors must participate in the risk of the underlying trade or business. Th e continuing desire to have the credit risk enhanced (usually by a bank guarantee) is an issue that must be questioned. Banks are under pressure to increase returns on the risks they assume and in some countries the costs of such guarantees are prohibitively expensive. Will investors continue to be willing to bear the costs of that credit risk enhancement?
It is only right that investors receive a fair return from the risks they have been required to undertake. However, central authorities have been driving down global interest rates to historical lows and most analysts agree that short-term rates will continue to stay at these levels.
In the international market. Islamic finance must compete on cost with interest-based products to gain market share. With margins also falling sharply in countries traditionally favoured by Islamic investors, profit returns on short-term business have become a major concern.
Nowhere is this better illustrated at the moment than in Pakistan. In 1994, a Mudaraba financing was arranged for the Rice Export Corporation of Pakistan. Pricing on the deal was around 200 basis points over LIBOR. More recently, a similar transaction was arranged by conventional banks at around 100 basis points over, a dramatic fall in return available to investors.
With the market awash in short-term funds, enabling major trading houses, for instance Japanese trading companies, to borrow money at a few basis points over LIBOR from their traditional banks or the commercial paper market, a dynamic approach must be adopted if Islamic finance is to be competitive on the international scene.
The need is therefore to develop a product which is longer term in nature but offers investors liquidity. The bond and capital markets were developed to achieve this for the interest-based system. This provides users with long-term money whilst giving investors liquid investments. This liquidity arises from a wide range of institutions participating in the market both as investors and market makers.
Once again though, a key area in the success of the bond and capital markets is standardisation of dealing. The risks of each investment are different, but the dealing practices and settlement systems are standard, thereby ensuring a high degree of confidence in participants.
There is apparently a wide gap in the Sharia interpretation between the Far and Middle East. I would not presume to comment on who is right or wrong on such issues, but lessons can certainly be learned from the work already undertaken.
The growth of privatisation in the developing economies of the Islamic world should be seen as a major opportunity for Islamic finance. Th e concept of project finance is very Islamic, with returns being earned from participation in a project by either equity or asset-leasing. Islamic institutions have been successful in this area domestically, but it must be said, little has been achieved on an international scale.
The major development agencies such as the Export Credit Agencies, the World Bank, the Asian Development Bank and, indeed, the Islamic Development Bank are all becoming increasingly involved in project finance. It is therefore possible with careful structuring to improve substantially some of the risks.
Several major issues must be resolved, (for instance, what happens if the project is delayed and payments are late?). However, with new projects under discussion throughout the Muslim world (e.g., power in Pakistan), Islamic finance has an opportunity to seize the initiative.
The financing of capital goods exports to developing economies has surprisingly been an area where Islamic finance has under-performed. The main reasons for this are, I think, unwillingness to take the longer-term exposures (discussed before) and inability (or unwillingness) to support investors during the bid process on contracts.
It is usually too late to offer finance once a contract has been awarded, as exporters arrange finance early in the bid, providing a commitment which ties up scarce risk limits and cannot be charged for.
However, many exporters have expressed a desire to use Islamic finance but have not done so because they could not obtain a commitment in advance of the contract being awarded. In this area, the Islamic finance market is placing itself at a serious competitive disadvantage and is losing the opportunity to work on many first-class deals.
The Islamic finance market has come far in a very short space of time and has established itself as a credible alternative to interest-based banking. As a more mature market, it is time to move forward to the next stage of growth and to be ready for the challenges of the next century. This can be achieved quite quickly, as the concepts on which many of the new products will be based already exist.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
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