University of Malaya

1
University of Malaya

• Islamic Banking and International Financial
  Markets
• Andrew Sheng
• Third 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
  Malaysias banking assets or US20 bn
• Under Financial Sector Masterplan, target of
  Islamic banking assets and takaful assets to be
  20 of total industry assets by 2010

4
Islamic Banking Globally

• Assets of US260 bn, mostly in Middle East, but
  growing in Malaysia and Indonesia
• International, non-Islamic banks issue around
  US200-250 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 US500 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 and
• foreign 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 US35 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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The Bretton Woods Architecture

• International Monetary Fund, total quota
  (capital) of SDR213 bn (USD306 bn), 184 members
  (2005 data)
• World Bank (International Bank for Reconstruction
  and Development), capital US38.6 bn, assets
  US222 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 US14.9 bn and
  US260.5 bn assets

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Post 1998 Architecture

• 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

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Global Assets Under Management (US trillion end
2003)

• International Banking Assets (BIS data)
  23.6
• International debt securities 14.6
• Insurance companies 13.5
• Pension Funds 15.0
• Investment Companies 14.0
• Hedge Funds 0.8
• Other Institutional Investors 3.4
• Memo OTC Derivative Contracts (notional)
  270.1
• Source BIS, IMF

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Stock Market Performance (end Dec 2004)
Market Cap Increase since Increase
since Country (US bn) Dec 94 () Index Dec 94 ()

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

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
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Asia 55 global population, 26 trade weight,
but small in equity markets
( of World, 2001)
MSCI
GDP Exports
Population Weighting ASIA 22.8 26.1 55.
4 13.15 China 3.7 3.7 21.1 0.26
Japan 13.3 7.0 2.1 9.38 India 1.5 0.8 16.6 0.12
US 32.3 14.2 4.6 55.30 EU 19.6 36.0 6.2 17.14 Oth
ers 25.3 23.7 33.8 14.41 World 100.0 100.0 100.0 1
00.00 Source IMF, World Economic Outlook, 2001
and World Bank, World Development Indicators,
2001.
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Asia The Third Zone?

• Asia is Third Time Zone to American and European
  time zones
• New York (US12.8 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
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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Corporate Crude Leverage Ratio

• 1993 1998 2003
• Hong Kong 30.0 55.4 20.5
• China 1,485.7 463.0 409.1
• 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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Key Capital Market Trends
Demographics around 300 million Asians earn
US5,000 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 US1 million or more to
middle income professionals Mutual Funds - in
US already US7.5 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 US136
bn in wages trends will continue

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Recent Key Market Trends in Asia
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
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Hedge Funds are driving the business
8,000 hedge funds with US1 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 US10-15 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)

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Private Equity Funds are reborn merchant banks
sans regulation
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 US5-10 bn in AUM In 1H2004, Asia
raised US5 bn, compared with US3.3 for 2003 and
US3 bn for 2002 (compared with US17.9 bn in
2000 and US9 bn in 2001) overall private
equity investments in Asia estimated at US8.6
bn Roughly 10 of UK pension funds invested in
private equity - still early days for Asian
pension funds

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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 You
• Address written questions to as_at_andrewsheng.net