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Key challenges for Islamic finance to continue thriving

June 5, 2012

SINGAPORE: Monetary Authority of Singapore (MAS) managing director Ravi Menon has underlined key challenges for Islamic finance to continue thriving.

“Islamic finance has come a long way. As it embarks on its next phase of growth, the industry must overcome the challenges posed by slower growth and global deleveraging, and build scale and reach critical mass.

“This requires financial institutions, regulators, and international standard setting agencies to work closely together,” he said in his address at the opening of third annual World Islamic Banking Conference: Asia Summit, here today.

Ravi said Islamic finance has shown remarkable resilience during the last five years – perhaps the most challenging economic environment in the post-war era.

He said the industry has grown by an estimated 20% annually in the last five years to reach US$1.3 trillion in total assets in 2011.

“Islamic banks have grown both in number and in scope. But the sustained growth of Islamic finance is in no way guaranteed.

“For Islamic finance to continue thriving, the industry has to overcome a few key challenges. But in every challenge, there is also opportunity,” he said.

Ravi pointed out that the clear and present danger to financial activity, including Islamic finance, is the risk of contagion from an escalation of the Eurozone crisis.

He said Islamic finance is closely intertwined with underlying economic activity and will be affected by the impact of slower global growth.

New customers

Contagion from the Eurozone has already curtailed economic growth and capital inflows to many emerging economies where Islamic finance has taken root.

“Potential spillovers from an escalation of the Eurozone crisis could lower output in the Middle East and North Africa region by about 3.25% relative to baseline, the largest spillover effect for any region outside Europe.

“But Islamic finance has a window of opportunity in the current climate of deleveraging in the global financial system. With its strict prohibition on excessive leverage, Islamic finance has been spared the worst of the financial crisis,” he said.

Ravi pointed out that Islamic banks are well positioned to reach out to new customers who are in need of financing as many global institutions pull back on their lending due to the need to repair their balance sheets.

He said Islamic finance should diversify into growth areas such as trade and infrastructure financing, where demand is still strong, especially in emerging economies.

With a focus on supporting real productive activities, Ravi said Islamic finance is naturally compatible with trade and infrastructure development.

He said tapping these sectors also brings about greater diversification benefits, especially for Islamic institutions which have been hurt by their significant lending exposure to the real estate sector.

A second factor that Islamic finance will have to contend with, the central bank chief said, is the ongoing global regulatory reforms.

He noted the scale and scope of these reforms are probably unmatched in recent history.

“Islamic financial institutions will have to devote considerable resources to meet the new international standards. But there are certain inherent characteristics of Islamic finance that will stand it in good stead in the emerging regulatory environment.”

Ravi said Islamic finance is also well placed to meet the increased “return-to-basics” investor demand.

Unknown risks

Following the global financial crisis, investors have become more averse to the unknown risks embedded in complex financial instruments.

Islamic finance, he said, with its stronger emphasis on transparency, price certainty and risk-sharing, can benefit from this renewed demand for more basic investments, from Muslim and non-Muslim investors alike.

“The third, and perhaps most important, challenge that Islamic finance must overcome is its present fragmented state. Islamic finance currently suffers from low economies of scale. The overall size of Islamic assets is still less than one percent of the global financial system.
“Being smaller and relatively young, Islamic finance currently offers fewer product choices for consumers and less comprehensive risk management options for institutions.

Cross-border investment flows are also constrained by differing interpretations of permissible transactions under syariah principles,” he said.

He said the isolated pools of Islamic liquidity in each market restrict opportunities for more efficient allocation of capital across consumers, industries, and jurisdictions.

Ravi suggested that Islamic finance must become more integrated with the global financial system.

He pointed out the industry must expand beyond its traditional markets to include a wider range of financial institutions, investors and consumers. This means Islamic finance must strike roots in key international financial centres of the world.

He said these centres can contribute to Islamic finance in several ways, including market liquidity, capabilities in global financial markets and opportunities for interaction and collaboration.

As Islamic finance gains prominence, he said conventional financial institutions increasingly want to be involved to tap these opportunities.

He said financial centres like Singapore serve as intersecting nodes where Islamic financial institutions collaborate with their conventional partners to jointly grow the industry.

“By applying the same regulatory framework to both conventional and Islamic financial institutions, Singapore aims to encourage financial institutions here to grow their suite of products and services for the Islamic finance industry,” he added.



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