Islamic finance: Hub or hubris?

Shariah banking is becoming big business in Southeast Asia, with Kuala Lumpur and Jakarta battling for the title of regional Islamic finance centre. But even the most optimistic bankers fear further expansion could be stymied by arcane regulation and lack of cross-border consensus. Eric Ellis reports.

HERE ARE SOME concepts that Islamic bankers in Southeast Asia like to throw around in their daily traverse between Mammon and mosque, and which might raise the collective eyebrows of the Western-dominated world of conventional banking – and provide pause for thought too as Islamic financing gains critical mass across Asia and beyond.

If Lehman Brothers was an Islamic bank, it would not have collapsed, because “making money from money” is haram, forbidden under Islam, so its sub-prime derivatives drama would not have happened. Ipso facto, there would not have been a global financial crisis, nor the resultant pain pace RBS, Citi, the bank bonus drama et al. Secondly, the US Federal Reserve is, in effect, now managing policy along Shariah principles because its reducing of interest rates to such a degree, in order to kick-start economic growth, is a Shariah-esque act.

If that’s not enough, these Asian upstarts point out that not one Islamic institution in Indonesia or Malaysia has crashed, been bailed out or required massive surgery, either during the 1990s’ Asian financial crisis or in the past two years.

And here’s another thought to rock the conventional banking world: Kuala Lumpur isn’t just an Asian tiger, the capital of a fast-emerging economy. It’s the new City, the new Wall Street, a financial centre soon to be crucial as the Islamic banking industry continues to expand. Worried about leakage, the big conventional banks such as Citi, HSBC and Deutsche Bank are all scaling up their Islamic banking business in Asia. Today some 400 Islamic financial institutions control around $600 billion in assets, much of it in Malaysia.

Call it hubris, or realistic ambition. But that Islamic bankers in Kuala Lumpur and Jakarta are even discussing such concepts among themselves speaks to the growing clout and soaring confidence of Shariah banking in one of the world’s most Islamic regions. After just 30-odd years in the region, the industry boasts annual asset growth of around 30% in recent times and as much as $50 billion in assets under its control. The clear implication is that it will soon overtake conventional banking – which, goes the mosque’s more extreme view, will devour itself in scandal, regulation and complexity, leaving Shariah banking as the prudent, customer-friendly, conservative alternative.

All of which, say Asia’s wiser banking hands, ignores the inconvenient fact that some Southeast Asian nations where Islamic finance is on the rise are burdened with less than transparent regulatory regimes and chronic corruption. But Islamic bankers have an answer for that too. Corruption is also haram in Islam. Thus, Islamic financing’s advocates claim the growing sector presents a force for good in the clean-up of these too-often corrupt and cronified economies.

Not that Southeast Asia’s Islamic banking is without its mysteries and, more to the point, industry-pausing regulatory issues, notably the complex Islamic testing of banking transactions. In two weeks of interviews in Kuala Lumpur and Jakarta with senior Islamic bankers and industry associations, it was difficult to determine who has the final say-so in what is religiously acceptable dealmaking, or indeed whether it much matters. Is it the mosque? Or the central bank? And who watches the watchers?

A tale of two countries

Kuala Lumpur’s Islamic sector is the most advanced in Asia in setting clear legal standards, but finessing the industry regionally remains a work in progress. That’s particularly so in chaotic Indonesia, still emerging from the political and ethnic bedlam of the 1990s and trying to cement one of Islam’s few functioning democracies.

“Malaysia has the most established framework anywhere in the world in terms of the legislation, regulation and the Shariah management framework,” says Badlisyah Abdul Ghani, chief executive of CIMB Islamic Bank. “No other country in the world has as comprehensive a framework as Malaysia. And business is extremely good.”

Malaysia is home to 35 million people and, although Islam is the official state religion, only a slender majority – some 55% – are ethnic Malays, and constitutionally designated as Muslims. In cultural and political Islam, Malaysia is a mid-level power, albeit one that under former strongman Mahathir Mohamad developed a passionate voice.

Indonesia, Malaysia’s next-door neighbour, has the world’s largest Islamic population: around 85% country of its 230 million inhabitants are Muslims. It is Southeast Asia’s economic powerhouse and, 12 years after the fall of Suharto’s autocracy, boasts a fast-rising economy that by dint of its size and resources is knocking on the door of the Bric club – Brazil, Russia, India, China – to such a degree that many claim it has already arrived.

So it seems curious that, given the vast disparity in size and spread of Islam, Malaysia’s Islamic banking industry controls around 19% to 20% of the country’s banking assets, whereas in powerful Indonesia, it is a rather underwhelming 2% to 3%. The answer seems to have less to do with the Quran, and more to do with proactive government and regulation.

The path to success

Islamic banking in Southeast Asia had its origins in efforts to send the region’s faithful to Mecca for the annual Haj pilgrimage. Ungku Abdul Aziz, father of the current governor of Malaysia’s central Bank Negara, Zeti Akhtar Aziz, helped conceive the Tabung Haji foundation in 1962-63. Fifty years on, the trust is now regarded as Asia’s first modern Islamic financial institution, formalizing an Islam-oriented asset management framework. Today, Tabung Haji has grown into a financial juggernaut. “Its success showed that there was more to it than simply a vehicle to save up to go to the Haj,” says CIMB’s Ghani. “And that it was possible to do this as a formal banking industry.”

Mahathir allowed competition to state-owned Bank Islam in 1993, creating global Islamic banking’s Big Bang

The Dubai-controlled Bank Islam Malaysia was formed out of the Malaysian state’s Islamic Banking Act of 1983, enacted in the second year of the Mahathir administration. Islamic firebrand Mahathir came to power championing Malaysia’s majority but economically disadvantaged and overwhelmingly Muslim Bumiputra community, at a time when local banking was dominated by the minority Chinese business community. So a bank designed to service the Muslim community wasn’t just symbolically important for Mahathir’s radical pro-Malay government, it also provided a vehicle to check the corporate dominance of the Chinese community and redistribute assets to downtrodden Malays.

As part of his National Economic Policy, regarded by its critics as a form of economic apartheid, Mahathir argued that as a Muslim country Malaysia needed a state-supported bank – Bank Islam – to service a rising customer base that had previously been prevented by religious conviction from accessing banking facilities. That it was closely associated with and part-owned by Tabung Haji, a venerable and trusted charity, enhanced Bank Islam’s credentials.

Until the establishment of Bank Islam, says Mohamed Rithuan Shamsuddin, executive director of the Association of Islamic Banking Institutions Malaysia (AIBIM), the faithful either shunned banks altogether, literally storing savings at home, or would make deposits in a bank but not accept the interest. “When Malaysia got independence our Malay Muslim community was outside the mainstream economic framework so there was a need for a solution to bring them in,” says CIMB’s Ghani. “One of the main reasons they did not participate in economic activities was because they could not do them in a Shariah-compliant manner.”

Bank Islam had a monopoly for a decade until 1993 when, as Rithuan puts it, “the government opened the floodgates”. The current opposition leader Anwar Ibrahim was then Mahathir’s finance minister (and designated successor) and with Mahathir directing and Aziz advising, Malaysia allowed competition into what was, admittedly, still a tiny sector dwarfed by the conventional banks. It was global Islamic banking’s Big Bang, in an economy that ranks alongside Saudi Arabia and Iran in Islamic finance. Non-Islamic commercial banks were allowed to open ‘Islamic windows’, which were in effect parallel operations, banks within banks, sometimes with their own branch network infrastructure. These windows were regulated by the Banking and Financial Institution Act, whereas Bank Islam came under the industry-specific Islamic Banking Act, making it something of a first among equals in the rising sector. Bank Bumiputra was the first to open a window, and was later acquired by the once Chinese-owned CIMB.

Rithuan says Islamic banking comprises around 19% of Malaysia’s total banking industry, a number he says meets the 20% cited in the ‘master plan’ when the sector was launched in 1983. Today, there are more than 40 financial institutions offering Islamic services in Malaysia. The sector is led by Maybank Islamic, an offshoot of conventional major Maybank, controlling around $9 billion in assets, and oft-rumoured as a possible buyer of the Dubai Group’s 40% stake in Bank Islam. Although Maybank has denied its interest, the Dubai royals are believed to be sellers after the recent financial dramas that have crippled their emirate. Such a deal would form the biggest standalone, Shariah-compliant bank in Asia.

The non-Muslim factor

If Islamic banking was designed to service the neglected Muslim community, it has seen an unexpected development that speaks to the sector’s rising sophistication and accessibility. Up to half of the customers in Malaysia and Indonesia opting to bank by Quranic principles have likely never read Islam’s holy book. That’s because they hail from the region’s ethnic Chinese and Indian communities: Christian, Buddhist and Hindu customers who have chosen Islamic banking because, according to Herry Hykmanto, Shariah director at Bank Danamon in Indonesia, “the returns are better”. He says Shariah banks tend to agree to fixed rates, allowing business costs to be better controlled “so you can sleep well”.

The father of current Bank Negara Malaysia’s central bank governor, Zeti Akhtar Aziz, helped conceive what is now regarded as Asia’s first modern Islamic financial institution, the Tabung Haji foundation, in the 1960s

In Indonesia, where secular inclusiveness is required by the constitution – the country is regarded as more moderately Islamic than its Malaysian neighbour – Christians dot the boards of Indonesia’s Shariah banks. One Indonesian Shariah bank is even headed by a Christian – and as Ahmad Riawan Amin of Indonesia’s Shariah banking lobby Asbisindo, and a former CEO of Bank Muamalat, observes: “He’s in the job because he is good at his job.” At Bank Muamalat, the first and arguably most pious of Indonesia’s standalone Islamic institutions, president director Arviyan Arifin says his branches in the Chinese-heavy trading city of Medan in northern Sumatra, in the prosperous and mostly Protestant principal city of Manado on Sulawesi island, and in Bali’s predominantly Hindu capital Denpasar are among the bank’s busiest.

At CIMB in Kuala Lumpur, Ghani seeks to keep its 5 million customers captive within the bank’s universe. It is common for customers of CIMB’s dominant conventional bank to use Islamic finance as well. “Quite a large number of customers at our Islamic bank are non-Muslim,” he says. “All our corporates when they tap the bond market simply do sukuk because they can enjoy savings of three to 20 basis points, depending on the size of the paper. An idiot would be the one not to do Islamic bonds if you can get those kinds of savings. Very few corporates cannot tap the Islamic market (notably alcohol, tobacco and gaming companies) and when they do, they tap a wider market, the conventional investors plus the full-fledged Islamic investors, so you get the price tension you desire.”

CIMB is now a fast-rising number two in Malaysia after Maybank’s Islamic arm. CIMB had around M$6 million ($1.8 million) in financing assets when it stepped, by acquisition, into Islamic banking five years ago; today it has more than M$18 billion. CIMB’s sudden success is partly thanks to a unique and pragmatic dual-branding strategy, which it touts as a model for banking. Instead of setting up a new bank with a totally separate infrastructure – and overheads to match – CIMB runs its conventional and Islamic banks side by side. A conventional branch is also an Islamic one, and vice versa. Staff are trained to handle a conventional transaction one minute, and an Islamic one the next.

AIBIM’s Rithuan acknowledges the need for procedural simplicity. “We find a lot of time is wasted on documentation and red tape,” he says. A big item on AIBIM’s agenda is to standardize basic operating procedures and agreements. Areas such as treasury have standard boilerplate documents finessed over years of conventional banking but newer areas need work. Rithuan says it speaks to the growing reach and sophistication of Islamic banking beyond retail that new standards need to be created. “We are looking at derivatives but we are not sure how we can do it,” he adds. “Trying to make them proper [under Islam] is the aim.”

Crisis and opportunity

Rithuan says the growth in Islamic banking coincides with the popularity of so-called ethical banking in conventional western institutions, and a market reaction to the uncertainties of such events as the sub-prime meltdown. “There’s more awareness now, and after sub-prime and these scandals people are uncomfortable. They want to better know what level they are at, what exposure.”

Now there’s talk of a public relations campaign to market Islamic banking to the west, to demystify the industry and demonstrate how similar Shariah principles are to the new prudence and regulation of conventional banking. “We are going to promote Islamic banking in a friendly way,” says Rithuan. Initiatives are under way to share knowledge and experience with regulators eyeing the new sector in London and Paris. “London is very keen to develop. They are not Muslims but it doesn’t matter.”

As part of an effort to promote Kuala Lumpur as Islamic banking’s Wall Street, Malaysia’s central bank has set up the Malaysia International Islamic Finance Centre (MIFC). Rithuan believes the new industry hubs will develop regionally: London for the Islamic transactions in the western world, Riyadh for the Middle East and Kuala Lumpur for Asia. Malaysia is more developed in retail whereas smaller Singapore is developing expertise in the sukuk market.

Indonesia started its Islamic finance sector 30 years after Malaysia, and the approach has been very different. Where Malaysia adopted a top-down approach to the sector, guided and promoted by government policy and industry-enhancing legislation, Indonesians began using Islamic finance in the early 1990s and then the law followed. Where Malaysia forced growth, Indonesia grew organically, unhindered by government direction – partly because the Suharto dictatorship, which fell in 1998 after 30 years in power, was often wary of Islam. The result, near 20 years on, is that around a fifth of Malaysia’s banking assets are deemed Islamic, whereas in Indonesia they amount to barely 2-3% of the $300 billion domestic banking industry.

But this is suddenly becoming crowded with big ambitions. “Indonesia is at a stage where Malaysia was 17 years ago, when there was deregulation here,” says Ghani at CIMB, which has tapped the Indonesian market with sukuks and other derivative products via its offshoot CIMB Niaga Sharia and plans to open up to 300 Shariah branches across the islands. “It’s just a matter of time that the boom happens in Indonesia. For the first time, you have greater certainty as to how to go about doing business there.” There are already signs of that: Indonesia last year completed one of Shariah banking’s biggest-ever sovereign deals, a $650 million sukuk arranged by CIMB.

Regulation, regulation, regulation

As the muezzin’s prayer from Jakarta’s state mosque punctuates conversation, Pak Rizqullah, vice-president of the Shariah unit at Indonesia’s state-owned Bank Negara, agrees that his country has made great strides in catching up on Malaysia’s 20-year lead in the region but says there is much more to do. The issues that concern Rizqullah are less religious than legislative. Indonesia has failed to clarify a key double-taxation issue in Islamic financing that Rizqullah says could devastate funds in the emerging sector. He says the government is aware of anomalies within Islamic banking legislation and is on side in correcting them, but that in Indonesia industry development has been piecemeal.

BNI is third on the Indonesian Shariah asset table behind Bank Mandiri and industry pioneer Bank Muamalat. Indonesia’s only standalone national Islamic bank, Muamalat was first to open in 1992, followed by Mandiri Sharia in 1999 after the 1998 Banking Act, formed from the ashes of the financial crisis and resultant bank reconstruction, when the government allowed Shariah windows for conventional banks. BNI Sharia opened in 2000. “We have very devoted non-Muslim clients,” says Rizqullah. “They think it’s a very fair and just banking business model.” BNI has around $500 million in Shariah assets, while Hykmanto says Danamon’s Shariah assets have grown by 30% to 50% year on year, albeit off very low bases, a growth number that seems to be mirrored across Indonesia’s Shariah banks and is expected to be maintained through coming years as the sector develops critical mass.

BNI’s Rizqullah says he understands the scepticism about the role of the national Shariah banking supervisors, given that they are scholars rather than bankers and their role is primarily a religious one. But, he says, “from time to time they come to us, talk to us and they gain knowledge of banking”. He adds that the membership of Indonesia’s Shariah supervisory board is widening, to include industry technocrats. “They are changing their style,” he says, pointing out that the board acts in cooperation with the technical team at the central bank. At present, the Shariah board issues fatwas, and it is the central bank’s role to ensure a fatwa rolls out across practical banking transactions. Mostly, says Rizqullah, BNI self-regulates its Shariah compliance, calling meetings of the national advisory board as religious compliance issues arise, such as whether a proposed new retail product is halal.

But as the industry grows exponentially, concerns have been raised about differing regulations between markets, particularly as to what constitute haram and halal transactions. In Kuala Lumpur, CIMB’s Ghani says there are no major religious issues precluding common international standards from developing critical mass. “Shariah transcends all legal framework, all political framework. It is a majority position within the faith that all things are allowed unless it is clearly stipulated in the Quran or in the hadiths [guidance derived from the words and deeds of Islam’s Prophet Mohammed] that it is not,” he says. “It’s very clear-cut – commerce is not something that is much debated, unlike other aspects of Islam.”

Ghani is not convinced that London and other leading financial centres can adapt their experience in conventional banking to the fast-evolving Shariah sector. “Because of the framework we have here, it’s the best platform anywhere in the world,” he claims. “All other established financial centres have the platform to facilitate Islamic finance if they want to but they must make sure they facilitate it in a manner that is conducive for Islamic finance in the manner that Malaysia has done it. They can catch up.”

He says a western bank – or financial centre – might not have the cultural background for the task. “There is a certain degree of respect you have to give to the industry. You cannot treat it in the same manner as conventional finance as it is distinct, even though it is similar. There are certain peculiarities that you have to adhere to, to comply with.” Ghani sees signs of Islamic practices influencing conventional banking in Malaysia, such as the more lenient approach to struggling borrowers. “This is best practice in the Islamic finance.”

More questions than answers

For the moment the industry in Southeast Asia is enjoying rapid growth but there remain many issues to be resolved, not least who is doing the regulating and how. Do an Islamic bank’s own required Shariah advisers ensure all aspects of a transaction, including the customer’s money, are halal, compliant under the Quran? Or is it the technical regulators of national central banks, and their new – read inexperienced – Shariah compliance officers?

What role is played by the authoritative councils of religious scholars, men and mullahs in robes, few if any of them bankers or technocrats, whose often elliptical fatwas are supposed to provide guidance to a sub-set of a wider banking industry that demands certainty and definition? And if it is these scholarly councils deciding what is right or wrong, are they transparent? And who has the defining influence – the national councils or majlis of, say, Indonesia, the world’s biggest Islamic country with its famously moderate, pragmatic interpretation of the faith? Or the tablets handed on by the remote, harder-line scholars of Saudi Arabia, the custodians of the Holy Places, who follow their own unique version of Islamic jurisprudence?

And does anyone else get a say in these international consultations to develop standards and beyond, to new Islamic stock exchanges and money markets as the industry develops, to become more like, well, conventional non-Islamic institutions? An influential extremist from Peshawar, or Bradford for that matter? A moderate from a hallowed Cairo university, or New York or even Sydney, where Westpac is embracing Islamic banking? It might be handy to know the ground rules when you are sweating on a $1 billion sukuk that tests the boundaries of what is currently acceptable in Quranic terms, as the industry starts to attract more conventional clients, and borrowers tailor their companies to meet the shifting criteria of being halal investment opportunities.

“Good governance means you have to go green,” says AIBIM’s Rithuan in Kuala Lumpur. That’s not just a remark about good environmental practices. Green is the international colour of Islam. It is also the colour associated with inexperience and immaturity, something the region’s Islamic bankers are working hard to overcome.