Islamic Finance: From niche to mainstream

Islamic Finance: From niche to mainstream

Islamic Finance: from niche to mainstream For many years, Islamic finance has been regarded as a niche market by the conventional financial services industry. But the growth and development of finance products generally has enabled competitive Islamic financial products to be developed. This, combined with the growing affluence of many Muslims, means it is well worth examining the potential for Islamic finance. The figures tell their own story. Demand for Islamic finance products has grown by up to 15% a year and present growth trends could see as much as $24 billion in savings per year flowing to Islamic savings products from households by 2020. Stage I: Demand from high net worth individuals. Most typically, this is a reallocation of oil-derived wealth into Islamic products. This latent demand can now be met due to the growing sophistication of financial products which have lowered the price and broadened the potential range of Islamic financial products. Stage II: Awakening demand from Muslims living in Europe. Developed world Muslims account for approximately 50% of mass affluent Islamic savings and our forecasts expect they will remain an important constituency in the medium term. This is an opportunity not widely appreciated and certainly not to be missed. Stage III: New demand from Islamic emerging markets and a new mass affluent Islamic middle class. The key will be if and when economic growth rises to the point where savings gain a critical mass and what part of this demand is met by Islamic financial products Islamic Finance Potential Scenarios Stage III Emerging Markets Stage II Mass Affluent Europeans Market opportunity Stage I HNWI Developments in financial markets make Shariah compliance possible Product costs fall Low costs make Islamic finance popular with European Muslims New price conscious consumers emerge Emerging economies begin to achieve mass affluence and consequential demand for Islamic finance products Phase of Development Source: Accenture Research 1

Defining Islamic Finance Debate continues over what constitutes Islamic Finance", but general guidelines are clear There is no absolute authority (and plenty of debate) as to which particular financial practices are allowable under Shariah law, and therefore what constitutes Islamic Finance". Banks and other institutes seeking to market Shariah compliant products must seek a review of their product by Islamic scholars who judge each case on its merits. Having said there is no overarching law, there are a number of guiding principles for any financial product wishing to comply with Shariah law: There is a prohibition on usury, which is generally interpreted as a ban on interest payments. Investments in gambling, pornography, tobacco, pig products and alcohol are all forbidden. Finally, Islamic finance is required to focus on real trade and transactions rather than speculation. High oil prices have expanded demand, while developments in financial products have created a supply of cost effective Islamic financial products Stage I: Capture of Market Share Stage I of the growth in Islamic finance has been under way for some time. This has been driven primarily by demand from High Net Worth Individuals (HNWI) in Muslim countries, or the sovereign funds of those countries themselves. Where there is demand, banks will create a supply, in this case through utilising their wide range of financial instruments in order to create cost effective, Shariah compliant, Islamic financial products. This demand has been further boosted by high oil prices; the IMF estimating that Arab states collected around $500 billion of oil revenue in 2006 alone. Much of this money is controlled by sovereign wealth funds, which are estimated to amount to $2,800 billion, of which approximately 60% are controlled by Muslim countries 1. As this capital seeks a home, Muslim nations and individuals in the post 9/11 world are both wary of investing in the United States, and increasingly interested in investments which comply with Shariah law. Placing this in context, conventional investment funds have $55,000 billion under management, while hedge funds control $3,000 billion. Looking to the future, Standard Chartered has estimated that sovereign wealth funds could be worth up to $13,400 billion by 2017. Composition of Islamic Finance (2005, %) Islamic Funds Malaysian Bonds Sukuk debt FI Assets Banking Windows Shariah Stocks Bank Assets Source: Islamic Finance Service Board Takaful Insurance Enabling growth with new products Islamic finance as an industry has been benefiting from significant developments within the broader market for financial products. Falling costs of complex financial instruments have enabled banks to 1. Sovereign Wealth Funds, Peterson Institute, August 2007. 2

Islamic finance has four distinct areas: insurance; capital markets; wealth management and retail banking Today's market has a large number of small players who have developed niche capabilities in developing and selling Islamic finance products create a variety of Shariahcompliant financial products which closely emulate standard non- Islamic financial products. Developments of Islamic finance products have taken place across four principal areas: insurance; capital markets; wealth management; and retail banking. The interrelation between these areas is helping to underpin not just the pace of progress, but also its sustainability over the long term. Insurance - recent developments have focused on Takaful, a form of Islamic insurance similar to conventional mutual insurance. Takaful provides attractive cover to the historically under-insured Muslim community, and creates institutional demand for Shariah-compliant products. If recent growth rates of around 20% in Takaful continued, the world premiums would rise from just over $2 billion in 2005 to $7.4 billion by 2015. With major global insurers and reinsurers now entering the market, together with the UK's first pure play' Takaful provider, there is scope for expansion into both Life and Property & Casualty sectors. Capital markets - The growth in Takaful is in turn fuelling Islamic capital markets, with a rising number of global investment banks now involved in Islamic products including structured finance, wealth management, and trade finance. With the Sukuk market estimated by Bloomberg at $16 billion in 2006, Islamic products are also becoming more sophisticated, extending to cross-currency profit rate swaps, puttable and callable Musharaka Sukuks, convertible Sukuks, and even Shariah-compliant hedge funds. Wealth management - Wealth managers and private bankers are another sector getting involved in Islamic finance, distributing Shariah-compliant capital markets products and tailored structured products to high net worth individuals. Traditional money managers have also been innovating in this area, and in the near future we may see the emergence of Shariah-compliant Exchange Traded Funds (ETFs). Shariahcompliant private equity and real estate funds are also becoming available. Retail banking - Even basic Islamic savings instruments require a degree of cross product co-ordination, which results in greater complexity than would be present in equivalent non- Islamic financial products. It is because the price of financial instruments is falling, as well as because complexity is no longer the impediment that it once was, that Islamic services have advanced from niche to mainstream in markets such as Bahrain, Qatar, United Arab Emirates, Kuwait and Malaysia. At present many of the developments in regional markets, such as the Middle East and Malaysia, have been driven by a large numbers of small focused players. Many of these smaller banks are now realising that they lack the scale to compete in such a fast-growing and competitive marketplace, opening the way to significant consolidation. 3

Value and Volume of Sukuk Issues 24,000 20,000 16,000 12,000 8,000 4,000 0 Global Sukuk Issuance ($ million) Number of Sukuk Issues (RHS) 2001 2002 2003 2004 2005 2006 2007e 90 80 70 60 50 40 30 20 10 0 Source: Zawya Islamic banks have been slow to adopt high performance banking models, giving Europe's bankers an edge in capturing future market share. Islamic banks thus face a dual challenge: they must keep pace with general banking in the development of sophisticated new products, and they must cope with restrictions that can add considerable complexity to both these new, as well as existing, Shariah-compliant products. In addition to managing the ever more complex modern financial markets, bankers will also need to educate Muslim consumers, providing information about the benefits of Shariah compliant products and how they compare with traditional products. While Shariah compliant products are now more competitive on price than they were a few years ago, Islamic institutions will still need to do more to drive their costs down and pass on pricing benefits to consumers. To date Islamic banks have been relatively slow to adopt the techniques commonly used by Western financial institutions, such as outsourcing IT, call centres and product development. This may not matter, given our expectation that much of the industry is going to consolidate but, for those niche players who do wish to remain independent, the challenge is clearly to adopt much of the function model used by western banks if they expect to be able to compete on price and product range. 4

Europe's 13 million Muslim's represent the next stage of growth for Islamic finance. Stage II: Expanding into the European Mass Market The key for the next stage of growth in Islamic finance is not the high net worth markets of the Middle East, or even the rise of Islamic emerging markets: it is the mass market of Muslims living in Europe. The European Commission has estimated that there are approximately 13 million Muslims in the European Union 2. Given the prosperity of Europe, these Muslims represent a block of Islamic mass affluence second only to the energy-rich states. What is needed to market to these people is an attractive set of products which cost-effectively mirrors what is more widely available in non- Shariah products, and as importantly, a comprehensive distribution network. Our forecast is for the total amount of savings by European Muslims to top $14 billion by 2020, an annual growth rate of almost 14%. This represents a conservative forecast, incorporating a considerable slowing of the 22% annual growth rate seen in recent years. Growth will also continue with the savings of energy-intensive Islamic Countries rising by almost 6% per annum. Meanwhile the growth in savings from rapidly developing Islamic countries is forecast to be just over 20% per annum, albeit from a very low base. While our forecast only considers the macro-economic GDP growth, the consequential propensity to save, and the resulting money put into some form of savings, these figures and trends clearly have implications for a wide array of Islamic financial products. Islamic Savings ($ billion) 40 35 30 25 20 15 10 5 0 Rapidly Developing Islam Energy Islam Islamic Europe Stage I Turkey begins to save significantly Stage II Stage III 1990 1995 2000 2005 2010 2015 2020 Source: IMF, UN Population Database, Accenture Research forecasts 2. Muslims in the European Union", European Monitoring Centre on Racism and Xenophobia, 2006. 5

Emerging markets Islamic savings could top those of both resource rich and European Muslims by 2020 Growth in Islamic finance is being hindered by debate over what qualifies as a Shariah complaint product Stage III: Growth of Islamic Economies If the marketing of Islamic financial products represent an immediate opportunity, it is the emergence of Islamic emerging markets which represents the most exciting medium to longer term prospect. Our estimate is that, by 2020, Islamic savings emanating from emerging markets could well be as large as the combined Islamic savings of oil rich Islam and European Muslims. Our forecast starts by looking at the trend rate of growth of individual countries purchasing power parity GDP per capita and the trend rate of growth of cash GDP, and converging the latter on the former. As economies develop, they move through a number of reasonably predictable stages. When GDP per capita reaches approximately $7000 (in real cash terms, not on a purchasing power parity basis), demand for financial products such as life insurance rises rapidly 3. Our model has therefore assumed that when per capita GDP moves through this threshold, five percent of income is saved. The next question is what portion of savings is likely to be placed in Islamic financial products. Penetration rates vary by country, but today's mature markets average between 15-20% of customers choosing Islamic financial products. We have assumed that increasing sophistication of Islamic products means that penetration rates rise to 25% of new savings. Thus our model assumes that Islamic financial products' market share rises from 2% of Muslim savings in 1990, to 16% in 2007 to slowly capturing 25% of savings by 2016. Growth beyond this level is dependant upon the unlikely agreement of a common set of rules as to what qualifies as Shariah. Islamic GDP: Forecast Scenarios ($ billion) 8,000 7,000 6,000 5,000 4,000 Rapidly Developing Is lam Emerging Islam Energy Islam Stagnant Islam Islamic GDP Down Islamic GDP Upside 3,000 2,000 1,000 0 1990 1995 2000 2005 2010 2015 2020 Source: IMF, UN Population Database, Accenture Research forecasts 3 Exploiting the Growth of Emerging Insurance Markets, Swiss Re, Sept 2004. 6

Our growth forecasts remain conservative, only focusing on the potential of those economies where cash GDP per capita rises above $7,000 per annum Once mass affluence is achieved, we assume that 5% of income is saved and that up to 25% of that is placed in Shariah compliant products Looking at the present stage of development and the potential for future development in individual Islamic countries, as well as the prospects of countries such as India where there are significant Muslim populations, we believe economic growth is going to be concentrated in a relatively few countries. In every case, our candidates for rapid development have already achieved cash GDP of at least $5,000 per annum. In determining our forecast, we have two central questions: what sort of growth can emerging markets expect and what will be the demand for Islamic financial products as these economies grow? In our Islamic GDP growth scenarios, we have divided countries into four distinct categories: Rapidly developing Islam, where economic growth has moved to the point where the economy is fully monetised (e.g. there is little or no subsistence farming or barter). Such countries have diversified economies and a growing and vibrant middle class. There is every reason to believe that such economies will continue to grow. This category includes countries such as Malaysia, Turkey, the UAE, and Oman. Emerging Islam, where purchasing power parity GDP per capita may be reasonable, but cash GDP is far lower, indicating that much of the economy remains semi-subsistence. In such circumstances, demand for financial products will only grow when the economies themselves monetise. Breaking through into being a rapid growth economy is possible, but in no way assured within our time frame. This category includes such countries as Morocco, Tunisia, Egypt, India and Indonesia. Savings within Islamic Countries ($ billion) 180 160 140 120 100 80 60 40 20 0 of which Islamic savings Total Savings of Islamic Countries 1990 1995 2000 2005 2010 2015 2020 Source: IMF, UN Population Database, Accenture Research forecasts 7

Our base case is for Islamic savings to grow by 12% p.a., our downside where growth fails to materialise sees growth of 6%p.a. Energy Islam, where oil and gas extraction, and accompanying activities, account for the majority of the GDP. Such countries do not have well diversified economies capable of generating wealth outside oil and gas, which limits their growth prospects. They do however already have middle classes who will often seek Islamic financial products. This category includes such countries as Saudi Arabia, Kuwait, Qatar, Algeria and Libya. Stagnant Islam, countries which, in our view, are unlikely to see significant economic growth into the medium term. These countries often have high birth rates and have proven unable to generate useful employment for their growing populations. The result is low rates of economic growth and in some cases falling levels of economic prosperity. These countries will not feature in any calculation about the long term potential demand for Islamic finance. This category includes such countries as Mauritania, Syria, Yemen and Bangladesh. In contrast to our scenario for Islamic GDP, where there is significant potential for greater growth than we expect in our base case, the danger in our savings forecast is significant underperformance when compared to our base case. This is a result of our forecast for many economies to grow well (boosting GDP) without reaching the point where the average household can be expected to afford to put savings aside. Finally it must be noted that the figures in our forecasts are for Islamic savings, and we have not made any attempt to forecast which financial products would benefit from these savings. Potential Islamic Savings: Forecast Scenarios ($ billion) 45 40 35 30 25 Total Islamic Savings Islamic Savings Upside Islamic Savings Down 20 15 10 5 0 1990 1995 2000 2005 2010 2015 2020 Source: IMF, UN Population Database, Accenture Research forecasts 8

Islamic finance is overcoming a legacy of expensive and little understood products and creating liquidity in the process There remain internal issues, including staff shortages, and complying with differing interpretations of Shariah compliance Challenges Islamic financial services providers still face several challenges, some relating to their own capabilities, and some to the market as a whole. Islamic retail products have traditionally been expensive. While the pricing gap has narrowed thanks to greater competition and commoditisation of financial products, it has not disappeared all together. Consumers lack knowledge about Shariah compliant products. Providers of Islamic financial services need to work harder than their conventional counterparts to educate people on Islamic principles and products, with Shariah compliance appearing to add a further level of complexity to a subject that most consumers already find daunting. There is a shortage of liquidity in some products. This is particularly the case within the Sukuk market, where investors can end up holding their assets for longer than they intended because of secondary market illiquidity. These external challenges are compounded by internal issues being faced by Islamic bankers. The growing significance of Islamic Finance has led to a shortage of skilled staff, driving salaries upwards. There is a high degree of inherent complexity. This brings in concerns over risk management, given the greater difficulty of hedging and swaps transactions in a Shariahcompliant environment and the generally lower levels of liquidity than conventional markets. Rigid, yet unclear rules. Shariah-compliant financial institutions have little or no latitude when implementing the opinions of its Shariah advisers, but the advice itself can be inconsistent, varying between advisors. Shariah compliance itself remains a thorny issue. While the creation of the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) will help to drive standardisation and convergence, the fact remains that interpretation by individual scholars will always play a role. The pure play' Islamic providers will face additional regulatory challenges, not only around compliance with Basel II but also relating to the capital requirements laid down by the Islamic Financial Services Board (IFSB) in Malaysia. 9

Conclusions High Net Worth Individuals, largely from the Middle East, have been a key to the development of Islamic financial products. While these customers remain important for private bankers and wealth managers, the next challenge is to market these Islamic finance products to a mass European Muslim clientele. The rise of sovereign funds offers significant scope for Islamic Financial products. High oil prices have enriched oil rich states funds which are now estimated to have at least $1,700 billion in funds under management. Marketing of Islamic Finance to the mass of potentially interested Europeans requires highly cost effective products. This will most often mean utilising large universal banks' low cost bases and operating models. Contacts James Sproule Accenture Research Growth & Strategy Tel. +44 207 844 3387 Mob. +44 7866 808 366 james.r.sproule@accenture.com Ismail Amla Accenture Capital Markets Tel. +44 161 435 5507 Mob. +44 7785 300 930 ismail.amla@accenture.com Sohail Syed Accenture Capital Markets Tel. +44 207 844 0824 Mob. +44 7917 050 050 sohail.a.syed@accenture.com Anton Pichler Accenture Research Growth & Strategy Tel. +44 207 844 3853 anton.l.pichler@accenture.com Small scale Islamic banks are likely to lose out in Stage II as Islamic finance will be dominated by those developed market banks which effectively capture business from European Muslims. The rules surrounding what qualifies for Shariah finance remain uncertain. So long as interpretation of what is Islamic" is open to a wide variety of opinions, consumers will remain uncertain and wide scale market development will be hindered. The long term potential for Islamic finance is good supported by the growth of a range of emerging Islamic markets such as Turkey and Malaysia. 10

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