Islamic finance at a crossroads -
how can Luxembourg help?
Luxembourg has been engaged for some time in Islamic finance and can claim to have been one of the first movers in this sector in Europe. Indeed, the track record is quite impressive and the history dates back to the 70’s. In 1976 Luxembourg organized a seminar on the Islamic banking system; in 1983 the first Shari'a compliant insurance company in Europe was established in Luxembourg; in 2002, the Luxembourg Stock Exchange became the first stock exchange in Europe to list a Sukuk.
More recently Luxembourg geared up its efforts towards Islamic finance with the Luxembourg tax authorities issuing circulars clarifying the tax treatment of various Islamic financing arrangements. Moreover, the Luxembourg Central Bank is the first European central bank which became an associate member of the Islamic Financial Services Board (IFSB) and is a founding member of the international Islamic Liquidity Management Cooperation (IILM) launched last year. Furthermore, the Luxembourg government and respective trade associations have put a huge amount of effort into promoting Luxembourg and its financial center as a center of excellence for Islamic finance.
Today Luxembourg is the leading Islamic investment fund domicile in Europe. There are about 40 regulated Shari'a compliant investment funds domiciled in Luxembourg with assets totaling US$500 million. The large majority of these funds are equity funds. More recently, funds investing in Sukuk or private equity have been launched as well. The fund initiators are foremost European banks and asset managers. Lately, fund initiators from the Middle East and Far East have also chosen Luxembourg as a fund domicile in order to leverage on the Luxembourg brand and experience regarding the distribution of funds on an international basis. Beside the regulated funds, it is estimated that approximately US$2 billion of assets are held through unregulated Shari'a compliant investment structures. Most of these assets are real estate related. Furthermore, Luxembourg is a major stock exchange for the listing of Sukuk, i.e. Islamic debt instruments comparable to bonds. The first Sukuk admitted to trading was the Malaysia Global Sukuk in 2002. As of June 2011, 16 Sukuk with a total amount of US$7.3 billion are listed on the Luxembourg Stock Exchange. Over the years, Luxembourg has developed the capacity and gained the experience in dealing with Islamic financial products from a regulation, operations, clearing, payment and settlement point of view.
After years of strong growth, Islamic finance has lost its momentum. The number of funds as well as assets under management has remained flat over the last three years. Projects for new funds are being discussed but just a few are launched. The same situation can be observed for the listing of Sukuk. Indeed, no new Sukuk has been listed during the last 18 months on the Luxembourg Stock Exchange. Taking a look at the global picture, a similar trend can be observed. Globally, Islamic funds assets under management remain flat at US$52 billion at 2008 figures. At the same time, the issues of new Sukuk declined by 50% to 2006 figures. It is only recently that a sharp resurgence in new Sukuk issuances has been observed. Of course, with the financial crisis, difficulties have been experienced across wider financial markets but since the end of the financial crisis in late 2009 Islamic finance has only slowly grown and not bounced back to the strong pre-crisis growth rates of 15% to 20% per annum. Islamic finance is a nascent industry. As for every young company or industry it has to overcome some major challenges in order to progress from one growth stage to the next. Understanding and meeting these challenges is important in order to reach the next growth stage. There are a number of challenges Islamic finance faces:
- No global Islamic finance market: the Islamic finance market is mostly local, at best regional with Islamic fund management being also a very local market still. Not only is the Islamic fund industry very scattered but 70% of the Islamic fund managers are below the threshold of US$80 million assets under management which is believed to be the required breakeven point. In addition, the diverse Islamic finance frameworks and practices in various countries hamper the development of a global Islamic finance market.
- Varying interpretation of Shari'a law: Shari'a law is open to interpretation and Shari'a boards can have different views on certain Shari'a matters. In some instances it may happen that opinions may deviate from previous decisions made by other Sharia'a scholars, something which happened recently for Sukuk issuances. A major catalyst for global acceptance and the growth of Islamic finance is the standardization of Shari'a law in order to avoid different interpretations and rulings inconsistencies. In January 2011 Malaysia introduced a new Shari'a Governance Framework for Islamic financial institutions at national level aiming at implementing a homogeneous Islamic-based operating environment. A similar framework at international level, and publically available documentation of Fatwa rulings, would further help in aligning and standardizing the regulatory and operating framework of the industry.
- Missing product authenticity: most of the Islamic products seem to be a copy of conventional products adapted to the Shari'a framework. This adaptation comes with some costs, which put Islamic products at a cost and also often at a performance disadvantage compared to its conventional lookalike. The Islamic finance industry has to have genuine products that inherently meet the standards and requirements of Shari'a.
- Lack of adoption of Islamic products by certain type of customers: the sensitivity for Shari'a products for certain type of investors is rather low. Ernst & Young estimates in its Islamic Funds & Investment Report 2010 that the propensity to invest in Shari'a-compliant products or assets ranges between 20% to 25% for high net individual investors and only 5% to 10% for Sovereign Wealth Funds from the Middle East. However these investors hold a substantial amount of wealth which is held mostly in conventional products today. The lack of specific Islamic products or investment opportunities, or too high Shari'a structuring costs, could be reasons for this lack of adoption. As there is a strong link between Islamic finance and Social, Responsible/Ethical Investments, putting Islamic finance into this area could potentially increase the adoption of Islamic products by other type of investors.
- Regulatory hurdles: it is interesting to note that Shari'a is often in conflict with local laws in various jurisdictions in the Middle East when it comes to the design of Islamic products. Rules and regulations have initially been laid out for conventional products. The launch of Islamic products thus renders necessary a review of local laws and regulations as well as a new way of thinking for central bankers and regulators.
Luxembourg can be of assistance to Islamic finance in different ways to lay the foundations to reach the next growth stage. Luxembourg can, for example, help to create a critical mass for Islamic products in Europe and beyond by acting as a global hub and permitting Islamic financial institutions to leverage on the expertise of the financial center with regard to cross-border distribution and clearing and settlement of financial products. Moreover, Luxembourg could reconsider issuing a sovereign Euro Sukuk to provide a missing benchmark to the Islamic debt market. At the same time this would strengthen Luxembourg’s position as a centre for Islamic finance. The potential for Islamic finance is huge. The Shari'a sensitive wealth pool is estimated at US$ 360 – 480 billion. However, in the end the fundamental point is that the new catalyst for Islamic finance must come from Muslim countries rather than Europe.
by Pierre Weimerskirch, Partner, Alternative Investment Funds Advisory, Ernst & Young Luxembourg