Islamic finance is winning many fans but further evolution is necessary.
Islamic investment banking is being described as the darling of the new financial age. At least that has been the overriding theme of much of the industry talk and articles written since the onset of the global crisis. One Asian newspaper recently described Islamic finance as the emerging "blue ocean", which is a reference to the business strategy book written by W. Chan Kim and Renée Mauborgne of INSEAD, an international business school. The two business gurus promote creating new market space or "blue ocean" rather than competing in an existing industry.
Islamic finance certainly fits this description. However, much of what has been written fails to acknowledge that the sector has been hurt by the global financial crisis too - and it would be unrealistic to think otherwise. And moreover, it may turn out that Islamic investment banking will find itself reproducing some of the characteristics which make conventional finance so successful.
Of course, that is not to say that a prudent, asset-backed banking model such as the one on which the Islamic finance model works does not have good reason to look to the future with optimism. Unquestionably it does.
The industry is currently worth $700 billion (Dh2.6 trillion), according to rating agency Moody's, but has the potential to amount an impressive $4 trillion. Although precise figures are not available, the rate of the industry's expansion is estimated at somewhere between 10 per cent and 20 per cent annually.
Another reason for optimism is the fact that many recession-weary finance experts in the West are coming round to an acceptance of merits of Islamic banking.
The ethical principles which form the cornerstone of the industry are seen as a more sustainable alternative to conventional investment banking, which has found itself accused of unhinging the global economy.
So it is almost inevitable that the current furore in international banking has resulted in the surge of interest in Islamic finance we're now seeing.
The Sharia-compliant sector is emerging from the global financial crisis in a relatively healthier position than its conventional counterparts.
Any Islamic bankers who migrated from conventional institutions must think themselves most fortuitous when they look at the position their old colleagues now face.
Their favourable situation, however, did not come down to luck. Rather, Islamic banking made its way through the worst of the financial conflagration primarily on the back of its more prudent risk management principles.
That is not to say that the sector did not suffer at all - according to Standard & Poor's, sukuk issuance globally fell 56 per cent year-on-year to $14.9 billion last year, largely mirroring the same curve as their conventional version, the bond.
It remains to be seen quite how fully regional states and corporates will use debt issuance in the post-crisis era, though there is a feeling amongst insiders that the private sector will be more inclined toward it if central banks take a lead.
Islamic funds are struggling, too. The average return for Islamic equity funds for 2008 was the equivalent of -39 per cent, while the average returns for the first quarter of 2009 stood at the equivalent of -3.7 per cent, according to Ernst & Young.
Meanwhile, Islamic private equity is also hobbled by the slump and the broader issue of exit strategy, which has long dogged this particular sector.
While these nasty side effects of the global slump will pass in time, two challenges remain to be tackled, especially in the Gulf, if the industry is to reach what many see as its significant potential.
Firstly, Islamic finance currently lacks diversity in its investment banking portfolio. Put simply, the product and service offering is not deep enough. If the industry wants to evolve from being a niche player - albeit operating profitably in its "own space" - Islamic innovators would do well to look for more equivalents to conventional vehicles. Just like traditional investment banking, a diverse range of asset classes offering multifaceted products will be necessary.
Secondly, and this is interrelated to the need for more products, the sector, just like the whole region, has become over dependent on real estate. But given the real estate asset deflation witnessed across the Gulf over the last year, that strategy, at least for now, has lived out its last days.
A more balanced spread of asset classes will help the industry to reduce its vulnerability in any one sector. This, in turn, will give it the depth needed to win over more customers, and at a time when many are looking for alternatives to the conventional system this can only be a good thing.
- The writer is editorial manager of Oxford Business Group, Abu Dhabi. Opinions expressed here are his own and do not reflect the views of Gulf News.
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