Finance & Banking

Islamic Finance – Opportunities and Challenges

The Islamic financial system has witnessed considerable developments in the past four decades and is now regarded as one of the fastest growing segments of the global financial system. Islamic finance assets grew at double-digit rates during the past decade, from about US$200 billion in 2003 to an estimated US$2.336 trillion at the end of 2015 (Global Islamic Finance Report 2017).

Key Islamic finance jurisdictions such as Malaysia and the GCC have gained much growth and traction over the past few years. However, other jurisdictions in Africa such as South Africa, Nigeria and Kenya have made considerable progress in the growth of Islamic finance. Bangladesh and Indonesia in the Asian region have shown key potential for growth.

European countries such as the UK and Germany have also shown heightened activities in the industry. Islamic finance has made considerable progress in the African region, spurred by demand from Muslims and non-Muslims. The Nigerian Central Bank issued a license to Jaiz Bank Plc, to operate as a fully-fledged non-interest financial institution (NIFI). There are other Islamic banking windows operational in Nigeria, which serve the Muslim population of 173.6 million.

There remains huge opportunity for Islamic banks to setup in Nigeria given the huge Muslim population and growing demand. Nigeria has facilitated the issuance of sukuk (Islamic bonds) by amending the regulations by the Securities and Exchange Commission of Nigeria (SECN). The State of Osun sold US$61 million of sukuk in 2013, becoming the first state in Nigeria to sell sukuk.

South Africa’s National Treasury wants to make the country the hub for Islamic finance in Africa. The South African banking regulators have taken various measures to develop and promote the industry including amending tax laws to create an equitable and level playing field for Islamic finance. The country currently has one full-fledged Islamic bank; Al Baraka Bank was registered in South Africa in 1989. Other banks such as First National Bank (FNB), Absa Bank and HBZ Bank house Islamic finance windows alongside their conventional banking services. The South African government issued their debut sukuk in the third quarter of 2014. The US$500 million 5.75-year was oversubscribed more than four times and attracted Middle Eastern and Asian investors.

In West Africa, Senegal successfully launched a four-year XOF100 billion (US$171.96 million) sukuk in June 2014. This sukuk represents a new era in the use of Islamic financing instruments in the country’s public finances. Senegal may consider additional sukuk issuance to support the country’s infrastructure needs and Dakar is aiming to position itself as the continent’s hub for Islamic finance.

Cote d’Ivoire launched its 150 billion CFA francs sukuk priced at a profit rate of 5.75% in the last quarter of 2015. Cote d’Ivoire mandated the ICD as the lead manager for its inaugural local currency sukuk programme worth XOF300 billion (US$515.87 million), which will be issued over the 2015-20 period in two equal phases.

In East Africa, the government of Uganda has approved the Financial Institutions (Amendment) Bill 2015, paving the way for Islamic banking and finance in the country. Kenya has set its sights on becoming the Islamic finance hub of the East Africa region. With two fully fledged Shari’a-compliant banks in operation, licensed takaful and retakaful businesses and a number of financial institutions offering products that comply with Islamic law.

There have been several key growth points for Islamic finance in the Asian region. Bangladesh is the third largest Muslim country in the word. With a predominantly Muslim population of 160 million, the industry has doubled in size in the past four years. The Islamic Bank of Bangladesh Limited (IBBL) was launched in 1983. The country has seven standalone Islamic banks and 16 conventional banks with Islamic banking windows (IFSB, 2014) The market share of Islamic banks in Bangladesh is sizeable and accounts for 18.9% of the total banking deposits and 21.1% of total financing (Annual Report, Bangladesh Bank, 2013). There is also a sizeable takaful market in Bangladesh with 8 takaful operators. The central bank has a small short-term sukuk programme, which issues six-month tenors to help Islamic banks manage their liquidity requirements. The central bank auctioned three-month and six-month sukuk on Jan. 1, 2015, selling 855 million taka (US$11 million) and 936 million taka, respectively.

Indonesia has the world’s largest Muslim population with 12.7% of the world’s Muslims. Indonesia’s capital market regulator has published a five-year strategy for the Islamic finance industry. Indonesian authorities want Indonesia’s Islamic banks to hold at least 15% of the market by 2023. Islamic banks in Indonesia comprise of 12 fully fledged Islamic banks and 22 conventional banks have Islamic banking windows. There are 45 Islamic insurance institutions in the country. Furthermore, there are 316 Shari’a-compliant stocks, which have been classified and listed under Shari’a listed stocks comprising of 60% of the total stocks in Indonesia.

Indonesia’s Islamic bond market is the second largest in East Asia. The government issued its first retail sukuk in February 2009 for US$144.4 million. The government issued its first sovereign sukuk based on the ijara principle in August 2008 with the sale of 7-year (IFR0001) and 10-year (IFR0002) Islamic bonds. The government has allocated IDR6.94 trillion for infrastructure projects via government sukuk issuance.

There has been key growth in several European countries. The United Kingdom issued the first sovereign sukuk by a European federal government. The government raised US$339.5 million with a profit rate of 2.036% and a five year tenure. The order book was oversubscribed by nearly 10 times the issuance size. The government-backed export credit guarantee agency has provided cover for a US$913 million (£617 million) Islamic bond issued by Dubai’s Emirates Airline to purchase aircraft including the giant Airbus A380.

More than 20 banks currently offer Islamic financial products and services in the UK. The value of sukuk already listed on the London market exceeds US$34 billion (£21 billion) over the past five years with more than 50 bonds quoted by the London Stock Exchange.

With a population of 4 million Muslims in Germany, holding an estimated wealth of €25 billion, Germany potentially is a big market for Islamic finance. According to a 2010 survey, 72% of Muslims living in Germany are interested in Islamic finance products. Germany launched its first fully-functional Islamic bank in Frankfurt under the name KT Bank AG. FWU Group, a Munich-based financial services company, issued a US$20 million five-year Islamic bond backed by insurance policies in October 2013 and issued a US$55 million seven-year sukuk through a private placement that was backed by intellectual property rights in December 2012. Luxembourg issued a sukuk for US$253 million with a five year tenure in October 2014. The sukuk was twice oversubscribed.


Despite the huge growth of the Islamic finance and bankingiIndustry over the past few years, the industry currently faces considerable challenges and in particular:

  1. Lack of Human Capital

Qualified human resources play a pivotal role in the development and success of any industry. There is a dearth of qualified bankers and professionals who are well versed in Islamic laws as well as contemporary economics and finance. Currently, various universities and training institutes are offering courses in Islamic finance but they also face lack of competent human resources to conduct these courses. There also remains a huge lack of human resources on the expert level. There remains a significant shortage of Shari’a scholars who are well versed in Islamic finance. Business schools and religious schools should offer Islamic finance qualifications in co-operation and conjunction with industry experts to create the next generation of Shari’a experts and professionals. Academic institutions should also be encouraged to establish centres of excellence for the Islamic finance industry.

  1. Shari’a Standardisation and Harmonisation

Islamic law accommodates for differences of opinion and interpretations of classical Islamic texts. This leads to different practices and policies adopted across different jurisdictions. This may impact on the growth and internationalisation of the Islamic finance industry. Islamic finance laws, policies and practices should be standardised and harmonised in order to create more unification and consolidation within the industry. This would strengthen the industry from a Shari’a perspective and root out weak and rejected views. Furthermore, Shari’a scholars should adopt these policies and procedures to prevent and mitigate Shari’a non-compliance risk.

  1. Lack of Public Awareness

There remains a low penetration rate and lack of critical mass in the Islamic finance industry. This is due to mainly a lack of public awareness and knowledge of Islamic finance. Islamic banks, regulators and governments should undertake mass awareness programmes to drive the growth of Islamic finance and create critical mass for the industry.

  1. Shari’a Law and Legal Framework

There remains a great need to harmonise Shari’a law with the existing legal frameworks. This creates huge difficulties and challenges in the event of disputes and legal matters as Islamic financial concepts are not recognized by certain legal frameworks. There should also be a drive to create more innovative products and gradual shift from products that closely resemble conventional financial products such as commodity murabaha and tawarruq.

  1. Regulation and Supervision

Islamic banks are exposed to various risks such as displaced commercial risk (DCR). This forces Islamic banks to lose profits in order to pay comparable returns to investment account holders (IAHs) and depositors. This create huge challenges for Islamic banks in creating excess reserves to cover losses and how this is viewed from a regulatory perspective.

Islamic banks also face equity investment risk, rate of return risk, Shari’a noncompliance risk in the event of perceived non-compliance and liquidity risk due to the shortage of liquidity products. Other challenges include the divergent interests of investment account holders and the Islamic banks’ shareholders. One of the major issues is that IAHs share profits and bear losses, but do not have shareholder rights (López-Mejía and others 2014). This leads to a lack of transparency in the reporting of profits and losses to the IAHs.

Various standards have been issued by the IFSB and AAIOFI. However, many jurisdictions have failed to implement these standards. There also remains a huge challenge in the adoption of Shari’a compliance. Various jurisdictions do not regulate and supervise the way Shari’a compliance is adopted. There should be a proper selection criteria for Shari’a scholars. Many jurisdictions have begun adopting central Shari’a boards in order to ensure harmonisation of Shari’a compliance within the industry.

  1. Access to Finance

Muslim countries have shown a lower level of financial inclusion than other countries in the World. This can be resolved by creating a better business model, reforms to increase competition within the banking sector, consumer protection, better credit information and education.

  1. Monetary Policy and Liquidity Management

Money and interbank markets for Shari’ah-compliant instruments have not yet developed in most countries, in part because of a lack of available instruments. There remains a huge shortage of Shari’a central banking facilities. Moreover many Islamic banks operate under a dual system of conventional and Islamic banking policy framework and are heavily influenced as a result by conventional banking instruments and conditions. Central banks should adopt more effective instruments and policies for Islamic banks. Many jurisdictions do not have a lender of last resort for Islamic banks. Only 6 out of 24 Jurisdictions for Islamic banking have a lender of last resort for Islamic banking.

  1. Tax Policy

Regulatory/tax reforms play a pivotal role for the growth of any industry. There remains various tax issues which need to be resolved in order to level playing field between Islamic banks and conventional banks. Some of these issues include the treatment of Islamic finance under income taxes, sales taxes (for example, value added taxes), specific transaction taxes, and bilateral tax treaties. International standards can encourage governments and jurisdictions to facilitate tax reforms.

  1. Benchmark

The usage of the conventional interest based benchmark (Libor) creates a negative perception among investors who tend to associate the Islamic financial system with the conventional financial system due to the usage of the interest based benchmark. Furthermore Islamic banks are placed at the mercy of the movements in the conventional money markets by using the conventional interest based benchmark.

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