Modern Islamic banking follows Islamic law according to the boards of Shariah scholars which differ between the conservative Middle East and more accepting South East Asian regions but the fundamentals remain the same: interest is banned and banks operate on a system of profit loss sharing (PLS). Loans involve the bank purchasing a commodity at market value and then selling it to the customer at a higher price with the bank keeping the difference. Similarly, interest is not paid on deposit accounts but investors share in the profit of the bank at a level set to compete on the conventional market. The Koran prohibits the financing of companies involved with goods and services deemed unethical (such as weapons, pork and gambling) and forbids speculative investments, insisting all financial transactions must be backed by tangible assets.

This lack of exposure to derivatives, sub-prime debt obligations and other risky business ventures meant the Islamic finance industry withstood the first wave of the global financial crisis relatively intact. As the impact of the crisis extended to the real economy, Islamic banks, particularly those in the Middle East, which invested heavily in real estate, began to feel the pinch. But with central banks around the world lowering returns, Islamic banks are finding themselves better able to compete for business.

A trillion dollar industry

Since the opening of the first modern commercial Islamic bank in Dubai in 1975, Islamic finance has developed from a niche service presenting Muslims with a Shariah-compliant means to invest and do business into a mature, fast-growing industry with an estimated one trillion dollars in assets. While the figure represents just over one percent of the world’s total assets, the strength of the Islamic finance industry lies in its growth prospects.

Noor, which launched to the UAE public in January 2008, a few months before the full force of the economic crisis hit the region, shelved its international growth when the extent of the downturn became apparent. After redirecting its efforts to the local market, Noor was in profit in the first half of 2011, six months ahead of schedule. AlQemsi says the bank will review its growth strategy in 2012 with a view to expanding into African nations such as Egypt and Tunisia, where market penetration remains below 10 percent as millions of Muslims begin to move from a cash economy and seek halal financial dealings.

A recent IMF study titled ‘Islamic Banks: More Resilient to Crisis,’ found Islamic financial institutions have experienced credit and asset growth at least twice as high as that of conventional banks since the crisis hit, with asset value increasing by 21 percent in 2011.

Robust growth has been reported across almost all regions in which it operates from the world’s biggest Islamic finance market in Malaysia, to the oil-rich Middle East and the emerging markets of North Africa. Today Islamic bankers are keen to capitalise on conventional banks’ lack of liquidity offering credit at competitive rates and expanding the sectors’ presence into the conventional banking market. “With products like sukuk (Islamic bonds) and new syndication structures, we can do basically anything conventional banks can… and we can do it competitively,” claims AlQemzi.

AlQemzi says about 40 percent of the bank’s retail and corporate clients are non-Muslim.

Not just for Muslims

In October, the Financial Times reported that Islamic banks were providing the best returns on cash deposited for two, three, four and five years, noting the Bank of London and the Middle East (BLME) has seen a four-fold increase in customer deposits mostly from non-Muslim investors. BLME, one of the main providers of Islamic finance in the UK sets a £50,000 minimum.

The real growth driver for the Islamic banking sector, however, is expected to come from international corporate finance as conventional banks tighten lending patterns and big business looks to include Islamic institutions in its funding mix.

Whether this is through Shariah-compliant syndications, trade finance or the use of other structured loan products, Islamic finance is leveraging off its deep pool of liquidity and experience with Gulf Cooperation Council (GCC) project finance to offer a competitive alternative to the international corporate finance market, David McLean managing director of MEGA, an umbrella company representing some of the world’s biggest Islamic finance conferences, told Knowledge. “The Islamic finance sector is starting to become part of the big loan syndications,” McLean says.

The market for sukuks

The most popular Islamic finance product used in corporate Islamic finance is the fore-mentioned Islamic bond, called a sukuk. Global sales of sukuks, which fell off dramatically after peaking at US$87 billion before the global financial crisis have rebounded.

In the first half of 2011, US$43.8 billion was raised globally, setting a new record. In May this year, HSBC Middle East became the first international bank to issue a benchmark sized - US$500 million - public sukuk. And in October, Goldman Sachs registered a US$2 billion Islamic bond programme.

Mohammed Dawood, managing director of Global Capital Financing, HSBC Amanah at HSBC Bank Middle East says the bank has noticed a change in the proportion of international buyers keen to access the sukuk market.

“There was a fairly even split between conventional and Islamic buyers and the spread of international buyers was broad, with Asian, European as well as Middle Eastern buyers picking it up,” Dawood told INSEAD Knowledge.

Investors were attracted by the price of the Islamic bond, which was issued flat to the conventional HSBC bond, meaning that the issuer did not have to pay a new issue premium, he says.

“The spread has tightened to 20 basis points inside the conventional equivalent - which suggests that, purely on current market levels, cheaper pricing can be achieved by issuing sukuk over conventional bonds,” Dawood says. “Liquidity is strong but, also more importantly, Islamic trades themselves have performed really well in the after market.”

Despite the sudden growth, Islamic finance is still in a very nascent stage with its own set of challenges. Whether it has enough liquidity to solely fund multi-billion projects is doubtful and there are still challenges relating to branding, product depth, perceived transparency and regulatory issues.

Islamic scholars are still arguing about certain aspects of Shariah law, making it difficult to standardise products across the Islamic world.

“Islamic banking is still a new industry,” Al Qemzi says. “It has three focussed areas where you will see it predominately strong: GCC, Turkey and South East Asia. “Each follow different approaches but this is changing and we are seeing the industry moving and getting more into synergy with each other.”