Islamic banking special: Money not seen as a commodity

Islamic finance refers to a system of banking and other financial activities that are in conformity with the principles of Sharia.
In the context of financial activities, Sharia prohibits dealing in interest, speculative transactions, excessive risk taking, and gambling. Money is seen only as a medium of exchange, and not as a commodity that generates incremental returns.

Islamic financial institutions can profit by risk sharing or by participating in the creation of a productive asset.

In practice, Islamic banks offer a range of products that are comparable to those offered by conventional institutions. At times, it may appear that these products are very similar to conventional products. However, the difference is in the underlying Sharia contracts, which define the roles, risks and rewards for each party involved. Advocates of Islamic finance maintain that the relationships under Sharia contracts are more equitable in terms or risk and reward sharing.

In addition to banking, Islamic financial system comprises takaful and Islamic capital markets. Takaful is similar to conventional cooperative insurance whereby participants pool their funds for their mutual benefit. It is based on the principles of ta'awun (mutual assistance).

And finally, the most notable development in Islamic capital market has been the advent of sukuks. Sukuks can be considered the Sharia-compliant form of conventional bonds, although there are once again striking dissimilarities between them both.
The growing acceptability of sukuks in international market means that the instrument could be used for financing infrastructure projects and stimulating corporate activity, which should be a good omen for Oman's economy.

Market size and growth
The market for Islamic finance has grown rapidly over the past decade. Global Sharia-compliant assets are estimated to have crossed $1 trillion in 2010. The industry is growing at a sustainable 15-30 per cent per annum, and has certainly gained recognition within the mainstream global finance. Muslims across the world have shown increasing propensity to adopt Islamic finance, reinforcing greater adherence to Sharia in their economic matters. At the current pace, Islamic assets are expected to quadruple to $4 trillion by 2020.

As a result, more financial institutions are beginning to offer Islamic financial services.

There are dedicated Islamic banks that only offer Sharia products. In addition, a number of conventional financial institutions offer Islamic products through window operation. Islamic banking windows are required to maintain separate books for Islamic and conventional businesses. All activities are regulated by the central bank, and monitored through the bank's Sharia advisory board and Sharia compliance officers.
For banks in Oman, the Islamic banking opportunity could be substantial. In Saudi Arabia, Sharia-compliant financing account for 57 per cent of the total lending and all of the retail banking activity is Sharia compliant.

In the UAE and Qatar, share of Islamic banking assets have grown at a compounded annual growth rate (CARG) of 38 per cent and 50 per cent respectively, over past several years. If lessons from these markets are any indication of how Islamic banking would evolve in Oman, one can be sure that Islamic banks and windows are set to capture a significant share of the market over coming months.

Impact of global crises
The recent global crises exposed many of the shortcomings of conventional banking system. Highly leveraged balance sheets and transactions with little or no linkage to the real economy led to significant losses. It is also fair to say that Islamic banks, while not affected by the crises to the same extent as conventional banks, had their own share of challenges. These institutions were significantly affected by the real estate correction in the GCC countries.

Building blocks for growth
Oman can learn from experiences of other markets. For Islamic windows and banks, the true opportunity lies in structuring a scalable operation, understanding the needs of the Islamic customer segment, developing a rich product offering, and investing to develop necessary Islamic banking skills.

One of the major issues with Islamic banks is their relatively small size. A consequence of having a small capital base is their inability to participate in large projects, hence a missed opportunity to make a meaningful economic impact. As banks in Oman mull over their Islamic banking strategies, it will be important to position the offering for long-term scalable growth.
Positioning strategy for banks would be driven by the needs of their target market. Typically, banks would initially compete for core Islamic customers who are motivated solely by their religious beliefs and would only work around Islamic products.

This segment, however, is a relatively small part of the overall banking population. The real opportunity lies with the mainstream customers who seek Sharia-compliant products as an add-on, and desirable, feature of their banking relationships, and only if all other aspects like product, service and convenience are at par with leading financial institutions. Sustainable growth for banks in Oman will come from carefully listening to their customers, and tailoring their strategy and operating model to fit their needs.

A third aspect is the range of products offered by Islamic banks. The topic of standardisation of contracts and instruments within the Islamic financial industry remains one for discussion.
Islamic contracts

The choice of Islamic contracts has implications for the overall risk profile of the bank. For example, a car financing based on Murabaha contract would have different risk and regulatory capital implications as compared to car financing based on Ijara principles. To improve this situation, many jurisdictions require Islamic banks to have documented product programmes to safeguard the interest of shareholders and customers.

And finally, despite the impressive developments in Islamic finance, there remains a shortage of skilled professionals who are conversant in both banking and Sharia knowledge.
The result is a majority of resources within the industry only have academic knowledge of practical application of Sharia in banking business. Banks that make serious investment in developing their talent pool are likely to come out more successful.

Oman has a population of 2.9 million and a GDP size of circa $50 billion. Total banking system assets were $42 billion in 2010. A successful roll out of Islamic banking system could easily see the industry gaining up to $6 billion in Islamic assets over next few years.

Managing expectations
A credible Islamic banking proposition would require banks to build an operating model aligned to their customer needs. This has implications on the capital size, lines of business, product segments, finance, business processes and governance framework. In the following article, we will elaborate on the more common Islamic products and their application.

Ashar Nazim and Abid Shakeel - two experts on Islamic finance - are employed with the Islamic Finance Centre of Excellence at Ernst and Young in Bahrain. Nazim is a director and leads the Islamic Finance Center of Excellence at E&Y, while Shakeel leads the banking, capital markets and takaful team within the Islamic Financial Centre of Excellence of E&Y.

The views expressed by our
contributing writers in the article are their own and
may not necessarily reflect those of Times of Oman.

Part: ii (Special to Times of Oman)