Islamic Finance as a Value Oriented Proposal for Modern Economy

1. Islamic Finance as a Value Oriented Proposal for Modern Economy Presented at the 4th Biennial International Conference on Business, Banking and Finance on ‘Restoring Business Confidence and Investments in the Caribbean’ organised by the Department of Management Studies of UWI with SALIES and CCMF, June 22-24, 2011, Hilton Trinidad & Conference Centre Dr Mehmet Asutay Durham Islamic Finance ProgrammeSchool of Government and International Affairs Durham University mehmet.asutay@durham.ac.uk

2. Financial sector acts as a catalyst to growth • Provides platform and incentives for savings and investments • Able to mobilise and allocate national savings and change their term and structure to finance longer term and relatively riskier investments Mobilise savings • Aid local community and real economy development • Enable company formation, expansion and competition in the market • Fund SME and Microfinance opportunities to contribute to employment and wealth generation Real economy channelling • Raises total factor productivity levels • Enable shift away from labour to capital intensive and higher value-add productivity sectors Productivity enabler • Integrates domestic economy into global financial system • Able to access funds from international capital markets and attract foreign direct investments • Reduce intermediation margins and costs by being “close to the market” Global capital market link

3. However, recent crisis in banking highlights dangers caused by failures of financial sector Lack of short-term lending Bank insolvency Corporate liquidity crisis Negative spiral Crisis of confidence Inability to meet financial obligations Disruption of payments Instability in the banking system can destroy otherwise healthy economies

4. Crisis underscores certain elements that need to be addressed • Need for savings and investment orientation to replace consumption and credit culture Financial Institutions Impact points Policy Implications Global Markets • Differentiation between deposit-taking institutions and investment managers • Dangers of opaque sale of debt now shown to be evident • Stronger links needed between banking and real economy investment Real Economy Material crisis requires moral solutions

5. Islamic Finance: A Value Oriented Proposition • A financing proposition shaped by the rules (fiqh) but also moral values of Islam; • ‘Form’ but also ‘substance’ is expected to be Islamic as well; • Islamic moral economy, in modern sense, developed since 1970s aiming at development issues; and • Islamic financing expected to provide an alternative solution as a financing tool and method; • Ethicality in this value proposition in the original sense is not only prohibition of riba (interest) but relating to larger social and economic development issues;

6. Islamic Finance: A Value Oriented Proposition Islamic moral economy assumes certain axioms: • Social justice and beneficence (adalah and ihsan); • Growth in harmony (tazkiyah); • Enabling individual, society and natural environment to reach its perfection (rubibiyah); • To overcome the conflict between individual and society, voluntary action is not perceived to be enough; and hence certain social oriented financial and economic obligations (fard); • Individual is perceived to be vicegerent of God on earth to fulfill the expected duties in their economic and financial behaviour to make their decision through a financial filter (vicegerent individual); • Operational dimensions of these axioms are possible with Maqasid al-Shari’ah – objective of Shari’ah: human well-being.

7. Crass materialism Islam Aesthetic spiritualism Islamic finance principles reinforce the ethos of Islam • Islamic economics has an explicit value framework • Based on justice, equity, human dignity, freedom of enterprise and moderation • Based on developing and harnessing economic resources to satisfy spiritual, material and social needs of all members of the community • Based on a moral obligation to serve poor and destitute from share of wealth Islamic finance is based on socially responsible investing

8. Islamic finance principles consist of core basic tenets 1 If something is immoral, one cannot profit from it 2 To share reward, one must also share risk 3 One cannot sell what one does not own 4 In any transaction, one must clearly specify what he or she is buying or selling and what price is being paid Removing speculation and ensuring value-enhancing activity

9. 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

10. Aims of Islamic Finance Islamic banking and finance aims at: • Community banking: Serving communities, not markets; • Responsible Finance, as it builds systematic checks on financial providers; and restrains consumer indebtedness; ethical investment, and CSR Initiatives; • Alternative Paradigm in terms of stability from linking financial services to the productive, real economy; and also it provides moral compass for capitalism; • Fulfils Aspirations in the sense it widens ownership base of society, and offers ‘success with authenticity’.

11. Conceptually, Islamic finance is more than financial contracts Tenet-bound Principles-based • Fundamental tenants are derived from Shariah • Absence of interest-based transactions • Avoidance of economic activity involving speculation • Prohibition on production of goods and services which contradict the values of Islam • Concept is grounded in ethics and values • Principles akin to ethical investing • Emphasis on risk-sharing and partnership contracts • Credit and debt products are not encouraged Real economy-linked Society-service • Islamic finance offers an alternative financing paradigm • Asset-backed transactions with investments in real, durable assets • Stability from linking financial services to the productive, real economy • Restrains consumer indebtedness as credit is linked to real assets • Islamic banking is community banking • Serving communities, not markets • Open to all-faith clients • Instruments of poverty-reduction are inherent part of Islamic finance (zakat & qard hasan) A holistic approach to financing a society

12. Islamic finance aims and positive impact 1 • Engagement of an under-served and previously un-banked market • Providing an ethical banking solution to local communities to deepen the banking market 2 • Promoting the investment mindset rather than the banking mindset • Investing in real assets rather than promoting speculation and leverage 3 • Making meaningful real economy impact • Investing in asset-backed instruments and real economy ventures 4 • Attracting foreign investment and cross-border partnerships from Islamic financial institutions • Attractive source of cross-market ventures and cross-border lines from Islamic countries A growing industry promising benefits

13. Industry presents an alternative banking paradigm to create ethical profits Accountability to God Corporate Social Responsibility Corporate Governance Ethical profits (rather than “profits-at-any-costs”) “More-than-profit” mentality Business Ethics Shari’a “Code of Ethics” Banking with morals

14. Several practices from the Islamic banking sector are relevant to the conventional sector following the crisis • Increased emphasis on asset-based financing 1 • Limits on the sale of debt and preference for equity financing 2 • Greater transparency in transfer of debt and linking to origin 3 • Introduction of “Ethical Supervisory Boards” 4 Evolving financial architecture to be based on separation of risk-free and risk-bearing accounts 5 • Prioritizing research and development with two-way transfer of best practices 6 Source: Relevance of Islamic Finance Principles to the Global Financial Crisis, Aamir A. Rehman, March 2009

15. structured products commercial banking debt issues insurance 2000s 2000s 1970s 1970s private equity 1980s 1980s 1990s 1990s project finance equity Development of Paradigm and Industry Development of industry Evolving richness in products • Development of theoretical framework • Muslim-majority nation independence 1950s • Egypt and Malaysia pioneering institutions • Establishment of the OIC 60s • Islamic Development Bank and DIB • One country-one bank setup 70s • Advancement of Islamic products • Full “Islamization” of Iran, Pakistan and Sudan 80s syndications 90s • Entry of global institutions e.g. HSBC Amanah 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

16. Industry has advanced from niche to critical mass • Islamic finance is a 40 year old industry • Mitghamr Savings Associations (1963) – Shaikh Ahmad Al-Najjar • Tabung Hajji Malaysia (1967) – Royal Professor Tunku Abdul Aziz • Islamic Development Bank (1974) – Dr. Ahmed Mohamed Ali & Dubai Islamic Bank (1975) – Sh. Saeed Lootah • Industry is a 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 Training Institutes • Market size estimated at about USD 950 billion globally • Growing at 15 to 20% per annum • Within 8-10 years, industry estimated to capture half the savings of the 1.6 billion Muslim world2 • Estimated to grow to USD 1.3 trillion by 2012 • Industry has global scale • More than 500 Islamic banks worldwide operating in over 75 countries1 • GCC accounts for two-thirds of global Islamic assets4 • Malaysia leading industry maturity and sophistication • Islamic Development Bank: largest pan-OIC financial institution Islamic banking assets as proportion of total (%) * 40% 33% growth 30% 20% 66% growth 12% Industry is fragmented and is gradually evolving and internationalising

17. 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 as 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 have embraced Islamic banking

18. Product Areas 1970s 1980s 1990s 2000+ Murabaha Ijara Takaful Equities Sukuk al-Ijara Structured Alternate Assets Product Development Over the Years

19. 1970s 1980s 1990s 2000+ • Retail • High Net-Worth • Islamic Financials • Non-Bank Financials • Institutions • Endowments • Ministries • Pension Funds • Governments • Local Govt • Central Banks • Investment Agents Developing nature of the client base • Retail sector has been the historic backbone to the industry’s recent development • Increasing trend of regional corporations tapping into Islamic markets for fundraising • Public sector and pension funds are key to next phase of industry development Biggest industry customers still waiting in the wings

20. Mature Maturing Emerging Development areas and products • Achieving depth across range would enable industry to capture NBFI, Institutional and government assets Real estate Equity Structured products Challenges to overcome Sophisticated client investment product depth needs • Achieving Shariah-compliance while building out asset range and depth • Achieving scale and capital efficiency • Attracting experienced and dedicated human capital • Real estate: REIT laws in OIC countries • Lack of Islamic private equity managers Cash management Fixed income Private equity Hedging products

21. 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

22. Overview of the Islamic Financial Service Industry Phases of Expansion 2000-2010 1970-1980 1980-2000 EMERGENCE EXPANSION BIRTH • Commercial Islamic banks • Islamic investment companies • Islamic insurance companies • Islamic investment banks • Islamic asset management • Islamic retail banks • Islamic brokers • Islamic internet companies • Islamic capital and financial markets • Commercial Islamic Banks • Commercial Islamic Banks • Islamic investment companies • Islamic Insurance companies EUROPE N. AMERICA ME GULF ASIA AFRICA S. AMERICA OCEANIA

23. Overview of the Islamic Financial Service Industry Offering Evolution 1970-1980 BASIC CONVENTIONAL 1980-2000 STRUCTURED 2000-2010 FULL ADDED VALUE • Trade finance • Working capital Finance • Project finance • Leasing • Capital markets • Insurance products • Debt capital market • Asset management • Funds • Islamic Indices • Retail products and services • Engineering capabilities • Wide range of P/S • More sophisticated offering • Return to investors become comparable to conventional benchmarks • Structuring Sharia compliant products and services in both Banking and Insurance • Replicate conventional basic banking PS • Sharia compliant substitute • // • Non Muslims who subscribe to ethical investment philosophy • // • // • Non Muslims who find Risk/Return Features attractive( 90% of HSBC’s corporate customers of its Islamic banking services are not Islamic companies) • Muslims to meet their religious obligations AREAS METHOD TARGET

24. Overview of the Islamic Financial Service Industry Worldwide Acceptability 1970-1990 1990-1997 1997-2010 A Folly System in the modern Economy Theoretically viable in the Modern Economy Globally accepted as a genuine alternative of Modern Finance • The challenge came from western analysts who suggested the folly of a system based on 0% interest rate on investment • The BBC and The Wall street journal qualified Islamic finance: • As a ‘voodoo’ economy • There is a clear recognition of the viability of the Islamic system and it’s firm significance in today’s finance worldwide • Islamic finance is an efficient and productive way of financial intermediation • Is Globally accepted • A system which prohibited a fixed ex-ante interest rate • Allowing the capital rate of return to be determined ex-post (based on the return to the economic activity) • Is theoretically viable

25. Mainstream Relevance Sovereigns, MNC’s and International Companies are tapping the growing IFI 5

26. Islamic Banking and Finance - Regional and Global Growth • Source: Maris Strategies & The Banker

27. Top 25 IBF Institutions by Shari’ah Compliant Assets

28. Top 25 Countries by Shari’ah Compliant Assets

29. Geographical Distribution of Reported Shari’ah Assets, GCC, 2009 (% Distribution)

30. Geographical Distribution of Reported Shari’ah Assets, Non-GCC MENA, 2009 (% Distribution)

31. Geographical Distribution of Reported Shari’ah Assets, Non-MENA Global, 2009 (% Distribution)

32. Institutions Registered for Shari’ah Compliant Products

33. Trends in the Number of Islamic Banks and Windows

34. Top 25 Fastest Growing IBF Institutions

35. New Entrants IBF Institutions

36. Global Islamic Fund Management Industry As the figure indicates, there has been a shift away from traditional asset classes such as equities and real estate funds with a number of new asset classes being introduced including Shari’ah compliant ETFs and hedge funds.

37. Global Islamic Fund Management Industry Assets Under Management of Islamic Funds by Categories (Q1 2010) As the figure depicts, however, overall Islamic funds still remains concentrated in traditional asset classes such as equities and fixed income.

38. The Dow Jones Islamic Market 100 Index- Performance, 2005 -2010

39. The Dow Jones Islamic Market 100 Index- Performance, 2008-2010

40. Developments in Sukuk Global Sukuk Issuance

41. FOCUS ON ISLAMIC POTENTIAL MARKETSIslamic Financial Service Industry: A Huge Potential • About 20-25% of the total population worldwide are Muslims, their global wealth is estimated at $3 trillions, the penetration of the Islamic financial service industry is still embryonic (less than 10%) • Within 8 to 10 years, as much as half the savings of the world’s then 1.6 billion Muslims would be in Islamic banks • The global Islamic insurance (Takaful) market is estimated to reach USD 14.4 billion by 2010 • 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

42. Focus On Islamic Potential MarketsIslamic Financial Service Industry: A Huge Potential

43. CONCLUSION • Islamic consumers are a niche market; but Islamic finance is no longer a niche market; • It is a market with huge growth potential; • Established institutions with a large consumer base are in a unique position to enhance “share of wallet” through Islamic products; • Reputed financial institutions providing competitive Islamic product will experience increased market share and bottom line success. Thank you…

44. “Through our scientific genius we have made this world a neighborhood; now through our moral and spiritual development, we must make it a brotherhood.” – Martin Luther King “If there is to be a human future, we must bring ourselves into balanced relationship with one another and the earth. This requires building economies with heart.” (David Korten, Author of “When Corporations Rule the World”)