Islamic finance industry saw its total assets grow to $950 billion (Dh3.48 trillion) in 2009 in spite of the global economic crisis. The market's potential is worth at least $5trn, Moody's said in its latest report.
Rapid growth in Islamic finance continues globally but the industry needs to be more innovative instead of being influenced by conventional derivative instruments, it said.
Islamic finance in this region would also grow more if it looks into opportunities of co-operation with Asian economies, many of which are under-banked markets, DIFC's Chief Economist Dr Nasser Saidi told Emirates Business.
"Population of the Gulf and Asia, particularly Muslim countries, is young and fast growing. It presents enormous opportunity to penetrate that market. There are under-banked markets. There is an opportunity for Islamic finance, including takaful, re-takaful to enter those markets," he said.
"In this region Islamic finance represents $800bn of banking assets. The growth has been encouraging but what we saw in the last two years was also due to plentiful liquidity and greater preference of investors toward Islamic finance. We now need to think closely what sort of retail products can be in place, Islamic mortgages, loans, how do we mainstream Islamic finance," he said.
According to a Special Comment by Moody's Investor Service, despite the recent gloomy economic environment globally, the Islamic finance industry's total assets scaled new heights in 2009, rising to $950 billion.
Moody's estimates that the market's potential is worth at least $5trn and the industry is continuing to expand globally.
"In this context, IFIs are continuing to deliver Shariah-compliant returns while, at the same time, focusing on efficiently mitigating the associated risks through a new risk management approach, including the use of derivatives," said Anouar Hassoune, a Moody's Vice-President – Senior Credit Officer and author of the report.
A combined use of securitisation and derivatives offers considerable scope for reducing the risk exposures of Islamic financial institutions (IFIs) and thus improving their overall credit worthiness, said the report.
"Islamic finance industry needs to develop its own innovation phase and not imitate conventional derivative instruments in order for IFIs to maintain their special status and Shariah-compliant approach," it said.
The application of derivates in Islamic finance is criticised mainly on account of the elements of speculation and uncertainty , which are banned under the Shariah law, said Moody's.
The varying scholarly opinions in the world of Islamic jurisprudence on the legitimacy of derivatives has so far translated into a total ban on these instruments in some countries and actual implementation – albeit on a limited scale – in others, said Moody's. If employed with care, derivatives can enhance efficiency in IFIs through risk mitigation, thereby making them more competitive as well as appealing to customers. However, their application in Islamic finance is highly controversial for reasons of speculation and uncertainty, two practices forbidden under Shariah," explained Hassoune.
The conventional global derivatives market is measured in trillions of dollars today and is many times larger than the underlying asset base it represents. The mind-boggling size of this market and derivatives' ubiquitous use bear witness to their immense relevance in finance, said Moody's.
On derivatives being blamed for the financial crisis, the report said the economic meltdown was in fact due to a combination of several factors, primarily a lack of proper risk monitoring and quantification mechanisms.
"The bubble in the derivatives industry was attributed to a copycat phenomenon, whereby banks took on more risk than they could possibly cope with, exceeding their liabilities many times over and building inverted pyramid structures on their balance sheets. The consequential seizure in the market has forced financial institutions to drastically scale back their proprietary risk-taking and to revamp models, but the innovation in derivatives and their deeper understanding continues to rule the world of finance."
Although many conventional derivatives cannot be explicitly used by Islamic banks as they have been banned by the Fiqh Academy, their use is mostly implicit and involves third parties such as conventional intermediary banks that provide hedging services, at a given step of the transaction, said Moody's.
"Credit derivatives are currently completely prohibited under Shari'ah law due to the lack of oversight and transparency, which translate into gharar. As a result, the number of Shari'ah-compliant instruments that mimic credit derivatives is negligible, and those that exist have been viewed as highly questionable from a Fiqh perspective. In addition, in a credit default, one party [the bank] has more information about the issuer than say the insurance company – which could encourage the privileged party to manipulate the transaction and benefit from the deal, which once again constitutes gharar."
Moody's said it currently rates eleven IFIs in the GCC region and Turkey. "Although their financial profiles display strengths, they are offset by weaker qualitative characteristics including their risk management."
According to the report, the fundamental problem with Islamic financial institutions (IFIs) is their inability to monitor various forms of risks more competently and liquidity risk is the prime concern.
It identified three major areas of concern with regard to IFIs' risk management capabilities that impact ratings- entanglement of varying risks in asset portfolios, inadequate management of asset- liability risks (which includes "displaced commercial risk", and the lack of a corporate governance framework for non-financial risk management.
"In confluence with these factors, market and credit risks are strongly interrelated at Islamic banks and, because of the emphasis on socio-ethical responsibility in which a legal action cannot be taken against a borrower, an IFI may find itself holding an asset worth less than the price promised by the defaulted buyer."
IFIs are further challenged by other structural risks due to their very limited range of instruments, the lack of regulatory consistency), insufficient credit and market risk management, and the underdeveloped nature of the Islamic money market – to name just a few, it said.
It said such concerns can be significantly alleviated by means of innovative structured products that are designed to accurately gauge the risk probability inherent in everyday complex financial transactions involving price volatility, prepayment, credit default, operational risks and concentration.