No shortage of interest
21 March 2005
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Once regarded as a marginal industry confined to a small number of countries in the Muslim world, Islamic finance is growing at a phenomenal rate, to a point where its global worth is now estimated at anywhere between $200bn (£103.98bn) and $500bn (£259.95bn).
Heavyweight conventional banks are becoming increasingly involved in the industry, in turn fuelling its growth with their credibility and sophistication. Product innovation is moving rapidly and the number of conventional structures lacking a sharia-compliant alternative are shrinking. The geographical reach of the industry is spreading as Western banks try to capture the funds of the Muslim diaspora and tap into the Middle East's plentiful liquidity.
The central tenet of Islamic finance is the prohibition on charging interest, or 'riba' in Arabic. Investment in what are considered by Muslims to be unethical activities, such as alcohol production or gambling for example, are also prohibited, while many of the intrinsically speculative tools of conventional banking are also unavailable to the Islamic financier owing to their speculative nature.
Although the industry has been around for many decades, the past three or four years have seen an upsurge in size and capability. Political will in Muslim countries has been deployed towards its development, while Islamic financial institutions have looked for outlets for the wealth built up over the years. Highly skilled bankers, lawyers and sharia scholars have worked together to widen dramatically the range of Islamic products available. Global banking giants such as BNP Paribas, Citigroup, Credit Suisse First Boston and HSBC have joined the fray, establishing Islamic subsidiaries and structuring Islamic capital markets and project finance transactions.
Increasing regulatory understanding of Islamic finance has also played an important role. Within the Muslim world, the focus is on Malaysia for South East Asia and Bahrain in the Middle East, although Singapore in the Far East and Dubai in the Middle East are demonstrating a great deal of enthusiasm for the sector. In the West, London is increasingly becoming the jurisdiction of choice, with two recent developments cementing its position.
In 2004, the Court of Appeal upheld the $50m (£26m) judgment awarded in the previous year to Shamil Bank of Bahrain against Bangladesh's Beximco Group. The precedent has reinforced the banker's choice in using English law as the applicable law for international cross-border transactions. In August, the Financial Services Authority (FSA) approved a licence for the Islamic Bank of Britain, the first for a fully sharia-compliant institution. There is now talk of a further application for an Islamic investment bank, which would also be majority-owned by shareholders from the Gulf Cooperation Council (GCC). A major attraction is that, after operating in the UK for two years, and contingent on a positive report from the FSA, a bank can move into the EU without the need to make a full application for a licence in each EU country.
On the retail side, conventional banks in the UK are increasing their Islamic product offerings for a growing Muslim community. ABC International Bank (through its Alburaq brand and its joint venture with Bristol & West), HSBC and Lloyds TSB have taken the lead. Islamically structured mortgages were initially the key product, but offerings are expanding to include consumer finance, savings products, credit cards and insurance.
Over the past decade, it is investment and wholesale banking that have seen the fastest pace of growth. For a long time, short-term 'Murabaha' (cost plus) instruments were the main tool available to the Islamic banker. However, recent years have seen the increasing use of 'Ijara' or leasing (and more recently Islamic forward leases) structures, allowing longer tenures with variable returns determined by reference to international benchmarks, such as the London Interbank Offered Rate (LIBOR).
The use of the Ijara structures has been central to the development of an Islamic equivalent to the conventional bond, the 'Sukuk'. Bahrain is now on the eleventh issue in its Sukuk programme and Malaysia, Qatar and most recently Pakistan have all employed the tool. Dubai's Department of Civil Aviation in late 2004 launched the largest ever Sukuk issue at $1bn (£520m) and is planning to return to the market. Notable in the take-up of the paper is the volume placed outside the Muslim world with Western investors, who simply see a security from a government with a good credit rating.
Project finance is another area where the use of Islamic finance has ballooned over the past four years, to the point where in the GCC states that it is rare to see a major project borrowing without an Islamic tranche. The seminal transaction was the Islamic tranche in Kuwait's Equate Petrochemical Company's project financing in 1997, but the deal failed to start a trend, as fears persisted about the difficulty of structuring an Islamic package alongside a conventional one. The more important moment came in 2001 with the $255m (£132.6m) Al-Hidd II water and desalination plant financing, which successfully integrated an Islamic tranche with an ECA-backed conventional facility, thus dismissing a lot of the doubts surrounding the use of Islamic funds in the project finance arena. This was followed by the use of sharia-compliant packages in all the recent project finance transactions in Bahrain: Aluminium Bahrain's Line 5 expansion and the upgrade of Bahrain Petroleum Company's Sitra refinery, and recently on the multibillion-dollar Qatar Liquefied Gas Company II (Qatargas II) financing, which included a $530m (£275.6m) Islamic tranche, the largest Islamic tranche utilised to date. The point when an off-the-shelf Islamic solution exists has yet to be reached, but the view of the market is that it is not far off.
The increasing size of Islamic funding tranches makes especially urgent the development of the main area, where conventional derivative alternatives are currently lacking, to hedge out the risk. These types of instruments involve elements of speculation, gambling and interest; therefore, in their conventional form, they are prohibited by sharia. However, a great deal of work is being done to overcome these obstacles and develop a sharia-compliant profit rate swap (as an alternative to interest rate swaps) and other derivative tools based on bai' al-salam structures.
Another much discussed obstacle on the development of the Islamic financial sector is the lack of standardisation. Efforts are being made with the creation of bodies such as the Accounting & Auditing Organisation for Islamic Financial Institutions, the Islamic Financial Services Board and the through the work of the Fiqh Academy. In international transactions, a set of norms is relatively well established, but at local level there are still considerable differences as to what is deemed Islamically acceptable. Greater coordination between the GCC and the Far East in this regard would be of considerable benefit, and there are signs that this is developing.
As legal and banking heavyweights in the Muslim world and in the West devote increasing attention to Islamic finance, and as the number of shortcomings diminishes, the future for the industry is bright.
Nadim Khan is head of banking and Islamic finance at Norton Rose's Dubai office; Mohammed Paracha is a senior associate at Norton Rose and is based in London