ISLAMIC FINANCE GROWTH AND DEVELOPMENT IN MALAYSIA

Amidst the global financial turmoil and harsh critiques that conventional banking is facing, Islamic banking system has emerged as a vibrant alternative in Malaysia. In this nation of 25 million people, few financial sectors have grown as quickly as the Islamic banking industry, whose religious precepts have struck a nerve not only with the older generations but with younger investors as well. An interesting point to note is that, Islamic finance in Malaysia is generally well accepted among all Malaysians—non-Muslims lead in subscribing to Islamic finance products and services.

It is widely known that Islamic financial services are among the fastest growing fields in the banking and finance industry. In its annual intelligence report, McKinsey & Co stated that Islamic banking assets and assets under management reached US$750 billion in 2006 and are expected to reach US$1 trillion by 2010. The financial authorities in the central bank, Bank Negara, as well as the Malaysian government and Kuala Lumpur’s banking community, understood the potential of this trend and sought to create the right conditions in which the nascent industry could thrive. Capitalising on the existing infrastructure and comprehensive local Islamic financial system, which has been developed for almost 30 years, the Malaysia International Islamic Financial Centre (MIFC), a strategic body that spearheads the development of Malaysia as an international Islamic financial hub, was set up in 2006 to promote Malaysia’s expertise in Islamic banking. Also in 2006, Malaysia, again led by its central bank, founded the International Centre for Education in Islamic Finance (INCEIF) as a global university for Islamic finance.

With all systems in place and the right knowledge and human capital, Malaysia spearheaded the world’s first global sovereign sukuk, when others were still hesitant, if not resistant. It became host to the Islamic financial services board, a standard-setting body that seeks to harmonise prudential, supervisory and disclosure practices in the global Islamic finance industry.

SURVIVAL OF THE FITTEST.....

As activity slowed to a crawl last year, one joke making the rounds among Islamic finance professionals was that the only groups still making money from the industry were conference organisers. And no wonder. The rapid rise in the profile of Islamic finance and the ever-increasing amounts of money flowing into the sector have spurred equally impressive growth in dedicated conferences. Sukuk, private equity, real estate, project finance, hedge funds: as each and everything that could possibly be made Shariah-compliant became hotter, organisers have matched them with every forum, symposium, seminar or summit possible.

“The conferences focusing on Islamic finance, like the industry itself, has witnessed extraordinary growth, especially over the past three or four years, which has seen many generalist conference companies dabble in the market,” says David McLean, managing director of Mega Events, Dubai.

In the quarter to December last year alone, there were no fewer than 30 Islamic finance-themed conferences held in Asia, Europe and the Middle East. In London, last summer it was possible for a banker to network at least once a week through an Islamic finance event, which are as much about discourse as they are about the informal mingling of suits and ties.

But quantity does not always mirror quality. While attendees are reluctant to criticise any conferences publicly, the consensus is that the huge increase in the events has meant a decrease in the number genuinely productive and worth attending. Only a handful of conferences stand out when executives are asked what they won’t miss, come rain, shine or snow

ARE WE RESILIENT OR ARE WE AT RISK ?

In advertising the first Asia Sukuk Summit 2009, the Hong Kong Monetary Authority offered this quote from the International Monetary Fund: “The Islamic financial system may be in a better position to withstand shocks in the global financial system than its conventional counterpart.”

It goes on to say: “Promoting dialogue and exchanges among financial markets and industry professionals is important in addressing some of the key challenges the [Islamic financial] industry faces, such as consensus on international standards and global awareness. Greater transparency and harnessing of standards are therefore demanded to push the industry to the next level of development, and it would not have been possible without the collective efforts of regulators and market players in respective regions.”

The above quotes provide rather conflicting views of Islamic finance. On the one hand, the Islamic financial system may be more resilient yet it needs to be pushed to the next level of development for the sake of “greater transparency and harnessing of standards”. One may wonder whether the resilience of the Islamic financial system rests on its lack of development, transparency or standards and if this is true, whether the conventional wisdom must apply: “If it ain’t broke, don’t fix it.”

Since the flare-up of the international financial crisis, it has become fashionable to cite the immunity of Islamic finance to financial crises as a testament of its resilience. This is obviously a self serving argument and an exercise in delusion. Islamic finance, as practised today, places the industry in a more vulnerable situation than conventional finance. The real issue is not the intrinsic resilience of Islamic finance, but that the industry has not yet faced the same conditions as conventional finance has faced. Islamic finance will likely traverse a far more dangerous terrain if it continues on its present path.

(Extracted from Islamic banking and finance, Issue 21)

WHY A MADOFF SCANDAL COULDN'T HAPPEN IN ISLAMIC FINANCE

The Madoff scandal reveals a major weakness in the hedge fund business, resulting in the fraudulent activity that is the fuel behind speculative bubbles and the “magic” behind all financial scams. No-one in recent times has exploited this as blatantly as Wall Street major player Bernard Madoff, a former NASDAQ chairman arrested for allegedly running the biggest dollar Ponzi scheme of all time.

His victims include wealthy friends and family as well as banks and numerous financial institutions such as HSBC Bank, BNP Paribas Bank, Fortis Bank, Bank Medici, Fairfield Greenwich, Nicola “Supermum” Horlick’s Bramdean Alternatives and many more, valued in total at more than $50bn. This figure raises questions. How could such a large shortfall have arisen, given that Bernard Madoff Investment Securities had assets of only $17bn under management at the start of the year? The funds run by Madoff were not advertised as being leveraged, although derivatives were supposedly used to reduce volatility. But who now knows? Nothing about his “black box” investment process can now be believed.

The supposition is that it was a giant Ponzi scheme, with returns funded by new investors. But if that is the case, Mr Madoff must have been raising hundreds of millions of dollars a month to achieve his alleged returns of about 10% a year. In these markets, however, raising that kind of money is tricky and his downfall came when some investors actually asked for their money back, as investors will now do from a host of other funds.

The biggest question is how a scam of this size can remain a secret for so long? This is especially pertinent considering that there had been suspicions about Mr Madoff’s consistent record for some time. Even if he was working alone, sophisticated investors as well as the SEC are accountable for negligence in their failure to perform risk assessment or report on unusual performance which could be the result of fraud on a large scale. Risk assessment in the conventional system needs to be re-examined.

WA'AD SWAP - SHARIAH COMPLIANT OR NOT?

At the 2008 Islamic Funds World conference held in Dubai, two top industry figures put forward opposing views on the wa'ad swap - the promise agreement with which returns from one basket of assets are swapped with returns from another. Increasingly, this mechanism is being used to give Shariah compliant investors exposure to returns from haram, or non-Shariah compliant, assets.

Supporters of the technique say that it is no different to issuing a sukuk, for example, against the LIBOR (London Inter-Bank Offered Rate) benchmark, which is widely used in pricing Islamic bonds even though it is an interest rate.

Shaykh Yusuf Talal DeLorenzo, chief Shariah officer and board member, Shariah Capital, is a staunch opponent of the wa'ad swap with haram returns. "The purpose of this swap is to bring returns that are not compliant to Shariah investors - and everyone knows it," he told the audience. "It is a mistake to say that the haram basket is no more than a benchmark. All that happens is the non-Shariah basket of assets sets a benchmark and it's no different from LIBOR - wrong." He said that the comparison with LIBOR was inappropriate, since the interest itself, rather than the benchmark rate, is the forbidden part." As a mere benchmark it has nothing to do with the transaction," DeLorenzo said. "In a wa'ad swap it is what creates the returns, and that is the problem." LIBOR for ijara is totally unrelated to the ijara transaction. With the haram basket of assets, its performance is directly related to the return. The funding, whether it's direct or indirect, is there." He pointed out that LIBOR has been approved by Shariah boards for use as a benchmark for Islamic returns."There is no participation by Muslim investors in LIBOR - it's the business of the London banks," he added.

DeLorenzo argued that a Muslim investor taking part in a wa'ad swap is implicated in every investment decision the bank subsequently takes with his funds. "When you accept this investment product, you accept the whole series, whether you know it or not," he said. "As the money moves, its character changes." DeLorenzo concluded by saying: "If you're going to swap returns of one basket of performing assets for another, then you must insist that the assets in both baskets are halal. "Only then can you be sure of receiving returns that are halal."

Taking a slightly different view was Dr Hussein Hassan, director of Islamic finance structuring for Deutsche Bank UAE, which has pioneered Shariah compliant products that give Islamic investors exposure to non-Shariah returns.

In the specific mechanism outlined in the white paper issued by Deutsche Bank in 2007, the wa'ad swap is an agreement between the bank and the investor to swap the returns from two baskets of performing assets, which are kept entirely separate and do not interfere with each other. When the assets are deposited with the bank, it agrees with the investor to hand over the return from the basket of haram assets at the due date, in return for the return from the basket of Shariah compliant assets. The Islamic investor therefore takes the risk that the Shariah compliant assets he deposited with the bank could outperform the haram returns he will receive when the swap is conducted. For this reason, two agreements need to be signed to ensure that both sides carry out their obligations on the due date. He said that he expected a greater range of benchmarks to be available to the Islamic finance industry in future, making it easier to create Shariah compliant investment products that are linked to other assets.

Alka Banerjee, chairperson of Standard & Poor's index committee, also argued that more Islamic benchmarks were necessary to develop the industry. "Commodities is one that's really crying out for indices," she said. "That's a no-brainer. They are a big source of revenue for most Islamic countries and we do not have a commodities index right now. All commodities indices are based on futures pricing and futures are not Shariah complaint, so until the scholars come up with an acceptable form of pricing that index, it's waiting to happen." She predicted that Islamic ETFs (exchange traded funds) would take off in the next two years, and called for more breadth and depth in the Islamic funds industry, something that was echoed by other participants.