ISLAMIC FINANCE – PAST, PRESENT AND FUTURE
DUNCAN SMITH
The Islamic financial marketplace of the late 1990s and the early years of the next millennium will be very different from anything that we have seen over the last twenty years or so.
How do we know this? Because the changes have already started. In fact, many of the changes are with us today. Islamic banking is increasingly appreciated as a global, rather than a regional, phenomenon by big business, bankers, entrepreneurs and (some) regulators. The next five years will, or should, see Islamic banking and, more generally. Islamic financial services, deliver on some of the promises made by earlier visionaries.
The purpose of this paper is to examine how we have arrived at where we are now, to look at how and why Islamic and conventional banks have interacted in the past, and to give some pointers as to how the new challenges will be taken up – and who will be taking them up.
I will refer to the localised nature of early Islamic banking and look at how recent developments have changed the market to the point where different institutions are trying to provide all Islamic financial services.
My approach to this task is not an academic one; having been involved in the practical applications of Islamic finance since the early 1980s, I am not qualified to express an opinion on the enormous amount of Sharia scholarship which has formed the base for the introduction of, and growth in. Islamic financial instruments.
However, I am in a position (as a market practitioner) to give my subjective analysis of the story so far and some personal views on where the Islamic financial industry goes from here. Of necessity, what follows must be superficial; the focus is on trends rather than detail.
Some Background
The roots of Islamic banking are frequently traced back to a few community-based banks on the Indian sub-continent in the 1950s and Egypt in the early 1960s. Whether these experiments really qualified as Islamic banks’ (as we now know them), is questionable.
What may be seen in these mutual or self-help organisations is the process – which has specific regional echoes in modern Islamic banking – of using funds mobilised in one locality in that self-same local environment, (in agriculture, basic industry, etc.). In fact, this local approach is being used to help very poor communities today.
Both the Islamic Bank of Bangladesh and Bank Islam Malaysia are using a system of interest-free loans to help tens of thousands of poor families in their countries and reinvesting local proceeds locally.
Following the scholarly consensus that ‘riba = interest’ in the mid-1960s and the OIC decision in 1973 to establish the Islamic Development Bank, the modern era of domestic commercial Islamic banking gathered pace in Dubai (Dubai Islamic Bank opened in 1975), Kuwait (Kuwait Finance House, 1977), Jordan (Jordan Islamic Bank, 1978), Bahrain (Bahrain Islamic Bank, 1979) and Qatar (Qatar Islamic Bank, 1984). Bank Islam Malaysia was also established in 1984.
The reasons behind the formation of these local-market-focused Islamic banks have been widely commented on elsewhere, but what is noteworthy in comparison with earlier efforts is the fact that very quickly it became apparent that the local Islamic banks’ success in mobilising funds from their customer bases was outstripping the capacity of domestic business to absorb locally-raised Islamic funds in local productive enterprises.
The same forces which caused massive exports of capital (along with oil) from the Middle East in the 1970s into the conventional Eurodollar deposit markets, also made it necessary for Islamic banks to look beyond national or regional boundaries for opportunities to invest their funds.
In many ways it is this (changing) direction of capital which has defined the process and progress of Islamic banking up to today and will continue to do so.
From the Middle Eastern countries, it has been reported elsewhere that approximately $650 billion has been channelled outwards – conventionally and Islamically, most of it, of course, into interest-bearing investments.
The Development of Co-operation Between Islamic Banks and Conventional Banks
As for their conventional counterparts. Islamic banks – because of their success in raising funds (which could not, in the main, be invested locally) – increasingly worked with conventional banks to find profitable, low-risk investment vehicles through which to deploy funds. A continuing focus has been the use of Islamic funds to finance raw commodities (particularly metals, but also, increasingly, energy products and soft commodities) and international cross-border trade. Pioneers in this process in the early 80s were such banks as Kleinwort Benson, Citibank and Saudi International Bank.
The justification for this co-operation – of Islamic banks co-operating with conventional institutions – had its base not only in religion (which it did) but also in the overriding need for efficiency and competitiveness.
For conventional international banks. Islamic funds represented a pool of untapped liquidity, which could be used to finance their corporate customers (in the early and mid 1980s but no longer) at a significant discount to interbank market pricing.
For the domestic Islamic banks, cooperation brought access to international business flows which would not have been available without the sort of capital investment (in international offices, branches and so forth) which would have been uneconomic for what were at that time new, under-capitalised entities.
This process enabled the commercial Islamic banks to compete with conventional banks in their own markets and to build a retail market share (currently ranging between 10% and 20% in most Gulf markets, excluding Saudi Arabia and, so far, Abu Dhabi).
For the large multi-national Islamic groups (Dallah A1 Baraka and Dar Al-Maal Al-Islami), co-operation with conventional banks was useful not only in terms of efficiency but also because it was through conventional banks that routine banking transactions (such as operating accounts. Letters of Credit, Foreign Exchange, etc.) needed to be executed.
Here also, I should note that in their desire to spread Islamic banking more widely and direct capital to Muslim communities rather than just through the Western markets, Dallah al-Baraka and DMI worked closely with governments who frequently tapped the international debt markets at interest, so as to achieve a laudable goal as to the direction of Islamic capital.
This effect of early co-operation – although it had, and still has, its detractors – has been broadly beneficial, and, in conventional banks, has led to perhaps twenty or so larger players devoting significant resources to serving the Islamic financial markets.
There are the truly international players – Citibank, Merrill Lynch, Kleinwort Dresdner, ANZ, ABN Amro, Goldman Sachs and the like, the large, regional-based entities, ABC, GIB, plus many of the Saudi Arabian and Malaysian commercial banks and, last but not least, specialist entities such as the Islamic Investment Banking Unit of the United Bank of Kuwait.
Up until three or four years ago, this was, broadly, the status quo. Broadly speaking, the role of conventional banks was one of serving the requirements of the Islamic banks (plus a few selected very rich individuals or families), developing almost exclusively commercial banking-type products and transactions, usually with a focus on short tenures, so trade finance syndicates and leasing were common.
For their part, the Islamic banks (with the exception of Al Rajhi, Dallah A1 Baraka and DMI, at least for a portion of their business) focused on their now traditional short-term investments in commodities or international trade with their conventional bank counterparts, plus some local business financing and real estate investments. Analyses of Islamic banks’ balance sheets demonstrated this historic bias towards short-term international murabaha business and its variants.
This is not to say that in isolated cases different types of investments were not done, they were; the odd ship here, the odd aeroplane there. It was, however, to my mind, an era, a phase, of confidence-building and consolidation; a period of building credibility and critical mass.
Although there were some hiccups involving real estate, gold and currency speculation, indifferent credit judgement and so on. Islamic banks were slowly but surely improving the quality of their staff and skills; Sharia committees were becoming more knowledgeable about commercial business and, crucially, new ways forward were being actively and enthusiastically researched.
From Commercial to Investment Banking to Globalisation
In the early 1990s, some Islamic banks, and a handful of people from conventional banks, began to look beyond the tried and tested asset/liability short-term investment patterns. The larger Islamic banks had already begun to look at, and deliver, products. In this process, the establishment of Al Tawfeek Co by the Dallah A1 Baraka Group (in 1987) was a turning point, with its first offerings in certificated form of medium-term investment assets with market-making or buy-back guarantees.
This was followed in 1990 by the IDB’s launch of its Unit Investment Fund, where again the sponsor provided liquidity for an offering invested in essentially illiquid assets. This fund now has its shares listed on the Bahrain Stock Exchange.
In 1993, The International Investor, quickly followed by the International Investment Group, set the pace, which has subsequently been followed by others. TII and IIG were set up to provide a broader range of investment banking products to the Islamic market. Not established to look after a local, retail base, these investment companies had a different focus from that of earlier Islamic banks. Emerging market equity funds, US equipment leasing funds, big-ticket single-asset transactions, project financings, underwritings, IPOs, etc. were their stock-in-trade.
In parallel, investment companies sprang up in Pakistan, in Malaysia and elsewhere in the Gulf. Thus, capital was being mobilised and directed into international and domestic markets. In a sense, the development of the necessary instruments was more important than where the capital ended up.
The commercial Islamic banks too began to use their better developed, now confident, muscle to gear up to the challenge, innovating products and opening up new markets. In short, during the last three years, the whole market has changed – not, in my opinion, as a result of any single event, but rather as part of a momentous wave, partly to do with involved, individual people, but mainly to do with market forces, entrepreneurship and commercial realities.
Redefining the Roles of the Market Participants
Ignoring for the moment where it comes from and where it goes, at either end of the Islamic banking ‘food chain’, there are, and have always been, providers of capital (account holders, savers, investors) and consumers of capital (businesses, assets requiring finance, trade, retail, consumers). In between these two extremities are the intermediaries – banks, investment companies, fund managers and, in some places, governments.
Direct investment flows are rarely identified in surveys of the size of the Islamic banking market. This is where sources of capital – in aggregate equal to that in the Islamic banks – flow into projects, businesses, real estate and equities, without touching any of the intermediaries.
It is, however, in this area – intermediation – that the changes in Islamic finance have taken place most rapidly and radically.
Islamic banks – even those with limited capital and customer funds under management – are increasingly confident in their ability to source and structure quite complex international transactions.
Islamic banks continue to work in partnership with conventional banks in this, but on a much more ‘shared’ basis, with the Islamic bank taking on a fair share of responsibility for structuring and analysis (as well as Sharia verification), and the conventional bank partner charged with the additional responsibility of raising funds (either internally generated, or from the conventional investor markets or, indeed, from other Islamic investors).
The market distinctions of who does what’ have been further blurred by conventional banks getting more deeply involved in the traditional preserve of the Islamic banks by establishing their own (or co-owned) Islamic banks, so far in Bahrain. The intention is for these banks to offer to their clients an integrated service that not only provides transactions, tax structuring, legal and credit services, etc, but also provides a local presence, Sharia supervision, and all that this implies. It is too recent a phenomenon to know how this will turn out, but it will be interesting to see how the other participants in the market will react when the success or otherwise of these ventures becomes apparent.
The mirror image of this process, too, is in train. With the establishment of the First Islamic Investment Bank in Bahrain, it is possible to see further evidence of the trend of Islamic banks and institutions consciously internationalising their operations, and looking to structuring – again, in some instances, in partnership with conventional banks, fund managers and investment boutiques – investment banking transactions and funds which will provide an integrated one-stop shopping facility for those with capital and those who require it, all done within the highest Sharia standards. In the case of First Islamic, as with the Abrar Group in Malaysia, as well as TII and IIG, investment banking, rather than commercial banking, is their focus.
For their part, the commercial Islamic banks will surely continue their drive to get a substantial slice of the new investment banking markets. The playing out of this process will again take some little time. What is extremely likely, however, is that the new generation of tradeable Islamic instruments will suck in fresh Islamic capital at the same time as allowing Islamic banks to restructure their balance sheets. This, in turn, will give the commercial Islamic banks more underwriting muscle.
Having said that, my own analysis suggests that as the Islamic banking market grows there will again be a move towards specialisation; this will happen – as it does in most businesses – when a refocusing on delivering shareholder value becomes paramount. But this is some way in the future.
This will lead, however, to different conventional banks. Islamic banks and their hybrids concentrating on their own specific areas of expertise (whether product, service or geography based). However, matters develop, what looks like a crowded market in the middle will lead to a bigger market with more choice for providers and consumers of capital.
Looking Forward
One of the areas only briefly touched on so far which will drive further changes in the Islamic banking market is the realisation from those involved in the market that as market imperfections are flattened out, there are still only two major considerations in terms of business building; first, where is the capital which requires direction, and second, how should it be deployed?
The economic engine which drove the development of Islamic banking during its formative years has, largely speaking, been in the Gulf; the reliance on this will change, and already has to a significant degree.
Other regions – South, and South East, Asia for example – will become increasingly influential as, I suspect, will the Muslim communities of non-Islamic states in Europe and North America, who have been (largely) starved of access to Islamic financial services but are natural providers of capital as well as consumers of capital and services.
As the opportunities to invest in Muslim countries and communities grow, it seems logical, and religiously, as well as socially, responsible for more Islamic capital to be directed into these areas.
This process is beginning. It is interesting to note two such projects on the go; the first, IICG’s plan to mobilise up to $I billion of capital for investment in infrastructural projects in OIC countries, and the second, ANZ’s plan to do something similar via its global network in emerging countries, many of which have substantial Muslim communities. Modern Islamic commercial banking is going back to its roots in its poorer communities.
In conclusion, and in part summary of the above, one final point needs to be made. We are now in the second stage in the evolution of Islamic banking; there has been an explosion of interest in the development of this market from many different sources. Different motivations and different aspirations have driven this interest.
Some of these sits well together, some do not. It is to be hoped that the development of this global phenomenon retains the purity and the clarity of the original vision and is not too far obscured by the new layer of sophistication, also that the structural changes in the intermediation process do not completely dilute the social dimension of Islamic banking. The destination of Islamic capital is, after all, more important than how it gets there.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
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