Islamic Finance Poised for a Comeback
As the new Parliament sets its gears in motion ahead of the May presidential elections, the field of Islamic finance is poised to become one of the greatest winners of the January 25 Revolution and the political changes that it unleashed.
"Now, with a change of political system in Egypt, the first thing that is happening on the financial side is that Islamic finance ideas are being introduced in the Parliament," says Walid Hegazy, cofounder and secretary general of the Egyptian Association of Islamic Finance and head of the Hegazy & Associates law firm.
Currently the Egyptian government is planning to issue its debut sovereign sukuk and is discussing changes to the constitution to provide more guidance and regulatory oversight for Islamic finance.
The proposed changes would allow Egypt to carve out a larger regional and global role in Islamic banking and finance.
The Egyptian Financial Supervisory Authority (EFSA), formerly known as the Capital Markets Authority (CMA), plans to finalize regulations governing Islamic corporate bond issue according to Ashraf Sharkawi, head of EFSA.
In February, the Finance Ministry announced a sovereign sukuk issue valued at $2 billion (LE 12.06 billion). A prominent Dubai-based Egyptian scholar Sheikh Hussein Hamid Hassan has said the sovereign sukuk issue could help fund Egypt's development projects and also bridge the gap in its currency reserves.
Beyond the sukuk issue, Parliament is considering adding an entire new chapter on Islamic finance to the existing banking law, which would fill a void in existing legal provisions and establish the legal groundwork in licensing for Islamic banks and regulation of Islamic financial instruments.
"It [sukuk issue] is very likely to happen because the Parliament seems to be very interested in at least giving it a try, with the legal changes or without them," says Hegazy, who is working closely with parliamentarians on drafting the new law on Islamic finance.
While these provisions are not currently in existence, it would not be the first time Islamic finance ideas were implemented in Egypt on a wider scale.
In fact, Islamic banking and finance in its modern form did not emerge in Saudi Arabia, the United Arab Emirates or Malaysia — current market leaders in Islamic banking globally. Its modern origins can be traced to Egypt and the rural town of Mit Ghamr 80 kilometers north of Cairo.
The first Islamic bank was a local savings bank, established by Egyptian economist Ahmad El Najjar in Mit Ghamr in 1963.
After he studied the local residents' financial habits and local market demand, he chose to downplay the Islamic aspect of the bank. "He did not want to be confrontational or cause any issues with the government at the time," says Hegazy, who studied the development of Islamic finance in the Middle East as a part of his dissertation at Harvard Law School in the late 1990s.
The first Islamic bank was the first modern institution to introduce Islamic financial instruments. It was also unique in that it did not directly compete with established commercial banks. Instead, it addressed a niche that was overlooked at the time: micro-financing, allowing small and low-income clients to borrow money.
Despite its early success, Nasser's socialist government eventually expropriated the bank over concerns about the founder's Islamist tendencies. El Najjar left Egypt to pursue his ideas in the Gulf.
There were other experiments. In the 1980s, a number of Islamic investment funds emerged that turned out to be get-rich-quick schemes.
"That experiment was booming for three to four years, but it ended in financial disaster because they were not regulated," Hegazy says. "A government investigation at the end found they had a lot of debt, committed fraud and they were not actually investing the money into legitimate channels."
The government eventually expropriated the funds of the most prominent fund, Al Rayyan, in November 1988. Economists at the time estimated $3 billion (LE 18.1 billion) was lost as a result of
Al Rayyan's and other companies' "get-rich-quick" schemes that paid dividends from incoming deposits, embezzlement and misappropriating funds. Hundreds of thousands of Egyptian investors were left empty-handed, which left the government uneasy about Islamic financing.
"It also contributed to the fear that the government and legislators had about any Islamic projects or initiatives, it left a very bad taste," Hegazy says.
Even though Faisal Islamic Bank of Egypt was established in 1979 and continues operations to date, it required a special law to issue a license. While a handful of other banks emerged as well including Al Baraka Egypt and
National Bank for Development, Faisal remained the major market player. The licensing process was on a case-by-case basis without a comprehensive legislative framework.
After decades of secularist regimes over the last 50 years, Islamic banking never caught on or reached the levels of development in neighboring countries.
Growing appetite for Islamic finance
Due to a combination of sociopolitical and economic factors, Gulf countries and non-Muslim states did not face the same obstacles. Islamic finance grew significantly over the past decade to its cur-rent growth of 15% per annum globally, according to a recent HSBC study.
Currently, it is a $1.3 trillion (LE 7.84 trillion) market and is estimated to grow from $4 trillion to $5 trillion (LE 24.13 trillion to LE 30.16 trillion) in 2015.
A study by Ernst & Young estimates the Islamic finance industry in MENA region to more than double to $990 billion (LE 5.97 trillion) by 2015.
"Before what happened in 2011, there were no real political incentives for any in-situations to go in the Islamic direction," says Magdy Eissa, business development director at IdealRatings. "But during the past six months we witnessed a huge growth in demand."
IdealRatings, based in San Francisco, US, is an Islamic finance data provider that specializes in stock screening for Shariah compliance, purification, fund and index management. Purification implies actions taken to offset the Shariah non-compliant share of the company's profits, for example profits derived from Shariah non-compliant sectors of a business such as alcohol or music.
It currently does not have any clients in Egypt, but has seen a great uptick in interest from both private and governmental sectors.
Eissa sees tremendous potential for Islamic banking in Egypt. "If you take the whole population, it could be 40-50% of the whole population in Egypt that might be looking for Islamic offerings, whether it is banking or Shariah compliant funds," he says.
Analysts project the initial push and driver for growth will be inherent religious conservatism with a predominantly Muslim population and a built-in market demand.
In the case of stock screenings, Eissa notes a lot of Egyptians tend to do them already. "Many automatically don't invest in coffee, cigarettes or alcohol," he says. "They do screenings by themselves."
The Islamic finance revival is happening at a time when Western-style commercial banking is undergoing a crisis following a series of financial upheavals over the past decade.
On March 14, a London-based Gold-man Sachs executive Greg Smith resigned in a well-publicized move. Smith headed the firm's US equity derivatives business in Europe, the Middle East and Africa. "I attend derivatives' sales meetings where not one single minute is spent asking questions about how we can help clients," he wrote in an opinion piece for The New York Times. "It's purely about how we can make the most possible money off of them. If you were an alien from Mars and sat in on one of these meetings, you would believe that a client's success or progress was not part of the thought process at all."
In fact, Goldman Sachs itself has got on the Islamic banking bandwagon. The investment firm, which has faced tough criticism on its practice in the lead up to the financial crisis, including nondisclosure of faulty Collateralized Debt Obligations (CDOs) to its clients, announced it would issue $2 billion (LE 12.06 billion) in sukuk or Islamic bonds, making it one of the first Western banks to do so.
Globally, Islamic banking has been on the rise. The Malaysian government, an established market leader with a centralized Shariah compliance system, sold $1.6 billion (LE 9.65 billion) of five-year sukuk and plans to grow Islamic banking to 20% from 13% this year.
The Libyan Foreign Bank is set to roll out Islamic products and the Libyan Stock Market plans to unveil Islamic funds within the next six months. Turkey is planning its debut sovereign sukuk issue this year as well.
Even non-Islamic countries have joined the Islamic banking rush. South Africa is set to raise $500 million (LE 3.02 billion) in debut sovereign sukuk next year.
Why Islamic banking?
For many scholars and investors, religious belief is the cornerstone of their investment activities and guiding principles. For other institutional and non-Muslim investors, Islamic banking offers a way to address a fast-growing market niche.
However, the exact definition of what constitutes Islamic banking varies widely in each country, with the exception of Malaysia, where it is the single governmental body that regulates the Shariah compliance of stocks, for example.
According to scholars of Islamic law, one of the most recognizable features of Islamic banking is that it forbids any interest, or riba, on borrowings. Another feature is the profit and loss sharing aspect of the Islamic institution, in which the investors, as well as the institution itself, share profits and losses.
There are exceptions and variations on the fundamental principles as well. Egypt currently remains the only country in the region where the Islamic banks' right to charge interest on loans is protected by a special fatwa issued by the late Sheikh Mohamed Tantawi, in his capacity as Egypt's grand mufti, allowing bank interest.
Egypt's Fatwa Council, Dar al-Ifta Al Misriyyah, an authority on religious verdicts established in 1895 and affiliated with the Ministry of Justice, also provides that stock market trading is not unlawful either, provided the business of the company is lawful and the company has "known and established assets and credentials."
Another advantage of Islamic financial instruments like sukuk is that governments and private actors can finance projects without having to borrow money.
"Sukuk is a very trendy product that has played a major role in financing public projects and financing major corporations in the region," says Hegazy, who views sukuk as one of the instruments with the greatest potential for Egypt. Sukuk are not standardized and have over 20 different structures, such as ijarah-based or mudarabah-based sukuk. "Sukuk offers a good alternative to borrowing money."
The more elaborate the financial instruments are, the more debate there is surrounding to what degree they are Shariah compliant.
For example, derivatives are traditionally viewed as some of the more sophisticated financial instruments in the market. Several Western scholars have argued that Islamic derivatives could help offset currency exposures, while others rule out any possibility derivatives could ever be Shariah-compliant. "The murabaha [derivative] structure for use in swaps is compatible with some schools of thought because it pertains to the direct ownership of an underlying asset, avoids reference of non-existent assets at does not contain either unnecessary risk or speculation," says Martin Forster-jones, an associate with Mohammad Al Ammar law firm based in Riyadh.
Nonetheless, lack of a universal regulating system and definition for what makes a product Shariah-compliant still discourages many investors worldwide.
"Emerging markets continue to offer a lot more variety and higher yields compared with sukuk, which is still very limited in scope," Scott Lim, CEO of Kuala Lumpur-based MIDF Amanah Asset Management told Islamic Finance News in February. "This means that when the conventional money is moving from the developed markets, this is the first preference."
As there is no universal definition of what constitutes Islamic finance, there is also no consensus on which model Egypt should pursue or how Islamic finance is likely to develop.
In an interview with Business Today in February, Freedom and Justice Party (FJP) spokesman Ahmed Soliman explained his party's plan to facilitate the development of Islamic banking in Egypt and said the party plans to study the Malaysian model as an example.
Soliman said that it was not possible to change the commercial banking system into an Islamic one. "What is an option is that we encourage the establishment and growth of Islamic banks," he said. "Commercial banks will continue to operate as they are.
Eissa, on the other hand, believes the GCC model is more likely to develop in Egypt than the Malaysian one. "In Islamic banking or Shariah-compliant investment in general, we have different schools of thought," he says, noting that there are a lot of Egyptian expats in the GCC region who can help implement the model in Egypt. "We don't have one entity telling everyone this is the correct way to do things."
Meanwhile Hegazy, who is actively involved with legislators in shaping the future of the Egyptian Islamic banking system, is a proponent of a homegrown, Egyptian way. "We want to have our own model rooted in the early initiatives in the 1960s," he says.
The path forward
No matter what the model is, it would have to offer competitive terms compared to conventional banking. While the religious and ethical component of Islamic banking will be the initial driving force for individual as well as institutional investors who seek to respond to market demand, the hope is that the market will then adjust and investors will want to diversify and do both.
Many, if not all major steps of the Islamic banking need to be clarified and ingrained in a legislative format. "We need a framework, we don't have a framework right now. FJP and [Al-Nour Party] are proposing draft laws to Parliament, which regulate Islamic funds, the sukuk issue as well as Islamic banking such as licensing in general," Eissa says.
A comprehensive legislative structure will allow for banks and the financial products they offer to be regulated properly, to prevent another surge of fraudulent Islamic funds luring investors under false pretenses of Islamic ethics. "From an Islamic fund perspective the legal framework should be forcing the institution in the prospectus of the fund to say what [...] criteria they are following, to say who the Shariah board are, the scholars who approve these criteria, to say how they are handling the purification, to say what might be happening with the liquidity management," Eissa explains.
One way for Islamic institutions to become competitive with conventional banks is to address the existing niche markets. "Right now I also see gaps that are not addressed by the conventional banking system: microfinance — small-and medium-size budgets, investors who do not have access to the conventional banking system — and the big infrastructure projects that are needed almost in every sector in Egypt and for which the government cannot provide financing."
According to Hegazy, these two major gaps are necessary for Egypt's socioeconomic development at this stage. "Islamic financing in Egypt has the potential to contribute to these two areas," he says. "And if that happens, then we have created our own model."
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