The West has much to learn from Islamic finance

by Ian Fraser

Given they are barred from charging interest and must abide by a strict religious code, Islamic financial institutions are often dismissed by sophisticated western bankers as living in the dark ages. However, according to a couple of recent major reports, shariah-compliant financial institutions are not only coming of age, but also have much to teach their western counterparts.

In a report, Empowering Risk Intelligence in Islamic Finance: Managing Risk in Uncertain times, Deloitte’s Islamic Finance Knowledge Center said that the approach to risk management used in Islamic finance has more in common with the western approach than is often assumed.

The report – based on a survey of 20 Islamic financial institutions located across the Middle East and South-East Asia, which have aggregate assets of $50 billion – suggested that Islamic finance, a cash-rich sector, has much to teach the west’s financial system, which has yet to fully recover from the near-death experiences of 2007-09.

The Empowering Risk Intelligence report found that Islamic financial institutions came late to adopting formal approaches to risk management. 79% of respondents had established their risk-management departments in the past five years, with only 5% having a risk management department prior to 2002. But things are changing, and fast. The report found that 83% of Islamic finance firms today have both a formal risk-management function and a risk committee responsible for overseeing all risks.

Yet Deloitte acknowledged there is room for improvement in the risk management area. Key risk-management and regulatory challenges facing the Islamic sector include that two-thirds of Islamic financial institutions don’t have any external credit rating, and that only 25% have considered or received an external rating from a specialist Islamic rating agency such the Bahrain-based Islamic International Rating Agency. The report said:

“This constitutes a real challenge posed to industry participants and standard-setters such as the [Kuala Lumpur-based] Islamic Financial Services Board, [Bahrain-based] Accounting & Auditing Organization for Islamic Financial Institutions (AAOIFI), [Bahrain-based] International Islamic Financial Market (IIFM) and the Islamic International Rating Agency (IIRA), to enforce best practices.”

The report suggested that the main causes of shariah-compliance risks include non-standardized practices, diverse interpretations of shariah law, and the fact shariah laws are unenforced in many jurisdictions. Dr Hatim El Tahir, director of Deloitte’s Middle East Islamic Finance Knowledge Center, said:

“One thing is certain – the traditional operations and management of Islamic finance will need to change. Institutions offering Islamic financial services around the globe will not only need to deal with risk management but will also need operational effectiveness and a skilled workforce to empower risk intelligence in Islamic finance.”

The Deloitte findings came as an op-ed published by Project Syndicate, The Challenge of Islamic Finance, sang the praises of Islamic finance and suggested it has an important role in counter-balancing the bonus-fuelled procyclicality and morally hazardous nature of western finance.

Authors Andrew Sheng, ex-chairman of the Hong Kong Securities &  Futures Commission (and one of the voices of sanity in the movie Inside Job) and Ajit Singh, emeritus professor of economics at Cambridge University, said there is growing convergence between Islamic and western finance.

“Despite skepticism regarding accommodation between Islamic and global finance, leading banks are buying Islamic bonds [also known as sukuk] and forming subsidiaries specifically to conduct Islamic finance. Special laws have been enacted in non-Muslim financial centers – London, Singapore, and Hong Kong – to facilitate the operation of Islamic banks and associated financial institutions.”

Sheng and Singh argued that Islamic finance, already a $3 trillion sector, has an important role to play in improving the ethical framework of western-style finance (which, as everyone other than bankers and financiers recognizes, seriously lost its way during the credit bubble of 1999-2007).

They suggested that if the ethical values in Islamic finance, rooted as they are in shariah religious law, could:

“further deter moral hazard and the abuse of fiduciary duties by financial institutions, Islamic finance could prove to be a serious alternative to current models of derivative finance.”

“The test of any alternative financial system depends ultimately on whether it is – or can be –
more efficient, ethical, stable, and adaptable than the prevailing system.”For now, there is no Islamic global reserve currency and no lender of last resort. But the Islamic world is the custodian of huge natural resources that back its trading and financial activities.”

If the scenario outlined by Sheng and Singh is correct, prepare for the centre of gravity of global finance to shift from London and New York to the Gulf and Kuala Lumpur.

Ian Fraser, a journalist since 1988, is working on programmes about the banking and financial crisis for the BBC.