Gillian Blease

TO SEE Islamic finance in action, visit the mutating coastline of the Gulf. Diggers claw sand out of the sea off Manama, Bahrain's capital, for a series of waterfront developments that are part-funded by Islamic instruments. To the east, Nakheel, a developer that issued the world's largest Islamic bond (or sukuk) in 2006, is using the money to reorganise the shoreline of Dubai into a mosaic of man-made islands.

Finance is undertaking some Islamic construction of its own. Islamic banks are opening their doors across the Gulf and a new platform for sharia-compliant hedge funds has attracted names such as BlackRock. Western law firms and banks, always quick to sniff out new business, are beefing up their Islamic-finance teams.

Governments are taking notice too. In July Indonesia, the most populous Muslim country, said it would issue the nation's first sukuk. The British government, which covets a position as the West's leading centre for Islamic finance, is also edging towards issuing a short-term sovereign sukuk. France has begun its own charm offensive aimed at Islamic investors.

Set against ailing Western markets such vigour looks impressive. The oil-fuelled liquidity that has pumped up Middle Eastern sovereign-wealth funds is also buoying demand for Islamic finance. Compared with the ethics of some American subprime lending, Islamic finance seems virtuous as well as vigorous. It frowns on speculation and applauds risk-sharing, even if some wonder whether the industry is really doing anything more than mimicking conventional finance and, more profoundly, if it is strictly necessary under Islam (see article).

Sukuks in the souk

As the buzz around the industry grows, so do expectations. The amount of Islamic assets under management stands at around $700 billion, according to the Islamic Financial Services Board, an industry body. Standard & Poor's, a rating agency, thinks that the industry could control $4 trillion of assets. Others go further, pointing out that Muslims account for 20% of the world's population, but Islamic finance for less than 1% of its financial instruments—that gap, they say, represents a big opportunity. With tongue partly in cheek, some say that Islamic finance should by rights displace conventional finance altogether. Western finance cannot service capital that wants to find a sharia-compliant home; but Islamic finance can satisfy everyone.

Confidence is one thing, hyperbole another. The industry remains minute on many measures: its total assets roughly match those of Lloyds TSB, Britain's fifth-largest bank (though some firms that meet sharia-compliant criteria may attract Islamic investors without realising it). The assets managed by Islamic rules are growing at 10-15% annually—not to be sniffed at, but underwhelming for an industry that attracts so much attention. Most of all, the industry's expansion is tempered by its need to address the tensions between its two purposes: to serve God and to make as much money as it can.

That is a stiff test. A few devout Muslims, many of them in Saudi Arabia, will pay what Paul Homsy of Crescent Asset Management calls a “piety premium” to satisfy sharia. But research into the investment preferences of Muslims shows that most of them want products that benefit their savings, as well as their souls—rather as ethical investors in the West want funds that do no harm, but are also at least as profitable as other investments.

A combination of ingenuity and persistence has enabled Islamic finance to conquer some of the main obstacles. Take transaction costs which tend to be higher in complex Islamic instruments than in more straightforward conventional ones. Sharia-compliant mortgages are typically structured so that the lender itself buys the property and then leases it out to the borrower at a price that combines a rental charge and a capital payment. At the end of the mortgage term, when the price of the property has been fully repaid, the house is transferred to the borrower. That additional complexity does not just add to the direct costs of the transaction, but can also fall foul of legal hurdles. Since the property changes hands twice in the transaction, an Islamic mortgage is theoretically liable to double stamp duty. Britain ironed out this kink in 2003 but it remains one of the few countries to have done so.

However, just as in conventional finance, as more transactions take place the economies of scale mean that the cost of each one rapidly falls. Financiers can recycle documentation rather than drawing it up from scratch. The contracts they now use for sharia-compliant mortgages in America draw on templates originally drafted at great cost for aircraft leases.

Islamic financiers can also streamline their processes. When Barclays Capital and Shariah Capital, a consultancy, developed the new hedge-fund platform, they had to screen the funds' portfolios to make sure that the shares they pick are sharia-compliant. That sounds as if it should be an additional cost, but prime brokers already screen hedge funds to make sure that risk concentrations do not build up. The checks they make for their Islamic hedge funds can piggyback on the checks they make for their conventional hedge funds.

Mohammed Amin of PricewaterhouseCoopers, a consulting firm, says the extra transaction costs for a commonly used Islamic financing instrument, called commodity murabaha, total about $50 for every $1m of business. That is small enough to be recouped through efficiencies in other areas, or to be absorbed in lenders' profit margins. In addition, bankers privately admit that less competition helps keep margins higher than in conventional finance. “Conceptually, Islamic finance should cost more, as it involves more transactions,” says Mr Amin. “The actual cost is tiny and can be lost in the wash.”

The other area of substantive development has been in redefining sharia-compliance. New products require scholars to cast sharia in fresh, and occasionally uncomfortable, directions. Some investors express surprise at the very idea of Islamic hedge funds, for example, because of prohibitions in sharia on selling something that an investor does not actually own.

“You encounter a wall of scepticism whenever you do something new,” says Eric Meyer of Shariah Capital. “It is no different in Islamic finance.” He says that it took eight long years to bring his idea of an Islamic hedge-fund platform to fruition, applying a technique called arboon to ensure that investors, in effect, take an equity position in shares before they sell them short. Industry insiders describe an iterative process, in which scholars, lawyers and bankers work together to understand new instruments and adapt them to the requirements of sharia.

Differences in interpretation of sharia between countries can still hinder the economies of scale. Moreover, the scholars can sometimes push back. Earlier this year, the chairman of the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI), an industry body, excited controversy by criticising a common form of sukuk issuance that guarantees the price at which the issuer will buy back the asset underpinning the transaction, thereby enabling investors' capital to be repaid. Such behaviour contravened an AAOIFI standard demanding that assets be bought back at market prices, in line with the sharia principle of risk-sharing. The sukuk market has enjoyed years of rapid growth (see chart), but early signs are that the AAOIFI judgment has dented demand.

Although Islamic finance has done well to reduce its costs and broaden its product range, it has yet to clear plenty of other hurdles. Scholars are the industry's central figures, but recognised ones are in short supply. A small cadre of 15-20 scholars repeatedly crops up on the boards of Islamic banks that do international business. That partly reflects the role, which demands a knowledge of Islamic law and Western finance, as well as fluency in Arabic and English. It also reflects the comfort that this handful of recognised names brings to investors and customers.

There are plenty of initiatives to nurture more scholars but for the moment, the stars are pressed for time. That can be a problem when banks are chasing their verdict on bespoke transactions. It takes a scholar about a day to wade through the documentation connected with a sukuk issue, for example. But scholars are not always immediately available. “You've got to have the scholar's number programmed into your mobile phone and be able to get hold of them,” says a banker in the Gulf. “That is real competitive advantage.”

Assets are another bottleneck. The ban on speculation means that Islamic transactions must be based on tangible assets, such as commodities, buildings or land. Observers say that exotic derivatives in intangibles such as weather or terrorism risk could not have an Islamic equivalent. But in the Middle East, at least, the supply of assets is limited. “Lots of companies in the Gulf are young and don't have assets such as buildings to use in transactions,” says Geert Bossuyt of Deutsche Bank. This limits the scope for securitisation, a modern financing technique that is backed by assets and is thus seen by sharia scholars as authentically Islamic. There are not enough properties to bundle into securities.

Governments have more assets to play with. The Indonesians have approved the use of up to $2 billion of property owned by the finance ministry in their planned sukuk issuance later this year. But oil-rich governments in the Gulf have little need to issue debt when they are flush with cash. That is a problem. Sovereign debt would establish benchmarks off which other issues can be priced. It would also add to the depth of the market, which would help solve another difficulty: liquidity.

It may seem odd to worry about liquidity when lots of Muslim countries are flush with cash, but many in Islamic finance put liquidity at the top of their watchlist. The chief concern is the mismatch between the duration of banks' liabilities and their assets. The banks struggle to raise long-term debt. In a youthful industry, their credit histories are often limited; they also lack the sort of inventory of assets that corporate sukuk issuers have.

Desert liquidity

As a result, Islamic banks depend on short-term deposit funding, which, as Western banks know all too well, can disappear very rapidly. “Lots of assets are generally of longer term than most deposits,” says Khairul Nizam of AAOIFI. “Banks have to manage this funding gap carefully.” If there were a liquidity freeze like the one that struck Western banks a year ago, insiders say that the damage among Islamic banks would be greater.

Gillian Blease

There are initiatives to develop a sharia-compliant repo market but for the time being the banks have only limited scope for getting hold of money fast. Loans and investments roll over slowly. The lack of sharia-compliant assets and a tendency for Islamic investors to buy and hold their investments have stunted the secondary market. The shortest-term money-management instruments available today are inflexible. Cash reserves are high, but inefficient. Western banks with Islamic finance units, or “windows”, are just as troubled by tight liquidity as purely Islamic institutions are: their sharia-compliant status requires them to hold assets and raise funds separately from their parent banks.

There are other sources of danger, too. Because Islamic banks face constraints on the availability and type of instruments they can invest in, their balance-sheets may concentrate risk more than those of conventional banks do. The industry's ability to steer its way through stormy waters is largely untested, although Malaysian banks do have memories of the Asian financial crisis in the 1990s to draw on.

None of these tensions need derail the growth of Islamic finance just yet. There is plenty of demand, whether from oil-rich investors, the faithful Muslim minorities in Western countries or the emerging middle classes in Muslim ones. There is lots of supply, in the form of infrastructure projects that need to be financed, Western borrowers looking for capital and ambitious rulers eager to set up their own Islamic-finance hubs. The industry is innovative; new products keep expanding the range of sharia-compliant instruments. And as in conventional finance, the economics of the Islamic kind improve as it gains scale.

But further growth itself contains a threat. The AAOIFI ruling on sukuk earlier this year neatly captured the contradictory pressures on the industry. On the one hand, bankers are worried that the narrow enforcement of sharia standards is liable to stifle growth; on the other some observers fear that Islamic finance is becoming so keen to drum up business that its products, with all their ingenuity, are designed to evade strict sharia standards. This presents a dilemma. If the industry introduces too many new products, cynics will argue that sharia is being twisted for economic ends—the scholars are being paid for their services, after all. But if it fails to innovate, the industry may look too medieval to play a full part in modern finance.

Balancing these imperatives will become even harder as competition grows fiercer. Anouar Hassoune of Moody's, a credit-rating agency, believes that unscrupulous newcomers could harm the reputation of the entire industry, “like the space shuttle undone by something the size of a 50 cent coin”. Islamic finance serves two masters: faith and economics. The success of the industry depends on satisfying both, even if the price of that is a bit more inefficiency and a bit less growth.