London: Centre of Islamic Finance?
Speech by Clive Briault, Managing Director, Retail Markets, FSA
Industry Forum, London
17 October 2007
Introduction
Thank you for asking me here to speak today. Islamic finance is playing an increasingly important role in world markets and I am delighted to offer some thoughts on this from a regulatory perspective.
I want to cover four main issues:
- why the UK is becoming a "gateway" for Islamic finance;
- the role which the FSA and the current regulatory framework have played in this;
- some of the risks and challenges which Islamic firms may face in the period ahead; and
- the scope for further growth in Islamic finance in the UK.
In doing so, I would however begin by recognising that the FSA is continuing to learn in this area. And in this respect we are keen to benefit from the experience of other markets and other regulators, for example in Malaysia and the Gulf region whose markets are considerably more mature than our own.
The UK as a Gateway
Today there are three wholly Islamic banks authorised by the FSA in the UK – the Islamic Bank of Britain, The European Islamic Investment Bank, and Bank of London and The Middle East. And I am pleased to say that there are more applications for Islamic banks in the pipeline. We have also authorised an Islamic hedge fund and we are looking at authorising a standalone Islamic insurance firm (Takaful). Several Sukuk issues (Islamic bonds) have been listed on the LSE.
There are a number of reasons for this. One is the growth of the global market for Islamic finance. Nobody knows the exact size of this market but several estimates put it at around £250bn. In recent years, the annual rate of growth has been conservatively estimated to be in the region of 10-15%, and some commentators expect this to continue over the next five years or so.
London – and the UK more generally - is well placed to take advantage of this trend. It has been a major financial centre for centuries, and has always been ready to innovate and to respond flexibly to new ideas. London has deep and liquid markets, and the London exchanges are among the most frequently used for listing financial instruments globally. Our financial services industry has a proven record of developing and delivering new products; and English law is already the preferred jurisdiction for many Islamic transactions.
Since 2003, the sharp rise in oil prices has resulted in huge liquidity surpluses in the Gulf region and local financial markets have been unable to keep up with the demand for financial assets. Several major firms, such as Citigroup, Deutsche Bank and HSBC, have established business lines known as Islamic 'Windows' to meet this demand. Around 25 of these 'Windows' are active in the UK financial markets, offering a range of products and services such as Treasury, Sukuk structuring, asset management and private banking.
On the retail side, the growth of Islamic financial services was slow in the UK throughout the 1990s and early 2000s. The products being offered, notably Islamic mortgages, compared unfavourably with their conventional equivalents in several respects, including their generally uncompetitive pricing. Many of these products fell outside the scope of regulation and consumers did not, therefore, have the same degree of protection as other consumers – for example, in terms of the regulation of financial promotions, the availability of the Financial Ombudsman Service and the possibility of redress from the Financial Services Compensation Scheme. Since then, however, the government has placed considerable emphasis on the need to combat social and financial exclusion in the population as a whole. More specifically, the government has wanted to give the 1.8 million Muslims (approximately 3% of the population) in the UK access to financial services consistent with their religious beliefs. This has been demonstrated by tax and other changes to encourage the development of a retail market.
Role of the FSA
As banking regulators, the Bank of England and then – from 1998 - the FSA have been open to the development of Islamic finance for some time. One important signal came in a speech by Eddie George, then Governor of the Bank of England, in September 1995. In this, he recognised "the growing importance of Islamic banking in the Muslim world and its emergence on the international stage". This approach was taken forward by Sir Howard Davies, when he was Chairman of the FSA. In a speech in Bahrain in September 2003, for example, he noted that a soundly financed and prudently managed Islamic institution would be "good for Muslim consumers, good for innovation and diversity in our markets, and good for London as an international financial centre".
This was first translated into practice when a high level working group - set up in 2001 and chaired by Lord George with representatives from the Bank, the City, government and the Muslim community - examined the barriers to Islamic mortgages in the UK. The main one identified was the fact that Islamic mortgages attracted double stamp duty; and this was abolished in 2003. The FSA, which was represented on the working group, welcomed this move.
Looking more widely, the Financial Services and Markets Act, which established the FSA, provides for a non-discriminatory regime when authorising financial institutions. There is a “level playing field", irrespective of where a firm comes from or whether it is Islamic or conventional. All firms have to meet five Threshold Conditions – essentially, good management, adequate resources and effective systems and controls. Within this framework there is some room for flexibility and, in the case of Islamic firms, close dialogue and careful preparation meant that their special characteristics could be accommodated.
In 2004 the Islamic Bank of Britain was the first retail Islamic bank to be authorised in the West. There were three particular issues we had to consider. The first was the definition of a deposit. In the UK, if you deposit a sum of money in a bank, your claim on the bank is fixed at that nominal amount. Islamic banks operate with a profit and loss sharing formula so it is possible if you put money in an Islamic bank you might get less back than you have put in. In the case of Islamic Bank of Britain, the solution arrived at was to say that, legally, depositors are entitled to full repayment but if they prefer to be repaid under the Islamic risk sharing formula, this is also acceptable. We are prepared to consider each case on its merits and to strive to reach solutions that are acceptable to all those involved.
Second, we need to know, from a financial and operational perspective, exactly what is the role of Sharia Supervisory Boards. In particular, we need to know how such a Board may affect the running of the bank. If the Board were to have an executive or directorial role – for example, in approving individual credits as well as products to assess whether they are Sharia compliant - then we would need to approve the individuals, some of whom may not have the relevant experience. So far this has not been an issue with the three Islamic banks we have authorised. Equally, the shortage of Sharia scholars means that some are members of several Boards at the same time. In such circumstances, we would expect the individual and the bank to manage any potential issues of confidentiality that may arise.
The third issue is more relevant on the retail side, namely financial promotions, where our requirement is that all advertising should be "clear, fair, and not misleading". This is particularly important for new products with different underlying structures, and we have monitored Islamic Bank of Britain’s financial promotions quite carefully. This has not caused any problems so far.
Risks and Challenges
Many of the risks which Islamic firms face are the same or very similar to the risks run by conventional banks. There are, however, some risks which are unique to Islamic firms and I would like to highlight two of these.
One is risk management. Some of the tools available to conventional firms are not available to Islamic firms; for example, certain types of derivatives are not acceptable to Sharia scholars. Islamic firms are therefore having to develop other methods for risk management. Commodity Murabaha for instance, which have a long history, are being structured so as to have almost exactly the same effect in terms of liquidity as the inter-bank deposits of conventional banks. If Islamic finance continues to develop as it has done, many of the constraints should lessen as more products are developed and more players enter the market. What is important to the FSA is how risks are managed, Islamic or non-Islamic, given our requirements around large exposures, capital and liquidity.
A second challenge concerns the diversity of opinion among Sharia scholars as to whether particular practices or products are Sharia-compliant. On a global level too, the ratification of Islamic firms' products and services may depend on the jurisdiction in which they are offered. This can add another layer of complications for regulators.
As I have already indicated, we are a secular not a religious regulator; and we are in no position either to determine ourselves whether a product is Sharia-compliant or to assess the suitability of scholars consulted by Islamic firms. We do, however, want to see that the basis on which an Islamic firm claims to be Sharia-compliant is communicated clearly to consumers. More generally, we support moves to develop common standards by organisations such as the Islamic Financial Services Board and the Accounting and Auditing Organisation for Islamic institutions. Greater standardisation could help western bankers and investors to understand Islamic markets better.
Outlook
Looking ahead, the foundations for the future growth of Islamic finance in the UK have been firmly laid.
On the wholesale side, at least eight Sukuks have been issued on the London Stock Exchange and the world's first secondary market has been established in London. The volume of Sukuk trading is still small but a few inter-dealer brokers in London are trying to develop closer links with Islamic firms in the Gulf, possibly by establishing regional offices there.
On the retail side, growth has been relatively modest since the Islamic Bank of Britain was established. A recent initiative, which may stimulate demand, has been to bring Home Purchase Plans (a form of Islamic mortgage) within the scope of FSA regulation. This took effect in April this year and provides Islamic consumers with the same degree of protection as holders of conventional mortgages. The size of the Islamic mortgage market remains small at around £500mn at present with only a few thousand borrowers, compared with the stock of mortgage lending of over £1.1 trillion in the UK as a whole and nearly 12 million borrowers.
Elsewhere in the retail market, the major High Street banks now offer Islamic products ranging from current accounts to personal finance through to savings and investment products. Some regional stockbrokers provide services to Muslim customers at all levels of the wealth spectrum; and some financial advisers are offering tailored advice to the Islamic community. Islamic insurance (Takaful) is still in its infancy in the UK although we will shortly consider the first application for authorisation by a Takaful firm. Takaful markets are considerably more developed in countries like Malaysia and in the Gulf region and it is possible that, as products are rolled-out in these established centres, there should be scope for both wholesale and retail Takaful markets to develop in the UK.
Education to familiarise Muslim and other consumers with new products and new forms of finance will be critical. In this context, we have devoted considerable resources to launching and implementing a "National Strategy for Financial Capability" across the population as a whole. As part of this, we provide clear, impartial information to help consumers make informed financial decisions. With respect to Islamic finance, we cannot and do not provide guidance on Sharia principles, but we have provided explanations of products and the associated risks. Our fact sheet on Home Purchase Plans issued earlier this year is a good example.
Finally, I should mention three further avenues for possible expansion. First, as has already begun to happen, Islamic financial products and services can be bought by all consumers. We should not think of the market for these products and services as being confined to a particular group of consumers.
Second, Islamic firms in the UK, like conventional ones, can "passport" their activities into EU member states without the need for separate authorisation in each country. This offers them access to an estimated 15 million potential Muslim customers; and one of the wholly Islamic banks we have authorised has already taken advantage of this.
Third, the Government has recently taken important steps to promote the industry. In April the Treasury established an "Islamic Finance Expert Group" representing a broad cross-section of opinion from the industry, the City and Muslim organisations. I am the FSA's representative. The general objective is to advise the government on opportunities in Islamic finance; and the group is also overseeing an official study on the possibility of the UK government issuing a sovereign Sukuk. This has already generated considerable interest among market participants; and the Government will publish a consultative document later this year. At the same time, National Savings and Investments has been asked to investigate the feasibility of offering retail Islamic products and will produce its report next year. If agreed, this could widen considerably the share of Islamic products held by the less affluent Muslim community.
Conclusion
The potential for the growth of Islamic finance in the UK is clear. This is true of both wholesale and retail markets. We are keen to play our part in facilitating this, within the possibilities offered by our legislative remit. And we are keen to see this happen, for the benefit of consumers, to promote competition, innovation and diversity in our markets, and to develop London further as an international financial centre.