November 9, 2003

Islamic banking is picking up at a time when interest rates are low and Muslim nationalism is on a high. While religious extremism is taboo, global financial institutions now covet a lucrative business in a region stretching from Indonesia to Morocco

HELPED by a faltering global financial market and a growing demand for Shariah-compliant products, Islamic banking has carved out a niche market in a fiercely competitive environment.

In the $43 trillion global industry, the total assets of Islamic banks is $360 billion, though small, but growing rapidly by 15 per cent per year. It has induced multilateral donors and financial institutions to consider how to integrate Islamic banking into the global financial architecture.

One of the topics of the seminar organized by the International Monetary Fund (IMF) on the eve of the recent World Bank/Fund annual meeting in Dubai was ‘Islamic Finance in the Context of the Middle East and Africa’. The issue, mind you, was not of its acceptability, but how to go about it.

The question posed at the seminar was: ‘Should Islamic financial institutions be integrated into the existing international regulatory and supervisory architecture, or is a special framework needed in the light of their distinct structure and operations?’

While recognizing the challenges, the secretary-general of the Basle Committee on Banking Supervision — Basle being the central bank of all central banks — observed that “the internationally acceptable standards were a good starting point”. Despite differences on the core issue of Riba, there is some commonality in the two systems; leasing business, for instance.

To develop a viable Islamic banking system, the Muslim countries are developing a separate regulatory framework. An Islamic Finances Service Board has been set up at Kuala Lumpur to formulate international standards for Islamic financial institutions.

The response of the international financial markets towards Islamic banking has been positive. Moody’s Investment Service estimates that the total global assets of Islamic banking stand at $360 billion. It means business that cannot be ignored. Andrew Cunningham, senior vice-president of Moody’s, says that integration of Islamic financial institutions in the global market is both “desirable and feasible”.

It is now increasingly being recognized that the growth potential of Islamic finance is enormous, given not only the huge wealth in Muslim world, but the interest shown by the international financial community.

In the last week of October, a two-member team from a German financial institution, FWU group, visited Pakistan to offer its services in developing Sharia-compliant banking and insurance products, systems and procedures on the basis of the expertise they had acquired in Saudi Arabia. The two-member team comprised Dr Manfred J. Dirrheimer and Sohail Jaffer.

The present global financial system is designed to transfer capital from the poor countries to the rich states, and Islamic banking tends to somewhat deviate from this process.

A point of departure is: Islamic banking principles require financial transactions to be supported by genuine trade or business-related activities. In the absence of trade-related financing, conditions are created for a speculative environment and capital flows from the periphery to the global financial centres.

“Instead of moving towards equilibrium, financial markets left to their devices are able to go to their extremes and eventually break down,” says George Soros, and adds, “it must be supervised and to some extent managed.”

To elaborate, there is some $5-6 trillion mobile capital in the global financial market that moves in and out of countries, often destroying development economies. The daily global trading of currencies ranges between $2-2.5 trillion dollars, over ninety per cent of which is speculative. Currency, a medium of exchange, is now traded like commodities. The world’s leading banks and financial institutions thrive on this speculative environment. And, still worse, this is driving a wedge between money and economic development.

Quite a sizable profit of the world’s top banks and financial institutions is made through trading in currency and stocks. About 40-50 per cent of the bank revenues come from non-interest incomes. There is a move in the European Union to allow banks to operate as stock exchanges. If allowed, the move will further erode the core banking business of financing real economy.

Hit by the East Asian currency crisis of 1997, Malaysian prime minister Mahathir Mohammed had spoken out against the speculators, saying: “We need an international financial system that is fair and rewards hard work rather than speculative activities, that take advantage of the weak and the ill-informed. Speculation is not business. It is a kind of gambling. It gets worse when in an effort to ensure high returns, manipulative efforts are used.”

As Islamic banking principles require financial transactions to be supported by trade transactions, funding of non-trading activities such as currency speculation, derivatives and other non-productive financial manipulations are excluded.

“The basic tenets of Islamic banking prescribes a financial system that rewards productivity,” Mahathir had said, adding, “Well administered, the Islamic financial system will create a better social order while increasing wealth for everyone.”

By replacing the interest with profit-sharing as the reward for the use of capital, the speculative motive for the demand of money would be not entertained. Money would not be traded as a commodity as the bank would have to be involved in trading.

As it would appear, Islamic banking is picking up at a time when interest rates are low and Muslim nationalism is at one of its highest peaks. Whereas religious extremism is a taboo, global financial institutions covet a lucrative business in a region stretching from Indonesia to Morocco.

The global financial market is awash with money. Bank credit is cheap. Japanese interest rate is zero plus administrative charges. The US Fed rate is at one per cent. In Pakistan, the Treasury bill rate ranges between 1-1.5 per cent. Some local banks have made more money in trading of financial instruments, currency and stocks than from lending, benefiting from the financial sector reforms carried out since 1997. On the other hand, the depositors are getting a negative return on their savings.

In short, Islamic banking is making a breakthrough when both lending by commercial banks and interest rates are declining. This is also true for multilateral donors which often lend to countries at 0.5 or one per cent service charges to reward them for integrating their national economies into the global market. To achieve its strategic objectives, the United States targets selected countries which become eligible for grants. The growing global debt stock makes further loaning unfeasible.

The interest rates environment also suffers from volatility. Fix rate of interests has been replaced by fluctuating floating rates. The financially weaker borrowers pay a heavy price for it.

Usury has been prohibited by Islam as well as all other religions because money-lenders in the mediaeval age exploited individual borrowers. In the market economy, firms borrow to acquire leverage, enhance production, sales and profits. Big corporations that give big business to banks are able to get loans at the cheapest available rates.

In Pakistan, companies get loans at 2-3 per cent interest whereas micro-finance to the poor is offered at 18-20 per cent. Global studies have shown that micro-finance banks are more profitable than commercial banks.

It is no wonder that Dr Mahathir has repeatedly called for the reshaping of the international financial architecture for a balanced and stable growth. There is a need to strengthen the global financial infrastructure to deal with the inherent tendencies for the financial markets to be de-stabilized periodically.

Markets are subject to excesses, including manipulations and disruptive capital flows. The assumption that free market will be self-disciplined is erroneous. The free market cannot be left absolutely free. Governments should provide them with necessary regulations. Left to the market, we would have a total financial disaster.

In the 1980s, Pakistan tried to Islamize the whole financial system in an emerging market environment. It was a failure. Now, the approach has been changed. It has been left to the market demand.

Pervez Said, Director of the Islamic Banking Department and Advisor to the State Bank Governor, says that the approach of the regulators towards Islamic banking is to put together a viable Islamic banking system which will operate parallel to the conventional banking system, leaving the choice and the option to the people at large. There is a definite demand, he said, but people are a bit confused. They do not know what is what.

Pervez Said says the future of Islamic banking has to be seen from the perspective of regulators, providers and users. The State Bank will facilitate banks and standardize Shariah-compliant products for meaningful contribution.

The providers, Islamic banks, have to develop know-how and expertise and train their manpower in the skills to evolve the required system, procedures and standardize Shariah-compliant products.

As the economy is already over-banked, the State Bank does not issue any fresh banking licence. In view of the demand for interest-free financial products, however, the central bank has decided to give licence for Islamic commercial banks, subsidiaries and branches.

So far, five banks have applied for bank branches. The MCB branch has already gone functional, while applications from Habib Bank Limited, Bank of Khyber, Bank Al Falah and Habib Bank Zurich have been approved in principle, but these banks are required to acquire the relevant Islamic banking skills and fulfil the required criteria for Islamic banking. Some bankers are also talking to the central bank for opening of subsidiaries.

The first licence to operate an Islamic Commercial Bank was issued to Meezan Investment Bank on January 21, 2002. On September 17 the same year, the bank was formally inaugurated by President Pervez Musharraf.

The Meezan ownership shows how diverse interests are involved in the first experiment. Its shareholders include Jeddah-based Islamic Development Bank, French bank Societe Generale, Shamil Bank of Bahrain, Kuwait Awqaf and Pak-Kuwait and Pak-Saudi investment companies. As it is a listed company, the shares are also held by the general public.

In the short span of its operations, Meezan has increased its branches from five to eight and in the six months ending June 30, 2003, its total assets have gone up from Rs6.9 billion to Rs8.8 billion.

Murahaba is the most actively used financing contract to finance acquisition of assets and meet the working capital needs of the customer. Other financing modes include Ijarah, a leasing contract to finance plant, machinery and cars, and Istisna, which is used to finance the manufacturing of products.

At Meezan, says bank president Irfan Siddiqui, “we strive to find commonalities with the conventional banking system with no compromise on the Shariah rulings.”

The Sharia audit is done by a Shariah Board headed by Justice (retd) Muhammad Taqi Usmani. In its annual report 2002, the bank carries a report of the board with the following observation: “Some irregularities (from the Shariah point of view) were found in a number of lease and Murahaba transactions. The irregularities were of a nature that the validity of the transactions and the income derived therefrom was not affected. The irregularities were unintentional and the bank undertook not to repeat them in the future.”

The bank’s corporate customers include large multinationals and big local firms like ICI Pakistan, Novartis, Engro, Crescent, Gul Ahmed, Nishat, Rafhan and General Tyres.

On the international stage, as it appears from more and more frequent fiscal crises, finance capital has sure been hit by organic failures. In such a scenario, a change in the global financial system appears to be inevitable. It has to be seen how much space Islamic financial system can create for itself in the future.

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