The new challenge to Wall Street?

PUBLISHED : Saturday, 30 October, 2010, 12:00am
UPDATED : Saturday, 30 October, 2010, 12:00am

Since Donald Tsang Yam-kuen announced Hong Kong's ambitions to be an Islamic finance centre, in 2007, there have been great advances in Islamic finance. I was in Kuala Lumpur this week attending the Global Islamic Finance Forum, which was attended by the whole glitterati of the Islamic world.

In the 1990s, Islamic finance was a fledgling, fringe industry. Today it has grown from roughly US$150 billion to about US$1 trillion. This is still small relative to some of the largest global fund managers and universal banks, who manage more than US$1 trillion each. But the double-digit growth and potential size of the market cannot be ignored. Some pundits think the market will reach US$2 trillion in the next five years.

There are roughly 1.3 billion Muslims in the world, with 138 million in India and roughly 30 million in mainland China (plus 200,000 in Hong Kong). These are growing markets in terms of income and wealth. Since the Muslim community wants to invest in interest-free banking, Islamic funds have been growing in leaps and bounds. There are roughly US$800 billion in Islamic banking funds, US$100 billion in the sukuk (or Islamic bond) market and another US$100 billion in the takaful (Islamic insurance) and fund management business. In 2008, Hong Kong sought to attract Muslim investors by introducing the Hang Seng Islamic China Index Fund, which complies with sharia law.

With oil prices remaining at high levels, Middle East producers continue to generate surpluses that must be parked somewhere. With Western markets and economies under pressure, some of that money has moved eastward.

Will Islamic finance be a serious challenge to traditional Wall Street finance? That question deserves a good answer.

First of all, thanks to the good work of Bank Negara Malaysia and the central banks of Persian Gulf nations, the infrastructure for Islamic finance has been laid. It includes the establishment of an accounting standards authority (the Accounting and Auditing Organisation for Islamic Financial Institutions); an international organisation to set regulatory standards (the Islamic Financial Services Board) and the Institute for Education in Islamic Finance.

The basic principle of Islamic banking is the sharing of profit and loss, and the prohibition of usury. Simply put, interest is prohibited, but profit sharing is not. The distinctive elements of Islamic finance are its ethical aspect (the prohibition of usury and exploitation of the borrower), the preference for trading in real assets (rather than synthetic products), partnership between the investor and investee, and its governance structure (requiring a sharia council).

The point to remember in Islamic finance is that there is no Islamic global reserve currency. Although Islamic banks are growing rapidly, there is no assurance that they will not be subject to the problems of non-performing loans and bank runs that are endemic in commercial banking.

This week saw the launch of the innovative International Islamic Liquidity Management Corporation (IILM). It aims to help institutions that offer Islamic financial services to manage liquidity more efficiently and effectively. It addresses a fundamental problem of Islamic financial institutions: providing adequate liquidity in times of stress. Once an international lender of last resort is in place (to supplement national facilities, not replace them), there will be better confidence in the liquidity of the Islamic financial services industry.

The IILM is expected to issue high-quality, sharia-compliant financial instruments at both the national and cross-border levels, to enhance the soundness and stability of Islamic financial markets.

The signatories to the IILM Articles of Agreement are the 11 central banks or monetary agencies of Indonesia, Iran, Luxembourg, Malaysia, Mauritius, Nigeria, Qatar, Saudi Arabia, Sudan, Turkey and the United Arab Emirates. Multilateral organisations participating in the initiative are the Islamic Development Bank and the Islamic Corporation for the Development of the Private Sector.

Islamic finance has come a long way, but there is still a long way to go, since US$1 trillion is still small relative to US$232 trillion in conventional financial assets (excluding derivatives).

The real test for any challenger to Wall Street finance is whether Islamic finance will be the more efficient, more ethical and more stable of the two. Islamic finance fulfils the needs of the Islamic customer. Ethics aside, there are two crucial problems in finance - information asymmetry and the principal-agent relationship. Because markets are not completely transparent and information is unequal among participants, we tend to rely on trusted institutions such as banks (the agents), to act on our (the principals) behalf.

The recent Wall Street crisis demonstrated how complex financial engineering enables very smart bankers to make profits at the expense of the public purse. When they fail, the public bears the losses because they are too large and too powerful to fail. This is the 'moral hazard' created in the absence of the level playing field that is a precondition of free markets.

The real question is, given our unequal access to information, how do the savers and borrowers know when the banks have shifted the risk back to them, because of moral hazard? Islamic finance faces exactly the same dilemma. If Islamic finance theoreticians can solve this problem, they would be doing a great service to the rest of the world. Then we would truly have an alternative to Wall Street.

Andrew Sheng is a former chairman of the Hong Kong Securities and Futures Commission and current adjunct professor at Tsinghua University's School of Economics and Management, Beijing