Islamic Finance: The Second Wave

Islamic finance encompasses banking, insurance and capital market which are operated in conformity to the guidelines of Shari’ah principles. It is an old as well as new phenomenon at the same time. It is new and contemporary because the products operation has no precedent in the history of Islamic law but at the same time it is as competitive as conventional banking products. However, in another aspect it is an old system as these products are based on classical Muamalah principles traced back to the time of the Prophet Muhammad (pbuh).

Options products in the stock market, for example, are new in its appearance and operations. Options are also, as a right and not an obligation to purchase a determined quantity of asset (such as stocks) at a determined price in a determined period of time, an old concept as the Islamic financial institutions viewed option as bay’ al-‘urbun (earnest money) or a kind of al-khiyarat (option) in Islamic law. Both principles are well documented in Islamic law.

Although the Muamalah principles which form the underlying foundations of Islamic banking products have not changed much but the features of the products have changed in the past 26 years (the first Islamic commercial bank was established in Dubai in 1979). The products in the current financial market are more complex and contemporary in-line with the features and value-added services offered by the conventional products. Products such as Equity Linked-Notes, Sukuk Al-Ijarah, Profit-Rate Swap, Forward Foreign Exchange or perhaps CFD and the like are something which were entirely unimaginable in the last decade.

26 years ago, the world has seen an emergence of a banking system which was considered new. That era has encountered various perceptions from various quarters of the globe especially the skepticism as to the compliance of this new banking system to principles of Shari’ah, the prospects and future of its financial instruments, the terms used and the validity and enforceability of the legal documents underlying the financial products.

However now, the issue of Shari’ah compliance and the actual potential of the Islamic financial system have managed to stand the test of time. Seminars and conferences around the globe are no longer discussing whether a product is Shari’ah compliant or whether Islamic finance will be able to grab a foot-hole in the current ultra-modern financial landscape. Whoever is still dwelling on those issues is definitely still living in the past.

The second wave for Islamic financial system has definitely arrived. The primary question in this era revolves around, inter-alia, four dimensions. The first dimension is how far would the Islamic financial products, within their compliance to principles of Shari’ah, provide a return to the investors and depositors which is equivalent if not more than the returns provided by their conventional banking counter-parts. Customers are no longer interested to know whether the Islamic banking or Takaful products offered are Shari’ah compliant as that is considered an established fact in this era due to the well established Shari’ah advisory services around the globe. What they are more interested in is whether the products are able to give them the maximum return or provide them with maximum protection proportionate to their respective risk profile. Marketing strategy which is based just on Shari’ah compliance argument is arguably not suitable anymore. Gone are the days where customers are buying Islamic financial products just because they are Shari’ah compliant. Now that is not enough anymore. Islamic financial products must not only be Shari’ah compliant but must also provide the same or better returns when compared to the same product from the conventional banking system. This sentiment has in fact becoming a driving factor for the financial institutions particularly in the West to offer Islamic investment products which are equivalent to the conventional banking products in terms of risk profile and expected returns.

Expertise and courage to offer these kinds of products are synonym with this era of second wave. Customers, individuals or institutions, will continue to search and look for these kinds of financial products whenever there is an opportunity because to secure a good return proportionate to the amount of risk undertaken is deeply rooted in the nature of man including Muslim investors who are looking for Shari’ah compliant products.

The second dimension is the dimension of private banking. Investors and customers are keener on getting more exclusive and personal services from their bankers. Intimate personal relationship coupled with expertise towards personalizing financial services to fulfill and satisfy the unique needs of individuals are important in this era. Thus this dimension requires high quality of exclusive services and financial planning and wealth management skills which will satisfy the unique and peculiar financial needs of customers. Private banking- Islamic financial services are yet to be unlocked. The key lies in the knowledge and expertise in financial planning and wealth management which emphasizes on the comparative analysis between the conventional and Islamic financial products and services.

The third dimension is the tendency for business and financial institutions to have an Off-balance sheet financing facility. There are many reasons why Off-balance sheet financing is a favourite nowadays. What is clear is that Off-balance sheet financing will provide the institutions with an avenue to securitise their cash-flow into papers to be subscribed by the general investors. This will not only give them immediate cash-inflow but also at a funding cost which is relatively cheaper than any financing products offered by the financial institutions.

In this context, the products in the primary market must be products the cash-flow of which can be securitized for purposes of securitization and secondary trading. This will also provide an opportunity for the public investors to invest in an investment where it involves huge working capital and where the securities are also liquid and tradable in the secondary market.

The fourth dimension is where Islamic finance activities moves away from financial institutions and hover around the non-financial institutions. Currently, there is strong inclination from non-financial institutions such as cooperatives, trust funds, public listed companies, car manufacturers and distributors, housing developers, transports companies and the like towards Islamic financial products and services. A number of them have converted, are converting and will convert their mainstream financial activities to those which are based on Shari’ah principles in terms of their working capital funding, treasury activities, internal and external financial schemes and various other financial transactions. The move by one of the leading car manufacturers in the world to introduce a car-financing scheme in Malaysia which is based on the Shari’ah concept on Al-Ijarah Thumma Al Bai’ (AITAB) is a clear indication of this dimension.

Islamic Finance in the second wave era requires or rather demands a paradigm shift and a more pro-active approach by all parties concerned to ensure the success of the mission of Islamic financial system in facing the challenges in this new era. The failure to understand the trends and the new needs of Islamic finance will hinder its development which has been thriving exceptionally in the last era. The Friday sermon delivered by Sheikh Shuraim in Masjidil Haram on 3 rd. June 2005 on Islamic finance generally and Islamic capital market specifically is a clear paradigm shift from Mecca. It is perhaps too early to make any forecast as to what are the dimensions of the third wave for Islamic finance as the second wave has just only arrived.

Dr. Mohd Daud Bakar
President/ Chief Executive Officer
International Institute of Islamic Finance Inc. / Amanie Business Solutions Sdn. Bhd.
www.iiif-inc.com / www.amanie.com.my

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