Commenting on the sharp decline in European banks’ share prices in the early weeks of 2016, which it described as a “concern”, the IMF advised that “a robust banking sector is required to support investment and economic recovery.” Islamic finance is in many respects ideally positioned to buttress the rejuvenation of the European economy.
There is broad agreement that Europe needs a Plan B for reinvigorating its moribund economy. Many economists believe that Plan A, which has been constructed around accommodative monetary policy and quantitative easing (QE), has demonstrably failed to underpin sustainable growth, encourage corporate investment and create new jobs. As the IMF notes in an update published in April,1 “in the euro area, low investment, high unemployment, and weak balance sheets weigh on growth, which will remain modest at 1.5 per cent this year and 1.6 per cent next year.”
In part at least, the IMF attributes Europe’s economic stagnation to the continued weakness of its banking system, which has been hamstrung since the global financial crisis by the twin burden of onerous regulation and weak asset quality. Commenting on the sharp decline in European banks’ share prices in the early weeks of 2016, which it described as a “concern”, the IMF advised that “a robust banking sector is required to support investment and economic recovery.”2
Few would disagree with this analysis. But a fresh approach to banking could also make a notable contribution to supporting a sustained recovery in Europe. More specifically, Islamic finance is in many respects ideally positioned to buttress the rejuvenation of the European economy, for a number of reasons.
One of these is that Islamic savings in the Middle East and South-East Asia remain an important source of liquidity that is looking for diversified investment opportunities beyond their home regions.
The Asset-Based Foundation of Islamic Banking
Perhaps more significant, for the long term application of Islamic finance to the real economy, is that the tenets of Shariah-compliant finance are very closely aligned with the investment that Europe needs if it is to build a sustainable and inclusive economic recovery. In a nutshell, this is because Islamic financing techniques are constructed around asset-based and risk-sharing principles that are generally regarded as more secure and appropriate mechanisms for supporting investment in real assets than conventional finance. According to a World Bank briefing,3 “Islamic finance is equity-based, asset-backed, ethical, sustainable, environmentally- and socially-responsible finance. It promotes risk sharing, connects the financial sector with the real economy, and emphasizes financial inclusion and social welfare.”
The SRI Credentials of Islamic Finance
Because Islamic finance is gaining increasing global recognition for its very high ethical and governance standards, it is ideally positioned to cater to growing demands for socially responsible investment (SRI) opportunities. In the European context, this does not just mean investments that avoid proscribed sectors such as alcohol, weapons, gambling and adult entertainment.
Much more significant, today, is the strength of demand among borrowers and investors for financing structures that address the threat of climate change and environmental degradation. It is this strong and growing demand that has underpinned the conspicuous expansion in recent years of the market for so-called Green Bonds, the proceeds of which must be used to support sustainable investment. According to data published by Moody’s,4 issuance of Green Bonds rose by 255% in 2013 and 233% in 2014. Although this rate of growth slowed to 16% in 2015, it reached $42.4 billion last year, and Moody’s believes the market could expand to $50 billion in 2016.
More broadly, Moody’s reports that between 2012 and 2014, global assets under management (AUM) linked to SRI strategies rose by more than 50% to $21 trillion.5
Islamic bonds, or sukuk, have already demonstrated their credentials as financing instruments for ethical initiatives. In December 2014, for example, the International Finance Facility for Immunisation (IFFIm), for which the World Bank acts as treasury manager, launched a $500 million sukuk, the proceeds of which were used to finance projects for the Global Alliance for Vaccines and Immunisation (GAVI). The strength of investor demand for this transaction, which was oversubscribed by 1.4 times, underscores the potential of Islamic finance to support transactions used for similar ethical purposes.
Standard & Poor’s, which estimates that global Islamic assets were worth about $2.1 trillion at the end of 2015, believes that Shariah-compliant financial instruments could play a role in meeting some of the Sustainable Development Goals (SDGs) adopted in September 2015 by the UN General Assembly.6 Its 2030 agenda for sustainable development outlines targets centred on the five pillars of people, planet, prosperity, peace and partnership.
“Looking at the UN SDGs and the principles of Islamic finance, we consider that there are some similarities,” observes S&P. “For example, the principle requiring underlying assets in each Islamic financial transaction makes Islamic finance a good match for the financing of SDGs 6, 7, 9, and 11.”
The S&P analysis adds that “Islamic finance also uses some specific products that can be used to finance SDGs. The first two SDGs aim to end poverty in all forms, and halt hunger and achieve food security in the world.” Islamic forms of concessional lending such as Qard Hassan (welfare loans), Zakat (a wealth tax used for social purposes) and Waqf (a donation to charities) could all be used in support of these SDGs, although they are likely to be more applicable to underdeveloped economies than Europe.
The Potential of Shariah-Compliant Infrastructure Finance
S&P’s reference to infrastructure investment, however, is highly relevant to the potential for the role Islamic finance could play in the rejuvenation of the European economy for two related reasons. The first is that with monetary policy increasingly looking like a blunt instrument as far as promoting growth and job creation is concerned, infrastructure investment – financed by private as well as public sector investors – is regarded as an alternative way of kick-starting sustainable economic activity in Europe. The so-called “Juncker Plan” which aims to mobilise at least €315 billion in new investment in Europe between 2015 and 2017 is not just about building infrastructure. The European Commission (EC) also estimates that it will add €330 – €415 billion to the EU’s GDP and create up to 1.3 million jobs.7
Second, much of the funding that Europe is aiming to attract to its infrastructure investment agenda will need to conform to increasingly strict ESG (environmental, social and governance) standards. Given that a rising number of investors are coming to see Islamic finance as a subsector of the broader global ESG universe, there is good reason to believe that Shariah-compliant funding is well-positioned to play a role in helping to support environmentally-responsible investment in Europe’s infrastructure.
Another reason why Islamic finance in general and sukuk in particular is regarded as a promising source of funding for infrastructure projects in Europe is the regulatory pressure that is intensifying on conventional banks. Because capital treatment under Basel III is leading to a decrease in banks’ appetite for long-dated assets, the financing of infrastructure projects is expected to gravitate towards the capital market. As a recent World Bank blog8 comments, “a sukuk in which the proceeds are used to fund a specific environmentally sustainable infrastructure project, such as the construction of a renewable energy generation facility, could appeal to both sukuk and conventional environment-focused investors.”
As a specific case study of the sort of project where Islamic finance could contribute to clean infrastructure investment in Europe, a recent study published by Deloitte points to wind farm development in Germany.9 Renewable energy sources, including solar, wind, hydropower, and biomass, made up 34% of Germany’s public net power supply in 2015, according to this report. With the government targeting an 80% share of renewables in electricity generation by 2050, Germany will need to attract substantial local and international investment to its clean energy sector. Sukuk, the Deloitte report advises, could be used as a conduit for attracting some of this investment. “The key transactional features and considerations which set sukuk issuance apart are the requirements for Shariah-compliant assets and utilisation in of proceeds,” Deloitte notes.
Beyond renewable energy developments such as wind farms, Islamic finance could play a central role in supporting investment across a wide range of social infrastructure projects in Europe, such as schools, hospitals and retirement homes. It is accepted that Shariah-compliant finance is fully compatible with the principles of public-private partnerships (PPP), and elements of financing mechanisms such as joint ventures (Musharaka), profit-sharing structures (Mudharaba), cost-plus financing (Murabaha) and leasing (Ijara) could all be applied to European social infrastructure investment.
Islamic Finance for SMEs
There are a number of other areas of Europe’s underperforming economy that are suitable for the asset-based tenets enshrined in Islamic finance. As S&P explains, “Shariah-compliant transactions must be backed by tangible and identifiable assets that anchor the financial sector in the real economy.”
In Europe, no sector of the business community is as pivotal to the real economy as small and medium-sized enterprises (SMEs), which are the engine of growth, investment and employment creation across much of the continent. In a number of European countries, micro companies – defined as those employing fewer than 10 employees – are also key drivers of the economy. According to data published by the OECD,10 in Spain, Hungary, Finland and the Netherlands, 80% of all firms are micro.
European banks, however, have largely been unable to provide the lending that SMEs need to support their growth, for two reasons. First, regulation is forcing them to hold more capital against lending to the corporate sector. Second, banks in many European markets are still hampered by weak asset quality and high exposure to non-performing loans (NPLs). According to Moody’s, while SME borrowing has risen over the last year in Germany, Spain, France and Italy, with companies taking advantage of increased availability of credit since 2014, it remains below pre-crisis levels.11
Globally, meanwhile, it has been estimated that the total financing gap among micro and SME companies in G20 countries is about $1.3 trillion of a global total of $2.4 trillion.12 A briefing published in October 2015 by the World Bank, Islamic Development Bank (IDB) and Islamic Research and Training Institute suggests that Islamic finance, which is growing at a much faster rate than conventional banking, has considerable potential to help plug this gap. “The asset-backed finance and risk-sharing nature of Islamic financial products aims to contribute to social and economic development by promoting entrepreneurship,” this notes.13 “Asset-based financing ensures that the transaction is financing real economic activity based on close linkage to the financed assets, ensuring less “financialisation” in the economy. Equity-based financing, on the other hand, promotes profit and loss sharing between financiers and entrepreneurs, resulting in increased alignment of interests and increased risk sharing. It also fosters entrepreneurship, especially of seed and early-stage start-ups, which rely purely on equity financing for their ventures.”
Malaysia provides an encouraging role model for the role that Islamic finance can play in supporting growth and investment among SMEs. In 2015, outstanding business loans to SMEs in Malaysia rose by 14.6%, almost double the overall growth rate in the overall market of 7.7%.14 Commenting on the increasingly prominent role of Shariah-compliant financing in the SME sector in 2015, Prime Minister Datuk Seri Najib Tun Razak was quoted as saying that “Islamic finance, with its equity-based partnership schemes, offers a truly workable alternative to conventional banking.”15
Supporting Affordable Home Ownership in Europe
A third area of the real economy in Europe where Shariah-compliant finance and investment could support more inclusive growth is in the property sector. Islamic mortgages, in particular, have made impressive headway in the UK over the last decade. Germany, too, is regarded as offering substantial potential for growth in the market for Islamic home loans. The country’s first Islamic bank, a subsidiary of Kuveyt Turk, opened its doors for business in 2015, and local specialists identify home lending as a potential dynamic source of growth for the bank. Although the total accumulated wealth of Germany’s 4.3 million Muslims is estimated at about €25 billion, only 8% are home-owners, compared with a nationwide average of 42%.16
Shariah-compliant banks operating in Europe have also identified student accommodation as a promising growth area. For example, the London-based investment bank, Gatehouse Bank, which specialises in Shariah-compliant products and services, recently announced the acquisition of Fountainbridge, a student accommodation property located in Edinburgh.17
Conclusion: Towards a Level Playing Field for Islamic Finance in Europe
There is little doubt that if Islamic finance is allowed to unleash its full potential, it could play an increasingly prominent role in supporting the long term recovery in Europe. If it is to realise its full potential, however, policymakers in Europe will need to work towards creating a level playing field for Islamic finance. Measures that would allow Islamic banking to compete more effectively would include ensuring that the regulatory and tax regime governing Shariah-compliant banking is put on an equal footing with conventional banking. The development of liquid secondary markets for Islamic instruments such as sukuk would also be supportive of the industry’s long term growth.
A number of European countries have already made notable progress towards accommodating Shariah-compliant financing mechanisms within their local banking and investment industries. “Governments in several European jurisdictions are attempting to provide level playing fields for Islamic finance practice,” notes Deloitte’s report on the potential for corporate sukuk in Europe. “Some have gone a long way, such as the UK, Luxembourg and Ireland. Others are striving to match the regulatory developments in these countries and have provided good breakthroughs in changing national regulatory frameworks to host the industry.” Among these countries, Deloitte lists “Turkey, Germany, Italy and possibly Spain, and to some degree France.”
About the Author
Sohail Jaffer is a Partner and Head of International Business Development for “private label” bancassurance with the FWU group based in Dubai. FWU is an international financial services group focusing on innovative and customised product design in the field of unit-linked investments and family Takaful savings plans for a number of emerging markets. Mr. Jaffer has successfully originated, negotiated and won several major bancassurance deals in the GCC region, Pakistan and Malaysia.
He has written extensively on alternative investments and has edited several Euromoney publications on hedge funds, multi-manager strategies and investing in the MENA region, as well as six books in the Euromoney Islamic finance series including Retail Banking, Asset Management, Takaful, Wealth Management, Investment Banking, Sukuk, and a CPI publication on investing in the GCC markets.
Mr. Jaffer is a speaker at international industry events, a participant member in the Gulf Bond and Sukuk Association, and is currently leading the activities of the Alternative Investment Management Association (AIMA) in the Middle East.
1. www.imf.org, April 12 2016
2. Reuters, February 11 2016
3. http://www.worldbank.org/en/topic/financialsector/brief/islamic-finance, March 31 2015
4. www.moodys.com, February 1 2016
5. www.moodys.com, February 24 2016
6. www.standardandpoors.com, April 18 2016 – “Islamic Finance Could Aid Modestly in Achieving Sustainable Development Goals”
9. “Corporate Sukuk in Europe – Alternative Financing for Investment Projects” – Deloitte
10. The Dynamics of Employment Growth, Chiara Criscuolo, Peter N. Gal, Carlo Menon, http://www.oecd-ilibrary.org/
11. www.moodys.com, April 14 2016
12. “Leveraging Islamic Finance for Small and Medium Enterprises (SMEs)” – World Bank, Islamic Development Bank, Islamic Research and Training Institute, October 2015
14. Bank Negara Malaysia annual report – www.bnm.my
15. The Borneo Post, November 21, 2015