MANAMA: The aftermath of the financial crisis presents the Islamic financial industry with both an opportunity and a challenge.
But anyone in the industry who thinks Islamic financial institutions can return to business as usual is wrong, according to Central Bank of Bahrain (CBB) Governor Rasheed Al Maraj.
Speaking in a keynote address at the opening of the 17th Annual World Islamic Banking Conference (WIBC) at the Gulf Hotel, he said that while Sharia-compliant institutions, by their very nature, did not get involved in structured investment vehicles and other instruments that turned into toxic assets, the industry did follow conventional banking in becoming overleveraged.
Assets in which Islamic institutions invested turned out to be just as illiquid as structured financial products, and in the past two years have been just as difficult for them to sell, he said.
"It is worth recalling the quite exceptional returns that some Sharia-compliant financial institutions managed to achieve in the decade prior to the financial crisis," he added.
"Assets doubled almost every two years, while net income doubled every year. Some institutions were able to earn a return on equity of more than 30 per cent and in some cases even more than 40pc.
"They were also able to earn an average return on assets approaching 10pc.
"Islamic financial institutions were not alone in posting exceptional returns pre-crisis. The years between 2000 and 2007 were, by any standards, extraordinary ones for the financial industry as a whole.
"Most financial institutions achieved returns on equity and on assets which far exceeded the average in the preceding decades," he said.
As we now know, in the case of conventional institutions, these exceptional rates of return could only be achieved by taking high risks.
"Excessive risk-taking was encouraged by an environment of cheap and plentiful liquidity, which meant that conventional financial institutions could massively increase their leverage.
"Not only did the conventional banks raise their leverage, but they also held fewer liquid assets.
"By now I am sure you will be asking what relevance do these comments on the conventional industry have for Sharia- compliant institutions," he said.
"My answer is - a great deal," he added.
"If we examine carefully the trends in Islamic banking in the years prior to the crisis, we can see that there are important similarities between the practices of Islamic financial institutions and those of conventional ones.
"This should not be surprising because high returns require high risks, and the high returns achieved by Islamic banks could only be generated by taking on a corresponding degree of risk.
"Although the parallels between conventional finance and Islamic finance in the years prior to the crisis are not total, there are enough of them to suggest that many of the lessons are the same," he said.
"For about 12 months after the crisis first reached this region, there was an understandable tendency to believe that it would be just a temporary interruption to a story of strong growth," he added.
"As the dust begins to settle on the global financial crisis it should now be clear this assumption of a temporary blip can no longer be sustained.
"It is no longer wise to base business models on the hope that the era of cheap and plentiful liquidity will soon return.
"Inevitably this means that the business models of many Islamic financial institutions will need to be rethought.
"They will need to build a more broadly-based franchise than in the past. It is very likely that there will be less scope in future for smaller niche players that provide only a limited range of services.
"Instead, Islamic financial institutions need to build diversified sources of revenue, relying not only on placement and performance fees, but also on the steady stream of income generated by such an unglamorous but essential activities as advisory services, asset management, and providing financial services to retail clients," he said.
"Diversification of the industry will need to go hand in hand with its consolidation. Developing those new business models will be a great challenge for the industry, but one that I am confident it will be able to confront," he added.