ISLAMIC FINANCE MART NEEDS MORE HYBRID PRODUCTS

(Extracted from Business Times, February 20, 2009)

The Islamic finance market is in need of more hybrid products to meet the increasingly sophisticated needs of corporate clients, said Zain Ibrahim & Co (ZICO) chairman Datuk Dr Nik Norzrul Thani.

Local players must grab the opportunity to become more product innovative, taking advantage of the strong Islamic finance framework already provided by the authorities.

"Japan and Hong Kong are now keen (to venture) into this market and if we could become more innovative, we could easily export our expertise," Nik Norzrul told Business Times in an interview.

Nik Norzrul, a former dean at the International Islamic University Malaysia, said the presence of foreign Islamic banks in Malaysia has been positive.

"The competition has brought about more product innovation among the local players, although there is still a lot of room for improvement," he said.

Nik Norzrul advises clients on a wide range of legal matters incorporating Islamic finance, banking, offshore finance, debt restructuring, international, corporate and commercial law.

A director of Al Rajhi Banking and Investment Corporation (Malaysia) Bhd, he has also written several articles on corporate and financial issues, particularly on Islamic banking.

ZICO is the country's largest legal firm and is active in Islamic finance locally and regionally. It has presence in Indonesia, Singapore and Thailand.

It is the first law firm in Malaysia to establish a shariah advisory firm called ZI Shariah and will soon open an office in Dubai.

ZI Shariah, which is licensed by the Securities Commission to advise on sukuk, has advised clients from the Middle East who came to Malaysia on syariah framework.

The advisory services include not only for the Islamic banking legal matters, but also on personal Islamic financing and syariah-compliant wealth management.

"We have done this quite successfully with the Middle East clients and we are now contemplating to open an office in the region, maybe in Dubai," Nik Norzrul said.

Realising the growing importance of Islamic finance globally, especially among those from the Middle East who are flushed with cash, ZI Shariah has hired Arab-speaking lawyers as well as Arabic classes are being provided for its lawyers and staff.

Nik Norzrul said apart from language, legal advisers must be well equipped in understanding the syariah field, especially in the area of Islamic financing.

There is still lack of experts in this area, he said, when compared with the huge demand for Islamic financial products.

"In Malaysia, for example, why is that Muslims are still generally hesitant to engage an expert in Islamic financial management? Why is there still this assumption that Muslims cannot have wills?" he asked.

Nik Norzrul said this is an area that posed great potential and shariah lawyers should be well equipped with Islamic financial management skill.

"Muslim lawyers can play the role of family counsellors and advise Muslims to plan their finances properly before their death," he added.

My comment :

This is a good example that Malaysians can go far with their knowledge in Islamic finance, even establish their own firm in the GCC and not restrict their presence in the South East Asia region only. After all, there are nearly I billion Muslims worldwide - one must also remember that Islamic finance is not only restricted to Muslims but can attract a lot of non-Muslims as well.

RISK MANAGEMENT IN ISLAMIC FINANCE

Risk management for Islamic banking financial products and services is one of the greatest challenges that many westernized, as well as Islamic Banks, are facing today.

As a result of this market growth in Islamic financial products there is a high demand to understand how to assess and manage the risks arising from applying these products and services. Credit, operational, market and liquidity risks together with the risk of non-compliance with the Shariah law are becoming very hot issues for financial institutions. This book presents a common framework of how to efficiently manage the risks faced and minimise the overall degree of Islamic financial risks.

Below is the view of Dr Shamshad Akhtar (Governor, State Bank of Pakistan published in The Banker on September 1, 2008)

Islamic finance has grown substantively in the past few years and with it there has been a growing interest and debate on the appreciation of its risk architecture and profile. It is now well recognised that, by and large, Islamic banks are prone to the same risks as conventional banks. Concurrently, however, Islamic banks face additional risks that emanate from the unique characteristics of Islamic finance transactions, along with risks associated with the real or perceived non-compliance of Shariah principles that may erode customer/investor confidence.

To understand the complexities of an appropriate risk and reward-sharing mechanism embedded in Islamic finance transactions, a better understanding of the management and mitigation of the risks associated with certain Islamic products is necessary. This requires a change of mindset for both the Islamic banking industry and the regulators, whose primary focus has been debt-based financial intermediation.

At the same time, it requires the development of a financial, legal and regulatory infrastructure to help manage principal agent-entrepreneur relationships in profit and loss-sharing transactions, where commercial banks are exposed directly to equity exposures of partners in business while catering for investment account holders’ concerns.

Most importantly, Islamic banks are generally exposed to substantial liquidity risk owing to the lack of access to standardised sharia-compliant investment portfolios and liquidity management instruments. This has affected their ability to successfully manage the maturity profile of both assets and liabilities, and has curtailed diversification.

Lack of instruments
Risk management in Islamic finance is further complicated by the lack of adequate risk hedging instruments and techniques. Shariah prohibition of riba and gharar means many techniques based on conventional tools, such as options, futures, and forwards, are not yet available to Islamic banks and this lack has increased banks’ vulnerability to foreign exchange, interest rate, commodity and equity price risks.

In order to address liquidity risks, the Islamic financial industry must develop appropriate liquidity management instruments. Moreover, the compound risks faced by Islamic banks have necessitated the development of a shariah-compliant derivatives market. Besides providing hedging, such derivative instruments are expected to improve transactional efficiency. However, further progress in this area would require substantial research and employment of financial engineering and innovation.
Further, the disclosure regime in Islamic banking needs to improve to ensure proper market discipline, removal of information asymmetries, better risk-return profile, building trust in shariah-compliance and improvement in internal governance. Better disclosure would also contribute towards the development of equity-based financing such as mudaraba and musharaka.

Consistent with the best practices of the corporate governance framework, Islamic banks also need to conform to its well-accepted and time-tested principles, in recognition of the fact that shariah offers a stakeholder-oriented model of corporate governance implicit in Islamic property and contract provisions. Also, the model of governance is affected by the role of investors as depositors, in addition to the oversight of Islamic banks by shariah advisory boards, and is critical for ensuring credibility and sanctity.

Regulatory framework
Work also needs to be accelerated to develop proper understanding of prudential regulations and shariah inspection and supervision of Islamic banks. Guidance on a prudential regulatory framework should incorporate appropriate amendment and refinements to the Basel II framework or other best practices, with the objective of providing effective treatment of risks associated with Islamic products and balance sheets.

There has been considerable movement in recent times in the development and promulgation of international best practices in Islamic risk management principles. In this regard, the work done by international bodies such as the Islamic Financial Services Board guides the industry and regulators. Notwithstanding, as the risk architecture for Islamic finance continues to evolve, a fuller appreciation of its risks will emerge as more empirical evidence comes forth with the growth in the size of the industry.

My comment :

I somehow agree with the above view. There is already a framework in terms of reporting (even though, they are non-conclusive as yet, but efforts are being made towards that direction) for Islamic financial institutions developed by AAOIFI, however, it is sad to note that only a few countries/organizations have made it compulsory to adopt it (e.g., Bahrain, Jordan and Dubai International Financial Centre). What about the other member countries or OIC? With the standardization, comparability can be made and the framework can cover the unique and peculiar characteristics that are only available in Islamic financial institutions.

Islamic finance also lacks financial instrument – what we have now, is just a direct replication of the conventional instruments, with the deletion of the word interest etc. But the substance remains the same. Therefore, efforts must be made, especially by the learned Islamic finance scholars and with the necessary support by the Central Banks and Governments to promote development of innovative and full-fledge shariah-compliant financial instruments that are accepted worldwide – we do not want a product, e.g. Bai Bithaman Ajil that is accepted in Malaysia but rejected everywhere else in the world.