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Islamic Finance: Sources of Growth and Prospects for Global Development

An Interview with Daud Vicary Abdullah

By Jennifer Steffensen
November 7, 2013

Islamic finance has emerged as a rapidly growing industry with an increasingly global presence. Through the use of instruments that adhere to Islamic principles, it seeks to promote inclusive growth, equitable risk-sharing, and social justice. Although the industry represents less than 2% of banking assets worldwide, it now holds an estimated $1.6 trillion in global assets.

The growth of Islamic finance partly stems from the large share of sovereign wealth funds concentrated in the Gulf Cooperation Council countries. In addition, the industry benefits from a large and expanding international Muslim population, as well as from its purported attractiveness to Muslim and non-Muslim investors alike as an ethical and, as some proponents argue, safer alternative to the conventional banking sector.

Recognizing this growth potential, financial capitals across Europe and Southeast Asia are vying to become hubs for Islamic finance. Malaysia, in particular, has already assumed a leadership role in the industry. Yet Islamic finance still faces many challenges to its development, including insufficient global expertise, lack of common standards for the industry, and misperceptions about Islam and sharia-compliant banking.

In the following interview, Daud Vicary Abdullah, President and CEO of Malaysia’s International Centre for Education in Islamic Finance (INCEIF), the Global University of Islamic Finance, offers insights on the recent growth of Islamic finance, the development of the industry in Malaysia, and the hurdles to its continued development in the United States and other parts of the world.

What is Islamic finance? How does it differ from conventional banking?

Islamic finance is a type of financial arrangement for Islamic institutions and markets that follows sharia (Islamic law) as the core value system. This means that it aims to serve the public interest by following various Koranic injunctions such as the prohibition of interest (riba) and the promotion of commerce (al-bay). Understanding this, the main characteristics of Islamic finance are that it is real-sector driven and promotes risk-sharing in financial transactions.

Transactions in Islamic finance are driven by productive activities. This type of trading arrangement is a unique feature of Islamic financing, which qualifies it as real-sector driven. Islamic finance sees financing based on trading and commerce as an alternative to collecting interest, and this activity is characterized by the contract of ownership exchange of goods at a price. Goods are produced—say, in manufacturing and agricultural activities—when raw materials are converted to finished products.

Conventional finance disconnects itself from the real sector as it only gives loans to clients and thus does not take a trading position. In this way, a loan faces one major risk, which is credit risk. By contrast, an Islamic-financing arrangement engages itself with the purchase of commodities or underlying assets to comply with sharia. By doing so, it carries a risk unique to Islamic finance known as commercial/business risk. Additionally, as most of the facilities are based on deferred payment, Islamic finance carries credit risk as well.

In investment, risk-sharing means that investors are seeking profits with the expectation that losses can happen. Based on the legal maxim “profit is accompanied with risk” (al-ghorm bil ghonm), risk-sharing in the trading environment is also known as risk-taking.

Risk-sharing exists in both conventional and Islamic finance, but the nature of these sharing arrangements is quite different. In conventional finance, typically in the bond and loan market, credit risk is carried by the creditor, while the debtor faces bankruptcy risk. Credit risk can also be shifted to a third party, which Islam does not allow under the prohibition of interest and gambling (maysir). One example of risk shifting in the conventional credit market is using a derivatives instrument such as a credit default swap.

The conventional equity market operates in a similar fashion to Islamic finance, with two exceptions. First, in Islamic finance, stocks are subject to the sharia screening process to claim sharia labeling; and secondly, financial derivatives such as options and futures can only be used for hedging purposes and not for speculating.

How has the Islamic finance sector grown and changed in recent years? Where is the most growth occurring, and where do you see the industry going in the next five to ten years?

Globally, the Islamic finance market has grown by more than 10%-15% annually, from 2000-2012. Sharia-compliant assets rose by more than 160% between 2009 and 2011. Islamic finance investments are now worth $1.6 trillion and are forecast to increase to $2.5 trillion by 2015.

There are many reasons to anticipate that the industry will continue to rapidly grow. Islam is the fastest-growing religion today—by both conversion and birth—and there has been an increase in oil wealth among Muslim nations. Beyond this, Islamic financial products and services have become increasingly competitive, and Muslims worldwide are starting to opt for sharia-compliant products. There is also increasing interest from non-Muslims who are looking for ethical financial products.

You have played a role in the development of Malaysia’s expertise in Islamic finance through your work as President and CEO of INCEIF, the Global University for Islamic Finance, set up by Malaysia’s central bank (Bank Negara Malaysia). What role does INCEIF play in training practitioners in Islamic finance, and to what extent is human capital still a challenge for the industry?

There is still much to do in developing Islamic finance around the world, and human capital development is key. It is not just a question of training qualified students but also a matter of having adequate resources to teach Islamic finance.

INCEIF is the only university in the world dedicated to the subject matter and has a full-time faculty of over 30 instructors, half of whom are full professors. Many universities have just one or two full-time or even part-time instructors to teach the subject.

Ultimately, it will be important to do two things. First, INCEIF must collaborate and share with other institutions as much as possible without diluting quality; and secondly, it needs to encourage the adaptation of international professional standards for the industry (like those used in the accounting profession). This will ensure common standards and the interoperability of technical, institutional, and human resources across borders.

What other hurdles does the industry face in its global development?

Besides human capital development, three other issues need to be addressed in Islamic finance. One issue is industry standards. The adoption of common standards and the shared understanding of terms used, product objectives, and processes are key to global growth.

Secondly, the industry needs to work very hard to change negative perceptions about Islam and Islamic finance around the world. These perceptions are based on ignorance and misrepresentation, and education can help significantly to counter both.

The third issue is liquidity. The fundamental ethos of Islamic finance is the efficient and effective mobilization of capital for the benefit of the real economy. This can only be done well, however, if there is sufficient liquidity coupled with the ability to move funds to where they are most needed.

Malaysia has become a regional hub for Islamic finance in Asia and the global leader in the Islamic bond (sukuk) market. What can be learned from the Malaysian experience? Are there lessons that are applicable on a global scale?

The primary lesson from the Malaysian experience is that strong government support is critical. The Malaysian government made the necessary changes to tax law to ensure tax neutrality for sharia-compliant transactions. In addition, there must be a willingness by all stakeholders to experiment with alternative structures within Islamic finance and for the system to evolve with market needs. Stakeholders also must be willing to share technical experts with other countries and foreign industry players. Finally, Malaysia was successful because it established a one-stop center, the Malaysian International Islamic Financial Centre (MIFC), to handle all financial transactions. MIFC, which is based at Bank Negara Malaysia, is an initiative of Malaysia’s financial market regulators and government agencies dedicated to developing the country’s Islamic finance market by engaging with industry and governments.

Apart from Bank Negara Malaysia, MIFC is also supported by the Securities Commission Malaysia, the Labuan Financial Services Authority, and Bursa Malaysia (the Malaysian stock exchange). MIFC’s private-sector partners include Islamic banks, conventional banks with Islamic-finance investment divisions, brokers, lawyers, sharia advisory firms, sharia scholars, accounting and tax advisers, ratings agencies, and takaful (Islamic insurance) providers. INCEIF is among a group of higher-education institutions that are part of the MIFC community. The inclusion of INCEIF in this community demonstrates the importance that the Malaysian government places on the development of human capital for the Islamic finance industry in both Malaysia and globally.

What opportunity do you see for the United States in Islamic banking? Why should Americans care about this industry?

Current U.S. laws and regulations are not considered flexible enough to accommodate most aspects of commercially viable Islamic financial products without significant changes. As a result, U.S. banks and mortgage brokers offering sharia-compliant products and services remain localized institutions catering to small, concentrated Muslim communities.

Yet there is no reason that Americans should not look at Islamic finance as a viable alternative to conventional finance. As discussed earlier, Islamic finance focuses on the real economy and puts significant emphasis on risk-sharing; by contrast, in conventional finance the risk is not shared with consumers but is transferred in total to them.

Will Americans be ready for Islamic finance? Perhaps the chances of this happening would be greater if the system were labeled as ethical finance or risk-sharing finance as opposed to Islamic finance. After all, this is a financial system that serves all people for the good of society as a whole.

Jennifer Steffensen is an Intern at NBR.

Daud Vicary Abdullah is the President and Chief Executive Officer of INCEIF, the Global University of Islamic Finance. He has been in the finance and consulting industry for almost 40 years, with significant experience in Asia, Europe, Latin America, and the Middle East. He spoke in Washington, D.C., at the conference “Islamic Finance: An Undiscovered Market in the United States” on November 4, 2013.

For more information on the topic, explore NBR’s previous publications: Islamic Finance.