Western debt crisis spurs exodus to Islamic finance

Sharia-compliant firms seen mopping up the fallout from global economic woes
Islamic finance will almost double to $1.8 trillion in assets by 2016, Deutsche Bank said
By Reuters
Tue 06 Dec 2011 02:52 PM

Chicago
native Mariam Khan never considered Islamic banking until her husband moved the
family to Dubai in 2007. But the 36-year-old housewife is a believer now as the
Western debt crisis deepens. Her husband opened a family account with HSBC
Amanah, the Islamic arm of international bank HSBC.

"When
I look at the damage that an interest-based system has done to the US and
Europe, I can see why God forbids riba (interest) in Islam," she said.
"I'm not particularly conservative as a Muslim but I definitely feel safer
within Islamic banking."

It is a
sentiment that proponents of Islamic finance, which is based on religious
principles including bans on interest and pure monetary speculation, hope will
spur unprecedented growth of their industry as a safer, more stable alternative
to conventional finance.

Bahrain's
central bank governor Rasheed Mohammed al-Maraj said last week that Islamic
finance had an opportunity to attract not only customers in its traditional
areas, the Gulf and Muslim parts of Asia, but also investors around the world
who had been hurt by the turmoil in mainstream capital markets.

"It
should provide the industry with a sustained period of growth for the next
decade," he said.

Ashar
Nazim, Islamic financial services leader at consultants Ernst & Young, said
the Occupy Wall Street movement in the United States showed mounting public
anger about inequality in the capitalist system. This could help Islamic
institutions gain market share by emphasizing Islam's preference for an
equitable distribution of wealth and dislike of excessive financial leverage,
he said.

It is
still unclear, however, how much of the recent growth of Islamic finance is due
to its merits - and how much is simply due to a temporary flight from
conventional finance which could reverse when global markets eventually
stabilize.

With its
assets estimated to total nearly $1 trillion globally, Islamic finance remains
tiny compared to conventional finance with its tens of trillions of dollars.
The market in Islamic bonds, or sukuk, is believed to total about $50bn,
roughly 1 percent of global bond issuance.

But
proponents of Islamic finance can point to impressive gains. Nazim said it had
expanded at a compound annual growth rate of 20 percent over the past three
years, compared to 9 percent for conventional finance. That performance gap has
probably widened further in the last two months as much new business in the
West has ground to a halt.

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Deutsche
Bank, a pillar of traditional banking, estimated in a report this month that
Islamic finance would almost double to $1.8 trillion in assets by 2016 as
stagnant conventional lending pushed companies to seek alternative financing
methods.

As much
of the international corporate bond market has frozen up over the last six
months, most bond issuance by Gulf companies has been in the form of sukuk.
Dubai's fast-growing Emirates airline said it was looking at the Islamic
finance market to fund aircraft deliveries as European banks backed out of
plane deals because of the euro zone debt crisis.

Some big
Western banks, facing tough conditions in the funding markets on which they
have long relied, are also turning to sukuk. HSBC issued a $500m sukuk in May and
Goldman Sachs announced a $2bn sukuk program last month. French bank Credit
Agricole has said it is considering issuing an Islamic bond or creating a wider
sukuk program that could lead to several issues.

This
year's Arab Spring uprisings in North Africa have installed governments which
are expected to promote Islamic finance more enthusiastically than their
authoritarian predecessors, partly because it can help them attract Islamic
investment funds in the Gulf.

And
Islamic finance is spreading farther afield. Senegal is expected to hold
investor meetings before the end of the year to issue its first sovereign
sukuk, while Nigeria said in June that it planned to issue a debut sovereign
sukuk within 18 months as part of efforts to boost Islamic banking in the
country.

In
September, AK Bars Bank in Tatarstan became the first Russian bank to secure an
Islamic loan, using the murabaha structure, in which the borrower essentially
sells an asset to the lender to obtain funds and agrees to buy it back on a
later date at a higher price.

The past
several years have exposed weaknesses in Islamic finance, however. The industry
claims sukuk are safer than traditional bonds because they are effectively
certificates of ownership in a real asset, not speculative instruments.

The
Dubai debt crisis of 2009 showed this claim to be on shaky ground. Companies
such as property developer Nakheel and Jebel Ali Free Zone raised funds through
sukuk but were forced to restructure once they found themselves unable to repay
creditors.

Similarly,
deposits in Islamic banks, which do not offer interest but may invest
depositors' money in relatively risk-free investments and give them a share of
the profits, are supposed to be safer because of Islam's curbs on speculation.
But Dubai Bank, an Islamic institution, ran into such serious debt problems
that the Dubai government had to arrange last month for it to be taken over by
a conventional bank.

"It's
still unclear whether you can really say Islamic finance has tackled the
leverage aspect," said Abdul Kadir Hussain, chief executive of Dubai-based
Mashreq Capital.

"You
still have companies that raise what ultimately constitutes debt at
unsustainable levels through sukuk. Just because it is done in a technically
sharia-compliant manner using an asset to back it, doesn't mean that you're not
taking the same risk as conventional finance."

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That
suggests Islamic finance may have succeeded this year not so much because it is
seen as safe, but because of a lucky accident: it has access to billions of
dollars of Islamic funds in the oil-rich Gulf and southeast Asia, which have
been hit less hard than other regions by global financial turmoil.

When
conventional finance eventually recovers, perhaps after reforms to make it less
volatile and risky, it may regain much of the market share lost to Islamic
finance even in regions such as the Gulf.

Other
obstacles to Islamic finance have existed since the industry was born in its
modern form in the 1970s, and will not disappear any time soon.

Tax and
regulatory environments are less favorable in many countries than they are for
conventional finance. Central banks have not yet developed a range of
sophisticated liquidity management tools for Islamic finance. And the industry
is plagued by differing, sometimes contradictory product standards set by
bodies such as Malaysia's Islamic Financial Services Board and Bahrain's
Accounting and Auditing Organisation for Islamic Financial Institutions. Adding
to the confusion is the fact that their rulings are guidelines rather than
firm, enforceable regulations.

"Participants
in conventional markets are sophisticated and there is consistency based on
precedence of how things happen when things go wrong," said Toby O'Connor,
chief executive of Singapore's Islamic Bank of Asia.

"Islamic
finance is a relatively new industry...the consistency isn't quite there yet
across the regulatory framework. That consistency is very important for new
investors coming into the market."

Some
also see dangers in Islamic finance's success. As it wins new customers from
the conventional financial world, they may compromise the principles on which
the industry is built. That worry seems to have been behind Qatar's decision
this year to ask conventional banks to close their Islamic operations, to
prevent any overlap of business with full-fledged Islamic banks.

"As
conventional financial institutions increasingly fund themselves through
Islamic finance, it will help drive growth going forward," said Harris
Irfan, managing partner at consultancy Cordoba Capital. "The hope is that
the conventional players will do Islamic deals without violating the spirit of
sharia."

Innovators
in the industry think the solution to this problem is creating new instruments
that will differentiate Islamic finance more clearly from conventional finance.

Last
week a consortium of banks and industry associations launched the first
international Islamic interbank rate, hoping it will become a benchmark for
pricing a wide range of instruments. Somehwat incongruously, the industry's
main benchmark at present is the London Interbank Offered Rate, a key interest
rate used in conventional finance.

British-based
investment firm Solum Asset Management, co-founded by a former head of Islamic
finance at J.P. Morgan, plans to launch the first "investment sukuk"
in the first quarter of next year, treating Islamic bonds as investment
vehicles rather than debt instruments. Investors will be outright owners of
assets underlying the sukuk, eliminating the problem of leverage, the firm
says.

"Islamic
finance is definitely a viable source of financing for governments and private
investors," Hussain said. "But the danger is if the industry
continues to mimic conventional products, especially complicated structures, it
is walking down the same path and may be in the same place 10 to 15 years from
now that conventional finance is in today."

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