UNIVERSITÀ CATTOLICA DEL SACRO CUORE SEDE DI MILANO Facoltà di Economia Corso di Laurea Magistrale in Economia E Finanza Internazionale Islamic Banking and Finance in Europe: A Challenge and Insight Possibilities in Italy Islamic finance, growing phenomenon to impulse the economy growth. European experience and an insight on the possibilities in Italy, the ethical challenges, future prospect and suggestions. Relatore: Chiar.mo Prof. Federico RAJOLA Tesi di Laurea di: Imad EL KANJ Matricola n. 3807255 Anno Accademico 2011/2012
Transcript
UNIVERSITÀ CATTOLICA DEL SACRO CUORE
SEDE DI MILANO
Facoltà di Economia
Corso di Laurea Magistrale in Economia E Finanza
Internazionale
Islamic Banking and Finance in Europe:
A Challenge and Insight Possibilities in Italy
Islamic finance, growing phenomenon to impulse the economy growth. European experience and an
insight on the possibilities in Italy, the ethical challenges, future prospect and suggestions.
Relatore:
Chiar.mo Prof. Federico RAJOLA
Tesi di Laurea di:
Imad EL KANJ
Matricola n. 3807255
Anno Accademico 2011/2012
1
2
Dedication
To my beloved Mother
الحبيبة أمي إلى
، واإلكرام الجالل ذا يا ، قيوم يا حي يا اللهم
إليك األحب ، المبارك الطيب األعظم باسمك أسألك
، رحمت به استرحمت وإذا ، أجبت به دعيت ذاا الذي
فرجت به استفرجت وإذا
، السابقين من درجاتك أعلى والى المقبولين من أمى تجعل أن
Fiqh Mu’amalat Islamic commercial jurisprudence (rules of transaction)
Hadithe Technical term for sources related to the sayings and doings of the Prophet,
authentic traditions
Ijarah / Ijarah wa Iqtina A contract determining a leasing agreement/A lease-purchase
agreement
Istisnaa A contract of sale of specified goods to be manufactured
Maisir Gambling
Manfa’a The right to use an asset
Mudarabah A partnership contract in which one partner contributes capital and the other
partner invests time and effort 1 The explanations are aligned with the Glossaries of Hassan
and Lewis 2007 and Jaffer 2005.
Mudarib The entrepreneur or manager in a Mudarabah contract
Murabaha The resale of goods with an agreed upon profit mark-up on the cost
Musharakah A partnership contract in which both parties contribute capital and may form
a joint management
Qard Hassan A benevolent (interest-free) loan
1 The explanations are aligned with the Glossaries of Hassan and Lewis 2007 and Jaffer 2005.
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Qirad A dormant partnership (for example in a Mudarabah contract)
Rabb al mal The partner in a Mudarabah agreement providing the funds
Shariah Islamic religious law derived from the Holy Quran and the Hadith
Sukuk (plural of sakk) Participation securities, coupons, investment certificate
Tabarru Donation
Takaful A Shariah compliant insurance concept (similar to conventional mutual
insurances)
Tawarruq The purchase of goods on deferred payment and their subsequent sale (to raise
cash)
Wakalah An agency contract
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ABSTRACT
Islamic banking is a relative young industry, with a high rate of growth, which in the last
years became a highly discussed subject, due to the challenges and opportunities that it
brings. Due to the fact, that in the last decade, the Islamic banking made its presence in the
European Union market, however, unlike in all of Europe, is far from appearing in Italy,
despite the fact that investors are saying they are ready for it and that Italy shares ethical
and religious principles with the Islamic world.
Italians have wrong perception on Islamic finance considering that it is only for Muslims
and on the other hand Muslim community is not a strong community in Italy and their
integration with the Italian community is limited and they are not debating how they can
develop this work and repair the Muslim image in Italy.
Moreover, other than Regulatory and tax obstacles, the main challenges for Islamic
institutions wishing to set up in Italy is that Italian traditional banking lobby is particularly
strong and closed in the territory, and has no interest in losing market share, neither its
monopolistic position in the Italian/European financial markets in favor of Islamic financial
institutions.
However, the success of a financial model in a market must not be allowed to depend on
market rules. Market participants must observe market rules but it will be the market itself
that decides whether or not a kind of institution may enter into the market, providing that its
products are complying with standards of contractual and market transparency as well as
investor protect legislation.
Italy’s strategic positioning, its dense network of small financial institutions throughout the
territory and the most powerful movement of business ethics in Europe make Italy a natural
candidate for the development of the Islamic sector. Once solved the problems of societal,
fiscal and regulatory, Italy will play a central role in the Mediterranean and Islamic
Banking will be a new engine for finance in Italy.
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INTRODUCTION
Islamic finance is growing fast. It has a global value of 1.7 trillion USD and counts 400
institutes with their offices. The Muslim population in Europe is over 18 million and in
Italy there are over 1.5 million Muslims (2011), who represent about one third of foreign
residents and 2.8% of Italy’s population, and a remarkable number of Italian non-Muslims
are willing to shift towards Islamic finance instruments but the system is not breaking
through into Italy.
Islamic finance can no longer be dismissed as a passing fad or as an epiphenomenon of
Islamic revivalism. Islamic financial institutions now operate in over 70 countries. They
have grown at respective annual rates of 10% and 15%. By certain (probably overly
optimistic) estimates, up to half of the savings of the Islamic world may in the near future
end up being managed by Islamic financial institutions. The first Islamic banks were
created in the 1970s, at the time when the aggiornamento of Islamic doctrine on banking
matters was taking shape. At the time, Islamic banks were typically commercial banks
operating on an interest-free basis. Today, as a consequence of broad changes in the
political–economic environment, a new generation of Islamic financial institutions, more
diverse and innovative, is emerging as the doctrine is undergoing a new aggiornamento.
Perhaps the most important development has been the growing integration of Islamic
finance into the global economy. There is now a Dow Jones Islamic Market Index2, which
tracks 600 companies (from inside and outside the Muslim world) whose products and
services do not violate Islamic law. Foreign institutions such as Citibank have established
Islamic banking subsidiaries, and many conventional banks – in the Muslim world but also
in the United States and Europe – are now offering ‘Islamic products’ that are sometimes
aimed at non-Muslims.
2 The Dow Jones Islamic Market Indexes, introduced in 1999, was the first representative set of Sharia compliant benchmark portfolios. Today the indices listed are over 70 and remains the most complete family of Islamic market indicators, includes global indexes, regional,
individual countries, individual industries. Among the most important are the Dow Jones Islamic Market Titans 100 index (indicator of
the 100 largest companies compatible with the dictates of Sharia), the Dow Jones Islamic Index (Dow Jones selection made with Islamic criteria), and the Dow Jones Islamic Market Asia / Pacific Titans 25 Index (the 25 largest companies in Asia and the Pacific).Other very
important group of indices are the FTSE Global Islamic Index Series, these are also an indicator for those wishing to invest in global
equity and in line with Islamic laws, we FTSE SGX Shariah then the Index Series, a set of indexes made in collaboration with the Stock Exchange of Singapore, representing the performance of companies in the markets of Asia and the Pacific (Japan, Singapore, Taiwan,
Korea and Hong Kong), the FTSE Bursa Malaysia Insex Series, with two indices for Muslim investors, and finally the FTSE DIFX Index
Series, in collaboration with the Dubai Stock Exchange, which represents the leading companies in the Arabian Peninsula.
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Islamic finance is thus in many ways well suited to the global economy. This is all the more
striking and paradoxical in that it is often said that Islam is incompatible with the “new
world order” that emerged with the end of the cold war. In addition, how could a medieval
economic system be relevant in a world of revolutionary, technology-driven global finance?
And how could an interest-free system fit within the broader interest-based financial
system?
The first part of the thesis provides background information on Islam and Finance,
introduces and describes the world of Islamic finance (Chapters 1 to 6). Explaining the
Islamic law , its principles, Islamic financial instruments, regulatory framework, Islamic
Management, strategy and culture (how the practices of Islamic financial institutions differ
from those of conventional ones.
The second part of the thesis traces the historical evolution of Islamic economics and
finance in the Arabic world and in Europe(Chapters 7 to 8). It traces the birth, challenges,
managerial problems, evolution of modern Islamic finance and places it in its proper
political and economic context. It accounts for the diversity of the industry by analyzing the
ways different countries have introduced and dealt with Islamic finance, and by providing a
typology of Islamic financial products.
The third part (Chapter 9) deals with the issues and challenges facing Italy to host Islamic
Finance and Islamic Retail Banking from four points: demand conditions, supply
conditions, societal conditions and regulatory conditions. Discussing the main challenges
embedding Islamic finance to locate in Italy and the cultural barriers to the implementation
of true Islamic financial systems; economics (the role of Islamic finance in mobilizing
savings, allocating funds, and promoting development; Islamic capital markets; the macro-
economic implications of Islamic finance); regulation (the regulatory issues raised,
domestically and internationally); politics (the connection between Islamic finance and
domestic politics); and religion (the battles over religious interpretation).
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I. INTRODUCTION TO ISLAMIC FINANCE
1. Understanding Islamic Finance
In order to understand how Islamic law informs Islamic finance, it is necessary to know
something about how law and authority are positioned in Islamic thought.
1.1. Islamic Law
In order to give more comprehensive idea about Islamic banking, some background
must be examined. Islamic financial principals are derived from Holy Qur'an. It
plays essential role in every Muslim's life. Basically it can be described as the
guidance for life, where duties and practices of crime, inheritance, worship, prayer,
moral values, marriage and commercial transactions are described. Islamic law or
Shariah is directly derived from it. Shariah embraces all aspects of human activity
moreover it consists of regulatory and constitutive rules according to which every
Muslim, must conduct their affairs.
As the primary source in conducting affairs Muslims rely on Qur'an, furthermore
secondary sources are Hadith, oral traditions relating to the words and deeds of the
prophet Muhammad (pbuh), and Sunna those religious achievements and manners
that were instituted by the prophet Muhammad (pbuh3) during the 23 years of his
ministry, which Muslims initially obtained through consensus of companions of
Muhammad (pbuh), and further through generation-to-generation transmission.
1.2. Fundamental Principles of Islamic Finance
The Islamic financial system broadly refers to financial market transactions,
operations and services that comply with Islamic rules, principles and codes of
practices. The laws and rules of the religion require certain types of activities, risks
3 Peace Be Upon Him
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or rewards to be either prohibited or promoted. While Muslims undertaking
financial transactions are encouraged to use financial instruments that comply with
these rules, other investors may find the appeal of these instruments from an ethical
standpoint.
Islamic laws and rules are known as Sharia and are also referred to as Islamic
jurisprudence. Sharia governs all aspects of Islamic Finance. The rules and laws are
derived from three important sources, namely the Holy Quran (the holy book of the
religion of Islam), Sunnah (the practice and tradition of the Prophet Muhammad
pbuh) and Ijtihad (the reasoning of qualified scholars). Further elaboration and
interpretation of the rules dictated by the Holy Quran and Sunnah are provided by
qualified scholars in Islamic jurisprudence via Ijtihad or an interpretative process
which is carried out within the framework of Quran and Sunna.
Modern Islamic financial products and services are developed using two different
approaches. The first approach is by identifying existing conventional products and
services that are generally acceptable to Islam, and modifying as well as removing
any prohibited elements so that they are able to comply with Sharia principles. The
second approach involves the application of various Sharia principles to facilitate
the origination and innovation of new products and services.
In order to provide a better understanding on the unique attributes of Islamic
finance, this Chapter discusses the fundamentals, principles and structure, which
form the foundation of Islamic financial services.
1.3. Basic Principles
Islamic law on commerce is known as fiqh4. Much of the laws, rules and
interpretations of Shariah takes into consideration issues of social justice,
4 Fiqh is the collection of all sources of law including Qur’an, Sunna, Qiyas (The practice of analogical reasoning) and Ijma (The
principle of independent human reasoning) and constitutes the Islamic jurisprudence. It regulates the relationship between men and Allah (Fiqh´Ibadah) as well as all aspects and relationships of men among each other (Fiqh Mu´amalat). The latter comprises the regulation of
commercial and financial transactions and financial institutions. The Shariah gives important incentives according to religious beliefs
whereas Fiqh adjusts to the pressure of society as it is subject to political influences and public opinions.
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equitability, and fairness as well as practicality of financial transactions. In general,
the Shariah legal maxim in relation to commercial transactions and contracts state,
“they are permissible unless there is a clear prohibition.” In a nutshell, prohibited
elements of a commercial transaction must first be removed for it to be Shariah-
compliant. The major prohibited elements under Shariah are riba (interest), gharar
(uncertainty), maisir (gambling), non-halal (prohibited) food and drinks and
immoral activities.
1.3.1. Prohibition of Riba (Usury)
Majority of conventional banks run its activity on the basis of interests,
which in turn not applicable and prohibited by Shariah law.
Riba has the literal meaning of “an excess” and is defined as an increase or
excess which accruesvto the owner in an exchange or sale of a commodity,
or, by virtue of a loan arrangement, withoutvproviding equivalent value to
the other party.
More precisely there are two categories of riba – riba qurudh and riba buyu`.
Riba qurudh, in its application to modern financial transactions, occurs
through loans. The prohibition of riba qurudh relates to any fixed or
predetermined rate of return tied to the maturity and the amount of principal
(i.e., guaranteed regardless of the performance of the investment). The
general consensus among Shariah scholars is that riba covers not only usury
but also the charging of “interest” as widely practiced.
However, the lending activities or loans are still allowed in Islam through
the concept of Qardh Hasan. This type of lending is a contract of loan
between two parties on the basis of social welfare or to fulfill a short-term
financial need of the borrower. The amount of repayment must be equivalent
to the amount borrowed. It is however legitimate for a borrower to pay more
20
than the amount borrowed as long as it is not stated or agreed at the point of
contract.
On the other hand, riba buyu` occurs through the sale and purchase of six
riba’s commodities (i.e., gold, silver, dates, wheat, barley and salt). The
transaction of riba’s commodities is required to adhere to the following
conditions84:
i) In trading commodities of the same group and kind, such as gold for gold
or dates for dates; two conditions must be fulfilled, i.e., both commodities
must be exactly equivalent and there must be prompt delivery
ii) In trading commodities of the same group but of different kinds, such as
gold for silver, or wheat for barley, there is only one condition, i.e., the
promptness in delivery is not a condition.
iii) In trading commodities of different groups and kinds, such as gold for
wheat, or silver for barley; no condition is imposed and free trading can
exist, whether there is equality, inequality, promptness or delay.
Thus, Islam encourages the earning of profits but forbids the charging of
interest. Profit symbolizes successful entrepreneurship and the creation of
additional wealth through the utilization of productive assets, whereas
interest is deemed as a cost that is accrued irrespective of the outcome of
business operations and may not create wealth if there are business losses.
Social justice under Shariah requires borrowers and lenders to share rewards
as well as losses equitably and that the process of wealth accumulation and
distribution in the economy be fair and representative of true productivity.
“Truly those who believe, and do deeds of righteousness, and perform As-
salat, and give Zakat, they will have their reward with their Lord. On them
shall be no fear, nor shall they grieve. O you who believe! Be afraid of Allah
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and give up what remains (due to you) from Riba (usury) (from now
onward), if you are (really) believers. And if you do not do it, then take a
notice of war from Allah and His Messenger but if you repent, you shall
have your capital sums. Deal not unjustly (by asking more than your capital
sums), and you shall not be deal with unjustly (by receiving less than your
capital sums)”.5 Linguistic definition of Riba is stated as follows:
“To increase, to augment, swellings, forbidden “addition”, to make more
than what is given, the practicing or taking of usury or the like, an excess or
an addition, or an addition over above the principal sum that is lent or
expended”6
1. Riba reinforces the tendency for wealth to accumulate in the hands of a
few, and thereby diminishes human beings concern their fellow men.
2. Islam does not allow gain from financial activity unless the beneficiary is
also subject to the risk of potential loss; the legal guarantee of at least
nominal interest would be viewed as guaranteed gain.
3. Islam regards the accumulation of wealth through interest or usury as
selfish compared with accumulation through hard work and personal
activity.
According to Mirakhor(1989) regarding interest as being a reward for
savings, it is justified if it resulted in reinvestment and growth in capital was
not due to only postponed consumption.
As for interest as productive capital, interest paid on money and is required
no matter whether capital used productively and thus is not justified. Interest
as an adjustment between value of capital goods in present and future is not
5 Surah al-Baqarah:275-279
6 E.W. Lane's Arabic-English Lexicon, zamir iqbal
22
rightness, it is more reasonable next year's economic condition to determine
the extent of reward as opposed to predetermining it in the form of interest.7
Table-1: Comparison between Riba and Profit
Riba Profit
1. When money is “charged”, its
imposed positive and definite result is
Riba
1. When money is used in
productive activity (e.g., in
trading), its uncertain result is
profit.
2. By definition, Riba is the premium
paid by the borrower to the lender along
with principal amount as a condition for
the loan.
2. By definition, profit is the
difference between the revenue
from production and the cost of
production.
3. Riba is prefixed, and hence there is
no uncertainty on the part of either the
givers or the takers of loans.
3. Even if a sharing ratio is agreed
in advance, profit is still uncertain,
as its amount is not known until the
activity is completed.
4. Riba con not be negative, it can at
best be very low or zero.
4. Profit can be positive, zero or
even negative.
5. From Islamic Shariah point of view,
it is Haram (prohibited).
5. From Islamic Shariah point of
view, it is Halal (allowed).
1.3.2. Prohibition of Activities With Elements of Gharar (Uncertainty)
Gharar is defined as activities that have elements of uncertainty, ambiguity
or deception. In a commercial transaction, it refers to either the uncertainty
of the goods, price of goods, deceiving the buyer on the price of goods,
payment terms are not specified in detail over a period of time, or ignorance
all this gharar occurs.
An element of gharar is considered a normal phenomenon in the market if it
is not excessive in the contracts and where the effect on the economy and
society is considered minimal. This is accepted by Shariah as it would be
practically impossible to eradicate this element completely from the market.
A large element of gharar in a commercial transaction, on the other hand, is
prohibited according to Shariah as it may affect the legality of a transaction.
7 Hennie van Greuning, Zamir Iqbal , risk analysis for islamic banks, p 9.
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One of the examples of gharar in the financial market is in conventional
insurance. Shariah scholars are of the opinion that conventional insurance is
not Shariah compliant due to the large element of gharar. This is because the
policyholder enters into an agreement to pay a certain sum of premium and
in turn the insurance company guarantees to pay a certain sum of
compensation in the event of disaster. However, the amount of
compensation that the company will pay to them is uncertain and it is also
dependant on the occurrence of specific events in the future. Prohibition of
Gharar clearly indicated in Hadith: Ahmad and 'Ibn Majah narrated on the
authority of 'Abu Said Al Khudriy (mAbpwh)8:
“The Prophet (pbuh) has forbidden the purchase of the unborn animal in its
mother's womb, the sale of the milk in the udder without measurement, the
purchase of spoils of war prior to their distribution, the purchase of
charities prior to their receipt, and the purchase of the catch of a diver.”
Thus in Islamic finance prohibits contract with high degree of asymmetric
information. Most financial derivatives like options, forward, futures, in
speculation and short-selling, are banned because it involves uncertainty
regarding future delivery of the underlying assets. More detailed explanation
is given by Sheikh Dhareer.
“In this variety of sale the offer is shifted from the present to a future date,
for example, one person say to another; 'I'll sell you this house at such price
as of the beginning of next year' and the other replies: 'I accept'. Majority of
Jurist are of the view that the sale contract cannot accept clauses of this
manner. If the sale is shifted to a future date the contract becomes invalid.
Gharar in a future contract lies in the possible lapse of the interest of either
party and to his consent with the contract when the time set therein after. If
somebody buys mudhaf (futures) contract and his circumstances changes or
8 May Allah be peace with him
24
market changes bringing its price down at the time set for fulfillment of the
contract, he undoubtedly be averse to its fulfillment and will regret entering
into it. Indeed, the object in question may itself change and the two parties
may dispute over it. Thus, gharar infiltrates the mudhaf contract from the
viewpoint of uncertainty over the time, when parties conclude the contract
they do not know whether they will be in agreement and have continued
interest in that contract when it falls due.”9
1.3.3. Prohibition of Maisir (Speculative, High-Risk, Gambling)
Gambling is referred to as qimar or maisir in Arabic, which means any
activity that involves an arrangement between two or more parties, each of
whom undertakes the risk of a loss where a loss for one means a gain for the
other, as it is common for gambling activities. The gain accruing from these
games is unlawful in Islam, as it diverts the player’s attention from
productive occupation, and amassing wealth without effort. It is considered
an immoral inducement by the person involved in expecting to make a profit
at the expense of another party.
In relation to the above, Muslims are also prohibited from having any
affiliation to gambling activities including participating, investing or
financing any businesses related to, or associated with, the gambling
industry.
Holy Qur'an explicitly prohibits games of chances:
“O ye who believe! Intoxicants and gambling, (dedication of) stones, and
(divination by) arrows, are an abomination,- of Satan's handwork: avoid
such (abomination), that ye may prosper. Satan's plan is (but) to excite
enmity and hatred between you, with intoxicants and gambling, and hinder
9 Mervyn K. Lewis, Latifa M. Algaoud (pp.18-19)
25
you from the remembrance of Allah, and from prayer: will ye not then
abstain?”10
Gambling in all forms are banned by Islam, besides its explicit forms,
business transactions involving gambling like features are prohibited.
Regarding the question whether is it permissible to invest in stock market,
many scholars agree that if the earnings are halal(permitted)11
it is lawful to
invest in the stock market if certain conditions are met which should exclude
prohibited elements (Haram)7. Prohibition of involvement into the financing
of Conventional Banking and Insurance, alcohol, pork-related products,
tobacco, adult entertainment, gambling, weapons, arms and defense
manufacturing. (Please refer to chapter 3.4.1. Industry Screen) Islam
prohibits any financing or business transaction which are not line with
ethical norms.
To summarize the essence and goal of Sharia I can quote Al-Ghazali's
statement regarding Islamic law:
"The very objective of the Shariah is to promote the welfare of the people
which lies in safeguarding their faith, their life, their intellect, their posterity
and their property. Whatever ensures the safeguard of these five serves
public interest and is desirable."
1.3.4. Zakat ”Alms For Poor”
Religious levy, is one of the five fundamental pillars of Islam. Fulfilling this
obligation causes Muslims for share one fortieth of their surplus wealth to
poor. By carrying this process Muslims are purifying themselves from
selfishness and greed.
10
Qur'an 5:90-91 11
Halal and Haram – Code of “ethical investment”
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“Believe in Allah and His apostle, and spend (in charity) out of the
(substance) whereof He has made you heirs. For, those of you who believe
and spend (in charity),- for them is a great Reward.”12
This wealth redistribution mechanism of income is inherited in Islam, so that
every Muslim individual is guaranteed fair living standard. Zakat plays
essential economic and social functions. Some scholar suggest that in can be
used in fiscal policy quite effectively. By redistributing wealth fr om rich to
poor, this instrument helps to maintain equality and justice within society.
Since all resources are gifts of God to all human beings, there is no reason
why they should remain concentrated in few hands (Chapra). Noble Qur'an
states:
“(so that) wealth does not circulate only among your rich”13
Moreover funds raised through zakat can be used only specific things. Noble
Qur'an clarifies where these funds can be utilized.
“the poor and needy, those who work to collect them, those whose hearts
are brought together[in the Truth], the ransoming of slaves, debtors, in the
God's way, and the traveler, so Allah ordains..”14
Zafar Sareshwala emphasizes main objectives and positive effects of Zakat.
(1) the promotion of stable economic growth through investments,
employment and balance consumption, and (2) the achievement of greater
income equality through an equitable distribution of wealth, thereby
eliminating poverty and extreme disparities of wealth between the rich and
the poor. Positive economic effect of Zakat is an increase in the money
supply and a consequent increase in the demand for goods and services.
Zakat also provides debt relief and enhances price stability.
12
Qur'an 57:7 13
Qur'an 59:7 14
At- Taubah, 60
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1.4. Understanding Time Value of Money in Islamic Finance
Interest rate is regarded as the main tool of making profit in finance. As interest is
clearly prohibited in Islamic finance, still there are some confusions regarding time
value of money. As already mentioned above, Islamic finance based on strict
principles. According to Najmul Hassan, in order to better understand time value of
money, basic principles of both Islamic and conventional banking should be
examined (Please refer to chapter 2.2.), having in mind that in Hadith Quoted by Ali
Ibn Talib: “All loans that draw interest is riba” and Qur'an's verse (2:275) where
any excess of loan besides principal amount is considered as riba, furthermore
money and commodity has different characteristics, as money has no intrinsic value
but can be regarded as medium of exchange and measure of value, in order to
satisfy human needs it should be converted into commodity.
Shariah, approves time value of money in the case of sale transaction, but in lending
interest is prohibited as material compensation for time. Zamir Iqbal and Abbas
Mirakhor (2011) As commodity has its quality and intrinsic value, and owner can
sell at whatever price both parties agree on even though the prevailing market price
is higher. Thus, excess money charged against deferred payment is riba where
money exchanged for money, as excess charged against nothing but time.15
15
Time value of money in Islamic Banking, Najmul Hassan
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II. ISLAMIC FINANCIAL SYSTEM (IFS)
2. The Stability of IFS and differences between Islamic -
Conventional Banking
2.1. Financial Stability of Islamic Finance
The Islamic financial system (IFS) consist of a banking sector, a stock market, an a
market for securitized assets. It was also shown that the banking sector may have a
sub-sector which specializes in high-credit and short-maturity securities to finance
trade or commodities on the basis of murabaha ( cost-plus sale) to support the
payment system. This would be analogous to the concept of narrow banking which
has been suggested in the conventional system to promote stability in the payment
system and in the financial system.
Proponents of the Islamic system claim that a financial system based on the Islamic
framework of risk sharing would be more efficient in allocating resources than a
conventional interest-based system. This claim can be defended on the basis of the
general proposition that any financial development that causes investment
alternatives to be compared to one another based strictly on their productivity and
rates of return is bound to produce improved allocations. Such a proposition is the
cornerstone of the Islamic financial system. But would such a system also improve
stability?
The general argument underlying the proposition that the Islamic financial system is
more stable that the conventional system is based on three notions: 1) the avoidance
of leverage and debt refinancing due to the prohibition of debt; 2) the matching of
assets and stabilities; and 3) the elimination of the multiplier effect.
29
Due to the essence of Islamic banking it was not or at least less affected by the
financial crisis. As Islamic banks do not deal with debt trading and engage in highly
speculative transactions that most conventional banks are undertaking. There are
several opinions of experts regarding this issue.
“Islamic banks do not rely on bonds or stocks, and are not involved in the buying
and selling of debt unlike most conventional European and US banks. He noted that
Islamic banking is distinguished by the fact that it is prohibited from buying debts
under Islamic Sharia law; therefore, Islamic banks are safe from the effects of the
global financial crisis.”-CEO of the Bahraini-based Albaraka Banking Group
Adnan Ahmed Yousif, adding also that Islamic banks became safe place for secured
liquidity.
“Islamic banks have not been affected by the mortgage crisis that afflicted the
international financial markets and that they are largely immune against such crisis
thanks to inherent factors within Islamic banking. The most important of these
factors is the prohibition of debt trading, taking precautions against money
laundering, as well as the official and professional restraints upon which banks are
based such as caution against embarking upon projects that entail financial
difficulties and risks, crisis has caused significant global inflation in world banks
because they buy debts and enlarge accounts without tangible transactions taking
place or without brokers being aware of them, in which Islamic banks do not
engage ”-General Manager and board member of the Arab Finance House Dr.
Fouad Nadim Matraji.
“Islamic banking is a part of the global economy and can be affected either
negatively or positively by it but Islamic banks are not major investors in
conventional western banks so as to be affected by such crises, I expect expects
Islamic banks to end the year successfully with the forthcoming announcements of
their budgets because of the clarity of contracts and Islamic banking projects that
30
are spread throughout the countries of the Islamic world.”-Dr. Tawfiq Bin Abdul
Aziz al Swailem, Chairman of the Gulf Bureau for Research and Economic
Consultation.
According to Zamir Iqbal and Abbas Mirakhor (2011) Conventional banks fail to
meet inherent stability conditions even in the presence of prudential regulations.
First, credit losses from debt default or the depreciation of assets may create a large
divergence in relation to liabilities that remain fixed in nominal value. Second, bank
credit has no fixed relation to real capital in the economy and bears no direct
relation to the real rate of return. Un- backed credit expansion through the credit
multiplier and further leveraging is a fundamental feature of conventional banks.
Cash flow could fall short of expectations and force large income losses on banks,
especially when the cost of funds is fixed through a predetermined interest rate.
Third, banks caught in a credit freeze, with a drying up of liquidity, may default on
their payments. Fourth, banks are fully interconnected with each other through a
complex debt structure; in particular, the assets of one bank instantaneously become
liabilities of another, leading to fast credit multiplication. Credit cash causes a
dramatic contagion and a domino effect that many impair even the soundest of
banks.
Credit can be issued to finance consumption, and hence many rapidly deplete
savings and investment. The depletion of savings could be significant if credit
finances large fiscal deficits. Hence, credit is no longer directly related to the
productive base, as it is in the equity-based system, and the income stream from
credit is no longer secured by real output as shown for the equity system. Credit can
expand through leverage to an unsustainable multiple of real national income,
increasing the risk of default. Credit expansion through the credit multiplier is
determined by the reserve- requirement system, whereas equity in the equity-based
system cannot expand more than real savings. In the case of securitization, credit
can, in the theory, expand to an infinite degree.
31
In an economy governed by the principles of Islamic finance, the rate of return on
equities is determined by the marginal efficiency of capital and time preference, and
is positive in a growing economy. This implies that Islamic banks are always
profitable provided that real economic growth, and conventional banking, where
profitability is not driven primarily by the real growth. As we have seen, the Islamic
banking system has two types of banking activity: deposit banking for safe keeping;
and banking for payment, and fees may be collected for this type of service. In the
system, investment banking operates on a risk/profit-sharing basis, with an overall
rate of return which is positive and determined by the real economic growth rate.
Islamic banks do not create and destroy money; consequently, the money multiplier,
defined by the savings rate in the economy, is much lower in the Islamic system
than in the conventional system, providing a basis for strong financial stability,
greater price stability, and sustained economic growth.
Conventional banks issue debt and earn interest. Debt accommodation by banks has
often been unlimited and has been checked only by crashes. We have shown that
credit expansion may have no relation to the real capital base an no direct relation to
the real cash flow in the economy that may be required for servicing debt. If
financing were to be extended to consumption, then credit could erode the capital
base and economic growth. The equilibrium interest rate that clears the money
market may have no direct relation with the real rate of return in the economy. Such
a deviation was acknowledged by the classical economists and was seen to be a
cause of booms and busts, and excessive speculation in commodities and assets.
Banks are obliged to pay the face value of their liabilities. In the case of credit loss,
banks have to fully absorb these losses from their capital reserves or through
recapitalization. Governments may be compelled to extend large and costly bailouts
to rescue impaired banks and prevent a total collapse of the financial system.
32
The conventional system is vulnerable to many sources of instability. Besides the
inability to reach full-employment output, the system can suffer from interest-rate
distortions in relation to a natural interest rate and can suffer from the absence of a
direct link to a real capital base that generates cash flow for servicing debt. Minsky
(1986) described the conventional system as endogenously unstable, evolving from
temporary stability to periods of crisis. Credit losses play havoc with the real
economy and cause unemployment. The drying-up of credit during credit crashes
makes the Modigliani-Miller theorem untenable. In such circumstances, leveraged
firms will face higher financing costs for their investments of fluctuations in their
operations. The issue of instability in conventional finance is not limited to the role
of commercial and investment banks. In conventional finance, the central bank
plays the critical role of lender of last resort. If it didn´t do so, conventional banks-
which are interrelated through loans- would risk simultaneous failure. Banks are
exposed to credit and interest rate risk and many run out of liquidity. In order to
maintain their payments, the rediscount and borrowing from the central bank
become pillars for the smooth functioning of conventional finance. In Islamic
finance, banks do not have or cause any liquidity mismatch and are thus nor
dependent on central bank finance to maintain their liquidity.
Finally, I should note that the social and human costs of financial instability and
financial crises, through impossible to quantify, might dwarf even the economic
costs. The human cost of prolonged unemployment-its impact on the individual
psyche and on families- cannot be overestimated. The impact on individual regions
is much more extreme than average effects. The unfair redistribution of wealth, at
the expense of individuals on fixed incomes and creditors, is simply immoral.
Islamic finance avoids these and other pitfalls of a financial system based on credit
and leveraging. Islamic Finance shed its reliance on debt, interest and leveraging, to
totally revamp the financial system to rely on risk sharing.
33
2.1.1. Theoretical Considerations
From a prudential perspective, given that Islamic banks are expanding their
presence in conventional systems, it is relevant to know whether Islamic
banks are more or less stable than conventional banks. As mentioned above,
some authors have argued that the risks posed to the financial system by
Islamic banks differ in many ways from those posed by conventional banks.
Risks unique to Islamic banks may arise directly from the specific features
of Islamic contracts, as well as indirectly from the overall legal, governance
and liquidity-management infrastructure available to Islamic institutions.
For example, PLS financing shifts the direct credit risk from banks to their
investment depositors. But it also increases the overall degree of risk on the
asset side of banks’ balance sheets, because it makes Islamic banks
vulnerable to risks normally borne by equity investors rather than holders of
debt.
In addition, the absence of viable Islamic money markets could exacerbate
liquidity risks. Similarly, prohibitions against the use of conventional
derivatives limit Islamic banks’ ability to hedge certain risks. Moreover,
most Islamic banks have operated in environments with less developed or
nonexistent interbank and money markets and government securities, and
with limited availability of and access to lender-of-last-resort facilities
operated by central banks. These differences have been reduced somewhat
because of recent developments in Islamic money market instruments and
Islamic lender-of-last resort modes, and the implicit commitment of most
authorities to provide liquidity support to all banks during exceptional
circumstances.
On the other hand, there are features of Islamic banks that could render them
less vulnerable than conventional banks. For example, Islamic banks are
able to pass through a negative shock from the asset side (such as a
worsened economic situation that causes lower cash flow from PLS
transactions) to the investment depositors. The risk-sharing arrangements on
34
the deposit side thus arguably provide another layer of protection to the
bank, in addition to its book capital. Also, it could be argued that the need to
provide a stable and competitive return to investors, the shareholders’
responsibility for negligence or misconduct (operational risk) and the more
difficult access to liquidity put pressure on Islamic banks to be more
conservative.
Furthermore, because investors (depositors) share in the risks (and typically
do not have deposit insurance), they have more incentive to exercise tight
oversight over bank management.
Finally, and partly due to the lack of short-term investment opportunities,
Islamic banks have traditionally held a larger proportion of their assets than
commercial banks in reserve accounts with central banks or in correspondent
accounts with other banks. Thus, even if Islamic investments were more
risky than conventional investments, from a financial stability perspective
the question is whether or not these higher risks are offset by bigger buffers.
In sum, whether Islamic banks are more or less stable than
conventional banks depends on the relative sizes of the effects discussed
above, and it may in principle differ from country to country and even bank
from bank.
2.1.2. Some Empirical Evidence
Čihák and Hesse (2008) find, based on a sample comprising 18 countries,
that larger Islamic banks tend to be riskier than smaller Islamic banks and
similar large commercial banks, while smaller Islamic banks tend to be more
stable than small commercial banks. Furthermore, as the presence of Islamic
banks grows in a country’s financial system, there is no significant impact
on the soundness of other banks. This suggests that Islamic and commercial
banks can co-exist in the same system without substantial “crowding out”
effects through competition and deteriorating soundness.
35
A plausible explanation of the contrast between the high stability in small
Islamic banks and the relatively lower stability in larger ones is that it is
significantly more complex for Islamic banks to adjust their credit risk
monitoring system as they become bigger. For example, the PLS modes,
used by Islamic banks, are more diverse and more difficult to standardize
than loans used by commercial banks. As a result, as the scale of the banking
operation grows, monitoring of credit risk becomes rapidly much more
complex. That results in greater prominence of problems relating to adverse
selection and moral hazard. Another explanation is that small banks
concentrate on low-risk investments and fee income, while large banks do
more PLS business.
2.2. Differences between Islamic and Conventional Banking
An Islamic bank is similar to a modern Western bank in almost all functions which
empower it to mediate any shortcomings or surpluses that may exist in a monetary
exchange economy. The Islamic bank requires a careful management team to
balance the different levels of credit (personal credit, secured credit, letters of
credit), and also functions as a specialist in estimating projects risks and estimated
returns. The main difference between Islamic and conventional banks (see Table-2)
lies in the fact that conventional banks charge and pay interest, whereas Islamic
banks do not as they consider interest as riba (Please refer to chapter 1.3.1.).
Traditionally, rather than charging interest, Islamic financial institutions will
typically share some of their borrowers’ risks and profits. A bank’s profit from these
‘loans’ depends on the overall success of the loans in generating additional revenue
or profits for the borrowers.
Islamic finance also avoids investing in ventures that may have components that are
not in line with the values of Islam (alcohol, gambling, drugs and tobacco) and
speculation (e.g., reliance on the occurrence of events that may or may not take
36
place). Despite such, Islamic law does not require that the seller of a product be
Muslim, or that its services also be Islamic.
Table-2: Differences between Islamic & Conventional Banking
Characteristics Islamic Banking System Conventional Banking System
Guiding
principle
Guided by Quranic edicts,
Hadeeth, Islamic ethics and
Islamic laws.
Guided by profit motive alone, with
no religious or ethical considerations.
Ethics of
financing
Financing being asset-backed,
and meant for productive use
helps reduce the overall debt
burden.
Debt burden arising out of excessive
use of credit leads to bankruptcies,
and waste of financial resources.
Liquidation
Assets
An Investment Account Holder
will have similar rights as
shareholders.
Depositors are paid before the
shareholders.
Involvement of
risk & Equity
financing
Equity financing is available to a
project or venture that involves
profit-and-loss sharing. Risk-
sharing and profit sharing go
together.
Commercial banks do not usually
indulge in equity financing, only
venture capital companies and
investment banks do. Conventional
banks carry much less risk, major part
of the risks being transferred to the
borrowers.
Return on
Capital
Depends on productivity, idle
money cannot earn any return.
Money is not capital per se, only
potential capital16
.
Even idle money in bank deposits
earns returns.
Prohibition of
Gharar
(uncertainty)
The existence of uncertainty in a
contract is prohibited because it
requires the occurrence of an
event which may not ultimately
occur. “Full disclosure” by both
parties is the norm in contracts.
Derivatives trading e.g. options
are considered as having
elements of Gharar.
Trading and dealing in derivatives are
widely considered as the main source
of liquidity in the conventional
financial, commodity and capital
markets.
Profit and Loss
Sharing
Most transactions are based on
this variable returns, dependent
on lenders’ performance. Greater
share of risks forces them to
manage risks more
There is no relationship between bank
performance and returns to the
depositors or investors, who mostly
enjoy a risk-free return. Conventional
institutions mostly act as
16 It becomes actual capital only when it joins hands with other resources to undertake a productive activity. Islam recognizes the time
value of money, but only when it acts as capital, not when it is "potential" capital.
37
professionally, to ensure better
returns than conventional
accounts. Depositors & investors
have opportunity to earn higher
returns than in conventional
systems.
intermediaries between lenders &
borrowers enjoying almost a risk-free
spread.
Zakat It has become one of the
functions of the Islamic banks to
collect and distribute Zakat.
Government Taxes perhaps serve the
same purpose - mode and rate of
charging are different, though.
Compounding
or Interest on
interest
The Islamic banks have no
provision to charge any extra
money from the defaulters.
It can charge additional money
(compound rate of interest) in case of
defaulters.
Money-Market
Borrowing
For the Islamic banks, it is
comparatively difficult to
borrow money from the money
market.
For commercial banks, borrowing
from the money market is the main
source of liquidity.
Developing
expertise
Since it shares profit and loss,
the Islamic banks pay greater
attention to developing project
appraisal and evaluation
systems.
Since income from the advances is
fixed, it gives little importance to
developing expertise in project
appraisal and evaluations.
Viability v/s
credit-
worthiness
The Islamic banks, on the other
hand, give greater emphasis on
the viability of the projects.
The conventional banks give greater
emphasis on credit-worthiness of the
clients.
Relationship
with Clients
The status of Islamic bank in
relation to its clients is that of
partners, investors and trader.
The status of a conventional bank, in
relation to its clients, is that of
creditor and debtors.
Capital
Guarantee
No guarantee. Built into the system.
Deposit
insurance
None An integral component
38
2.3. Advantages and Disadvantage of Islamic Finance
2.3.1. Advantages of Islamic Finance
Efficient allocation of funds: Since allocation of funds by banks will be
dependent upon the soundness of projects under the PLS17
arrangements,
the allocation is more efficient.
Productive use of capital: Banks are likely to know their fund users
better in order to ensure that the funds are used for productive purposes.
In this way, both the fund providers and the financial intermediary
contribute to promoting productive economic activities and greater
financial responsibility. Thus, IBFs would promote economic growth
(Chapra 1998 and Siddiqui 1983)
Similarly, since banks have no pressure of fixed regular payments on
deposits, the efficiency of allocating resources to profitable and more
productive use is further boosted.
Equitable distribution of wealth: The efficiency in allocation leads to
this, and creates additional wealth as well. Interest distribution is
considered unjust and inequitable because it is not based on any
productive use of capital, and it exploits the misfortune of the borrower
(who has run out of money).
Generation of employment: Productive use of capital implies
investments and creation of jobs. The investment is not dependent upon
the cost of capital (and positive NPVs) or time value of money, hence
number of investible projects is likely to be much higher resulting in
larger capital formation.
Saving-in information costs: Being a partner of the entrepreneur (or a
firm), the financial institution has easier and cheaper access to
17 Profit Loss Sharing
39
information on matters relating to the firm. This may make credit rating
agencies redundant, and lending more efficient.
Saving in deposit insurance costs: Risk-sharing concept built into the
IBF system, there will be no need for deposits to be insured.
Reduction of debt burden: The IBF system of equity financing
encourages debt to be swapped with equity which can help many
developing countries get rid of the immense debt-burden. Instead of
rescheduling of existing loans or selling Brady bonds at heavy discounts,
which does not help relieve the pressure much, converting debt to equity
promises a much more fruitful alternative.
Promoting Ethical behavior: Because of its strong emphasis on the
ethical and moral dimensions of doing the business and selecting the
activities/ commodities to be financed, the Islamic financing institutions
could play an important role in promoting socially desirable investment
and corporate behavior. In this context, it is worth mentioning that
Islamic financing institutions are subject to Shariah (Islamic Law)
regulations in addition to conforming to the conventional regulatory
standards. This is further expected to ensure greater prudence and
responsibility.
Higher profits: Account holders under Islamic finance could expect
higher profit from their investment as Islamic banks are required to share
the entire net profit according to the agreed formula rather than just a
portion of the profit, as is the conventional practice.
Reduction in run-on-deposits: Banks using profit and loss sharing (PLS)
to mobilize resources are less likely to face a sudden run on their
deposits.
More stable economic environment: The perspective of investments is
long-term in comparison to short-term expectations of returns in
40
conventional financial system – this may result in a more stable
economic environment less dependent on business cycles.
Less likelihood of flight of capital: Under Islamic finance, debt
instruments that may be created through selling goods and services on
credit are not readily tradable. This greatly eliminates the possibility of
sudden mass movement of funds from one country to another.
Reduction in speculative transactions: Examination of daily records of
trading in financial markets vividly shows that institutional participants
carry out huge speculative transactions. More often than not, such
transactions are sources of instabilities. In contrast, Islamic banks and
financial institutions are inherently prevented from carrying out such
activities. As a result destabilizing speculations would be significantly
curtailed in financial markets, although liquidity will remain with
secondary market trading allowed in stocks or investment certificates.
Reduction of inflationary pressures: Under Islamic economics the
inflationary pressures would be reduced to a great extent, as over or
under-supply of money with respect of supply of goods is not allowed
(money directly linked to supply of goods in the economy).
Reduction in unproductive use of borrowings: By eliminating
unnecessary and excessive borrowing (borrowing beyond productive
use), risk to lenders is reduced under PLS, as lending is directly related
to project appraisals and feasibility.
Automatic Shock-absorption: For banks involved in the equity-based
system, Khan (1986) argues that the shocks to asset positions are
immediately absorbed by changes in the values of shares held by
depositors in the bank. This makes the real values of assets and liabilities
of banks equal at all times, preventing banking crises. Nienhaus (1986)
agrees with the argument.
41
Box-1: Landmark Islamic finance deal inked
Khaleej Times: 03 July 2003
DUBAI - In a landmark deal for Islamic finance, Dubai Islamic Bank (DIB), in partnership
with ABC Islamic Asset Management of London, has signed a leasing transaction agreement
with the AAA-rated General Electric of the USA. The transaction involves the purchase of
machines and engineering equipment by DIB and ABC and leased under Sharia principles to
General Electric.
"We intend to source more deals with investment grade companies from around the world," Mr
Aref Kooheji, DIB's Executive Vice-President for Investment Banking said. "We pay special
attention to the elimination of risk by means of watertight structures that provide protection
against residual risk during the term of the lease."
Mr Kooheji concluded the signing with Mr Duncan Smith, ABC Islamic Asset Management's
CEO, in Dubai recently.
"This is a landmark deal. If General Electric is prepared to go the Islamic financing route, then
it's hard to see how similar multinationals will not avail themselves of this excellent financing
facility in the future. This will give the Islamic industry a tremendous boost," Mr Smith said.
Mr Smith added that the partnership transaction was made possible through cooperation
between investment professionals at DIB and ABC Islamic Asset Management, whose
understanding of complex structures, legal and other matters, particularly Sharia compliance,
facilitated smooth cross-border dealings of significance in the development of investments in
the Islamic financial industry.
Abu Dhabi power project signs $1.8b loan deal
Khaleej Times: 3 July 2003
ABU DHABI - A $1.8-billion loan facility was signed here yesterday for the expansion of
Abu Dhabi's fourth independent power and water project in what was described as "the largest
project financing ever" in the capital of the United Arab Emirates.
Project developers International Power of Britain and Japan's Mitsui and Co. and Tokyo
Electric Power Company (Tepco), signed the facility with a consortium of local and
international banks to finance the Umm Al Nar project.
Lead arrangers of the conventional loan include Gulf International Bank, HSBC, Sumitomo,
Mitsui Banking Corporation and National Bank of Abu Dhabi, while Abu Dhabi Islamic
Bank lead arranged a $250-million Islamic tranche.
42
2.3.2. Perceived Disadvantages of Islamic Finance
With Profit-Loss Sharing (PLS), the role of the bank undergoes a change
from being an intermediary trader of money, earning profits from the
margin between lending and borrowing, to being an investing partner.
The role of an investment bank brings in added costs:
- Search cost resulting from the need to decide on the most
profitable ventures. With an Islamic bank required to finance so
many different kinds of businesses, acquiring skills in all of them
may be immensely costly.
- Monitoring costs resulting from the need to prevent mishandling
of the venture and fraudulent means (including creative
accounting) adopted by borrowers/ partners are in addition to
those involved in conventional financial system.
- Managing costs incurred because of its obligation as a partner in
the PLS deals.
Determination of mechanism for profit sharing in the short-term is
difficult in a PLS system based on returns only from productive
deployment of funds. In the absence of a standard mechanism for profit/
loss sharing (both for short-term as well as long-term), the possibility of
exploitative contracts cannot be eliminated.
Eliminating interest may reduce the propensity to save (with banks) or
invest (considering the risk associated with returns), thus curtailing
economic growth affecting employment (Pryor-1985), generation of
wealth and its distribution. Of course, IBF proponents do not agree, as an
opportunity for equitable sharing of wealth earned from productive
activities could be enough stimulant for investors.
Dispute settlement mechanism adds to the cost further, as the account put
forward by the borrower (entrepreneur) may not be convincing enough
43
for the banks or other investor partners. Fixed return of the conventional
system has no such costs.
A risk sharing proposition of IFBs and resulting absence of deposit
insurance system leaves small investors in the risky avenues, particularly
when the Islamic financial institution carries fraudulent intentions.
Curtailing speculative activities in the secondary market would be
extremely difficult resulting in the same risks and costs that the
conventional financial systems carry.
The mark-up system of most of the non-PLS schemes resembles the
interest-based system to the extent of becoming indistinguishable,
sometimes, and provides unscrupulous financiers opportunity to replicate
the conventional system.
Additional cost of supervision by the Sharia Board: Product
development, its offering, agreements between counterparties,
functioning of the IBF system, accounting, etc.. Need to be Sharia
compliant which needs certification by the Sharia Boards resulting in
additional cost burden over the IBF Operators.
Account holders under Islamic finance could expect higher profit from
their investment as Islamic banks are required to share the entire net
profit according to the agreed formula rather than just a portion of the
profit, as is the conventional practice.
Box-2: Do Islamic Banks Perform Better than Conventional Banks?
Evidence from Gulf Cooperation Council countries
Hadeel Abu Loghod: 2011
Islamic Banking has been growing worldwide significantly in the past three decades and is
developing remarkably in the Southeast Asia, Middle East and even in Europe and in North
America. The Gulf Cooperation Council Countries (GCC18
), have dual banking system
18 Gulf Cooperation Council. Economic cooperation between Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates.
44
where Islamic and conventional banks are operating side by side. The purpose of this paper
is to compare the financial performance (profitability, liquidity and structure) of the two
banking styles over the 2000-2005 time period.
The Empirical Results
To summarize, there are some ratios indicate that there are differences between the
performance of both types of banks and some showed that there are no differences.
Empirical results showed that there were no significant differences in terms of profitability
between both types of banking. However, Islamic banks proved to be profitable in all GCC
banks except for UAE. That was due to high competition, and more diverse market. In
markets where there are customers who are willing to deal with Islamic banks, such as,
Kuwait, Bahrain, Saudi Arabia and Qatar, Islamic banks proved to be more profitable.
As expected that Islamic banks tend to have high liquidity ratios relative to conventional
banks and that was due to the fact that Islamic banks cannot rely on borrowing money from
central bank or any other sources. On the other hand, conventional banks are more
leveraged compared to Islamic banks. This is my partially explained by the nature of
Islamic banking, they cannot borrow money from central bank or other sources because of
the interest.
Summary and conclusions
The aim of this paper was to compare between the financial performance of Islamic banks
and conventional banks in the GCC countries using statistical analysis of summary
financial information and selected financial ratios. Most of the published literature explains
the differences in culture and principles between both banking types, but very few studied
the differences in financial performance in practice utilizing statistical model.
In this paper, quantitative method is used to examine the differences in financial
performance between both types of banks. For the most part, financial ratios were also
used to predict future performance such as type of a bank. The analysis utilized an
econometric LOGIT technique to find out the differences between the financial
performance of Islamic banks and conventional banks using key financial ratios over the
period (2000–2005), in a panel sample of both types of banking in the GCC countries. Six
models were developed to avoid multi collinearity.
The results were very significant and robust and were confirmed by the calculation of
marginal effect, since the magnitude of calculated marginal effects of financial ratios to the
probability of bank type is less than one and standard errors were very small. Models were
successful in describing the differences in financial performance based on selected
financial ratios.
The obtained statistical results suggest that:
1- Market share, defined as total assets, of the financial data published over the period
(2000-2005), shows that conventional banks are dominant in GCC countries.
However, they are losing their market share against Islamic banks. Since in 2000 the
45
total assets of conventional banks in GCC countries was 87.91%. It decreased to
85.84% in 2005 with 40.64% growth rate. Islamic banks increased from 12.09% in
2000 to 14.16% in 2005 with 50.53% growth rate. This indicates that Islamic banks
are growing faster than conventional banks over time.
2- Analysis of differences in Profitability ratios, presented in this paper, by return on
assets, return on equity and dividend payout ratios, the statistical results show that
there are no significant differences between both types of banks. However, comparing
averages of both banking types and industry in each country of the GCC countries
show that Islamic banks had higher ratios in GCC countries except in the case of
UAE. The result is reasonable, market and management play important role in
determining profitability, in addition to the bank performance.
3- As for differences in Liquidity ratios, it is vital for the survival of a bank. Liquidity
ratios are presented by Cash to Assets and Cash to Deposits ratios in this paper.
Analysis of the ratios shows that conventional banks are exposed to liquidity risk
more than Islamic banks. Liquidity ratios are in favor of Islamic banks.
4- Analysis of differences in structure ratios shows the following statistical results:
Debt to Asset ratio is in favor of Conventional banks indicating that conventional
banks depend more on external liabilities.
Loans/Receivables to Assets ratio is in favor of Islamic banks too. This implies
that customers are more attracted to use Islamic banking financing instruments
because they comply with Islamic sharia.
Deposits to Equity, Deposits to Assets and Investments and deposits to Assets
were in favor of conventional banks but this result is debatable. Average of these
ratios for both banking types showed that Islamic banks in some GCC countries
like Kuwait and Qatar had higher ratios than conventional banks, while in
Bahrain, Saudi Arabia and UAE showed the opposite. This can be explained by
conventional banks outnumbered Islamic banks in these countries, which made
competition high in attracting deposits.
Fixed Assets to Assets ratio is in favor of Islamic banks. This result is very
rational because Islamic banks use financial instruments such as Murabaha, Ijara,
and these instruments increase the rate of Fixed Assets to Assets.
The statistical results show that there are no significant differences between both
banking types in terms of Internal Growth rates.
Loans/Receivables to Deposits and Loans to Equity ratios are in favor of Islamic
banks, indicate that Islamic banks are more into financing operations rather than
receiving deposits and this implies that credit risk of conventional banks is less
than it is in Islamic banks.
Deposit to Equity ratios and Investment and deposits to Assets ratios are in favor
of conventional banks. Obviously, this result indicates that the ability of
conventional banks to leverage their operations by attracting more deposits and
investments.
Equity to Assets ratio is in favor of conventional banks. This ratio is an important
measure of capital adequacy; higher values of this ratios reflect a strong financial
structure of the bank and less possibilities of financial difficulty.
46
III. FINANCIAL INSTRUMENTS
3. Islamic Financing Techniques and Products
One may view the Islamic financial system as grounded in four basic principles:
Risk-sharing -- the terms of financial transactions need to reflect a symmetrical
risk/return distribution each participant to the transaction may face;
Materiality -- a financial transaction needs to have a “material finality”, that is it is
directly or indirectly linked to a real economic transaction;
No exploitation -- a financial transaction should not lead to the exploitation of any
party to the transaction;
No financing of sinful activities such as the production of alcoholic beverages.
Financial intermediation based on the principles of Islam has an established historical
record and has made significant contributions to economic development over time.
Financiers in early periods of Islam were known as sarrafs who undertook many of the
traditional and basic functions of a conventional financial institution, such as intermediation
between borrowers and lenders, operation of a secure and reliable domestic as well as
cross-border payment system, and offering services such as issuance of promissory notes
and letters of credit.19
Sarrafs operated through an organized network and well-functioning markets, which
established them as a sophisticated intermediary given the tools and technology of their
time.20
19
For further details see Udovitch (1981), who equated the function of sarrafs with a bank and considered them as "bankers without
banks". 20
Chapra and Ahmed (2002). It is claimed that financial intermediaries in the early Islamic period also helped each other overcome
liquidity shortages on the basis of a mutual help arrangement.
47
There is evidence that some of the concepts, contracts, practices and institutions developed
in the Islamic legal sources of the late eighth century provided the foundations for similar
instruments in Europe several centuries later.21
In Islam, the whole fabric of Divine Law is contractual in its conceptualization, content,
and application. Islam forcefully places all economic relations on the firm footing of
“contractus”.22
Islamic economics is based on a set of contracts and instruments which
form the backbone and building blocks for more complex and elaborate frameworks.
Islamic banking and financial institutions have developed a wide range of techniques which
allow them to uphold the religious and legal principles while enabling them, at the same
time, to offer viable financial products. The search is actually still going on to find newer
techniques, and for variations based upon the existing ones to offer more attractive and
useful instruments for the investors.
The four root transactions according to Shariah are sales (Bay), hire (Ijâra), gift (Hiba) and
loan (Ariyah) describing respectively the transfer of ownership, the transfer of the right to
use, the gratuitous transfer of ownership and the gratuitous transfer of the right to use.
These basic forms are applied to specific transactions such as pledge, deposit and guarantee
and build the basis for all transaction structures in Islamic finance. (Lewis and Algaoud
2001)
The traditionally most accepted and most correct forms of Islamic financing are the profit-
and loss sharing contracts: Mudaraba and Musharaka. According to Algaoud and Lewis
(2007) this form of equity based financing is considered as the “backbone of Islamic
banking practice” as it represents the idea of the Holy Qur’an, namely that every
investment should foster economic development by providing capital to companies and
infrastructure projects (Gassner and Wackerbeck 2007). As can be derived from the name,
profits and losses are shared between the creditor and the borrower on a predetermined
21
Udovitch (1981). 22
Mirakhor (1989). Contractual foundation of the Shariah judges the virtue of justice in man not only for his material performance but
also by the essential attribute of his forthright intention (niyya) with which he enters into every contract. This intention consists of sincerity, truthfulness and insistence on rigorous and loyal fulfillment of what he/she has consented to do (or not to do). This faithfulness
to one’s contractual obligations is so central to Islamic belief that when the Prophet was asked “who is the believer?” He replied that “a
believer is a person in whom the people can trust their person and possessions.”
48
basis. Consequently it is considered as a “return-bearing” contract in contrast to an
“interest-bearing” contract in conventional banking (Mirakhor and Zaidi 2007). The two
basic concepts Mudarabah and Musharakah and other financial products will be explained
in the following chapter.
The following list covers many of them:
3.1. Equity-Based Financing Techniques
Mudarabah (fund management) and musharakah (equity partnership) are
mainstream contracts for capital investment.
3.1.1. Mudarabah
The Mudarabah contract is a two tiered transaction for an Islamic bank. On
the asset side it provides money, for example for an entrepreneur called
“Mudarib”, and finances its project as so called “Rabb al-mal”. As such it
possesses all assets but does not have any active part in the enterprise. At the
end of the contract the investment is redeemed by the entrepreneur and the
bank participates in the generated profit on a predetermined basis. However
if the project fails it participates simultaneously in the losses and can, in the
worst case, lose all its investment (but not more). The entrepreneur manages
the project and provides his economic and technical knowhow.
49
Figure 1 -- Example of a Mudarabah
He is liable to the bank in case of gross negligence and might lose his
income. As he has not invested capital, his financial damage will be very
limited (Mirakhor and Zaidi 2007 and Zamir Iqbal and Abbas Mirakhor
2011). The funds used by the bank are usually held in trusteeship from
savings or investment account holders, i.e. depositors (liability side). The
depositors share in turn the profits and losses experienced by the bank and
thus participate in the earnings of the projects or companies the bank has
invested in. To come to full circle their rate of return depends from the real
sector and cannot be considered as interest (please refer to chapter 1.3.1.)
(Mirakhor and Zaidi 2007). As the bank only provides capital but no
management expertise this form of financing is also called “Qirad”, to be
translated as “dormant partnership” (Lewis and Algaoud 2001). The
50
mechanism of a Mudaraba contract between a bank and a company (i.e. the
asset side) is shown in Figure 1.
3.1.2. Musharakah
The Musharakah partnerships are very similar to the Mudarabah form
however in contrast to the former both, entrepreneur and bank, provide
capital for the project and form de facto a kind of Joint Venture. Both
partners have the rights (but not the obligation) to participate in the
management and share profits according to a predetermined ratio and losses
in proportion to their respective capital invested. Consequently both have the
incentive to invest wisely and should have an active interest in the
investment (Mirakhor and Zaidi 2007). In order to illustrate the structure of
a Musharakah partnership, please refer to Figure 2.
Figure 2 – Permanent or diminishing Musharakah transaction
Subcategories of the Musharakah contract can be differentiated according to
the duration the bank’s engagement in the venture:
Permanent Musharakah
The duration of the contract is unlimited until one party resigns the
contract or the project is liquidated. This form of financing is
51
designed for long-term financial investment of the bank. (Altundag
and Nadia 2005,)
Diminishing Musharakah
In contrast to the permanent Musharakah, the bank’s engagement is
reduced over time and another party (usually the entrepreneur) buys
the bank’s shares to a higher price than the original value. Hence the
bank commits to a short or medium term investments and receives a
profit out of the difference between original share value and received
price. The diminishing Musharakah structure is used for example in
house financing. (Zamir Iqbal and Abbas Mirakhor 2011).
3.1.3. Wakalah
A recent trend among Islamic banks is to apply the concept of Wakalah, or
agency, to both financing and deposit taking. While Wakala bears strong
resemblances to Mudarabah, there is a key difference: a Wakil, or agent,
merely represents the party that has the money.
For instance, if the bank appointed Mario as Wakil instead of Mudarib, then
Mario would be eligible for a salary, not just a share of the profits. As an
agent of the bank, Mario uses the bank’s money, but owes it back (unless
there is a loss). Here the financial dynamics are more like those of a loan.
Conversely, if after many successful years, Mario wishes to deposit his
funds with the bank, he may place them in a Wakalah deposit. This too is a
PSIA, except that it is one in which the funds belong to Mario and are
applied by the bank. The bank is able to pay itself a fee akin to margin. If the
bank loses money, so may Mario. If not, the bank must return his money at
the term of the Wakala.
The main difference beyond the fee concept is that the Mudarabah is either a
formal partnership or a business operation contract. As a formality, the
Mudarabah must be terminated and the partnership dissolved or bought out.
The Wakalah, however, ends without a business operation terminating or a
52
partnership being formally dissolved. The Wakalah simply ends with the
repayment of funds.
3.1.4. Difference Between Mudarabah and Musharakah Contracts
In a Mudarabah contract, the managing agent (beneficiary or the borrower,
called the Mudarib) does not have any financial participation. In a
Musharakah contract, the agent is a financial partner along with the provider
of fund (Rabb-al-Mal of Mudarabah contract) sharing the gain or loss at the
pre-designated ratio which is likely to be higher than what he is likely to get
in a Mudarabah contract. Thus, in Mudarabah, the agent acts as a working
partner who does not bear any losses and simply manages the fund (the
project in which the fund is invested), whereas in Musharakah, all the parties
are shareholders in the venture.
For both Mudarabah and Musharakah contracts, the profitability of Islamic
banks is directly linked to their physical investments. This is the main
difference to conventional banks who earn interest on the loans they provide
irrespective of the profitability. Therefore Islamic banks are more likely to
demand a continuous, complete flow of information from their counterparty
which might lead to higher transparency and stability. They tend to be more
interested in stable long-term relationships with their clients. (Mirakhor and
Zaidi 2007) According to Iqbal these forms of equity financing fosters the
better understanding and monitoring of the business and involved risks from
the bank’s side. However Gassner and Wackerbeck argue that the current
use of equity-based forms in Islamic finance is very low (approximately 5
percent on the asset side in Islamic banks). This is mainly due to the high
risk involvement of the banks, an obvious principal-agent problem and the
increasing innovation in the Islamic finance industry evolving debt-based
instruments, leasing forms and efficient capital market instruments.
53
Figure 3 -- comparing equity and agency structures
3.2. Debt-Based Financing Techniques
These contracts can be categorized into two components. First component is more
concerned with sale, which includes deferred purchase, manufacturing, deferred
payment sale and etc. Second type of contracts deals mainly with operational and
financial leasing.
3.2.1. Murabaha
In Islamic banking business, loans to private and business clients have to be
granted for a specific purpose (for example to buy a specific commodity). In
this way the Islamic bank purchases the commodity from a third party on
behalf of its client. Before reselling it to him it adds a predetermined mark-
up on the spot price constituting the return for its services. The client
redeems the amount either immediately or on a deferred payment basis-
called “Murabaha-bimuajjal”. (Mirakhor and Zaidi 2007 & Lewis and
Algaoud 2001) The mark-up is fixed in a contract before hand and cannot be
changed during the duration of the contract. Therefore it is to be clearly
differentiated from interest at it is not linked to the duration but “computed
on transaction basis for services rendered” (Lewis and Algaoud 2001). The
54
bank bears an associated risk as it owns the assets between purchase and
resale. (Mirakhor and Zaidi 2007)
Figure 4 -- Murabaha transaction
In order to adapt the Murabaha concept to different customer needs, several
variations exist. Two of them are Bay Salam and Istisnaa.
3.2.2. Bay Salam
According to the Shariah, goods cannot be sold if they are not yet in
existence, at the time when the contract is closed. The Salam contract
constitutes an exception, provided strict rules are adhered. It is mostly used
in agricultural context and recently as Islamic alternative to conventional
derivatives. Following this transaction, the bank purchases the goods (for
example the yield of a farmer) in advance before they are produced. It pays
the full purchase price immediately to the farmer as soon as the contract is
closed (please refer to Figure 5). Therefore both parties have an advantage.
55
Figure 5 -- Salam transaction
The quality and quantities of the goods to be sold, the date and place of
delivery and the purchase price have to be exactly determined in the
contract. The deal cannot be closed if the provision of the goods is uncertain.
(Zamir Iqbal and Abbas Mirakhor 2011) Furthermore it has to be about
“homogenous goods” (Zamir Iqbal and Abbas Mirakhor 2011) which are not
characterized by special features that could make it difficult to find a
substitute. The contract is binding. In this way that the seller (farmer) has to
buy the goods on the market if he is not able to provide them at the agreed
date. (Zamir Iqbal and Abbas Mirakhor 2011) Usually the Islamic financial
institutions tries to resell the goods immediately as it does not want to be in
the physical possession of it.
Consequently they might enter a parallel contract. Either the goods are
resold to the original seller or to a third party for a higher price than the
purchase price, so that the Islamic financial institutions makes a profit.
(Bacha 1999)
3.2.3. Istisnaa
The Istisnaa contract can be seen as subcategory of Salam, designed for a
special purpose, such as the financing of manufacturing on contract or for
project financing. The structure becomes obvious using an example: A
56
customer approaches the Islamic bank because he needs a specific good (for
example a machine), which is not yet produced and which he cannot pay
immediately. After the Istisnaa contract is closed, the bank assigns a
respective supplier with the production of the machine according to the
specifications of its customer. The manufacturer receives a first installment
from the bank at the start and further payments as the production advances
until the machine is finished. Subsequently the machine is handed over to
the bank and later on to the customer who pays the purchase price plus a
predetermined margin to the bank in regular installments after he has
received the good.
Additionally to Salam and Istisnaa there exist further forms of contracts that
are based on the Murabaha concept (for example Arbun) which will not be
explained in the context of this paper.23
Figure 5a -- Istisna
3.3. Leasing
“The transfer of the right to use” (Ijarah) was mentioned before as one out of four
root transactions in Islamic banking. Ijarah contracts are quite similar to the
conventional concept of leasing, however some aspects are different in order to
23
Further information can be retrieved from for example from Gassner and Wackerbeck (2007, 53 to 63) or Lewis and Algaoud (2001,
55 to 59).
57
avoid Riba and Gharar (please refer to chapters 1.3.1. and 1.3.2.). They are very
popular with Islamic financial institutions and can be found in the structures of the
most innovative structures (please refer, for example, to Ijarah Sukuk in chapter
3.4.2.) owing their great flexibility. In one of the largest Islamic financial centers,
Malaysia, 31.6 percent of the total Islamic financing activities in 2005 was based on
the Ijarah concept.24
(Bank Negara Malaysia 2005) As described below the bank
owns the assets until the end of the lease term at least. Even if the lessee fails to pay
the rental payments, the bank still can sell the asset on the market easily. Additional
to the pure Ijarah contract, the further development Ijarah wa Iqtina exist.
3.3.1. Pure Ijarah
Core of the Ijarah contract is the sale of the “Manfa’a”, the right to use an
asset, for a specific period. The goods are bought by the Islamic bank from a
third party. Afterwards they are leased out to the clients who pay rental fees
for their use (please refer to Figure 6). The bank, as lessor, bears the risk as
it is the owner of the assets. Consequently it is responsible for maintenance
and insurance.
Figure 6 -- Pure Ijarah transaction
24 The Annual Report states further that only 0.3 percent was based on Mudaraba and Musharaka contracts and the Mudaraba principle
was applied in 6.9 percent of the cases. (Bank Negara Malaysia 2005)
58
The leased asset must have a productive usage (for example building,
aircraft, car) and the rent is pre-agreed for the whole period, in order to
avoid speculation. (Mirakhor and Zaidi 2007) However the terms of the
lease payment can be renegotiated at agreed time intervals so that the bank
can react to major market developments. (Bergmann 2008) The pure Ijarah
transaction can be compared with the conventional operating lease contract.
(Lewis and Algaoud 2001) Ijarah wa Iqtina.
In the pure Ijarah contract (refer to the chapter above) the lessee has not
option to buy the asset at the end of the lease term. In the Ijarah wa Iqtina, to
be translated as “hire and purchase”, he has. (Mirakhor and Zaidi 2007),
Consequently the ownership is transferred to the lessee after the term of the
contract when all rental payments have been made. Up to this point of time,
the lessor bears all risks for possible losses or damages regarding the lease
asset, except they are caused by gross negligence of the lessee. The Ijarah
wa iqtina contract is similar to a financing lease arrangement in the
conventional system. (Lewis and Algaoud 2001)
3.4. Capital Market Instruments
Due to the infancy of the Islamic financial industry the number of Shariah-
compliant capital market instruments is very small compared to the conventional
market. However numerous product innovations have been developed in the last
decades in order to create competitive products for private and business customers
as well as for the Islamic financial institutions themselves. Islamic capital markets
are generally underdeveloped. Religious constraints on permissible investment rule
out conventional forms of interest-bearing debt finance. In the absence of tradable
debt and valuation problems of financing contracts, Islamic finance has proven
conceptually difficult especially for money management. Banks operating under
Islamic law are predisposed to adopt buy-and-hold investment strategies and carry
59
excess short-term reserves for lack of sufficient long-term reinvestment
opportunities, which has inhibited efficient financial intermediation and capital-
market deepening. Nonetheless, financial institutions have been able to develop
various forms of Islamic finance instruments that are virtually identical to their
conventional counterparts in substance. However, as I will explain in this chapter,
these securities are not surrogates for conventional interest-based securities that
mimic the interest rate structure.
To give some examples, this chapter will focus on Islamic stocks, mutual equity
funds, Sukuk and Islamic derivatives.
Before examining the implications of shariah compliance on conventional
structured finance, it is necessary to clarify how Islamic securitization fits with the
notion of Islamic finance. Since most Islamic financial products are based on the
concept of asset backing, the economic concept of asset securitization is
particularly amenable to the basic tenets of Islamic finance. Asset securitization
describes the process and the result of issuing certificates of ownership as pledge
against existing or future cash flows from a diversified pool of assets (“reference
portfolio”) to investors. It registers as an alternative, capital market-based
refinancing mechanism to diversify external sources of asset funding in lieu of
intermediated debt finance based primarily on the risk assessment of securitized
assets (Jobst, 2006).
Islamic securitization transforms bilateral risk sharing between borrowers and
lenders in Islamic finance into the market-based refinancing of one or more
underlying Islamic finance transactions. In its basic concept, originators would sell
existing or future revenues from lease receivables (asset-based), “sale-back profit”
(debt-based) or private equity from a portfolio of Islamically acceptable assets to a
60
special purpose vehicle (SPV),25
which refinances itself by issuing unsecured
securities to market investors, who are the “capital market corollary” to a singular
lender in Islamic finance (see Figure 7). They assume the role of a “collective
financier” whose entrepreneurial investment does not involve guaranteed, interest-
based earnings.
Figure 7 -- The pay-off profile of asset-backed securities under the three basic
forms of Islamic finance.
In keeping with our previous presentation of the three basic forms of Islamic
finance above, I can illustrate the concept of Islamic securitization by simply
reversing the ex-ante lender payoff from Islamic finance transactions (Exhibits 1
and 2). Using a pass-through securitization structure on the proceeds from a
dedicated reference portfolio of one or more Mudharabah futures with deferred
delivery or payment (which implies limited recourse due to market risk or other
25
In conventional securitization, a SPV is set up solely for the purpose of the securitization and might be a trust, limited liability
company, partnership, or a corporation. In Islamic securitization, the objectives set out in the constitutional documents of the SPV also
must not infringe on the prohibition of riba and haram under Islamic law.
61
contingencies from certain payment and repurchase provisions), originators would
be able to issue unsecured financial obligations with investor payoff S+C(E)-P(F)
backed by expected repayment L2. Investors receive full repayment of principal and
a pre-specified share of profits (as investment return) if the asset performance of the
underlying Islamic transaction generates proceeds in the amount of PV(F) or higher
(indicated by area “A” in Figure 1). Whenever the issuer is unable to repay some or
all of the promised return (and original investment amount), default occurs
(indicated by areas “B” and “C” in Figure 1). If the originator had no endowment to
finance the underlying asset(s) in the first place, expected repayment L2 would be
reduced by asset value –S owed to a third party as “asset supplier” over the term of
the lending transaction, who holds a short position –P(E). Therefore, the maximum
issuance amount would be limited to PV(E)-PV(F).
3.4.1. Islamic Stocks and Equity Funds
Investment in shares is very interesting for Muslim investor as no element of
Riba (please refer to 1.3.1.) is involved in contrast to other capital market
instruments, like bonds for example.
From the point of view of Shariah scholars, equity shares are preferred
instruments because the capital is provided for productive purposes and the
shareholder participates directly in the entrepreneurial success. However
investment targets have to be filtered following two processes: the “industry
screen” and the “financial-ratio screen”. (Dow Jones Indexes 2012)
Industry screen
Firstly there exist restrictions regarding the industry in which the
target company operates. According to the code of ethical investment
that distinguishes between Haram and Halal investments, Muslims
are only allowed to invest in shares of Halal businesses.
The business activity screening aim to exclude Investment in
companies dealing with haram activities/products such as:
62
- Companies that produce/sell/trade/slaughter/distribute pork-
related products;
- Companies that promote pornography or obscenity in any form;
- Companies whose activity involves gambling, such as casinos,
lotteries, bingo, Internet gambling…;
- Companies active in the conventional banking and insurance;
- Companies primarily active in the pure entertainment business
(e.g. movies, theater, cinema…)
- Companies active in the defense or weapons industry;
- Companies active in the tobacco or alcohol business (this
includes producers, sellers and distributers); and Any other type
of company that might be prohibited by the Shariah board.
Although some business activities are very easy to monitor, others
are more difficult to determine precisely. Indeed, halal businesses
such as grocery stores, supermarkets, airlines, hotels and restaurants
may derive part of their profits from prohibited activities such as
selling cigarettes or alcohol.
In these cases, Islamic scholars generally allow Islamic funds to
invest in such halal businesses on condition that the income derived
from that prohibited activity is no more than 5% of the companies'
total income and that any dividends received as a result of investing
in these companies are purified. The purification principle is
relatively straight-forward and involves donating to a charitable
organisation (not necessarily Islamic) 5% of the dividends received
from that particular investee company as it is deemed to be attributed
to the non Shariah compliant activities.
63
Financial - ratio screen
As soon as a stock passed the industry screen its financial parameters
are scrutinized.
Firstly the debt to equity ratio26
has to be lower than 33 percent.
Secondly the percentage of cash and interest bearing securities has to
be lower than 33 percent in reference to market capitalization. The
same is true for the relation between accounts receivables and market
capitalization. (Dow Jones Indexes 2008). Due to complexity of
modern companies, in cannot be avoided that firms are to a very
limited extend active in Haram businesses. Therefore more liberal
Shariah scholars argue that the ratio of Haram business in relation to
total revenues must not exceed 5%. However this ratio is
controversial and not applied by all Shariah Supervisory Boards.
(Zamir Iqbal and Abbas Mirakhor 2011). As can been seen from
both the industry and financial-ratio screen it is rather complicated
for a private investor to find a Shariah-compliant investment.
Therefore Islamic equity indices are very popular as the screening
processes are executed by professional firms and supervised by a
Shariah supervisory board. The major Islamic equity indices are the
Dow Jones Islamic Market Index series, the Standard and Poor’s
Shariah Indices and the FTSE Global Islamic Index Series. Many
Islamic funds as well as private and business investors align their
portfolio with these indices.
Islamic equity funds
Islamic equity funds can be structured in two ways- either as a
Mudarabah partnership (please refer to 3.1.1.) or according to the
Wakalah model27
. In both cases a Shariah Supervisory Board has to
26
The debt to equity ratio is calculated by dividing the total debt by the 12-months average of equity capital or the firm’s market
capitalization. (Dow Jones Indexes 2008) 27
Literally Wakalah means “looking after, taking custody” (Ayub 2007, 347) and describes an agency contract in Islamic finance.
64
supervise the Shariah-conformity of the investment decisions and the
investment companies operations.
In the first case the investment company is the Mudarib and the
shareholders assume the role of the Raab-al-mal. The remuneration
for the investment company is taken from the generated profits and
variable depending on the result. If the fund generates a loss, it is
passed on to the shareholders and the investment company receives
nothing. (Zamir Iqbal and Abbas Mirakhor 2011 and Ayub 2007)
Figure 8 -- Islamic equity fund based on Mudarabah partnership
from Gassner and Wackerbeck (2007)
In the second case the investment company operates as an agent for
the shareholders and agrees on fix remuneration in advance (absolute
or percentage of the fund volume). This has to be approved by the
Shariah Supervisory Board and disclosed in the fund prospectus.
Furthermore this concept is consistent with the conventional equity
fund. (Zamir Iqbal and Abbas Mirakhor 2011). There are several
other categories of Shariah compliant funds in existence for example
Ijarah funds, commodity funds, Murabaha funds or mixed funds.
65
(Ayub 2007) At present approximately 350 islamic funds are issued,
the majority of them being equity funds.
3.4.2. Islamic Investment Certificates (Sukuk)
Sukuk is probably the most well-known instrument in Islamic finance and is
most correctly identified as an investment certificate. It is often called a
bond type instrument because it has some similar characteristics.
Although the religious prohibition of the exchange of debt and the required
conferral of ownership interest to participate in business risk still poses
challenges to further development of Islamic securitization, the gradual
acceptance of Islamic investment certificates, so-called sukuk bonds,
represents a successful attempt to overcome these impediments based on the
adequate interpretation and analogical reasoning of shariah principles
applied in Islamic finance. Sukuks are shariah-compliant and tradable asset-
backed, medium-term notes,28
which have been issued internationally by
governments, quasi-sovereign agencies, and corporations after their
legitimization by the ruling of the Fiqh Academy of the Organization of the
Islamic Conference in February of 1988.29
“Over the last five years, the
sukuk has evolved as a viable form of capital market-based Islamic
structured finance”30
, which reconciles the concept of securitization and
28
“Investment sukuk are certificates of equal value representing undivided shares in ownership of tangible assets, usufructs and services
or (in the ownership of) the assets of particular projects or special investment activities.” (AAOIFI Standard No. 17). 29
Although there is no formal obligation of compliance associated with the ruling, it carries considerable weight with most Islamic
financial institutions. 30
Source Financial Management | March 2011: The global Islamic finance industry grown from about $10bn worth of invested assets
in 1975 to $2.2trn today, according to the 1st Ethical Charitable Trust, an adviser on sharia compliance in the UK. The tenets of Islamic
finance generally forbid the payment of interest and investing in activities deemed speculative, uncertain or unjust (such as gambling, alcohol and the sale of certain foods). This has appeal beyond the Muslim world. Indeed, about 80 per cent of sharia-compliant
investment products in Malaysia are held by non-Muslim investors.
So will the rise of Islamic finance continue, particularly given the lack of trust in Western banking? And what changes can be expected in the global sharia investment mix?
By the end of 2010 5.5 per cent of the $2.2trn invested in Islamic instruments was held in dedicated Islamic funds, with 31.1 per cent in
broader-based assets (mainly in sharia-compliant bank accounts and money-market vehicles). The rest was held in other Islamic instruments, particularly sharia-compliant bonds (sukuk), insurance packages (takaful) and equities products.
Where are the world's Islamic finance hot spots? "The main centres have stayed largely the same for the past three years: Malaysia
continues to lead the way in sukuk and equities products, while Saudi Arabia does the same for bank deposits," says Sohaib Umar, a partner in Ernst & Young's Islamic financial services group in Bahrain. Dedicated multi-product Islamic funds are
split largely among Malaysia, Saudi Arabia, Kuwait, Luxembourg, Bahrain, the Cayman Islands and Ireland. Yet the focus of the Islamic
finance industry - especially for bond and equity products.
66
principles of the shariah law on the provision and use of financial products
and services in a risk-mitigation structure subject to competitive pricing (El-
Qorchi, 2005). The Accounting and Auditing Organization of Islamic
Finance Institutions (AAOIFI) (please refer to chapter 4.5.2.) currently
recognizes different types of sukuks, which are traded on the Scripless
Securities Trading System (SSTS)31
in Malaysia. Only appropriate Islamic
bodies, so-called shariah boards, may adjudicate the shariah compliance of
the terms of any sukuk issuance. Sukuk notes convey equity interest to
(capital market) investors in the form of a call option on partial or complete
ownership of underlying reference assets, including the right to some
calculable rate of return as a share of profit (secondary notes) and the
repayment of the principal amount (primary notes). All three broad types of
Islamic finance transactions (asset, debt, and equity-based) can be reference
assets of such Islamic securities. I distinguish between two broad structures
of sukuk contracts that convey shariah-compliant asset ownership to
investors: either (i) asset originators themselves issue notes backed by
existing Islamic assets, or (ii) the originator sells Islamic assets (and/or the
proceeds thereof) to an unaffiliated SPV, which issues notes with a
put/tender feature to fund the acquisition of assets. The notes are funded by
the proceeds from the underlying assets paid to the SPV as part of the
repurchase obligation by the asset originator. Depending on the claim-
generating asset type of Islamic finance, the SPV acquires ownership rights
on either (i) existing assets within a lease-purchase or sale-repurchase
agreement, or (ii) future assets as equity investor, and structures the
anticipated cash flows from these assets into sukuk payment obligations of
different risk and maturity. These obligations entitle investors to a pro rata
ownership in the SPV and the proceeds generated from the net revenue of a
31 The SSTS is a system operated by the Bank Negara Malaysia (BNM)’s real time gross settlement/deliveryversus- payment system through which sovereign and unlisted corporate bonds are registered, cleared, and settled via the Real-time Electronic Transfer of Funds
and Securities (RENTAS), Malaysia’s scripless book-entry securities trading and funds transfer system. SSTS also maintains securities
accounts for financial institutions.
67
loan, a lease or an investment project. The amount of debt issued is limited
to the value of assets held by the SPV.
Most sukuk issues have been sponsored by sovereign and quasi-sovereign
issuers in Islamic countries. A government-linked SPV would issue
discounted and tradable zero coupon bonds with varying maturities on the
back of Islamically approved assets with pre-fixed terms to maturity.
However, the indemnification of investors in such transactions may not
conform to the shariah prohibition of guaranteed investment income. The
shariah compliance of these bonds has been contested by Islamic scholars on
two grounds: (i) the discount on the issued bonds could be construed as
equating to interest return, and (ii) the guaranteed ex ante profit from a
discounted offer does not exposure investors to investment risk.
Figure 9 -- Simple Sukuk Structure
Sukuk always has one of the following underlying transaction types as a
basis:
68
Mudarabah
Musharakah
Ijarah
Salam
Istisna
Although asset-based (ijarah) sukuks are the most common form of Islamic
securitization, sukuks on other Islamic finance transactions have been
structured as well over the recent past.
Ijarah Sukuks
Are financial obligations, issued by a lessor, and backed primarily by
cash flows from lease receivables from a credit lessee, such as
sovereign governments, regional governments, corporations, and
multilateral lending institutions (Richard, 2006). In the popular sale-
leaseback ijarah sukuk transaction structure (“sale model”), the SPV
holds legal title to the assets, which are leased back to the originator
in return for rental payments (and possibly other cash flows from the
assets depending on the transaction structure) to service payments on
the issued sukuks. The SPV holds a repurchase obligation for a price
equal to the amount of outstanding debt in order to insulate the
transaction from an adverse performance of the underlying assets
(see Figure 10). In the head lease-sublease ijarah sukuk model, the
owner of the assets head leases them to the issuer and rents them
back. Since this arrangement does not include a repurchase
obligation of transferred assets like a sale-leaseback ijarah sukuk, the
credit risk of non-performance by the sub-lessee is usually covered
by a quasi-guarantee on payments due to sukuk note holders. One
69
recent example of such a transaction was the US$250 million sukuk
issued by the Bahrain Monetary Agency International Sukuk Co. in
June 2004 as an unconditional, unsubordinated, unsecured and
general-payment obligation, backed by the full faith and credit of the
Kingdom of Bahrain.32
In this case, the notes are more akin to
guaranteed obligations than to non-recourse, secured obligations of
RMBS or CMBS transactions.33
Figure 10 -- The concept of an Ijarah Sukuk transaction
3.5. Funding operations and Accounts
Islamic retail banking is a very recent phenomenon and fostered by certain newly
established Islamic financial institutions, for example the Islamic Bank of Britain.34
32
The payments to sukuk note holders were serviced by the Kingdom of Bahrain acting through the Ministry of Finance and National
Economy (“sub-lessee”). 33
An alternative guarantee is the purchase of sukuks by the asset originator if the underlying assets fail to perform.
In April 2005, the Dubai Metals and Commodities Centre Authority (DMCC) issued a US$200 million musharaka sukuk (joint venture)
backed by the sale of three residential tower complexes via the Gold Sukuk DMCC transaction. In order to insulate the transaction’s rating from the performance of the underlying assets, DMCC as originator would be required to purchase musharaka units from the issuer
and not the commercial property per se in the case of credit event. 34
In 2004 when the Islamic Bank of Britain (IBB) received authorization by the FSA, it attracted major media attention being the first
fully-fledged Islamic bank in the United Kingdom, after the Al Baraka company gave up its banking license in 1993 (please refer to
2.1.1), and the pioneer in Islamic retail banking business. (Wilson 2007, 421) The company formerly known as “Islamic House of
Britain” was found in 2002 with £14 million start-up capital raised by a private placement in the Gulf, major contributors being the Qatar International Islamic Bank with 49 percent share in initial capital and the Abu Dhabi Islamic Bank which provided resources and
personnel. (Middle East Economic Digest 2004 and Islamic Bank of Britain 2008) In October 2004 the bank became listed on the
Alternative Investment Market of the London Stock Exchange in order to broaden the shareholder base and especially to include more
70
In the following chapters, typical retail banking products like Islamic current,
savings and investment accounts are briefly described.
3.5.1. Current Accounts
Deposits in current accounts are guaranteed loans to the Islamic bank. These
funds are held in trust by the bank and can be used for its operations, as long
as they are in conformity with the Shariah. However these deposits cannot
be invested in profit and loss sharing ventures by the bank (in contrast to
deposits of other accounts, please read below) as this might endanger the
customers’ deposits. As taking of interest is prohibited (please refer to
chapter 1.3.1.), the
depositor receives no remuneration. The money is hold according to either
of the following principles: “Al wadiah” to be translated as trust and
safekeeping (Lewis and Algaoud 2001), “Qard hassan”, to be translated as
good, interest free loan (Gassner and Wackerbeck 2007) or as a benevolent
loan (Lewis and Algaoud 2001).
Basically Islamic banks provide the same services in conjunction with
current accounts like conventional banks. These are, for example, the
execution of bank transfers, the use of automated teller machines (ATMs)
with the help of debit cards or the provision of online banking facilities and
credit cards. Obviously Islamic banks are not entitled to charge interest on
overdraft. In order to compensate this problem, banks might charge a
“penalty charge” which is a lump sum, independent from the amount and
duration of the overdraft. (Gassner and Wackerbeck 2007)
3.5.2. Savings and Investment Accounts
Islamic savings and investment accounts are similar in their nature to their
conventional counterparts. In a savings account the customer makes a
UK investors (Middle East Economic Digest 2004). IBB’s board and management are staffed with Gulf and UK business men who all
have gained extensive working experiences in Bahrain and Qatar before.
71
deposit at the bank and is guaranteed the full repayment plus a small return.
In investment accounts, however, the full repayment is not secured but the
return is usually higher. The major difference between conventional and
Islamic accounts is that the return (if paid) is not fixed in advance, as this
would constitute interest.
For the savings accounts the already mentioned principle of “Al wadiah” can
be extended by a permission, granted by the depositor, that the funds can be
employed at own risk. This guarantees him full return and voluntary profit
sharing in the return generated with the help of his funds. A second
possibility to realize a savings account is to treat the deposits as “Qard
hassan” deposits (please refer to chapter above) while the bank grants
“pecuniary or non-pecuniary benefits”(Lewis and Algaoud 2001).
Investment accounts are realized on the basis of Mudaraba contracts. In this
way the depositors participates in the entrepreneurial risk resulting from the
use of his funds in equity participations. Thereby the bank acts as Mudarib
and the depositor takes the role of the capital provider Raab al mal. The
returns generated are shared, according to an agreement made in advance,
between the bank and the depositor. However in case of a loss, the depositor
risks parts or all of his deposits. (Lewis and Algaoud 2001)
3.5.3. Islamic Credit Cards
An Islamic credit card holder does not pay interest on outstanding debt. The
cardholder pays an upfront fee which represents a part of the total payment
and through this mechanism it is possible to rollover the outstanding debt
balance to the next payment cycle. Some Islamic banks return a part of the
upfront fee to an Islamic card holder if the credit is repaid in time.
The Islamic credit card is based on the principle of Al Bai Bithaman Ajil
(BBA) (deferred payment sale). In other words, the bank issues an interest
free and penalty free credit card. As goods are purchased using this credit
72
card, the bank makes the transaction on behalf of the customer and
simultaneously sells it back to the customer. This credit is payable over a
deferred period through installments within a certain time frame. However,
the BBA principle is sometimes criticized as a two-party transaction that
tries to circumvent Riba. This is because the financing of the credit amount
is normally done based on the bank selling a part of its assets (based on
“cost + margin”). Instead of paying cash to the credit card holder, s/he is
given ‘an overdraft’ facility which can be utilized when paying using the
card.35
Several banks are doing away with this concept and are using Tawarruq
(Commodity Murabaha) and Ijarah instead. In Tawarruq, the relationship
between the issuer (a bank) and borrower (credit card holder) is developed
based on actual sale and purchase of a tangible asset through a third party.
Ijarah is a new principle used where a bank grants financing (the credit
limit) to the holder with an agreed predetermined profit. The holder will then
pay the bank a fee for utilizing the facility. This fee is calculated based on
the total profit amount due (based on the credit limit) minus the percentages
of the unutilized amount.
The most common features of an Islamic credit card in the UK are:
A small fee may be charged annually for the credit card.
Customers may enjoy the value-added benefits of conventional credit
cards e.g. bonus points, gifts, shopping discounts, travel cheques etc.
Customers may need to have some kind of collateral that has been
agreed upon in advance with the financial institution.
A credit limit will be based on the customer’s collateral value.
It may be possible to obtain general Takaful (insurance) coverage.
Some banks may provide other services such as Zakah (welfare
contribution) payment via this credit card.
It may be possible to apply for a supplementary card.
35 Bhattacharya 2007.
73
3.6. Takaful (A Shariah Compliant Insurance Concept)
“Analogue to the development of Islamic banks, Muslim economists have tried to
find a Shariah-compliant alternative to conventional insurance. In this way the so-
called Takaful insurance evolved.” (Zamir Iqbal and Abbas Mirakhor 2011) Given
the increasing popularity and the high market growth rates in this segment (10 to 25
percent per annum according to Ayub (2007), the Islamic alternative to
conventional (non-mutual) insurance products will be briefly explained in the
following focusing on the basic concept. In principle Takaful products are
distributed by Islamic banks which either promote their own takaful products or
establish a separate takaful company.
Conventional insurance products are not Shariah-compliant due to the involvement
of Riba, Maisir, Gharar and an “invalid transfer of risk from the insured to the
insurer” (Ayub 2007).
Firstly Riba (please refer to 1.3.1.) is involved as the insurance companies usually
invest the capital in interest-bearing capital market instruments and secondly as
soon as the amount insured is exchanged against the amount of premiums, there
emerges an excess of money on one side, constituting Riba, too. (Ayub 2007)
Furthermore the insurer-insured relationship contradicts with Shariah principles as
“commercial benefit is involved on both sides for an uncertain event” (Ayub 2007),
hence Gharar (please refer to 1.3.2.). Assuming a life insurance one could also
detect elements of Maisir (please refer to 1.3.3.) as the insured person “bets” on the
fact that he is still alive when the insurance contract term ends, so that he can enjoy
the redemption. In other words “the profit of one party is dependent on the loss of
the other” (Ayub 2007).
The Islamic alternative to conventional insurance, called Takaful is based on the
concept of mutuality and a contributory agreement among the insured parties,
similar to conventional mutual insurance models. The International Monetary Fund
(Solé 2007) explains:
74
“Several individuals agree to pool resources with the understanding that in case of
need, each of them is entitled to draw resources from the pool.”
In this way the Takaful concept is based on “shared responsibility, common benefit
and mutual solidarity” (Ayub 2007). The pool mentioned above is a Takaful fund
which might be complemented by savings funds. The Takaful operator (either an
Islamic bank or a Takaful company) manages these funds and receives
remuneration from the premium payers. The mode of operation of the Takaful
insurance depends on the underlying basic transaction (for example Mudaraba or
Wakalah) and the type of insurance (for example property insurance or life
insurance). (Ayub 2007).
To take an example out of Gassner and Wackerbeck (2007), a Takaful insurance
based on a Mudarabah transaction is assumed (please refer to Figure 11). In the first
step the insured persons pay their premiums in the Takaful funds in form of a
donation (called Tabarru concept). The Takaful operator administers these funds
and withdraws resources needed for potential damages of the insured, for Retakaful
premiums for Islamic reinsurer and for distribution costs. The fund and the operator
close a Mudarabah agreement (please refer to 3.1.1.), in which the operator takes
the role of a Mudarib, who is agent of the Takaful funds (Rabb-al-mal), responsible
for the Shariah-compliant investment of the premiums. Consequently the annual
surplus is shared on a predetermined basis between the two parties whereas the
operator distributes parts of the results to the shareholders. In this way the operator
has an incentive to generate positive results and minimize risks. However the
operator has the responsibility to provide for the risk of a loss. Firstly reserves are
accumulated in profitable years and secondly the operator commits to provide
interest-free loans (Qard hassan principle) to the funds to be used for payment in
cases of damage.
75
According to Iqbal a main difference to conventional insurance products is that the
insured person in a Mudarabah Takaful insurance participates in the profits or losses
generated by his/ her funds.
Figure 11 -- Takaful model based on Mudaraba transaction from Gassner and
Wackerbeck (2007)
3.7. Use of Islamic Financing Products and Profitability
On a global base Iqbal and Mirakhor (2007) note that “Murabaha (41 percent) has
been the first choice of Islamic banks, followed by Musharakah (11 percent),
Mudaraba (12 percent), Ijarah (10 percent) and others (26 percent)”.
Being subject to several religious restrictions Islamic finance and banking products
bear generally higher risks. At the same time they should render the same return as
conventional products in order to stay competitive. Given the requirement that every
contract must be based on assets, transaction costs are significantly higher as well as
monitoring costs, especially in equity contracts (Iqbal and Mirakhor 2007).
Consequently it could be assumed that Islamic products and services are more
76
expensive, which might be partially accepted by Muslims who appreciate the
Shariah conformity. According to Gassner and Wackerbeck (2007) empirical
researches have shown that lower competitiveness of this product cannot be proven
and Muslims and non-Muslims alike are increasingly attracted by those offers. For
example a high percentage of Chinese (non-Muslims) in Malaysia buy Islamic
financial products. However other sources indicate that it is very difficult in practice
to measure the performance of Shariah compliant products and the efficiency of
Islamic banks as adequate and transparent benchmarks are missing so far. At
present the LIBOR (London Inter-Bank Offer Rate) is used generally, however it
belongs to the interestbased system. (Iqbal and Mirakhor 2007)
Furthermore it has to be kept
in mind that the industry is
driven by high growth rates
and rising demand whilst
institutions face few market
pressure and competition.
This situation might lead to
unrealistic assessments. In
this way “some levels of
inefficiency is compensated
by the abnormal initial profit
margin” that might erode fast as more banks become active in this Islamic
financing. (Iqbal and Mirakhor 2007) Additionally to the special requirements for
products and services offered by Islamic financial institutions, the latter are
challenged by further specifications resulting from Islam. In this way they have, for
example, to establish a second layer of governance and compensate the lacking
Islamic inter-bank market to manage their liquidity and risks. These aspects will be
discussed in the next chapters.
77
IV. GOVERNANCE AND SHARIAH BOARD
4. Governance and Compliance Structure of Islamic
Banks The governance issues in Islamic banking differ substantially from those of the
conventional system. The main difference lies in additional key stakeholders that have to be
considered in everyday operation.
One out of two new stakeholder groups is, according to Algaoud and Lewis (2001), the
Islamic Community. The Islamic bank has an “overriding obligation” (Lewis and Algaoud
2001) to obey Islamic law, being the Shariah. That implies that all products and services
offered have to be strictly Shariah compliant. The ideas of “Amanah” (trust) and
stewardship play important roles in this respect and should guide the operational practice of
every Islamic financial institution. In order to safeguard the compliance with the strict
religious standards, each Islamic financial institution is supposed to have a Shariah
Supervisory Board as defined in chapter 4.2.
The second stakeholder group which is not present in conventional financial institutions
consists of Musharakah and Mudarabah partners (please refer to chapter 3.1.1. and 3.1.2.).
The Islamic bank captures the role of a management or dormant partner in a selected
business venture and has therefore different obligations and risks to bear. These two
stakeholder groups provide “strong justification for an additional layer in the corporate
governance of an Islamic bank” according to Voker Nienhaus (2007), being the Shariah
Supervisory Board.
4.1. Corporate Governance and Shariah Board
From its nature, a bank conducting Islamic finance is subject both to those forms of
regulation which apply to conventional banks (banking supervision, financial
reporting standards and external audit), with due regard to the characteristics of
78
Islamic banks, and also to the review of its compliance with Islamic principles and
rules by the Shariah board, which constitutes a key organ of governance in an
Islamic bank. The Shariah board of a bank is part of the corporate governance
framework. (Racha Ghayad)36
Islamic banks offer Islamic banking products and services (IBS banks) are required
to establish Shariah board /consultants to advise them and to ensure that the
operations and activities of the bank comply with Shariah principles. Each Islamic
bank will have a Shariah board which reviews both proposed new products of the
bank, and the types of transactions into which that bank has entered, to ensure that
they are Shariah-compliant. New products will not be introduced until they are in a
form acceptable of Shariah board.
Shariah board in the past has been composed of Shariah scholars, some of whom
had little knowledge of modern banking and who often could not understand the
language in which transactions were documented. This could be a significant
handicap to the progress of Islamic finance and the development of new products.
There is currently a move to recruit Shariah board members with more experience
of banking and this can only be welcomed.
4.1.1. Shariah Board and Performance of Islamic Banks
The Islamic system imposes important constraints on operation of Islamic
banks and their directors. In fact, added to the governorship exerted by the
board of directors, undertaken very conventionally, the directors of the
Islamic banks are subjected to a second governorship, that of the Shariah
board. In theory, the Islamic bank should not seek the profit at any price
because this last is not an end in itself.
Unlike the directors of the conventional banks, the directors of the Islamic
banks are subjected to important constraints as they do not have a margin of
rather broad work.
36
Paper “Corporate governance and the global performance of Islamic banks” Lebanese University-CNAM, Beirut, Lebanon.
79
In an Islamic bank, the director does not have the autonomy to deploy their
resources in any activity or any sector.
Unlike conventional banks, Islamic banks do not have many instruments on
the secondary market. Also Islamic banks do not have an inter-bank deposits
market to make the excess of short-term liquidity profitable or to meet
immediate requirements in liquidity. In general, they cannot use derived
products and even less the financial lever. Additionally, the leaders can
make only ethical decisions and which ensure the legitimacy and the
acceptability of the organization.
The role of an Islamic bank director is to ensure profit in compliance with
Islamic law. In addition the governorship of an extremely demanding of
board directors with regards to the financial performance, which remainder
it is not easy to reach under such conditions, are subjected to the strict
control of the Shariah Board which is laid out to approve only the
compliance of the banking transactions with the rules of Shariah, without
consideration of the dimension profit required by the leaders.
Which role does the Shariah board play in the operation of Islamic banks?
And what influence does it have on the performance of these banks? I will
discuss in the following chapter.
4.2. The Shariah Supervisory Board
The Shariah Supervisory Board takes a “unique position in the governance structure
of an Islamic Bank”. It acts as a religious supervisory board ensuring that the bank’s
practices and activities do not contradict Islamic ethics. One distinct feature of the
modern Islamic banking movement is the role of the Shariah board, which forms an
integral part of an Islamic bank. A Shariah board monitors the workings of the
Islamic bank and every new transaction that is doubtful from a Shari’ah standpoint
has to be cleared by it. These boards include some of the most respected
80
contemporary scholars of Shariah and the opinions of these boards are expressed in
the form of fatwas. In addition, the International Association of Islamic Bankers, an
independent body, supervises the workings of individual Shariah boards while its
Supreme Religious Board studies the fatwas of the Shariah boards of member banks
to determine whether they conform with Shariah.
Shariah law is open to interpretation and Shariah boards often have divergent views
on key Shariah issues. In this regard, there is no practical guide as to what
constitutes an acceptable Islamic financial instrument. A document or structure may
be accepted by one Shariah board but rejected by a different Shariah board.
4.2.1. Shariah Supervisory Board Standards
Until recently there was a lack of unique requirements and standards
regarding the composition, characteristics and functions of Shariah
Supervisory Boards. However as the industry grows, they are increasingly
important in order to create a level playing field for all Islamic financial
institutions. By today, approaches to harmonize essential standards are taken
by the “Accounting and Auditing Organization for Islamic Financial
Institutions” (abbreviated AAOIFI, please refer to chapter 4.3.2.). An
increasing number of financial insitutions committs to the “Accounting and
Auditing General Standards for Islamic Financial Institutions ” (AAGSIF)
issued by the AAOIFI.
4.2.2. Characteristics of a Shariah Supervisory Board
For every fully-fledged Islamic bank it is obligatory to have a permanent
Shariah Supervisory Board. (Iqbal and Mirakhor 2007) This religious
committee is characterized in three features, being the qualification of its
members, their independence from the financial institution and the binding
nature of its decisions for the respective financial institutions (Zamir Iqbal
and Abbas Mirakhor 2011).
81
Qualification
According to the AAOIFI (please refer to 4.3.2.) a Shariah
Supervisory Board should consist of at least three Shariah scholars,
who must have a comprehensive education in legal questions (Fiqh
Mu’amalat, please refer to 1.3.1.) (Zamir Iqbal and Abbas Mirakhor
2011). Traditionally the scholars’ reputation in public, achieved by
excellent education and a high position in society, was most decisive
for their appointment (Altundag und Nadia 2005). Today the
financial expertise of the Sharia Supervisory Boards members
becomes increasingly important as they have to assess financial
instruments, products and processes that are becoming more and
more complex (Zamir Iqbal and Abbas Mirakhor 2011) there are
currently not more than fifty scholars worldwide who fulfill both of
the prementioned requirements. Often, one Sharia scholar holds
several mandates in various Sharia Supervisory Boards of different
financial institutions and additionally in standard setting
organizations like the AAOIFI. The shortage of adequate Scharia
Scholars hinders the development of this industry as religious
supervision is one of the most important features in Islamic banking.
Out of the funds that report their assets under management, the majority
hold assets below $50 million. Only very few funds hold assets under
management in excess of $ 500 million, the amount which for conventional
funds is deemed to be benchmark size.
Figure 17 -- Average assets under management (own illustration)
The geographic investment mandate of the majority of shariah-compliant
funds focuses on Asia, the Middle East51
and Africa or has a global mandate.
50 http://www.lipperweb.com/default.aspx 51 Eurekahedge: There is a wide variety of asset managers operating and investing in the Middle East. They run the gamut of large
international banks and independent money managers to local entrepreneurial firms that are gaining assets and attention. There is believed to be more than US$15 billion in assets in about 125 Islamic funds worldwide. The asset managers with the highest number of
funds include Wellington Management Co, Pictet & Cie, Worms & CIE/SEDCO, Al Rajhi Banking & Investment and Azzad Asset
Management. Some estimates place the number of funds overall in equities, structured products and real estate at more than 500, including both open and closed funds.
Prominent local financial institutions in the Middle East and Southeast Asia include Dubai Islamic Bank, Global Finance House
(Bahrain), National Commercial Bank (Saudi Arabia), Bank Islam Malaysia and Bahrain Islamic Bank, among many others. Asset management firms active in Shariah fields include international money managers such as Société Générale Asset Management
Alternative Investment and numerous entrepreneurial asset managers in the local markets. Although the Islamic asset management
market has existed for some time, progress has only really occurred in this decade, specifically with advancements in the capital markets, coupled with Middle Eastern and Asian governments updating regulation and formalising greater acceptance of a foreign presence in
their countries. These changes have created a market considered ripe with opportunity, attracting multinational foreign firms.
A few foreign, conventional, multinational firms that focus on the capital market side of the business have extended their participation into Shariah asset management through their firms’ money management divisions active in the capital markets or asset management. Two
notable firms with Shariah-compliant asset management products are HSBC, which works through its Amanah Capital division, and
UBS, which operates under Noriba Bank. Barclays wealth division launched a presence in Dubai in 2007.
0%
10%
20%
30%
40%
50%
60%
70%
80%
Below $50 million $50 million - $ 100million
$100 million - $ 500million
In excess of $500million
109
Most funds have a fairly wide remit within which they invest. Few funds
have specific focus on sub-segments such as the gulf cooperation Council
In excess of 65 per cent of the funds listed does not specify a particular
industry, but reports all industries are in scope of the investment mandate.
Generally, the types of fund offered are similar to the ones offered in the
conventional world. The funds are divided into following broad categories:
1. Fixed income funds
2. Lease funds
3. Commodity funds
4. Equity funds
a) Private equity
b) Public equity
c) Equity index funds
5. Real state funds
6. Exchange traded funds
7. Hedge funds
0%
5%
10%
15%
20%
25%
30%
35%
40%
NorthAmerica
Global Europe Emergingmarkets
Asia Pacific Middle East& Africa
110
Box-4 How to Invest Today According to Shariah according to
Eurekahedge (2009)
How to Invest Today According to Shariah
Islamic asset management is no different than conventional asset management when it
comes to constructing a portfolio that will have a high probability of achieving an
investor’s goals. To do that, an investor seeking professional investments with competent
fatwa does not need to sacrifice anything: not performance, not transparency and not
pricing.
The process starts by choosing an asset manager who understands Shariah. For many
bankers, the entire concept of socially conscious investing is perfectly acceptable, but the
idea of Shariah-compliant investing is strange and exotic. It is not. Shariah is not rocket
science, understood only by a rare qualified few. It is the guiding principles of a faith
with over a billion adherents. Surely such a popular and common religion does not exist
based on mysteries and secrets. The moral precepts of Shariah are abundantly clear to
anyone who wishes to pick up a copy of the Holy Quran. Bankers unfamiliar with Islam
will find nothing alien in Shariah, in particular when it comes to Shariah compliance of
investment products.
The community of generally accepted Shariah scholars makes it easier for the novice
investment manager to achieve a balanced and professional portfolio allocation. By
choosing assets that have been granted a fatwa by that group of Shariah specialists who
closely follow financial markets, any investor or asset manager can start the process to
assemble a portfolio allocation that meets both Shariah and MPT standards.
All that said, we are living in dangerous times. One major investment company chairman
declared earlier this year that nearly 40% of worldwide wealth had been destroyed by the
global credit crisis. Clearly we have to be careful.
Being careful means diversifying your assets. It means not overloading on any single
asset class, but instead ensuring that your portfolio is carefully constructed with certain
amounts of cash, fixed income, stocks and alternative investments. A typical allocation
111
today for a non-Muslim investor might be 5% in money market investments (cash), 45%
in a diversified mix of bond funds (fixed income), 35% in a globally diversified
allocation of stock funds, and 15% in a mix of real estate funds, hedge funds, commodity
funds and other alternative investments (but no structured products, please!). This
provides no guarantee of outstanding performance in the short-run, but it does guarantee
that your savings are protected from the worst of the swings we have seen in the world
today.
A Muslim investor who wants to achieve the same objectives can do so, as long as he
seeks the aid of a dedicated professional who understands both Shariah compliance and
MPT. Proper security selection can now be made at every level of the allocation
spectrum, from cash to fixed income to stocks to alternative investments, all with
respectable fatwa from notable Shariah scholars. While presently there is a dearth of
professional managers in Islamic asset management sector, with the high demand this
trend is likely to change.
The Shariah asset management industry is small but growing. Shariah investment
products are found most easily on the equity side of the business. The Shariah committee
screens or filters listed securities according to the restrictions and requirements of
Shariah law. Portfolio managers then use the approved list of securities to construct an
investment portfolio. For the bond and derivative asset classes, an entire industry has yet
to be developed, and capital market participants are just gearing up to the market’s
demand for products.
Shariah investing requires trained religious scholars who combine an understanding of
Islamic law with a firm grasp on the financial markets. It is a unique combination,
particularly given the relatively young industry of Shariah investments and a still new
capital market. Global estimates claim that there are about 250 qualified religious
scholars and only about two dozen or so that are internationally known, and who are
therefore coveted to help design and approve investment products. Portfolio managers
must have trades approved by the Shariah committee.
Islamic institutions and governments are now advocating the training of additional
scholars to create a broader base of available and qualified individuals and to create a
future pipeline of scholars. Several have set up funds to develop more scholars.
112
VI. ISLAMIC RISK MANAGEMENT
6. IF Risk Management
Islamic banking is a relatively new concept and its instruments are generally not well
comprehended, neither are their risks. Risk management in Islamic banks deserves special
attention. However, it has many complex issues that need to be better understand. In
particular, the nature of specific risks facing Islamic banks together with the virtually
unlimited number of ways available to them to provide funds through the use of
combinations of the permissible Islamic modes of financing – PLS and non-PLS – raise a
host of issues in risk measurement, income recognition, adequacy of collateral and etc.
Thus, innovative solutions and an appropriate adoption of available risk management are
needed to reflect the special characteristics of Islamic financial products and services.
Several studies have identified weaknesses and vulnerabilities among Islamic banks in the
areas of risk management and governance. Operational risk, which arises due to the failure
of systems, processes, and procedures, is one area of concern. Weak internal control
processes may present operational risks and expose an Islamic bank to potential losses.
Governance issues are equally important for Islamic banks, investors, regulators, and other
stakeholders. The role of Shariah boards brings unique challenges to the governance of
Islamic financial institutions.
6.1. Specific Risk Surrounding Islamic Banks
The features of Islamic banks and the modes of financing that they follow include
special risks that needed to be recognized to help make risk management.52
The PLS
modes of financing raise several important considerations. Specifically, while PLS
modes shift the direct risk of Islamic banks to their investment depositors, they may
also increase the overall degree of risk of the asset side of banks. In practice, PLS
52 Special risks in Islamic banking can be seen in Chapra and Khan (2000).
113
modes make Islamic banks vulnerable to risks normally borne by equity investors
rather than holders of debts. There are a number of reasons for this, including:
The administration of PLS modes is more complex than conventional financing.
These modes imply several activities that are not normally performed by
conventional banks, including the determination of profit / loss sharing ratios on
investment projects in various sectors of the economy, as well as the ongoing
auditing of financed projects to ensure proper governance is doing. Also, there is a
number of activities that Islamic banks can engage in, in addition to a number of
ways they can provide funds through the use of the PLS and non-PLS modes.
When Islamic banks provide funds through their PLS facilities especially in
Mudarabah contract, there is no recognizable default on the part of the entrepreneur
until PLS contracts expire. A default of PLS contracts means that the investment
project failed to deliver what was expected. In this case the low profit or loss is
shared between parties according to stipulated PLS ratios.
Islamic banks have no legal means to control the entrepreneur who manages the
business financed through Mudarabah contracts. This individual has complete
freedom to run the enterprise according to his judgment. Banks are entitled only to
share profit or loss from the agent according to the contract ratio. In Musharakah
and direct investment contracts, banks have better opportunities to monitor the
business because, in these contracts, partners may influence on the enterprise and
use the voting rights.
In Islamic finance PLS modes cannot logically be made with collateral or other
guarantees to reduce credit risk.
The mentioned considerations underline operational risk in Islamic banking.
Operational risk may arise from various sources:
The unique activities that Islamic banks must perform.
The non-standardized nature of some Islamic products.
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The lack of an efficient and reliable Shariah legislation system to
enforce financial contracts.
Non-PLS modes of financing also carry special risks that need to be recognized.
Specifically, Salam (purchase with deferred delivery) contracts expose Islamic
banks to both credit and commodity price risk. This is because banks agree to buy
the commodity on a future date against current payment and also hold the
commodity until it can be converted to a cash. Similar risk is also involved in Ijarah
(leasing), because this contract do not provide Islamic banks with the ability to
transfer substantial risks and rewards to the lessee as leased assets must be carried
on the balance sheet of banks for the term of the lease.
In the liability side, the specific risk inherent the operations of Islamic banks arise
from the special nature of investment deposit, that is the capital value and rate of
return are not guaranteed. This feature coupled with asymmetric information
resulting from the unrestricted PLS and non-PLS contracts where banks manage
deposit of people at their own discretion.53
This increases the potential of moral
hazard and creates an incentive for risk taking and for operating Islamic financial
institutions without adequate capital.
6.2. General Risk Surrounding Islamic Banks
In addition to the specific risks mentioned above, there are other more general
factors that make the operation of Islamic banks riskier and/or less profitable than
traditional banks. These are:
Lack of risk-hedging instruments. The prohibition against riba and some
fiqh issues in the interpretation of gharar mean that many risk hedging
instruments based on traditional tools, such as option, futures and
forwards are not available to Islamic banks in the current state of Islamic
banking.
53 According to the unrestricted contract, depositors agree that their funds be used by banks at their discretion and they expect to share
with banks the overall profits that the bank may earn.
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Underdeveloped money market and government securities based on
profit – loss sharing. This may difficult to manage the liquidity in term
of mismatching the asset-liquidity and increases the liquidity shocks.
Fortunately, significant progress has been made in Iran for government
securities and short-term instruments such as National Participation
Certificates and Central Bank Musharakah for such issues.
Limited availability to access to lender- of- last resort (LOLR) facilities
by central banks. The lack of Shari’ah-compatible LOLR facilities is
associated to the prohibition of interest and thus discount rate.
Islamic banks have historically been forced to hold a large proportion of
their assets in reserve accounts in central banks or in correspondent
accounts than conventional banks. This has significantly affected their
profitability because central banks give minimum or no return to these
reserves. This in turn, has affected their competitiveness and increases
their potentiality to the external shocks with its consequences.
6.3. Reducing Risks of Islamic Banks
Islamic banks bear considerable risks in providing their products and conducting
their business. These risks include firstly those faced by conventional banks
likewise (for example the credit risk), moreover Islamic banks are often unable to
afford high-cost management information systems or the technology to assess and
monitor risk in a timely fashion. With weak management and lack of proper risk-
monitoring systems, the risk exposure of Islamic banks is high. (Iqbal 2011).
However additionally they are affected by additional risks unique to Islamic banks
“owing their compliance with the Shariah” (Ahmed and Khan 2007).
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Based on the list in Ahmed and Khan (2007) and in comparison with several other
literature sources54
, the most important risk classes for Islamic banks are outlined
below.
6.3.1. Credit Risk
The Credit Risk can be defined as “the potential that the counterparty fails to
meet its obligations in accordance with agreed terms” (IFSB 2005). The
claim for interest paid on overdraft is forbidden, like every form of interest,
and cannot be used to compensate the banks shortfall in payment. Credit risk
can arise, for instance, out of a Murabaha contract (please refer to 3.2.1.)
when the counterparty fails to fulfill the debt. The IFSB defines in its
principle guideline 1 (please refer to 1.3.6.2) a subcategory of credit risk,
being the “Equity Investment Risk”. This relates in particular to the risk
exposure in equity participations in Mudarabah and Musharakah contracts
(please refer to 3.1.1. and 3.1.2.). (Islamic Financial Services Board[2]
2005) The bank is exposed to the risk that the counterparty does not redeem
the shares if due or provides false information about generated profits. In
these cases the bank has little opportunity to counteract. (Ahmed and Khan
2007)
6.3.2. Market Risk
Market risk refers “to the potential impact of adverse price movements on
the economic value of an asset” resulting in a “loss in on- and off-balance
sheet positions” (Islamic Financial Services Board[2] 2005). The systematic
market risk arises out of macro sources. In Islamic Finance and Banking a
typical example is the “mark-up risk” comprised in Murabaha contracts. As
explained banks usually use a benchmark to price their product, for example
the LIBOR.
54 Please refer also to the Risk Management Standard of the Islamic Financial Services Board[2] 2005, Zamir Iqbal and abbas Mirakhor
(2011) Chapter Risk Management.
117
However an important prerequisite for the product’s Shariah compliance is
that the mark-up is fixed in advance. Assuming a Murabaha contract over a
longer duration, the benchmark, in this example the LIBOR, may change
significantly whereas the mark-up has to stay the same. (Ahmed and Khan
2007) In this way the bank might be charged higher mark-ups in short-term
liquidity transactions with other banks than it receives.
The unsystematic market risk is asset or instrument specific. All Mudarabah,
Musharakah, Bay Salam and Ijarah (please refer to chapters 3.1.1., 3.1.2.
and 3.2.2.) contracts comprise the commodity/ asset price risk. It emerges
out of the fact that the bank buys a durable asset on behalf of its customers
and might, in case the customer does not fulfill his obligation, be forced to
resell the commodity for the lower price.
6.3.3. Liquidity Risk
In general it is problematic for Islamic banks to “obtain cash at reasonable
cost”, also called “funding liquidity risk”, and to sell assets at a profitable
price, also called “asset liquidity risk”. This is due to three obstacles. Firstly
there are strict Fiqh restrictions (please refer to 1.3.) on the securitization of
debt instruments leading to the fact that banks have problems to sell its
receivables. Secondly the inter-bank money market for Islamic banks
develops very slowly. The main reason for this dilemma is that conventional
money market instruments “cannot or hardly be converted to a Shariah-
compliant form” (please refer to chapter 4.2.). Therefore Islamic banks
cannot raise funds quickly from the market. Finally the lender of last resort
facilities provided by central banks are not accessible for Islamic banks as
they are all based on interest.55
(Ahmed and Khan 2007)
55 There exist some exceptions, for example in Malaysia. There the Bank Negara offers interest-free lending
facilities to Islamic financial institutions. (Bank Negara Malaysia 2005)
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6.3.4. Operational Risk
The Basel Committee on Banking Supervision (2004) defines operational
risk as follows: “Operational risk is defined as the risk of loss resulting from
inadequate or failed internal processes, people and systems or from external
events. This definition includes legal risk,56
but excludes strategic and
reputational risk.”. In Islamic banking the personal risk is especially high
due to the infancy of the industry, for example lacking qualified
professionally or appropriate IT infrastructure.
6.3.5. Legal Risk
The legal systems (except Sudan, Pakistan and Iran) do not provide for or
even hinder of the activities of Islamic financial institutions. Regulations
aligned with the conventional system might constrain Islamic bank’s
efficiency or make certain transactions impossible. Transactions and
contracts are only standardized to a small extent and banks have to invest
considerable time and money in the negotiation of complex transactions.
Finally Islamic law is not enforceable in front of courts in Non-Muslim
countries so that Islamic banks might have problems to sue counterparties
who failed to fulfill their obligations. (Ahmed and Khan 2007)
6.3.6. Displaced Commercial Risk
The displaced commercial risk can also be referred to as “rate of return risk”
according to IFSB 1 and “derives from competitive pressures on IIFS to
attract and retain investors (fund providers)” (IFSB 2005). Ahmed and Khan
(2007) give an example: In case the Islamic bank is not able to “offer
competitive rates of return” compared to its peer group (including
conventional banks) due to the restrictions of Shariah, it may be forced to
56 Legal risk includes, but is not limited to, exposure to fines, penalties, or punitive damages resulting from supervisory actions, as well as
private settlements.
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“apportion part of [its] own share in profits to investment depositors” in
order to avoid that depositors withdraw their funds. (Ahmed and Khan 2007)
6.3.7. Shariah Risk
Shariah risk describes “the risk that the terms agreed in the contract do not
effectively comply with Islamic jurisprudence and thus are not valid under
Islamic law” (Solé 2007). It can be minimized by constant monitoring of a
Shariah Supervisory Board or Shariah adviser. However it might still be
rejected by other Shariah scholars or customers, as the interpretation of
Islamic law is not uniform. Consequently the product has to be withdrawn
from the market and restructured and the Islamic bank might lose in
reputation within the Muslim community. Furthermore it is possible that
standard setting organizations change the requirements and likewise the
competitive basis for the financial institutions. The Frankfurter Allgemeine
Zeitung (2008) reported the following example. In March 2008 the AAOIFI
(please refer to 4.3.2.) tightened the regulations for the emission of Sukuk
(please refer to 3.4.2.). Its scholars declared that most products available on
the market are not compliant with Islamic faith because issuers are
guaranteed to receive the original face value at maturity on the buyback of
the respective commodity, no matter whether it generated profit or loss.
Such transactions are now forbidden according to the AAOFIF as the
investor and issuer have to participate both in profits and losses equally
generated by the commodity. Fortunately already issued Sukuk did not have
to be restructured but only new ones. However Sukuk issued before the
change might be rejected by some investors and banks have to invest in the
product development of the new Sukuk.
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6.3.8. Risk Management Techniques And Regulations
Regarding the product descriptions in chapter 1.2 and the various types of
risk mentioned in this chapter, it becomes obvious that “Islamic banking
goes beyond the pure financing activities of conventional banking” (Lewis
and Algaoud 2001). Therefore risk management and diversification of risk is
of utmost importance. In the following several approaches to deal with the
high risk exposure are presented.
Firstly most Islamic banks have a strong preference for particular contracts.
For example, they prefer a debt financing mode (like Murabaha) over an
equity participation (like Musharaka) in order to limit the potential loss. In
this way the original “twin pillars” (Lewis and Algaoud 2001) of Islamic
banking, being Musharakah and Mudarabah contracts (please refer to 3.1.1.),
lose importance compared to more innovative and more secure modes of
financing, for example Ijarah (please refer to 3.3.) and Sukuk issuance
(please refer to 3.4.2.).
Secondly banks establish extensive “reserve funds out of past profits”
(Lewis and Algaoud 2001) to compensate major losses resulting, for
example, from counterparty default in a partnership contract (Musharaka or
Mudaraba). Consequently they hold a higher, more conservative, level of
equity in relation to debt compared to conventional banks that usually
operate with higher leverage ratios (Lewis and Algaoud 2001). Due to large
conceptional difference compared with the conventional system, regulatory
frameworks like Basel II57
can only be adopted in Islamic banking to a small
extent. However the standard setting organization IFSB mentioned in
chapter 4.3.3. issued own guiding principles for risk management and capital
adequacy that “serve to complement BCBS’s guidelines in order to cater for
the specifities of IIFS [Institutions offering only Islamic Financial Services]”
57 The Basel Committee of Banking Supervision (BSCB) is a standard-setting body on all aspects of banking supervision in the conventional (interest-based) banking system. The framework “Basel II” provides a measure and a minimum standard for capital
adequacy that is implemented by various national authorities. (Bank for International Settlement 2008)
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(Islamic Financial Services Board[2] 2005). These are in particular the
standards “IFSB 1: Guiding Principles of Risk Management for Institutions
(other than Insurance Institutions) offering only Islamic Financial Services
(IIFS)” and “IFSB 2: Capital Adequacy Standard for Institutions (other than
Insurance Institutions) offering only Islamic Financial Services (IIFS)”
(IFSB 2005).
It is quite problematic to structure derivatives in compliance with Shariah.
(Gassner and Wackerbeck 2007). Eventhough the demand is increasing such
instruments are very rare in the Islamic banking system, so far. This leads to
major difficulties in efficient risk management.
6.3.9. Suitable Clear Information Strategy
A Clear information system in Islamic banks is more important than the
conventional banking system. This is because the impact of PLS methods on
depositors and the need for such investments is at the core of Islamic
banking. The more depositors are needed, the more public disclosure of
information about banks’ strategy become necessary to enable depositors to
monitor banks’ performance. Moreover, in the Islamic banking system,
depositors have more incentives to monitor banks operations than traditional
banks, because in Islamic banks return to depositors depends on the
performance of the bank. Monitoring ensure depositors that the rates of
return paid to them reflect the application of PLS principle, which are the
cornerstone of Islamic finance, by banks and also reduces the possibility of
asymmetric information and thus, adverse selection and moral hazard. The
advantageous of such a system are:
This System helps depositors to choose a specific bank in which they
can allocate their funds according to its performance.
A clear information system in Islamic banks assists depositors with
regard to diversification of their portfolio.
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Disclosure provides information on the main risk factors associated
with the investment portfolio.
Good governance and internal controls which reduce
mismanagement and also brings market confidence for banks.
Providing data for depositors for the expected rate of return which is
an important consideration of the public.
Providing information on the education and professional background
of the banks’ staff and management.
The basis for the above considerations for more developing of Islamic banking in the future
is an Islamic financial regime which could compete with the international financial
organizations.
One of the major pillars required to be put in the place in order to strengthen both
international and domestic financial system is; to develop a uniform supervisory and
regulatory frameworks which are consistent with internationally accepted practices for
banks and non-banks financial entities. Organizations such as Islamic Development Bank58
(IDB) in Saudi Arabia can play a major role in the development of Islamic banks and the
essential dissemination of information on the above issues to its global membership. The
issues include such vital topic as:
The need for regulation and uniform supervisory of Islamic Banks.
Issues of risk management and guidelines on risk weight of assets.
Capital adequacy, liquidity management and issues of controlling of
the asset side of Islamic banks.
Issues in profitability and good governance.
In the next chapter will be discussed the development of IF and its Issues/Challenges.
58 http://www.isdb.org
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VII. ISLAMIC BANKING AND FINANCE:
ON ITS WAY TO GLOBALIZATION
7. History and Current Development of Islamic Finance
Being the third and last “great monotheistic religion” the Islam counts over 1.2 billion
followers worldwide and is the second largest religion in terms of numbers after
Christianity. It was “promulgated by the Prophet Muhammad in Arabia early in the 17th
century” (Lewis and Algaoud 2001) and spread around the world since then. Today
Muslims constitute the majority of population in more than 40 countries (for example
Malaysia, Indonesia, Saudi Arabia, Bahrain). Further to over 18 million59
live in Western
Europe. (Lewis and Algaoud 2001) It is important to mention that the Muslims population
is growing faster with 1.8 percent per annum (see Figure 19) than the rest of the population.
(Walker, et al. 2007)
Figure 19 -- Muslims as a Share of world population, 1990-2030 (Pew Research
Center)
59 Pew Research Center’s Forum on Religion & Public Life • The Future of the Global Muslim Population, January 2011
124
Figure 20 -- Muslims population by Region, 1990-2030 (Pew Research Center)
7.1. Historical Milestones
Islamic vision of socio-economic justice is based on abolishing interest and all other
exploitative elements from the economic sphere. The Islamic financial system
facilitates lending, borrowing and investment functions on a risk-sharing basis. This
allows market forces to determine the productivity of capital rather than fixing it in
priori as an ‘‘interest rate’’ to sabotage the free market mechanism and encourage
speculative use and hoarding of capital. The Islamic financial system ensures the
optimal rate of capital formulation and its efficient utilization leading to a
sustainable economic growth and fair opportunities for all. It is a value-based
system that primarily aims at ensuring moral and material wellbeing of the
individual and society as a whole (Naqvi, 1982; Zarqa, 1983; Ahmed, 1994;
Siddiqi, 2000). The Islamic banking and finance discipline is nearly four decades
old. The conceptual developments of Islamic banking took cognizance in late 1940s
and in the next two decades, they got to a point of yielding a model which was
adopted in the Middle Eastern countries to fulfill their aspiration of having their
own banks. Many reputable Islamic banks came into being in 1970s that included
Nasser Social Bank Cairo (1972), Islamic Development Bank (IDB) (1975), Dubai
Islamic Bank (1975), Kuwait Finance House (KFH) (1977), Faisal Islamic Bank of
Sudan (1977) and Dar Al-Maal Al-Islami (1980). In early 1980s, the nascent
125
industry took the world by surprise when three Muslim countries, namely, Iran,
Pakistan and Sudan decided to transform their economies and financial sector on
Islamic lines. The Western financial market players such as Citibank, ABN AMRO,
HSBC and others established their own Islamic windows or subsidiaries to attract
petrodollars’ deposits from the Middle East and Muslims clientele in local markets.
The Islamic banking and finance system continued to grow by seeking innovation
and diversity of products, clientele and markets. It has been growing in areas such
as Sukuk, Takaful, hedging funds, Mutual Funds, private equity and assets
management, wealth management, real estate, corporate finance, liquidity
management, treasury, derivatives, swaps, future and forward market, Islamic Stock
Exchange and Dow Jones Islamic Index.
Islamic banking and finance activities are mainly clustered around three parts of the
world that include the Middle East, South Asia and Southeast Asia.
The Middle East, overwhelmingly populated by Muslims, is a motherland of
Islamic banking and finance. Islamic banks enjoy strong support from rich
individuals, governments and other state institutions in the Middle East. The
majority of regulatory and other supporting bodies of the Islamic banking and
finance industry are located in the Middle East. The Gulf countries have decided to
merge their monetary and central banking systems by 2010. These developments
will bear far-reaching impacts on the Islamic banking and finance industry in the
Middle East and worldwide. Referring to South Asia, Islamic banking has been
recently revived in Pakistan under the duel banking system. Bangladesh has been
following more rigorous Islamic banking policies under the increasing market and
public demands. India and Afghanistan may adopt Islamic banking operations in the
near future. Three Southeast Asian countries, namely, Indonesia, Malaysia and
Singapore are promoting the most comprehensive and advanced version of Islamic
banking and finance in their region so as to attract Islamic business and finance
from the Middle Eastern countries and elsewhere.
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The government of Sudan has recently adopted more pragmatic approach to
promote the Islamic banking and finance practice in the region. Islamic banking and
finance is gaining momentum in the USA and European countries. These countries
are now more willing to bring changes to their banking and tax laws so as to allow
the Islamic banking and finance practice in their markets. The increasing number of
ethically based business organizations and individuals worldwide are dealing with
Islamic financial institutions. The Middle East Southeast Asia and South Asia are
the main emerging hubs of Islamic banking and finance. At present, there about 300
Islamic banking and financial institutions across 75 countries, holding a paid-up
capital of over US$13 billion, controlling assets worth US$300-US$500 and
investments US$500 billion-US$800 billion, with an average annual growth of 15
per cent over the past five years to reach over $1trillion in March 2011, suggesting
robust demand for Islamic investing. It is expected Islamic finance will continue to
grow at this rate for the next few years and that total assets in Islamic finance could
reach US$4 trillion to US$5 trillion by 2015. (HSBC Amanah)
7.2. Islamic Banking and Finance in the Middle East
The Middle East is the mainstream of Islamic banking and finance. Islamic financial
institutions are making individual and collective efforts to develop a wide array of
innovative, customer-oriented and competitive products services to their clientele. It
is their core objective to get strong hold over the indigenous oil-wealth and
discourage its outgoing to financial institutions in the European and Western world.
Recent market developments suggest that the Islamic banking and finance industry
is a big success and enjoys a very strong regional support. An increasing number of
conventional financial institutions in the Middle Eastern markets are converting
their operations either fully or partially on Islamic lines, which could pose a serious
threat to a long established legacy of conventional banking in the region.
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7.2.1. Bahrain
Bahrain is sitting on the top of Islamic banking affairs worldwide. It is the
house of Islamic banking practice, regulations, research, innovation and
scholarship. It hosts the largest number of Islamic financial institutions and
other supporting bodies. In 1978, the first Islamic bank – Bahrain Islamic
Bank – was established in the country. There are over 400 financial
institutions in Bahrain, out of which 33 are Islamic with a total capital of
US$2.24 billion. Islamic banking operations in Bahrain are undertaken by
full-fledged commercial banks, offshore banking units and investments
banks. A significant number of Islamic banks use Bahrain as a base to
operate in the Gulf, European Union and North America. Bahrain hosts the
biggest Takaful industry of the Islamic finance world. Presently there are
more than 26 Takaful and three re-Takaful companies in Bahrain. Dubai
International Financial Centre is promoting trade in Sukuk at regional and
international levels. Bahrain plans to establish Sukuk Exchange Centre
which will enhance the investment and liquidity options for Islamic financial
institutions in the Middle East and elsewhere. The Islamic mortgage industry
is rapidly growing in Bahrain due to prolonged boom in its real estate sector.
Business firms and individual investors in Bahrain are increasing their
reliance on Mutual Funds. Islamic financial institutions have secured
unprecedented growth in Bahrain in terms of income, assets and deposits
over the years. They are expected to experience further growth down the
track.
The Bahrain Monetary Agency has developed internationally recognized
standards, regulations and infrastructure for Islamic financial institutions. It
is very keen on increasing the co-operation among main players of Islamic
banking in the Middle East and worldwide. It is actively contributing in the
pool of Islamic banking training and research. It has developed a network of
Islamic banking research and regulatory institutions such as Accounting and
Auditing Organization for Islamic Financial Institutions, International
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Islamic Financial Market and Islamic International Rating Agency. These
institutions are making significant efforts to strengthen the base of Islamic
banking and finance and make it more dynamic and competitive in local and
international financial markets. Bahrain is making worthwhile contributions
to improve Islamic banking systems such as regulatory frameworks,
accounting standards, capital adequacy, liquidity, asset management,
hedging, corporate governance, etc. The country has assumed a key role in
developing the Islamic financial market in the areas that include asset
securitization, syndicated financing and credit, collective investment
schemes, Mutual Funds, Sukuk, Takaful, etc. Islamic financial institutions in
Bahrain enjoy greater community recognition and support. For example, 91
per cent of new staff appointments in 2001 consisted of citizens of Bahrain.
7.2.2. Iran
It is a novel feature of Islamic banking practice in Iran that it has been
adopted at state level since the Islamic revolution 1979. In the early two
decades of Islamic banking practice, the Iranian banking sector was highly
centralized and did not share much from the pool of knowledge, experience
and developments in global markets as well as Islamic banking world. After
mid-1990s, however, the Iranian government showed some inclination
towards adopting privatization and deregulation in the financial sector. In
1997, the central bank of Iran – Bank Markaz – issued licences to a number
of credit cooperatives, interest-free Qardhul Hasan centres and three non-
bank credit institutions to launch their operations in Iran. Since 1999 foreign
banks have been working in the designated free trade zones of Iran. The
private banking sector started to build up in Iran at the beginning of twenty-
first century. In December 2001, the first private bank – Bank Karafarin –
was granted a licence to commence its operations in Iran. Two private
banks, Bank Eqtesdae-e Novin and Bank Parsian emerged in the Iranian
129
market. The Iranian government denationalized its two banks, i.e. Bank
Saderat and Bank Rfah-e Kargaran to enhance the diversity of private
banking sector in the country. Presently, more than 44 applications for
establishing private banking and financial institutions in Iran have yet to be
decided by the Bank Markaz. The Iranian government has been working on
evolving more flexible, competitive and innovative financial system in the
country. The growing global exposure and deregulation of the oil-rich
Iranian economy and financial sector may bear far-reaching implications on
Islamic banking growth and development in Iran. The Iranian government
should achieve greater integration of its Islamic financial sector with global
finance as well as the Islamic banking and finance world.
7.2.3. Jordan
Jordan Islamic Bank has been dominating the Islamic banking practice in
Sudan since 1978. Presently, it operates through 64 branches and cash
offices established across the country. It also offers mutual insurance funds
and products in the financial market of Jordan. It held 10.8 per cent of total
investment facilities of the local Jordanian banking industry in 2005 (Jordan
Islamic Bank, 2005). In March 1997, another Islamic bank –Islamic
International Arab Bank – was established in Jordan. It has 12 branches that
offer a wide range of products and services to their customers. Its assets and
income amounted over US$5.71 billion and over US$3.348 million,
respectively, at the end of 2011. Takaful or Islamic insurance services and
Sukuks are becoming popular in business and finance spheres of Jordan.
Jordan’s Investment House for Financial Services (Investhouse) has decided
to establish an Islamic financing company in the country. Recently, the
government inserted the Articles 50-59 in the Banking Constitution of
Jordan so as to provide proper legal cover to Islamic banking activities in the
country. The government of Jordon aims to use Islamic banking and finance
130
as a tool to attract business and investments from regional and international
players of the Islamic banking world.
7.2.4. Kuwait
Kuwait hosts the largest number of Islamic financial institutions. It has been
ranked as third in terms of holding the Islamic banking assets of worth
US$22.7 billion. It is estimated that Islamic financial institutions in Kuwait
will manage funds about US$60 billion by 2015. The establishment of KFH
in 1977 laid down the foundation of Islamic banking in Kuwait. KFH has
made great success over time and presently, it has been successfully
competing with 12 conventional banks and three specialized government
banks in the Kuwaiti financial market. The National Bank of Kuwait and
some other conventional banks also offer a wide range of Islamic financial
products and services in Kuwait. In early 2006, Kuwaiti Parliament gave
approval for the establishment of two new Islamic financial institutions,
namely, Jaber Islamic bank and Jaber Funds in the country. A new Islamic
bank, Boubyan Bank, will launch its operations very soon in the country.
Kuwait Retail Estate Bank has decided to gradually transform itself into a
fully dedicated Islamic entity. Islamic finance and insurance activities have
also rapidly grown in Kuwait.
Currently, five Takaful and one re-Takaful companies are operating
alongside 18 conventional insurance companies in Kuwait. They hold a 14
per cent share of the Kuwaiti insurance market (Islamic Finance news).
There is an increasing demand for Sukuk in the corporate and real estate
sectors and the government is working on developing proper regulatory
framework for Sukuk market. The FTSE Doha International Financial
Latvia, Lithuania, Luxembourg, Malta, Netherlands, Poland, Portugal, Romania, Slovakia, Slovenia, Spain, Sweden, Switzerland, United
Kingdom. 61 Rodney Wilson, Economics, Ethics and Religion: Jewish, Christian and Muslim Economic Thought, Palgrave Macmillan, London,
1997. 62 Rodney Wilson: This section is based on an address given by the author to the Union of Arab banks in Brussels on 29 June 2007.
170
Europe (see Figure 27 and 28). Thanks to the emergence of Islamic banking,
knowledge transfers in finance have become a two way process rather than simply a
one side affair. European banks have as much to learn from the Arab World as the
latter have from Europe as interdependence replaces dependence.
The increasing spread of Shariah compliant finance, and the dynamism of the
economies where it is important, is making the Euro-Arab financial relationship
more a partnership of equals in the twenty first century. In contrast for much of the
nineteenth and twentieth centuries the Arab economies underperformed those of
Europe, and one explanation for this underperformance was the development of a
financial system in the region based on Riba that was never fully accepted given its
inherent conflict with Islamic values. Fortunately now pious Muslims have a real
choice, as shariah compliant products have been developed over the last three
decades to serve most of their financial needs, and these products are at least as
efficient as their conventional counterparts.
The United Kingdom has been the gateway for Islamic finance to enter Europe,
partly reflecting the role of London as the leading international financial center, but
also as a consequence of the exposure of leading British banks to the Arab and
wider Islamic World and their knowledge of these markets. It was the Arab joint
venture banks that first brought Islamic finance to London in the early 1980s as
Islamic banks in the Gulf found that re-depositing on Murabaha basis could be an
effective tool for liquidity management, with the marks-ups generated from trading
activity on the London Metal Exchange. UK has also hosted the first Islamic retail
bank in Europe, the Islamic Bank of Britain which started operations in September
2004, and the European Islamic Investment Bank, which opened for business in
2006. The leading conventional banks have also become involved in serving the
local retail market for Islamic financial services, notably HSBC and Lloyds TSB,
both of which provide Islamic deposit facilities and housing finance using Shariah
compliant structures.
171
It is of course internationally that European banks have made the greatest
contribution to Islamic finance with Barclay Capital partnering Dubai Islamic Bank
for the world’s largest Sukuk issuances, Standard Chartered making a notable
contribution to Islamic finance through its networks in the Gulf, Pakistan and
Malaysia, Deutsche Bank in pioneering capital protected funds in the Gulf and UBS
in developing shariah compliant wealth management services to name just some
examples. It is operations of these major European banks that will be also reviewed
here.
8.2. Islamic Finance in Europe
The number of Muslims in Europe has grown from 6 million in 1990 to 18 million
in 2010.63
Europe’s Muslim population is projected to exceed 29 million by 2030.
Muslims today account for about 6% of Europe’s total population, up from 4.1% in
1990. By 2030, Muslims are expected to make up 8% of Europe’s population.
Although Europe’s Muslim population is growing, Europe’s share of the global
Muslim population will remain quite small. Less than 3% of the world’s Muslims
are expected to be living in Europe in 2030, about the same portion as in 2010
(2.7%).. The following table provides an overview of the Muslim population and
the potential customer base in mainland Europe.
63 The 2010 population estimates for 25 of the 50 European countries and territories vary significantly from the 2009 estimates contained
in the Pew Forum’s 2009 report Mapping the Global Muslim Population, http://pewforum.org/Muslim/Mapping-the-Global-Muslim Population.aspx. The updated estimates take into account new and better sources of data that have become available since the first report
was published. They also reflect differences between the methodology used in this report and the one used in the 2009 report. (See
methodology beginning on page 165.) The 2010 estimates were calculated primarily by the staff of the Age and Cohort Change project of the International Institute for Applied Systems Analysis, Laxenburg, Austria. Updated population estimates are used for the following
Italy, Kosovo, Luxembourg, Montenegro, Netherlands, Norway, Portugal, Republic of Macedonia, Romania, Serbia, Spain, Sweden, Switzerland, Ukraine and United Kingdom. In all but a few cases, the 2010 estimates are higher than the 2009 estimates. In the
Netherlands, for example, the percentage of the population that is Muslim in 2010 (5.5%) is actually lower than the percentage reported
in the 2009 Pew Forum report (5.7%). IIASA used a newer source from Statistics Netherlands to calculate the 2010 estimate.
172
Figure 27 - EUROPE -- Number of Muslims in Western Europe, 2010-2030
(Pew Research Center)
Figure 28 EUROPE -- Projected Distribution of Muslim Population, 2030 (Pew
Research Center)
173
8.2.1. Shariah Compliant Liquidity Management in Europe
All banks need to maintain liquid assets to meet depositor withdrawals and financial
obligations to other institutions including banks. Rather than merely holding cash,
which yields no return, usually liquid assets are held as treasury bills or repos,
repurchase obligations on which a financial institution which holds these monetary
instruments earns interest.64
Islamic banks cannot hold such instruments, as interest
is regarded as Riba, which is explicitly prohibited in the Holy Quran.65
This
presented a challenge for Islamic banks, as they were required by regulators to hold
liquid assets as part of prudential risk management requirements, but there were no
Shariah compliant liquid instruments available which they could hold.
From 1980 onward a number of banks in London offered Shariah compliant
liquidity management services to Islamic banks from the Gulf and the Jeddah based
Islamic Development Bank. This involved inter-bank wholesale operations, with
banks in London providing overnight deposit facilities for the newly established
Islamic banks in the Gulf. The major institutions involved were the joint venture
Arab banks in London, such as Saudi International Bank and the United Bank of
Kuwait. They accepted deposits on a Murabaha mark-up basis, with the associated
short term trading transaction being conducted on the London Metal Exchange.66
The margins were very small on these buying and selling transactions, but they were
sufficient for the banks in London to offer the Islamic financial institutions in the
Gulf and Jeddah a return which was comparable to that on conventional treasury
bills. The attraction of London was the financial expertise available and the low risk
transactions facilitated by the London Metal Exchange because of the depth of the
market. The joint venture counterparties were not directly involved in the trading,
but rather engaged specialist brokers, notably Dawnay Day, which soon acquired
the knowledge of the Shariah issues that concerned their Gulf clients.67
64 Shelagh Heffernan, Modern Banking, John Wiley and Sons, Chichester, 2005, p. 59. 65 Sura 2:275 66 For a wider discussion of liquidity management issues see Youssef Shaheed Maroun, ‘Liquidity management and trade financing’, in
Simon Archer and Rifaat Abdel Karim, Islamic Finance: Innovation and Growth, Euromoney Books, London, 2002, pp. 163-175. 67 www.dawnayday.com/Display.aspx?&MasterId=019b5780-e3
174
Although the provision of Murabaha facilities as an instrument for liquidity
management remains significant, the real transactions involved result in it being a
relatively costly means of ensuring Shariah compliance. A preferable and less costly
solution is for Islamic banks to hold modified treasury bills that satisfy Shariah
requirements.68
Progress has been slow in developing such instruments, and the
trading of securities based on Bai Dayn69
debt contracts, which is allowed by Shafii
scholars70
in Malaysia, is not permitted by more conservative schools of Islamic
jurisprudence, including those whose opinions prevail in the Gulf.71
European
Shariah scholars tend to follow the more conservative interpretations in the Gulf and
South Asia associated with the Hanafi72
and Malaki73
schools of Islamic
jurisprudence rather than the Shafii School which prevails in Malaysia and
Indonesia.
How to manage liquid assets remains a major matter of controversy in Islamic
finance, not least because many Islamic banks continue to have liquidity well in
excess of regulatory requirements.74
Although the Islamic Financial Services Board
has provided guidelines for regulators on liquidity management, it does not specify
68 Osman Babikir Ahmed, Islamic Financial Instruments to Manage Short-Term Excess Liquidity, Islamic Research and Training
Institute, Islamic Development Bank, Jeddah, 1997, Research Paper No. 41, p. 77. 69
Bay dayn is an Arabic term for “sale of debt” as originated from two words; bay’ which means sale, while dayn means debt. As far as
bay dayn is concerned, it simply means a sale and purchase transaction of a quality debt. The selling of debts is to avoid the occurrence of
riba between two debts and also to avoid any kinds of gharar and makhatara which may arise at the level of inability of a buyer from
possessing what he has bought as it is not permitted that the buyer sold before actual receipt of the purchased item. On 21st August 1996,
The Malaysian Securities Commission Shariah Advisory Council passed a resolution unanimously agreed to accept the principle of bay
dayn as one of the concepts for developing Islamic capital market instruments. This was based on the views of some of the Islamic jurists
who allowed this concept subject to certain conditions for instance there is a transparent regulatory system in the capital market to safeguard the maslahah (public interest) of the market participants. 70Shafii School is one of the schools of fiqh, or religious law, within the Sunni branch of Islam. Named after Imām ash-Shafii, it is
followed by approximately 35% of Muslims worldwide in Southeast Asia, Northeast Africa, the Middle East, and parts of the Indian subcontinent. 71 Resolutions of the Securities Commission Shariah Advisory Council, Kuala Lumpur, 2nd edition, 2006. 72 Among the four established Sunni schools of legal thought in Islam, the Hanafi school is one of the oldest and by far, the largest in parts of the world. It has a reputation for putting greater emphasis on the role of reason and being more liberal than the other three
schools. The Hanafii school also has many followers among the four major Sunni schools. This is largely to its being adopted as the
official madhab of The Abbasid Caliphate, the Ottoman Empire and the Mughal Empire. As such, the influence of the Hanafii school is still widespread in the former lands of these empires. Today, the Hanafii school is predominant in Pakistan, Afghanistan, Bangladesh,
India, China as well as in Mauritius, Turkey, Albania, Bosnia And Herzegovina. It is also practiced in large numbers in other parts of
Muslim world, particularly in parts of the Levant and Iraq. 73 is one of the schools of Fiqh or religious law within Sunni Islam. It is one of the four schools, followed by approximately 35% of
Muslims, mostly in North Africa, West Africa, the United Arab Emirates, Kuwait, in parts of Saudi Arabia, Oman and many middle
eastern countries. In the past, it was also followed in parts of Europe under Islamic rule, particularly Islamic Spain and the Emirate of Sicily. 74 Tariqullah Khan and Habib Ahmed, Risk Management: An Analysis of Issues in the Islamic Financial Industry, Islamic Research and
Training Institute, Islamic Development Bank, Jeddah, 1997, Occasional Paper No. 5.
175
what instruments should be used.75
In Bahrain Salam Sukuk securities have been
developed which serve the same function as treasury bills, but as these are asset
backed, the issuance and redemption involves buying or selling a claim to the
underlying real asset rather than simply acquiring or disposing of debt.76
This has
been approved by the more conservative Shariah scholars in the Gulf as a preferable
alternative to Bai Dayn debt contracts and the Bai Bithaman Ajil77
Sukuk traded in
Malaysia which are backed by financial rather than real assets. A Salam contract
involves a payment for a real asset to be delivered in the future, with the timing of
delivery and the precise details of the asset specified in the contract. In the case of
Bahrain the issuer is the government, the assets are commodities such as aluminum
used by the country’s smelter and the time to maturity is ninety days. Islamic
financial institutions purchase the Salam Sukuk and on maturity are reimbursed
after ninety days with a mark-up representing their return on the asset. On receipt of
these funds they relinquish their rights to the underlying asset which reverts to the
government as the issuer.
At present Salam Sukuk are not traded on a secondary market, even though Bahrain
has a Liquidity Management Centre established for Sukuk trading, as the Shariah
scholars view them as financial instruments and are concerned about the link with
the underlying asset.78
This is a major limitation for Salam Sukuk, as treasury bills
and repos are usually widely traded in secondary markets, resulting in greater
liquidity.
8.2.2. Sukuk Issuance and Trading in Europe
At present there are no Salam Sukuk available in Europe although most countries
have active treasury bill and repo money markets. This presents a problem for
Islamic banks in Europe that have to continue to rely on Murabaha inter-bank
deposits for their treasury management. There is an opportunity to develop markets
75 Islamic Financial Services Board, Guiding Principles of Risk Management for Institutions (Other Than Insurance Institutions) Offering
Only Islamic Financial Services, Kuala Lumpur, December 2005. 76 Rodney Wilson, ‘Overview of the sukuk market’, in Nathif J. Adam and Abdulkader Thomas, (eds.) Islamic Bonds: Your Guide to Issuing, Structuring and Investing in Sukuk, Euromoney Books, London, 2004, pp. 6-7. 77 sale of goods with deferred payment 78 Zamir Iqbal and Abbas Mirakhor, An Introduction to Islamic Finance, John Wiley and Sons (Asia), Singapore, 2007.
176
in Islamic securities in Europe which would attract institutional Shariah compliant
investment from the Middle East as well as serving Islamic banks in Europe.
London is an obvious location given the depth and breadth of its financial markets,
especially as the Islamic Bank of Britain and the European Islamic Investment Bank
are listed on the Alternative Investments Market (AIM). Developing a market in
salam Sukuk is problematic however unless tradability is allowed by the shariah
scholars, as merely having issuance is not a substitute for an Islamic money market.
The pioneering Sukuk in Europe was by the German Federal State of Saxony-
Anhalt which raised €100 million through an issuance on 31st July 2004. The sukuk
is for five years using an Ijara leasing structure with a floating return based on the
six month Euribor rate plus one percent. In other words in financial terms it is
identical to a floating rate note but because of the Ijara structure the payments to the
investors represent rent rather than interest or Riba which is prohibited under
Shariah. This is not merely the renaming of the return, but rather having a structure
that is recognized as distinctive under national law, and in the case of the Saxony-
Anhalt Sukuk, German law. Like other German state debt instruments the sukuk
was listed in Luxembourg, with an additional listing in Bahrain to attract Gulf
investors. Citigroup Global Markets was the arranger for the Sukuk, and the Shariah
advisory board of Citi Islamic Investment Bank in Bahrain vetted the legal
documentation for Shariah compliance.
The Sukuk was rated –AA by S&P and –AAA by Fitch with the state of Saxony-
Anhalt acting as guarantor.79
The Kuwait Finance House, the second largest Islamic
bank in the Gulf, acted as lead manager for the issue, with its visibility and
reputation helping ensure that other Islamic financial institutions would invest in the
Sukuk.
79‘Saxony-Anhalt sukuk to be offered’, Eastern Oracle, August 2nd 2004. (cited in Islamic Finance Information Service, ISI Emerging
As Sukuk have to be asset backed, the solution under German law was to establish a
‘Dutch’ foundation, which corresponded to the classical Islamic concept of a waqf.
The Ministry of Finance then transferred usufruct rights to its building to the
foundation, which served as the underlying asset.80
When the Sukuk is traded investors are buying and selling rights to the real
underlying asset which is permissible under Shariah, rather than simply paper debt
instruments which cannot be traded in the view of Gulf Shariah scholars as already
indicated. Effectively the structure is a sale and lease back arrangement, with the
foundation serving as a special purpose vehicle, (SPV), which is wound up on
termination of the Sukuk, when the usufruct rights revert back to the Ministry of
Finance which no longer pays rent to service the investors. In this respect it is
different from a Waqf81
religious endowment trust which exists in perpetuity rather
than for a definitive period. The idea for the Sukuk followed an earlier road show
during 2001 when German states tried to ascertain if there was a market for near
sovereign issuers in the Gulf countries, with institutions there suggesting that any
offering would attract more attention if it was Shariah compliant rather than being
structured as a conventional bond or floating rate note.82
Most of the Sukuk issued in the Gulf and South East Asia are for corporate clients
rather than sovereign Sukuk, but corporate issuances have been slow to start in
Europe. The Swiss company, EnergyMixx AG announced on 15 August 2007 that it
had appointed Faisal Private Bank and the law firm Vinson Elkins to advise it on a
suitable Sukuk structure to fund a power plant project in the Gulf, but the structure
and the terms have still to be decided.83
A relatively small corporate Sukuk worth
$26 million was arranged in April 2005 by ABC Islamic Asset Management in
London and the Abu Dhabi Commercial Bank on behalf of Al Safeena Ltd of
80 Michael Saleh Gassner, ‘Sukuk breathes new life into federal state’, Islamic Banking and Finance Magazine, December 2004. 81 It is under the context of 'sadaqah', a inalienable religious endowment in Islamic law, typically denoting a building or plot of land or
even cash for Muslim religious or charitable purposes. The donated assets are held by a charitable trust. The grant is known as mushrut-
ul-khidmat, while a person making such dedication is known as wakif 82 Michael Saleh Gassner, ‘How a sukuk was developed in the state of Saxony-Anhalt’, Islamic Banking and Finance Magazine,
December 2004. 83 Islamic Finance Information Service, ISI Emerging Markets: subscription website, 13 September 2007.
178
London.84
The English Law firm Norton Rose advised on the structure together with
Voisin and Co. of Jersey, as the trust structure governing the sukuk was registered
under Jersey’s offshore laws. This was the first Islamic security to be used to
finance shipping, as the asset used was a Very Large Crude Carrier (VLCC), Venus
Glory, which was chartered to a Saudi Arabian shipping company.85
An ijara
structure was used for the sukuk, with the tenor being five years and the return a
fixed six percent payable quarterly with the return of the principle on maturity. A
fixed return is unusual on an ijara sukuk, which in this case means in financial terms
it is equivalent to a bond rather than a floating rate note. Normally a murabaha
structure with a mark-up would be used for a fixed return sukuk, but as murabaha is
a short term instrument, arguably an ijara structure is preferable for a period of five
years. A larger corporate sukuk worth $261 million was used to finance the
purchase of the Sanctuary Building in London in 2005.86
Taylor Wessing, the international law firm, advised on the structuring, the clients
being Bahrain based Taib Bank and Hong Kong based Dominion Asset
Management, represented in the United Kingdom by Pelham Associates. This sukuk
was also based on an ijara structure, but with a variable return linked to LIBOR, the
London Inter-Bank Offer Rate, rather than a fixed return.
Turkey, an aspiring European Union member, has more Islamic bank branches than
any other European country, although the role of shariah compliant finance in its
banking system remains marginal. It is an active member of the Jeddah based
Organization of the Islamic Conference (OIC) and subscribes to and has received
shariah compliant funding from the Islamic Development Bank, the aid agency of
the OIC. At present all of Turkey’s government debt is funded through conventional
bill, bond and note issuance involving interest based payments, but since September
84 21 ‘ABC Islamic and ADCB co-underwrite $26 million ‘Al Safeena’ sukuk’, Islamic Finance Information Service, ISI Emerging
Markets: subscription website, 17 April 2005. 85 ‘Norton Rose acts on first ever Islamic bond for the shipping sector’, Islamic Finance Information Service, ISI Emerging Markets:
subscription website, 26 April 2005. 86 Islamic Finance Information Service, ISI Emerging Markets: subscription website, 24 August 2005.
179
2005 consideration has been given as to whether some debt should be funded
through sukuk securities.87
As always in Turkey the issue has been complicated by political considerations,
given the tensions between the AK, the moderate Islamist governing party, which
supports Islamic finance, and the former president, and upholder of Turkey’s
secularist constitution, who was at best skeptical towards the notion of finance
being shariah compliant. The tensions between Islamists and secularists in Turkey
are long standing, and Islamic banking and finance is viewed from the perspective
of political symbolism, rather than being simply about financial choices.88
The
change in Turkish law necessary for the issuance of sukuk has been made more
likely since the decisive election win by AK in 2007 under the Prime Minister,
Recep Tayyip Erdogan, and the appointment of his political ally, Abdullah Gül, as
President.
It is inevitably London that has the most potential as a centre for sukuk issuance in
Europe given itsvestablished reputation in Islamic banking, the depth and breadth of
its financial markets and avregulatory framework that encourages rather than
inhibits financial innovation. There has been overvthree decades of official support,
initially by the Bank of England, and from 1997 onwards by the Financial Services
Authority as it took over regulatory responsibility for banking, including Islamic
banking. However the Treasury has only been marginally involved, largely through
granting tax concessions to ensure a level playing field for shariah compliant
housing finance, rather than viewing Islamic finance as a vehicle for raising
revenue.
During 2006 the idea of London serving as a center for sukuk issuance was first
raised at an Islamic finance conference in June, which was attended by the then
Chancellor of the Exchequer, Gordon Brown, and his deputy Ed Balls.89
As they
87 Farhan Bokhari, ‘Turkey weighs up benefits of Islamic bond’, Financial Times, 27 September 2005. 88 Filiz Baskan, ‘The political economy of Islamic finance in Turkey: the role of Fethullah Gülen and Asya Finans’, in Clement M. Henry
and Rodney Wilson, (eds.), The Politics of Islamic Finance, Edinburgh University Press, 2004. 89 Mustak Parker, ‘Waterloo sunset’, Islamic Business and Finance Magazine, London, 1st April 2007.
180
became involved this gave the cause of sukuk issuance political momentum which
has propelled subsequent developments. Three factors appear to be positively
influencing developments. The first is to ensure that British Muslims see that their
government is open and responsive to the opportunities that Islamic finance offers.
There is a political desire to ensure that British Muslims feel included rather than
excluded, not least because Muslims who are United Kingdom nationals may vote,
and their support is crucial to ensure that the Labor Party maintains control of key
marginal constituencies. A second factor is to ensure that the City of London
continues to play a major international role in Islamic finance and attracts business
for investment banks and law firms, which results in well-paid jobs. The
government has established a Working Group on City Competitiveness to ensure
that London’s leading role in international finance is consolidated and enhanced,
and the encouragement of Islamic finance is viewed as part of this strategy. Third
although government debt is relatively modest in relation to gross domestic product
(GDP) in the United Kingdom and funding can be secured easily, there is a desire to
diversify funding sources to keep costs low and attract attention to Sterling as a
stable and attractive currency for international investors, including Muslim
institutions and individuals concerned with shariah compliance.
On 23rd April 2007 the Treasury announced that it would be undertaking a
feasibility study of the potential for sovereign sukuk issuance by the British
government, the am being to include a statement of progress in the pre-budget
report for 2007.90
On 16 August 2007 the first meeting of the Islamic Finance
Experts Group was convened in London, an official body established to advise the
Treasury and the Financial Services Authority on issues relating to Islamic finance,
including sukuk issuance.91
Issues being considered include who and how shariah compliance will be ensured,
the structure and size of the issuance, the period to maturity and the pricing. Shariah
90 Mustak Parker, ‘UK government serious about sukuk’, Arab News, Jeddah, 27 April 2007. 91 ‘City Minister Kitty Usher chairs Islamic Finance Experts Group meeting on feasibility study into government sukuk,’ Islamic Finance
Information Service, ISI Emerging Markets: subscription website, 16 August 2007.
181
assurance could imply the Treasury either appointing its own shariah board or
outsourcing compliance, both options having advantages and disadvantages. The
structure is most likely to be based on an ijara leasing contract, with the payments to
the sukuk holders being rents. As with other ijara based sukuk the government
would establish an SPV which would hold the asset, a piece of state owned land, for
the duration of the sukuk that is anticipated to be five years. The government rental
payments for the use of the asset would be paid through the SPV to the investors
with the tax treatment the same as for conventional securities.92
Rents would be
benchmarked to either the London Inter-Bank Offer Rate (LIBOR) or Bank of
England Minimum Lending Rates (MLR), the expectation being that the actual rents
paid would be at a discount to LIBOR or MLR reflecting the high quality of the
government paper issued and its implicit AAA rating as the United Kingdom
government always meets its financial obligations. The pricing would be in line
with conventional government debt instruments, and it is anticipated that the same
financial institutions will take up the offer as hold the conventional equivalent. The
prime aim is not to attract Gulf capital inflows, but rather to establish a benchmark
for high quality Islamic debt that can be used as a base for the higher pricing of
future more risky corporate sukuk issuance in London. There was some
disappointment that no sukuk announcement was made in the Chancellor of the
Exchequer’s pre-budget statement of October 2007, but given the complexity of the
legal and technical issues to be resolved, the omission at this early stage was not
surprising.93
The Chancellor
Alistair Darling indicated that further announcements would be made in 2008, and
that a report identifying key issues in the sukuk issuance would be announced,
including the tax treatment of assets transferred into and from the SPV.94
It was also
proposed that National Savings and Investment (NS&I), the British government
92 ‘Sukuk not feasible’, Islamic Finance News, 12 October 2007, p. 4. 93 Mohammed Amin, ‘Promoting Islamic finance: the new UK tax law on sukuk’, New Horizon, July-September 2007. 94 Mushtak Parker, ‘UK Islamic bond plan progressing’, Arab News, Jeddah, 15 October 2007.
182
savings scheme, would offer shariah compliant products to retail investors through
the national post office branch network.
8.2.3. Shariah Compliant Fund Management
Funds represent an ideal vehicle for Muslim investors as the fund manager can
assume responsibility for shariah compliance whereas an individual investing
directly in assets cannot easily know if they are compliant. In many respects the
principles of Islamic fund management are similar to ethical fund management, as
both types of investment rely on pre-determined screening criteria to determine
what it is legitimate to fund. There are two types of screens used for shariah
compliant investment, sector screens and financial screens.95
Unacceptable sectors to invest in include brewing and distilling and the production
and distribution of other alcoholic beverages, pork production and distribution,
gambling and casino operations and media companies whose output includes
material seen as offensive, including pornography.96
In practice this rules out a wide
range of companies, as for example hotels chains with gaming operations are
excluded, as are supermarket companies selling alcohol, although some more liberal
shariah scholars may not object to the latter if it is a secondary segment of the
business. Conventional banks are the most significant sector screened out because
of their dealings in interest and it is this exclusion that has the greatest significance
for returns on shariah compliant equity investment. Empirical studies have shown
that shariah compliant investments out-perform the market when bank shares fare
badly but under-perform when conventional bank profits are healthy.97
The financial screens are designed to avoid exposure to heavily leveraged
companies or those having excessive interest earnings. Hence, using the criteria
developed by the Dow Jones Islamic Market Index, companies that have borrowing
95 Rodney Wilson, ‘Screening criteria for Islamic equity funds’, in Sohail Jaffer, Islamic Asset Management: Forming the Future for
Shariah Compliant Investment Strategies, Euromoney Books, London, 2004, pp. 38-40. 96 FTSE, Ground Rules for the Management of the FTSE Global Islamic Index Series, London, October 2001, p. 6. 97 The Dow Jones Islamic Indices or FTSE Islamic Indices have been compared to total market indices and banking sector indices to
appraise performance.
183
in excess of one third of their market capitalization are excluded, as are companies
that derive more than one third of their income from interest, as is the case with
most conventional banks.98
Companies whose ratio of conventional receivables
exceeds 45 percent of their market capitalization are also excluded, the argument
being that such companies are in practice offering conventional lending, as the
revenue from the receivables will include a premium reflecting market rates of
interest.
Islamic funds have been offered in Europe for over two decades, the pioneering
fund being offered by Kleinwort Benson in 1986 and the most publicized being
Flemings Oasis Fund launched in 1996 which was closed after the take-over by
Chase of Flemings.99
The challenge for Islamic equity funds in Europe was to
attract sufficient investment to achieve viability, which proved difficult for stand-
alone offerings. The funds currently available are mostly offered by those large
multinational banks that have a portfolio of shariah compliant services for their
clients. HSBC Amanah for example offers three funds from Dublin and one from
Luxembourg, European centers that have attracted offshore fund business. Those
offered from Dublin include an American equity fund, managed by Wellington, an
Asia-Pacific Fund managed by Aberdeen Asset Management and a Pan-European
Fund managed by Pictet Asset Management. The fund management outsourcing to
specialist managers enhances performance, the aim of HSBC Amanah being to
provide its existing Muslim clients with more choice. For each of the funds the
initial charge is 3.25 percent, the annual management fee 1.85 percent and there is
in addition a switching charge of 1 percent for those wishing to move to other
HSBC funds. The minimum investment is only $10,000 with daily dealing, the
leading holdings of the pan-European fund being BP, Royal Dutch Shell, Glaxo
Smith Klein, Total and Novartis.100
Exposure to European oil companies is thought
to appeal to Gulf investors.
98 Dow Jones, Guide to the Dow Jones Islamic Market Index, New York, June 2005, p. 6. 99 Rodney Wilson, ‘Islamic fund management’, in Muhammad Anwar and Mohamad Aslam Haneef, (eds.), Studies in Islamic Banking
and Finance in the 21st Century: Theory and Practice, International Islamic University of Malaysia, 2005. 100 HSBC Ammanah Pan-European Equity Fund, Report, Dublin, 31st December 2006.
184
The only independent shariah compliant fund offered in Europe is by Oasis, a South
African based financial services group with extensive ties with the Gulf. Their
Crescent Global Equity Fund, which was launched from Dublin, is valued at almost
$37 million. Nearly half of the fund’s exposure is to European equities, with the
United States accounting for less than one third. The major sectors for investment
are retailing, healthcare, manufacturing industry and information technology. The
fund has performed well since inception, with an annualized return of 14.5 percent
in dollar terms, well above the 2.6 percent annualized returns from the Dow Jones
Islamic Market Index.101
The appreciation of the Euro has undoubtedly helped
performance given the higher exposure to European stock than is the case for most
global equity funds, whether conventional or Islamic.
The major shariah compliant funds managed from London are offered by Deutsche
Bank and Scottish Widows, the fund management and subsidiary of Lloyds TSB.
The Deutsche Islamic Equity Builder Certificates have been offered since January
2003 and are marketed in the UAE by Emirates Islamic Bank, and white labelled in
Saudi Arabia by the National Commercial Bank, the largest provider of shariah
compliant funds worldwide, as Alahli Islamic Equity Builder Certificates. Shariah
compliance is provided by the shariah board of the National Commercial Bank in
Jeddah. Although managed from London the certificates are listed in Frankfurt.
There are four certificates available based on the United States, the Asia-Pacific
region, Europe and a Global fund combining the other three. The Asia Pacific
Certificates have given a return of 139.6 percent since inception, the European
Certificates a return of 83.9 percent and the United States Certificates a return of
57.6 percent.102
The appreciation of the Euro undoubtedly accounts for the superior
performance of the Euro Certificates in dollar terms relative to the United States
Certificates.
The Scottish Widows Islamic Global Equity Fund was launched in October 2005
the aim being to provide a fund that could be offered to Lloyds TSB Muslim clients
101 Oasis Fund Facts: Crescent Global Equity Fund, Fourth Quarter 2006, Dublin, March 2007. 102 National Commercial Bank Investment Services, Fact Sheet: Alahli Islamic Equity Builder Certificates, Jeddah, 25 December 2006.
185
both in the United Kingdom and in the Gulf from their Dubai branch. Scottish
Widows Investment Partnership is one of Europe’s leading asset managers with
funds worth £97.8 billion being managed. The Islamic Global Equity Fund was
valued at $19.3 million, with its major shareholdings including Intel, Pfizer, Bayer,
Rolls Royce, OCC Petrol, China Mobile and Merck.103
The annual management
charge is 1.5 percent, which is very competitive for an Islamic fund given the
additional costs incurred with shariah compliance. Scottish Widows and Lloyds
TSB also market the Children’s Mutual Shariah Baby Bond which qualifies for a
tax free lump sum for children and young people once they become 18. The United
Kingdom government also contributes to this saving scheme by providing vouchers
worth £500 all parents in receipt of Child Benefits.104
Up to £100 per month can be
paid into the fund which can generate a considerable sum which the young person
can use on maturity after their 18th birthday to cover further education costs, a
deposit on a apartment or other expenses. The Shariah Baby Bond is also marketed
by the West Bromwich Building Society, which has a substantial branch network in
the Midlands, where many British Muslim families reside.105
London is also a center for shariah compliant property and leasing funds, although
these are all closed ended, with only a few institutions and individuals of high net
worth subscribing, rather than the general public as with the open ended equity
funds. The property and leasing funds are usually less liquid, with the investment
typically locked in for periods of 3 to 5 years and only limited facilities for
redemptions, usually with exit penalties. ABC Islamic Asset Management is the
leading player in the market through funds that invest in the student, healthcare and
residential property markets as well as club transactions and private portfolio
management where the bank forms partnerships with small groups of investors and
provides leverage through Murabaha and Ijara structures, with the largest residential
property project being in Leeds where almost £60 million was invested.106
The total
103 Scottish Widows Investment Partnership, Islamic Global Equity Fund Report, London, September 2007. 104 Children’s Mutual Shariah Baby Bond Stakeholder Child Trust Fund Account, Key Features, London, 2007. 105 www.westbrom.co.uk/westbrom/news?id=1484 106 Arab Banking Corporation, Islamic Asset Management, London, 2007.
186
value of the United Kingdom shariah compliant commercial property portfolio
exceeds £329 million, with the property restricted to halal use which excludes
tenants such as betting shops or alcohol vendors.
Although the leasing funds are offered and managed from London the assets are
worldwide, examples being G.E. Quartz Japan whose operating equipment leases
were financed and the Burlington Northern Santa Fe Railroad in the United States
where the leases covered railway equipment and rolling stock.
8.2.4. Islamic Retail Banking Europe
As the main source of support for Islamic banking has always come from ordinary
Muslims, and the development of Islamic finance can be regarded as a populist
movement rather than an initiative from governments, it is not surprising that retail
Islamic banking has been the dominant activity.107
The world’s largest Islamic
financial institutions, the Al Rajhi Bank of Saudi Arabia and the Kuwait Finance
House, primarily provide retail, personal and private banking products, as do the
Dubai Islamic Bank and Bank Islam Malaysia. In Europe Islamic finance has also
been a bottom up rather than a top down movement, although it is only in the
United Kingdom that the regulator, the Financial Services Authority, has actively
facilitated the development of the industry. Yet France and Germany have much
larger Muslim populations than the United Kingdom, where the total was only 1.8
million when Islamic retail banking started in the 1990s and still remains below
three million today.108
As Muslims are no different to non-Muslims in their needs
and demands for financial services, not surprisingly Islamic banks and conventional
banks offer shariah compliant retail products that mirror those provided to ordinary
clients. Current account or transactions deposits are always offered, as these
facilitate payments through cheques, standing orders, direct debits and most
importantly debit cards for use at point of sale or through automated teller
107 Rodney Wilson, ‘The growth of Islamic banking and product development among Islamic retail banks’, in Sohail Jaffer, (ed.) Islamic Retail Banking and Finance: Global Challenges and Opportunities, Euromoney Books, London, 2005. 108 Rodney Wilson, ‘Challenges and opportunities for Islamic banking and finance in the West: the United Kingdom experience’,
Thunderbird International Business Review, Vol. 41, Nos. 4/5, 1999, pp. 421-444.
187
machines. Of course as conventional current accounts pay little or no interest, some
observers may question the need for special shariah compliant current accounts.
Such accounts however are provided using wakala trust structures, where the
financial institutions guarantees that the amounts deposited will not be used for
interest based financing, or under the qard hassan principle, where the depositor
provides the bank with in interest free loan on the understanding that no riba will be
charged when the finance is utilized. In the United Kingdom both Lloyds TSB109
and HSBC Amanah110
offer shariah compliant current accounts. Banks providing
shariah compliant retail financial services in Europe all offer a range of savings and
investment products. The Islamic Bank of Britain offers a treasury account, where
those who have £100,000 or more to invest can place their funds for fixed periods
ranging from 1-24 months, with higher returns offered for longer time deposits.111
The deposits are structured on a murabaha basis, with the funds used to buy and sell
commodities on the London Metal Exchange, with the client being paid a mark-up
reflecting the trading profit. The profit rate is pre-determined, eliminating risk for
the client, and the bank covers its position in the commodity exchange by agreeing
the sale price at the time of purchase. Such transactions are permissible under
shariah, as the hedging does not involve the use of derivatives such as futures and
options, but rather real trading transactions involving physical commodities.
Savings accounts are also offered where no minimum balance is required but returns
are significantly lower than with the treasury placements. The Islamic Bank of
Britain offers three instant access accounts, an internet direct access account paying
3 percent in September 2007, a young person’s account paying 2.5 percent and a
undetermined savings account using a passbook with branch deposits and
withdrawals paying 2.0 percent. It also offers term savings deposits with minimum
notice periods for withdrawals, the 30 day account paying 3.25 percent, the 90 day
account 3.50 percent and the 180 day account 3.75 percent.112
based on a mudarabah structure, with the depositor sharing in the profits of the bank
rather than earning interest. It should be noted that the percentage returns indicated
are target rates, which are not guaranteed, as under a mudaraba structure returns
cannot be pre-determined.
With mudaraba the profit rate declared on which returns on deposits are based
should be related to the profitability of the financial institution.113
However most
Islamic banks, including the Islamic Bank of Britain, maintain a profit equalization
reserve into which a proportion of bank revenue is paid rather than being distributed
to depositors. The aim is to maintain a reserve fund, from which a profit share can
be paid, even in years when the bank generates less profit.114
The cost to depositors
is that they receive less in the more profitable years. This profit smoothing, which is
encouraged by regulators, including the Financial Services Authority, enables
Islamic banks to stay competitive with conventional banks, with the option of
increasing profit rates when interest is rising and other financial institutions pay
more to depositors. Islamic banks are often criticized by strict Muslims for
benchmarking profit rates to interest indices, but legally the returns they pay are
profits, not interest, and as Islamic banks only account for a minute share of bank
deposits in most markets, they are price takers, not price makers. There is a
potential conflict between mudaraba depositors and shareholders in an Islamic bank,
as higher dividend payments to the latter may be at the expense of profit share
payments to the former.
However if the mudarabah depositors are not sufficiently rewarded, not many will
be attracted to the bank, which will adversely affect the bank’s growth and its long
run profitability. In other words the market can provide a solution, without the need
for regulatory intervention. Mudarabah is regarded as an equity type arrangement,
but it is not the same as equity investment, as it is the shareholders who own the
bank and enjoy voting rights, not the mudarabah depositors. However while the
shareholders may receive very variable dividends, and suffer capital losses as well
113 Mervyn K. Lewis and Latifa M. Algaoud, Islamic Banking, Edward Elgar, Cleltenham, 2001. 114 Islamic Financial Services Board, Guiding Principles of Risk Management for Institutions (Other than Insurance Institutions) Offering
only Islamic Financial Services, Kuala Lumpur, December 2005.
189
as gains, returns to the mudarabah depositors fluctuate less, but they do not benefit
from capital gains. Under shariah the nominal capital value of mudarabah deposits
cannot be guaranteed, but in practice it is never written down as it is the
shareholders dividend that is cut or eliminated when losses occur, with mudaraba
depositors also higher in the pecking order with regard to claims in the case of
insolvency. In addition to offering mudarabah accounts which entitle the depositor
to a share in the bank’s profits, a number of Islamic banks provide specified
mudaraba accounts where the funds deposited are allocated to a single company
with the agreement of the depositor. The Islamic bank in these cases acts as an
agent, charging an arrangement and annual management fee, with the depositor
sharing in the profits of the specified company. The returns will normally be more
volatile than those in general investment accounts, as bank profits will partly
depend on its competency in risk and debt portfolio management. The depositor
expectation would however be for a higher return with a specified investment
account. So far such accounts are not offered in Europe, but they have proved
popular elsewhere, notably with Jordan Islamic Bank depositors.115
Islamic banks cannot provide overdraft facilities or personal loans on which interest
is payable, but rather structured financing facilities for specific purposes usually
involving the acquisition of physical assets. In markets such as Europe however
many retail clients want cash loans, so that they can shop around for the best price,
rather than relying on murabaha facilities, where an Islamic bank purchases a
commodity on behalf of a client, who then purchases the commodity from the bank
for a larger payment including a mark-up, with settlement being on a deferred
payments basis. To avoid tying financing to particular trading transactions, and
provide greater flexibility, a number of Islamic banks, including the Islamic Bank of
Britain, offer a tawarruq facility.116
This involves an initial murabaha transaction,
and a simultaneous reverse transaction, where the client sells the commodity
115 Jordan Islamic Bank, Annual Report 2006, Amman: www.jordanislamicbank.com/annualreport.html 116 http://www.islamic-bank.com/islamicbanklive/PFGenerateCash/1/Home/1/Home.jsp
190
received to a third party nominated by the Islamic bank, in return for a cash sum
being deposited in his or her
current account.117
The effect is identical to an overdraft or personal loan with the
client repaying on a deferred payments basis, but the legitimacy under shariah is
that the financing is asset backed and involves trading rather than a straight loan.
The legal rights and obligations under English law, as well as under shariah, are
distinctive, but because tawarruq mirrors conventional financing, it has many
critics.118
In most European countries, especially in the United Kingdom and France, most
people, including Muslims, want to own the home they live in, and are prepared to
take out substantial mortgages for this purpose, with this becoming their largest
single financial commitment. As conventional mortgages are based on interest on
the amounts borrowed, the challenge in Islamic finance was to develop satisfactory
shariah compliant alternatives. The first Islamic mortgages in Europe were offered
in 1988 by Al Baraka Bank to Gulf Arabs for properties in London, with the
mortgages structured through an ijara rental contract, whereby the bank purchased
the property, and the client repaid by monthly instalments and in addition paying
rent to the bank, which was based on the implicit rental value of the property as
agreed through an independent valuation.119
After the Al Baraka Bank reverted to
becoming an investment company it ceased to provide housing finance and the
United Bank of Kuwait, which already provided conventional mortgages, started to
offer mortgages based on murabaha from 1997, and the following year housing
finance based on ijara contracts, the latter being the equivalent to a variable rate
mortgage, while repayments and the mark-up for the murabaha mortgage was fixed.
Both were perceived as expensive, not least because stamp duty had to be paid
twice, initially when the bank purchased the property and subsequently when the
client purchased from the bank. It was only after the 2004 budget in the United
117 Harvard Law School Islamic Legal Studies Programme, Workshop on Tawarruq, 1st February 2007, London School of Economics.
Included papers presented by Mohamed A. Elgari and Mohammad Nejatullah Siddiqi. 118 Mahmoud A. El-Gamal, Islamic Finance: Law, Practice and Economics, Cambridge University Press, 2006. 119 Rodney Wilson, ‘Islamic banking in the West’, in M. Kabir Hassan and Mervyn K. Lewis, Handbook of Islamic Banking, Edward
Elgar, Cheltenham, England and Northampton, Massachusetts, 2007.
191
Kingdom, when the Chancellor of the Exchequer announced the abolition of the
double stamp duties on these mortgages, that shariah compliant housing finance
became more competitive.
Following the stamp duty relief, Al Buraq, the Islamic retail finance subsidiary of
the Arab Banking Corporation, devoted more energy and resources to marketing
shariah compliant home finance. As a result it has become the leading player in the
United Kingdom market. Al Buraq does not have a branch network, but it markets
its Islamic home finance through Bristol and West,45 a former building society
purchased by the Bank of Ireland, with a substantial branch network, including in
areas with significant Muslim populations. In addition the Islamic Bank of Britain
offers Al Buraq shariah compliant home finance through a white labeling agreement
under which they receive a fee for every client signed up. The Arab Banking
Corporation has a large base of shariah compliant deposits which can be used to
finance the Islamic mortgages, unlike Islamic Bank of Britain, whose deposit base is
small. Lloyds TSB also offers Al Buraq mortgages,120
as although it is one of the
largest banks in the United Kingdom, with enormous deposits, these are
conventional and pay interest, and hence cannot be used to fund shariah compliant
housing finance. Al Buraq’s Islamic mortgages are based on a combined ijara and
musharaka structure with the bank and the client entering a partnership, and the
bank paying up to 90 percent of the capital and the client at least 10 percent.
Repayments are scheduled up to 25 years, with the client paying rent to the bank for
its share of the property, this being the main element in the bank’s profit.121
Most
young clients are more concerned with their initial monthly payments rather than
payments after 10 or 20 years, as by then their financial circumstances should have
improved as their careers progress.
Therefore to ensure the initial payments are competitive, only very small
repayments are made at first, the major servicing element being the rent. After
several years repayments increase as rent diminishes, but the aim is to backload
rather than frontload total monthly payments so that they increase rather than
decrease over time. Actual repayments can be tailored to the needs of individual
clients and their future income prospects. Most types of property are acceptable for
shariah compliant mortgages including leaseholds with more than 70 years of life.
Self-certification of income is permitted, and Islamic mortgages are also available
on a buy to let basis. The major competitor to Al Buraq in shariah compliant
housing finance is HSBC Amanah which offers a similar financing structure.122
Their mortgages were seen by some as more expensive, but the terms have become
more favourable as they have sought to increase market share. (Please see
ANNEXES 1, 2 and 3)
8.2.5. Islamic Investment Banking
It is only during the last decade that investment banking has become significant in
the Muslim world, and all of the largest Islamic banks, such as Al Rajhi Bank or the
Kuwait Finance House, are retail rather than investment institutions. Investment
banks are focused on financing mergers and acquisitions; the arranging of initial
public offerings (IPOs) of shares when companies are floated; the securitization of
assets, as well as bond and note issuance and the development of structured
products and financial derivatives.123
Most, but not all, of these activities are shariah
compliant, but what makes investment banking potentially attractive from a shariah
perspective is that most of their income is fee based, rather than being dependent on
interest, as with conventional retail banks.
There is only one exclusively shariah compliant investment bank in Europe, the
European Islamic Investment Bank, (EIIB) which was established on 11 January
2005.124
The EIIB obtained its license from the United Kingdom’s Financial
Services Authority on 8 March 2006 and has its headquarters in the City of London,
Europe’s major investment banking center. Its initial financial backing was from
123 Shelagh Heffernan, Modern Banking, John Wiley & Sons, Chichester, 2005. 124 European Islamic Investment Bank, Annual Report and Accounts, London.
193
Gulf investors, but like Islamic Bank of Britain, it was admitted to the London
Stock Exchange Alternative Investment Market (AIM) where its shares were listed
for its IPO. This raised capital worth £73 million, giving the bank a capital base of
£184 million, which is of course very small in relation to most major investment
banks.
The EIIB is focused on three business areas with specialized divisions: treasury and
capital markets, asset management and corporate finance and advisory.125
The
treasury and capital market division provides spot foreign exchange rate quotes and
the Islamic equivalent of forward quotes for transactions which must be undertaken
as futures trading is not permissible under shariah. It also quotes sukuk prices in
London, and is involved in inter-bank commodity murabaha and wakala money
market transactions mostly through the London Metal Exchange. The capital
markets remit covers sukuk securitization and structured trade finance and the bank
is hoping it can play a leading role in Sterling and Euro corporate sukuk issuance.
Asset management services include the provision of property investment, structured
product and private equity funds although all of these products is at an early stage of
development within EIIB. The corporate finance services involve advising on
capital raising opportunities, mergers and acquisitions and cross border private
equity placements, with the focus on businesses based in the Gulf but with financial
interests, including subsidiaries, in Europe.
The market for investment banking services is highly competitive and the leading
European investment banks have of course much more expertise and resources than
niche operators such as EIIB. In contrast to wealth management and private banking
where the stress is on building long term client relationships, in investment banking
clients are more likely to shop around for the best deal when awarding their
mandates. Several leading European investment banks have secured the services of
shariah advisors or appointed shariah boards so that they can compete for
investment banking business in the Gulf and South East Asia which involves
125 European Islamic Investment Bank, Our Business, London, 2006, pp. 3-8.
194
Muslim clients or institutions concerned with shariah compliance. Deutsche Bank
has been particularly active through its specialist Islamic banking operation based in
Dubai. It has provided investment structures that facilitate the issuance of shariah
compliant securities that offer investors access to alternative asset classes.126
Together with Merrill Lynch and Morgan Stanley, Deutsche Bank launched 14
structured products in August 2007 which are traded on the Dubai International
Financial Exchange (DIFX). Returns are linked through DIFX TraX that gives
investors exposure to shares listed on the Dubai Financial Market and the Abu
Dhabi Securities Market, as well as commodities including oil.127
Earlier in June
2007 Deutsche Bank joined forces with Dubai Islamic Bank to issue five year
capital protected notes with the returns linked to the Deutsche Bank – Goldman
Sachs Asset Management ALPS Index.128
Deutsche Bank also pioneered a shariah
compliant profit rate swap with Dubai Islamic Bank, the equivalent to a variable and
fixed interest rate swap through a transaction worth $500 million.129
French investment banks have also been actively involved in Islamic finance,
notably Société Générale and Calyon, the investment banking subsidiary of Credit
Agricole. Société Générale arranged refinanced the Taweelah desalination plant in
Abu Dhabi through its Islamic banking unit in Dubai with a $150 million share
being shariah compliant and the remaining $390 million share including
conventional bonds and corporate lending.130
Calyon has been active with its
affiliated bank, Banque Saudi Fransi, in syndicated Islamic financing. Its largest
deal to date in June 2007 was the arrangement of a $2.9 billion shariah compliant
financing facility for Mobily, the Saudi Arabian mobile phone subsidiary of
Etisalat, the UAE telephone company.131
This was based on a murabaha fixed mark-
up pricing arrangement, as was an earlier $150 syndicated facility for the Alliance
126 www.db.com/press/en/content/press-releases-2007-3347.htm 127 DIFX Press Release, Dubai, 28 August 2007. 128 ‘DIB launches DB structured notes’, Trade Arabia Banking and Finance, Dubai, 14 June 2007. 129 ‘Deutsche Bank closes first Islamic collar profit rate swap with Dubai Islamic Bank’, ISI Emerging Markets Press Release, London, 3rd October 2007. 130 www.sgcib.com/deal-focus.rha?c=deal-focus{unid=64AA780BF11046BFC1256E... 131 www.calyon.com/news/corporate-investment-bank/etisalat-mobiliy-murabaha-refer...
195
Bank, one of the leading financial institutions in Kazakhstan, Central Asia.132
The
shariah board of Abu Dhabi Islamic Bank provided the compliance advice, as
Calyon does not have its own shariah board.
8.3. European Countries - Current Situation and Future Outlook
8.3.1. The UK
The UK is the first country in Europe to have promoted and encouraged retail
Islamic banking. It is in the process of embracing Islamic financial techniques by
introducing new laws to facilitate further market entry and practice of Islamic
finance in the UK.
According to the Office of National Statistics133
the UK Muslims within the UK
have the following countries of origin:
Pakistan - 43%
Bangladesh - 16%
India - 8%
Other Asian - 6%
Other - 27%
According to research carried out by The Runnymede Trust the Muslims from
Middle East and Africa represent 24% of the total Muslim population in the UK.
The UK already has five licensed Islamic banks including The Islamic Bank of
Britain, which was formed by a group of investors from the Middle East, and The
European Islamic Investment Bank (EIIB), which is the first investment bank in
Europe that offers Shariah compliant investment banking products and services. The
founding shareholders of European Islamic Investment Bank (EIIB) include Persian
Gulf based individuals and institutions, including a number of Islamic banks, as
well as individuals and companies based in Europe. The Bank of London & the
132 www.calyon.com/news/corporate-investment-bank/references-2007141 133 UK Office of Statistics 2004.
196
Middle East (BLME), Securities House (UK) and the European Finance House
(EFH) are the other three Islamic financial institutions authorised in the UK.
The role of the UK Government in facilitating the expansion of Islamic banking in
the country is remarkable. Since the early 2000s the Government has introduced a
series of tax and legislative changes specifically designed to remove obstacles to the
development of Islamic finance. The first significant change came in the Finance
Act 2003 which introduced relief to prevent multiple payment of Stamp Duty Land
Tax on Islamic mortgages. The Finance Acts of 2005 and 2006 contained further
measures aimed at putting other Islamic products on the same tax footing as their
conventional counterparts. Most recently, the Finance Act 2007 clarified the tax
framework further in the case of Sukuk. In March 2008 the first government Sukuk
was listed on the London Stock Exchange. The sovereign bond is a USD 350
million bond issued by the Gulf Kingdom of Bahrain and it is structured to avoid
paying interest in line with the Islamic law. At the end of 2008 a license for an
Islamic investment bank was also lodged by Gatehouse Capital PLC, a wholly
owned subsidiary of Kuwait’s Global Securities House.
Furthermore, the UK Government is determined to maintain its momentum on work
on Islamic finance and to make clear to stakeholders its commitment to this
industry. As such, it aims to publish a paper detailing the UK strategy on Islamic
finance in 2009. There are many conventional banks in the UK which provide
Islamic products:
HSBC Amanah is the global Islamic banking division of the HSBC Group. It
was established in 1998 with the aim of making HSBC an international provider
of Islamic banking worldwide. In the UK the HSBC Amanah Finance UK134
is
the division which provides a wide
range of Islamic financial products, developed in consultation with independent
Sharia scholars such as current accounts for private and business customers as
well as mortgages, chequing facilities, investment opportunities, personal and
corporate financial solutions.
134 For further information on HSBC Amanah UK, please visit: www.hsbcamanah.co.uk/amanahuk/index.html.
197
UBS operates the UBS Islamic Finance service135
providing investors the
freedom to choose a Shariah-compliant investment profile across a range of
assets such as commodities, equities, fixed income, FX, indices and investment
banking. In December 2008 Barclays launched the UK's first Sharia-compliant
exchange-traded funds (ETFs) and has formed a panel of Islamic scholars to
supervise such products.
Lloyds TSB is the best example within the retail and commercial sector as they
have developed a suite of Shariah approved products for their customers –
including those who wish to bank ethically who are not necessarily Muslim. It
offers current, business and student accounts, mortgages and investment funds.
In January 2008 it launched its new current account, the Islamic Nostro
Account136
. Related to Islamic home finance, Lloyds TSB collaborates with the
Arab Banking Corporation International Bank (ABC) which provides Alburaq, a
Shariah-compliant home finance service for Islamic house purchases.137
8.3.1.1. Government Initiatives
In the course of researches and investigations initiated after the terrorist
attacks on September 11, 2001 it was found that many Muslims in Western
countries face social exclusion and live concentrated in urban areas of large
cities. (Plews 2005 and Wilson 2000) The United Kingdom government
promoted thereupon more tolerance in British society and issued several
programs. (Plews 2005) Some of those facilitated the provision of Shariah
compliant financial services, by abolishing regulatory hurdles and tax
disadvantages, in order to give local Muslims the possibility to handle their
financial matters in accordance with their faith.
135 To obtain more details on the UBS Islamic offer, please visit: www.ibb.ubs.com/mc/islamicfinance/index.shtml. 136 LLOYDS TSB has launched a new bank account enabling Muslims to transfer money around the world without breaking the rules of Islam. The group claimed its Islamic Nostro Account was the first of its kind to be offered by a mainstream Western bank. A Nostro
account, complying with Shariah law, does not pay interest on money and does not offer an overdraft facility and it does not allow any of
the funds held to be invested in industries – such as alcohol and gambling – which are prohibited under the rules of the faith. Read more at: http://menmedia.co.uk/asiannews/news/business/s/1033498_new_islamic_account_for_lloyds 137 To obtain further information on the Lloyds offer of Islamic products and services, please visit:
Lord Edward George (Governor of the Bank of England) emphasized
already in 1995 the growing importance on Islamic banking on an
international level and suggested to “put Islamic banking in the context of
London’s tradition of ‘competitive innovation’” (Financial Services
Authority 2007). It became apparent that the United Kingdom has a “clear
economic interest” (Financial Services Authority 2007) in establishing as the
European Islamic financial center. In 2001 a high level working group was
initiated chaired by Lord George with the target to “examine the barriers to
Islamic finance in the UK” (Financial Services Authority 2007). Its
members included representatives from the City of London, the government,
the Muslim community and the FSA who identified, for example, the
problem of double stamp duty paid on Islamic mortgages138
. All resolutions
passed became a matter of public policy and were translated into respective
government legislations (please see figure 29). The overriding principle is
“no obstacles, but no special favors” for Islamic banks with the purpose to
create a level playing field facing competition of conventional banks.
In the subsequent years the interaction with the Muslim community has been
reinforced, for example, by maintaining working level contacts with Islamic
institutions (such as the IIBI), other regulatory agencies, the Islamic
financial service industry and international organizations (such as the
AAOIFI). (Financial Services Authority 2007) Since 2004, at least four
fully-fledged Islamic banks have be granted a banking license by the FSA,
namely the Islamic Bank of Britain (2004), the European Islamic Investment
Bank (2006), the Bank of London and Middle East (2007) and the
Gatehouse Bank (2008). Together with the numerous Islamic Windows
operated by London’s conventional banks (who are not subject to special
authorisation by the FSA), this results in the highest concentration of Islamic
financial insitutions in a non-Muslim country.
138 Before the stamp duty had to be paid in Islamic mortgage contracts twice as it was first paid on the purchase of the property by the
bank and secondly it emerged on the transfer of the property by the bank to the customer at the end of the mortgage term. Similar tax
disadvantages for Islamic financial products exist in several legislations due to the asset transactions involved.
199
8.3.1.2. Future Prospect Outlook
The UK is the hub of Islamic financial activity in the West and I also
discover that UK based conventional Banks with Islamic banking window
providing best services in compliance with Shariah law that fulfill the
requirements of Muslim community in different sectors especially in Ijarah
(leasing), Takaful (insurance) Sukuk (bond) and also provide services in
home finance, personal loan, current and saving accounts. In the UK Islamic
Banking have great opportunities to growth because a large number of
Muslims from all over the world living in the UK, they are playing their role
effectively in country’s economy. Islamic banking has also great challenges
due to lack of awareness about Islamic banking by its customers and as well
as some other issues related to UK Regulatory Authority, structure of
Islamic Shariah Board and its implementation.
Figure 29 -- Regulatory initiative in the United Kingdom (Financial Services
Authority 2007)
200
8.3.2. France
France has a Muslim population of around 6 million. However, authorities and
regulators have been slow to introduce changes in the regulatory framework to
accommodate Islamic financial products. Finally in 2007, France announced
reforms to adapt its banking legislation to allow more traditional banks to engage in
Islamic products.139
In April 2008 the French Government asked to the Paris
Europlace, the Paris financial markets organization, to produce a report analyzing
the necessary measures in order to make this marketplace a competitive one
worldwide in the provision of Islamic products and services. In May 2008 France’s
Upper House of Parliament – the Senate – hosted roundtable discussions with
politicians, bankers and Shariah scholars to discuss how to support Islamic finance
by raising awareness and changing the legal and fiscal framework.140
In July 2008
the Financial Markets Authority (AMF) requested the Paris Europlace to establish a
working group composed of representantives of the financial industry to give
market participants a clear picture of the legal and transparency requirements for
listing Sukuk in France.141
The findings of the Paris Europlace report (known as “the Jouini-Pastre report142
”)
concluded that France provides a welcoming environment for Islamic finance
subject to certain legal and tax adjustments. This statement is based on the cultural
similarities between France and the Muslim countries. Therefore the report said that
France could be among the world leaders in providing Islamic financial products if
the country made a small number of legal reforms. To reach this objective it would
be necessary to attract an important amount of capital to the Paris Europlace. The
report estimates that this sum should be around EUR100 billion. These conclusions
complement the recommendations presented by the Chairman of the Paris
Europlace Islamic Finance Committee Gilles Saint Marc143
to the Senate. In his
139 adnmundo.com 2007. 140 Ramadier 2008. 141 Gordon 2008. 142 The Jouini-Pastre report provides 10 proposals to reach the abovementioned objectives –Paris Europlace 2008 143 Gilles Saint Marc is the Chairman of the Paris Europlace Islamic Finance Committee. He presented his recommendations to the Senate
on 14 May 2008. See Saint Marc 2008a for the French presentation and Saint Marc 2008b for the English version.
201
recommendations, he provides a study on the compatibility between Islamic finance
and the French law.
The Islamic finance represents an opportunity for France and it is necessary to make
some reforms. These reforms include the enactment of a law modifying the French
Monetary and Financial Code and to include adequate regulatory provisions in the
next finance bill and the enactment of appropriate tax instruction.144
In addition,
these modifications will benefit from other reforms currently underway (trust
(fiducie) and civil transfer of receivables as security). The study states that Islamic
finance will bring the following advantages to the French financial system:
1. Access to new liquidity;
2. Positive external factors such as the integration of Muslims in France; and
3. Proof of the modernity of French law and its capacity for adaptation.
As a result of the abovementioned studies’ conclusions, three measures were
adopted in 2008 related to the conditions for issuing Sukuk in Euronext-
Paris – the French securities market; the elimination of double taxation on
registration rights in Murabaha contracts and implementation of the tax
deduction on capital earned from Sukuk.
In February 2009 the Paris Europlace Islamic Finance Committee published a 2009
program, which defines 8 action points to pursue in-depth the development of
Islamic finance in France.145
These actions show that there is a clear political will to
change the French financial regulatory framework to include the offer of Islamic
products.
Concerning the French financial actors, some French banks have Islamic investment
portfolios that operate through their branches in Muslim countries.146
Only a
handful of French banks, such as Société Générale or BNP and its subsidiary BNP
Paribas Najmahis, currently offer Islamic products based on “Murabaha”. This
product is a form of credit that enables customers to make purchases without taking
an interest bearing loan. The bank buys the goods for the customer and re-sells them
144 Saint Marc 2008b. 145 Further details of this plan are provided in Paris Europlace (2009). 146 Fulconis-Tielens 2007.
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to the customer on a deferred basis, adding an agreed upon margin of return. The
customer then pays the sale price for the goods in installments, effectively obtaining
credit without paying interest. The contract and the liquidation date of the Murabaha
are fixed, and the payment to the bank is settled directly after a Murabaha
liquidation.
There is a potentially one Islamic retail bank – Tayseer Bank – going through the
authorization process with regulators. Negotiations began at the end of 2005 and it
should be operational after the French Government carries out the necessary
regulatory reforms.147
At the end of 2008, Qatar Islamic Bank, Kuwait Finance
House and Al-Baraka Islamic Bank (Bahrain) requested licenses to operate in
France, which could be possible before the end of 2009.
France started in retail and expansion with reduced speed:
Tax and legislative changes in support of Islamic finance (in particular
regarding ijarah, istisna’ and murabahah)
French government hopes to take 10% of the global Islamic market by 2020
Graduate degree programs in Islamic Finance at the universities of Paris and
Strasbourg
AAOIFI approved sukuk structures which are in accordance with French law
(2010), framework for sukuk issues ready by early 2011 – but no issue so far
AAOIFI standards translated into French
No Islamic windows of conventional banks
Moroccan Chaabi Bank (in France since 1972) first to offer licensed Islamic
retail banking products; Al Baraka Bank announced market entry 2012
IDB Group’s Islamic Corporation for the Development of the Private Sector
(ICD) French partner Islamic financing tools for SMEs
Public opinion not in favor of Islamic peculiarities (see ban on burqa)
147 Saddy 2007.
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8.3.2.1. Government Initiatives
Given the possible market potential, Paris “aims at competing with London
as European hub for Islamic finance” (Moody’s Investors service 2008) by
establishing an Islamic financial services sector. For the time being the
political and governmental authorities have already launched several
initiatives to support this development. Initially the French Financial
Markets Authority (FMA) issued a note in 2007, comprising among others
the authorization of Shariah compliant collective investment schemes and
specific criteria charactering Islamic funds (according to the screen process
of the two major index suppliers, please refer to 1.2.4.1). Moreover the Paris
Europlace Committee, a French financial think tank, carried out a study on
necessary technical adjustments for a level playing field of conventional and
Islamic financial products in the French legal and tax framework. It has to be
mentioned that only Islamic wholesale business was subject to this research.
In the result the French economy minister Christine Lagarde concluded that
“French law already offers the best flexibility and adaptability to welcome
Islamic financial operations”. (Terdeyet 2008) Nevertheless there are still
new measures and tax incentives for Islamic financial services in
preparation. The support of the French state is regarded as indispensable for
the development of the financial service industry, according to Moody’s
Investors Service.
Currently the governmental efforts concentrate on investment and corporate
banking, in particular on the issuance of Sukuk (please refer to 1.2.4.2) by
private sector companies in order to raise funds in Middle East. The process
for the development of Islamic retail banking is in a much earlier stage and
the establishment of a French fully-fledged Islamic retail bank is not
foreseeable in the near future. (Moody’s Investors Service 2008)
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8.3.2.2. Future Prospect Outlook
In the coming weeks, Bank Chaabi148
will open its Shariah compliant
deposit account to SMEs, thus addressing a latent need of small businesses
for Islamic banking products. SMEs have voiced an important demand for
Islamic products, as French Muslims are known for their entrepreneurship
and represent an interesting customer base for Islamic banking. Hopes are
now high again that France will develop a sound Islamic finance market. But
much remains to be done.
First, the French AAOIFI standards have yet to be distributed and spread.
Second, Chaabi Bank is not yet offering the most complex products:
corporate funding and mortgages. Chaabi says it is aiming at a full set of
products by the end of 2012, which seems realistic in light of the recent 10-
year Murabahah home fi nuancing product.
Third, wholesale banking and capital markets are yet to be developed.
Chaabi’s first French Islamic window should pave the way for international
Islamic investment banks willing to penetrate the French market. The Sukuk
market may also benefit from the current funding difficulties experienced by
French international corporations, which could take advantage of the
comprehensive French framework for Sukuk issuance and listing.
Fourth, Takaful is not yet a mature topic in France, even though synergies
will appear evident with the rise of distribution networks for Islamic banking
products.
Finally, among the key 2012 drivers are the coming presidential and
legislative elections in May and June. But no matter what the results will be,
the industry will keep developing in France thanks to sound foundations and
strong potential. The election result only effect will be to influence the pace
of the industry’s growth.
148 http://www.chaabibank.fr
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8.3.3. Germany
Although it has an important Muslim population, Germany has not adopted its
regulatory framework to allow for the offer of Islamic products and services in the
country. Two factors can explain this situation. First, the development of Islamic
finance in the country has not received the necessary political support. Second, the
Muslim population of Germany is essentially composed of ethnically Turkish
people (second or third generation), which in general have shown less interest in
Islamic finance than other Muslims. The Deutsche Bundesbank argued that there are
still some challenges confronting the financial community with regard to Islamic
finance. Among the most significant factors which directly affects Germany is that
the supply of Islamic products is still largely geographically constrained in the
Middle East, Malaysia and London. This makes it difficult for a large number of
Muslims who live in Germany and in Europe to access these services.
The products are still aimed at a limited demographic target, designed for wealthy
private and institutional investors. The German financial institutions that offer
Islamic products do not advertise them and the product information is mostly only
written in English since it is aimed at investors from Islamic countries abroad and
not at the German Muslim population.149
In spite of this, some Governmental
initiatives can be observed. For example, in June 2004, the federal state of Saxony-
Anhalt issued a EUR 100 million Sukuk to Middle-eastern institutional investors
and also to attract Muslim investors to invest in their state.
The Sukuk launched was structured by Citigroup’s Islamic division and was backed
by real estate owned by the Ministry of Finance. The rights of use of this real estate
were transferred to a Dutch foundation which was offering the Sukuk. Saxony-
Anhalt therefore became the first state government in Germany and Europe to issue
a sub-sovereign bond under Islamic principles.150
There are some Muslims banks such as the Irani Bank Sepah established in the
country which have the largest share of the Islamic banking market in Germany.
149 Further information in Böhmler (2007). 150 IslamicFinance.de 2004.
206
Recently KuveytTurk announced its interest in establishing a branch in Germany in
the coming years to satisfy the financial needs of the Muslim Turks. Among
conventional commercial banks, Commerzbank, Deutsche Bank and Dresdner Bank
have experience offering Islamic products and services, however they are
concentrating their Islamic operations on extending their presence in Islamic
countries. Deutsche Bank offers Islamic products thanks to an agreement with the
National Commercial Bank of Saudi Arabia that allows them to provide a unique
class of investment products – the Islamic EquityBuilder CertificatesTM. The
Certificates, which are all in compliance with Shariah principles and approved by
the highly esteemed and regarded Shariah Board of National Commercial Bank of
Saudi Arabia, use an objective and transparent quantitative strategy rather than an
active management type of strategy. With these Certificates, investors have a choice
to invest in one or more regions or globally, and are able to use them as portfolio
building blocks, with the objective of building long term wealth and diversifying
risk. In 2008 Deutsche Bank received the go ahead from the Bank Negara of
Malaysia to set up a dedicated Islamic banking subsidiary in Malaysia. The
Commerzbank focuses on Islamic investment products, however also offers a
variety of interest-free competitive products meeting Islamic finance requirements
such as Murabaha deposits. Commerzbank has a presence in Dubai, Cairo, Beirut
and Singapore.
Continued talks, little action:
German banks, wealth managers and insurance companies active abroad
(mostly out of London and Dubai) for Middle Eastern and Asian markets but
not in Germany;
First sovereign sukuk: Saxony-Anhalt (2004-2009), no successor;
BaFin (= German regulator) conferences 2009 and 5/2012 to signal
openness, but no comparable signal from tax authorities;
Growing interest of insurance brokers in takaful products, but so far no
active distribution;
207
Kuveyt Türk’s application for full banking license pending;
Two Shariah compliant investment funds terminated/liquidated:
Commerzbank’s “Al Sukoor” (2000-2005), Meridio’s “Global Islamic Multi
index tracker certificate with a stop loss mechanism) sold through savings
banks.
8.3.3.1. Future Prospect Outlook
The nucleus of Islamic banking in Germany is the Kuveyt Türk Beteiligungs
bank, a subsidiary of the Turkish member of the Kuwait Finance House
Group. Established in 2010 in Mannheim, it started operations on a modest
scale in 2011. To become the first Islamic bank in Germany, Kuveyt Türk
has to extend its present license for the brokering of deposits with
enterprises outside the European Economic Area into a full banking license.
An application has been made, and it seems possible it can meet the
regulatory requirements. However, the unsolved (or even untouched) legal
and tax issues make it doubtful that the full banking business can start early
in 2012. Other Islamic banks (including some with European passports)
have verbally expressed their interest in operations in Germany, but none
have taken concrete steps. It seems that Kuveyt Türk has to prepare the
ground alone. It may benefit from the growing interest from German
business associations, legal and tax consultants and academics, who produce
an increasing number of studies, articles and conference papers on specific
topics of Islamic finance under the German corporate law and tax regime.
The Federal Financial Supervisory Authority (BaFin) will organize a follow-
up to its 2009 conference on Islamic finance in May 2012. This could place
Islamic finance (once again) on the political agenda. Another noteworthy
event in Germany, although not restricted to the German market, is a
Workshop on “Islamic Finance and Financial Stability”, jointly organized by
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the Islamic Financial Services Board and the European Central Bank in
Frankfurt by the end of January 2012. The German market will see the
introduction of a new savings product for Muslims: At roughly the same
time in December 2011, when the “Meridio Global Islamic Multi Asset
Funds”, launched only in May 2010, was liquidated, WestLB151
opened the
subscription for its “Islamic Strategy-Index-Certificate”. In the past, WestLB
had structured a number of Shariah compliant deals as an investment bank.
This time it acts in its retail capacity as the central institution for the savings
banks in two German states (North Rhine-Westphalia and Brandenburg).
The savings banks will become the main distribution channels for WestLB’s
open ended index tracker certificate with a stop loss mechanism.
The new “WestLB Islamic German Index” comprises the largest German
(DAX and MDAX) companies whose businesses and financial ratios meet
the criteria of Shariah compliance. Initially, the certificates will represent a
basket of 10 stocks that will be purchased physically. The issuing date for
certificates (with an issue price of 10.00 Euros) is the 17th January 2012,
and trading will start on the Frankfurt and Stuttgart exchanges on the 20th
January 2012.
The stop loss mechanism of the certificate will be triggered by a loss of 8%
(or more): In this case the stocks will be sold and the proceeds will be kept
on an interest-free money account until the index has reached or exceeded its
previous level. Since the new retail product differs from the liquidated one
in all relevant respects – portfolio composition, distribution channel, risk
limitation and Shariah certification —, its prospects may be much better.
151 WestLB AG is a European commercial bank based in Düsseldorf in Germany which is partly owned by the German state of North Rhine Westphalia. The letters LB in the name stand for Landesbank. The Landesbanken are a group of state owned banks unique to
Germany. They are regionally organized and their business is predominantly wholesale banking, however today the WestLB is no longer
a Landesbank.
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8.3.4. Other European Countries
Spain: The Spanish central bank, Banco De España remarks in one of its “Financial
Stability” reports that Islamic finance offers clear opportunities for the Spanish
banking sector. First, the Spanish retail banking sector could diversify their business
and find new commercial opportunities thanks to the economic relationship of Spain
with the Magreb (Northwest Africa) region and also, because these countries’
financial markets have a low correlation with the international financial markets.
Second, there is an interesting possibility of accessing the abundant Islamic savings
through the issuing of Sukuk, which can be used for financing banks or providing
credit to clients. In addition, the growth of the Muslim population in Spain could
mean an extra source of funds for expanding the Spanish retail banking sector. As
this population is consolidated in Spain and they increase their purchasing power,
the Spanish financial institutions could extend their customer base if they are able to
respond to the needs of this population. However, apart from these positive
possibilities, the Banco of España provides a list of arguments remarking several
risks surrounding the Islamic finance in a similar way that Germany does. The
national Islamic authority in Spain, “La Junta Islamica” has begun a process for
creating an Islamic Bank in Spain. The first phase of this process consists of
creating Islamic window facilities in one Spanish bank “Bancorreos” to sell Islamic
financial products such as current accounts and mortgages. Currently they are
offering just information and they have designed some brochures for the public in
order to educate potential customers about these products. Other Spanish banks such
as Santander and the Spanish savings bank “Caixa Bank ” announced their
intentions of entering in the Islamic market.
However, IRB is still relatively unknown in Spain and there is very little Spanish
language information available. Current situation:
Islamic finance is seen as a vehicle to promote employment generating
investments from Muslim countries (in particular GCC)
Conference of Madrid Stock Exchange to explore Islamic finance (2010)
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Exploring in particular sukuk as an alternative vehicle for corporate and
infrastructure finance
Establishment of the Center for Islamic Economics and Finance (CIEF) by
Instituto de Empresa business school and King Abdulaziz University, Saudi
Arabia; re-named November 2011 as Saudi-Spanish Center for Islamic
Economics and Finance (SCIEF)
Cooperation of Dubai International Financial Center (DIFC) with Madrid
Financial Center (MCF) for investment promotion
No Islamic financial institution, no sukuk issuance
Problems with racism and Islamophobia
Luxembourg: Has not been recognized in the world of Islamic finance for a long
period but it has a recent history of innovation in this field. Sukuks and products
structured on contracts such as Mudaraba, Musharaka, Murabaha, Istisna and Ijara
can in principle be set up within the existing legal framework of Luxembourg. Local
financial institutions are increasingly entering the Sukuk market and Shariah
compliant investment funds are being launched under Luxembourg law. In 1983,
Luxembourg was the chosen domicile of the first Shariah compliant insurance
company in Europe. The Luxembourg Stock Exchange was the first European stock
exchange to enter the Sukuk market, having listed Sukuks since 2002. In September
2008, 14 Sukuks with a combined value of USD 5.5 billion were listed and traded
on the Luxembourg Stock Exchange. In September 2008 there were 31 Shariah-
compliant investment funds held in 17 Luxembourg domiciled investment
vehicles.152
Malta: In 2008 the Malta Financial Services Authority (MFSA) launched a
consultation to analyze conventional Islamic funding structures and financing
vehicles vis-à-vis the Maltese regime applicable to collective investment schemes,
152 Source: Luxembourg for Finance (2008). Luxembourg for Finance is an agency for the development of the financial sector and is a
public-private partnership between the Luxembourg Government and the Luxembourg Financial Industry Federation.
211
investment service providers, credit and financial institutions. At the end of 2008
and beginning of 2009 the MFSA launched two consultations related to Islamic
bonds and Shariah insurance. The feedback from the first consultation was very
positive and the MFSA envisages a number of opportunities for the setting up of
Malta-based Islamic financial institutions as fully fledged banking institutions, as
well as a number of opportunities for the setting up of Shariah-compliant funds in
Malta. In fact, despite the current global financial troubles, in March 2009 investors
from Dubai have started negotiations with government officials in Malta on a
number of assets and projects. Malta, which joined the European Union in 2004, has
also become part of the Schengen visa regime, which it makes it easily accessible,
especially for investors from the Persian Gulf.
Austria: Among 8.2 million people in Austria, over 450,000 belong to the Muslim
faith in 2001, constituting 4.1 percent. In the early 20th century, when Bosnia-
Herzegovina was annexed by Austria-Hungary, a significant number of Muslims
was ruled by the Austrian government. Later on large immigrations flows from
Turkey and the Balkans arrived during the world wars. Islam is recognized as
official religion in Austria, meaning that it is taught in schools, for example. (BBC
2008) Walker, et al. (2007) state that the Muslim population in Austria will grow by
10 to 15 percent per annum in the next years and Philipp Wackerbeck (2008)
assigns around €230 million market potential to this target group. Alexander von
Pock (2007) estimates that 20 to 30 percent of Austrian Muslims would prefer a
Shariah compliant financial product to a conventional one, even to worse
conditions. Around one third would prefer it for the same conditions (compared to a
conventional product) and for additional 33 percent the religious orientation is not
relevant. There might emerge new market opportunities for Austrian financial
institutions, as Muslims in Austria are in general younger and save more (savings
rate around 18 percent). Of special interest are mortgage financing solutions,
insurance products and mutual funds, according to Mr. Wackerbeck (2008). The
regulatory and fiscal framework conditions have to be adapted in advance in order
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to provide a suitable market environment. For instance, the double stamp duty for
Islamic mortgage financing has to be abolished, like in other European markets. In
establishing itself in the Islamic financial market, Austrian institutions should base
on cooperation’s with Middle Eastern partners for example in the United Arab
Emirates, Saudi Arabia, Indonesia or Pakistan in order to obtain knowledge in
product development, operations, IT and sales. At the same time the local banks can
provide market knowledge and a distribution network. (Wackerbeck 2008 and
Walker et al. 2007) Looking at suitable distribution strategies, Walker, et al. (2007)
suggest to have employees from the same ethnical and religious background to
advise customers in their mother tongue. Furthermore a sensitive marketing strategy
is of utmost importance in order to approach the target group effectively.
There are already some banks in Austria that offer tailor-made products and services
for ethnic minorities. (Walker, et al. 2007) In this way several Turkish and
Slovenian banks cater their customers with export financing solutions and other
services destined towards their home country. However it is not apparent whether
those banks offer Shariah compliant services. The only Austrian financial institution
that offers Shariah compliant services to a small extent, is the Raiffaisen
Zentralbank 153
. According to the institution’s website (RZB 2009), it provides an
interest free Euro clearing account for Islamic financial institutions satisfying the
requirements of the Shariah. Furthermore Islamic financing solutions and structured
products are apparently offered on demand, according to an interview of
“diewirtschaft” with Tarek Mourad (2007) from RZB. He stated that the current
demand for their offerings concentrates on the GCC countries, only. Austrian
companies show interest only in case their business partners are provided by an
Islamic bank. RZB’s customers for Shariah compliant products are majorly
institutions. Shariah compliancy is ensured by the Shariah Supervisory Boards of
the respective Islamic partner bank on customer side and only in case of project
financing solutions RZB refers to external Shariah scholars. Mr. Mourad (2007)
153 The Raiffeisen Zentralbank Österreich AG (RZB) is headquartered in Vienna and belongs to the leading commercial and investment
banks in Austria. It is the third largest national institution.
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admitted that it would not be recommendable to concentrate on the Austrian market,
only (for example by offering an Islamic fund exclusively equipped with Austrian
securities). The demand for such a product would not be sufficient (Mourad 2007).
Switzerland: In 2008 the Islamic Bank of Britain (IBB) announced a plan to capture
part of the European market through the opening of branch offices in Germany and
Switzerland. However the results of these negotiations have not yet seen the light.
In 2006 Faisal Private Bank opened in Geneva, becoming the first in the country to
operate according to Shariah principles. In 2008 the National Bank of Kuwait
announced that they applied for regulatory approval to set up an Islamic bank with a
Saudi partner in Switzerland. In 2009 however, due to the financial crisis, the bank
stated that the process is still ongoing but has slowed. Switzerland given the good
international reputation of Swiss financial institutions, especially in private banking,
wealthy individuals from Muslim majority countries might become increasingly
interested in their Shariah compliant product offerings as this trend proceeds.
Therefore it seems likely that Switzerland establishes itself as center for Shariah
compliant private wealth management in Europe. The Swiss financial institutions
will thereby cater their international clients in Switzerland and, via respective
subsidiaries, in Middle East. However, due to the fact that neither initiatives from
the Swiss government are known nor Swiss banks have made advances in this
respect, it can estimated that the local Muslim community might not be targeted due
to the low socio-economic status.
Ireland: Ireland has launched a bid to become the home of Islamic finance in
Europe as it seeks to rebuild its once dominant financial services sector. Ireland is
already a significant location for Islamic funds with an estimated 20% of the Islamic
funds market outside the Middle East located in Ireland. The Financial Regulator
can and does authorize Shariah compliant investment funds under collective
investment scheme legislation.
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The Revenue Commissioners issued an e-brief in October, 2009 that clarifies the tax
treatment of Shariah compliant funds, leasing and insurance services in Ireland.
The technical changes provided in Finance Bill 2010 will give equality of treatment
to Islamic financial products as compared to conventional financial products.
Opportunities for Ireland
The Government has highlighted the Gulf Region as an area of growth for
Irish businesses and investors. The Region is also home to large numbers of
Sovereign Wealth Funds and large Regional Banks and finance houses with
access to significant investment capital. Ireland has recently concluded four
Double Taxation Agreements with Gulf States (Saudi Arabia, Bahrain,
Kuwait and UAE) – significant opportunities for investment are now
available provided the necessary framework is in place for Islamic financial
products. There are opportunities for Islamic financial services institutions to
establish EU headquarters locations here. As is currently the case with
conventional financial services products the majority of business activity
associated with Islamic financial products can be ‘pass-ported’ from Ireland
into the EU in accordance with the relevant EU Directives.
Aside from opportunities associated with headquarter operations Islamic
finance also offers a wide range of retail and commercial products, which
would be of interest in Ireland. This includes products such as a sukuk (the
Islamic equivalent of a bond), Murabaha (this financial product could be
used as a replacement for a term loan) and a Diminishing Musharaka
(Musharaka means partnership in Arabic and this arrangement can be used
to craft a mortgage or asset backed loan). These products will open new
sources of capital for Irish businesses from Islamic finance houses.
Conventional equity backed assets have fallen out of favor for some
investors. The ethical approach and the physical nature of the traded asset in
Islamic finance is an opportunity that the Irish Financial Services industry
would be in a strong position to promote to Muslim and Non-Muslim
clients.
215
There are about 30,000 Muslims living in Ireland. The Muslim Community,
through the Islamic Cultural Centre of Ireland and the Immigrant Council of
Ireland, as well as through initiatives with individual lenders, has indicated a
demand for Shariah compliant finance.
From a tax perspective, the groundwork has now been laid for the
introduction of such products in that part of the payments made by a person
paying a mortgage may be treated as interest for tax purposes thus qualifying
for mortgage interest relief. However, further changes are required to Stamp
Duties to enable the purchase of an Irish property pursuant to a Shariah
compliant mortgage to come fully within current tax arrangements.
The Netherlands: In 2008, the Dutch supervisory authorities, De Nederlandsche
Bank, and the Autoriteit Financiële Markten carried out a study with respect to
Islamic finance. The conclusion of this study was positive. Demand for Islamic
finance exists in the Netherlands as a result of the substantial number of Muslims in
the country. Dutch central bank reported that although a few domestic banks already
offer Islamic investment products in the Netherlands, the largest demand for Islamic
banking actually exists for Islamic retail finance and mortgages. The authors of the
study point out that important regulatory changes still have to be made to facilitate
Shariah compliant retail banking. Islamic mortgages, for example, are currently not
competitive vis-à-vis conventional mortgages as tax advantages are not applicable
and transfer taxes are charged twice.
Belgium and Italy (Italy is questioned deeply in the next chapter) are examples of
countries where the financial regulatory framework has not been adapted to allow
for the offer of Islamic products and services. The Islamic financial activities in
these countries are based on investment operations carried out by subsidiary
companies of Islamic banks from outside Europe – mainly in the Middle East.
However, Islamic finance has not been developed in this country. Belgium has an
important Muslim population – mainly of Moroccan origin – who are interested in
216
Islamic finance. However, the Belgian financial sector estimates that this demand is
not solid enough to develop a whole new Islamic retail banking activity. Banks such
as Fortis and ING have some Islamic financial activities but based in Malaysia.
The Governments of these countries have two alternatives.154
The first is to address
the current regulatory challenges that Islamic financial services have by law. This
involves adapting the regulatory framework for the entire banking sector in order to
support the expansion of the Islamic finance industry. The second alternative is to
address the growth of Islamic finance by separately regulating unique aspects of
Islamic banking. For instance, this would involve regulating how Shariah
Supervisory Boards should work in the country. In parallel, Governments should
keep in mind the rules introduced by the Islamic regulatory authorities that have set
Islamic Shariah rules for finance and accounting (among other standards).
8.3.5. Future Prospects for Islamic Finance in Europe
Although Islamic banking and financial services have been offered from Europe for
almost three decades in many respects the industry is still in its infancy. Much of
the business activity has been focused on shariah compliant institutions from the
Gulf and Muslim investors of high net worth, but this has resulted in activity being
somewhat cyclical and linked to oil market developments.155
The impact on
Europe’s resident Muslim population has been marginal, and mostly confined to the
United Kingdom, even though France and Germany have much larger Muslim
populations, with that of France exceeding five million. The Gulf and wider Muslim
world is likely to continue to generate substantial Islamic finance business for
London as an international financial center and Europe’s leading investment banks
and asset managers, but the longer term prospects are more likely to be shaped by
developments within Europe and further European Union enlargements. There are
two major issues, the first being whether retail Islamic banking services can be
provided for continental Europe’s Muslim population and if this is desirable.
154 Islam 2008. 155 Farmida Bi, ‘The global development of Islamic finance’, Business Islamica, Dubai, September 2007.
217
Secondly there is the issue of European Union enlargement to encompass countries
and regions with long established Muslim populations in the Balkans, and Turkey,
the most populous state in Europe, with over 72 million Muslims.
Although the European Union functions as a single market, banking and financial
regulation is devolved to member states. In the United Kingdom the Financial
Services Authority has played a proactive role with respect to Islamic banking and
finance and been broadly supportive, but that has not been the position elsewhere in
Europe, where central banks and other regulatory authorities have shown little
interest. There is also a negative perception of shariah, especially amongst right
wing and nationalist politicians, which potentially inhibits the spread of Islamic
banking and finance. What is not always appreciated is that shariah compliance in
finance is a choice, and not about the imposition of shariah on those, including
Muslims, who want to lead secular lives and manage their financial affairs in a
conventional manner. Some critics assert that Islamic finance is simply another
facet of segregation and places Muslim banking in a ghetto, but those who rebut this
argument point out, as shown earlier, that many leading European banks are now
heavily involved in Islamic finance. There
is certainly potential to develop more shariah compliant savings and financing
products for Europe’s Muslim community, as well as distribute Islamic takaful
insurance which remains in its infancy in Europe, despite the involvement of firms
such as Allianz and Prudential in the takaful industry in the Gulf. At present the
worldwide value of takaful premiums amounts to $1.7 billion, but less than one
percent of this is spent in Europe.156
The greatest potential for Islamic finance in Europe is undoubtedly in Turkey where
Islamic banking has been established since the 1980s although it remains on the
fringes of the financial system, accounting for less than five percent of deposits, and
opinions on its merits are politicized as already indicated. Turkey currently has six
special finance houses, as Islamic banks in the country are designated, most being
156 Susan Dingwall and Ffion Flockhart, ‘The potential for takaful in Europe’, Business Islamica, Dubai, September 2007.
218
under joint Gulf and Turkish ownership. The largest shariah compliant bank, Ihlas
Finance House, collapsed during the financial crisis of 2001-2002, but depositors
were compensated through Central Bank and the Ministry of Finance which helped
maintain public confidence in the special finance houses. The leading institutions
are Kuveyt Turk Participation Bank, which was established in 1989, and is majority
owned by Kuwait Finance House and the Kuwait Social Security Fund,92 and Bank
Asya, which is under majority Turkish ownership, and dates from 1996.157
Kuveyt
Turk has a network of 79 branches while Bank Asya has 111 branches spread
throughout the country, but with the largest number in Istanbul and Ankara. Both
banks receive most of their deposits through profit sharing mudaraba accounts, and
Kuveryt Turk, like its Kuwait parent, is heavily involved in leasing finance using an
ijara structure.
Turkey has the greatest potential for expansion of banking in Europe, including
Islamic banking, as the fastest growing economy, with GDP growth averaging 7.5
percent over the period from 2004 to 2006; and although this slowed to 5.7 percent
in 2007, growth is expected to accelerate to 6.2 percent for 2008.94 Turkey of
course starts from a low base given its per capita GDP of under $8,000, but it has
attracted foreign direct investment of almost $10 billion annually since 2005 and
remittances, mainly from Turks working in the European Union, average almost $ 1
billion annually.158
Turkey can serve as a bridge between the European Union and
the wider Muslim World and in the longer term it is likely to be Istanbul, not
London, which becomes Europe’s leading center for Islamic banking and finance.
9. Islamic Finance Growing, But Not In Italy Islamic finance is growing at an annual rate of 10%-15%. It has a global value of 1.7
trillion USD and counts 400 institutes with their offices. But the system is not breaking
through in Italy, but according to Hatem Abou Said of Al Baraka Banking Group (Bahrain)
''it could be useful also to support SMEs, which have limited access to credit through the
traditional systems, with their internationalization process." Abou Said spoke during a
conference in Milan on the issue, saying that the crisis in the West and the Arab Spring
''there is complementarity''. It would be useful, in his view, to ''attract the attention of
Islamic finance to help Italian companies that could be active in the re-launch of the
countries on the southern shore of the Mediterranean Sea." ''Islamic finance,'' Abou Said
continued, ''is determined to help the European economies that are in difficulties. But I'm
afraid that people in Italy have wrong ideas about these instruments, which are meant for
everybody, not only for Muslims." In this context, Pierfrancesco Gaggi, head international
relations of Italian Banking Association ABI admits, ''little has changed since a few years
ago'' and the debate that was opened to change regulations to allow the introduction of
'sukuk' and other Islamic instruments in Italy as well has been halted by the crisis. ''The
banking sector had to deal with more urgent issues,'' Gaggi confirmed.
I will summarize the previous chapters before I start analyzing the Italian market. The
Islamic Finance Service Industry (IFSI), which has marketed itself as being an alternative
to the conventional financial system, has come a long way from its rather modest and
relatively recent beginnings. Islamic finance requires all transactions to comply with
Shariah principles (The term “Shariah” refers to Islamic law and principles). The most
important principles of Islamic finance include a prohibition on earning interest (Riba), on
uncertainty/speculation (Gharar) and investment in ‘unethical’ businesses, products or
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services (such as alcohol, tobacco, pork, gambling, adult entertainment, and weapons).
Shariah compliant products are typically backed by or based on an identifiable and tangible
underlying asset; it is also important that the investor and investee share the risk of all
financial transactions. Under Shariah law money is used to measure value and is not an
asset in itself.
Islamic finance is considered to be the fastest growing sector of finance in the world,
growing at roughly 10%-15% per annum. Approximately one quarter of the world’s
population is Muslim, yet according to recent evidence less than 1% of global financial
assets are Shariah compliant. It has been forecast that the industry could potentially have
assets totaling $4 trillion under control.
Islamic Financial products, while they are faith based, are not limited to Muslims but are
available to everybody. The legislation is necessary, without this legislation certain Islamic
finance transactions may incur a higher tax charge or different VAT treatment, or may not
fall within the charge to tax. These changes will ensure equality of treatment between
Islamic financial products and their conventional counterparts. These products are the
same in substance as conventional financial products.
The UK introduced legislation on a phased basis. In addition to the UK, France, Ireland,
Russia, the Netherlands and in particular Luxembourg have introduced or are planning to
introduce legislation that allows for Islamic finance transactions.
Italy remains one of the few major European countries had not yet implemented the Islamic
financial system. Italian banks are, in fact, slowly becoming aware of the opportunities that
the implementation of the Islamic sector offers competitive terms, including increased bank
deposits, the potential synergies with the entire Arab world, the greater capacity of
internationalization of firms and The strong message of social integration. However, in this
regard it is noted a recent significant interest from both the market and the political system
in general.
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The Recent growing interest bred because Italy is a privileged partner in trade with the
Mediterranean states and the Arab Gulf and also considering the presence in Italy of
citizens of Muslim religion now have business activities and financial assets available. On
September 25, 2007 Adnan Yousif, Chairman of the Union of Arab Banks, has signed a
memorandum of understanding with the Italian Banking Association to open in Italy by
2008 of a bank based on the principles of the Quran, in line with as already happens in
other European countries. To date, this understanding has remained only a declaration of
intent.
The spread of Sharia-compliant financial instruments in Italy is definitely a need for the
country's competitiveness and adaptation to the international trend, but their introduction
and their use requires proper management and supervision, for the many difficulties and
their of interpretation and implementation. The issues related to the opening of an Islamic
bank in Italy concerning different areas. From a statutory point of view, the essential
problem is the collection scheme and the Islamic bank loan that requires no repayment
obligation, but a most in the conventional banking systems. The English model, have
already faced and solved these problems. The British choice wasn’t to define separate
legislation but seeking, instead, with flexibility to frame the phenomenon of Islamic
banking in the existing regulatory framework, it seems, in fact, the most appropriate for
European countries. For an initial analysis of existing conditions, implementation of an
Islamic bank in Italy can greatly promote the country as an additional channel for economic
development and finance available to the population growth in its economic relations with
the neighboring Arab world. It seems necessary, in fact, given the global liquidity crisis,
promote investment in both directions and intercept a portion of surplus savings from the
Islamic world.
Islamic finance has entered a bright new stage of development, emerging after the global
financial crisis as a more equitable and efficient alternative to the Western approach." The
widely read Arabic daily Asharq Al Awsat opined, "Islamic banks are untouched by the
current crisis due to the nature of Islamic banking especially that it does not deal in debt
trading and distances itself from market speculation that takes place in European and
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American banks." The question that arise, does Islamic banks have a solution for the Italian
current economic and financial crisis?
9.1. The European Experience: A Message to Italy
Recently it seems to be random coming to light of funding Shariah-compliant
banking products in several European countries. The institutional response from
both governments and the authorities control of the banking system has been very
different in various countries. United Kingdom, France, Ireland and Germany
responded with varying intensity, to those needs. In other situations, the great
interest in the field has been vulnerable by the attitude of cautious waiting, as in
Italy, the development of this alternative financial system is almost completely
limited.
The future growth of this application are based on the fact that Islam today is the
fastest growing religion in the world, especially in European countries, also an
increase in the Muslim middle class. Therefore, it is difficult not to assume Islamic
finance in Europe for the future growth.
Currently more than 18 million Muslims across Europe, the strong liquidity
available to Arab countries and the very positive response of Islamic banks to the
recent crisis makes the development of Islamic finance a necessity for Europe.
Islamic Finance Begins to spread among the European public financial system,
considerations made on the economic relations regulated by Islamic law as a solid
and workable alternative, or rather an alternative to the conventional financial
system. In this regard, the traditional banking lobby is particularly strong and closed
in some countries, and has no interest in losing market share, neither its
monopolistic position in the European financial markets in favor of Islamic
financial institutions.
UK remains the nation to have gained the most significant experience in the field,
representing a model to follow. It has been able to attract more Islamic banks in
addition to the large resident Muslim population, a result of the strong historical
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relations with Eastern countries, thanks to the remarkable ability of the financial
industry and the importance of the international English market. Geographically, the
English alternative is attractive when compared with that of America, also favored
by the current political relations with Islamic countries. The sum of all these
variables has led to a naturally address the Muslim world to Great Britain.
Over the years, the British have dealt with the implementation of Islamic finance
while avoiding any discussion of religious or cultural. The Islamic banking was
regarded simply financial innovation, emerged in the financial services industry. It
is, in fact, avoided legislation that was tied to a specific religious belief, maintaining
the important principle of the one banking license, unlike other countries which
have opted instead for a dual banking system. In the United Kingdom has decided
not to introduce the category of the Islamic bank but only amend existing legislation
to allow it to operate:
Particular issues have catalyzed the attention, the fiscal neutrality of Sharia
compliant products and the principle of protection of deposits.
On the first point, without ever mentioning the names of Islamic contractual
structures, the British legislature has defined the general concepts, however,
specifying precise conditions under which it is possible to include the main Islamic
contracts. Regarding the protection of deposits, the English law requires the
mandatory redemption. However, as stated in the text, which is inconsistent with
basic principles of Islamic finance, which makes the reimbursement of business
related to the result. The problem was easily overcome by the inclusion, in the
English law, for certain specific clauses in the contract of deposit.
The current objectives of the British Government on Islamic finance are clear and
are to maintain the leading position of London as an international financial center,
continuing to expand the range of financial products available to consumers and
ensuring that no one is denied to undertake any financial asset, because of religious
discrimination.
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The legislative choice in UK, about the principle of single banking license, seems to
have indirectly affected the common choice, the adoption of "Islamic windows".
These handy windows on the world of Islamic banking allows, in fact, an initial
analysis of the real sector demand Islamic. The working formula has been a key
factor in the recent development of Islamic finance in the United Kingdom.
France Despite the financial leadership of London, France is the first European
country in terms of Muslim residents, These peculiarities that increase exponentially
the needs of financial services required, especially in real estate. The French
government's stated aim is to vigorously implement the Sharia-compliant system,
with particular attention to the wholesale segment, which is the main business of the
Islamic sector globally, and only later, will develop the attractive retail segment.
This plan aims to bring France a significant share of liquidity East to compete in the
long run, with London, for the leadership of the sector at European level.
The objective of the European leadership might seem feasible, given the current
significant french disadvantage French approach to Islamic banking, but with a
more careful evaluation, considering the starting positions and the potential, if it re-
evaluates the credibility, at least for the long-term goal. In this way, France is
working hard to regain lost ground trying to stimulate interest in the French
financial community by developing a deeper knowledge on the subject.
Currently the French debate has focused on policy issues and regulations, to make
possible the necessary technical adjustments to the French legislation to reduce the
typical tax and legal impediments to the development of Islamic finance. From a
technical point of view, the square of Paris seems to provide the necessary skills to
be able to create great synergies between the Islamic and the conventional system.
The speed with which Islamic banking will grow will depend a lot on French
territory, then, by the work of government and how this innovative sector will be
perceived by the population.
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Germany, which works typically with Islamic windows, was the first in Europe to
issue, in 2004, a sovereign Sukuk. Investments in the Gulf countries of Europe into
the most important applications are facilitated by the first financial structures
compatible with sharia as is already done for some years in the United Kingdom.
Ireland has made some important improvements to facilitate Islamic finance
transactions in Ireland over the past number of years. Under Finance Bill 2010159
,
the Irish Government160
introduced significant amendments to Irish tax legislation
to further facilitate Islamic finance transactions in Ireland. These amendments were
supplemented by detailed guidance notes which were issued by the Irish tax
authorities in November 2010. Recent activity in Islamic finance in Ireland
includes the listing on the Irish Stock Exchange of a US$2 billion Goldman Sachs
backed Sukuk on 19 October 2011.
Spain, Islamic banks are not yet present, although there are ongoing negotiations
and agreements. The Banco de Desarrollo Islamic, based in Saudi Arabia, is the
institution most affected and is currently studying a series of agreements in the
industrial and financial sectors. It is, however, no activity directed at private
customers, but at least for the first phase, companies and entrepreneurs.
9.1.1. Europe’s Countries Market Players
In the last decade, the European Union became an attractive market for expansion
for the Islamic banks, due to its big potential. Following the Statistics provided by
the Pew Research Center (see figure 31), there are about 18 million of the Muslim
inhabitants in the European Union, most of them living in United Kingdom, (2.8
mln, about 4.6% of total population), France (5 mln, 8% of total population),
Germany (4.1 mln, 4% of total population). Also, following these statistics, a great
percent of Muslims, live mainly in the big cities of the mentioned countries.
159 http://taxpolicy.gov.ie/wp-content/uploads/2011/03/Information-Note-on-Islamic-Finance-in-Ireland-March-2010.pdf 160 Political Support from the Irish Prime Minister pledged his full support to ‘ensure’ that Dublin becomes a ‘Centre of excellence for Islamic finance’ in an address to the Irish Funds Industry Association in June 2011. This commitment was further underpinned by
highlighting Islamic finance as a key opportunity for growth in the “Strategy for the IFSC in Ireland 2011-2016” published by the Irish
government in 2011.
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The United Kingdom, where the Muslim population is one time less than in France,
is home to five licensed Islamic banks, the only licensed ones in the European
Union, and lists £5.5bn in sukuk, or Islamic bonds, on its stock exchange. Since
2003 the United Kingdom has been reforming laws to ensure that Shariah compliant
investments are not prone to higher levies than their conventional equivalents.
Up to 2012 in France, several financial institutions seem to be willing now to enter
into a licensing process for this purpose, the development of Islamic finance has
concerned mainly investment banking and not retail banking, but this situation
could evolve: even though France has a Muslim population of about 6m, only a
handful of French banks, such as BNP Paribas and Société Générale currently offer
wholesale Islamic services. These types of structures are called ‘Islamic windows’.
These windows have contributed significantly to the development of Islamic
finance, although the French Islamic windows do not provide retail products at all.
However, France is taking a significant step towards establishing Paris as a western
center for Islamic finance. Generally speaking, France’s goals are to attract global
funds, and, particularly, to make France more competitive in the area of Islamic
finance since France, being an international finance center, has to handle the
phenomenon of forum shopping within Europe and the rest of the world.
Germany, the country with the second largest Muslim population in Western
Europe, is among the least developed European markets for Islamic Retail Banking
(IRB).
It is noteworthy that the short supply of IRB in Germany cannot simply be
explained by a lack of interest among the 3.5 million Muslims living in the country.
A recent study among German Muslims conducted by the Institute for Islamic
Banking and Finance and published in a major German newspaper reported that 66
per cent are interested in Shariah-compliant investments, 19 per cent are, maybe,
interested and only 15 per cent are not interested. In a similar poll, two thirds of the
Muslim respondents expressed interest in Islamic mortgages and about 40 per cent
227
were interested in Islamic consumer credits, insurance products and mutual funds.
IRB is prospering in the UK with 2.8 mln Muslims resident while being largely
stagnant in Germany with 4.1 mln Muslims resident.
Many large German banks offer Islamic banking solutions to wealthy customers in
the Middle East but no institution in Germany currently makes a similar offer to
local German customers. In 2004, the federal state of Saxony-Anhalt issued a 5-year
Sukuk (a Shariah-compliant equivalent of a bond) with a volume of S 100 million.
This was the first Sukuk issued in Europe, but again with focus on investors from
the Gulf States. Only a few Middle Eastern banks offer to German customers a
small range of Islamic banking services through their branches in Frankfurt. The
Kuwait Turkish Participation Bank KFHTurkey recently obtained a license from the
German Federal Financial Supervisory Authority (BaFin) allowing the bank to
introduce Islamic banking services to the German banking system. The bank
announced to open the first Islamic bank in Germany in 2010. This will, however,
only be an indirect offer of Islamic finance in Germany, as all collected money will
be transferred to Shariah-compliant accounts in Turkey.
Islamic finance had a considerable growth in EU, both in the presence of
immigrants and for increasing opportunities for cooperation between Europe and the
Middle East. In many European nations, the Islamic banks coexist with other
commercial banks. The models can be two:
Specialized Islamic banks, which are structured on the basis of Islamic
principles and offer only compatible with these services;
Islamic windows, doors or offices specialize in offering Islamic finance
products in the context of conventional banks.
The most common are now the second, in fact, the major European banks offer to
their domestic branches and dedicated products, such as current accounts and
investment funds. It is still almost no diffusion of products of business financing
after the pattern of Mudarabah and Musharakah.
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The largest Islamic banks are mainly present in four countries: France, Germany,
Switzerland and United Kingdom:
United Kingdom: the Islamic Bank of Britain (IBB), the European Islamic
Investment Bank (EIIB) – first Islamic investment bank from Europe, the
Bank of London & the Middle East (BLME), Securities House (UK), the
European Finance House (EFH);
France opened doors to the for Islamic banking: : National Bank of Kuwait
(NBK), Tejerat Bank (TB), Qatar National Bank (QNB) etc.;
Germany opened doors for the Irani Bank Sepah, KuveytTurk.
In Switzerland, the first Islamic bank license was given in 2006, Faisal
Private Bank Switzerland Ltd. is the first private banking institution
operating in Helvetian territory. It offers asset management services to a
clientele of high-end products compatible with Islamic law.
From a regulatory and policy framework, the Italian market suffers delays in
relation to other European countries that are adapting to hospitalize the Islamic
Banks. The question, therefore, arises can Italy open doors for IRB with 1.5 mln
Muslim resident? Is IRB only for Muslims? Does IF has a solution for Italian rises?
In the next chapters I will shed light on this question.
9.2. Italy A Potential Market For Islamic Banking?
The Muslim population in Europe is over 18 million and in Italy there are over 1.5 million
Muslims (2011), who represent about one third of foreign residents and 2.8% of Italy’s
population. Islamic Banks are 26 in Europe. As for Italy, currently no Islamic Banks. Apart
from the Iranian Bank Sepah, which has a branch in Rome but it only elaborate transaction
with Italian companies, and that is the only Islamic bank operating in Italy according to the
principles of Islamic finance, to date there are very few Italian institutions that have been
responsive to this type of finance.
229
One of the traits that distinguish the Muslim population in Italy from other European
countries, characterized by two or three nationalities clearly prevalent, is the number of
countries of origin. The main countries of origin are basically nine: Albania, Morocco,
Tunisia, Egypt, Bangladesh, Senegal, Pakistan, Algeria and Turkey. To mention that there
are 121,000 Indian in Italy, Islam is India’s second largest religion.
According to Istat161
for the year 2011 the number of residents by origin are the
establish whether and to what extent they could participate in the Italian market.
Before entering into the details of this issue some preliminary considerations are
needed. On the one hand there is a limit to the analysis stemming from the fact that
to date Italy has had no direct, practical experience with Islamic financial
institutions. As a result the analysis and the conclusions necessarily suffer from
some degree of abstractness. This limitation can be overcome, at least in part, by
drawing on the experience of other national markets with a regulatory framework
similar to Italy’s.
Supervision is no longer conceived as a set of strictly domestic arrangements but as
part of a boarder system in which the basic rules are European or international.
What happens within this global supervisory system can certainly help us in
understanding phenomena, such as Islamic Finance, that are concretely present at
the national level.
On the other hand there is a secure point of reference that consists of the standards
and basic supervisory rules that cannot be altered at the national level because, as
noted, they are founded at the EU level or higher. The regulatory framework
governing financial activities in Italy and Europe rests upon objective rules whose
purpose is to ensure the prudent management of intermediaries and the stability of
the system as a whole, absolutely without prejudice to entrepreneurial independence
and a level playing field for intermediaries.
In any event, the entry of Islamic finance cannot be dealt with by imagining the
creation of a special regulatory regime (adoption of ad hoc rules), either for or
against. Against this background the issue must be dealt with in terms of integration
with, rather than separation from, conventional finance. Any setting of the two
financial systems in opposition to one another would be not only anti-historical but
also irrational, in that it would be a source of conflict, of impediment to economic
integration, and instability. The work of the Islamic Financial Services Board –
especially the rules on capital requirements – testifies the effort being made by
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Islamic Finance to operate on the basis of standards, internationally accepted and
comparable to those that apply to conventional financial institutions (IFSB 2005)164
.
The UK experience, which proves how the setting-up of an Islamic bank is possible
in a background characterized by the enforcement of supervisory rules based on EU
directives, might be the starting point to verify the compatibility of such a bank with
the Italian regulatory system (FSA-UK 2007)165
.
However, it must be noted that the operations of Islamic financial institutions may
also involve the application of laws that are not subject to EU or international
harmonization, such as private law and commercial law. This may produce
differences in the operating conditions granted to Islamic financial institutions in
different EU countries.
Finally it must also be considered that Islamic finance is considered a complex
phenomenon for non-Muslims. In the countries in which they are active, Islamic
financial institutions in banking, insurance and financial services offer a well-
ramified set of products ranging from micro-credit to the issue of complex bond-like
securities, from small deposits to personalized portfolio management for prime
customers. Even without considering insurance products and matters related to
trading in financial instruments, it is plain to see that Islamic financial
intermediation departs from the classical commercial banking model specifically in
the area of fund-raising and lending alternative to the deposit and loan contracts that
conventional banks ordinarily use. It follows that one must examine the
phenomenon from a broader perspective that used to study conventional banking,
considering Islamic financial institutions as operating primarily along lines that can
be linked to those of investment banking, asset management or collective
investment schemes.
164 The IFSB has also adopted guidelines on risk management (2005), corporate governance (2006), transparency and market discipline
(2007), supervisory review process (2007), and recognition of ECAIs (2008). 165 As at November 2007 three Islamic banks were licensed by the UK FSA. The Islamic Bank of Britain initiated its operations as an authorized institution in 2004; the European Islamic Investment Bank and the Bank of London and the Middle East were licensed
respectively in 2006 and 2007. The first of these is retail, while the other two are wholesale. At the end of 2007 other applications for
license by Islamic banks were under consideration by the UK financial supervisory authority.
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The economic function of Islamic finance nevertheless remains financing economic
activity by employing surplus funds in investments that reward the most meritorious
initiatives. The risks are those typical of financial intermediation and imply the
necessity of applying forms of prudential supervision over intermediaries and over
activities, to safeguard their proper management and prevent any crisis from having
systemic repercussions (Iqbal 2003; El Hawary, Grais and Iqbal 2004).
The statistics and likely future developments suggest that the issue of Islamic
finance needs very careful consideration in countries not currently hosting Islamic
intermediaries. This is the frame in which to set the prospect for the demand for
Islamic financial products in Italy.
9.3.3. Islamic Banking: Impression of an Italian Jurist: Pietro Abbadessa
The banking model is totally different from the one adopted in non-Islamic
countries, but does not lack an adequate competitive force on this account. Maybe it
is true that ideally the object to be pursued is the development of a dualistic banking
system, in which Islamic banks may co- exist with conventional banks and compete
with them. Dr Fahim Khan (1986) has shown that it cannot be taken for granted that
the outcome of this competition would weigh in favor of non- Islamic banks. At any
rate, in order to compare these two banking models – if it is necessary to clearly
distinguish one from the other – two different institutional frameworks should also
exist, both at the primary level and at the regulatory level, valid for the banks
operating under the Islamic and the traditional paradigm respectively. Currently,
however, this condition does not exist; therefore, reasoning about Islamic banking
today forces us to constrain this experience within the cultural, juridical and
technical categories which belong to conventional banking. And this is no easy task.
From juridical perspective, this chapter will try to explore to what extent, within the
Italian legal system, it is possible to constitute a bank that, even though not aiming
to fully implement the program traced by Dr Fahim Khan, internalizes, at least to
some extent, the objectives characterizing Islamic banking.
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With regard to this issue, Alessandro Nigro (2006) has proposed a radical theory,
according to which, in its present state, the Italian banking system would not
tolerate a credit institution governed by the principles of Islamic banking. The
reason lies in the fact that, under Italian law, an institution can operate as a bank
only if it exercises an activity which combines collecting money on deposit from the
public, without having the saver run any risk, and granting credit: operational
patterns both forbidden to Islamic banks. In fact, on the basis of the Riba
prohibition, banks are neither allowed to offer a fixed rate of return on deposits nor
to charge interests on loans.
Surely, it would be very difficult to disagree with the premise from which this
observation stems. Nevertheless, the conclusion at which Nigro arrives does not
take into due consideration the circumstance that if, on the one hand, the
Consolidated Law on Banking still defines banking activity in traditional terms, on
the other, it has given banks the chance to exercise other financial activity in
addition to banking (complying with the respective discipline) without prescribing
that the second (banking) should be prevalent over the others (financial). That is
precisely where the flourishing of new banks in the Italian market comes from.
Sometimes they are a result of the transformation of pre- existing investment
institutions which keep the denomination of bank because of the pull that it still
possesses over the public, and most of them are focused in the field of financial
activities other than banking, in the first instance, financial services.
On the other hand, it has been argued that the Consolidated Law on Banking would
legitimate the existence of banks which exclude, ex ante, the exercise of banking
activity or which, even though such activity is stated in their own corporate objects
and programs, do not in fact pursue it. This reconstruction is in sharp contrast with
both a traditional opinion and art. 10, paragraph 3, of the Consolidated Law on
Banking. This article clearly states that the above mentioned financial activities may
be exercised ‘in addition to the banking activity’, leaving no doubt that this element
cannot be set aside.
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The circumstances that Supervisory Instructions do not specify (so far) as being the
minimum requirements in order to qualify as banking activity, are not enough to
modify the conclusion reached above, therefore authorizing an expansion of the
bank paradigm beyond the boundaries which the law draws. In addition, it would
not be difficult to find out the possible sanctions enforceable against a bank that
does not comply, in its bylaws or in its program, with the legal provisions
(withdrawal of banking license, loss of authorization on account of failure to start
the activity, extraordinary administration).
This might be the juridical framework which it is necessary to examine in order to
examine the acceptability of Islamic banking within the Italian system. On this
issue, it is widely known that collecting savings without charge accompanied by an
unconditioned repayment right is common in the Islamic banking context. The
existence of these kinds of savings, which are not unknown in European practice,
makes it possible to think that one of the essential conditions that needs to be
fulfilled in order to constitute a bank (the collection of deposits without any
assumption of risk by the saver), the remuneration of the deposit, is not necessary.
Vice versa, it is not required that the bank collect money in forms that imply some
risk for the saver (for example, direct collecting, obtained through the issue of the
peculiar kind of securities called ibridi (hybrid) in the Italian system – and now after
the 2003 company law reform strumenti finanziari partecipativi or indirect
collecting, where the bank operates as a simple intermediary between the saver and
the investment), which is the core feature of Islamic banking.
In both cases, we are faced with absolutely legitimate operations, widely practiced
in the Italian context, but which are not able to qualify an institution as a bank. In
order to constitute a bank, collecting activity which does not involve the saver in
any corporate risk is a prerequisite.
Therefore, in order to exist, under Italian law, an Islamic bank will have to combine
the collection of reimbursable funds with credit- granting activity, using contracts
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that, by their specific nature, put the bank in a risk- free position, with the sole
exemption of pure factual risk associated with creditor insolvency. Keeping in mind
the riba prohibition, the contracts which, in Italian banking practice, can be used as
vehicles for this specifi c kind of activity are free loans (the so- called mutuo a titolo
gratuito) and, above all, leasing contracts which, on one side, do not envisage strictu
sensu interest payments (even though the observation smacks of formalization, the
last word on the subject belongs to Islamic law scholars) and, on the other, can be
brought back to the credit- granting paradigm, as Renzo Costi (2007) has
demonstrated.
Secondly, all the operations in which the bank operates as a simple intermediary in
the circulation of goods (largely performed, in practice, by Islamic banks in order to
bypass the Riba prohibition) are surely not part of it. These operations cannot be
considered to be credit granting activities as defined by the Consolidated Law on
Banking (in fact they lack the quid proprium of these operations that consist in a
temporary increase of wealth for the credited party accompanied by a duty of
reimbursement towards the crediting party) or the financial activities that banks are
allowed to perform. Therefore, they are absolutely forbidden to credit institutions
regulated by Italian law.
However, the restrictions imposed by Italian law on the constitution of Islamic
banks could not be bypassed through the incorporation of the bank in a more
tolerant European country, with the objective of operating in Italy later on under the
shield of the mutual recognition principle. European law guarantees, in fact, such
benefit only to enterprises whose activity consists in receiving deposits or other
reimbursable funds from the public and granting credit. It follows that, if these
requirements are not met (the same ones that Italian law provides for in order to be
able to speak of a bank), the communitarian enterprise even qualified as a bank
under the law of the country of incorporation could never be allowed to operate in
Italy, given the principle of home country control.
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If Italian law gives enough space for the incorporation of banks that follow Islamic
principles, it should not be overlooked that, under the Supervisory Instructions in
force, such a bank would be subject to relevant restrictions in the specific kind of
activity that, as a consequence of the Riba prohibition, is practiced more. In
particular, resources collected from the public could not be used to assume
participation implying subjection to corporate risk, such as shares or other financial
instruments (under different names), and that do not guarantee the reimbursement of
capital.
In fact, the use of these instruments is allowed under Islamic law because the return
of the investment is justified in terms of risk rather than simple interest revenues,
which are forbidden by the Riba prohibition. That having been said, at present, the
only chance available for the development of Islamic banking in Italy is to
concentrate operations in the financial services market, once all the minimum
requirements in order to obtain and keep the banking license are met. This option
would make it possible to offer the clients the services of negotiation of financial
instruments, portfolio management on an individual basis and, above all, to foster
the institution of Islamic- characterized investment funds through the constitution of
investment management companies (SGR).
A possible alternative would be to appeal to the new instrument of separate
financial patrimony, but at present this is an unexplored track. Under this kind of
reconstruction the space available for Islamic banks is very distant from the
ambitious banking model described by Dr Fahim Khan. In any case, if the
regulatory system has been correctly considered, today, in Italy, Islamic banking
could not be much further removed from what Italian banks born at the end of the
transformation from investment companies do. They do not hesitate to squeeze
banking activity in favor of indirect collecting and financial services.
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9.4. Prospect for Islamic Finance and Banking in Italy
The success and spread of a product or of an institutional operational model for the
financial industry must not be allowed to depend on the rules. It is not the regulator’s
supervisor’s job to determine the economic needs of the market, the products and services
that firms and households need. Selection of the enterprise that offer financial services and
products is up to the market. Market participants, for their part, must observe the rules,
whose objective in the financial sector is to ensure stability, transparency, investor
protection, and hence a level playing field among financial institutions.
It will therefore be the market itself that determines whether or not Islamic banks will enter
the Italian financial system and stay there.
Their presence will be weighted by the same general rules applicable to all intermediaries
operating in Italy and that guarantee financial stability and a level playing field. The offer
of Islamic products must also comply with standards of contractual and market
transparency and with investor protection legislation.
In general, Islamic financial institutions may enjoy two sources of attraction for customers:
the awareness that they are investing their savings without violating religious precepts and
higher yields in return for forgoing the right to immediate restitution of the money lent. In
theory, this second feature could attract funds from non-Muslim investors as well.
The problem of protecting savers for whom profit is not the root of their investment choices
has already been pondered by the supervisory authorities in relation to initiatives of ethical
banking and the offer of ethical saving and investment products. The solution was to
recognize the legitimacy of motivations different from the mere search for the highest
return, but to concede no derogation from the rules on financial intermediation that would
result in disparities in guaranteeing the interest that it is the supervisors’ duty to safeguard:
of intermediaries and investor protection.
Allowing lower prudential standards for Islamic banks than those required of conventional
banks would not only discriminate against Islamic customers in terms of safeguards for
256
their economic interests but also give those institutions an unfair competitive advantage
over their conventional counterparts, the price of whose products incorporates the cost of
complying with the supervisory requirements (FSA-UK, 2007).
As for the second potential point of attraction for Islamic banks, we have seen that in
general the relationship between savers and the bank cannot be simply reduced to the
‘deposit’ scheme of conventional banking. Rather it is more comparable to other kinds of
fund- raising and, especially, to collective asset management. But especially when we are
dealing with persons long since integrated into the economic and social life of non- Muslim
countries and used to conceiving the relationship with their bank the way Europeans do, we
must wonder how far this aspect, which sets Islamic banking sharply apart from
conventional banking, can be truly perceived by the saver and hence accepted in the event
of a negative investment outcome. For that matter, the experience indicates that Italian
investors themselves are hardly inclined to accept negative financial events, and not only
when the responsibility lies with the issuers or sellers of financial products.
Actually, the Islamic financial institutions themselves and some supervisory authorities
implicitly recognize that savers have a ‘right’ to the expected profit. It is therefore
important, in order among other things to contain ‘displaced commercial risk’, that in
application of the Consolidated Law on Banking and the Consolidated Law on Finance
customers be given all due information and fully transparent contractual conditions.
9.5. Results: The Determinants of IRB in the Italian Context
After a deep study of understanding Islamic Finance and covering all the important topics,
an important conclusions can be drawn for the Italian system. In this thesis, I therefore used
the insights gained from this cross-country comparison to develop a framework that
identifies the most important determinants of IRB in the Italian context. My approach is
based on archival research, using multiple sources of information:
First, I reviewed the IRB in Europe and its historical experience.
257
Second, I conducted analysis of Italy’s potential market for Islamic Banking
Third, I conducted a thorough search of newspaper and web articles to cover the
latest developments, current opinions and ongoing controversial discussions on this
topic in Italy.
Fourth, I reviewed a number of industry publications and company brochures.
Owing to the novelty of the topic, so far few academic articles have been published
in this area and none of them provide an overall picture of the IRB drivers in
Europe, neither a future prospect for Italy’s possible IRB.
Figure 35 -- The determinants of Islamic retail banking (IRB) in Italy. (own
illustration)
258
However, in thesis, I attempt to fill this gap by proposing a systematic framework that
illustrates the embeddedness of IRB in Italian socio-economic context, which shows how
these environmental factors are interrelated and demonstrates how they determine IRB
systems.
Based on my research, I identified four major attributes of a nation’s socio-economic
environment that individually and interactively determine the evolution of a domestic retail
market for Islamic finance in the Italian context. These connections are depicted in Figure
35. Already from viewing Figure 35 it will become apparent that my framework is modeled
on Porter’s diamond of national competitive advantage166
. The arrows indicate that the four
determinants are interdependent and mutually reinforcing in their impact on the respective
IRB system and the circles are the support that should be made to promote the four
determinants.
For example, favorable supply conditions can only exist in a country if there are supportive
government regulations, which, in turn, depend on societal support for IRB.
9.5.1. Demand Conditions
Although the focus of Islamic wholesale banking is on international institutional
investors, IRB is largely driven by domestic demand of local consumers and small
businesses. The first important determinant of the development of IRB is, therefore,
the level of domestic demand, which depends, in turn, on the size of the relevant
market segment. Apart from a small segment of non-Muslim consumers who
perceive IRB as an ethical investment opportunity, as it avoids engagements in
areas such as alcohol, tobacco or weapons production, most consumers choose IRB
for religious reasons. The most important target group for IRB in European
countries is, therefore, the local Muslim community. The size of this community is,
accordingly, a first indicator of the potential of a nation ’ s IRB market.
166 It recognizes four pillars of research (factor conditions, demand conditions, related and supporting industries, firm structure, strategy
and rivalry) that one must undertake in analysing the viability of a nation competing in a particular international market, but it also can be
used as a comparative analysis tool in recognising which country a particular firm is suited to expanding into.
259
However, the UK ’ s leading position in IRB cannot be explained by the size of its
Muslim community alone, as it is significantly smaller than the Muslim
communities of other European countries such as Germany or France.
A more exact indicator of the demand for IRB might therefore be the number of
Muslims actually interested in Shariah-compliant banking services. This, in turn,
could be a function of religiosity and of how strictly Muslims interpret the Shariah.
The majority of Italy’s 1.5 million Muslims are of North Africa and Albania origin,
indeed be described as somewhat less strict in religious terms than the 2.5 million
British Muslims of mainly Indo-Pakistani descent. Recent studies, however, show
that the lower degree of religiosity does not translate automatically into a lower
interest in IRB among Italian Muslims. I can, therefore, conclude that despite a
higher degree of secularization among Italian Muslims, there is an equal demand for
IRB compared with British Muslims. Given the above mentioned larger Muslim
population in Italy, the demand conditions appear to be not very decisive in
explaining the more developed IRB market in the UK. This indicates that there is an
unmet demand for IRB in Italy and that it is the supply side forming obstacles
factors.
9.5.1.1. Challenges and opportunities for IRB from a demand perspective
It appears that in Italy, as in other European countries with a significant Muslim
population, a considerable demand for IRB exists. This demand will create a strong
pull effect, which Italian banks cannot ignore for long. This effect will be further
reinforced by the strong growth of Muslim communities in many European
countries creating ample opportunities for IRB. However, conventional banks in
Italy are still concerned about their image among non-Muslim customers. This is a
major challenge for IRB as Italian banks do not offer an Islamic banking window
out of a fear of losing more conventional customers than gaining new ones.
260
9.5.2. Supply Conditions
The second determinant of the development of IRB is the nature of domestic supply.
The colonial legacy of the UK has helped British banks to gain competence and
experience in dealing with Muslim clients. This experience, paired with the
knowledge and skills available in Europe’s financial capital, London, has fostered
the development of a wide range of Shariah-compliant retail banking products and
services that appeal to local customers. Major British qualified accountancy bodies
and British universities offer courses in Islamic finance, including a “Scholar
Professional Development Program” that trains Shariah scholars in conventional
finance. These courses have helped to substantially improve Islamic finance
qualifications in the UK. Furthermore, the high level of competition in the British
banking market is likely to stimulate product and process innovations as banks
struggle to gain an edge over their rivals. Until today in Italy few has been done!!
9.5.2.1. Challenges and Opportunities for IRB from a Supply Perspective
With most European banks not yet providing IRB in their home markets,
opportunities for a better supply of Shariah-compliant financial retail products arise
from non-European banks and investors. In particular financial institutions from the
Middle East are willing to bear the risks and costs involved in developing the
European market. The first Islamic retail bank in the UK, the Islamic Bank of
Britain, was founded, for example, by investors from Qatar. Similarly, the first
Islamic retail bank in Germany opened by the Kuwait Turkish Bank KFH-Turkey
and the first Islamic retail bank in France will be founded by investors from
Bahrain. It is likely that these institutions will pave the way for other financial
institutions seeking to participate in the European market of Islamic retail finance.
The strategic positioning of Italy, its dense network of small financial institutions
throughout the territory and the most powerful movement of business ethics in
Europe make Italy a natural candidate for the development of the Islamic sector.
Lately the Qatar Investment Authority (QIA) published that Qatar is looking for
261
ways and methods to invest in Italy: these are the words of Emir Hamad bin Khalifa
Al Thani after meeting the Italian Prime Minister Mario Monti in Rome.
9.5.3. Societal Conditions
The third determinant of the development of IRB is a society’s attitude towards
Islamic culture in general and Islamic banking in particular. In fact, a considerable
part of public opinion in Europe has some concerns with the open expression of the
Muslim faith in their countries, as indicated by the dispute over wearing the
headscarf in schools in France and Germany a couple of years ago or, more
recently, the referendum about building Mosques in Switzerland, and Islam is not
an established religion in Italy and there is only one official mosque in the country,
Rome's Grand Mosque. A large-scale study of attitudes towards Islam in European
countries found considerable prejudice against Muslims.
According to this study, 70% per cent of Italians do not believe that Muslim culture
fits well into their country. Furthermore, 70% believe that Islam is a religion of
intolerance. Such a strong public disapproval of Islam creates a major challenge for
IRB in the European context, in particular because there is no such thing as
Christian or Jewish banking.
Societal conditions seem also to be a major part of the explanation as to why the
Europe is ahead and Italy behind in the implementation of IRB. The IRB sector in
the UK appears to have greatly benefited from the British society’s tradition of
tolerance towards religious and ethnic minorities. For example, 30% of the British
respondents in the above mentioned survey agreed that Muslim culture fits well into
their country, Italy’s had the same percentage 30% of the Italian respondents were
of the same opinion.
Moreover, the Muslim community in Italy is not a strong community and is doing
almost nothing to promote the Islamic Finance or to repair the Muslim image. As a
Muslim, I started promoting Islamic Finance and repair within my community the
Muslim image, my initiatives started November 2010 through a small business to
262
help Italian companies to access the Middle East market (KS Italia167
), and creating
a group for Islamic Finance on the biggest social business network in Italy
(Innovazione di officina Italiana168
) to explain the growing phenomenon. All this
led to be invited the 4th
of July 2012 to speak to over 200 business about this
argument. Individual Initiative is needed too.
The UK government has placed considerable emphasis on the need to combat social
and financial exclusion in the population as a whole. More specifically, the UK
government has wanted to give the 1.8 million Muslims (approximately 3 per cent
of the population) in the UK access to financial services consistent with their
religious beliefs. This has been demonstrated by tax and other changes to encourage
the development of a retail market. The above comments illustrate the important
role political debates have played in the past for the divergent development of IRB
in the UK, France, Ireland and Germany. Favorable political attitudes towards IRB,
for example, were at the core of the implementation of the necessary legal and
regulatory framework in the UK.
9.5.3.1. Challenges and Opportunities for IRB from a Societal Perspective
Shariah conform savings plans, endowment insurances and above all schemes
leading to homeownership can potentially greatly assist Italian Muslims to live their
lives in accordance to their religious beliefs and at the same time manage their lives
in accordance to the demands of a modern life in a Western country, thus
strengthening simultaneously their religious identity and their inclusion and
participation in the society they live in. In this sense, IRB could be understood as an
opportunity to facilitate the integration of Muslims in Italian society. However,
there is still substantial public disapproval of and resistance against the inclusion of
Shariah-based law into the Italian legal system. This antagonism paired with
virulent Islamophobia creates a major challenge for IRB in the Italian context.
A special thanks for Prof. Dr. Volker Nienhaus and Dr.A lberto Brugnoni.
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ANNEXES
ANNEX 1 Islamic Banking Structures Within The Conventional Banking
System
Introducing Islamic banks into conventional banking systems
Islamic financial institutions can be divided into two types:
1. Those institutions whose entire business is conducted in compliance with the Shariah law
and are full Islamic financial institutions;
2. Those institutions that offer Shariah compliant products and/or services, but whose
business is not conducted in compliance with the Islamic law and are ‘conventional’
financial institutions.
Islamic window structures
An increasing number of commercial banks around the world are considering the
possibility of offering Islamic financial products. At first, a commercial bank may only
want to probe the potential of this market, and thus may be interested in launching a pilot
project. The bank can
take advantage of its existing branch network to open an ‘Islamic window’, through which
it can reach potential new customers.
An Islamic window is simply a special facility offered by conventional banks to provide
services to Muslims who wish to have an Islamic banking service. At the inception of the
Islamic service, the products typically offered are deposits on the liability side of the bank
and Islamic trade-finance products for small and medium sized companies on the asset side
of the bank.169
Where it is necessary to deal with sources of capital, many Shariah Boards have recognised
that it is acceptable for financial institutions to ‘cleanse’ these sources by donating the
proportion of the funds derived from non-Shariah-compliant sources to charity. This is
169 Sole 2007.
284
despite the fact that, under the equivalent secular law principles, only a portion of these
funds may be
”cleansed” in this way. This process of cleansing funds has been approved by the
Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) in its
Shariah Standard on Conversion of a Conventional Bank to an Islamic Bank.170
In order to
ensure compliance with Islamic principles, conventional banks wishing to offer Islamic
products must guarantee and publicize that the sources of capital devoted to conventional
activities will not be mixed with those destined for Islamic activities.171
Other ways of separating Shariah-compliant and non-Shariah-compliant business have been
guided by best practice guidelines published by other industry bodies such as the Islamic
Financial Services Board (IFSB). At the same time, a number of financial services
regulators (mainly the Governors of central banks of Saudi Arabia, Sudan, Qatar, Bahrain,
Indonesia and Malaysia) are beginning to introduce formal regulatory rules on the subject.
As the activities of the Islamic window expand, a bank may consider fully segregating the
window into a separate subsidiary. The use of Islamic windows as a take-off platform for
moving into the Islamic financial industry has been a more common practice in South East
Asia and Western countries than in the Middle East, where the tendency has been to
establish stand-alone Islamic banks.
Possibility of offering Islamic funds
Any financial institution is permitted to offer Islamic investment products, unless it is
prohibited from doing so for regulatory reasons. A non-Islamic bank or a non-Muslim can
engage in trading or investing in a Shariah compliant manner. A conventional financial
institution in London or New York is permitted, therefore, to promote an Islamic private
equity fund that caters to the needs of its Muslim investors.
In many instances, this does not require the creation of an independent subsidiary.
Typically, a separate department within an institution can develop and offer Shariah
compliant products.
170 Motaleb 2008. 171 Sundararajan and Errico 2002.
285
Establishing an Islamic bank
Once a conventional bank has operated an Islamic window for some time and has gathered
a sizeable customer base for its Islamic activities, it may decide to establish an Islamic
subsidiary, or even convert into a fully-fledged Islamic bank. By following either of these
two routes, the bank may benefit from economies of scale and concentration of knowledge
and expertise. The bank will be able to offer, under one roof, a wider range of Shariah-
compliant banking products than through the Islamic window alone.
The advantage of opening a subsidiary over a full conversion is that, with the former, the
parent bank may continue servicing its conventional customers, while the subsidiary
expands its Islamic activities in clear separation from the conventional business. Normally,
in the case of Islamic windows, the treasury department of the parent bank is typically in
charge of managing the liquidity requirements of the bank as a whole, which poses the
threat of mixing conventional and Islamic funds. On the other hand, a full conversion
signals the bank’s firm commitment to operate under Shariah principles, thus enhancing its
credibility.
Although it does not seem to be a widespread concern within the industry, it must be
mentioned that some Shariah scholars have raised concerns regarding the legitimacy of
establishing Islamic subsidiaries or banks using capital from conventional banks. The
concern arises because it is not guaranteed that the funds provided by the parent bank will
originate from Islamic compliant sources. Hence, the subsidiary’s initial capital may be
unacceptable from an Islamic point of view. Although there is an ongoing debate over this
matter, one of the proposed solutions is to allow the formation of the new Islamic
institution, if it commits to making future charitable donations as a way to purify the
original funds.
Be that as it may, the transition from a conventional to an Islamic bank also presents
operational challenges, as a number of items in the conventional bank’s existing balance
sheet are tied to interest-bearing transactions. The financial institution must ensure that all
the items on its balance sheet are compatible with the Shariah. Probably, it will be
necessary to transform all of its loans and deposits into non-interest bearing assets and
286
liabilities - such as Murabaha contracts (in the case of assets) or Mudarabah deposits (in the
case of liabilities). Annex 2 provides an example of how to transform a conventional loan
into an Islam compatible instrument and the UK example in Annex 3.
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ANNEX 2: Example: The use of Tawarruq172
to make the transition from
conventional to Islamic balance sheets
When a conventional bank decides to fully convert into an Islamic institution, it must
ensure that all the items on its balance sheet are compatible with the Shariah. Therefore, it
will have to transform all its loans and deposits into non-interest bearing assets and
liabilities. For instance, in the case of assets, this would mean converting them to murabaha
(cost plus financing) contracts. For liabilities, this means converting conventional deposits
to mudarabah (profit-and-loss sharing) deposits. The bank could use a Tawarruq instrument
in order to convert an existing loan (bearing interest) into an Islam compatible instrument.
A Tawarruq
is a contract whereby a customer requests a bank to acquire a specific commodity (e.g.
metal or wool) on his behalf. The customer will repay the bank the cost of the commodity
plus an agreed margin in installments. The customer then requests that the bank sell the
commodity right away in the commodity spot market. Hence, through this transaction, the
customer can obtain immediate financing (via the spot sale of the commodity) which will
be repaid at a later date (via the installment payments to the bank).
A Tawarruq can be used to transform an existing debt contract into an Islamic instrument.
The procedure is best explained with an example (see Figure -- below). Suppose that some
years ago, the bank had extended a loan for an amount of $100 to be repaid over 10 years at
a 5 percent interest rate. Suppose also that at the time of the bank’s conversion, the
customer had already paid half of the loan principal, and so s/he has a remaining debt of
$50 with the bank. The bank and the customer then enter into a Tawarruq contract by which
the bank will buy
$50-worth of commodities for the customer and then sell them on his behalf. The customer
then uses the $50 received from the spot sale to cancel its loan with the bank. Note that at
this point the customer owes the bank $50 by virtue of the Tawarruq contract, but not as an
interest bearing loan. In repayment for the bank’s purchase of the commodities, the
customer will include in the installment payments to the bank an amount commensurate
172 The purchase of goods on deferred payment and their subsequent sale (to raise cash)
288
with the forgone interest on the loan. It must be acknowledged that, although the Tawarruq
accomplishes the goal of transforming interest bearing contracts into interest-free
instruments, it is seen as controversial by some Shariah scholars.
Figure Transforming conventional assets and liabilities into Shariah-compliant assets
and liabilities
289
ANNEX 3 The UK Example
Licensing and compliance
Licensing Islamic banks and windows will increase the supervisory burden on the regulator
since there would then be a new type of institution/activity that requires its own legislation
such as the regulatory framework. In other words, in the case of Europe, in addition to the
Basel III International Framework, supervisors will have to be familiar with the application
of the Islamic Financial Services Board (IFSB) standards for Islamic banks. The national
requirements to grant an Islamic license vary depending on the country where the financial
institution wishes to operate.173
The UK Example174
The first Islamic bank in Europe: the Islamic Bank of Britain, was created in the UK in
August 2004. This process helped the Financial Services Authority (FSA) to redefine the
authorisation requirements for the creation of a bank in the UK, including Islamic banks.175
These are:
The firm must provide a credible business plan.
The firm must have the appropriate legal status for the activities it wishes to
undertake.
For a firm in the UK, its head office and mind and management must also be in the
UK.
If the firm has close links with another firm, these should not prevent the effective
supervision of the firm
The firm has adequate resources, both financial and non-financial, for the activities
which it seeks to carry on.
173
Please note that there are no cases of licensed Islamic banks in Europe except in the UK. Conditions in Muslim countries vary according to the national central bank requirements. Therefore, in this study the UK case is shown as the most relevant European example. 174
Information provided in Ainly et al. 2007. 175 Ainly et al. 2007.
290
The capital requirements for an Islamic and a conventional bank are applied on the same
basis. Operations performed by traditional banks through Islamic windows do not require
separate authorization.
The process of establishment of the Islamic Bank of Britain raised new questions and it
took 18-24 months to complete. Areas where there was a need for more research and work
were:
Regulatory definition of products: firms need to be sure they apply for the correct
range of permission for the regulated activities they wish to undertake.
The role of Shariah scholars, which examine each new product or transaction and, if
satisfied that it is Shariah-compliant, issue an approval.
Financial promotions: especially important in Islamic finance since the products are
new and differ from traditional products.
The European Islamic Investment Bank was established in London in January 2005 and
received authorisation to operate from the FSA in March 2006. The bank’s aim is the
provision of Sharia-compliant investment banking products and services. In general terms,
a financial institution wishing to open an Islamic bank/window should consider the
following issues related to corporate governance and regulatory requirements in order to
ensure compliance with Shariah and national rules:176
Corporate governance issues:
- Establishment of a Shariah Board
- Internal coordination of the administrative board’s work with the new supervisory
Shariah Board
- Rewording of the financial institution objectives: including clear definition (in the
case of an Islamic bank) or segregation (in an Islamic windows structure) of the
bank’s funds and of its uses
- Integration of Shariah standards (e.g. AAOIFI) in business policy (code of
conduct, board regulation, etc.)
176 See “Islamic Banking: Issues in Prudential Regulation and Supervision” by Errico, Luca and Mitra Farahbaksh. IMF Working Paper
WP/98/30 (March 1998).
291
Regulatory requirements:
- To offer products and services that are considered as banking activities in order to
receive a national banking license.
- To fulfill the capital adequacy requirements (national and international
requirements suggested by the IFSB)
- To fulfil liquidity requirements, subsequent to national regulation It is clear that in
many countries there is still an inadequate legal and regulatory framework. That is
true in some parts of the Islamic world, but it is certainly true in the U.S. and in
Europe (with the exception of the UK). There are other European countries with
larger Muslim populations than the UK, yet where the regulators have not yet come
to grips with the issues in the way that the Financial Service Authority (FSA) has
done.
The IFSB has provided some guidance notes on capital adequacy and risk management
which are very useful, but they are not applied everywhere. Concerning capital adequacy,
the IFSB suggests national supervisors should follow their recommendations when
determining which external credit assessment institutions ratings may be used to calculate
capital adequacy ratios under the IFSB’s December 2005 Capital Adequacy Standards
(CAS). The CAS of December 2005 addresses the structure and contents of Shariah-
compliant products and services that
are not specifically addressed by Basel II and seeks to standardise the approach to risk
weighting such products and services.
The IFSB in its guidance note on capital adequacy asserts that Shariah compliant financial
assets should be regarded as a set of asset classes with distinct characteristics, and that
consequently credit rating agencies (CRAs) should incorporate in their rating
methodologies an explicit understanding of these distinct features, including clear
explanations of
how these are addressed.
292
Rating analysis of Shariah-compliant assets may differ from analysis of conventional
assets, both in terms of the general principles that govern Shariah-compliant finance (for
example, the concept of default) and in terms of the features of specific financial
instruments (for example the concept of displaced commercial risk (DCR) when dealing
with returns on investment accounts that are based on a Mudarabah contract).
In Islamic finance, assets may be:
a) such that periodic payments are due contractually
b) based on return and loss-sharing or return-sharing and loss-bearing contracts where the
obligation to make a payment and the maintenance of capital are subject to investment
performance. In terms of capital adequacy calculations, the principal areas where
Shariah-compliant finance may differ from conventional finance include, though are not
limited to, the following:
a) Different meanings of ratings and the concept of default: as a result of the different
natures of default considered, the meaning of ratings may differ depending on the type of
instrument being rated.
b) Priority of claims: in conventional finance, priority of claim is defined in the loan
documentation and by local laws. However, within Shariah compliant finance, additional
factors may come into play – such as Shariah requirements for equitable treatment of
creditors.
c) Corporate governance and the role of the Shariah Board: governance standards
applicable to Islamic financial institutions are set out in the IFSB’s “Guiding Principles on
Corporate Governance” for Islamic financial institutions. These principles include all those
that are applicable to conventional banks, as well as principles related to compliance with
Shariah rules and principles. This may have implications for credit characteristics,
especially as issues of reputational risk assume greater importance for Shariah compliant
issuers of financial instruments than for conventional issuers.
d) Risk mitigation techniques to cater for displaced commercial risk (DCR): DCR
derives from competitive pressures on the Islamic financial institution to attract and retain
293
investors. It may respond to these pressures by creating reserves. The existence or non-
existence of such reserves could have a significant impact on the creditworthiness of the
institution.
e) Definition of capital: an Islamic financial institution uses capital to protect the
depositors and some classes of investor from losses. Therefore it is necessary that external
credit assessment institutions make clear what constitutes capital in an Islamic financial
institution
and the extent to which depositors and certain classes of investors are protected against
losses.
f) Trading in Sukuk does not involve trading in debt (unlike conventional bonds):
Sukuk holders derive their returns either from an underlying real asset(s) or the usufruct of
such assets, which is fractionally owned by the Sukuk holders rather than being collateral
for a debt as with conventional asset-backed securities; or from a securitised partnership in
an underlying business venture.
g) Asset valuations: many of the Islamic financial instruments used by Islamic financial
institutions for financing working capital or projects have particular risk characteristics that
need to be understood. For example, a Murabahah contract requires an Islamic financial
institution to have ownership of assets as part of asset-based financing activities on its
balance sheet for a short period of time pending resale. Such assets may be subject to
substantial market risks if the contract is non-binding in nature. As a result, the risks
associated with these
assets are not confined to credit risk.
h) Loss given default: the IFSB recognises that statistics on loss rates of defaulted
Shariah-compliant instruments are at a very early stage of compilation. This may put
investors in a stronger position to attach assets in the event that the issuer defaults than the
investor would be
if they were holding conventional instruments. In fact, this may or may not be the case,
depending on the applicable legal system.
294
The IFBS recognises that national supervisors retain the ultimate authority in determining
both recognition criteria and the recognition process.177
177 Further information about regulatory capital requirements, risk management and corporate governance is available through IFSB
2007.
295
ANNEX 4 Islamic banking for Italian SMEs
Within Islamic finance there is a wide range of financial instruments, each with a specific
purpose. When considering Islamic finance, it is important to ensure that the instrument
used is suitable for the economic purpose that a company seeks to achieve.
There are two main categories of transaction types:
Profit- and loss-sharing partnership methods which can be compared with equity
investments; and
Transactions with a predictable or fixed return structure.
Other financial instruments such as foreign exchange, letters of credit, agency contracts and
guarantees are also available. This chapter is takes up four categories of instruments:
partnership contracts, structures with predictable returns, other contract types and Sukuk.
Partnership contracts
There are two types of partnership transactions: joint venture (Musharakah) and passive
partnership (Mudarabah). The main difference between the two structures relates to what
the partners contribute to the partnership.
Joint venture
The Arabic term “Musharakah” means sharing and is used in financial transactions
to identify joint ventures or partnerships. More than two parties can be involved,
and generally each provides knowledge and skill as well as a share of the capital.
Knowledge and skill can take the form of management or advisory services or even
doing the actual work itself. It is possible for one of the partners only to provide
capital, in which case he or she becomes a sleeping partner. The profit ratio is pre-
agreed in the contract and reflects the level of capital provided, effort, skill and
expertise the partners bring to the joint venture. Losses are borne by the partners in
proportion to the capital they have provided. The liability of the partners is
technically unlimited.
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Once the contract has been agreed between the partners, the process can be broken
down into the following two main components:
Cash and expertise
All partners contribute to the capital and expertise of the business or project. They
do not have to provide equal amounts of capital or equal amounts of expertise.
Profits and losses
Any profit earned from the joint venture is to be shared between the partners
according to the ratios agreed in the original contract. Any losses borne by the
partners are strictly in proportion to the amount of capital they have contributed. It
is not permissible to fix a lump-sum profit for any single partner.
Diminishing Musharakah
Diminishing Musharakah is a variation of partnership in which it is agreed
between the parties at the start that one partner will, over time, purchase
units in the joint venture from the others at a pre-agreed unit price. At the
start of the agreement, the project is divided into a number of equal units
(shares) that are bought by one of the partners over the life of the
transaction. In a diminishing Musharakah, the repurchasing agreement is
part of the contract.
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The purchasing party will gradually own a larger share of the joint venture
and, as a result, his or her share of the capital increases. With this increase in
capital, the purchasing party will be liable for a larger proportion of any loss.
Profit ratios will be revised either with each purchase or on a periodic basis
as agreed between the partners.
Passive partnership
The Mudarabah transaction is a partnership transaction in which only one partner
contributes capital (the capital providing investor or Rab al maal), and the other (the
business manager or Mudarib) contributes skill and expertise.
The investor has no right to interfere in the day-to-day operations of the business,
although the contract between the partners can contain mutually agreed conditions
the business manager has to abide by. The relationship between the partners is
founded upon trust, with the investor having to rely heavily on the business
manager, his or her ability to manage the business and honesty when it comes to
profit share payments.
The passive partnership transaction can be used for private equity investments, but
is also often used when clients deposit money with a bank. When used for deposits,
the bank contributes its skill and expertise in identifying appropriate investment
opportunities.
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Once the contract has been agreed between the partners, the process can be broken
down into the following main components:
Capital injection
The investor provides capital to the project or company. Generally, an investor will
not provide any capital unless a clearly defined business plan is presented. In this
structure, the investor pays 100% of the capital.
Skill and expertise
The business manager’s contribution to the partnership is his or her skill and
expertise in the industry or area.
Profit and loss
As in the joint venture, profits are shared according to a pre-agreed ratio; losses are
distributed in proportion to the capital provided. Since only one party provides all
the capital, this party bears all the loss.
In the event of a loss, the business manager does not receive any compensation for
his or her efforts. The only exception to this is if the business manager has been
negligent, in which case he or she will be liable for the total loss.
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The investor is liable only for the amount of capital provided, which means that the
Mudarib cannot commit the business to any sum that is over and above the capital
provided.
Instruments with predictable returns
These are favoured by banks and their regulators as reliance on third party profit
calculations is eliminated. There are four main instruments in this category: Murabahah,
Ijarah, Istisna and Salam.
Deferred payment sale
Deferred payment sale or instalment credit sale transactions are known as
Murabahah. They are mainly used for the purchase of goods for immediate delivery
with payment to be settled at a later date. In its most basic form, this transaction
involves the seller and buyer of the merchandise as illustrated below:
As part of the contract between the buyer and the seller, the price of the goods,
markup, delivery date and payment date are agreed. The seller takes immediate
possession of the goods, against future payment. The buyer has full knowledge of
the price and quality of the goods purchased. In addition, the buyer is aware of the
exact amount of markup paid for the convenience of paying later. In the context of
trading, the advantage to the buyer is that
he or she can use the goods to generate a profit and use this profit to pay the original
seller.
Example of a deferred payment sale
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KS imports linen from Italy on a wholesale basis and sells it to local shops in the
region. One of its clients, newly incorporated Beds Inc., has purchased 500 sets of bed
linen at a price of EURO 25 each. Beds Inc., having just started operating, needs to
generate a profit from selling the linen to clients and has requested that payment to KS
be made in three months’ time. Asian KS agrees, and charges Beds Inc. a fixed markup
of EURO 160.
KS delivers the linen today and, three months later, receives EURO 12,500 for the bed
linen supplied, plus a markup of EURO 160. The payment from Beds Inc. totals EURO
12,660.
The underlying asset can vary, and can include raw materials and goods for resale.
In Islamic finance, the Murabahah transaction can, for instance, be applied to trade
finance and working capital financing.
Leasing
An Ijarah transaction is a lease in which one party (lessor) allows another party
(lessee) to use an asset against the payment of a rental fee. As with conventional
finance, two types of leasing transactions exist: financial and operating.
In a financial lease (Ijarah wa Iqtina or Ijarah Muntahiya bi Tamleek), the lessee
provides a purchase undertaking at the start of the transaction, stating that he or she
will buy the asset at the end of the lease period.
In an operating lease, such a purchase undertaking is not included and the lease
cannot be conditional on a purchase undertaking.
Not every asset is suitable for leasing. The asset needs to be tangible, nonperishable,
valuable, identifiable and quantifiable.
In an operational lease, depicted in the figure 4 below, the lessor leases the asset to
the lessee, for a pre-agreed period and the lessee pays pre-agreed periodic rentals.
The rental or lease payments can either be fixed for the period or floating with
periodical re-fixing. The latter is usually done by linking it to a conventional index
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such as the London Interbank Offered Rate (LIBOR), which represents the cost of
capital.
At the end of the period, the lessee can either request to extend the lease or hand the
asset back to the lessor. The lessor takes a view of the residual asset value at the end
of the lease term, and takes ownership risk. When the asset is returned to the lessor
at the end of the period, he or she can either lease it to another party, or sell the asset
on the open market. In the case of a sale, the lessor may offer the asset to the lessee.
A financial lease, as depicted in figure 5, has an additional step, which is the sale of
the asset to the lessee at the end of the period.
As with an operating lease, rentals can be fixed for the period or floating based on a
benchmark. As part of the lease agreement, the lessee provides the lessor with a
unilateral purchase undertaking which specifies the amount at which the lessee will
purchase the asset upon expiry of the lease.
Three options are possible:
Gift. In this case, the lessor has gradually paid for ownership of the asset during the
lease period, as part of the rental fee. Once all rentals are paid, there is no further
payment required from the lessee to obtain the asset.
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Against fixed payment. At the end of the lease, the lessee becomes the owner of the
asset once he or she has paid the purchase amount agreed in the contract.
Against market value. At the end of the lease, the lessee becomes the owner of the
asset once he or she has paid the market value to the lessor.
In practice, options 1 and 2 are the most common.
In both cases, the lessor owns the asset and runs all risks associated with ownership.
He or she is also responsible for major maintenance and insurance. Because the
lessee is using the asset on a daily basis, he or she is often better positioned to
determine maintenance requirements, and is generally appointed by the lessor as an
agent to ensure all maintenance is carried out. In addition, the lessee is, in some
cases, similarly appointed as an agent for the lessor to
insure the asset.
In the event of a total loss of the asset, the lessee is no longer obliged to pay any
rentals. The lessor, however, has full recourse to any insurance payments.
Example of a lease
KS Transport is looking to extend its distribution network and wants to invest in new
delivery trucks. Instead of tying up a significant amount of money in new trucks, it
decides to lease them instead from Lease A Truck on an operational lease basis.
Lease-A-Truck provides Early Bird with two trucks against a monthly rental fee, which
covers maintenance, depreciation and insurance. Lease-A-Truck retains ownership
throughout the duration of the transaction, and informs Early Bird which garage to
take the trucks to for maintenance and repairs. Lease-A-Truck settles any bills directly
with the garage.
At the end of the lease period, Early Bird has one of the following choices:
Extend the lease for a further period;
Purchase the trucks at current market value from Lease-A-Truck; or
Hand the trucks back to Lease-A-Truck.
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Short-term production finance
Short-term production, construction and agriculture contracts can be financed using
a Salam contract.
In this type of contract, a payment is made today against future delivery of the asset.
As the purpose of the funding is to construct or produce the asset, the asset itself
does not have to be in existence, and the seller does not need to have ownership. In
its simplest form, Salam is a contract between a buyer and a seller as shown below:
The contract is typically short term (one to three months in duration), but could be
entered into for longer periods. The type, quality and quantity of the asset need to be
clearly specified in the contract. Any asset that cannot be specified in this way, such
as precious stones, cannot be made the subject of a Salam transaction.
The seller has a contractual obligation to deliver the specified quantity and quality
at the agreed delivery date. If the seller cannot deliver from his or her own
production, he or she will have to buy the remaining quantity to fulfill the
contractual obligation. The goods involved must be commodities that are freely
available.
The seller receives the funds to enable production of the underlying asset, while the
buyer obtains an asset in the future with the expectation that the eventual price will
be higher than the original payment. Because the buyer takes a business risk, the
transaction is not subject to any of the prohibitions on uncertainty and gambling.
Example of short-term production finance
Farmer Mario has noticed a substantial demand for pumpkin seeds and wants to enter
this market. In order to be able to harvest the pumpkins in November of the following
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year, extract the seeds and package them, he requires an up-front investment of EURO
2,500.
Mario comes to an agreement with Super Duper Supermarkets, which wants to buy
100 kg of quality.
A pumpkin seeds, packaged in 100 g bags for EURO 2,500, for delivery in November.
Mario receives the
EURO 2,500 and starts the process of making the soil ready and planting the seeds.
Come November, Mario harvests the pumpkins, extracts 150 kg of seeds and packages
100 kg of quality.
A seeds, which he delivers to Super Duper. The seeds are sold for EURO 3 a packet,
generating revenue of EURO 500 (EURO 3,000 – EURO 2,500) for Super Duper.
The remaining 50 kg varies in quality from A to C, which Mario then sells for a total
amount of EURO 1,000.
Long-term production finance
Like a Salam contract, Istisna is a purchase contract for future delivery of an asset.
It is exempt from the same two conditions regarding the asset, ownership and
existence.
The contract is typically for a longer term, and payment to the producer or
contractor of the asset does not have to be in full in advance. Payment is likely to be
in various installments in line with the progress made on the development of the
asset and is, therefore, well suited to project finance and construction.
The asset typically needs to be manufactured, constructed or processed, and is of a
significant size and capital outlay.
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Under the simple structure shown in figure 7, it is assumed that the buyer will have
the money to pay for the asset during its construction. However, this is not
necessarily the case and a financier could be involved. The financier will finance the
construction and consequently sell or lease the asset to the buyer for a pre-agreed
period.
As in a Salam transaction, the buyer takes a business risk in this transaction. It is
therefore not subject to any of the prohibitions on uncertainty and gambling.
Example of long-term production finance
KS is expanding and in need of a new manufacturing plant with a total cost of EURO
500,000 which will be built by Considerate Builders Inc. KS negotiates the following
payment schedule and pays Considerate Builders upon completion of each phase:
EURO
10% of the amount to be paid up front to prepare the site . . . . . . . . . . . 50,000.00
10% once the foundation is laid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .50,000.00
