On the verge of a financial crisis? (Part 3)

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Recent events in the financial world could be early warning signs of a global crisis. But investors who are prepared for it can grab the opportunities that arise. Author Tariq Alrifai discusses how Islamic finance can be part of the solution to current problems in the global economy.

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WHILE Islamic finance makes up less than 1% of the financial assets globally, the industry has grown exponentially in recent years. According the Malaysia International Islamic Financial Centre (MIFC), the global Islamic finance industry stood at US$2.1 trillion (RM7.8 trillion) at end-2014, with key markets being Saudi Arabia, Iran and Malaysia. The figure represents a compound annual growth rate of 17.3% between 2010 and 2014. 

MIFC data shows that Islamic banking assets currently represent more than half the banking assets of Saudi Arabia’s domestic system, 45% of Kuwait’s and a significant portion of Malaysia’s (26%).

Tariq Alrifai, author of Islamic Finance and the New Financial System: An Ethical Approach to Preventing Future Financial Crises, believes that Islamic finance can play a huge role in fixing the current financial system. The first thing the financial system needs is a reform of its ethics, he says. “Ethics is not just an Islamic principle. Everyone believes in ethics.” 

And there must be an overall shift in the industry to bring back ethics, he adds. 

Tariq believes that the too-big-to-fail financial institutions have been the cause of much instability in the global financial system. As a result, a moral hazard has been created because of the fear that these banking conglomerates are too big to fail. They can no longer get away with just a slap on the wrist, he says. 

“One method is to bring back ethics. That means trust, principles of equality and shared risk. These banks paid the fine and moved on. There is no ethics in that and ethics needs to be brought back into the system.” 

Since the problem lies with having too much debt in the system, the principle of shared risk in Islamic finance needs to be replicated. This means a greater overhaul is needed to do away with the debt-based financial system. 

One solution to this problem is to convert the debt into equity, something which author Nassim Taleb suggests in his book, Black Swan

“In his book, he asks what does one do with underwater mortgages [which occur when the value of the mortgage is higher than the value of the property itself]. He says banks should convert them into equity so that both the bank and homeowner have a stake. If you convert debt into equity, then both the company and investors will have a stake in making sure the company makes it,” Tariq says.

“The same can be applied to other debt. It doesn’t have to be an Islamic bank pushing for this. It is the principle of shared risk.”

But Tariq acknowledges that Islamic finance has its fair share of challenges. Despite the industry’s impressive growth, more innovation is needed to develop the landscape further.

“When you say Islamic finance is an alternative banking system, it has to provide true alternatives. Consumer finance products such as loans and credit are Islamic products made to fit the conventional [banking] product line,” he says. 

“For example, if banks finance my car, it makes no difference if they are Islamic or conventional. The transaction is shariah-compliant, but it is not a true alternative.” 

A true alternative, he says, would be something like buying a house on equity, like on a musyarakah basis. “I think for Islamic finance to move to the next level, there must be more alternatives,” he adds.

Tariq strongly believes that Islamic councils will be open to such innovations. It is getting the banks to come up with ideas to propose first. 

“Banks are conservative by nature and don’t like taking high risks. What is conservative is to use what is already working on the conventional side and putting an Islamic label on it. They do it because it is a safe bet and they know they will capture a certain segment of customers,” he says.

“But if you tell a shariah scholar that you want to do a home plan financing solution that is 100% equity based, he will say, ‘Perfect. This is what we are talking about’. It is just a matter of getting the people who are developing the product to go with it.”

Another hurdle for Islamic finance is getting things approved in certain jurisdictions. “Most regulators are regulators for banks across the board. Islamic banking just falls under their mandates. Again, they are trying to make Islamic banks fit into conventional banking,” Tariq says.

“So, if you bring up this idea of a 100% equity-based home-financing product to the regulators, they will say it is a crazy concept.”

The Islamic finance industry also lacks products in the fixed income segment for retail consumers, but that is where the demand happens to be, says Tariq. 

“It could be leasing or ijarah (similar to instalment leasing agreement) products. For example, banks could create something like a bond fund that pays dividends to owners and is based on the ownership of multiple real estate projects. These are available at the institutional level but not at the retail level,” he adds.

“There are not enough products in the Islamic world, so investors tend to go back to the conventional side.”

For the high net worth segment, Islamic finance solutions are often one-off products. One reason for this is because Islamic product development costs are very high compared with conventional products owing to the lack of demand. It is a chicken-and-egg situation, says Tariq. 

“Demand needs to pick up. But I think there aren’t enough innovative products out there for that.”

At the end of the day, high net worth investors are not going to look just at Islamic options, he says. “They want what is best to protect their portfolio.”

This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on June 8 - 14, 2015.