Islamic Finance: Opportunity for Long-Term Growth
by Rod Ringrow, State Street
Modern Islamic finance has experienced steady growth for more than two decades, but interest in
the sector accelerated in 2008 as the more conventional financial industry faltered. Contributing to
its appeal is a unique investment philosophy that differs from traditional approaches—particularly as
it relates to risk. With investors significantly reducing their risk appetite in light of the global financial
crisis, Islamic finance has the potential to become more attractive around the world.
History and Current State
Although its roots can be traced back 14 centuries,
Islamic finance is still in the early stages of growth
with Islamic assets representing less than one
percent of world capital. In addition, the industry
has only scratched the surface of the world’s estimated 1. 5 billion Muslims—who together represent 20 percent of the world’s total population.
Historically, Muslim nations have used Islamic
finance as a vehicle to offer banking services to
parts of the Muslim population whose religious
beliefs may have prevented them from participating in conventional financial activities. Today, it
has evolved into a sophisticated multinational business that is engaged in private equity and project
finance, as well as fund, asset and wealth management. As indicated in Figure 1, the evolution of
Islamic finance products reflects a concerted effort
to accommodate a growing global customer base.
What makes Islamic finance uniquely different is
the bond that its Muslim customers share: their
religion, whose moral lessons are shared through
the teachings of the Koran, but whose legal principles and codes are governed by Shariah, or Islamic
law. Its tenets—lower leverage, transparency and
Figure 1. Islamic Investment Product Depth
Source: Aamir A. Rehman, “The Commercial Impact
of Islamic Finance: Industry Overview and Implications,”
no speculation—make it an attractive investment
option in any market environment.
The application of these faith-based principles,
which directly impacts the underlying structure
of Islamic finance products and services, ultimately serves as one of the sector’s biggest selling
points. At its core, Shariah specifies that money
has no intrinsic value of its own and should be
used as a tool for measuring the value of assets.
Islamic financial institutions aren’t able to charge
interest, even on basic deposit accounts, and
they can’t employ many hedging and derivative
instruments commonly used in more conventional
Shariah also requires that financial transactions
be linked to an underlying activity or hard asset,
providing a direct connection between financial
and productive flows. Furthermore, it demands
that risk, as well as profits and losses, be shared
between a financier and its customer. This principle aims to encourage both parties to conduct
appropriate due diligence before agreeing to a
transaction, including the evaluation of whether
the agreement will generate sufficient wealth to
compensate for any risks.
Proponents of Islamic finance say that these and
other Shariah principles provide a built-in system
of checks and balances for financial transactions,
and are what make the industry relatively stable.
Seeing opportunity in this emerging market, a
number of global financial centers, including
London, Singapore and Hong Kong, have initiated plans to integrate Islamic finance into their
financial systems. With more than 500 Islamic
financial institutions (IFIs) operating around the
world, the scope of Islamic financial business is
Assets under management by Islamic financial
institutions now exceed $600 billion, making the
sector a viable option for investors and a competitive form of financing for commercial enterprises.
It is also allowing for the further diversification of
risks and is contributing to an efficient international allocation of resources.
Growth Fueled by Oil
The founding of the first large Islamic banks in the
1970s, including Dubai Islamic Bank and Albaraka
Banking Group, is generally considered to mark
the birth of modern Islamic finance. The industry’s