Diversified offerings: Working to develop new sharia-compliant products and services

As of late 2012 Saudi Arabia’s Islamic financial services (IFS) industry was focused almost exclusively on a handful of products, namely sharia-compliant retail banking, murabaha and other related financing arrangements, cooperative insurance and sukuk (Islamic bond) issuances. Together, these products have accounted for more than 95% of activity in the sector in recent years. This is in line with the global IFS industry. According to a March 2012 report released by the UK Islamic Finance Secretariat, a part of TheCityUK, as of the end of 2011 global Islamic finance assets had reached $1.29trn, which included $1.2trn in banking assets, $60bn in funds and capital markets, $25bn in the Islamic insurance sector, and around $4bn in other IFS products and services. While banks, funds and insurance companies are expected to account for the bulk of the activity in the industry for the long term, many IFS players are working to develop products and services in new areas.

Indeed, IFS players around the world are in the process of expanding into a number of underdeveloped segments, including trade, corporate banking, international investment, asset management, structured finance derivatives, private equity, short-term liquidity, and project and infrastructure financing, among others. “These new areas will allow Islamic banks to reduce their exposure to the real estate sector and to take advantage of the stronger growth potential of the emerging market economies,” said Tharman Shanmugaratnam, chairman of the Monetary Authority of Singapore, in a speech delivered in Malaysia at the eighth annual World Islamic Economic Forum in early December 2012. “There are gaps to be filled in structured trade finance and in funding for infrastructural projects as the emerging markets grow, and as global finance consolidates.”

Hurdles

The industry faces a number of challenges in terms of developing new products and services, particularly the lack of widely agreed upon standards for sharia compliance. Indeed, different interpretations of Islamic law around the world have resulted in a variety of standards in IFS markets. While regulatory frameworks proposed by the Malaysia-based Islamic Financial Services Board and Bahrain’s Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) have gained traction on the global stage in recent years, there are still disparities between leading sharia scholars and financial authorities across the world.

This is a challenging issue in Saudi, as the government’s regulatory framework, which is overseen by the Saudi Arabian Monetary Agency (SAMA), the Kingdom’s central bank, is somewhat light on details in terms of sharia compliance compared to many other nations in the region. Most sharia-compliant firms in the Kingdom are allowed to develop new products and services as they see fit, so long as they adhere to a few basic tenets of sharia compliance (see overview). While this flexible operating environment encourages innovation in the market, it also has the potential to create products that are inconsistent with sharia standards elsewhere.

For example, sharia boards worldwide are currently divided on the subject of derivatives. Conventional derivatives have been outlawed in most IFS markets for years, due to their reliance on a number of concepts that contravene basic precepts of sharia, including riba (interest), gharar (uncertainty) and maisir (gambling), among others. However, as sharia-compliant finance has become more popular over the past decade, Islamic banks have begun to consider developing more complex products to help manage risk, including derivatives. According to an IMF working paper on Islamic derivatives released in March 2012, “So far, Islamic financial institutions and corporates have either resorted to existing conventional derivatives or developed specific sharia-compliant and customised hedging solutions, so-called ‘wrappers’, to manage risks”.

A Natural Leader

The ongoing controversy over Islamic derivatives among sharia scholars globally is representative of the lack of universal standards in terms of sharia compliance. Saudi, as the birthplace of Islam and an increasingly important global IFS player, is well positioned to fill this gap. By many accounts the Kingdom boasts the largest IFS sector in the Gulf, and it is only expected to grow over the course of the coming decade. Additionally, SAMA, the central bank, has made an effort to shore up the country’s growing reputation as a major IFS player in recent years.

In particular, SAMA has begun to look into setting up an IFS-focused federal sharia authority, which would develop, implement and enforce a wide set of rules and regulations on sharia compliance. According to many local players, formalising the Kingdom’s sharia framework could lead to a surge in innovation and new developments from the industry, as companies work to take advantage of newfound regulatory clarity.

Asset Management

As of late 2012 the launch of a new sharia regulatory authority was still a long way off. In the meantime, local players are working to develop new products and services based on external sharia standards. Asset management, in particular, has become a key growth area in recent years, covering pension fund management, mutual funds, investment strategies for Islamic insurance firms, corporate treasury management and retail household investing, among others.

The majority of the expansion in IFS through the first decade of the 2000s took place in the high-volume, high-return retail, corporate and investment banking segments. Asset management, which is considered to be an important component of conventional financial markets, was largely ignored. As the market has matured, however, demand for product diversification and, consequently, asset management services, has risen dramatically. With this in mind, in recent years an increasing number of conventional asset management firms have worked to roll out sharia-compliant products and several new management companies have opened their doors in key GCC and Asian markets.

Saudi-based firms have taken a leading role in the nascent industry. In 1987 the Jeddah-based National Commercial Bank (NCB), one of the largest banks in the Gulf region, introduced the Al Ahli International Trade Fund, which was the world’s first sharia-compliant mutual fund. Since then the Kingdom’s asset management industry has grown exponentially. NCB is currently the largest fund manager in Saudi, overseeing around SR45.5bn ($12.1bn) in assets in total, which makes up around 40% of local managed funds. The bank’s numerous fund offerings are underpinned by a variety of sharia-compliant investments, including Saudi riyal-and euro-based murabaha arrangements, real estate investments and, in the past few years, sukuk securities. In December 2012, the bank announced that it would launch two new equity funds from Dublin. The funds, which will focus on Saudi and other GCC investments, will be certified under the EU’s Undertakings for Collective Investment in Transferable Securities framework, which will allow them to be sold both within and outside of the EU. Other sharia-compliant fund managers in the Kingdom include Al Rajhi Capital, the investment arm of Al Rajhi Bank, which oversees more than SR25.1bn ($6.7bn) in assets; Samba Capital, the investment wing of the Samba Financial Group; and Riyad Capital, the investment group for Riyad Bank.

Challenges

According to John Sandwick, the manager at Safa Investment Services, a Riyadh-based asset management firm, most assets under management at Islamic firms around the world are not, in fact, sharia compliant. This is a direct result of the lack of universal and widely agree-upon sharia standards. “Professionally managed assets worldwide are now worth around $80trn, of which Muslims own at least $3trn,” said Sandwick at Safa’s launch in October 2012. “What is striking is that almost none of that is invested with any respect for sharia. A lot is invested in the type of securities that accelerated the global financial crisis.”

Safa, a joint venture between the Saudi-based The Investor for Securities and the Geneva-based Islamic Wealth and Asset Management, was set up to offer strictly sharia-compliant products and services to investors in the GCC and Switzerland. In matters of sharia compliance, the company is advised by the Sharia Review Bureau, a Bahrain-based firm that is a member of the AAOIFI and the General Council of Islamic Banks and Financial Institutions, the latter of which is affiliated with the Organisation of Islamic Cooperation.