At a time when the conventional lending system is going up in flames, a quiet yet fast-growing segment of the financial services industry is emerging from the embers as the hero the industry desperately needs.

It’s always the quiet ones; yet the potential of Islamic finance to become the preferred model of lending globally is sounding out loud and clear.

While conventional share market indices continue their fiery plummet downwards, Islamic indices around the world are lighting up; and Sharia-compliant financial assets are growing faster than any other banking sector, at more than 15 percent per annum. The current market potential of Islamic financial bodies is estimated to be in excess of $5trn, with the value of its worldwide financial assets projected to reach $1.6trn by 2012.

Such growth demonstrates very real opportunities for investors, businesses and governments worldwide.

The new lending model
Islamic finance is spectacularly different from its Western lending counterpart. Guided by Islamic Law, known as Sharia, it is built around principles of fairness, partnership and resistance to excessive risk. Strong emphasis is placed on the existence of an underlying asset to a transaction, and profit and risk sharing is encouraged.

Excessive speculation is banned, and dealings in forbidden assets such as alcohol and gambling are prohibited. Charging interest is illegal and perceived as immoral, since interest does not factor in how a change in the loan’s value could negatively impact the borrower. Instead, the bank will buy property outright and charge the owner a utility fee for its use.

This principle, however, is a cause for contention – depending on whether the institution charges for the “time value of money,” deemed by critics as simply interest dressed up.

The principles of Islamic finance contrast with those of the conventional lending model, frequently characterised by individual gain, exposure to unrealistic risk levels, high interest rates, and the creation of financial products so fanciful and exotic that they can barely be pronounced anymore.

Consequently, Islamic finance is revered by proponents as a more ethical banking option, and better connected to the real economy. This moral character, combined with a low risk profile, is likely to appeal to a wider investor pool in the future, and enhance its potential to become a viable alternative to the Western model of funding.

Engine for growth
Thanks to the sector’s strong principles, the global financial crisis was largely positive to the growth of Islamic finance.

Profit and risk sharing ensured adequate due diligence and risk profiling of investments, shielding many banks from unwarranted exposures. The prohibition against short selling reduced losses further. The sector was impacted by over-exposure to real estate, which was used frequently as a tangible asset to back transactions, but overall the crisis did more good than bad. It normalised pricing between conventional and Islamic debt sources and bought Islamic finance out from under the radar.

In fact, one could commend the industry for the impeccable timing of its coming out party. Just as the global customer was left with a souring taste from the fancy, frivolous spending of the Western lending system now up in smoke, Islamic financing delicately tiptoed onto the world stage as the alternative model of lending.

Beyond timing, a number of key growth factors continue to enhance the investment appeal of Sharia-compliant finance.

As a relatively young market, it has strong untapped potential for product innovation and design. Growth opportunities exist for conventional banks and fund managers to enhance their product offerings. Fund managers can benefit from a diversified source of debt finance, and banks can increase socially responsible investment options through Sharia-compliant funds while simultaneously helping to cultivate social inclusion.
Equally, there are a number of virgin markets to explore: such as Indonesia, which boasts the highest Muslim population in the world. Established markets around the Asia-Pacific are likely to take advantage of regional growth in these markets, as well as establish new Islamic listing platforms later on.

Sharia-compliant financing is also attractive as a result of the strong cashflow out of petrodollar regimes such as the UAE. This creates demand for banks in larger financial markets to offer culturally relevant products and services to absorb the capital.

Emerging power brokers
The value of Islamic finance in petro-dollar markets such as the UAE is best approached with a long-term investment horizon.

Although the UAE is revered as one of the most important centres for Islamic finance – and rightly so, with the highest number of Islamic sovereign wealth funds in the world – large losses from public infrastructure projects financed in part by conventional debt mechanisms have left the overall economy weak.

In the immediate term, a number of smaller transitional markets and future Islamic finance hot-beds are grabbing investor attention.

Pakistan is one such market. The strength of this South Asian nation lies in its large, 180 million-strong Muslim population, with a growing appetite for culturally-relevant banking practices. The country’s Sharia-compliant financial assets have climbed an astonishing 30 percent per year from 2006 to 2010, and Islamic banking is currently worth $4.74bn – or 7.3 percent of the entire banking system.

A particularly attractive growth opportunity sits with the country’s rural market, comprising of customers traditionally sceptical of banks as a result of the interest applied to products. Importantly, and as part of an ambitious plan to double Islamic financial services by 2015, Pakistan’s government has requested that 20 percent of all new branches created by Islamic lenders be opened in rural areas.

In general, public policy has been highly supportive of Islamic finance. The country’s central bank, the State Bank of Pakistan, is using a three-pillared approach to encourage development, and is focused on boosting the number of Islamic banks in the private sector, setting up Islamic subsidiaries in existing banks, and promoting the development of Islamic branches in conventional banks.

To maintain growth and increase foreign investment opportunities, the government will need to focus attention on developing regulatory infrastructure that supports Islamic finance. Currently, the segment operates under the existing laws and regulations of conventional banks. Furthermore, political risk associated with the country’s almost decade-long battle with militants along the Afghan border must be curbed to reduce capital flight.

Further south, Malaysia is another new darling of Islamic finance – in fact; it’s practically a bonafide star. The country currently holds $30.9bn worth of Islamic banking assets, and has the world’s largest Islamic private debt securities market, at $34bn of local corporate bonds. The small Asian nation is revered by the global finance industry for its progressive reform of regulatory and tax structures as complementary to Islamic finance guidelines. Under the Islamic Banking Act 1983 and the Takaful Act 1984, the Sharia-compliant financial market operates separately to conventional markets. Tax laws are largely deregulated, and provide for a number of important exemptions across the industry – naturally, whetting investor appetite. The country has also set high benchmarks in Islamic finance for efficient market discipline and risk management, with policies clearly spelt out in the Financial Sector Master Plan and Capital Master Plan.

Similarly, Malaysia’s attraction lies in product innovation, and it proudly boasts a large and holistic product range: spanning from wealth management options aimed at the wealthy, through to microfinance options designed for the less affluent consumer. In particular, Malaysia is revered for its highly sophisticated Islamic insurance product offering (Takaful).

Malaysia also plays a pro-active role in establishing strategic alliances to spread its model of Islamic finance globally. A key example is ING Public Takaful Ehsan, a joint venture between Dutch group ING and the local Public Bank Bhd and Public Islamic Bank Berhad.  Similarly, the country works closely with its neighbour to the south, Indonesia.

As the world’s most populous Muslim country, Indonesia offers Islamic finance a tantalising target market of more than 210 million potential customers. It holds promising potential: local Islamic banking assets have grown 47 percent between 2005 and 2011, with account holders increasing from 300,000 in 2001 to 8.5 million in 2011.

Since July 2011, Indonesia and Malaysia have signed two strategic partnerships. The first Memorandum of Understanding (MoU) was between The Association of Islamic Banking Institutions Malaysia and the Indonesian Sharia Banking Association, and focused on establishing an industry taskforce to develop cross-border liquidity management products. The second MoU was between Malaysia’s Maybank Islamic Bhd and PT Bank Syariah Mandiri of Indonesia, and formally initiated a cross-border Islamic treasury, and trade finance products.

Growing beyond borders
Such connectivity and information sharing between regional counterparts is fuelling the Islamic finance growth machine further, with the communication of best practice approaches vital to the long-term sustainability of the sector.

This knowledge transfer is also occurring in more developed markets. Geographically, a politically stable and well-established economy such as Australia is well-positioned within the Asia-Pacific region to benefit from new product flows from its already strong trading partners in Asia.

The Oceanic country’s influential 2010 Johnson Report, Australia as a Financial Centre – Building on our Strengths, linked the importance of Islamic finance to the goal of making Australia a regional leader in financial services. With a Muslim population that exceeds the combined Muslim populations of both Hong Kong and Japan, as well as the Indonesian market on its back doorstep, Australia has significant incentive to boost its access to Islamic products. Australia’s recognition of Islamic finance is a positive indication that conventional markets are supportive of the industry’s growth.

With so many business opportunities in Islamic finance across the globe, and a number of new players to add to the watch-list, a country’s legal and tax structure is likely to be a deciding factor for investors. Too often, the key barrier to the growth of Islamic finance is local regulatory barriers.

In the case of Australia, for example, the Johnson report highlighted how local tax restrictions must be removed to ensure that Islamic products have equal treatment to their conventional counterparts. The government has recently taken heed to this suggestion, appointing the Board of Taxation to perform a comprehensive review of local tax laws to ensure they are complementary to Islamic finance offerings.

Equally positive, this year Oman legalised Islamic banking, the final Gulf Arab state to do so. In Indonesia, the government’s ability to take a leaf from Malaysia’s book and focus on building a legal system that complements Islamic finance will put it in good stead.

Of course, the speed with which countries can amend legal and tax structures will of course determine the pace of growth.  Regardless, public sector support will be vital to the sustainability and success of Islamic finance in each country.

Looking forward
There is little doubt that Islamic Finance is blazing a hot trail across the global economic stage.

The sector’s commitment to financing real economic activity rather than engaging in speculation, coupled with a separation of risk and reward, has enabled it to achieve credibility with numerous audiences. Its ‘ethical’ market appeal is also likely to continue to increase its popularity well beyond a traditionally Muslim customer base.

Strong growth opportunities in a number of regional markets give it further potential to become the new, alternative engine of global economic growth. Long-term sustainability will depend on the level of effective public-private co-ordination. Responsibility lies with governments to develop complementary tax and regulatory infrastructure. Similarly, onus lies with the private sector to share lessons learnt and best practice approaches with trade partners and allies.

Should all players continue to work together cohesively, the once-quiet industry of Islamic finance will become a loud force to be reckoned with – and perhaps even the reluctant hero to give finance back its manners.