In late 2009, the Basel Committee on Banking Supervision – an international forum on banking regulation comprised of representatives from the central banks of major economies – presented its framework for new global banking standards in the post-crisis world economy. Dubbed “Basel III,” the roadmap included a comprehensive set of reforms aimed at addressing the causes of the credit crisis through improving financial regulation and risk management, sustaining adequate leverage ratios, and increasing general transparency and capital ratios among banks worldwide. As such, the final document that was published in June 2011 mandated global financial institutions to meet the newly introduced minimum leverage ratio in excess of 3%, maintain common equity holdings of 4.5% and Tier I capital of risk-weighted assets of 6%, and institute additional capital buffers such as the capital conservation buffer of 2.5% (1).
Experts have drawn parallels between these standards and the central tenets of Islamic finance, which also stresses the importance of risk management, minimal leverage, collective risk sharing, moral hazard elimination, reputation and transparency (2). Since 1990, the total volume of Islamic financial assets has steadily grown by 15-20% annually, and now stands at $1.7 trillion (3). Moreover - during the recent financial crisis, the sector of Islamic finance had tripled and expanded more rapidly than the conventional financial sector in all market areas ranging from insurance (takaful) to commercial and investment banking (mudarabah) across the Islamic world.
Several factors have left Islamic banks and institutions immune to the ills of the global financial stress. First and foremost, Sharia law strictly bans any sort of speculative and excessively risky (gharar) operations such as securitization of subprime lending, short-selling, and credit-default swaps, which have been among the major catalysts that caused the de-regulated market crash of 2008. AIG’s bankruptcy resulting from incongruence in the high amount of credit-default swaps that it had undertaken and the minimal volume of its assets stands out as a prime example of such failure.
In the meantime, the limited use of derivatives and other securitized structures by the vast majority of Islamic financial institutions has led to substantially higher capital adequacy ratios than in most conventional banks. Thus, minimal leverage ratios generated from risk-sharing and speculation-free parameters of the Sharia have placed Islamic banks on an advantageous position in regards to the Basel III requirements (4).
Due to the emerging global support for principles of Basel III initiated by the European Union and the US, it is not surprising that there has been a concurrent surge in demand for Islamic financial products in the West. Islamic sukuks - which are Sharia-compliant bonds - issued by major financial institutions such as the Islamic Development Bank have been consistently ranked as AAA because of their prudent risk management nature (5). The trend has caught the eye of the British government, which became the first non-Muslim country to issue £200 million of five-year Islamic sukuks with marketing assistance from major European and Middle Eastern banks (6).
According to latest reports, the British sukuk sale program has become a paramount success, attracting more than £2.3 billion in orders from investors in the UK, the Middle East and Asia (7). Furthermore, the establishment of Islamic banking divisions within major international banks such as Credit Agricole, HSBC, and Standard Chartered signals the vested interest of global investors in Islamic assets.
At this point, it is worthy to ask: what exactly has contributed to the rise of Islamic finance in the Basel III-dominated West, so much so that the Chancellor of the Exchequer George Osborne promised to turn London into an “unrivalled western center for Islamic finance”? Emergence of excessive liquidity in the form of petrodollars among investors in the Middle East who are keen on investing into Western Sharia-compliant products is certainly part of the amalgam. However, more fundamentally – the evolving revolution of Islamic finance in the West is ought to be viewed as a Western attempt to diversify the world of conventional finance by delving into a rising paradigm that is yet to be extensively addressed in the West.
This way, Western governments and investors are seeking to explore Sharia’s systemic nature of financial regulation that serves as a buffer against the superfluities of conventional finance, just as Basel III has prioritized on fostering increased regulation at the individual bank level in order to prevent the possibility of system-wide shocks in the future. With mandatory asset-backing and emphasis on risk sharing, Islamic finance can emerge as a safe haven for diverse investors amidst turbulent financial times in the Western world.
(1) “Basel III Handbook,” Accenture
(2) “The Impact of Basel III on Islamic Banks: A Theoretical Study and Comparison with Conventional Banks” by Adel Harzi, Paris-Sorbonne University
(3) “Economic Premise: Realizing the Potential of Islamic Finance” by Mahmoud Mohieldin, The World Bank
(4) “Islamic Banks Hold Basel III Advantage” by Hafsa Kara, The Banker
(5) “Moody’s Assigns Aaa Ratings to Islamic Development Bank’s Malaysian Sukuk,” Moody’s
(6) “Islamic Finance: By The Book” by Robin Wigglesworth, The Financial Times
(7) “UK Sukuk Bond Sale Attracts £2 bn. In Orders” by Elaine Moore and Thomas Hale, The Financial Times
Figure 1 – Source: BIS (Bank for International Settlements)
Figure 2 – Source: The CityUK