Is Islamic finance the new challenge to Wall Street?

I WAS in Kuala Lumpur in October attending the Global Islamic Finance Forum, organised by Bank Negara and the Malaysian International Islamic Finance Centre. The whole glitterati of the Islamic world was here, and coincidentally, the HSBC Asia Board also held its meeting, so it was also good time to catch up with all the Hong Kong good and great, including the incoming taipans at the bank.

In the 1990s, Islamic finance was a fledgling fringe industry. But today, its size has grown from roughly US$150bil to about US$1 trillion in size. This is, of course, still small relative to some of the largest global fund managers and universal banks, who manage more than US$1 trillion each. But the double-digit growth and potential size of the market cannot be ignored. Some pundits think that the market size will reach US$2 trillion within the next five years.

There are roughly 1.3 billion Muslims in the world, with 138 million in India and roughly 30 million in China. These are growing markets in terms of income and wealth. As the Muslim community seeks to invest in interest-free banking, Islamic funds have been growing in leaps and bounds. Today, there are roughly US$800bil in Islamic banking funds, US$100bil in the sukuk (or Islamic bond) market and another US$100bil in takaful (Islamic insurance) and fund management business. Hong Kong, of course, introduced the Hang Seng Syariah Compliant China Index Fund in 2008 to attract Muslim investors.

As oil prices continue to remain at high levels, the Middle East oil-producers will continue to generate surpluses that must be parked somewhere. With the Western markets and economies under pressure, some of that money has moved Eastwards.

Will Islamic finance be a serious challenge to traditional Wall Street finance' That is a question that deserves a good answer.

First of all, thanks to the good work of Bank Negara and the Gulf central banks, the infrastructure for Islamic finance has been laid, with the establishment of the Accounting and Auditing Organization for Islamic Financial Institutions or Aoffi, the Islamic accounting standards authority, the Islamic Financial Services Board or IFSB, the international Islamic financial regulatory standard-setting organisation and the Institute for Education in Islamic Finance or Inceif. The International Shariah Research Academy for Islamic Finance or Isra also provides an invaluable website that is increasingly the transparent source for syariah interpretations on what is considered acceptable under Islamic law.

For people unfamiliar with Islamic finance, the basic principle of Islamic banking is the sharing of profit and loss and the prohibition of usury. Simply put, interest is prohibited, but profit sharing is not. A cynic can say that with zero-interest rate policies adopted by advanced country central banks today, they are also practicing Islamic banking.

The distinctive elements of Islamic finance are its ethical element (the prohibition of usury and exploitation of the borrower), the preference for trading in real assets (rather than synthetic products), partnership between the investor and investee and its governance structure (requiring a syariah council).

The point to remember in Islamic finance is that there is no Islamic global reserve currency. Although Islamic banks are growing rapidly, there is no assurance that they are not subject to the problems of non-performing loans and bank runs that are endemic in commercial banking.

What has been most innovative was the launching this week of an International Islamic Liquidity Management Corp (IILM) aimed to assist institutions offering Islamic financial services in addressing their liquidity management in an efficient and effective manner. This institution addresses one of the fundamental problems of Islamic financial institutions the provision of adequate liquidity in times of stress. Once there is an international lender of last resort facility (to supplement and not to replace national facilities), there would be better confidence in the liquidity of the Islamic financial services industry.

The IILM is expected to issue high quality syariah-compliant financial instruments at both the national level and across borders to enhance the soundness and stability of the Islamic financial markets.

The signatories of the IILM Articles of Agreement are the eleven central banks or monetary agencies of Indonesia, Iran, Luxembourg, Malaysia, Mauritius, Nigeria, Qatar, Saudi Arabia, Sudan, Turkey and the United Arab Emirates. The Islamic Development Bank and the Islamic Corp for the Development of the Private Sector are the multilateral organisations participating in the initiative.

Islamic finance has come a long way, but there is still a long way to go, since US$1 trillion is still small relative to US$232 trillion in conventional financial assets (excluding derivatives).

The real test with any challenger to Wall Street finance is whether Islamic finance will be more efficient, more ethical and more stable. Islamic finance fulfills the needs of the Islamic customer. Ethics aside, there are two crucial problems in finance information asymmetry and the principal-agent problem. Because markets are not completely transparent and information is unequal among market participants, we tend to rely on trusted agents, such as banks, to act on our behalf. Financial institutions are fiduciary agents on behalf of the principals, the real sector savers and borrowers.

What this Wall Street crisis has demonstrated is that complex financial engineering enabled very smart bankers to make profits at the expense of the public purse, because they have become larger (five times greater than GDP). When they fail, the public bears the losses because they are too large and too powerful to fail. This is not the level playing field that is a pre-condition of free markets.

The real question is that under information asymmetry, how do the principals know that the risks of the agents (the banks) have shifted to principals through moral hazard' Islamic finance faces exactly the same dilemma.

If Islamic finance theoreticians can solve this problem, they would be doing a great service to the rest of the world. Then we would truly have an alternative to Wall Street.

THINK ASIAN BY ANDREW SHENG

Tan Sri Andrew Sheng is adjunct professor at Universiti Malaya, Kuala Lumpur, and Tsinghua University, Beijing. He has served in key positions at Bank Negara, the Hong Kong Monetary Authority and the Hong Kong Securities and Futures Commission, and is currently a member of Malaysia's National Economic Advisory Council.