Editor’s Notes

Editor’s Notes

Article Type: Editorial From: International Journal of Islamic and Middle Eastern Finance and Management, Volume 7, Issue 3

Islamic finance has grown dramatically from its modern beginnings in the 1970s; however, the Islamic financial industry in the USA has been very slow to develop, despite the USA having a significant Muslim population, and this has important growth implications for the industry. There are two important areas of the Islamic finance system: the wholesale side, which specializes in selling Islamic financial products to other brokers, dealers and financial institutions; and retail banking, which focuses on selling Islamic financial products to the investing public. Both retail and wholesale Islamic financial activity has been slow to develop in the USA; however, there are several Gulf-based institutions that maintain a presence in the USA. In particular, there has been much growth and interest in real estate investment in the USA from Islamic intuitions following the housing crash of the 2008 financial crisis, such as the Kuwait Finance House.

Large Islamic financial institutions have had a presence in the USA, but there remain significant gaps in the Islamic investing environment that may indicate an unmet demand for Islamic financial products, particularly from US-based Muslim investors. The class of institutional investors is one of the largest drivers for investment products, and the availability of Islamic financial products to US-based institutional investors has been particularly weak. Gulf-based banks have historically offered two sukuk products based out of the USA. However, these products took advantage of Regulation S of the Securities Act of 1933, which, while providing relief from some regulatory burdens, makes the security unavailable for purchase by US investors.

Two possible explanations account for the lack of available Islamic investment vehicles for US-based investors. First, there is unfulfilled demand for Islamic financial products within the USA, and Islamic financial institutions could meet this demand by offering products to US investors and institutions. Second, the concept of Islamic finance may still be "foreign" to most US institutions and investors, and the demand for Islamic investment products is not strong enough to justify entry into the US public markets, which involves significant costs. If demand from US institutions is strong, Islamic finance companies can claim exemption from many regulations under Rule 1444A, which would allow them to offer products to US institutional investors at a relatively lower cost. While there have been sukuk products offered under this arrangement, including two in 2009, there is little indication that there will be reliable growth in the near future. Thus, it seems as though foreign interest in Islamic financial products offering US asset positions is strong, which is reflected in the growth of some US-based Islamic financial products. However, US investor institutional demand for Islamic financial products appears to remain weak, which is reflected by the fact that most have thus far been unwilling to expend the costs necessary to offer their products to US investors.

One potential reason that wholesale demand for Islamic sukuk products may be small is due to the relatively small Islamic finance retail industry in the U.S. Much of the demand for sukuk products is driven by Islamic insurance (takaful) companies and Islamic banking institutions. These institutions need to hold sukuk products on their balance sheets as an alternative to traditional fixed-income securities. Most of the demand from takaful firms and Islamic banks comes from overseas, as the USA has a relatively small market share. For example, the UK has five major Islamic banks that engage in both the retail and wholesale markets. In contrast, the USA has only one retail Islamic bank, and there are no wholesale banks. Likewise, the only provider of takaful products within the USA is American International Group, and their Islamic business is headquartered outside the USA. Additionally, several major US banks engage in some Islamic banking activities, but these are typically done as part of operations in other counties with more dominant Islamic finance industries.

There are several consequences for the lack of Islamic financial products offered to wholesale and retail investors in the USA. First, the diminished role of the USA in providing Islamic products limits the influence of the USA in the global Islamic finance industry. Thus, the centers of global influence for Islamic finance will be London, Singapore and Honk Kong, rather than New York. Second, the lack of Islamic products impacts retail investors in the USA. There are an estimated 7-10 million Muslims living in the USA, and most of them desire to interact with the capital markets at some point, even if for the simple purpose of preparing for retirement. While there have been developments in the USA of mutual and exchange traded funds for this purpose, where American Muslims can access the capital markets in a way that is Shari'ah-compliant, most of these products consist entirely in equity positions. Thus, without the implementation of sukuk and other Islamic financial products in the USA, retail investors remain limited in terms of the degree to which they can interact with the broader markets. As a result, the efficiency of their (as well as that of the market) portfolio is diminished.

The first paper is by Kiong, Giorgioni and Laws and examines the possibility of a Shari'ah-compliant financial product that serves as a financial option to shift risk, rather than transfer it. The main contribution of the paper is the development of an Islamic financial product that combines wa'ad (promise) and murabaha (cost plus sale) and acts as a risk-sharing option, assuming that the payoffs are dependent of bi-period outcomes. The value derived from the instrument is dependent on market movements in terms of whether the options are in or out of the money. While the paper is not able to address the Shari'ah compliance of the product, it expands the study of Islamic financial products in the area of derivatives. Derivatives are an important and a controversial area in Islamic finance, because there are provisions of Shari'ah against excessive risk taking, and financial transactions are required to be directly tied to underlying assets. However, the concept of an Islamic financial product that shares risk, rather than transfers it, may provide interesting implications for Islamic risk management, as some forms of hedging behaviors are permitted under Shari'ah.

In the second paper, Farooq and Ali analyze the efficiency of analyst recommendations in the MENA region from 1999 to 2010. The authors use post-announcement market-adjusted returns over different holding periods to measure the informational impact of analysts on the markets. The results show a significant positive performance after a buy recommendation, which indicates that analysts' forecasts contain valuable information. On the one hand, there appears to be no significant abnormal returns following analysts' sell recommendations, indicating that sell recommendations provide no additional information to the market. In addition, the authors show that their results hold only for markets where institutions are fairly strong, as measured by property rights and agency costs. Countries having weak property rights and high agency conflicts exhibit no value of analyst recommendations. The paper shows some impost results regarding the value of analyst recommendations in the MENA countries and the conditions under which they provide valuable information to the markets.

In the third paper, Gunn and Shackman study the impact of Islam on firm capital structure. The authors compare the capital structures of firms in Muslim and non-Muslim counties using a sample of 658 firms across 16 countries. The study finds that there is no significant difference between the total debt ratios of Muslim and non-Muslim countries. However, Muslim counties are found to hold a significantly larger amount of short-term debt. The results are consistent with the theory that firms in Muslim countries should hold more short-term debt; however, failure to find a difference in terms of the total debt ratio is not consistent with theory. Due to limitations on the use of debt that is specific to the Islamic religion, Islamic firms are expected to have lower debt ratios, which is contrary to the results presented. The results of the paper suggest that Muslim firms have the capacity to maintain capital structures that are similar to those of non-Muslim countries, which has important implications as to the relative efficiency of Islamic firms.

In the fourth paper, Ringim examines the drivers of Islamic bank utilization in Nigeria. Previous papers on Islamic bank utilization have focused on several factors such as religion, reputation, advertising, service satisfaction, staff, convenience and confidentiality. The results of this study show that high awareness is associated with public knowledge of major Islamic financial products such as Mudharabah, Musharakah, Murabahah and Ijarah (lease) products. In addition, bank customers cite religion as their primary reason for utilizing Islamic banking services. Also, other factors such as rewards given by Islamic banks, the influence of family and friends, location and customer education and awareness also drive bank patronage. It is important to understand the factors that drive Islamic bank awareness and utilization, because Islamic banking is growing in many areas and becoming increasingly competitive with conventional banks. This paper advances the literature on this topic and can be applied to improve the operations and effectiveness of Islamic banks.

The fifth paper, by Rachdi and Mokni, examines the determinants of bank profitability in the MENA region. The study analyzes data from 15 Islamic and 15 conventional banks in the MENA region to determine the impact of macroeconomic variables and firm characteristics on levels of bank profitability commonly used in the literature. Based on a dynamic model specification, several factors are found to significantly affect bank profitability. Non-performing loans significantly negatively impact bank profitability. Liquidity is found to have a positive effect. In addition, off-balance sheet activities affect Islamic banks negatively, but conventional banks positively. Also, the ownership of the bank is significant for explaining Islamic bank profitability. From a macroeconomic perspective, economic growth rates affect profitability of conventional banks. The paper expands the literature on the determinants of Islamic banks profitability and how they differ from those of the conventional banking system.

In the sixth paper, Mahmud et al. examine the degree to which zakat funding is able to help improve the stability of food sources among poor households. An ordinary least squares logit methodology is performed to determine whether zakat improves food production or food expenditures. Zakat recipients were asked whether the zakat contribution either helped their household agricultural production or increased their food expenditure. The results show that zakat does not impact the food status of poorer households. Instead, the authors focus on other factors for improving food availability among the poor, including total household income. In addition, improving infrastructure, access to insurance and employment opportunities may improve the food status of poor. The paper has important implications as to the efficacy of zakat, because it is intended to improve the lives of the less fortunate.

The seventh paper, by Grassa and Matoussi, examines the governance structure and practices of Islamic banks in the Gulf Cooperation Council (GCC) and Southeast Asian countries. The study uses data from 83 Islamic banks from 2002 to 2011 to test for statistical differences in the governance measures of the banks between GCC and Southeast Asian countries. The paper tests for differences of many key governance variables, including those related to ownership structure, the board of directors, the Shari'ah board and the chief executive officer. The results show a significant difference between the corporate governance practices between Islamic banks in GCC and Southeast Asian countries. In light of the results, the paper has significant implications for the management and understanding of Islamic financial institutions across international borders.

I hope you will enjoy reading the papers of this current issue.

M. Kabir Hassan

Further reading

Goud, B. and Kabir Hassan, M. (2011), "Islamic finance in the United States", in Kabir Hassan, M. and Mahlknecht, M. (Eds), Islamic Capital Markets: Products and Strategies, Chapter 14, John Wiley and Sons, London.