Internationalising Islamic Finance: Prospects & Challenges
Not long ago, the Islamic finance industry was seen as a niche market, catering only for a specialised segment within the global banking industry. However, the credit crisis of 2007-08 and the more recent Eurozone debt crisis have catapulted Islamic finance into the mainstream. Today, the industry is worth over US$1 trillion, with market share crossing the critical 25% threshold, in the Gulf Cooperation Council (GCC) countries. But Islamic banking has reached a crucial crossroads. As conventional banks increasingly come under pressure for damaging local businesses and global economies, can Islamic financial institutions fill the global financing gap, with their focus on serving the real economy?
For Islamic banking to remain relevant it must move beyond its traditional strongholds. If the industry wants to shape the future and attract and develop the most promising talent then it must internationalise further. As noted by Dr Zeti Akhtar Aziz, Governor of the Central Bank of Malaysia, in 2012, “the increased internationalisation of Islamic finance would thus influence the patterns of global financial and economic integration, and in particular facilitate the revival of financial and economic integration between the countries along the old silk road from Asia to Turkey and the Middle East, and Africa and to the more established financial markets and developed economies.”
The economic argument is compelling also: multinational banks with geographically diverse investment portfolio are in a better position to deal with market failures in their home countries, research indicates. What is more, as customers become international, a truly global mind-set is required from Islamic banking executives in facilitating commerce and trade. This coupled with the continuing doubts around the role being played by the conventional market, presents a unique opportunity for Islamic financial institutions.
However, there are various dimensions to the process of internationalising Islamic finance: standardisation, regulation, talent development, and liquidity management, to name but a few. Each represents considerable challenges.
The standardisation of Sharia’ practices has become a perennial debate in Islamic banking, that often goes no further than the view that Islamic banking will not reach its true potential until there is a global Sharia’ standard. Moreover, it is argued, this lack of standardisation leads to confusion within the corporate sector and loss of confidence at the retail level.
The predominant view is that addressing this issue is a key step towards internationalisation of the industry since it would facilitate cross-border marketability of products. Furthermore, it is argued that global standardisation will lead to greater consistency in product development and lower transaction costs, making Islamic financial institutions more competitive. However, there are some potential pitfalls here. Probably the most obvious is that today we already have global standards framework developed by the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI). But the application of these standards is quite limited, since AAOIFI is lacking enforcement power in many countries.
So what does this mean for cross-border marketability and internationalisation of Islamic banking? There are two key points. Firstly, for Islamic banking to flourish on a global level, it needs to establish a foothold into a number of diverse economies and cultures. This suggests that one global standard is not the only way - a more a nationalised strategy, where the Sharia’ considerations of individual countries is taken into account, and a more practical approach must be considered. Secondly, sensing a lack of direction, several economies, including, Dubai, Pakistan, Nigeria and Oman have renewed effort to establish country-level Sharia’ governance, an approach pioneered by Malaysia. Certainly this will clear much of the confusion at the retail and corporate levels, and increase the effectiveness of a nationalised strategy.
It must be noted that differences of opinion are relatively few and far between and should not hinder progress. As mentioned by Iqbal Khan, chief executive at Fajr Capital, in 2011 (Reuters) “the Islamic finance industry has had about 6,500 fatwas and with 95 percent of them, there is consensus, the 5 percent where the difference lies gives us hope that there will be more innovation”. Indeed, from the outset, Islamic scholars have supported and respected variety of views. As Umar ibn `Abd al-`Aziz declared in the 8th-century: "It would not please me if the Companions of Muhammad, upon whom be blessings and peace, had not disagreed, for had they not done so, no mercy would have come down."
The Efficiency Gap
To date, the vast amount of research on banking efficiency focuses on the conventional banking market. In 2006, Kabir Hassan from the University of New Orleans, conducted one of the few efficiency studies on Islamic banking, confirming that the industry is at a crossroads, with the average Islamic bank requiring 36% more resources to produce the same amount as the most efficient Islamic bank, compared to just 5% to 10% for conventional banks in the United Kingdom.
There are a number of reasons for lower efficiency of Islamic banks, some of which have already been discussed. For example, due to the decentralised nature of Sharia’ governance, the transactions costs of Islamic banking products are higher. Secondly, there are technical constraints, and as confirmed by Hassan, there is “substantial room for significant cost savings” if Islamic banks can use technology as efficiently as conventional banks. And thirdly, interestingly, those Islamic banks that are relatively more efficient tend to be foreign owned. This could be due to foreign owned banks sharing good practice more effectively and benefiting from their expertise in other markets.
As the industry continues to spread its wings across the GCC, Asia and Europe, the need for more research into this area is clear. Bringing together leaders in academia and industry pioneers, will not only fill a significant gap in academic literature, but it will also provide the foundation for Islamic banking practitioners to learn from each other and share good practice.
Cross-Border Regulatory Cooperation & Liquidity Management
The share of Islamic banking assets continues to increase globally. But, the pace of growth to a large extent depends on the role played by governments and regulators. For example, Malaysia is widely regarded as an Islamic banking powerhouse, with the country proactively supporting the industry’s development. More recently, Dubai has announced plans on promoting the Islamic economy, with particular focus on developing a hub for Islamic finance instruments and Islamic insurance.
These and other government initiatives will increase the pace of development and reach of Islamic banking. However, with internationalisation comes responsibility. As Islamic financial institutions become more globalised, the risks to the stability of the financial system increase. Therefore, enhancing cross-border regulation and increasing cooperation with other countries will be key to the long-term viability of Islamic banking. Indeed, as Dr Zeti noted in 2013, there “is an important imperative to ensure the resilience and stability of the Islamic financial system, as well as to reduce the cost of intermediation.”
Another challenge facing Islamic banks as they grow, is managing liquidity risks. There is an old adage in conventional finance that "liquidity can be an illusion - it is there when you don't need it and can disappear when you do." Certainly, the credit crisis - the biggest shock to the conventional financial system since the 1930s - raised serious concerns about liquidity management. A key lesson here for Islamic financial institutions is that they must address their own liquidity risks. This includes developing a strong Islamic interbank money market and overcoming the shortage of short-term investment products. Due to the size of Islamic banking industry, it will be challenging to create a local liquidity market, which explains why efficient cross-border liquidity risk management tools have been explored. The establishment of International Islamic Liquidity Management Corporation (IILM), in 2010, is an important development in facilitating effective cross-border liquidity management. However, with the aim of managing liquidity risk, it is important that other risks (e.g. currency risk for cross-border liquidity management products) are not introduced.
There is increasing need for qualified people to not only support continued growth of the industry, but to drive change and innovation. However, to develop talent, you need a system. From an institutional level this system includes structured staff training programmes that support career progression and mentorship schemes that nurture expertise. And from an industry level, a closer link must be established between Islamic financial institutions and academia, where curriculum can be designed around real business needs.
Today, Islamic financial institutions are playing a crucial role in the economic and social development of many countries. Although there are challenges, the opportunities are greater. By coming together, collaborating and sharing good practice, the industry will reach sustainable internationalisation.