Islamic finance industry faces need for innovation, says Moody’s

A combined use of securitisation and derivatives offers considerable scope for reducing the risk exposures of Islamic financial institutions (IFIs) and thus improving their overall creditworthiness, Moody's Investors Service said in a new Special Comment. However, the Islamic finance industry needs to develop its own innovation phase and not imitate conventional derivative instruments in order for IFIs to maintain their special status and Shari'ah-compliant approach, the Moody's report explained.
Despite the recent gloomy economic environment globally, the Islamic finance industry's total assets scaled new heights in 2009, rising to US$ 950 bln. Moody's estimates that the market's potential is worth at least US$ 5 trln and the industry is continuing to expand globally.
"In this context, IFIs are continuing to deliver Shari'ah-compliant returns whilst, at the same time, focusing on efficiently mitigating the associated risks through a new risk management approach, including the use of derivatives," said Anouar Hassoune, author of the report.
"If employed with care, derivatives can enhance efficiency in IFIs through risk mitigation, thereby making them more competitive as well as appealing to customers. However, their application in Islamic finance is highly controversial for reasons of speculation and uncertainty, two practices forbidden under Shari'ah," explained Hassoune. The varying scholarly opinions in the world of Islamic jurisprudence on the legitimacy of derivatives has so far translated into a total ban on these instruments in some countries and actual implementation — albeit on a limited scale — in others.
"IFIs aim to utilise derivative instruments to hedge against risk and to improve risk monitoring practices. However, they are keen to do so in a Shari'ah-compliant manner, rather than imitating conventional derivative instruments — in order to avoid losing their special status as Shari'ah-compliant banks, which makes them very attractive to a large population of Muslims. For this reason, a new innovation phase in the industry is critical," Hassoune noted.
Moody's currently rates eleven IFIs in the GCC region and Turkey. Although their financial profiles display strengths, they are offset by weaker qualitative characteristics including their risk management.