KUWAIT CITY, Sunday 5 September 2010 (AFP) -- Islamic finance, which prohibits charging interest, is set to double in size in five years, but the one-trillion-dollar industry must diversify and regulate to realise its full potential, analysts and economic reports say.
Diversification into new territories is also necessary to reduce the risk of exposure and utilise their full potential, they add.
Islamic law not only forbids charging or paying interest, but also bans speculation and investment in sectors deemed haram (prohibited), such as pornography, gambling, arms, alcohol and pork products.
Perhaps the most popular product is Murabaha, which is used to finance a variety of consumer purchases from cars to houses. Sukuk is the equivalent of bonds used to raise funds for large-scale investments.
Under a product called Musharaka, which means partnership, the bank provides the funds to enable the customer to buy an asset, with the two parties agreeing a profit or equity sharing ratio for that asset. Losses are shared on a similar basis.
The broader principle of Islamic finance is based on sharing risk as well as profit.
Despite the number of products offered, Amrith Mukkamala, director of asset allocation at Kuwait and Middle East Financial Investment Co (KMEFIC), believes they are still limited.
"The products (of Islamic finance) that are available for investors are still very limited ... compared to high demand," said Mukkamala, adding that the field of derivatives should be explored seriously.
For his part, Kuwaiti economist Hajjaj Bukhdur believes there are enough products, and that even greater expansion has been subdued by a lack of both sufficient regulation and management skills.
"Islamic finance already has around 30 different types of products and instruments, giving it a large degree of flexibility to meet investors' demand and continue to expand rapidly," Bukhdur told AFP.
"But it has two major shortcomings: there are different regulatory systems ... and managements have been less competent to realise the full potential," he said.
Assets of Islamic financial institutions increased five-fold to around one trillion dollars (787 billion euros) between 2003 and last year, but Moody's Investors Service believes the full potential is at least five trillion dollars.
But for now, it only makes up around five percent of the global financial industry.
In May, speakers at a forum on challenges facing the sector, said it took 40 years to reach one trillion dollars in assets, but now it will take just five years to double.
The number of Islamic financial institutions and banks grew from just a few in the mid-1970s to several hundred now operating in more than 50 countries across the world, and with leading global banks getting into the business.
The International Monetary Fund said last month that the September 11, 2001 attacks on the United States and a sharp rise in oil price and revenue have greatly helped the rise of Islamic finance because more Muslim investors wanted to keep money at home.
In a report in April, Moody's urged the Islamic finance industry to innovate, particularly in the area of risk hedging, if it is to really thrive.
The combined use of securitisation and derivatives "offers considerable scope for reducing the risk exposures of Islamic financial institutions (IFIs) and thus improving their overall creditworthiness," the agency said.
"If employed with care, derivatives can enhance efficiency in IFIs through risk mitigation, thereby making them more competitive as well as appealing to customers," it said.
However, their application in Islamic finance is "highly controversial for reasons of speculation and uncertainty, two practices forbidden under Sharia," or Islamic law, Moody's said.
"Islamic financial institutions have to be much more aggressive ... as there is a huge potential for growth. So far, they have been far less active than conventional finance," Mukkamala said.
The 2009/2010 World Islamic Banking Conference Competitiveness Report, produced in collaboration with McKinsey & Company, said Islamic banks must determine their future course of action by exploring new key areas.
"They should enhance and diversify their business mix, by tapping into new growth business lines, such as personal finance, asset management and various areas of investment banking," it said.
The report, released in December, said that during the global economic downturn, Islamic banks have outperformed conventional units but were not immune from the fallouts.
A number of Islamic banks have also been more strongly affected by non-performing loans than conventional banks, and they also continue to have greater exposure to real estate assets, it said.
Bukhdur attributes much of the impact to slow response by managements to the crisis.
"Islamic financial units were less impacted by the global crisis than conventional banking industry," he said.
"But conventional banks have reacted quickly, and most of them are almost out of the crisis. On the contrary, the response by Islamic firms was very slow, resulting in a magnified impact. Many Islamic firms have not yet recovered."
The need to harmonise regulations is also a major issue.
Each Islamic financial unit is normally advised by a Sharia board, which is responsible for interpreting Islamic jurisprudence. That has resulted in somewhat different interpretations by various boards.
The leading regulatory bodies have all been working towards aligning Sharia law principles towards a consistent basis to ensure uniformity.
Bukhdur said Islamic finance will continue to expand, but he believes the main expansion will come from the Islamic units of leading international banks rather than in new independent Islamic financial units. (By OMAR HASAN/AFP)