Islamic Finance: Relevance and Growth in the Modern Financial Age

1. Islamic Finance: Relevance and Growth in the Modern Financial Age Iqbal Khan Founding ex-CEO, HSBC Amanah London School of Economics 1 February 2007

2. Agenda • What is Islamic finance? • What relevance does it have in the modern financial system? • What are the areas of current growth and initiatives? • What does the future hold?

3. Shariah filter Islamic finance is the outcome of religion in banking Banking and finance needs Fiqh al-Muamalaat contracts Shariah sources • Musharaka - Partnership • Mudaraba - Partnership • Murabaha - Purchase-resale • Ijara - Lease • Istisna’ - Manufacturing contract • Salam - Forward sale • Quran • Sunnah • Ijma’ (jurist consensus) • Qiyas (analogy) • Ijtihad (reasoning) Islamic banking and finance solutions • Prohibition on: • Interest • Speculation • Gambling • Prohibition of certain investments: • Sectors (e.g.: alcohol, armaments, financial services, gambling, pork, pornography, tobacco) • Instruments (e.g. no forward transactions, limited option use, no derivatives, short-selling) • Asset-backed transactions with investments in real, durable assets • Credit and debt products are not encouraged

4. Islamic finance is embedded within values • Synthesis of Islamic law and contemporary finance • Community banking: serving communities, not markets • Widens ownership base of society • Offers “success with authenticity” Client affinity Fulfils aspirations • Builds systematic checks on financial providers • Restrains consumer indebtedness Parallel trends Responsible finance • Ethical investment • CSR initiatives Inclusive proposition Alternative paradigm • Stability from linking financial services to the productive, real economy • Moral compass for capitalism • Open to all-faith clients • Available to Islamic and conventional issuers Islamic finance is more than financial contracts

5. Values of good governance are central to Islam Best practices of corporate governance Quranic code of ethics • Accountability and obligation to shareholders • Vicegerent concept of accountability (2:30) • Honest fulfilment of contracts (5:1) • Prohibition against betraying any trusts (8:27) • Prohibition against deriving income from cheating, dishonesty or fraud (4:29) • Prohibition against bribery (2:188) • Integrity and ethical behaviour • Fiduciary role and responsibility of board • Prohibition against concealing evidence (2:283) • Disclosure and transparency “O ye who believe! Be ye staunch in justice, witnesses for Allah, even though it be against yourselves or (your) parents or (your) kindred…” (4:135) Accountability to God raises level of awareness

6. SOCIAL IMPERATIVE ZONE OF SUSTAINABILITY Islamic businesses NGOs not-for-profits Islamic Financial Institutions are positioned in a “zone of sustainability” ECONOMIC IMPERATIVE prohibited sectors Islamic finance characteristics: • Market-driven yet values-based • Gradualist and evolutionary nature • Symbiotic and synergistic relationship with mainstream finance

7. 33% growth 66% growth Industry has advanced from niche to critical mass • Growing at 15 to 20% per annum1 • Within 8-10 years, industry estimated to capture half the savings of the 1.6 billion Muslim world2 • Young industry • Mitghamr Savings Associations (1963) & Tabung Hajji Malaysia (1967) • Islamic Development Bank (1974) & Dubai Islamic Bank (1975) • Market-driven proposition • Retail customers historically the backbone of the industry • Tipping point in retail sector: Saudi Arabia, UAE, Bahrain and Kuwait • Self-regulating organisations, Standards bodies and Research and Training Institutes Islamic banking assets as proportion of total (%) * 40% • Market size estimated at USD 750 billion globally1 30% 20% 12% • Global scale • More than 250 Islamic banks worldwide operating in over 75 countries 3 • GCC accounts for two-thirds of global Islamic assets* • Malaysia leading industry maturity and sophistication • Islamic Development Bank: largest pan-OIC financial institution Industry is fragmented, with slowly internationalising players Source:1: S&P Report ( 31 Aug 2006); 2: IIR Middle East (Apr 2006); 3 Bursa Malaysia “The Islamic Capital Market” 2005; * HSBC analysis

8. structured products commercial banking debt issues insurance 2000s 2000s 1970s 1970s private equity 1980s 1980s 1990s 1990s project finance equity Industry has developed a comprehensive product offering over its young history Development of industry Evolving richness in products • Development of theoretical framework • Muslim-majority nation independence 1950s • Egypt and Malaysia pioneering institutions • Establishment of OIC (1969) 60s • Islamic Development Bank (1974) and DIB • One country-one bank setup 70s • Advancement of Islamic products • Full “Islamization” of Pakistan, Sudan and Iran 80s syndications 90s • Entry of global institutions, e.g. HSBC structured and trade finance • Tipping point reached in some markets • Development of industry-building institutions 00s Industry has near like-for-like parity with conventional offering

9. Islamic finance industry is developing a global reach… Source: HSBC Amanah

10. Germany: Saxony issues E100m Sukuk (2004) …with worldwide momentum from retail to regulator involvement China: Active member of Islamic Financial Services Board (2004) Japan: JBIC exploring Islamic financing opportunities (Dec. 2006) UK: New legislation for Islamic mortgages (2003) USA: Harvard workshop with six regulators (1995) • Saudi Arabia: • 95%+ of new consumer • lending is Islamic (2006) • Retail market rapidly converting to Islamic (2006) Bahrain: Leading Islamic financial centre, and housing regulatory bodies Singapore: Active in developing Islamic finance • UAE: • 30% of retail banking • is Islamic (2005) • Several institutions have converted from conventional to Islamic . Malaysia: Islamic product and industry, development and sophistication leader Source: HSBC Amanah, Press Reviews Each region is contributing in a unique way

11. Self-regulatory organizations bring credibility through standardization of practices AAO-IFI (1991) Bahrain • Benchmark of Islamic accounting standards • 56 accounting, auditing, governance and Shariah standards • Enhancing clarity, transparency and harmonisation IIFM(2001) Bahrain • Development of global Islamic capital and money market • Promoting active and regulated trading and capital flows • Catalyzing trading infrastructure, product innovation and information flows GCIBFI(2001) Bahrain • Promoting industry in theory and practice • Disseminating Shariah concepts & multilateral understanding between IFIs and public • Improving IFI practices, cooperation, professionalism and transparency IFSB (2002) Malaysia • Standard-setting body of regulatory and supervisory agencies • Complementing Basel II Capital Accord • Key standards: risk management, capital adequacy & corporate governance LMC(2002) Bahrain • Creation of active Islamic inter-bank market • Creating secondary market for short-term Shariah-compliant treasury products • Enabling IFI management of liquidity mismatch IIRA(2005) Bahrain • Reference point for IFI ratings • Issuing sovereign, credit, Shariah quality and corporate governance ratings • Providing effective tool for informed investment decision-making

12. Why Islamic financing is flourishing Strong growth of OIC economies Institutional capital Innovative product development EXPLOSIVE GROWTH OF ISLAMIC FINANCE Resurgence of Muslim cultural values Liberalisation of capital markets Retail customer commitment Industry is driven by fundamental factors

13. Multinational banks have gradually increased their focus on Islamic finance Market entry strategy Evolving commitment Ad hoc participation • Correspondent banking for IFIs • Tailored Private Banking services for HNWIs Proactive strategy Defensive strategy • Service and retain existing Muslim clients • Refine current proposition to reflect local needs • Particularly important and economic clout of locals increased • Protect and embed the brand • Acquire new customers, especially wealthy locals • Build a sustainable community banking proposition • Benefit from higher growth rates of emerging markets • Crucial as developed market growth slows Islamic client services • Dedicated Relationship Managers for IFIs • Dedicated Private bankers for HNWIs Islamic window model • Committed unit for Islamic financial services • Citi Islamic (1996), HSBC Amanah (1998) Dedicated Islamic subsidiary • Islamic subsidiaries of conventional banks • Joint ventures and partnerships Mainstream institutions are embracing Islamic banking

14. Industry is reaching mainstream relevance in global financial system Relevance to OIC countries Relevance to non-OIC countries • Fulfilment of financial needs of Muslims • Islamic finance is the equilibrium choice • Widens stakeholder base of society • Increases bankable population of economy • Increases economic efficiency as a result of society’s increased engagement • Enhances stability of financial model • Asset-based framework links financial services to real economy • Reaching a broader market • Muslim-minority populations become inclusive, economic, productive agents • Alternative source of funding • Debt issuance with the widest acceptance • Attract “new-to-industry” investors with Shariah-compliant funds and transactions • Gateway to OIC markets • Regional preference of Islamic investors • Infrastructure investment opportunities Islamic finance benefits are not exclusive to Muslims

15. The industry has not yet reached its potential • Within 8 to 10 years, as much as half the savings of the world’s then 1.6 billion Muslims would be in Islamic banks1 • The global Islamic insurance (Takaful) market is estimated to reach USD14.4 billion by 20101 • Most Islamic financial institutions are highly liquid, and seek new asset classes and markets to diversify • Project finance requirements of USD 500 billion in 5 years2 • Capital markets developments: Malaysia – Sukuks account for 71% of 1H06 debt issues3 • Islamic finance has also gained popularity in Muslim-minority countries • Germany issued the first Islamic Eurobond (2004) • UK’s first standalone Islamic bank (2004) • Trends of convergence and conversion • Ethical investing, community banking • Conversion of banks: e.g. National Bank of Sharjah, Bank al Jazira, Dubai Bank Source: 1: IIR Middle East (Apr 2006); 2 Banker ME (June 2006); 3 RAM Islamic Ratings Services (2006)

16. Islamic framework provides solutions for key limitations of conventional banking system Conventional banking issues IFI solutions • Asset/need-based approach to financing • Growing consumer indebtedness • TSV maximisation ultimate goal • Systemic conflict between shareholders and credit-financed customers • Check on profit-seeking alone as sole business motive • Investment channels towards ethical activities • Equitable distribution of risk and reward • Speculation-fuelled crises • 1997 East Asia Crisis • 1998 Russia • 1999 Argentina • Prevention of speculation • Ownership is prerequisite of sale • Excessive risks are prohibited • The case for “Narrow Banking” • Regulation often reactive and lagging corporate misbehaviour • Collusion between research and M&A teams • Enron, WorldCom, Arthur Anderson, Tyco and other collapses • Shariah-based IFI is Taqwa-based • Regulation is reactive to corporate innovation • Shariah-based system prioritises God over regulators – (SRO) An ethical grounding prevents a wide set of problems

17. Equity financing mudaraba & musharaka Debt financing ijarah, murabaha, salam, istisna‘ Key internal issues that need addressing… • Reducing debt-based products • Islam permits commercial debt for productive ends • Debt-based consumer products permitted on basis of need • More the exception than the desired norm • Building income-sharing products • Musharaka is true form of financing • Develop with “fixed” income payment profile • Removing bias towards debt • Current tax, accounting and regulatory systems and risk-weighting promote debt instruments An alternative banking model in development Suppliers of capital Deposits Profit, not interest, becomes the basis for financial intermediation Productive economic actors with capital needs Liabilities Assets Investments

18. Shariah-based solutions • Income-sharing products • Shift from debt-based product offering Savings & Investments Indebtedness x Shariah-compliant products • Letter of the law • Replicating conventional credit service offering Shariah-based mindset is crucial direction for product development Shariah-based industry is the new vision

19. A number of factors need to be engaged to bring success • Dedicated people • Greatest intangible to enable Islamic finance and build its future • Human capital development: bankers and Shariah scholars • Committed sponsorship • Academic input to formulate visionary framework and development • Capital sponsorship to bring plans to life • Change in mindset • From Shariah-compliant to Shariah-driven products and services • Education of all key stakeholders • To build understanding and awareness • Proactive engagement • Regulators, practitioners and Shariah scholars to set a common agenda Key enablers Need for co-ordination to enable further development

20. Concluding remarks • We must preserve what is distinctive about Islamic finance • Industry regulations and governance heading towards mainstream globalization • Balancing different elements of Shariah credibility • Current expanding reach and richness of Islamic finance • Despite the absence of an enabling framework • But at a cost: culture of exceptions, Shariah credibility, competitive disadvantages • To build an enabling framework requires concerted efforts • Collaboration between IFIs, endowed industry institutions and regulators • Exploration of narrow banking principles Japanese proverb: “Vision without action is a daydream. Action without vision is a nightmare.” Imperative is for moving to Shariah-based services

21. Thank you Iqbal Khan Founding ex-CEO, HSBC Amanah