The Islamic finance industry has grown at double digits, in the past few decade, despite the weak global economic environment. It has been projected that by the end of 2020, it will reach $3 trillion in total assets with 1 billion users.
Islamic finance can play a significant role in narrowing the gap of financial inclusion in Muslim countries. Malaysia has been a leader in developing innovative Shariah-compliant savings, credit, and investment instruments for low-income households. However Malaysia has also established specialized financial institutions offering only Islamic finance products (for example Bank Rakyat, the largest Islamic cooperative bank in the Malaysia).
Technology has the potential to drive change in the Islamic finance industry, especially for the 2.3 million Small and Medium Sized Enterprises (SMEs) located in the Middle East and North Africa (MENA). Surprisingly, 76 percent of enterprises in MENA has a bank account, only 26 percent reported having a credit from a financial institution. Given this low credit penetration at the corporate level in Muslim countries, some solutions have been implemented to narrow the credit gap which is estimated to be more than US$140 billion. Here comes the Financial Technology (FinTech) companies. They can make the access to financial solution more effective by using innovative solutions.
In the case of Malaysia, an Investment Account Platform (IAP) was implemented in the beginning of 2016. Through this solution, Islamic banks match investors with projects in need of funding. The innovation of this approach is that after the bank screens the project, a credit rating is assigned, and then the project is uploaded to a platform where the investors can select the investment according to their risk appetite.
The authorities are continuously addressing the challenge of revising the regulatory standards; in order to foster innovation in the alternative finance platforms. The current debate is centered on how to regulate non-financial institutions that are receiving money from global investors and lend it to local companies or entrepreneurs through the Internet.
Another challenge for Muslim countries is to upgrade their financial standards to common international principles that are applicable in all Muslim jurisdictions. There is still no consensus on whether a financial product such as an investment account or bond is compliant in all Muslim territories. This generates uncertainty to non-Muslim investors that are willing to finance infrastructure projects but are not sure that their investments are 100% compliant to the generally accepted principles of financial securities.
The Islamic finance industry is well positioned to seize the opportunities to embrace new market technological developments. The need to create new products to attend the unbanked population such as zero-fee accounts, small loans, or family insurance could open a new window to provide formal financial services to the unserved population in Muslim countries.
The Islamic Finance Development Report 2018 shows that the global Islamic finance industry grew year-on-year by of 11% to US$ 2.4 trillion in assets in 2017 or by CAGR growth of 6% from 2012, based on figures reported for 56 countries, mostly in the Middle East and South and Southeast Asia. Iran, Saudi Arabia and Malaysia remain the largest Islamic finance markets in terms of assets, while Cyprus, Nigeria and Australia saw the most rapid growth.
This rapid superior growth record will continue as approximately one-sixth of the world’s population is Muslim and majority of which is based in the Middle East and Asia. Keeping in view the fact, a number of western countries have recently started allowing Islamic banks to operate in their respective jurisdictions. The UK became the first leading western country to issue a government Sukuk (Islamic bond.) The first full-fledged Islamic bank in Germany has been launched while Japanese regulators are considering issuing regulations that will allow Japanese banks to provide Islamic finance products in Japan.
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The Islamic banking penetration in non-Muslim countries is comparatively slow as Islamic banks find it difficult to expand into different jurisdictions and face regulatory and Shariah complications in terms of approvals.
Islamic banks are also finding it challenging to cope with the evolving global banking environment and making appropriate rules and regulations to cope with these changes while still remaining competitive with their conventional counterparts. Moreover the Islamic Banking Industry lacks consistency in product structures and investment practices. It is adversely affects its credibility, reputation, perception and regulation capabilities.
The Islamic banks are essentially governed by Shariah boards; which are comprises of eminent religious scholars that consider a product Shariah-compliant or not. But the challenge is that there is no central authority promulgating Shariah law and the understanding of what is permissible and what is not varies among Islamic scholars and jurisdictions.
The rapid growth of Islamic banking over the years has resulted in the introduction of complex banking products and structures, which now require Shariah harmonization at a global level; which is lacking at present. For example, the Islamic contract of Tawwaruq or Commodity Murabaha is only allowed by certain scholars. Similarly Bai-al-dain, or sale of debt, although disallowed by the majority of Muslim scholars, is allowed by some scholars in Malaysia. Recently, a prominent Shariah scholar concluded that approximately 85 percent of Sukuks in the market fall short of basic Shariah principles.
Because of the prohibition of interest, the Islamic banks mobilizes and utilizes funds using Shariah-compliant instruments or contracts that are not used by the conventional banks and hence their capital structure primarily consists of “Tier 1 capital” only. A very few Islamic banks have “Tier 2 capital”. Likewise, in Islamic banking contracts the bank own the asset for a period of time (e.g. Murabaha) whereas it is not required in conventional banking practices.
The industry realizes these challenges and certain countries and governments have fostered the development of the Islamic banking sector.
It is imperative for the Islamic banking industry to focus on the development of products that foster market integration and attract investors and entrepreneurs to the risk-return characteristics of the product rather than concentrating only on its Shariah compliance. Islamic banks need to invest in the research and the development of new products that are acceptable by a Global Shariah Board.
[box type=”note” align=”” class=”” width=””]The author, Nazir Ahmed Shaikh, is a freelance columnist and is an academician by profession. He could be reached at nazir_shaikh86@hotmail.com[/box]