ISLAMIC finance has done well to get to where it is today, and it’s no surprise it has a lot of satisfied customers. Every article on Shariah-compliant finance begins with impressive figures on how industry growth has comfortably outpaced conventional peers. Reports state that Islamic finance has catapulted into an over $2 trillion industry, encompassing more than 100 million customers. The potential is much bigger: while the chest-thumping is justified, there are no guarantees that this will continue indefinitely.
Shariah-compliant banks have enjoyed an uninterrupted reign of swift growth. Initially it was an alternative for the most pious Muslims, but quickly morphed into a robust system with far-flung acceptance. It has evolved into a value proposition with universal appeal encompassing individuals of all faiths, from Australia to North America. While Islamic banks have done well to integrate into the mainstream, competing effectively for the same market share of conventional banks, the industry needs to tackle challenges to avoid veering off into a restrictive market niche.
Shariah-compliant banks are governed by a Shariah board that needs to certify that products and services are in line with the principles of Islam. While there is vehement and unanimous agreement on several overarching principles (such as the prohibition of interest), the real world is more complicated. The growing complexity of financial instruments has led to subjective interpretations on Shariah-compliance adequacy of an offering. The combination of sect, traditions and mind sets churn out varying rulings on the same product structures. There is divergence in what is deemed Shariah-compliant to begin with. As a result, disagreement on the acceptability of product constructs across different banks still persists in several markets.
In 2016, the UAE announced the formation of a Shariah authority that will have oversight on matters related to Islamic finance. This is already beginning to drive consensus and consistency, at least within our borders.
While country Shariah boards will promote standardisation at a local level, there may still be disagreement beyond borders. There is a need for harmonisation to overcome geographical silos.
Organisations such as the Accounting and Auditing Organisation for Islamic Financial Institutions and the Islamic Financial Services Board have been pivotal in successfully navigating uniformity. However, neither have regulatory mandates and operate only in an advisory capacity. It would serve the industry well to create a body with global oversight and powers to regulate, including sanction.
An emerging challenge is the durability of Shariah-compliance in Sukuks, a Shariah-compliant alternative to bonds in conventional finance. A Sukuk issuer recently declared its own issue non-Shariah-compliant several years after its issuance.
This sets a dangerous precedent for the credibility of Sukuks. Efficient markets are ruthlessly effective in pricing in such events. Shariah-compliance longevity risk could be a new pricing element that can make Sukuks less attractive for issuers – due to this additional risk premium being priced in. If the argument holds up in court it could have a detrimental impact on the industry – and could concern issuers and investors alike, thus resulting in a thinner Sukuk market.
Another challenge has been the reluctance of regulators to appreciate the difference between a conventional operating model and a Shariah-compliant one. Individual country regulators have adopted a plethora of attitudes towards, and regulations for, Shariah-compliant banks. There is a need to enhance awareness so that regulatory mandates recognise the specific needs of Shariah-compliant institutions and agree on at least some common framework to licence and regulate them.
The same holds true for global standards. Basel III, for instance, stipulates the need for banks to be prudent with capital management and hold high-quality liquid assets (HQLAs), which follow a very specific set of criteria. The requirement puts Shariah Compliant banks at a disadvantage, at least in the short run. There simply aren’t enough eligible instruments. Whether the issuance of Shariah-compliant HQLAs will keep up with growing demand from the banks, only time will tell. Prudential directives from both local regulators and global standards issuers need to acknowledge the specific needs of Shariah-compliance. The industry needs to promote awareness among authorities who have historically been confined to regulating conventional banks.
Despite the obstacles, Islamic finance continues to flourish. These challenges are merely chinks in the armour. A broad consensus, harmonisation of fatwas and uniformity in legal interpretations will all help.
Additionally, improved knowledge of the intricacies of Shariah-compliant finance on the part of regulators will also support the industry. Islamic institutions therefore have a critical role to play in driving this process forward. This would provide the platform for sustained adoption and growth. Islamic finance has done well to get to where it is today and the industry needs to keep the faith and continue to do more of what it has done so far.