University of Malaya

“Islamic Banking and International Financial Markets”

Andrew ShengThird Chair

Tun Ismail Mohd Ali Visiting Professor in Money and Banking

16 March 2006

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Contents

• How does Islamic Banking fit into

International Financial Markets?

• Evolution of International Financial

System

• International Financial Architecture

• Overview of trends in Asian markets

• Issues in International Financial Markets

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Islamic Banking in Malaysia• One in 10 banking transactions in

Malaysia today is Islamic-based

• Islamic banking in Malaysia began with

Pilgrims Fund Board in 1963, today 9.7%

of total Malaysia’s banking assets or

US$20 bn

• Under Financial Sector Masterplan,

target of Islamic banking assets and

takaful assets to be 20% of total industry

assets by 2010

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Islamic Banking Globally Assets of US$260 bn, mostly in Middle East,

but growing in Malaysia and Indonesia International, non-Islamic banks issue around

US$200-250 bn of Islamic financial instruments With Muslims accounting for 1.6 billion or 25%

of world population, demand for Islamic finance is growing

However, scale of Islamic financial institutions still small

Only 1 bank has capital exceeding US$500 mn. Total Islamic banking account for 1% of global

banking system

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Need to Understand International Financial Markets

International Financial Markets are a network of domestic markets

There is a hierarchy of financial markets, beginning with banks operating basic payments functions, and moving towards savings, foreign exchange, and then risk-sharing (equity), insurance and long-term pension functions. Derivative products emerge as markets become more sophisticated

Islamic markets emerge to fill market need

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Hierarchy of Domestic Financial Markets

Asset-backed securities and

derivatives

Corporate bond and equity markets

Government bond market

Treasury bill market andforeign exchange markets

Money market

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Evolution of International Financial Markets: Four phases

• 1821-1914 Gold standard (international trade settled in gold or silver), essentially fixed exchange rates and free capital movement

• 1914-1946 First World War led to global imbalances, competing devaluations against gold and prevalence of capital controls

• 1947-1971 Bretton Woods, dominated by the US dollar, which was pegged to gold at US$35 to one ounce. Exchange rates could be adjusted, but capital controls were gradually removed

• Post 1973, oil crisis caused abandonment of fixed exchange rate regimes for floating rates. 1998 crisis pushed for more flexible regimes.

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International Monetary Fund, total quota (capital) of SDR213 bn (USD306 bn), 184 members (2005 data)

World Bank (International Bank for Reconstruction and Development), capital US$38.6 bn, assets US$222 bn

Other development banks, ADB, African Development Bank, EBRD, Inter-American Development Bank etc

Bank for International Settlements (BIS), owned by member central banks, equity of US$14.9 bn and US$260.5 bn assets

The Bretton Woods Architecture

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Financial Stability Forum – Central Banks, Ministries of Finance, IFIs, Standard Setters, Supervisory Agencies

Major move to incorporate Emerging Market views

Greater coordination of efforts of different implementation agencies, eg IFIs, Standard Setters (eg IASC, IOSCO, Basle Committee) and supervisory agencies also represented

BIS acts as secretariat to FSF, currently chaired by Roger Ferguson

Post 1998 Architecture

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Global Assets Under Management (US$ trillion end 2003)

International Banking Assets (BIS data) 23.6International debt securities

14.6Insurance companies

13.5Pension Funds

15.0Investment Companies

14.0Hedge Funds

0.8Other Institutional Investors

3.4

Memo: OTC Derivative Contracts (notional) 270.1

Source: BIS, IMF

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Who Accounts for Most Financial Assets? (US$bn 2003)

53.7

19,251

7,026

5,994

4,833

1,398

United

States

16.0

5,724

493

928

2,969

1,334

Japan

100-12.018.3% of total

-35,8624,3206,567Total

25.469,1291,063547Investment companies

23.918,5754621,191Pension Funds

29.4110,5471,0091,736Insurance

21.227,6111,7863,093Int. Banking assets

% of totalTotalGermanyUK

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Size of Global Foreign Exchange Market

Turnover – Average Daily (US$ bn)

1880

107

944

208

621

2004

218.6

91.1

396.8

670.4

95.9

Growth

(%)

100.0590Total traditional turnover

5.756Estimated gaps in reporting

50.2190Foreign exchange swaps

11.127Outright forwards

33.0317Spot transactions

% of total

1989

Source: BIS, Triennial Bank Survey 2004

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Currency Distribution of FX Turnover (%)

18.51.936.936.2Other Currencies

28.0

-10.6

-1.1

-1.8

% of Changes

200

16.9

20.3

37.2

88.7

2004

100200Total

8.513.2Sterling

10.222.7Jap. Yen

18.637.6Euro

44.490.3US$

% of Total

2001Currency

Source: BIS, Triennial Bank Survey 2004

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Stock Market Performance (end Dec 2004)

Australia 776.4 258 4,053 112China 447.7 925 1,330* 99Hong Kong 861.5 220 14,230 74Korea 389.5 103 896 -13Taiwan 441.4 78 6,140 -14 Average** 535.0 184 45India 363.3 289 2,081 76Indonesia 73.3 55 1,000 113Malaysia 181.6 -4 907 -7Philippines 28.6 -50 1,823 -35Singapore 217.6 60 2,066 11Thailand 115.4 -8 668 -51 Average** 163.3 51 31Japan 3,557.7 -1 11,489 -42Germany 1,194.5 139 4,256 102UK 2,865.2 150 4,814 57US 16,240.5 229 (NYSE) 12,707.6 206 10,783 181 (NASDAQ) 3,532.9 345 2,175 189 Average** 5,964.5 134 130

Remark: * Shanghai A-share Index ** the average index performance is weighted by market capitalization Sources : World Bank, WFE, CEIC, Bloomberg, various central banks and government websites

Market Cap Increase since Increase sinceCountry (US$ bn) Dec 94 (%) Index Dec 94 (%)

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(% of World, 2001) MSCI GDP Exports Population WeightingASIA 22.8 26.1 55.4 13.15 China3.7 3.7 21.1 0.26 Japan 13.3 7.0 2.1 9.38 India 1.5 0.8 16.6 0.12US 32.3 14.2 4.6 55.30EU 19.6 36.0 6.2 17.14Others 25.3 23.7 33.8 14.41World 100.0 100.0 100.0 100.00

Source: IMF, World Economic Outlook, 2001 and World Bank, World Development Indicators, 2001.

Asia – 55% global population, 26% trade weight, but small in equity markets

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Asia – The Third Zone? Asia is Third Time Zone to American and

European time zones

New York (US$12.8 trn or 50% of global market cap) now services global + Latin American capital markets

European financial markets consolidating under EU and euro

Asia has tremendous savings, but lacks deep and liquid financial markets, with little integration among Asian markets

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Asian Stock Markets – Third Time Zone

Market Cap by Region (end 2003, in US$ terms)

America51%

Asia Pacific

20%

Europe, Africa,Middle East 29%

Turnover by Region (2003, in US$ terms)

America54%

Asia Pacific

15%

Europe, Africa,Middle East 31%

Remark: Global market cap and turnover refer to the total of all member exchanges of the WFE. Categorization of regions is also based on the WFE.

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Asia still Dependent on Bank Financing (% of GDP)

Remark: * 2001 figureSources: World Bank, IMF, WFE, FIBV, CEIC, Bloomberg, BIS, International Financial Statistics, various central banks and government websites

Bank Assets Equity Market Bond Market1998 2002 1998 2003 1998 2002

China 139 140 25 36 12 33Hong Kong 214 149 206 451 32 27India 69 36 24 42 21 33Japan 145 107 64 68 101 169Korea 233 115 35 49 53 81Singapore 220 112 112 144 20 66Taiwan 226 125 97 133 41 33Thailand 176 82 30 83 23 38

Germany 273 155* 51 58* 97 90*US 65 78 158 130 141 156

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Funding Sources to Corporate Sector (US$bn, 2003)

  Bank Credit to Corporate Sector

(A)

Total Capitalisation of Equity Market

(B)

Outstanding Amount of Corporate Bond

(C)

(A) + (B) + (C)

  US$ bn % of GDP

US$ bn % of GDP

US$ bn % of GDP

US$ bn % of GDP

9 Asian Regions*

3,345.3 86.1 3,171.7 81.6 392.9 10.1 6,909.9 177.8

Japan 3,770.3 87.8 2,953.1 68.7 769.7 17.9 7,493.1 174.4

US 4,975.4 45.2 14173.1 128.8 2,484.0 22.6 21632.6 196.6

UK 1,228.3 68.3 2,460.1 136.8 382.0 21.3 4,070.3 226.4

Germany 1,581.5 65.7 1,079.0 44.8 958.2 39.8 3,618.8 150.4

*Hong Kong, China, Australia, Korea, Singapore, Taiwan, Thailand, Malaysia and India

Source: International Financial Statistics, World Federation of Exchanges, BIS, IMF, CEIC, various central banks and government websites

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Corporate Crude Leverage Ratio

1993 1998 2003Hong Kong 30.0% 55.4% 20.5%China1,485.7% 463.0% 409.1%Australia 70.1% 61.9% 63.9%Korea 89.0% 197.5% 121.7%Singapore 33.6% 86.3% 61.3%Taiwan 66.2% 79.8% 54.6%Thailand 73.8% 409.8% 100.5%Malaysia 28.5% 135.6% 104.3%India 60.6% 93.1% 67.4%Total 89.0% 147.0% 117.9%

Japan 160.9% 205.1% 153.7%US 81.9% 45.5% 52.6%UK 41.5% 37.5% 65.5%Germany 431.7% 254.4% 235.4%Sources: World Federation of Exchanges, BIS, IMF, CEIC, various central banks and government websites

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Demographics – around 300 million Asians earn US$5,000 or more annually; by 2020, discretionary spenders will grow to 1.4 billion. Huge demand for asset management and consumer banking needs

Wealth management - private banking spreading from those with US$1 million or more to middle income professionals

Mutual Funds - in US already US$7.5 trillion market, but becoming more leveraged – no longer just long-only funds; line between mutual funds and hedge funds blurred

Market makers - Asian investment banks still small by any standard

Outsourcing - over 100,000 jobs moved to India from US, worth US$136 bn in wages – trends will continue

Key Capital Market Trends

*

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Deposit-taking Institutions – demographics changing customer pattern – growth of consumer banking, credit cards, demand for structured products

Risk-pooling Institutions - still foreign dominated, but demand growing

Contractual Savings Institutions - huge liquidity pools, but shortage of professional fund management skills

Market Makers - key investment banking skills still dominated by large foreign players, with foreign fund managers as key clients

Specialized Sectoral Financiers - policy-based banks shrinking in market size; venture capital and private equity becoming more important

Financial Service Providers – exchanges demutualizing

Recent Key Market Trends in Asia

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8,000 hedge funds with US$1 trillion in assets under management – leveraged around 2-3 times

Trading velocity much higher than mutual funds - currently account for 40-50% of turnover in US and EU

Fees around 1-2% of AUM + 20% of profits

Larger funds around US$10-15 bn in AUM

Depend upon prime brokerage for transactions and funding - if we do not allow in prime brokers, how can emerging markets benefit from hedge fund activities?

Highly skilled business - talents drawn from fund managers and investment banks (ie difficult to home grow)

Hedge Funds are driving the business

*

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3,000 private equity funds with unknown total assets under management – leveraged levels also unknown

More involved in direct equity investments rather than trading

Fees around 1-2% of AUM + 20% of profits

Longer lock-ups

Larger funds of around US$5-10 bn in AUM

In 1H2004, Asia raised US$5 bn, compared with US$3.3 for 2003 and US$3 bn for 2002 (compared with US$17.9 bn in 2000 and US$9 bn in 2001) – overall private equity investments in Asia estimated at US$8.6 bn

Roughly 10% of UK pension funds invested in private equity - still early days for Asian pension funds*

Private Equity Funds are reborn merchant banks sans regulation

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Positioning of Islamic Finance in global markets

• International financial markets are growing fast in sophistication, speed and concentration. The larger markets are getting bigger and more dominant

• Smaller and newer markets must offer superior service, speed and customer satisfaction in order to compete

• Islamic finance must meet needs of corporate sector and savers in order to grow

• There is huge potential for Islamic finance to grow. But success depends on creating transparent, fair and stable markets that satisfy customer needs.

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Thank YouAddress written questions to as@andrewsheng.net