The Potential of Islamic Finance

Several challenges need to be addressed in order to realize the full potential of Islamic finance, including: improving regulatory oversight, rebalancing tax treatment, strengthening insolvency frameworks, promoting standardization, ensuring adequate liquidity, and establishing sound risk-management practices. Knowledge sharing can play an important role in underpinning initiatives in all of these areas.

Sound regulation is essential for a well-functioning financial sector. More effort is needed in order to ensure effective regulation of Islamic financial institutions. Initiatives to improve the regulatory framework have varied from minimal alterations in the United Kingdom, to a dual approach in Bahrain and Oman. Under the dual approach, conventional banks and Islamic banks are chartered and supervised separately, giving Islamic banks greater autonomy and banning conventional banks from offering Shariah-compliant services. Issues of compliance and standardization in Islamic finance are being remedied through internationally recognized standard-setting bodies for Islamic accounting and auditing (AAIOFI) and supervision (IFSB). The mandate of these organizations is to promote common risk-management, accounting, and governance standards. Addressing these factors is helping to lower entry barriers and facilitating product development and innovation, essentially by allowing conventional banks to use their existing networks to provide Shariah-compliant financial services.

The rapid expansion in the use of Shariah-compliant instruments has increased the urgency to improve exit rules in the event of Islamic financial institution insolvency. There is also a need to establish reliable mechanisms for dealing with Sukuk defaults, as well as transparent frameworks to address adverse outcomes, with special adaptations for risk sharing. Setting up these mechanisms requires the specification of parties' rights under Shariah-compliant finance, especially in the case of cross-border transactions. More work is needed to ensure convergence between best insolvency practices on the conventional and Shariah-compliant sides.

In many countries, leveling the playing field with respect to the tax treatment of financial instruments is an urgent need. At present, conventional debt often receives advantageous tax treatment (encouraging leverage), while some Islamic finance products face double taxation, especially investment income generated from Sukuk. Malaysia and Thailand took fundamental steps to ensure that Islamic financial transactions operate on a level playing field and are treated equally for tax purposes. In Malaysia, this principle has extended to ensuring that profits, asset transfers, and expatriation of profits by foreigners are treated equally, whether occurring under conventional or Islamic financial contracts. In Thailand, a package of proposed tax changes for Sukuk issuances has been introduced to address the main hurdles faced by Sukuk issuers: (i) exempting the originator from income tax, value-added tax, special business tax and stamp duty, and (ii) treating investment income from Sukuk, or capital gains from selling Sukuk, the same as conventional counterparts for the purpose of computing annual income tax.

Lack of standardization and cohesion, especially in Sukuk products, hinders the growth potential of Islamic finance and deprives the market of an organized structure to facilitate secondary trading and liquidity. For example, the industry would benefit from more widely accepted benchmarks and indices. Innovation and knowledge sharing between various market players are essential to facilitate the standardization and unification of global markets for Islamic financial products.

A challenging area in generating adequate liquidity is the divergence between fully guaranteed Sukuk by sponsors (for example, corporate bonds), partially guaranteed Sukuk, and those that are not covered by any guarantee. Infrastructure companies that are looking to raise funds to finance projects are more likely to adopt Sukuk structures with full guarantees. In the case of stand-alone infrastructure projects, asset-backed Sukuk with no guarantees from the sponsors may be more attractive. The challenge is that these structures are uncommon and poorly understood. Although investors seem keen to invest in Sukuk that will give creditors control of the underlying assets in the event of a default, the market is underdeveloped, partly because Sukuk transactions without guarantees tend to be lengthier, costlier, and more complex. This is an area that needs innovative solutions based on sharing knowledge of what can work on the ground.

While the theoretical framework of Islamic finance and the main principles provide an alternative paradigm and guidance to practical solutions for funding requirements of economic activities, many aspects of the practice of Islamic finance suffer from emulation and reengineering of conventional instruments. This has resulted in inefficient replications of conventional instruments and higher transaction costs.

Moreover, the challenges associated with Basel III compliance and concerns about liquidity risk management need to be addressed. By relying on equity-based finance, Islamic banks incur a higher cost of capital, since by definition they hold more equity than conventional banks. This places Islamic financial institutions at a disadvantage under Basel III's new core tier 1 capital requirements. The current standards of the IFSB and the Bank of International Settlements are in agreement on Basel III's guidelines on asset risk weighting, credit risk mitigation, market risk, operational risk, and eligible capital for Islamic financial institutions. Still, more work is needed to find a greater convergence on the rules governing risk weighting and the treatment of investment accounts in Islamic banks. Islamic financial services are overly concentrated in the banking business, yet nonbank financial instruments, such as mortgages and mutual insurance takaful, are growing rapidly, especially in Southeast Asian markets). For example, gross takaful contributions expanded by 67 percent in Indonesia in 2009. Key challenges to the future growth of the nonbank financial instruments are limited competition and lack of diversification. More work is also needed on consumer awareness and financial literacy. The Islamic mortgage industry is also underdeveloped. Strong growth can be expected in the GCC going forward, spurred by the increasingly affluent younger generations (about 65 percent of the population in the GCC is under the age of 30) and the advent of the institution of freehold property. Recent estimates show that Saudi Arabia alone may see Islamic mortgage assets rise to US$100 billion in the coming years.

Despite the aforementioned challenges, the prospects for the expansion of Islamic finance are strong. Entrepreneurs in the business sector are demanding more Shariah-compliant products to finance their investments. Meanwhile, there are important factors that continue to contribute to the growth of Islamic finance:

1. The commodity boom has generated surpluses in some Muslim countries that need to be allocated through financial intermediaries and sovereign wealth funds.
2. Through quality improvements and the development of new instruments, Islamic finance is increasingly considered a practical alternative to conventional instruments for savers and investors.
3. Conventional multinational financial institutions are offering Islamic windows and have increased their Islamic finance operations and portfolios to meet growing demand in London, Luxembourg, and other capitals.
4. The formation of Shariah-compliant indices for companies listed in stock markets is boosting the demand for Islamic finance.
5. Recent political developments in several majority Muslim countries point to a growing role for Islamic financial instruments.