Islamic finance remains one of the bright spots in the global financial industry post the 2008 financial crisis. Despite two decades of strong growth, the industry is now finally poised to break into conventional financial markets in the West.
Islamic finance is comprised of instruments, infrastructure, institutions, and markets that apply Sharia rules and principles. You might be wondering how Islamic finance impacts you, if you’re based in a non-Muslim country. Increasingly it’s being viewed as an avenue of growth for global banks, as the industry caters to the world’s 1.6 billion Muslims.
The advent of Islamic finance allowed devout Muslims the ability to access financial products and services without compromising on their beliefs. As a result, total global Islamic banking assets are projected to surpass US$2 trillion in 2014.
The Islamic finance sector is primarily comprised of Islamic Banking, Sukuk (Islamic Bonds), Takaful (Islamic Insurance), and Islamic Mutual Funds. The geographic centers of Islamic finance are primarily in Asia (Malaysia and Indonesia) and the Gulf Cooperation Council (Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates).
At its core, Islamic finance is governed by fundamental principles outlined in Sharia law. The main distinction between conventional finance and Islamic finance is that the latter prohibits riba (usury/interest). Thus, virtually all Islamic finance products are based on the principle of risk sharing as opposed to risk transfer.
For example, an Islamic mortgage transaction would entail the bank purchasing a property and then reselling it to the homebuyer at a fixed profit. The buyer would then have the option to make the payments in installments. However, due to the concept of risk sharing, the bank could not charge additional penalties for late payments but would retain ownership until the loan was paid off.
Global Investors and Islamic Finance
For global investors, the sukuk (Islamic bond) market is probably the area of greatest interest within Islamic finance. The sukuk is an asset-backed security, which represents ownership in a tangible asset. With a sukuk the initial face value of the bond isn’t guaranteed. Unlike a conventional bondholder, a sukuk investor shares the risk from the underlying asset.
In practice, some sukuks are issued with repurchase guarantees, which would result in the investor receiving face value at maturity, much like a conventional bondholder. However, not all Sharia scholars agree this structure isSharia compliant.
Traditionally, governments and government-related entities in Asia and the Gulf Cooperation Council (GCC) issuedsukuks denominated in the local currency to domestic investors. However, increased demand from global investors has led to increased cross-border issuance from non-traditional sources.
Last September, rating agency Moody’s observed,
The year 2014 has become a landmark year for sovereign sukuk, with the UK issuing its inaugural sukuk, and with Hong Kong and South Africa expecting to conclude sales in September 2014. All three are major non-Islamic countries, and the transactions indicate a significant change in the potential size, depth, and liquidity of this market.
This move into sukuk finance by countries with populations that are not predominately Muslim marks a shift in the long-held perception that Islamic finance is the domain of Muslim countries.
In an effort to assist countries that seek to issue sukuk, Islamic institutions like the Islamic Corporation for the Development of the Private Sector offer help with the structure of sovereign sukuk finance.