Episode #69 Bashar Al Natoor from Fitch Ratings – Islamic Finance, Intro, Challenges, and Opportunities

Bashar Al-Natoor is Fitch Rating’s Global Head Islamic Finance. Bashar is responsible for coordinating all Islamic Finance activities across Fitch’s Sovereign, Financial Institutions, Corporate, Structured Finance, Infrastructure and Insurance teams. Bashar has more than 16 years’ experience in the Islamic Finance market. Prior to joining Fitch, Bashar spent seven years at the Islamic Development Bank (IDB) in key roles. Bashar graduated with an MSc in banking and financial studies from the Arab Academy for Finance and Banking Science and a BS in finance and banking from Amman University. Bashar is also a Certified Bank Auditor (CBA), a Certified Risk Professional (CRP), a Chartered Market Analyst (FAD-CMA), and a Certified Risk Analyst (CRA).

In this episode, we dig into an entirely new topic that we never covered before with Fitch Ratings’ global head of Islamic finance, Bashar Al-Natoor. We are given an introduction to the Islamic Finance industry, a topic that hasn’t received much attention in the western world. We learn about key Islamic finance terms like sukuk and takaful, as well as learning about the rules that govern Islamic finance and Islamic banking. We talk about the biggest Islamic finance markets, like Dubai, Kuwait and Malaysia. After learning about the basics, we dive into challenges, and opportunities in the market, as well as the future of Islamic finance, including fintech. 

Links

https://www.fitchratings.com/

https://www.fitchratings.com/islamic-finance#insights

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TRANSCRIPT

EPISODE 69

[INTRODUCTION]

[00:00:04] ANNOUNCER: Welcome to The Wall Street Lab Podcast, where we interviewed top financial professionals and deconstruct their practices to give you an insider look into the world of finance.

[00:00:23] AVH: Hello and welcome to another episode of The Wall Street Lab Podcast. I’m your host, Andy and my guest today is Bashar Al Natoor. Bashar is Fitch Rating’s Global Head of Islamic Finance. Bashar is responsible for coordinating all Islamic finance activities across Fitch’s sovereign financial institutions, corporates, structured finance, infrastructure and interim teams. He has more than 16 years if experience in the Islamic finance market.

Prior to joining Fitch, Bashar spent seven years at the Islamic Development Bank in several key roles. Bashar graduated with Master’s in Science in Banking and Financial Studies from the Arabic Academy for Funds and Banking Science and a Bachelor in Finance and Banking from Imam University. Bashar is also a certified bank auditor, certified risk professional, a chartered market analyst and a certified risk analyst. So many C level acronyms.

In this episode, with such an expert in Islamic finance, we get an intro to Islamic finance. We clarify somoe of the terms like takafol and sukuk. We then talk about several Islamic finance banking products and issuing and buying sukuk. Then we talked about the similarities between ESG and Islamic finance. In the end, we talked a bit about fintech and innovation in the Islamic finance space. We talked about challenges, but also opportunities and of course, where to start your careeer in Islamic finance and where to get more information on this very interesting topic.

For me, it was a really cool episode because I’ve never really gotten in touch with Islamic finance. As we want to bring you a lot of different topics, I really hope you enjoy this episode. Now, without further ado, my interview with Bashar Al Natoor.

[INTERVIEW]

[00:02:30] AVH: Bashar, welcome on The Wall Street Lab podcast. It’s a pleasure to have you here. I’m really grateful to speak with you because, even though I’ve been in finance for a while and I’m pretty clueless about Islamic finance. You yourself as the global head of Islamic finance for Fitch Ratings, I think you will be a great resource to teach our listeners about a topic and as you might know, we set a tone that we want to bring as many diverse topics as possible to the listeners. I’m super excited to pick your brain about Islamic finance today.

[00:03:06] BAN: Thank you very much and I hope that we’ll have the opportunity to make Islamic finance less ambiguous.

[00:03:15] AVH: Bashar, let’s start with a bit of background on Fitch Ratings. I pretty much assume everybody know, but in case people don’t know it yet, could you give a bit of background on Fitch Ratings and what exactly is your role withing the company?

[00:03:29] BAN: I think the starting when I’m talking about Fitch, it has to be to say that it is a credit rating agency. I think saying a credit rating agency is very important because it is the main focus for the work that we do, specifically within the analytical team on the various sectors. Whether you’re talking about banks, sovereigns, corporates, et cetera. The outcome of that is a credit rating. Now, I mean, as you correctly said, most of your audience might be familiar with that. Actually, Fitch invented the scale of rating, which is the AAA, BBB and CCC. I mean, the whole scale and spectrum of that and the way that it is booked.

I mean, in a nutshell, I mean, the rating is really is talking towards the credit strengths and the credit aspects with the drivers, with the sensitivities and many aspects depending on that issuer or issuance, depending on how you’re looking at it. It is used by a wide spectrum of stakeholders. But investors is a primary focus and a primary user, you have also regulators and you have banking usage of it. Depending on where you’re looking at it.

My role and maybe to zoom in directly to that is I am the global head of Islamic finance at Fitch Rating. When I say Islamic finance, it is actually a cross group, cross region, cross function. It covers the globe, whatever Islamic finance is out there and it is crossed groups. Whether it’s sovereign issuing a sukuk or an Islamic bank, or [inaudible 00:05:04] company, or a corporate issuing sukuk, or a corporate operating under shari’ah. It is covered by the Islamic Finance Group in Fitch, which I head. We have a skilled team. They are leaders by their own and in their own sectors that are part of that Islamic Finance Group that actually covers this and they share that knowledge.

[00:05:24] AVH: To just clarify. Your role is, you just focus on Islamic finance but as a credit evaluation. You don’t help with any other kind of — you don’t have any other banking products yourself, but you actually only rate Islamic finance products issued by other companies. Is this correct?

[00:05:43] BAN: Fitch in general is actually on the analytical side is divided into groups that are specialized in certain sectors and certain regions. You could be part of the banking group covering middle east or specific countries. Corporate is the same thing. You can be part of the corporate, [inaudible 00:06:04] covering industrial or telecoms. It is actually, they’re specialized. Now, the Islamic finance function and the one I head is actually cross group and cross regions. It is looking and focusing on Islamic finance, but the actual issuers could be a sovereign, or a bank, or a takafol, which is Islamic insurance as we are going to be discussing.

It goes actually across that, and each of these, they have their own criteria, they have they own standard. On top of that, wherever relevant, the rating approach that is relevant to Islamic finance or sukuk is also part of that. It is a cross fund. I’ve been with Fitch for more than 13 years and I started actually on the corporate credit team. I was part of that team covering various sector in the middle east. That is how I started, but now, I head the group that looks at various groups and various sectors globally. But whenever Islamic finance is relevant and is needed.

[00:07:05] AVH: Basically, you help with making the credit rating for Islamic financial products.

[00:07:12] BAN: To simplify it that?

[00:07:14] AVH: Yes.

[00:07:14] BAN: Through Islamic finance issuers and instruments.

[00:07:18] AVH: Perfect. That’s really helpful to kind of set the frame. I guess we’ve talked about the ways around what Fitch, what you are doing. Now, as I already mentioned, I have very little idea about Islamic finance. Embarrassingly little so as I live in I think one of the big Islamic finance countries in Malaysia. Could you just quickly introduce our listeners and me to the concept of Islamic finance. You already mentioned sukuk and takafol. Maybe you can whiffle in because in my research, I stumble across those words but I was at a lost at what they actually mean.

[00:07:59] BAN: Okay. Perfect. Let me start with maybe an introduction to Islamic finance. With that, the first thing is, what is Islamic finance? What is Islamic finance? The thing is, the simplest way to put it, it is part of something that is bigger and I think maybe taking one step back, which is called the Islamic economy. Islamic economy, you have various vertical steps, which is more than Islamic finance. I’ll give you just one example. I think many people are familiar with the Halal industry and Halal food and the way that you deal with that, which is also a segment of the Islamic economy. Islamic finance focuses on financing, and transactions that are complying with shari’ah.

What is shari’ah? Shari’ah is actually Islamic ruling and it has broad terms that covers a lot of the rules and the way that Islamic transactions are governed. It is derived many by the Holy Qur’an and Sunnah, which is teachings and guidance of Prophet Muhammad. Peace be upon him. It is not something new and this is something that I think is very interested. The thing is, these principles were established almost more than 1400 years ago when actually Islam emerged. They set the rules or the key principles of dealing, whether on a commercial basis, financial basis, trading basis, et cetera.

Now, maybe to give you how that is structured, maybe focus on what does it include, how is it structured and what does it not include. The key things and since we’re talking about financing is actually, you have a principle that prohibits the use of riba. Riba, it has many forms and I think the most prevalent form in the conventionism is actually interest. Interest is forbidden by Islamic Finance and by shari’ah, because in the guidance and rulings there, money cannot earn money. It has other elements that you need to look at, which is the end justified the way of getting fund. In short, you need to have an underlying transaction. You need to have an underlying product to sell and buy, lease or what have you to generate income. Just simply having money, and lending it to someone and asking you to pay you back with interest is forbidden.

There are other elements that are forbidden which is gharar, maysir and what have you. It covers ambiguity, it covers gambling, it covers injustice. There is a lot of elements that also are prohibited by shari’ah, which we said before is the Islamic ruling. Now, on top of that, you have things that even if we comply with, i.e., they don’t have interest, they are structured in the right way but they are prohibited by Islam. For example, pork is not allowed by Islam. Cigarettes, the whole industry to some extent. There are whole industries that you cannot do because they categorially do not comply with shari’ah.

If you look at this, this is the just and the core of it. You have things that are forbidden, that’s one. The other key thing is, even if you want to do something that is not forbidden by Islam, but it means to be structured in a way that complies with shari’ah and have substance in it that justifies the gaining process if I want to put it in a very simple way. This is how it is. We said it’s okay, more than 1400 years ago, et cetera, et cetera. Why are we talking about it now? I think the thing is, as in many countries that are Muslim population is either majority or significant et cetera. They started emerge and they started to develop their banking systems, their capital market systems, their trading with the international world.

With that, the actual need to have the tools that you can deal with between yourselves and other came just in the past I would say, 50 to 40 years, depending on what you’re looking at it, i.e., banks or sukuk, which is Islamic bonds or takafol, which is Islamic insurance. I mean, we’ll come to the detail about it. It came from a need that you need to interact between yourselves and with the more developed, I would say conventional world globally because the developmental of banking system and the capital market system started way ahead in the western world before it came to the regions where Islamic finance is active, and with oil becoming a significant part of some of these countries. Interacting with them became important.

In the past 50 to 40 years, the actual emergence of what is called modern Islamic finance started with some Islamic banks being established, whether in the UAE, or in Saudi Arabi, or Kuwait, or in other countries, in Malaysia. Then you started having other pillars, which I’m going to be discussing shortly. That is why it is becoming more relevant.

Now, if we are to look at the key five pillars of Islamic finance, we can divide them into five categories. The first one and the largest one is Islamic banks, which is banks that operate under shari’ah. It accounts to almost 75% of the Islamic finance industry depending on the year you’re looking at it, and the whole industry is again depending on the family looking at it. It’s between $2.2 to $2.4 trillion. The second pillar is, actually Islamic bonds or sukuk. It accounts to around 15% of the Islamic finance industry. The third pillar is what is called Islamic insurance or takafol. You have also corporates, which is the fourth pillar that operates under shari’ah. Then you have funds that operate under shari’ah. They account for the rest of the percentage. Around 75% banks, around 15% Islamic bonds or sukuk and the remainder three pillars accounts for the remaining.

As you can see, it covers a wide spectrum of the key sectors in financing. Now, the growth of the industry and if we start with the Islamic banking industry, it has been a very clear growth in the past decade specifically. I mean, it started as I said almost 40 years back. But in the last, I would say 14 years, 10 years, the growth of the Islamic banking industry has [inaudible 00:14:30] as the banking systems of the countries where Islamic finance is active started to develop more. The same story, when it comes to Islamic bond, which is sukuk, and we have many of these almost double-digits growth. In many of the cases, we have the Islamic banking industry in these countries, growing in a faster pace compared to conventional.

Where do we start? If we focus on the, where is Islamic finance? I mean, Islamic finance is in many countries. It’s more than 70 countries globally. But the potential and the focus is the OIC countries, which is around 56 countries. They are the organization of Islamic countries in general. I we focus on Zoom and on the top 10, it will Gulf cooperation countries, which is the six countries: Saudi Arabia, UAE, Kuwait, Qatar, Bahrain and Oman. You add to that Malaysia, Indonesia, Turkey and Pakistan. I think this can be the top 10 countries. In these countries, the five pillars that we’ve discussed, they’ve risen their degrees with penetration and the developmental story in these countries.

For example, in Saudi Arabia, you have almost 80% of bank financing, being Islamic finance, which is Islamic banks and Islamic windows. What does Islamic windows mean? You have conventional banks that offer shari’ah compliant or Islamic products to their customer, although they are themselves are conventional bank and you have purely Islamic banks, so a bank that only deals under the shrai’ah ruling. The example that are cited, which is Saudi Arabia, you have around 80% of bank financing being Islamic finance in Saudi Arabia. If you look at Kuwait, it’s around 40%. If you look at Malaysia, it’s around 36%.

Now, other countries, Qatar, UAE, it’s around 30%. Bahrain and Oman, around 15%. Then you go to Malaysia and Turkey, then you’ll find that Islamic banking industry, although they are in terms of population, one of the countries that have most significant Muslim population, you’re still talking about less than 10%. The development even in these countries, depending on the sector that you’re looking at, it also varies from one country to another. Here, I’m talking about only Islamic banks. If we move to sukuk, which is the Islamic banks as we’ve described before. The actual growth story there is linked not only to Islamic finance, but it is linked to the development of the debt capital market in countries where Islamic finance is active.

Many of these countries, if you look at the GCC countries, the six countries that I’ve just mentioned, they actually were mainly funding particularly on the government side themselves on the oil proceeds and the government reserves and the government revenues rather than tapping into the capital market. However, that changed starting significantly in 2015 and many of these countries started to diversify their funding and they’re tapping into the debt capital market, whether bond or sukuk. That had also a positive impact on the growth of the sukuk industry itself.

The third pillar, and here I’m going to talk about the insurance, Islamic insurance, is still lagging behind in terms of growth. The main I would say challenge for that sector is actually the maturity and development of the insurance market in general in these countries and the insurance culture and the penetration levels. That is something that is also spilling out and impacting the takafol industry itself. We can talk about the challenges that are facing the Islamic finance industry in general in a later section. But you can see that when you’re looking at the Islamic finance industry, you need to look at it from two dimensions.

The first dimension is, the development of that sector in countries where Islamic finance is active, so whether banking, whether insurance, whether debt capital market or funds. Then you need to look and zoom in how much is the Islamic finance industry itself is developing in the infrastructure, the standardization and other challenges, which we can cover in a later section.

[00:18:43] AVH: That’s really, really interesting. As I said, I’ve had very little exposure to Islamic finance. Now, I slowly start to understand a couple of things. But could you for example of Islamic banking, because banking in conventional banking is very broad. Is it that Islamic banking means “loans” or is it deposits? Could you give one or two examples of what we can see as an Islamic banking service and then how it differentiates itself from a conventional bank? I know that for example, loans work a bit differently, so maybe you can give one or three examples on what’s the actual difference in that part.

[00:19:30] BAN: Perfect. That’s an excellent question. I think as you correctly said, it’s okay, you fine, you’re telling me an Islamic bank. What does that really mean? Let me tell you, in many of the countries where you have a developed Islamic banking industry, the product offering is similar to conventional. Whether on the assets side or the liability side. However, what is different is the way that that product is structured. For example, if you’re going to a bank and you’re seeking to finance your house, or you’re seeking to finance your car, or you’re a corporate that want to deal with an Islamic bank and you want to have specific financing for a project tor what have you. You will get the same product offering from an Islamic bank that you might get from a conventional. Yes, in some countries, the actual product offering is limited in the Islamic banks compared to conventional, because of not very developed Islamic banking industry.

However, in countries where like the GCC, where you have relay developed Islamic banking and conventional banking, the actual product offering is almost similar when it comes to the traditional lending side or the deposit taking side. However, the actual structure really varies significantly, and the way that they are done, they are done to comply with shari’ah. But that is something that I would say in a different way, is the way the that specific country is regulated. For example, you have countries that does not have really what is called profit and loss sharing accounts. There are countries where you can actually open an account, and that account which is a forward deposit is actually an investment account and your money can be lost or it can gain more or it can get less.

However, in practice, we don’t see this is really widely the case. We mostly see that the actual offering, even in the deposit side or the financing side is more or less competitive and trying to compete with the conventional side. Though, it’s structured in a shari’ah-compliant way. Maybe to give you an example. If you are to finance a car, from a conventional bank. You go to the bank, you sign the loan agreement, and you get the loan and you know how much is the principal that you need to pay back and how much is he interest.

But in Islamic bank, if they are using one of the contracts and they have various contracts. I’ll give you an example for a contract that is called Murabaha, which is one of the simplest one. Murabaha, if I want to simplify it, it’ s a cost plus. You go to the bank and the bank will do another transaction today. You say, “I want to buy a car.” What happens is, in some banks, they will go and say, “Okay. We will buy that car for you, and then we will add the markup on that car, and then sell it back to you.” Then that markup is actually the profit that the bank is going to earn, which is in many cases close to the same percentage that you’re going to get if you’re financing yourself from a conventional bank, but in shari’ah-compliant way.

We can definitely discuss why are we going through that complexity, who is using that, what’s the driver for that. I mean, that is an interest to you. But is this simple example clear or you need more clarity on some of that aspects?

[00:22:48] AVH: No, I think actually makes a lot of sense. The only question I have, so the bank buys the car, and it’s the same for a house, right? I know the example of a house. The bank buys you house and then sells it back to you over time. And you still pay a monthly rate, it’s not an interest rate. It’s just you’re paying over time, giving the bank the money for the house that the bank purchased. Right?

[00:23:15] BAN: Plus their profit. If the bank bought for example a hundred, it’s going to sell it to you 110 or 115. You can see that, okay, the difference is between the cost of the bank paid and the one that you are going to be paying back is the actual profit. This is how they make money.

[00:23:36] AVH: Who owns the property until the loan is paid off? Do I own the property right away, right from the day I first pay the monthly fee or does the bank keep owning the property until I paid every last bit of it?

[00:23:54] BAN: Okay, a very interesting question. Let me ask you, if you are looking at this from a conventional way, there is various modes that you can do this. Also in Islamic, you can — we discussed Murabaha, but there is something that’s called Ijarah, which is a lease format. You can actually buy a property, and then lease it to the actual end buyer. Then at the end of that period, the title lead will be transferred. It’s leased to own. There is a lot of fragments. At the end of the day, if the bank is using and it’s something that you have even in the conventional side, if that asset is going to be a security, then the bank and the title lead will be held still with the bank. If it’s not a security and there is other security or other dimensions to it, it could not be.

But the thing is, you need to look at it, okay. If you’re buying from a conventional bank, do they own that house, or do you own it, or is it something that is mortgaged or is it something that the title you keep? That is where it falls with Islamic finance, because you have various contracts that you can use to accommodate various forms.

[00:25:01] AVH: Okay. Basically, it’s just all about the structure, right? The end product is more or less the same. You can structure it this way or that way. Then I’m just thinking out loud, does it change, the style of a balance from Islamic bank to a conventional bank? Because I think, most conventional banks for example if you talk about a house, right? The person owns the house and then the bank has a mortgage or can reposes the house if the person doesn’t pay. But from Islamic bank, is the balance sheet in comparison higher because they keep more assets on their balance sheet/

[00:25:41] BAN: An excellent question. This depends on two factors, the regulation in that country. Because you have some — the balance sheet of a bank, of an Islamic bank in countries where they have something that is — there is accounting standard, regional accounting standard, which his called [inaudible 00:25:58]. If you are implementing a certain and you’re adapting certain accounting standard that allows you to keep that asset on your balance sheet, you actually some banks, although not much that have that asset. And evaluation is based on the market, rather than the [inaudible 00:26:17].

But the vast majority of Islamic banks, they actually do it the other way. It’s at the end of the day, no, the ownership is very clear toward the end, where is it going and it’s not on their balance sheet. But also, it’s not only on the asset side, it’s also on the liability side. You have some banks, I mean conventional banks, you have assets, liability and equity. Now, in some Islamic banks, you have an additional box on the liability side that is called investment accounts. What does that mean? That means if under that country and in that specific bank you have deposited or something that is resembling depositors. Entering into a profit and loss sharing kind of investments or deposits, they are actually wearing some of the risks and there is specific consideration to that in terms of the capital adequacy ratio and other ratios.

The Islamic banks that when you look at their balance sheet, it is 100% resembling a conventional bank from an accounting point of view. Although the underlying contract are different and they implement IFRS. Some other banks, they have some differentiating factor depending on the regulation in that country and what type of accounting standard that they’re adapting. The Islamic finance industry is not one, it’s really different from one country to a country. Even in some countries in one bank to another, the actual treatment is different. Standardization and harmonization is one of the key challenges, and I’m sure we’re going to be talking about that hopefully at one point in time.

The other thing, the other two challenges that are facing the industry among others is a awareness of Islamic finance and confidence in the product offering of Islamic finance. These three things: standardization, awareness and confidence are soft practice that are challenges, that are limiting the growth of the industry, in addition to other challenges that the market is facing, whether in the operating environment, or the individual credits or what have you. There is an overlay and additional challenges just by doing Islamic finance.

[00:28:23] AVH: I find it really interesting. One thing that you said, I just call for the lack of my understanding with depositors. They have a profit-sharing agreement with the bank. That does mean that if I’m going and giving my money to an Islamic bank and they are lending it out, that I get — I’m just making it up. Again, sorry for the conventional terms, but it’s just easier for me. But if they didn’t loan the money out, and they make profit of that, I as a depositor got a share of the profit they’re loaning out. But if the bank kind of miscalculated the credit risk, I might also make loss on my deposit? Is that how it works?

[00:29:02] BAN: Okay. That is how it works in some banks, some Islamic banks in some limited products. The vast majority that we’ve seen is not like this. There are banks and in old countries and banking system that this is not allowed. You cannot do this. The deposit is actually guaranteed under the National Deposit’s Scheme. If the bank defaults, you’ll get your deposit [inaudible 00:29:25]. There are some countries that have an allowance for what is called profit and loss sharing accounts. That type of accounts, some of it is on balance sheet, some of it is off balance sheet. Yes, they share profit and loss sharing. But you have also some other mechanism to smooth this out, like an equalization reserve, so they accumulate reserve to guarantee that that pool is not really fluctuating a lot and it’s giving you a decent return across the period.

There are profit equalization, return equalization, top up mechanism that the shareholders can step in. Because if you really go back — we did not really significant practice of actually deposit holders losing their money. Because if that happens, that actually could shake the confidence of these customers in that bank. There are mechanisms even when you have these accounts. Whether the bank will do a top up from their shareholders part or there are specific, what is called like reserves and provisions that is built. The smooth re-returns and make it comparable to a regular deposit, these mechanisms are rare and we did not see even in this crisis, of the COVID-19 where the industry in many side came under pressure. An extensive exercise of profit and loss sharing.

You need to also understand that the Islamic banking industry and Islamic finance actually is broader than the actual practices that you see in the banking system. Because you have things that are charitable, like [inaudible 00:30:57] or other forms of charity that is not there. You have pure profit and loss sharing. You have partnership. There is a lot of other pockets that is not yet really tapped into the market. With a crisis that we saw and with COVID 19, there has been some discussion should they invest and actually evolve and embrace more of these and get more like what is called in Arabic [inaudible 00:31:24 Arabic word], the value-based proposition of Islamic finance. We did not see really a lot of that taking place. There is a lot of talk. Is the industry going to adapt part of that and we are going to see more of that? That’s a question that —

But your question is very rare, because this is really the questions [inaudible 00:31:40]. Am I going to be giving you the money and you’re going to be losing it or not? As I said, the actual practice really is limited when it comes to that. There are some allowances, but there is even in the countries where there’s some allowances, you have some mechanism to smooth that side of the equation.

[00:31:56] AVH: Thank you so much. This is super interesting to me, that’s why I’m deep diving so deep into this because I think it’s really interesting to see how this is done. Now, you mentioned a couple of times and I want to dig deeper into those challenges that Islamic finance is facing. You’ve talked about several things like the lack of awareness that people don’t trust the process. Why is that? Because that the products are new or because they don’t know how it compares. It’s like a lack of knowledge or where do you attribute this lack of awareness to?

[00:32:37] BAN: Okay. This is one of the key challenges and there are actually two. Awareness and confidence are two different things. Maybe to put that in context, so when you say awareness as you correctly said, part of it is because the industry is actually relatively is new, but that is not the case in all countries. What we’ve done is we actually classified the countries globally into five categories. One category is the developed Islamic finance industry, where you have actually the awareness and confidence higher and much developed, although there is still room for improvement. You have emerging, you have secondary emerging, you have frontier and you have leased developed. We classified the countries globally just to look at their awareness, confidence, penetration. It’s not the same across the world, and I think that’s a very important thing.

Now, to answer your question. The awareness side is specifically in where you don’t have the actual understanding that there is something that is right. You are looking at countries like Nigeria, where you have a significant Muslim population, or country like Indonesia or Turkey. As I said, Islamic finance is still at less than 10% there and you have a vast Muslim population. Some of that is, they don’t know there is something that is called Islamic finance and this is partially because of the various stakeholders, whether the regulators, the banks, and the stakeholders that are in that industry and how they’re positioning themselves.

But the lack of awareness is not only in the customer side and this is very important. You can go to some even employees and some senior employees of an Islamic bank and at the end of the day, you enter into the bank and you say, “Okay. I want to get an Islamic loan” and then start discussing with him and he will tell you within the discussion. This is exactly like a loan, and then if you’re someone that’s sensitive to shari’ah, and he’s telling this is exactly like a loan, so why am I taking this with this complexity? Here, it touches upon the confidence side.

There are some people that are aware of the Islamic finance industry and its offering, but they are not confident that it is really giving them the shari’ah side of things that they’re seeking. Maybe here, let me just zoom on the type of customers or stakeholders that deals with Islamic finance industry, which is every important. The first kind, you have the category. When we say a category, you’re talking about almost 1.8 billion Muslims around the world, just around the 25% of the earth population. It’s a significant part of the globe.

You have a lot of these that are really unbanked. The unbankability issues in countries, 57 countries where Islamic population is significant and it’s active, we have around 60% that is unbanked, which is a significant number. It gives you a potential, but it gives you the status of the development of the banking industry. Out of that 60, you have around 6% that are not entering into the banking system because of their religious beliefs. Here it’s important. You have already a huge potential, you have an infrastructure that needs to be built [inaudible 00:35:43]. Within that, you have a category that is depriving themselves of entering because of shari’ah.

Back to the three categories. The first category is the category that is very sensitive to shari’ah. They will not put their money in anything other than Islamic banks, because anything else is considered haram or forbidden [inaudible 00:36:04]. He’s going to put his money for example in Islamic bank or issue a sukuk or do whatever because it’s an Islamic bank. If it’s a bank or if it’s a person very sensitive to shari’ah, he’ll only deal with shari’ah compliant instrument. Regardless of the quality of service, the product offering or what have you, that is one category.

The other category, you have some Muslims that have sensitivity, but they will look at it and asses what are the alternatives available to me. If I have a conventional and Islamic, and they’re giving me the same product offering, same quality, I’ll go with Islamic one to have clearer conscience and deal with that. But if it’s really not developed or it’s not there, they will not deprive themselves, they will deal and take that service until they have something that can satisfy their other side or the actual quality of service they need.

Then you have the broader category globally, which is non-Muslims or Muslims that are not really sensitive to shari’ah or Islamic finance. Then they will deal with the Islamic finance industry or Islamic banking industry if it’s offering them something that they’re looking for, i.e., why do an international investor buy sukuk for example, Islamic bonds? They buy sukuk because they are purely looking at it purely from risk and return. If it’s achieving their target and their credibility, they will go and buy that. If you are a customer that is having Islamic insurance and conventional insurance, why are you not sensitive of shari’ah? You’re not a Muslim?” “I’m Muslim.” You’ll deal with that if they are giving you a better offering or satisfying something in some aspects that some people are trying to see the similarities between ESG and Islamic finance and how they interact together.

If it’s giving you something that is whether on a monetary basis or an ethical basis that satisfies some of your needs. I hope these landscapes of the potential and who is dealing with the Islamic finance industry is clear.

[00:37:55] AVH: Yes, very clear. I just actually picked up two points that I wanted to ask and I think it gets really interesting here. Because one question that I was about to ask was, “Who buys sukuk bonds? Is it only as you said, the first or second type of people or it’s also the first type of people that actually just look at the risk return profile? If you have a numbers on that, it would be interesting to know, how many percent of people of non-Muslims, or people not interested in Islamic banking and shari’ah-compliant banking buy sukuk bonds?

[00:38:37] BAN: If we’re only talking about sukuk, it’s different than when we’re talking about Islamic banking. Because Islamic banking is more, specifically if you’re talking about the customers, it’s driven by customers’ needs and how they’re approaching that. Now, if you’re talking about sukuk, you’re really talking about more sophisticated investors. The investors can be divided into, I mean, many categories when it comes to Islamic finance. Maybe let’s focus on the top three, but also, you need to focus on the top three of the issuer side.

Let me talk about your question and I’m telling you who’s really is buying. You have three main categories among others that are really buying Islamic finance. You have first, Islamic investors which include Islamic banks that only can by sukuk. If you offer a bond for an issuer that you’re happy with the risk and return, because of the structure and because you being an Islamic investor, with an Islamic banks, or an Islamic investor fund or what have you, you cannot actually buy that if it’s in a bond format. It has to be structured in a shari’ah-compliant way. Because in your articles of association and your operating, you need to abide by shari’ah. That is one category.

The second category, you need have some institutions, developmental or sovereign or what have you that are really trying to develop the industry. From that side, they are trying to develop the industry, they try to also help the industry on the issuing side. They act as an issuer and they also act as, some central banks, they buy actually sukuk.

Then the third category, which is the non-shari’ah sensitive category, which is whether international investor or the conventional investor in the region. They will buy that specific sukuk if it fits their risk and return appetite. This is I think the three categories on the investor side. But you also need to ask the other questions. Who issue sukuk and why do they issue sukuk? Maybe of that is something interest to you, I’m happy to go on and discuss that.

[00:40:32] AVH: Yeah, if you could talk about just quickly about who’s issuing and then I have two more topics I really want to dive into while I have you.

[00:40:41] BAN: Perfect. Very quickly, the issuers are again, you have institutions like Islamic banks that comply with shari’ah or corporates that comply with shari’ah that can only issue sukuk, so they don’t have the choice of sukuk and bonds. You have other issuers that are conventional by nature, but because you have a large investor phase that includes shari’ah compliant, you want not to deprive yourself from tapping into that when they offer sukuk and bonds or sukuk just to broaden their investor base. Then you have institutions or government that are trying to develop the market and issuing sukuk to develop that and they have strategies and milestone to develop the Islamic finance industry in general.

[00:41:19] AVH: That’s really interesting, and I guess it make sense on both perspective, right? As of bank, as a conventional bank trying to reach new buyers, new investors and as a shari’ah-compliant bank, you have no choice. Now, throughout the conversation, we had this like at the edge coming propping on the kind of ESG social responsibility that some things are prohibited. What I thought about instantly was when you said, “Well, they can’t do certain kind of transactions. They can’t in certain industries.” Is it that Islamic finance is inherently a bit closer to what is now ESG and could you explain how green sukuks and social sukuks are like social ESG kind of banking now as part of Islamic finance?

[00:42:12] BAN: Spot on. I think you — I mean, the thing is, ESG is a trend that picked up just recently. I would say, for the ones that believe in the ethical proposition of Islamic finance, it is actually something that is giving them a from of an ESG in general, whether on the social side, whether on the — even environmental side if it’s something that’s forbidden by Islam. Or on the governance side because it’s governed in a simple way. I would say, it’s an ancient type of things that is more linked to some ethical side and believes that are structuring it and influencing it since it’s initiation. So it’s not something that is — yes, there is similarities but there is also difference.

Initially when we started with investor, we only learned that there is risk and return. Recently, with the emerging of ESG, there is risk return and impact. Now, Islamic finance has risk, has return, it has impact and on top of that, it has structure. We said in the beginning, it needs to be structured in a certain way to be shari’ah compliant. It is having certain part of that, but is every Islamic transaction ESG complaint? I would say, no. Are there similarities? There are similarities. There are [inaudible 00:43:30]. For example, of you’re issuing your bond, you already have an identified asset pool, then it becomes easier for you to say, “Okay. That asset pool, can we make it green and attract a wider investor base?”

We’ve seen even in last year, we’ve seen many institutions in the Gulf region trying and issuing actually green and social to broaden the investor base. Not to include only Islamic finance and conventional, but also to include the green or sustainable side of the investor base. So it is cumulative, but it is not like — and you need really to go the extra mile to comply with the certain framework that you’re trying to relate to within the green or social or et cetera. This is in the issuance, the instrument side.

On the banking side, Islamic banks initially have their own way and identity in structuring their product. We do rate them from a credit point of view similarly to conventional one. However, we identify that there is significant differences in the way that they conduct business. From a credit point of view, these methods are factoring the rating. However, in ESG scores because we assign ESG scores to issuers, we differentiated Islamic banks for example in two dimensions. One of them the governance structure and the way that they are governed in terms of, whether they have shari’ah committees, i.e., are they doing shari’ah audit that you need to comply with that board, you need to do audit for that, you need to structure instruments in a certain way. Thus, we’re scoring banks higher than conventional peers in the same countries because of that.

We also recognize they have also a social side, thus we’re scoring Islamic banks in a peer comparison with conventional in the same countries. If you’re in a conventional bank, you’ll get for example a two score, but if you’re in Islamic, you’re going to get a higher score because you are actually a shari’ah compliant and you’re doing your activities in a certain way that gives you a score.

[00:45:32] AVH: There could be a rank, it’s like a score of two, it’s like sort of a conventional bank that does not focus at all on ESG, a score of three would go to Islamic bank that does not focus on any other ESG factors other than those in the shari’ah. But then a score four could for example go to a conventional bank that focuses highly on ESG. Is that correct?

[00:45:59] BAN: Yeah. I would say that we have a lot of scores and I’ve just mentioned two where we differentiated Islamic banks, which is just to summarize. The governance structure where Islamic banks is higher, i.e., this score usually four compared to a typical bank in a comparable environment of three. And social, where exposure to social impacts, where if you’re an Islamic bank, you score three and then if you’re a conventional one in a comparable banking environment, you score two. They’re getting higher scores, indicating their exposure, higher exposure.

These scores, they are relevant, they’re credit relevant. What a four means, that means that this structure is actually relevant to the rating but not a key rating driver by itself, because there is higher score, which is five. But it has an impact on the rating combined with other factors. You need to really understand what is a four, what is three at the system. But I just wanted to give you a flavor on how do you differentiate even when you’re looking at Islamic finance.

[00:47:04] AVH: Okay. Does that then translate if we look — I mean, this is fiction example, but we have the exact same bank, exact same balance sheet, exact same revenues, everything exactly the same, just one shari’ah compliant and because they score higher on the ESG score. They would likely have a slightly better rating. Like all else the same?

[00:47:26] BAN: No. The ESG score is not the credit rating by the way. The ESG score is ESG score highlighting the ESG relevance in credit. For us, I’m sensitive when you say better. It does not indicate better, it means higher influence in a certain way in terms of a credit.

[00:47:47] AVH: Okay. Got it. Before we wrap up, I have one thought when you said the principles of Islamic banking emerge 1400 years. We see in conventional banks a lot of fintech coming up that really take away traditional banking, banking products that take away traditional banking into action that really revolutionize traditional or conventional banking. Is there anything of the like in Islamic finance?

[00:48:22] BAN: Definitely. I think I would like maybe just to set the scene. I think theirs is two type of fintech, there is the conventional fintech and I’m not here talking about shari’ah compliant and not shari’ah compliant. I am talking like the online banking, the mobile banking, the branches thar does not have employee, et cetera, et cetera. There is the more exotic fintech, which is the blockchain, P2P, B2B, crowdfunding, et cetera. Now, the conventional side in countries where the Islamic banking industry is developed. The Islamic banks are competing in a similar footing in many ways, like the conventional one. They’re offering you the same offering.

Because, succinctly after COVID-19 and lockdowns and social distancing, that type of offering is not something that’s good to have. It’s actually innate. Yes, we saw a lot of adoption even before that, and in countries where you have a good infrastructure and platform, and established makes them really competing in a very similar footing to conventional one. Now, not all Islamic banking industries are developed. There are in some countries, they’re facing more, I would say severe challenges of having the right product offering, having the right regulations, having the right liquidity tools. They’re prioritizing fintech among other things and facing other challenges. That depends on which country you are. There is no one lacking.

Now, if we look at the actual, more exotic one with crowdfunding, cryptocurrency, B2B, P2P, et cetera, you have in countries where Islamic finance is active, these are still in a very early stage of development. Few countries like UAE, like Malaysia, they are trying to develop that. But in other countries, they’re still — other countries are trying, but still at an early stage. That type of the industry is still developing in these countries, even on the conventional side. On top of that, the Islamic finance industry needs to go the extra mile of having the right product offerings that comply with shari’ah because you need to deal with it and that is an additional complexity and a challenge.

This is a thing the same with the industries. The credential is really high. As we said, you’re talking about the huge unbanked population. You’re talking about in many countries a young population, they’re tech savvies, the mobile penetration is high. There is actually a potential the industry can gain around that and we’ve seen that some examples in some of the countries. But I think the road is much wider than Islamic finance because you’re talking about in some countries less developed banking industry, less developed capital markets, less developed insurance industry. Then after that, you need to [inaudible 00:50:57]. Definitely, fintech can play a role in inclusion, and bridging these gaps and reaching out to a wider audience. So it has a role. It’s used in some countries in some extent but it is not yet there reaching its full potential.

[00:51:14] AVH: I think to me it sounds without knowing a lot about the topic, but that it could be the same as in Africa. In Africa, you never really had branch-based banking, you never really had online banking. You move directly from unbanked to a huge mobile penetration. It seems this could be a huge market for fintech, because the traditional Islamic finance banks, they are not really penetrating the actual market. It cast the potential for fintech to jump the hurdle and directly establish itself before in front of a traditional Islamic bank, because now they have to direct exercise. You kind of like jump one evolution, one step of evolution in technology.

[00:52:05] BAN: Many of these countries in Africa are actually having significant Muslim population. At the end of the day, if you are achieving that on the conventional side, then you need to look at the development of the Islamic finance industry in these countries and the political will to develop it. If it’s there, what do you want to include, because you have as we mentioned before, some of your population is not entering into the banking industry because of religious reasons.

If you want to really widen the net and have a more inclusive one, I need you need to really look at that. But if you’re still just trying to have a bank account, I think for some, the luxury of saying, Islamic and not Islamic is not yet there. But for some, it is prohibited. I’m not going to deal with the whole banking industry. I think the potential, as you mentioned, and as I said, it is really that in Africa, in Asia, and in many of these countries, the [inaudible 00:52:56] is not that high, so the actual potential is there.

Are we going to have the right infrastructure, the right offering and the political will to transfer this Islamic finance? This is something in turn that is interesting to watch.

[00:53:09] AVH: Absolutely. I’m curious now that I have a slight understanding and I feel like we’re just only scratching the surface on that, but how would my listeners, how would we get more knowledge on the topic if we’re interested on that? Do you have any resources, any references that you could point us to? Then as a follow-up question, if people are interested to get in the industry, how would they start?

[00:53:38] BAN: There are a lot of resources out there, but we have our own and in Fitch, we actually have a dedicated page for Islamic finance, so it has all of our research, but it’s a rating agency perspective. We’re independent, we’re looking at the industry and assisting it as it is. We’ve just actually published a report recently, which his like a credit encyclopedia for Islamic finance. It has the essentials and basics of Islamic finance that we touched upon highly here. That can also give further and a bit more deeper insight on the industry, and maybe some of its complexity. That is helpful, but there is a lot of ground to data.

Now, the other part of your question is. How to interact with it? The industry is really significant. In some areas where Islamic finance is active, as I said, you’re talking about a banking system that is 40% in Kuwait or 80% of financing in Saudi Arabia, 30% in — so it’s there, but in other countries, it’s not there. Whether you’re on the banking side, whether you’re on the investor side, you can really encounter that. How do you want to interact with it? It’s really diverse because it is across the board. The Islamic finance industry, you can find it in insurance, you can find it in capital market, you can find it in ranging, you can find in banking, in structuring, in issues. It’s really a wide offering. However, that wide offering is limited in few countries.

If you look at the size of Islamic finance industry from the total financing, global financing, it’s still less than two percent. It’s not that big. From a global perspective, it might be significant in some of the countries where you’re zooming in, but it is available even in countries in a niche format, even in the UK. So the UK government issued a sukuk before, Luxemburg issued a sukuk, Hong Kong issued a sukuk, South Africa issued a sukuk. In the UK, you have Islamic banks in certain ways. So it is there, but it depends, if you remember, we classified these countries into five categories depending on where you are, you’ll find different format, different platform, and develop infrastructure in interacting with the industry.

[00:55:47] BAN: Perfect, Bashar. I think you’ve given us a lot of food for thought, a lot of things to jump into deeper topics here. Thank you so much for taking the time to introducing us to this very interesting topic.

[00:56:02] AVH: It is my pleasure. Thank you very much for having me, and take care and stay safe.

[END OF INTERVIEW]

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