In December 2015, the Bank of England joined the Islamic Financial Services Board (IFSB), a key body that sets standards for Islamic financial institutions. The UK was not the first country in the EU that decided to become an associate member of the IFSB. Banque centrale du Luxembourg did it five years earlier. These moves may seem unusual for European institutions, but they are part of a bigger strategy that the UK and Luxemburg have been implementing for nearly 40 years, namely adopting Islamic instruments and reaping benefits from diversifying their financial sectors.
Luxemburg was the first country in Europe to open its market to so-called unconventional finance. In 1978, it enabled the establishment of the Islamic Banking System, the first Islamic financial institution in a non-Muslim country. The UK followed suit. In the 1980s, the London Metal Exchange started offering Sharia-compliant overnight deposit facilities. Now Luxemburg and the City of London are leading Islamic finance hubs in the Western world. In 2014, the value of assets managed by Luxemburg and the UK amounted to 5 billion euros and 19 billion dollars respectively (KPMG and UK government data).
But how is conventional finance different from its Islamic counterpart? Islamic finance is quite unique in that it is based on three main principles that derive from Sharia law, namely the prohibition of interest (Ar. riba), elimination of risk, deception, delusion and excessive uncertainty, and “profit and risk sharing.” This means that although in general Islamic instruments are used for the same purposes as the conventional ones, they cannot be based on debt and are structured in a different way than their traditional counterparts. All financial services must be based on and support real economic activity upon which profit is calculated. It cannot be determined as a lump sum paid after completing the transaction, but as a percentage of the generated profits or mark-up.
Given the specific characteristic of Islamic finance, some may wonder why exactly the UK and Luxemburg decided to implement products so different from those used around the world, including Muslim countries. Back in the 1970s and 1980s, these two European states saw a chance to earn a profit on supplying instruments that the Arab world (mainly the Gulf countries) was interested in and started offering liquidity and asset management instruments to Islamic institutions. They also realized that, by widening the range of financial products offered, they would become more attractive to current and potential customers. In short, being able to use Islamic financial services, investors from Muslim countries were more willing to not only put money in this sector but also invest in other segments of the economy, as transactions could be financed with Sharia-compliant instruments.
Islamic finance has also become attractive to conventional entities. Watching the development of Islamic finance in Muslim countries (mainly those in the Gulf region as well as Malaysia), investors in the UK and Luxemburg have recognized the benefits of using Islamic financial services as yet another source of funding for investment projects, especially big ones. In June 2014, the UK became the first non-Islamic country to issue a sovereign sukuk. Luxemburg followed suit in the autumn of 2014, becoming the first eurozone country to do so. Unconventional instruments, mainly sukuk, have become a popular mode of financing infrastructure development in the UK. The Olympic Village, the Shard, Battersea Power Station regeneration, London Gateway—all these projects were financed with use of unconventional services.
A growing number of conventional entities perceive Sharia-compliant instruments as an attractive tool for diversifying their investment portfolio. An estimated 50 to 60 percent of sukuk issuances (corporate and sovereign) are subscribed by conventional institutions. The profit rate of sovereign sukuk issued by the UK was set at 2.036 percent, in line with the yield on bonds of similar maturity. This proves that, despite their different characteristics, Islamic instruments are priced and treated similarly to conventional bonds.
Others to join the fray
Although Islamic finance has been developing for 40 years, the sector is still growing. In 2014, the global value of Sharia-compliant assets grew by 12 percent to $2 trillion. Islamic financial instruments, including those dedicated to retail customers, are offered by 20 banks in the UK, five of which are fully Sharia-compliant. In November 2015, the value of assets in Islamic funds in that country amounted to $600 million, and 57 sukuk were listed on the London Stock Exchange (TheCityUK, 2015). In Luxemburg, there were 111 Sharia-compliant funds (the country was the third-largest Islamic Fund Center in the world), and 16 sukuk were listed on the Luxembourg Stock Exchange (EY, 2015).
These numbers have impressed other European countries. France, Germany Italy, Ireland and Russia are all embracing Islamic finance. Although their paths to Islamic financial instruments are different, they are all aware that, in order to make their economies more competitive and attractive to investors, they need to adopt innovative solutions, which sometimes seems to be completely at variance with the conventional system and its principles.
Source: The Warsaw Voice