Islamic Finance: 3,000 year old Financial Innovation

Finance is a massive and dynamic industry which generates more media coverage, macroeconomic fluctuations and social upheaval than any other. Yet, it is strangely short on innovation. Ask somebody – even from the broader financial sphere about innovations in finance in the past forty years and the answers might could range from internet banking to sophisticated debt instruments.

Given the relative lack of innovation, it could come as a surprise that so few consider the growing realm of Islamic finance. True, Islamic (or Sharia complaint) finance in some form has been in existence for close to 3,000 years. However, it was really in Mit Ghamr in Egypt in the 1980s that the modern version of what we consider to be Islamic Finance began. And despite this – undoubtedly important – addition to financial innovation, many financiers could do with a better understanding of what Islamic Finance means.

Gaining an Understanding

Islamic Finance is comprised of two components, both of which are clearly defined for practitioners. The first is that loans are always equity-based. That is to say that interest on loans (sometimes referred to as “usury” or “Riba” in Arabic) is forbidden by Sharia law. In theory, this means that there is risk-sharing involved but this perhaps overlooks the idea that interest-bearing loans have an element of risk-sharing as well.

The second component is that investments must be “socially responsible.” This means that shares in arms, alcohol, tobacco and the like are not available to practitioners of Islamic Finance. These shares comprise a smaller and smaller part of the world of finance in any case, but given the myriad of inter-connected interests in the world of finance, some grey areas may appear at times (in the case of investing in suppliers to one of the above industries, for example).

So, for from being a concept which excludes those outside of the Muslim community, Islamic Finance is an inclusive and easily understandable form of finance. Perhaps it is for this reason that secular states outside of the Middle East have begun to see its appeal as a means of financing their spiralling government debt. In 2014, the Central Bank of England released plans for its first issue of £200m Sukuk bonds. The UK’s Chancellor of the Exchequer George Osborne even went as far as to say that his aim was to turn London into ““unrivalled western center for Islamic finance” This is just the tip of the iceberg of an industry which has grown strongly since the 1980s, weathering most of the financial storms in the interim.

A Growing Industry

As always, growth forecasts for the Islamic Finance industry vary depending on which source you turn to. What isn’t in question is that the industry will continue to grow. Perhaps some of the growth will be tempered by falling oil prices, which contributed to much of the growth, but this industry will provide resilient. One look at its growth until now is a testament to this. As the graph below shows, in the years after 2006 – when the global financial crisis was at its peak – the global assets of Islamic Finance grew year on year.

Now, the near US$ 2 trillion industry is forecast to hit the US$ 4 trillion mark within 5 years. An industry of this size can hardly be considered a fringe element of finance. And perhaps the first real test for any sector of the financial industry only comes in the aftermath of a crisis – how the sector recovers both in monetary and reputational terms. Even on this count, Islamic Finance should be better poised than most corners of the financial world.

A Risk Profile of Islamic Finance

Islamic Finance is, by its very nature, low risk and low return. This runs somewhat contrary to the speculative nature of the Anglo-Saxon model for investing which has come under such scrutiny in the past ten years. It means that some of the complex derivatives that gained such notoriety (“weapons of financial mass destruction”) are extremely limited in use by Islamic Finance Institutions (for now at least – again, let us observe how this pattern continues when growth starts to tail off at the higher end of the industry).

This limited use of derivatives, minimal leverage and preference for low-risk asset classes in turn means that Islamic financial institutions generally have substantially higher capital adequacy rations than their Western counterparts. Whereas many of the large Western banks still have some way to go to meet Basel III requirements (and indeed, some will probably fail to meet the requirements at all), most Islamic Financial Institutions have already passed the capital adequacy tests with some ease.

Coming to a Retail Bank near you

The tents of Islamic finance are those which most retail investors would agree should form the tenets of sensible, long-term investing: risk management, minimal leverage, minimal moral hazard and transparency, all within a socially responsible framework. Once investors have grasped that that Islamic finance has no religious consequences for them, it might be that the industry really begins to take off across the world.

Predicting the future for any sector or industry is a fool’s errand but perhaps all investors would be well advised to familiarize themselves with Islamic Finance. Giants of the retail banking world such as Crédit Agricole, Barclays and HSBC are investing ever-increasing resources in the sector, suggesting that they see a future for it both in Muslim and non-Muslim states. The UK government’s bond will surely be the first of several such government bonds looking for a piece of the ever-growing action.

This article began by suggesting that , for an industry of such size and dynamism, innovation has been rather short on the ground in finance in the past 30 years. The ongoing success of an “innovation” like Islamic Finance might well be an indication that the best investment vehicles were the ones that were essentially available to us thousands of years ago – sensible, low risk, low moral hazard investments.