Fundamentals Of Islamic Finance

State Street Global Advisers senior vice president and managing director of the Doha Office, Rod Ringrow, tells Business Spectator's Isabelle Oderberg how Islamic finance works and why it is set for enormous growth amid the meltdown of western style financial systems.

Isabelle Oderberg: I was wondering if just to start with for some of our readers who aren’t familiar with Islamic finance if you could just go through the fundamentals of it?

Rod Ringrow: The underlying principle for Islamic finance is it’s based on Islamic law and there are a number of key tenets that are critical to how the whole thing hangs to together. So, there’s the underlying premise that social and economic justice go hand in hand. There is a ban on interest. There is a ban to the extent possible on uncertainty. There is the promotion and the concept of risk and profit sharing between the provider of the finance and the recipient. Ethical, socially responsible investments.

So for example, nothing in gambling, armaments, alcohol, pork, obviously for Muslims, and in almost all cases there’s an underlying financial and physical asset that go with the transaction, so the concept of money making money is really what’s behind what is prohibited. So, in many ways it appeals to the Muslim community and also I think a great number of non-Muslims, in the fact that it is back to basics almost in terms of Western finance where there’s a physical asset underlying it, there’s not excess of leverage, etc.

IO: So you can’t invest in, for instance, bonds or anything like that because they pay interest. What kinds of investments would an Islamic fund manager be making?

RR: Well, there’s short-term and longer-term and we’ll come to the bond concept later, but a good example of a short-term fund would be a trading transaction, so the promoter buys a shipment of sugar or iron ore and pre-sells it at a predetermined price, so you buy it at 100 and sell it for 120 and that’s considered acceptable, because as I say, there’s an underlying physical asset and you’re pre-financing that shipment. The uncertainty element’s gone, because you know what you’ve bought it at and you know what you’re selling it at. That’s one example.

You’re right in the true sense of a bond not being able to be invested in, but there are some instruments called sukuks, which are really referred to as 'Islamic bonds' and there’s been a huge interest in those. In 2007 there were US$47 billion issued. The market took a bit of a tumble in 2008, but there’s a lot of potential demand out there for sukuk issuance.

There are 14 different kinds of sukuks and that creates another problem which we can come back to later, but in the 14 kinds of sukuks, there’s one called an ijara and that’s more like a lease transaction. Again, there has to be a physical asset underlying the financing here, but that ijara is closest probably to a leasing transaction in western finance. So somebody buys the asset then leases it for a monthly fee to the user. There are bonds issued, backed by that kind of structure, and there are a number of fund management houses beginning to look at how to create investment funds using sukuk as the kind of underlying investment. The traditional sort of Islamic investment funds have traditionally been equity based investment.

IO: Are dividend payments seen as sort of interest?

RR: No, because you’re sharing part of the risk in the underlying transaction, then that’s your payment for sharing the risk. That’s how it’s structured.

IO: I see. And before you got involved in this sort of area, can I ask what you were doing before and whether it’s been challenging to get your head around some of these concepts?

RR: I’ve been working for State Street’s business in the Middle East for the last 10 years and I’m currently actually based in Doha in Qatar, running our investor services and global markets business for North Africa and the Middle East. It's just a very interesting development of finance and I think the other thing that’s fascinating is that Islamic assets today account for less than 1 per cent of global financial assets and yet the market is growing in some cases at 20 per cent, 30 per cent a year over the last five to six years. It’s a huge growth, but still only a very small fraction of overall financial assets.

IO: I’m not sure whether there’s a lot of people that transfer within State Street, but if you get someone who’s been managing a sort of more generic portfolio and they move to doing this kind of fund management work, is it quite challenging? Is there any culture shock among the fund managers from a technical point of view?

RR: I’m not on the fund management side, but from talking to my colleagues and global advisers it’s really the screening process you are using to create the types of assets that are eligible for an equity fund for example. I think it becomes more challenging if you’re investing in sukuks because there are just so few of them around.

IO: And from reading your report The Opportunity for Long Term Growth that was issued, it said that State Street has $6 billion in Islamic finance products. What’s the potential for growth and are there any restrictions to marketing based on Sharia?

RR: There are no restrictions on marketing based on Sharia law, no, not that I’m aware of. I think the growth is substantial and the potential is substantial. If you take, for example, in the Gulf at the moment there’s something like $1.5 trillion of infrastructure investments that need to be financed. Now, with the fluctuations in oil prices governments can either run budget deficits, draw down on reserves or they could turn to the sukuk market to try and create financing vehicles and opportunities.

The Saudi Arabians for example have just introduced some mortgage laws and we believe that as those develop further there may be the opportunity to securitise some of the underlying holdings and then create a secondary market. A lot of the issues with the sukuk market to date have been they’re bought by end investors. The secondary market is relatively limited and a lot of that is driven by the fact that each structure can be different, so it’s not as easy to say 'well, I’m going to move from this sukuk to this sukuk', because remember I said there’re 14 different potential structures. So there have been lots of assets recently by people like the Islamic Financial Services Board or the Accounting Standards Board to try and create some standardisation in the industry that will help promote a secondary market and greater institutional involvement because a lot of the involvement to date has been in the retail side.

IO: In the report, it also says that there’s $600 billion overall in Islamic institutions. Is the growth going to come and the opportunities for private managers going to come from diversification of that investment or from new funds flowing into the Islamic finance space?

RR: I think it’s going to be a combination of both. I think we’ve already seen people like Scottish Widows in the UK set up an operation in Saudi Arabia with a local partner to try and develop. There’s an Islamic conservative insurance called Takaful. There’s a lot of growth in this Takaful product and that’s growing at around 40 per cent in the Gulf. So Scottish Widows who traditionally provided long-term investment pension plans on a fixed-income basis, have been looking to see how they can take their existing product and try and sell it to meet the growing need for fixed income products within the Takaful sector.

That’s untapped, but that’s growing, as I say, at around 40 per cent a year and I think with new players coming in, the market will deepen and develop, but the biggest problem comes back to a lack of Sharia scholars, because each Sharia board need three scholars. The best way I could describe it is a little bit perhaps like your non-executive directors. One Sharia board can say a structure is fine and another board will say no, it’s not, so again it’s that lack of uniformity that has hindered the growth and yet the market is still growing at, you know, double digit growth a year.

Our belief if some of those impediments become standardised and there’re lots of efforts to do so, then the market will grow organically even more and then as I say some of the products being developed that will emerge again. There have been lots of discussions about Islamic finance trying to replicate Western finance, so you know Western hedge fund had to get an Islamic hedge fund and people think they may have found a structure that’s suitable. The question is whether that structure is replicable across a wider market? That’s one of the factors that are holding back the growth of the market.

IO: You said that there are efforts being made to standardise the process. Where are those efforts coming from and how long before they’re likely to provide benefits?

RR: I was at the Islamic Financial Services Board conference last week in Singapore and there’s no shortage of desire to move faster. Malaysia, for example, and Her Excellency Dr Zeti Akhtar Aziz the Governor of Bank Negara has played a very key role in trying to create institutions that will help further Islamic finance. The Islamic Financial Services Board, which is based in Kuala Lumpur, Malaysia, has also tried to create a chartered financial diploma in Islamic finance again creating the building blocks at the ground level for people to come into the industry and then take it forward. You have the AOFI, which is the Islamic financial accounting standards board in Bahrain trying to help push it forward and then you have certain countries saying 'well, we may be more Islamically pure therefore what we deem to be a sukuk is not a sukuk somewhere else'.

The Dubai financial market has created some rules or about to release some rules for what their definition is to have a sukuk listed, so if it meets those definitions, therefore it’s an official sukuk, therefore it can be listed. So, there’re lots of efforts going on in areas around the world to help propel that development and then you’ve got places like London and Singapore and they're the only two non-Islamic centres to actually create the platform for Islamic instruments to be traded and that I think is a very useful development as the industry looks to mature.

IO: There is interest from non-Muslims in these products – where is that interest coming from? Are there specific sort of demographics that are interested in this sort of product?

RR: I think it’s coming across a pretty broad spectrum. I think as investors are looking at conventional finance and realising that it hasn’t covered itself in glory in the last 18 months in particular, there are people looking either from a what I’ll call a socially responsible perspective you like the fact that investments aren’t being made in gambling, alcohol, armaments or like the fact that there’s more equal sharing of risk rather than a typically one sided approach.

So, I think you’re seeing it across a wider spectrum and I think the other thing is what you’re seeing is countries with a large indigenous Muslim population, for example the amount of Islamic money managed in the UK is greater than anything managed in Pakistan. Some of the Western countries with large Muslim populations are beginning to find increasing demand for Islamic products. From investors who are looking for a more ethical approach, a lot of those are actually saying 'well, actually I quite like this'. It’s back in favour. There’s almost a tipping point available to Islamic finance in terms of as it’s growing itself anywhere there’ve been lots of discussions about it merging and moving towards conventional finance, but you could almost argue the reverse that conventional finance as it looks to work out where it needs to go to rehabilitate itself, it may in fact move closer to some of those ideals espoused in Islamic finance.

IO: It’s interesting that you say it’s becoming popular in places like the UK, because I was going to ask you which geographic regions that State Street’s current targeting for growth in this area and I was sort of thinking the Middle East and Indonesia and places like that, but from what you’re saying it sounds like it’s far more diversified than just the traditionally thought of high Muslim population markets.

RR: Absolutely. There are 1.5 billion Muslims around the world, so you’ve got an inherently large market anyway, but there are large pockets now in certain places in the US for example with large Muslim populations that are finding a demand and an attraction for Islamic finance. Parts of South Africa, so yeah it has a pretty wide geographic appeal.

From Business Spectator