Islamic finance in an experimental age
By Gillian Tett, Financial Times

When international bankers discuss Islamic finance, one word that repeatedly crops up is "innovation".

In the past five years, Islamic finance has not only swelled in size, but expanded in complexity, as bankers around the world have competed furiously to produce new, Sharia-compliant ideas - and proclaim how "innovative" they are being in marrying the Quran with modern finance.
Some of these claims need to be taken with a pinch of salt, given that the word "innovation" is often overused by bankers to justify high margin. Nevertheless, it is clear that the sector has seen striking product proliferation in the past few years - and most bankers say it offers fertile territory for innovation in the future.

There are several reasons for this. One is that many of the natural users of Islamic finance are now becoming markedly more sophisticated in their financial demands. Middle Eastern issuers are now increasingly embracing the concept of using the capital markets, alongside bank loans. Islamic banks in the region - and elsewhere in the Muslim world - are also becoming more aware of the benefits of diversifying the risk on their own balance sheet.
More adventurous

And the investor base of the Islamic finance world has become slightly more adventurous, too: investors are turning to hedge funds and more complex capital markets products.
This has prompted Islamic finance to move increasingly into the capital markets arena, and embrace a host of new liquidity management tools as well as more structured products. It has also fostered the creation of new institutions, such as Islamic hedge funds, with a clutch of these springing up in London and the US recently.

Moreover, as this trend has got under way, it has been greatly boosted by the arrival of Western investment banking groups into the field. Thus, behind the scenes, a bitter competitive struggle has broken out between the banks, as they each rush to transfer these innovative ideas to Islamic finance - often in conditions of great secrecy.

The most visible sign of this innovation is seen in the world of sukuk: although these instruments, akin to bonds, were invented less than a decade ago, their issuance has risen sharply and are now producing numerous permutations. Retail products, such as Islamic mortgages, have also produced rich territory for innovation.

Meanwhile, Oliver Wyman, the consultancy, believes that areas such as Islamic credit cards, or the creation of quasi-overdraft facilities (based on a concept known as tawarruq), will be the next focus for innovation in retail products. Less obviously, experimental ideas are now also emerging in product and infrastructure finance, aside from sukuk. Private equity is attracting intense interest too, as is the so-called diminishing musharaka structure, which produces an effect akin to the amortisation of a loan.

However, the field that is arguably attracting most brainpower of all is derivatives and structured finance. Until now, the use of such instruments has been extremely low in the Islamic world, meaning that most banks, investors and corporate issuers had little way of protecting themselves from items such as inflation risk.

Now, hower, investment bankers are scrambling to do precisely this - in a Sharia-compliant way. "Interesting products include profit rate swaps, which help banks hedge their foreign exchange and interest rate position," says Alexander Lis of Oliver Wyman.

This endeavour has provoked unease in some quarters. Some observers suspect that the industry should focus on developing existing products more deeply - and create a more mature, robust infrastructure - before it embraces too many new ideas.

"There is... some question as to how much product innovation is actually needed at the moment, given that the industry is relatively young and that many of its products are still nascent," points out KPMG, the consultancy, in a recent report on Islamic finance. "Some practitioners stress that the market is as much in need of consolidation and refinement as it is of innovation and new products."
Controversy
Moreover, a few devout Muslims argue that these innovations increasingly contravene the spirit of Islamic finance - even if they might match its letter. Concepts such as derivatives and hedge funds, for example, are considered particularly controversial, given the Quran's ban on gharar (speculation).

"The theme of innovation brings to the surface a constant underlying debate in the industry," says Dawood Ahmedji, of Deloitte consultants. "Critics of the industry claim that innovation to date has been a case of 'Sharia Synthetics' - that is, creating compliant copycat products, with hedge funds being the latest development of this kind. Others cite the need to have conventional equivalent tools available for the Islamic customers, who have been underserved to date."
Nevertheless, these criticisms are certainly not hampering the development of new ideas at present; on the contrary most observers think that product proliferation will only intensify this year.

And as this occurs, it is a sure bet that the word "innovation" will remain on the Islamic bankers' lips. "The market is not mature," says Lis. "There is plenty of room for product innovation and improvement."