The modern variant of Islamic banking and finance as we now know, has been around for more than three decades, closing in on 40 years. There is no doubting that Islamic Banking and Finance (IBF) has made huge strides. Today Islamic banking has a global presence operating in not just Muslim countries but several non-Muslim jurisdictions too. Though less pervasive, Islamic capital markets, in particular sukuk, have a global presence too. Sovereign sukuk for example have been issued by many Muslim governments and non-Muslim ones alike. Today the total assets of IBF is estimated to exceed $2 trillion. Though still small compared to conventional finance, the fact that a new model has taken root and established a global footprint within a fairly short time, is by any measure, a success.
The early proponents and practitioners of IBF aspired for a world in which it contributes to correcting the many problems and injustices that conventional banking and finance has produced. A more egalitarian world in which a value-based banking model reduces poverty, inequality and leads to fairness and justice. In fact some of the earlier experiments in Egypt for example, failed because the banking model was long on aspiration and short on the economics. The current version of IBF appears to have gotten the economics right by quite simply replicating conventional products. While such a strategy would have been sensible in the early days as IBF was seeking to get a foothold, the imitation now appears to have been carried on too far and for too long. What initially began as mimicking products, went further into replicating the processes and systems and finally even the regulations. The sheer absence of original-thinking and innovation has resulted in an IBF sector that is now hard to differentiate from its conventional counterpart. The basis of Islamic finance and its true value added, the risk-sharing philosophy has been relegated to insignificance. Today IBF is little more than another purveyor of debt.
Unfortunately, in choosing to play the same game of debt creation and money lending but having started at least a century later, IBF, despite its global footprint has serious gaps and inconsistencies. Much of these gaps are in some ways the result of an inability to compete and force a presence within a contested space. A first obvious gap is the inability of IBF to intermediate Muslim world resources to meet its own needs. For example, at least half of the world’s top twenty sovereign wealth funds (SWFs) come from the Muslim world. Their total assets are approximately $3 trillion. Yet, the average market capitalization of the top ten Muslim world stock exchanges is a mere $208 billion, the total value of outstanding sukuk is $320 billion and listed Islamic equity funds total a mere US$56 billion. It is obvious that Muslim SWF money has not gone into any of these IBF sectors. The entire Islamic banking sector has total assets of $1.5 trillion. Given its deposit-taking model, Islamic SWF money could not have gone into them either. What seems obvious is that intermediation between Muslim world surplus and deficit units is taking place via the financial centers of the west. The large Islamic SWFs invest their resources in the west, and Muslim world institutions in need of funds borrow/raise them from western banks. As a result, the value-added that comes from intermediation is lost together with the potential for high income employment.
The gap in intermediation is one of several gaps, another key gap being the disconnection between IBF and the funding for development needs. Just about every Muslim nation is economically an emerging market developing economy (EMDE). Their need for development infrastructure is massive. The World Bank estimates needed investment in development infrastructure to be at least $1 trillion per year. The consulting firm McKinsey Global estimates the need to reach $57 trillion by 2030. Much of these infrastructure funding needs are within the Muslim world, yet, IBF appears unable to bridge the gap. For example, of the $320 billion of sukuk outstanding, it is estimated that less than 10 percent has gone into infrastructure financing. The majority of sukuk have maturities of 5 years or less and mainly go to short-term working capital type financing. A similar picture emerges when Islamic banking assets are examined. A majority of Islamic bank financing revolves around personal financing, with most of the long-term financing being for home mortgages.
While Islamic banks and the other IBF players have been going head-long into replicating conventional products, an inconsistency has also arisen. There appears to have been insufficient attention to the development of Sharia compliant risk management tools to manage the resulting risks. Thus, even though the duration gaps of Islamic banks may be equal, if not larger than conventional ones, they lack the swaps and interest rate derivatives with which to hedge. Similarly, Islamic Mutual Funds have no Sharia compliant means by which to hedge their equity exposure. While conventional equity fund managers have a wide array of hedging instruments available: index options, index futures, portfolio insurance strategies etc, the Sharia compliant equity fund manager has none.
The ultimate gap within IBF is probably the near absence of risk sharing instruments/contracts. The risk-sharing philosophy may be at the heart of Islamic finance, but the percentage of outstanding sukuk or of Islamic bank financing under risk-sharing contracts is only in the vicinity of 15-20 percent. The majority of transactions within IBF is debt-based. Aside from missing out on the true value-added of Islamic finance, reliance on a replication strategy puts IBF on the path of convergence and possible irrelevance.
It is unfortunate that despite impressive growth, global presence and a system supposedly anchored in real assets, IBF has not had the kind impact expected of it. Had IBF beaten its own path, rather than follow that of conventional finance it would certainly have had a more meaningful impact.
