emerging market islamic banking and finance: … previouse issues... · 24 azerbaijan: emerging...

GLOBAL PERSPECTIVE ON ISLAMIC BANKING & INSURANCE

ISSUE NO. 169OCTOBER–DECEMBER 2008

SHAWWAL–DHU AL HIJJAH 1429

AZERBAIJAN: EMERGING MARKET

ISLAMIC BANKING AND FINANCE: SOCIAL FAILURE

TAKAFUL FOCUS: UK

INNOVATION SPOTLIGHT:ISLAMIC DYNAMIC STRATEGIES

CORPORATE GOVERNANCE:PLAYING CATCH-UP

IIBI CAMBRIDGE WORKSHOP REVIEW

PUBLISHED SINCE 1991

www.newhorizon-islamicbanking.com IIBI 3

NEWHORIZON Shawwal–Dhu Al Hijjah 1429

Features

Regulars

10 Islamic banking and finance:social failure

Dr Mehmet Asutay from Durham University, UK, raisesa pertinent question of whether the Islamic financeindustry in its current shape and form is true to itsethical principles.

14 Islamic dynamic strategiesFocus on the innovations for Islamic wealth managementindustry – ‘Islamic dynamic strategies’ and ‘IslamicNavigator’.

20 Insurance with principlesInterview with Iqbal Gelu from Principal Insurance Holdings about the launchof the company’s new venture, Salaam Halal Insurance, the UK’s firstindependent takaful provider.

CONTENTS

24

37 CALENDARComprehensive diary of upcoming Islamic finance events worldwide endorsed by the IIBI.

44 ACADEMIC ARTICLEPlaying catch-up: implementing corporate governance in Islamic financial institutions.

50 GLOSSARY

22 APPOINTMENTSSummary of appointments within the Islamic finance industry.

30 IIBI LECTURESJuly lecture reviewed;October lecture preview.

32 IIBI NEWSCambridge workshop review and other developments within the IIBI.

05 NEWSRound-up of the important stories from the last quarter around the globe.

16 ACADEMIC ARTICLEIslamic banking and financial stability.

19 RATINGS AND INDICESIslamic credit ratings: how is your bank doing?

24 Azerbaijan: emerging marketCountry focus on the small Caucasian country of Azerbaijan, whose boomingeconomy and forthcoming sweeping reforms of the financial sector lookpromising for Islamic finance development.

38 Iran: technology focus

With growing demand for modern banking technology and a struggle forinternational IT vendors to find a foothold in the Iran, domestic suppliers areenjoying dominance in the market.

42 Innovation and authenticityDr Nazim Ali, director of Islamic Finance Project at Harvard Law School, US,focuses on these two crucial contributors to the industry’s success.

38

4 IIBI www.newhorizon-islamicbanking.com

NEWHORIZON October–December 2008

Executive Editor’s NoteIslamic finance presents itself as a discipline promising ethicaland diversified tools and systems. But has it drifted away fromits social origins in pursuit of unbridled profit? Has the industrymimicked its conventional counterpart so much that it itself has become purely commercially-oriented? Are there lessons to be learnt from what many view as one of the worst financialcrises, fuelled by irresponsible financial practices, and thecreation of ever-more complex financial instruments whileignoring common sense regulations and procedures? These arethe questions to seriously ponder as Ramadan, the Holy Month for Muslims, comes to an end.

There have been implications of the ongoing ‘form oversubstance’ debate. A sharp drop in sukuk sales (a staggering 50 per cent), for example, was a direct result of a ruling byShaikh Muhammad Taqi Usmani, head of Shari’ah committeeof AAOIFI, which labelled many sukuk issues as not Shari’ah-compliant.

However, overall, the criticism (which is always needed inhealthy doses for any industry to stay on track) has notdeterred Islamic finance from moving forward. The pastquarter of 2008 has seen such new developments worldwide asmembership of Korea’s financial services authority in IFSB, theroll out of Russia’s only Islamic debit card product across thecountry, Indonesia’s first sukuk, the UK’s first independenttakaful company and the introduction of a masters degree inIslamic commerce from an Australian university.

There have been developments within the IIBI, too. Our second annual three-day residential workshop, ‘StructuringInnovative Islamic Financial Products’, held at the University of Cambridge, was very successful – you can read more about it on the pages of this issue. Also, the IIBI is assisting the UKFinancial Services Skills Council with the development ofNational Occupational Standards (NOS) in Islamic financialservices, aiming to standardise skills and requirements in thevibrant Islamic finance market of the UK.

Mohammad Ali QayyumDirector General, IIBI

EDITORIAL

This magazine is published to provide information on developments in Islamic finance, and not to provide professional advice. The views expressed inthe articles are those of the authors alone and should not be attributed to the organisations they are associated with or their management. Any errorsand omissions are the sole responsibility of the authors. The Publishers, Editors and Contributors accept no responsibility to any person who acts, orrefrains from acting, based upon any material published in the magazine. The Editorial Advisory Panel exists to provide general advice to the editorsregarding matters that may be of interest to readers. All decisions regarding the published content of the magazine are the sole responsibility of theEditors, and the Editorial Advisory Panel accepts no responsibility for the content.

EXECUTIVE EDITORMohammad Ali Qayyum,Director General, IIBI

EDITORTanya Andreasyan

IIBI EDITORMohammad Shafique

CONTRIBUTING EDITORJames Ling

NEWS EDITORLawrence Freeborn

IIBI EDITORIAL ADVISORY PANELMohammed AminRichard T de BelderAjmal BhattyStella CoxDr Humayon Dar Iqbal KhanDr Imran Ashraf Usmani

DESIGN CONSULTANTEmily Brown

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©Institute of Islamic Banking and InsuranceISSN 0955-095X

Cover photo: Mosque in Baku, Azerbaijan

Deal not unjustly,and ye shall not be dealt with unjustly.

Surat Al Baqara, Holy Quran


NEWHORIZON Shawwal–Dhu Al Hijjah 1429 NEWS

Since Shaikh Muhammad TaqiUsmani, head of Shari’ahcommittee of the Bahrain-basedAccounting and AuditingOrganisation for IslamicFinancial Institutions (AAOIFI),ruled in February this year thatmany sukuk issues were notShari’ah-compliant, sales ofsukuk have fallen 50 per cent in2008, and prices have droppedan average of 1.5 per cent,according to HSBC Holdings Plcindex data.

Shaikh Usmani pointed outseveral issues, such as purchaseundertaking by the obligor incase of sukuk with underlyingcontract as mudarabah ormusharakah was not Shari’ah-compliant as it does not fulfilthe conditions of the contract.

The sukuk market has doubledin size every year since 2004,and had become worth $90

billion. However, since the edictin February, borrowing costshave been pushed up across the region, including on $200billion of real estatedevelopments in the UAEcapital. Sales of sukuk droppedto $11 billion in the period ofJanuary to August this year,compared to $21 billion in thecorresponding period in 2007.

Some have suggested the drop isdue to global economic factors,however the decline in prices ofsukuk is more severe than thedecline in the value of UScorporate debt over the sameperiod, which has been hit bythe credit crunch.

The purpose of the ShaikhUsmani’s ruling was to reinforcethe message that Shari’ahboards and sukuk issuers shouldfollow the Shari’ah principles ‘insubstance as well as in form’.

Sharp drop in sukuk sales

Gulf African Bank targetspilgrims with new

Hajj account Gulf African Bank, the fullyShari’ah-compliant Kenyaninstitution, has launched asavings account designed to helpMuslims fulfil their obligationof Hajj (pilgrimage to Mecca).This pilgrimage is one of the fivepillars of Islam, according towhich every Muslim is requiredto travel at least once to Meccaif his/her financial circumstancessupport doing so. This year’sHajj will take place in the firstweek of December.

The Hajj savings account willgrow through earnings onsavings, and clients who hold a

Hajj account will enjoy anumber of benefits such as pre-travel information sessions,travel insurance and a hamperpack including a Hajj guide, atravel pouch and a jammaratbag. A deal between GulfAfrican Bank and QatarAirways means that accountholders can also expect specialfares with the airline, along witha stop over in Doha.

There are currently six millionMuslims in Kenya. The bankhas also recently announcedspecial accounts for women andchildren.

Two innovations from Sharjah Islamic Bank

UAE-based Sharjah IslamicBank (SIB) has launched ‘AlHurr’, the Emirates’ firstmobile ATM service in Islamicbanking. This move will easeaccess of Muslims to their cashin the Emirates. The mobileATMs will offer the sameservices as stationary ones, andare designed to workregardless of how far they arefrom a stationary ATM orbank branch, anywhere acrossthe UAE. In April this year, SIBalso launched ATMs designedfor the handicapped.

SIB has also launched aShari’ah-compliant prepaidcard, which acts in the sameway as a credit or debit card,but must be loaded with fundsbefore they can be spent. This‘Jeans Card’ will be aimed atall age groups of customer,from 14 years old upwards.Customers will receive a textmessage each time the card hasbeen used. As well as beingsecure, the card can help teachyouths to be responsible withcash, since the user cannot gooverdrawn.

Mecca © Aidar Ayazbayev Dreamstime.com


NEWHORIZON October–December 2008NEWS

Express Bank, a regionalRussian bank, which has beenissuing Islamic debit cards inthe Russian republic ofDagestan since July, intends tolaunch the product across thewhole country, by making itpossible for customers to applyfor the card online. The rollout is a response to thepopularity of the card inDagestan, a predominantlyMuslim area. The terms of thecard have been designed incollaboration with theSpiritual Council of Muslimsin Dagestan. According to aspokesman from the bank, theproduct has also provedpopular with many Christiansand Jews in Dagestan.

To comply with Shari’ah andat the same time with theRussian banking legislation,

the accrued interest will not be paid into the cardholder’saccount, but instead will bedonated to charitable causes,primarily child healthcare,purchase of hospitalequipment and moderndiagnostic and life supportapparatus for maternity wards.

This will be the only card of its type on the market inRussia, though it will not bethe first foray by a Russianbank into Shari’ah-compliantfinance. Badr-Forte Bank, the only Islamic bank to havebeen established in Russia,offered a similar interest-freedebit card after opening in1991. However, Badr-Fortehad its license revoked in2006, with many Russiansconsidering the decisioncontroversial.

Express Bank extendsIslamic card across Russia

Amar Singh, a member ofparliament and generalsecretary of the SamajwadiParty in India, is to meet theIndian government toencourage the growth ofIslamic banking. Singh said hewill press Indian PrimeMinister, Dr ManmohanSingh, face to face on the issue,while attending a gathering ofeconomists and intellectuals atthe India Islamic CulturalCentre in New Delhi. AbdurRaqueeb, director of theCentre, also stronglysupported Islamic finance,saying that opening the doorto the industry wouldimmediately unleash trillionsof dollars in foreign directinvestment.

Raqueeb went on to say thatan Islamic banking system hasalready been introduced inmany nearby countries,

including Singapore, Malaysiaand Japan, and that investors inthe Gulf region were less keenthan previously to invest in theWest. India, Raqueeb believes,should be an attractive targetgiven the level of economicgrowth in the country. Raqueebstated that, since Islamic financeis based on equity and justice, itshould be an antidote to the USsub-prime mortgage crisis, andthat it should decreaseinequalities in the country. Areport by Raghuram Rajan,former chief economist of theIMF (International MonetaryFund) will also be submitted tothe government, calling for theencouragement of Islamicfinance in response to thefinancial exclusion of India’sMuslims. There areapproximately 150 millionMuslims in India, equal toabout 13 per cent of thecountry’s population.

Prominent Indians insupport of Islamic banking

Kremlin of Kazan, Russia

The Islamic Financial ServicesBoard (IFSB) in Malaysia hasadmitted South Korea’sFinancial Services Commissionand Financial SupervisoryService to its membership, alongwith ten other organisations.New members include KuwaitInternational Bank (Kuwait),Sudanese French Bank (Sudan),Deutsche Bank AG (UAE),Gatehouse Bank plc (UK),Mitsubishi UFJ Securities CoLtd (Japan) and UnicornInternational Islamic Bank(Malaysia).

This takes the total of IFSBmembership up to 34 juris-dictions and 175 organisationsaround the world. IFSB,officially inaugurated in 2002,serves as an internationalstandard-setting body ofregulatory and supervisoryagencies for the Islamic financialindustry.

The number of memberorganisations has continued torise steadily; it was 150 at thestart of the year (NewHorizonJanuary–March 2008).

Korea joins IFSB

© Anver Dreamstime.com



La Trobe University inMelbourne, Australia, is to bethe first university in thecountry to offer a mastersdegree in Islamic commerce. Thecourse will begin in February2009 and will cost AU$17,000(US$14,000), and will be eitherone or two years’ durationdepending on the priority of thestudent. The course shouldappeal to international studentsfrom the subcontinent, andthose countries in Asia whichvalue learning about Shari’ah-compliant finance in the Englishlanguage.

Eight subjects will be covered,including legal and Islamicjurisprudence, Islamiccommercial law, Islamicbanking, Islamic insurance,Islamic financial markets andgeneral areas of finance. Thecourse has been set up torespond to the expected growthin demand for staff in Islamicfinance which, according to

experts’ estimates, might requireup to 50,000 extra employees inthe next five to ten years. Anumber of banks in Australiaare already active in Shari’ah-compliant finance, such asKuwait Finance House (KFH)and HSBC. National AustraliaBank (NAB), one of thecountry’s top financial institut-ions, has also been researchingIslamic finance options, in-cluding buying into a Shari’ah-compliant industrial propertytrust. NAB has attempted tobuild bridges with the domesticIslamic community by setting up a scholarship in Islamicfinance, named after SheikhFehmi Naji El-Imam, Mufti ofAustralia.

Hayat Khan, co-founder of thecourse at La Trobe University,believes that Islamic finance willaccount for 40 to 50 per cent oftotal savings of the worldwideMuslim population within adecade.

Australian university to offerIslamic finance course

Standard Chartered has re-launched the Shari’ah-compliant version of its online treasury FX andhedging platform under itsSaadiq Islamic products brand.

‘Incorporating the Islamiconline treasury channel underthe bank’s Saadiq brandunifies our Islamic productbase under a single name, and demonstrates ourcommitment to providing afully integrated service for our customers who operateunder Shari’ah law,’ says thebank’s head of Islamicproducts, Ghazanfar Naqvi.

The system itself will not bemodified as part of theexercise. According to Naqvi,Standard Chartered is the firstbank to launch online servicesin Islamic FX utilising thewa’ad structure. This structureis defined as a promise to buy or sell certain goods in acertain quantity at a certaintime in the future at a certainprice. The system, he says,‘allows Islamic companies and institutions to hedgeforward FX exposures under a Shari’ah-compliantstructure’.

It has been designed to deliverautomated prices from thebank’s trading floors to anydesktop. By utilising the bank’scoverage of global FXmarkets, it supports spot,

Islamic online treasuryplatform from

Standard Chartered

NEWS

Islamic banking heads for Sweden

Islamic Bank of Britain (IBB),which was first grantedauthorisation in 2004 in the UK,is now considering a move intoSweden. IBB has been in contactwith Sweden’s authorities forsome time. The SwedishFinancial Authority has statedthat ‘in general there are nolegal obstacles to conductingIslamic banking operations inSweden’. IBB is also eyeing

Germany for an expansion of itsEuropean presence.

Meanwhile, Sweden’s firstIslamic investment fund has alsorecently opened. The fundfollows Shari’ah-compliantcriteria, and includes 110international firms which maynot be associated with haramactivities, such as alcoholbrewing, for example.

forward and swap pricing inmore than 100 currencies.Naqvi claims it ‘offerscustomers instant access to liquidity, reduction inoperating costs and reductionon operational risk, whileallowing them to efficientlyachieve their FX managementobjectives’.

Naqvi is expecting the re-branded system to be apopular offering. He has seena sharp growth in Shari’ah-compliant corporates andinstitutions, and a rapidadoption of eFX services in the Middle East.

‘Over 2500 clients useStandard Chartered’s onlinetreasury system. With thenumber of corporates andfinancial institutions operatingunder Islamic principals weanticipate considerabledemand for the Shari’ah-compliant version.’

This will not be the last ofStandard Chartered’s Shari’ah-compliant products to beoffered via this channel. ‘Weanticipate migrating moreIslamic products to our onlineplatforms as part of aprogressive technology buildout,’ confirms Naqvi. ‘It isessential to us and to ourclients that our Shari’ah-compliant FX products can be delivered electronicallyalongside our conventionaleFX offering.’


NEWHORIZON October–December 2008NEWS

The State Bank of Pakistan,Pakistan’s central bank andregulator, has drawn up andissued new draft guidelineswhich are intended tofacilitate Islamic (andconventional) banks inagricultural financing. Theguidelines cover most modes

of Islamic finance that can be used to support farm and non-farm sector activities, suchas agricultural implements, farm mechanisation anddevelopment, and transport.

The guidelines were prepared bya taskforce which included

Pakistan encourages Islamic agriculture financing

Indonesia raised Rp4699 billion($500 million) from its firstrupiah-denominated Islamicbond issue. The figure was just short of the target ofRp5000 billion. The sukuk wasissued with seven and ten yearmaturities, and it is thought thatit will pave the way for the issueof foreign currency sukuk soon.

Total demand, according toRahmat Waluyanto fromIndonesia’s finance ministry, wasworth almost twice the figureraised, but many applicantswanted higher yields than thoseon offer. Indonesia’s high

inflation, at eleven per cent, may have been a deterrent toinvestors.

Islamic finance in Indonesia lagsbehind that of its neighbour,Malaysia, and Indonesia’sfinance minister, Sir MulyaniIndrawati, indicated that thesukuk issue was part of thegovernment’s efforts to help the development of Islamicfinance in the country, as well as diversify its fundraisingsources. The seven year bondswere priced at a yield of 11.8per cent, and the ten year bondsat 11.95 per cent.

Indonesia issues first sukuk

Qatari First Investment Bank(QFIB), a new Islamicinvestment bank, has beenawarded a license by QatarFinancial Centre RegulationAuthority (QFCRA).

QFIB plans to become asignificant player in Qatar,and harbours regional

DIB to ‘convert’ Jordanian bank

senior officials from the bank,Shari’ah compliance advisersand heads of agriculture fromprivate banks. They aredesigned to help particularlyIslamic banks which areextending their branch networksinto rural areas. Officials believethat there has long been a

demand in agriculture forIslamic finance. Dr ShamshadAkhtar, governor of the StateBank of Pakistan, also saidthat Pakistan intends to launchthe country’s first ijara sukuk,to increase liquidity in themarket, and to help thegovernment diversify its debts.

New Shari’ah-compliant bank in Qatar

Dubai Islamic Bank (DIB), theworld’s first fully-fledgedIslamic bank, has announcedplans to buy a majority stake in Industrial Development Bankof Jordan, with the intention ofturning the Jordanian institutioninto a Shari’ah-compliantbusiness. The acquisition isplanned to be a joint venturebetween DIB, DubaiInternational Capital (DIC), and Jordan Dubai Capital, andwill lead to an entity under thename of Jordan Dubai IslamicBank, if all goes to plan.

DIC already has interests inJordan through a $500 millioninvestment fund, and declaredearlier this year that it intendedto partner with DIB to set up anIslamic lender in the country. Ithas also partnered with AmlakFinance to start a Shari’ah-

ambitions also. Phillip Thorpe, chairman and CEO of QFCRA welcomed theestablishment of QFIB stating,‘we recognise the importanceof attracting major Islamicfinancial institutions as part of our aim of broadeningQatar’s financial servicesbase’.

compliant lending firm. Mean-while, DIB has already createdShari’ah-compliant subsidiariesin other countries, includingSudan and Pakistan. Khaled al-Kamda, group managingdirector and CEO of DIB, stated that the bank is ‘verykeen to expand its businessmethods to countries through-out the Arab and Muslimworld’.

In the meantime, anotherDubai-based Islamic bank,Dubai Bank (which became aShari’ah-compliant financialinstitution last year), is alsoconsidering acquisitions worth$5 billion in Africa and Asia.Ahmed Elshall, Dubai Bank’schief financial officer, toldReuters that the bank plans tobecome a major Islamic lenderover the next five years.

To stay up to date with all the news in the Islamic financialsector, visit the ‘Breaking News’ section of the NewHorizon

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Introduction

The phenomenal growth of the Islamicbanking and finance (IBF) industry has been remarkable since it came into existencejust over thirty years ago. However, a closer reading of this positive developmentindicates that IBF does not necessarily sharethe aspirations or the foundational claims of Islamic moral economy (IME), anauthentic value system for human-centredeconomic development and social justice.Despite its contribution in expanding thefinancial base in Muslim countries andovercoming financial exclusion throughproduct diversification, IBF, in respondingto the realities of the international financialsystem has converged towards theconventional notion of managing wealth,resulting in tensions with the foundationalaxioms upon which an Islamo-ethicalfinancial system was intended to be built. Insuch transformation, the identity of IBF isreduced to the mere removal of riba andconducting financial activity in contractualnorms derived from the Shari’ah. The result,therefore, has been the divergence betweenthe aspirations of IME and IBF as aninstrument of that system.

Philosophical sources of Islamicfinance: utopia

IME, in its modern usage, came intoexistence in the early 1970s mainly as acritique of economic development strategiesthat ignored the importance of societal well-

Islamic banking and finance:social failureHave Islamic financial institutions lost their social origins and become too ‘commercialised’ inpursuit of profits? How can the industry be true to its ethical principles? Dr Mehmet Asutay,lecturer in political economy at the School of Government and International Affairs, DurhamUniversity, UK, explores this controversial issue.

being. Therefore, it aimed at formulating ahuman-centric development strategy byproviding the following foundational basethrough which financial and economicactivity could be conducted:

❏ Tawhid (unity) indicates the vertical dimension of the Islamic ethical system in terms of equality in front of God;

❏ Al-’adl wa’l-ihsan (justice and equilibrium) provides for the horizontal dimension of equity in terms of equality between individuals;

❏ Ikhtiyar (free will), provides individual opportunities in the economic system to choose between various options;

❏ Fard (responsibility) implies that individuals and society need to uphold the public good;

❏ Rububiyyah indicates divine arrangements for nourishment, sustenance and directing things towards their perfection;

❏ Tazkiyah calls for growth with purification to incorporate the good of the others and be conducted with ethicaland moral considerations;

❏ Khilafah indicating an individual’s role as God’s vicegerent on earth.

Within this framework, maqasid al-Shari’ah, or the objectives of Shari’ah, isinterpreted to suggest that economic and financial activity must lead to ‘humanwell-being’.

Being the institutional aspect of this IME,

POINT OF VIEW

Dr Mehmet Asutay,Durham University


NEWHORIZON Shawwal–Dhu Al Hijjah 1429 POINT OF VIEW

IBF institutions are expected to operatewithin this framework to produce a socialand environmentally acceptable optimum.

From utopia to reality

In responding to this moral economystrategy, the initial experience of IBF inEgypt in late 1960s was structured as asocially-oriented institution, aimed toprovide credit to peasants, small businesses, and workers to overcomefinancial exclusion and expand theownership base of society.

However, despite such a novel origin, withthe internationalisation and unprecedentedgrowth in their assets base and financingsince 1980s, the lives of Muslim individualshave not been significantly affected by such development of IBF, as the socialdimension is limited to zakat and other non-systematic charitable activities, whichnegates systematic economic development.

It might be useful, therefore, to compare the realities against the aspirationalworldview by deconstructing the practicesof IBF through values the practitionersattach to IBF against the foundationalvalues mentioned above. Speaking at theIslamic Finance Seminar held in London last year, Iqbal Khan, a leading contributorto the development of the sector, suggestedthe following values among the aims of IBF:

❏ Profit-and-loss (PLS) sharing and risk-sharing is preferred alongside creating more value addition to the economy;

❏ Community banking: serving communities, not markets;

❏ Responsible finance, as it builds systematic checks on financial providers;and restrains consumer indebtedness; ethical investment, and corporate social responsibility (CSR) initiatives;

❏ Alternative paradigm in terms of stability from linking financial services to the productive, real economy; and

also it provides moral compass for capitalism;

❏ Fulfils aspirations in the sense it widens ownership base of society, and offers ‘success with authenticity’.

It is clear that these values fit into theaspirational values of IME as well. A criticalexamination of these objectives, however,indicates that the reality is far from fulfillingthese objectives.

Regarding preference towards equity-basedPLS and risk-sharing financing over debtfinancing, data analysis, for instance, in the Malaysian IBF case depicts that thepercentage share of musharakah declinedfrom 1.4 per cent in 2000 to 0.2 per cent in 2006, while major modes of Islamicfinancing remain to be bai bithaman ajil(sale of goods on a deferred payment basis;another term used for such sales is baimu’ajjal) and ijara wa iqtina (leasing andsubsequent purchase) with 55.9 per centand 25.2 per cent respectively in 2006. Inaddition, from 1984 to 2006, murabahaconstituted 88.1 per cent of the mode offinancing for Bank Islam Malaysia Berhad,and 67.3 per cent for Dubai Islamic Bank,while mudarabah and musharakah wasabout 1.7 per cent and 9.3 per centrespectively.

Moreover, in relation to social lending, thepercentage of qard hasan (an interest-freeloan for welfare purposes/short-termfunding requirements) is at a negligible levelin IBF sector. Taking into account that IMEaims for equity financing for creating valueaddition in economic activity, the changetowards debt-financing is rather meaningful,which indicates that IBF institutions havedeviated from the economic developmentand social welfare objectives of IME. Thus,the promise of Islamic finance in relation to its performance failed to be realised inproviding socio-economic development forthe larger parts of the Muslim world andcommunities.

Data analysis also shows that long-termfinancing is not the norm, as most of the

financing focuses on projects withmaturities lasting less than a year. Inaddition, while developmental financingnecessitates financing sectors such asagriculture and manufacturing, the majorityof IBF is related to retail or trade financing.For instance, after the initial years, Islamicbanks in the Sudan moved away fromfinancing agriculture and industry using PLS schemes. Furthermore, instead ofinvesting in value-added economic activityin the Muslim countries, there has been atendency to invest the funds abroad. As aresult, the value addition of IBF to the localeconomy has further declined, and thecontribution of IBF for economicdevelopment through real economy hasbeen rather elusive.

Regarding the community bankingobjective, experience shows that IBF has done little to contribute to capacitybuilding in the communities. On thecontrary, IBF has aimed at becoming part of the international financial markets and,despite the social expectations, IBF claimsthat it is not a charity, and that firms haveto work under difficult competitiveconditions. Clearly, this indicates profitmaximisation as the aim, which negates theimportance of societal responsibility.

As regards to responsible finance, there is no universally accepted regulatory body that systematically checks Islamicfinancial providers. The initiatives byAAOIFI (Accounting and AuditingOrganisation for Islamic FinancialInstitutions) in Bahrain and IFSB (IslamicFinancial Services Board) in Malaysiaremain weak and are not generally adopted. To evidence this, a recent studydemonstrates that a large number of SaudiIslamic finance practitioners, accountantsand auditors, are largely unaware ofAAOIFI standards.

Pertaining to fulfilling aspirations, IBF has not positively affected social capacitybuilding and contributed to wideningownership, which could have been possiblethrough venture capital or PLS type ofinvestments. However, as discussed


NEWHORIZON October–December 2008POINT OF VIEW

previously, these do not seem to be preferredby IBF.

As part of restraining consumerindebtedness, the data indicates that IBFinstitutions prefer to involve themselves in transactions, which are debt-financingoriented, as they are more profitable. Thus,this aim remains unfulfilled.

Concerning ethical investments, restrainingthe investment areas does not necessarilymake IBF ethical. Rather, it only impliesthat IBF fulfils its legal expectations, asscreening of Islamic investment is part of Shari’ah. However, considering thatethicality includes being pro-active inregards to IBF, there is little indication that the industry is entirely ethical. This, again,refers to the CSR, as recent studies on theseinitiatives of IBF demonstrate they have not pro-actively developed such an under-standing. Their perceptions of CSR remainwithin the framework of zakat distributionand other non-systemic charitable activitiesrather than working towards capacitybuilding for developing communities.

In terms of real economy consequences, the claim that IBF links financial services to the economy’s productive side is notconvincing, since IBF does not exhibitmacroeconomic consequences. Particularlyso, when considering the most preferredfinancing is debt financing as opposed toequity financing. It is, therefore, difficult to argue that IBF is related to the realeconomy beyond financing the retailmarkets. In addition, further involvement of IBF sector in debt-like financing,including tawaruq products (sale of acommodity to the customer by a bank ondeferred payment at cost plus profit), clearlyundermines the ‘productive economicactivity’ discourse in Islamic economics.

The realities of financial markets, whichprioritise economic incentives rather thanreligious behavioural norms, has thus forcedIBF to become part of the internationalfinancial system by adopting the commercialbanking model. In that predicament, IBF is described as heterogeneous financialproducts deprived of their value system as

expected by IME. Under such circum-stances, it is difficult to argue that IBF actsas a moral compass for capitalism, either.On the contrary, recent studies show thatIBF has much to learn from conventionalfinance in terms of ethical and CSRfinancing issues.

As to locating the principles governing IBF in the Quran, indeed it reveals theimportance of authenticity. Yet, thecharacteristics of IBF do not necessarilyreflect the Quranic economic meaning ofauthenticity or, for that matter, Shari’ah-based principles as formulated in theaspirational notions of IME. Instead,religion serves to provide justification forIBF’s current operations by claiminglegitimacy in the form of ethicality andsocial responsibility as shaped by Islam.

Conclusion

The discussion so far should not beconsidered to undermine the progress of IBF, as its contribution in terms of bringingeconomic growth through expansion of the financial base in Islamic commercialbanking is self-evidenced with thedevelopments in the sector. Also, provisionof alterative products in compliance withShari’ah overcomes financial exclusion.However, against this ‘commercial’ nature,social aspects of IBF, in terms of economicdevelopment and as described in IME needto be addressed, which constitutes the gapbetween promised expectations andperformance.

It can, therefore, be suggested that IBF has failed to internalise the social dimension and social justice into its own operationalfunction, as the distinguishing character-istics of IBF has been reduced to atechnicality in which the value system isreferred to only in describing the Quranicprohibition of riba. As a consequence, asolution to overcome social failure requiresnew models of institutional developmentsbeyond commercial IBF, by going back tothe Islamic construction. In this newmodelling or reorienting social banking,community banking, ethical and socialinvestment, community development-

oriented projects and microfinance have to be endogenised and addressed asobjectives.

In reorienting towards social banking,Professor Mahmoud El-Gamal, a renownedcontributor to academic discourse in thefield, in his recent books states that ‘the“Islamic” in “Islamic finance” should relateto the social and economic ends of financialtransactions, rather than the contractmechanics through which financial ends are achieved’.

The difficult state of economic affairs in the developing world requires such atransformation. In this effort, theevolutionary financial experience in theWest can be taken as an example indeveloping Islamic community develop-ment banks and Islamic social banksalongside commercial IBF. Such aninstitutional solution aiming at correctingand moderating the social failure of IBF will contribute to the development ofindividual lives by focusing on societies’micro-dynamics rather than affecting the financial equilibrium by extending financialinvolvement to embrace larger society inthis economic dynamics. This fits into thenew development paradigm, which hasshifted focus from macroeconomicdevelopment to micro dynamics.

Thus, a move towards goals and policyrather than the mechanistic and legalstructure of IBF will serve human well-beingmuch better, as suggested by ProfessorNejatullah Siddiqi, a leading scholar in thefield. This will help to establish optimalitybetween venal behaviour and sacrificialbehaviour, and the choice between the twowill be determined by the values of theparticipants in the sector and the interest of the larger environment. However, Islamic social and community banking can provide this balance, and the new brand in compliance with ethical religious normsof IME regarding economic and financialactivity for achieving prosperity (falah) in this world and in hereafter throughpurification and perfection of individualsand institutions for growth anddevelopment, as tazkiyah suggests.



narrows the target audience to high networth individuals and institutionalproprietary books. As a result, a sizeableretail market is left to choose its investmentsfrom an Islamic wealth management marketthat offers a limited choice of innovative,low risk alpha strategies.

Secondly, hedge funds, be they Islamic orconventional, very rarely offer capitalprotection. If the market turns considerablyagainst the fund, investors could lose asignificant amount of the invested principal.In such an event, losses to investors can becompounded by the fact that hedge fundsroutinely limit or even ban redemptionswhen it suits them. In practice this meanshedge funds restrict redemptions when theyincur losses and investors would like towithdraw funds. In effect, liquidity in hedgefunds is even more limited than assumed atthe outset of the investment precisely atthose times when investors may want it.

This leads to the third issue: the level of risk taken by these vehicles. Whilst it isgenerally true that hedge funds operate with strong risk controls in place, inpractice it is impossible to tell exactly whatthe individual fund is doing. One has totrust on faith that the fund’s managers havenot decided to take on board excessive riskrelative to their advertised mandate. At theend of the day, this is left at the fund’sdiscretion and investors have no way ofensuring or even demanding compliance.

Since the spring 2006 correction in GCCequity markets and the global credit crunchjust over a year later, buy-and-holdstrategies on the two dominant asset classesin the Islamic wealth management industry,namely Islamic equities and real estate, havebegun to develop a less desirable risk-reward profile. That is, investors findthemselves facing higher levels of volatilityfor lower returns.

Because of this deterioration in the risk-reward trade-off, Islamic investors areshifting attention to Islamic hedge funds.These aim to provide stable, positive returns by means of a Shari’ah-compliantinvestment. On the one hand, critics of these vehicles highlight the intrinsiccontradiction between Islamic finance andspeculation/arbitrage, whilst on the otherShari’ah-compliant investors have expresseda need for investments which offer decentreturns without exposing their capital toexcessive risk.

The issue of the level of Shari’ah complianceobserved by Islamic hedge funds is beyondthe scope of this discussion. Instead, wefocus here on whether Islamic hedge fundvehicles meet the goals and expectations of investors and whether there arealternative ways of achieving the samegoals. The first and sometimes mostfrustrating limitation for investors when itcomes to hedge funds is the large minimuminvestment amounts. This automatically

Islamic dynamic strategiesIn light of the recent market turmoil, a number of Islamic investors have turned to Islamic hedgefunds in search of alpha (a risk-adjusted measure of the active return on an investment). In thisarticle, Ahmad Chaudry and Ruggiero Lomonaco of RBS Global Banking & Markets discusssome of the problems associated with these vehicles and instead propose a movement of theIslamic wealth management industry towards ‘Islamic dynamic strategies’. In this context, thearticle presents the ‘Islamic Navigator’, the first multi-asset strategy that utilises a uniquedynamic allocation and volatility stabilisation mechanism on a number of Islamic underlyings.

This in turn leads us to the fourth issue: lackof regulation. It is because of this thatIslamic hedge funds are able to operate asblack boxes, making it difficult to followtheir trading activities, which are oftenexecuted at high frequency. This also meansthat the level of protection that wouldotherwise be available legally to investors islacking when they take up hedge fundinvestments.

The fifth issue is that despite all this, Islamichedge funds charge high management fees,which can be as high as ten per cent upfrontof the invested principal and up to 30 percent of the performance.

Finally, additional issues include an illiquid– or even complete lack of a – secondarymarket, as well as short track records.Islamic hedge funds are relatively newvehicles.

In an effort to address these concerns andprovide Islamic investors with moreaccessible alpha ideas, the Islamic wealthmanagement industry needs to encouragethe development of ‘Islamic dynamicstrategies’ (see also NewHorizon,July–September 2008 issue). Throughwhatever strategy the investor may believe is optimum, whether it be based on mean-reversion/momentum, a dynamic weightingsadaptation of the ‘efficient frontier’ or someother fundamental-based algorithm, it couldbe this breed of investing that will drive the

INNOVATION SPOTLIGHT


NEWHORIZON Shawwal–Dhu Al Hijjah 1429 INNOVATION SPOTLIGHT

Islamic wealth management industry overthe next several years.

These strategies should be transparent andmade available in the form of capital-protected certificates which, in the event ofa collapse of the issuer or a malfunction ofthe strategy, have the ability to offer 100 per cent redemption by adopting a strictsegregation of the Islamic principal via anIslamic trust, which in turn invests inShari’ah-compliant assets only. Thiscertificate must be offered at competitivelevels in an attempt to rival theirconventional counterparts and be madeavailable in the secondary market atreasonable bid/offer spreads. Targetinvestors should include retail, private andinstitutional clients.

One such Islamic dynamic strategy is the‘Islamic Navigator’, which invests in fourShari’ah-compliant assets based on analgorithm that identifies medium-termtrends in these assets. The trend is identifiedby comparing the prevailing spot price ofthe asset to its recent moving average. Thelength of the moving average may vary foreach asset and can be optimised based onhistorical simulations. Should the algorithmdetect a positive trend (i.e. when spot priceis above the moving average) for an asset, a fixed allocation is provided to that asset.In the event of a negative trend beingdetected, the allocation for the asset isdirected to a commodity-based reserve asset.The shift in these weightings is conductedon a monthly basis. The initial result is adynamic index linked to a number ofunderlying assets.

The strategy is then controlled through avolatility stabilisation mechanism, whichemploys a ‘dynamic participation’ levelbased on the volatility of the initial index.Should the index observe high short-termvolatility, the mechanism reduces exposureto the index, and vice versa. In effect, thestrategy targets a certain standard deviationfrom the average daily returns by decreasingor increasing the exposure to the index.Hence, the volatility is ex ante defined andis measurable at the outset, which is unusualfor Islamic strategies.

The result is a transparent, Shari’ah-compliant, low volatility strategy whichprovides stable returns. A simple historicalsimulation of the Islamic Navigatorvindicates the attractive risk-return profilethis strategy offers. Since January 2002, theIslamic Navigator has provided an IRR(internal rate of return) of approximately13.6 per cent p.a. with an annualisedvolatility of only seven per cent. Thiscompares favourably against the Dow JonesIslamic Market Index, which during thesame period provided an IRR ofapproximately 7.2 per cent p.a. with an

annualised volatility of around 14 per cent(see the graphs below).

The goal of Islamic dynamic strategies is todevelop low risk but stable return strategiesthat do not suffer from the same issues asIslamic hedge fund investments. Historicalsimulations of strategies such as the IslamicNavigator indicate that they have beenlargely successful in achieving these goals.This provides an excellent addition toIslamic portfolios which have traditionallymissed this ‘quadrant’ on the risk-returnprofile of their investments.



other Muslim countries, but also byinvestors around the world, thus renderingthe expansion of Islamic finance a globalphenomenon. Besides its wide geographicalscope, the rapid expansion of Islamicfinance is also taking place across the whole spectrum of financial activities,ranging from retail banking to insuranceand capital market investments. But perhapsthe most striking has been the fast growthof sukuk (Islamic bonds), the most popularform of securitised credit finance within theindustry. Sukuk issuance has soared over the last three years in response to growingdemand for alternative investments.

A prudential perspective

Shari’ah-compliant banking provides anduses financial services and products thatconform to Islamic religious practices andlaws, which, in particular, prohibit thepayment and receipt of interest at a fixed orpredetermined rate. In practice, this meansthat instead of loans, Islamic banks useprofit-and-loss sharing (PLS) arrangements,purchase and resale of goods and services,and the provision of services for fees formthe basis of contracts. In PLS modes, therate of return on financial assets is notknown or fixed prior to undertaking thetransaction. In purchase-resale transactions,

Since the inception of Islamic banking aboutthree decades ago, the number and reach of Islamic financial institutions worldwidehas risen significantly. Institutions offeringIslamic financial services constitute asignificant and growing share of thefinancial system in several countries. Forexample, the entire banking system of Iranis based on Islamic principles. AlthoughIslamic banks are concentrated in theMiddle East and Southeast Asia, they arealso niche players in Europe and the UnitedStates. Islamic banking assets and assetsunder management are currently standing at over $800 billion. According to a recentstudy by a global management consultingfirm, McKinsey, ‘The World IslamicBanking Competitiveness Report 2007/08:Capturing the Trillion Dollar Opportunity’,the value of Islamic banking assets andassets under management is expected toreach US$1 trillion by 2010, with Islamicbanks growing more rapidly than theaverage banking sector in many countries.

The Islamic finance industry is in the midstof a phenomenal expansionary phase,exhibiting average annual growth rates ofabout 15 per cent in recent years. This rapidgrowth has been fuelled not only by surgingdemand for Shari’ah-compliant productsfrom financiers from the Middle East and

Islamic banking and financial stability

The ongoing turbulence in the global financial markets highlights the importance of financialstability for broader economic developments. Although Islamic banking and finance have so far remained on the sidelines of this unrest, given the ongoing rapid growth of the industryworldwide it is relevant to ask about its potential role and input in steering through the crisis.Hesse Heiko (above right), economist at the global stability division of the International MonetaryFund (IMF), and Martin Cihak (above left), senior economist at the IMF, discuss a prudentialperspective on Islamic versus commercial banks, surveying recent empirical work on the subject,and discussing some of the challenges faced by Islamic banks.

a mark-up is based on a benchmark rate ofreturn, typically a return determined ininternational markets such as LIBOR(London Interbank Offered Rate, an inter-nationally recognised reference interest rate).

Islamic banks also determine return ondeposits differently. In a commercial bank,the rate of return is set contractually (fixed in advance or tied to a reference rate) anddoes not directly depend on the bank'slending performance. In an Islamic bank, the rate of return on a deposit is directlylinked to the quality of the bank’s investmentdecisions. If the bank records losses as aresult of bad investments, depositors maylose some (or all) of their deposits. Thecontractual agreement between depositorsand Islamic banks does not pre-determineany rates of return, it only sets the ratioaccording to which profits and losses aredistributed between the parties to the depositcontract.

A majority of the relevant literature suggeststhat the risks posed by Islamic banks to thefinancial system differ in many ways fromthose posed by conventional banks. Risksunique to Islamic banks arise from thespecific features of Islamic contracts, and the overall legal, governance, and liquidityinfrastructure of Islamic finance. For

ACADEMIC ARTICLE


NEWHORIZON Shawwal–Dhu Al Hijjah 1429 ACADEMIC ARTICLE

example, PLS financing shifts the directcredit risk from banks to their investmentdepositors. But it also increases the overalldegree of risk on the asset side of banks’balance sheets, because it makes Islamicbanks vulnerable to risks normally borne by equity investors rather than holders ofdebt. Also, because of their compliance with Shari’ah, Islamic banks can use fewerrisk-hedging techniques and instruments(such as derivatives and swaps) thanconventional banks. Moreover, most Islamicbanks have operated in environments withless developed or non-existent interbankand money markets and governmentsecurities, and with limited availability of and access to lender-of-last-resortfacilities operated by central banks. Thesedifferences have been reduced somewhatbecause of recent developments in Islamicmoney market instruments and Islamiclender-of-last-resort modes, and the implicitcommitment to provide liquidity support to all banks during exceptional circum-stances in most countries.

In some ways, Islamic banks could be lessrisky than conventional banks. For example,Islamic banks are able to pass through anegative shock from the asset side (such as a worsened economic situation that causeslower cash flow from PLS transactions) tothe investment depositors. The risk-sharingarrangements on the deposit side thusarguably provide another layer of protectionto the bank, in addition to its book capital.Also, it could be argued that the need toprovide a stable and competitive return toinvestors, the shareholders’ responsibilityfor negligence or misconduct (operationalrisk) and the more difficult access toliquidity put pressures on Islamic banks tobe more conservative. Furthermore, becauseinvestors (depositors) share in the risks (and typically do not have depositinsurance), they have more incentive toexercise tight oversight over bankmanagement. Finally, Islamic banks havetraditionally held a larger proportion oftheir assets than commercial banks inreserve accounts with central banks or incorrespondent accounts with other banks.So, even if Islamic investments are morerisky than conventional investments, from

a financial stability perspective the questionis whether or not these higher risks areoffset by bigger buffers.

Are Islamic banks more or less stable thanconventional banks? The answer dependson the relative sizes of the effects discussedabove, and it may in principle differ fromcountry to country and even from bank tobank.

Islamic banking and financialsoundness: some empiricalevidence

There is a large body of descriptiveliterature about Islamic finance, but therehas been relatively little empirical work on Islamic banking and financial stability,an area of increasing interest as Islamicbanking grows. In recent IMF research,‘Islamic Banks and Financial Stability: AnEmpirical Analysis’, we attempt to fill thisgap in the literature, using data on 18banking systems with a substantial presenceof Shari’ah-compliant banks to provide a cross-country empirical analysis of therole of these banks in financial stability. An increasingly popular way of assessingbanks’ soundness is to analyse their so-called z-scores. The z-score combines abank’s capitalisation, profitability, and a measure of risk faced by the bank into a single index. The interpretation of the z-score is straightforward: the lower thescore, the more likely it is that a bank willrun out of capital.

Defining large banks as those with totalassets of more than $1 billion and small banks as all others, the paper findsthat:

❏ small Islamic banks tend to be financially stronger (that is, have higher z-scores) than small and large conventional banks;

❏ large conventional banks tend to be financially stronger than large Islamic banks;

❏ small Islamic banks tend to be financially stronger than large Islamic banks (see the bar chart).

A plausible explanation of the contrastbetween the high stability in small Islamicbanks and the relatively lower stability inlarger ones is that it is significantly morecomplex for Islamic banks to adjust theircredit risk monitoring system as theybecome bigger. For example, the PLS modesused by Islamic banks are more diverse and more difficult to standardise than loansused by conventional banks. As a result, asthe scale of the banking operation grows,monitoring of credit risk rapidly becomesmuch more complex. That results in agreater prominence of problems relating to adverse selection and moral hazard.Another explanation is that small banksconcentrate on low risk investments and feeincome, while large banks do more PLSbusiness.

We also found that as the presence ofIslamic banks grows in a country’s financialsystem, there is no significant impact on thesoundness of other banks. This suggests thatIslamic and conventional banks can co-existin the same system without substantial‘crowding out’ effects through competitionand deteriorating soundness.

These findings are subject to several caveats relating to the cross-country data. Databases are often incomplete incoverage of Shari’ah-compliant andconventional banks. Moreover, we focusedonly on fully-fledged Islamic banks and did not cover Islamic branches operated bysome conventional banks. Data limitationsalso prevented the study from fully takinginto account all aspects of Islamic financialcontracts, for example, by distinguishingbetween PLS and other investments.Nonetheless, the main results are encourag-ingly robust with respect to a range ofsensitivity tests, such as using differentmeasures of financial soundness anddifferent estimation methods.

Our findings provide some comfortregarding the financial soundness of smallIslamic banks. At the same time, theyunderscore the importance for regulators of paying attention to the prudential risks of Islamic banks, in particular those that arelarge.


NEWHORIZON October–December 2008ACADEMIC ARTICLE

Islamic banks going forward:challenges

The continuing rapid growth of demand for Islamic financial services is clearly goodnews for Islamic banks. At the same time, italso presents some challenges, as the banksneed to invest in upgrading their credit riskmanagement capabilities in line with themore complex and larger projects intowhich they are entering.

Despite the rapid growth, business modelsand products of Islamic banks are stillrather homogeneous, while Shari’ahcompliance amplifies risks stemming fromproduct configuration and processimplementation. The success of Islamic

banking in recent years has produced toomany Islamic banks with the same businessmodels. There is a lack of ‘bread and butter’lending, and the current excess liquidity hasled to too much complacency among Islamicbanks.

In addition, there is a large and diverse setof accounting standard differences acrossdifferent jurisdictions. The development and setting of simple standard legalcontracts is necessary in order to overcomethe complexity and heterogeneity of currentcontracts. Furthermore, the deployment ofIT systems that help monitor the fulfilmentand visibility of processes on an end-to-endbasis are crucial to facilitate the continuousmonitoring of activities by Shari’ah scholars

while eliminating the possibilities of non-compliance, which in some cases mightrender transactions invalid.

Liquidity risk management of Islamic banks is an important challenge and isconstrained due to limited availability oftradable Islamic money market instrumentsand weak systemic liquidity infrastructure.At the moment, there is no Shari’ah-compliant short-term Islamic money market(less than one week maturity) in localcurrency or in US dollars, and Islamic repomarkets have not yet developed. Islamicmoney markets with longer maturities,which are based on commodity murabahatransactions (mark-up financing), sometimessuffer from unreliable brokers with lowcreditworthiness. Islamic banks also have a competitive disadvantage withconventional banks, as they deposit theirovernight money with their domestic centralbank interest free. The lack of liquidity and viable alternatives, combined with thecompetitive disadvantage, hamper the localIslamic banks and can even create aliquidity crisis.

Islamic banks going forward:solutions and opportunities

Both risk managers and regulators areworking to address the above challenges. To overcome the shortcomings of theIslamic money market, many investmentbanks are currently designing new complexproducts, compliant with Shari’ah law. Itremains to be seen whether these newsolutions will obtain widespread Shari’ah-compliant status in the Islamic financecommunity, and generate enough demandfor a functional Islamic money market todevelop.

The rapid developments are likely tocontinue. Financial institutions in countriessuch as Bahrain, the UAE and Malaysiahave been gearing up for more Shari’ah-compliant financial instruments andstructured finance – on both the asset andliability sides. At the same time, the leadingfinancial centres, such as London, NewYork and Singapore, are making significantprogress in establishing the legal and

Source: authors’ calculations, based on data from BankScope (a global database of public and private banks)

Note: individual bank risk is measured by the z-score, which increases with equity and ROA and decreaseswith return volatility. The z-score has become a popular measure in the recent literature on bank soundnesssince it is inversely related to the probability of a bank’s insolvency.

Comparison of average z-scores


NEWHORIZON Shawwal–Dhu Al Hijjah 1429 RATINGS & INDICES

prudential foundations to accommodateIslamic finance side-by-side with theconventional financial system. Many of the largest western banks, through theirIslamic windows, have become active and sometimes leading players in financialinnovation, through new Shari’ah-compliantfinancial instruments that attempt toalleviate many of the current constraintssuch as a weak systemic liquidity infra-structure. More conventional banks areexpected to offer Islamic products, enticedby enormous profit opportunities and alsoample liquidity, especially across the MiddleEast.

New product innovation is also driven by domestic banks’ interest in riskdiversification. With a large number of newIslamic banks across the Middle East andAsia especially, diversification of productsenables banks to offer the right product mixto more sophisticated clients. A few banksare already active across differentjurisdictions, and this trend is certainlygoing to continue in the near future,possibly with some consolidation.

On the regulatory front, the IslamicFinancial Services Board (IFSB), an inter-national standard-setting organisation based in Malaysia, has moved ahead withits efforts aimed at fostering of thesoundness and stability of the Islamicfinancial services industry through morestandardised regulation. Globally acceptedprudential standards have been adopted bythe IFSB that smoothly integrate Islamicfinance with the conventional financialsystem. For instance, the adoption of theIFSB standards (somewhat akin to Basel II),which take into account the specificities ofIslamic finance, ensures a level playing fieldbetween Islamic and conventional banks.

Many challenges still lie ahead, as is clear from the discussion above. However,the ongoing improvements in banks’ riskmanagement techniques and prudentialframeworks for Shari’ah-compliant banking give reasonable hope that theIslamic financial industry’s growth willcontribute positively to broader financialand economic stability.

BBAANNKKSSLLOONNGGTTEERRMM

SHORTTERM

FINANCIALSTRENGTH

DATE OUTLOOK COUNTRY

Boubyan Bank Baa2 P-2 D 22-Oct-07 Stable Kuwait

Kuwait Finance House Aa3 P-1 C- 06-Nov-06 Stable Kuwait

Al Rajhi Bank A1 P-1 C 27-Jul-07 Stable Saudi Arabia

Bank Al-Jazira A3 P-2 D+ 16-Nov-05 Stable Saudi Arabia

Asya Katilim BankasiA.S.

B1 D 10-Aug-07 Stable Turkey

Abu Dhabi Islamic Bank A2* P-1 D 10-Oct-06 Stable UAE

Dubai Islamic Bank PJSC A1* P-1 D+ 16-Nov-06 Stable UAE

Dubai Bank A3 P-2 D 18-Aug-08 Positive UAE

Tamweel PJSC A3* P-2 12-Nov-07 Stable UAE

Islamic credit ratings: how is your bank doing?Below is a list of the current credit ratings for Islamic financialinstitutions monitored by Moody’s Investors Service, aninternational credit rating agency. Detailed information on ratingprocesses and definitions can be found on the Moody’s websitewww.moodys.com

*Issuer rating



Despite all the positive words about makingthe UK a global Islamic finance hub, it hadbeen severely lacking one aspect of Shari’ah-compliant financial services – a dedicatedtakaful provider. This is no longer the case.

The UK’s first independent Islamic insurancecompany, Salaam Halal Insurance (SHI),was granted approval by the UK’s FinancialServices Authority (FSA) in April of thisyear, and, at the end of July, it came tomarket with its first product, motorinsurance.

The UK takaful market had previously beenseriously under served. Whilst there wereproducts on the market, these only camethrough specialist Islamic windows atbanks, and Muslims would usually have tocompromise their faith in order to getinsurance.

The decision to offer takaful in the UK,therefore, seems like an obvious choice.‘Islamic finance is growing at a very rapidrate universally, but [UK Prime Minister]Gordon Brown and the Government, TheBank of England and the FSA have allprovided support in terms of Islamic finance and banking,’ says Iqbal Gelu,business development director for PrincipalInsurance Holdings. ‘The Government really wants Britain to be the global centrefor Islamic financial products. We feel thatthere’s a great opportunity for us as the firstindependent takaful provider in this countryto make a difference.’

It has been a long journey to get this far,and one regular NewHorizon readers willbe familiar with. The seeds of the idea weresown in 2005, British Islamic Insurance

Insurance with principlesAfter three years of negotiations and preparations, Salaam Halal Insurance is finally open forbusiness. James Ling, NewHorizon’s contributing editor, takes a look at the UK’s firstindependent takaful provider.

Holdings (BIIH) was formed and attracted£60 million ($107 million) of investmentfrom Saudi Arabia, the GCC and Asia. BIIHset about the lengthy discussions with theFSA to become the first insurance companyin the country authorised to act entirelyunder Islamic rules. During this process italso changed its name to become PrincipalInsurance Holdings, before finally getting itsapproval.

Principal then underwent a marketingexercise to find the most relevant brand for the company. It presented a choice of 30 potential names to focus groups to find the one that people could most identify with. This selection was narroweddown to five before Salaam Halal Insurance was chosen. ‘Salaam was preferred because it has strong positive connotationswith our target audience, and similarly with all ages and backgrounds,’ explainsGelu.

The decision to come to market with motorinsurance first was a tactical one. In the UK every driver is required by law to havecar insurance. If you add to this the twomillion Muslims in the country, the size of the potential market is clear. ‘We decidedthat car insurance is probably the productthat has the largest distribution,’ says Gelu.‘We wanted to go into the personal linesbusiness first because it’s a producteverybody needs.’

Gelu is keen to point out that SHI will notbe providing products that are exclusivelyfor Muslims. ‘One of the most importantaspects of ourselves, our raison d’être as itwere, is that this product is not only forMuslims. This is a mutual product and we

TAKAFUL FOCUS

We know there are 140,000Muslim-owned businesses andwe believe there is a marketthere.

Iqbal Gelu, Principal Insurance Holdings


NEWHORIZON Shawwal–Dhu Al Hijjah 1429 TAKAFUL FOCUS

would like to promote it to the communityat large as an ethical product.’

The car insurance product has beendesigned as a mutual product withinShari’ah principals. Policy holders (takafulparticipants) contribute a premium into atakaful pool. Any money in this pool is then invested into Shari’ah-compliant orethical products that don’t provide interest.Any return on these investments goes backinto the pool and any claims are taken outof it. Anything that is left over in that poolis then distributed to the policy holders as a discount on their renewal premium for the next year. ‘It’s a mutual pot, they areguaranteeing each other. They are theinsurer and the insured,’ explains Gelu.‘When they put in premiums it’s their money that’s invested, any return is theirmoney.’

Principal will act as the takaful operator.Therefore, it will make its money throughtaking a wakala fee. ‘That fee covers us for all our costs, including administration,operating costs and the profit for theshareholders,’ say Gelu. The details of thewakala fee and the specifics of the takafulmodel adopted will be communicated to the participants through theirdocumentation.

To ensure that Principal’s activities are inline with Islamic law, it has appointed aShari’ah supervisory committee made up of three prominent Shari’ah scholars: ShaikhNizam Yaquby of Bahrain, Dr MohammedElgari of Saudi Arabia, and Mufti AbdulKader Barkatulla from the UK. ‘All aspectsof our business are underpinned byindependent Muslim scholars, specialising in Islamic law, who give guidance, approvaland supervision of our activities,’ explainsGelu. This is not just restricted to theproducts the insurer will put out. Thecommittee will look at everything thetakaful operator does to ensure it isShari’ah-compliant.

The company is working to a timetable ofmotor insurance first, followed by contentsand buildings insurance, a product Gelusays will be ready for the market by the end

of the year. In the next 18 to 24 months it is also looking to launch family takafulproducts, such as life insurance. It is alsolooking at commercial lines for SMEs. ‘Weknow there are 140,000 Muslim-ownedbusinesses and we believe there is a marketthere,’ he explains. On top of this, it wantsto examine expansion plans into Europeand the GCC.

Gelu believes ‘the climate is right’ forIslamic finance. He is determined tochallenge the stereotype that Islamicproducts are more expensive than con-ventional ones. ‘With our motor productswe have to be competitive [in terms ofprice], and also our products will becompetitive in terms of their features andconditions. We feel that we have to give our customers the same product that theyenjoy today.’

The next challenge for Principal is to makeits audience aware of SHI. To do this it isembarking on a community awareness and outreach programme. It is looking toget in touch with mosques, imams andcommunity leaders, as well as organisationssuch as the Muslim Council of Britain toraise awareness of its products.

It is taking a dual approach bring itsproducts to the market. The first is takingthe direct route. It has a UK-based callcentre with advisers who can speak anumber of languages to deal directly withcustomers. It is also using the online channel where people can get a quote andpurchase insurance via its website. Geluthinks this is a particularly importantchannel because ‘web-based businessaccounts for around 60 per cent of theinsurance business’. However, this will notbe the only route to market. The takafulcompany is also looking to sell its productsthrough other Islamic financial serviceproviders, such as banks. It is in discussionswith these institutions in order to ‘try to getsome cohesion and synergy with them topromote our products in conjunction withtheir financial products’. Principal is alsolooking at other organisations not currentlyinvolved with Shari’ah-compliant finance,such as supermarkets, to try and get its

products sold this way as well. ‘It is veryimportant that we have other channels,’ heconcludes.

One thing that Principal has benefited fromin its marathon quest to get to market, istalking to the other Islamic financial serviceproviders in the UK to get their experiencesof starting out in this market. ‘Although weare a different type of organisation, we havelearnt a lot, and experience has shown to us it’s going to be a slow process,’ explainsGelu. ‘Like any new business you can’t sayyou’re going to start making profitstomorrow. But in this case, because it’s aunique market, we have talked to theIslamic Bank of Britain and others, andtaken their advice.’

By learning from others, Principal knows it needs to be in for the long-haul to be asuccessful business. ‘Currently we arepositioned as an organisation to takemarket share in time. We’ve done a lot ofanalysis to see how our rates and pricesmatch up.’ To take that market share itmust provide products that are attractiveacross the board. Whilst it is true thatMuslims do tend to buy products inaccordance with their faith, to gain asignificant market share the products mustbe universally appealing.

In order to be a success, SHI’s productsmust be in line with what the market isdemanding. Gelu knows that he is in for a challenge, the competition will be fierce and where Principal has led, others arebound to follow. But the company doeshave first mover advantage in a market thatis clearly ready for its products. ModernBritain is a cultural melting pot, and anyproducts that can provide ethical benefitsare sure to be a hit with consumers.

Only time will tell if SHI will be a success.Currently it has everything going for it; now it must take advantage of this, andpush on to drive the industry forward. TheUK has a long way to go if it is to achieveits aim of being a global hub for Islamicfinance. But with its first takaful providermaking it to the market, it is certainly onthe right path.

of the UAE. Bernard previously served ashead of investment funds at GlobalInvestment House, Kuwait. He also workedas chief investment officer at Banque FerrierLullin & Cie Geneva, a subsidiary of UBS,as managing director with PrudentialFinance in New York, and as head ofCitibank Asset Management Group inLondon.

Reef, the Islamic real estate finance firm in Bahrain, has announced two newappointments. Ali Salem joins as head ofretail and placement, and Mukhtar AlToblani has been named the new head ofsales and marketing. The appointmentsform part of Reef’s plan to expand andbring a new approach to Islamic mortgagefinance in Bahrain.

HSBC Amanah has named Khaled Rasheedas regional head for Middle East and NorthAfrica. Rasheed will oversee Islamic bank-ing business, including private, consumerand commercial banking as well as personalfinance. He will also be in charge of theunit’s regional expansion. Rasheed hasworked with HSBC in the Middle East since1996.

www.newhorizon-islamicbanking.com22 IIBI


Datuk Mohammed Azahari Kamil is thenew CEO of Asian Finance Bhd. Kamil isthe first Malaysian to be CEO of a foreignIslamic bank in Malaysia. He will bringclose to 30 years of experience in fundmanagement and corporate finance. Kamilmoves from Amanahraya Investment Bank(Labuan), where he was managing directorand CEO. Kamil replaces Faisal Alshowaikhat Asian Finance, who recently resigned.

Qatar-based Al Khaliji has appointedRosmah Ismail to lead the bank’s Islamicbanking activities. Ismail moves from ABNAmro in Malaysia, where she was in chargeof the bank’s global Islamic finance.

Dr Salman Khan has taken up the role ofhead of Shari’ah of the Dubai office in theShari’ah division of Abu Dhabi IslamicBank. Dr Khan has much varied expertise inShari’ah and advisory services, including all-round knowledge of corporate, retail andinvestment banking products, Shari’ahreview and coordination. Dr Khan is also anIslamic finance trainer, and NIBAF-certifiedIslamic finance practitioner. Previously, heworked as senior product manager at Dar

Al Istithmar, and at BMB Islamic, both UK-headquartered Shari’ah advisory firms.

Abu Dhabi Islamic Bank has also appointedAli Al Shaqoosh Al Mueen as senior vicepresident, head of branches in the UAE. AlMueen will be responsible for all branchesin the Emirates, and also further expansion.He has previously built up 20 years ofexperience in the banking industry in theregion, including in roles with Citigroupand Standard Chartered Bank.

Dubai Islamic Bank (DIB) has announcedthe appointment of two senior additions to its management. Dr Adnan Chilwan hasbeen appointed chief of retail and businessbanking at DIB. Over 14 years in theindustry Dr Chilwan has worked for manybanks in the region, both conventional and Islamic. These include Dubai Bank,Commercial Bank of Qatar, Mashreq Bank,Abu Dhabi Islamic Bank and HSBC.

DIB’s second appointment is of MohamedAl Nahdi as chief of central operations, tofocus on business in the UAE. Al Nahdi hasworked in banking operations, projectmanagement, corporate banking andpersonal banking for 26 years. Havingstarted his career with HSBC, he held manysenior posts before becoming chief retailbanking officer at Dubai Bank.

European Islamic Investment Bank (EIIB)has appointed Keith McLeod as financedirector. He replaces Atif Raza. McLeodtrained with Price Waterhouse (now part of PricewaterhouseCoopers) and waspreviously executive director at UBS GlobalAsset Management, where he was also headof fund services and logistical reporting.

Jacques Bernard has been appointed chiefinvestment officer of National Bonds, theShari’ah-compliant national savings scheme

On the move

APPOINTMENTS

UK-basedGatehouse Bankplc, has namedMichael Clarke(left) as its newdirector, capitalmarkets. Clarkejoins Gatehousefrom Abu DhabiIslamic Bank,where he

worked for seven and a half years inmultiple roles, including assistant vicepresident of financial institutions.Clarke has also previously worked withNatWest Bank in the UK, US and HongKong, and Jordan International Bank.

Oliver Agha(right), globalhead of Islamicfinance at aninternational law firm, DLAPiper, has beenappointed to the Accountingand AuditingStandards Boardand Auditingand Governance Standards Committee of Bahrain-based AAOIFI. Aghaspearheaded the development of DLAPiper’s Islamic finance team in 2007.

Two innovative firms...

One colourful combination

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NEWHORIZON Shawwal–Dhu Al Hijjah 1429 COUNTRY FOCUS

Like many other former republics of theUSSR, for a few years after the October(Soviet) Revolution of 1917 Azerbaijan was an independent state. Azerbaijanis are proud that the Azerbaijani DemocraticRepublic (ADR), declared in 1918, becamethe first secular state in the region, a fewyears prior to abolition of the caliphate inTurkey. At that time, the ADR was a classicparliamentary republic.

Furthermore, Azerbaijani historiansemphasise that all reforms in the countrywere carried out in a democratic way,unlike, for example, in neighbouring Turkeyat the time of conversion to a republicansystem (based on the Kemalist ideology) andAtatürk’s Reforms under the leadership ofMustafa Kemal Atatürk.

The modern Republic of Azerbaijan, whichgained independence in 1991 after thedemise of the USSR, adopted ADR’s flag,the national emblem and the anthem, aswell as the policy of secularism, whichmeant minimisation of Islamic influence in the public and political life of the country.ADR’s ideology was based on the views of the founders of the Musavat Party(‘musavat’ is translated as ‘equality’), whobelieved that religion should be separatefrom the state. Interestingly, today’sMusavat Party, which considers itself thesuccessor of original Musavat movement of early 1900s, is in the opposition to thecurrent Azerbaijani government, despite the mutual support of secularism.

Analysing the role of Islam in Azerbaijantoday, it is important to remember that at

the time of ADR’s emergence, Musavat’sopposition, an Islamist party called Ittihad(Arabic word for ‘alliance, union’), wasagainst the creation of ADR. The ideologistsof Ittihad were true pan-Islamists andtherefore were calling for the unification ofall Muslim nations of the Russian Empireand against the concept of the nation stateof Azerbaijanis, or ‘Transcaucasian Tatars’, as they were often referred to in those days.So, the leaders of Ittihad felt there was noother option but to support the Sovietregime as the only power, in their opinion,capable of uniting the Muslims of the fallenapart Russian Empire.

So, the idea of national statehood inAzerbaijan is closely connected withsecularism and anti-clericalism rather than with Islam and religious values. Thereligious observance of Muslims residing inthe country is relatively low and Muslimidentity tends to be based more on cultureand ethnicity rather than religion. Evenhardcore Azerbaijani nationalists admit thatover 70 years of imposed atheism during the Soviet era strengthened the foundationof the country’s national identity.

Nevertheless, starting from the early 1990s the number of mosques across Azerbaijanhas risen dramatically. Many were builtwith the support of other Muslim states,such as Iran, Oman and Saudi Arabia. AMuslim seminary was also establishedduring that period. In the last five years orso, local imams have reported increasedattendance at mosques, especially amongthe younger generation. However, Islamdoes not yet play a major role in the

Azerbaijan: emerging marketWith a long history of secularism, Azerbaijan has not been prominent in the Islamic world,despite being essentially a Muslim state, with around 95 per cent of the 8.5 million populationMuslim. Can this oil-rich state on the shores of the Caspian Sea be put on the map of Islamicfinance? Renat Bekkin, PhD in Law, senior researcher at the Institute for African Studies of theRussian Academy of Sciences, reports from the country’s capital, Baku.

country’s social and political life. The keypartner of modern Azerbaijan is Turkey,which advocates the principles ofsecularism, and not its other neighbour,Iran, despite the fact that the overwhelmingmajority of Azerbaijani and IranianMuslims share the same denomination ofIslam – Shia.

A handful of initiatives to amendAzerbaijan’s banking legislation toaccommodate Islamic banks and facilitatetheir development are still by and largeblocked by the regulatory bodies on thegrounds of the constitution that proclaimsAzerbaijan a ‘democratic, constitutional,secular and unitary republic’, and asserts the separation of religion and state as well as the equality of all religions beforethe law.

However, with the forthcoming sweepingreforms of Azerbaijan’s financial sector and the need for investment in the economy,there are expectations of the shift in theregulators’ politics (particularly of thecentral bank, National Bank of Azerbaijan)towards Shari’ah-compliant banking andfinance.

The banking sector of Azerbaijan ischaracterised, above all, by a low level of transparency and a lack of capital(although the current economic upturn has spurred notable growth of the bankingmarket, quadrupling the assets of domesticbanks in the last three years). State-ownedfinancial institutions dominate the market,but are gradually losing ground to theemerging commercial banking segment.

26 IIBI

COUNTRY FOCUS

Since Azerbaijan is a country with atraditional banking system, Islamic banksdo not have a special status or fall under a separate category. The first and onlyShari’ah-compliant bank in the country,Kauthar Bank, is considered to be aconventional bank according to the officialdocuments. Nevertheless, it is probably safe to say that Kauthar is the only fully-fledged Islamic bank in the post-Sovietspace, though Ekobank in Kyrgyzstan has an Islamic window (NewHorizon,April–June 2007 issue) and in Kazakhstan, a standalone Islamic bank is currently awork in progress (NewHorizon,January–March 2008 issue).

Kauthar is one of the first non-state banksin Azerbaijan. It obtained a licence back in1988 and until September 2001 was knownas Universal Bank. A year later the bankobtained a new banking licence to carry outthe full range of banking operations, andaround the same time, it started to cleanseits loan and debt portfolios of riba. It alsoceased participating in all transactions thatinvolved usury. All interest-accruing loansthat had been issued prior to the bank goingIslamic were sold off to a specialistcompany.

It is worth noting that Kauthar is regardedas a Shari’ah-compliant bank by theworldwide community. At the same time, it is still too early to state that the bankoffers a complete range of Islamic bankingproducts and services. At the moment, it has only four offerings – investmentaccounts based on mudarabah (profit-and-loss sharing), loans to businesses based on musharakah (joint venture), loans forretail and corporate clients by purchase and sale of bills of exchange analogous tosukuk (Islamic bonds), and consumer loansbased on ijara wa iqtina (leasing andsubsequent purchase). Due to restrictions on banks’ trading activity stipulated in theAzerbaijani legislation, Kauthar cannot base any of its operations on the murabahaprinciple (the bank buys and sells the itemsrequired by the customer).

Not being able to use some of the Islamicfinance instruments, Kauthar fulfils its

potential in financing halal sectors ofeconomy, although not always with adesired outcome. A good example is amulti-million dollar project of constructingseveral skyscrapers in Baku. In 2004, thebank signed an agreement with ICD(Corporation for the Development of the Private Sector, a member of IslamicDevelopment Bank (IDB) group). Accord-ing to this agreement, ICD was going tofinance the bulk of the project. Kauthar’sassets and one of the multi-storey buildings was the guarantee. The same year, ICDpurchased a shareholding stake in the bank.

The project remained at a standstill for along time due to the developers’ mainstipulation requiring financing of the entireconstruction project. In due course, anumber of significant changes were made tothe plans, such as building four 24-storeystructures instead of two 45-storey ones.

Baku,Azerbaijan

www.newhorizon-islamicbanking.com

IIBI 27

COUNTRY FOCUS

With the forthcoming sweeping reforms of Azerbaijan’s financialsector and the need for investment in the economy, there areexpectations of the shift in the regulators’ politics (particularly of the central bank, National Bank of Azerbaijan) towardsShari’ah-compliant banking and finance.

© Elnur Dreamstime.com

Then it was decided to create a complex oftwo 39-storey buildings with a gross floorarea of 170 thousand square metres. Thelast option attracted $300 million fromsome Korean investors (conventionalbanks). In the end, the participation ofKauthar in the project was minimised andthere was no longer a need for ICD’sinvestment.

The entire complex is going to be rented out as offices and apartments. The project is managed by a local firm, Baku Pride, setup by the Korean investors with minimalinput from the Azerbaijani partner (close to Kauthar’s management).

Nevertheless, it seems that at present it is precisely the Shari’ah-compliantinvestment business that is the best optionfor unlocking the Islamic finance potentialin Azerbaijan (as opposed to expanding the range of Islamic banking products and services). And the recent flurry ofactivity in this area seems to substantiate the point. One of the notable ventures is the launch of Caspian InternationalInvestment Corporation (CIIC), whichoperates according to Shari’ah principles.CIIC was established in June this year as a result of an agreement signed at theInternational Investment Conference inBaku in 2006, a high profile event organisedby the IDB.

ICD has a 75 per cent stake in the company,with the remaining 25 per cent owned by a domestic investment firm, AzerbaijanInvestment Company (AIC). The mainobjective of the CIIC is to attract foreigninvestment to Azerbaijan and gain a strongfoothold in the international market. It isexpected that in the next two years thecapital of the CIIC will increase many foldto reach $70 million from a current $4million.

The corporation’s investment activity willkick off with financing logistics projects,although other favourable spheres are alsobeing analysed. The priority segmentsinclude agriculture, the pharmaceuticalindustry, the building materials industry and the services sector.

www.newhorizon-islamicbanking.com

Overall, ICD and its parent, IDB, show agreat deal of interest in Azerbaijan. Inaddition to partnerships with AIC andKauthar, the group has issued a number ofcredit lines for SME financing to anotherdomestic bank, Rabitabank. InternationalBank of Azerbaijan and Unibank alsoreceived loans from ICD. Most recently, in September, a similar agreement wassigned with Azerdemiryolbank, securing a$3 million credit line for SME developmentin agricultural, bio-technology, multimedia,telecommunications and transport sectors.Both parties emphasise that none of thefinancing will be directed at spheresprohibited by Shari’ah. Two other domesticbanks, Bank Standard and TuranBank, alsoheld talks with ICD about possiblecooperation.

IDB group is not the only Islamic financialinstitution investing in Azerbaijan (althoughto date, it is the largest Shari’ah-compliantinvestor, having contributed around $300 million). In May last year, Kuwait Finance House (KFH) and AIC signed amemorandum of understanding, accordingto which a company similar to CIIC is to be established. KFH will have a majorityshareholding of 75 per cent in the newentity and AIC a 25 per cent stake.

Despite not being able to set up an Islamicbank in Azerbaijan so far, IDB is notabandoning this idea. Nik Zeinal Abidin,director of IDB’s regional office in Almaty,Kazakhstan, has noted on numerousoccasions that IDB is ready to providesupport in establishing an Islamic bank inAzerbaijan, but the initiative has to comefrom the country’s government.

The lack of dedicated legislation andsomewhat disapproving attitude towardsthe industry from the regulators, withoutdoubt, hinder the development of thecountry’s Islamic banking sector. In October 2007, Bahrain-based InternationalInvestment Bank (IIB) purchased a 49 percent stake in Amrahbank. IIB, which is ashareholder of European Islamic InvestmentBank (EIIB) in the UK, is actively supportingthe development of Islamic finance in bothMuslim and non-Muslim countries.


NEWHORIZON October–December 2008COUNTRY FOCUS

Amrahbank was to be converted to a fully-fledged Shari’ah-compliant bank to seize thebenefits of Azerbaijan’s ‘untapped demandfor Islamic banking products and services’,according to the IIB’s CEO, Aabed Al-Zeera. However, this initiative has neverbeen put into practice due to regulatory andlegislative uncertainty. To date, the Islamicbanking section of Amrahbank’s websitestates that this type of products and serviceswill be introduced in near future.

As for Kauthar’s Shari’ah-compliant activity,it is not being widely advertised and theinformation about it is mainly spread byword of mouth. Furthermore, the bank’sofficial documents contain hardly anyArabic terminology relating to Islamicfinance. There is hardly any mention ofShari’ah principles the bank adheres to inthe published information about Kauthar.For example, in the English version ofKauthar’s promotional literature its activityis described as ‘Islamic banking’, while inAzeri language version the phrase used is‘faizsiz qazanc’, which is translated as ‘non-interest banking’.

Such discrepancy in terminology is not aconspiracy, but rather a sensible precaution,says Heydar Ibrahimov, chairman ofKauthar. ‘Shari’ah-compliant banking inAzerbaijan has its foes, including in theNational Bank,’ says Ibrahimov. ‘Butnevertheless, compared to Russian Badr-Forte Bank, we are in a more favourableenvironment.’ Badr-Forte, the only Islamicbank in Russia, had its licence revoked in late 2006 on the grounds of moneylaundering activity and terrorism financing(for more details on Badr-Forte’s story andIslamic finance in Russia, see NewHorizon,January–March 2007 issue). Badr-Forte andits chairman, Adalet Dzhabiev, are wellknown to Kauthar and Ibrahimov. Back in2002, when nothing seemed to threatenBadr-Forte’s existence, Dzhabiev consultedKauthar’s management on applying Islamicfinance methods. The two banks have,indeed, a lot in common. Similar toKauthar, Badr-Forte was restricted inapplying Islamic principles. The centralbank not only refused to make anyconcessions for Badr-Forte’s specifics (for

Needless to say, that the futureof Islamic banking andinsurance in Azerbaijandepends not only on thepoliticians and regulators, buton the country’s Muslims as a whole.

Renat Bekkin, Russian Academy of Sciences

today, but so far none of them haveexpressed interest in takaful.

The issue is complicated by the newinsurance legislation (compliant with the key principles of the InternationalAssociation of Insurance Supervisors, IAIS)that came into effect in Azerbaijan in March2008. This regulatory act does not cater for the specifics of takaful, and it seems that the same omission has been made inpreparing another law on compulsoryinsurance, drawn up by the Ministry ofFinance with the assistance from LawrieSavage & Associates, a Canadian law firm.Development of takaful is also hampered by the deficiency of effective instrumentsthat would enable Shari’ah-compliantinvestment of actuarial reserves.

A lack of an insurance culture in Azerbaijanis not to the benefit of takaful either. There

example, a mandatory deposit insurancescheme introduced by the Central Bank of Russia was a huge stumbling-block forthe bank), but also demonstrated excessiveregulatory pressure towards every aspect of the bank’s activity. All this resulted inBadr-Forte eventually losing its licence.

In their reluctance to accommodate Islamicfinance, both Russian and Azerbaijaniregulators consistently refer to theconstitution and the secular foundation of the state, as well as absence of thenecessary regulatory control over bankingactivity based on Shari’ah principles.

However, to be fair, Kauthar’s managementis in no rush to advertise its Shari’ah-compliant products, and not just forpolitical reasons. ‘The information aboutour bank gets about through the system ofsocial networks,’ observes Ibrahimov. ‘Inother words, Kauthar Bank adheres toKnow Your Customer (KYC) principles by more than 100 per cent. Our clients are religious people and understand thataccording to Shari’ah, we cannot guaranteethem fixed profit. Our customers know and trust us and we, in our turn, know thatthey are prepared to accept profit as well as loss. They realise that mudarabah is not a guaranteed income. But if we advertisewidely in the mass media, we’ll gain clientsthat we don’t know and who might not beaware of the specifics of Islamic banking.And we won’t feel comfortable if we can’tprovide them with the same level of profitas a conventional bank.’

As a result of such caution within Kauthar’smanagement, many Muslims in Baku haveno idea that an Islamic bank has beenoperating in the country for over five yearsnow.

And what about Islamic insurance (takaful),is there a market for it in Azerbaijan? Thepotential is there. However, at present, the country’s overall insurance sector isunderdeveloped, constituting only one percent of the GDP (gross domestic product).There are 28 insurance companies and seven insurance brokers, as well as onereinsurance firm operating in Azerbaijan


NEWHORIZON Shawwal–Dhu Al Hijjah 1429 COUNTRY FOCUS

is widespread mistrust from the populationtowards long term investments such asinsurance and as a result life insurancerepresents just over one per cent ofinsurance premiums. Nevertheless,Ibrahimov states that despite the obstacles takaful is a high priority task for Kauthar.

Needless to say that the future of Islamicbanking and insurance in Azerbaijandepends not only on the politicians andregulators, but on the country’s Muslims as a whole. And the word of mouthspreading by the system of social networks that Kauthar extensively relies on is clearly not enough. The demand forShari’ah-compliant products and servicescan appear and flourish only when thepopulation of Azerbaijan has access tocomprehensive information about theindustry.

The Mausoleum of the Shirvanshahs,Baku, Azerbaijan

July: UK taxation of Islamic finance – levelling the playing field

Promoting Islamic finance


NEWHORIZON October–December 2008IIBI LECTURES

Mohammed Amin, MA FCA AMCT CTA (Fellow), tax partner at PricewaterhouseCoopers LLPand head of the firm’s Islamic finance practice in the UK, reviewed the tax law changes the UKhas made since 2005 to facilitate Islamic finance, and assessed whether the playing field is nowlevel.

Amin is a member of the Council of the Chartered Institute of Taxation, of the Policy & TechnicalCommittee of the Association of Corporate Treasurers and of the HM Treasury Islamic FinanceExperts Group. He is also chairman of the Muslim Council of Britain’s Business & EconomicsCommittee and member of the IIBI editorial panel of NewHorizon.

The lecture began by explaining why UKtax law needed to change to enable Islamicfinance transactions to be carried outwithout excessive tax costs. Amincontrasted two transactions, which from thecustomer’s perspective have identicaleconomic consequences and identical netcash flow.

Diagram 1 below shows the purchase of amachine financed by conventional bankdebt, with a loan of £1000 to be repaid

after two years with rolled up interest of£100.

Diagram 2 below shows the purchase of amachine with Islamic finance, which thebank provides through a murabahatransaction. The customer purchases themachine from the bank for £1100 which ispayable in two years time.

Although the two transactions result in thecustomer obtaining a machine immediately

and paying £1100 in two years time, underUK tax law prior to modification, the taxconsequences of the two transactions werevery different.

In the case of the conventional transaction,the customer claims capital allowances on amachine costing £1000 and deducts £50 inyears one and two as interest expense.Capital allowances are a deduction for thecost of the machine, which in general wouldbe given at 20 per cent per year on a

Diagram 1 Conventional purchase Diagram 2 Islamic purchase

though the customer will be committed torepurchasing the property in due course. ‘A level playing field for Islamic andconventional finance remains several yearsaway. However, the UK has made goodprogress,’ concluded Amin.


NEWHORIZON Shawwal–Dhu Al Hijjah 1429 IIBI LECTURES

reducing balance basis, so the cost of themachine can only be amortised over anumber of years.

With the Islamic transaction, the customerclaims capital allowances on a machinecosting £1100. As the capital allowances are given over an extended period of time,the customer’s tax relief with the Islamictransaction would be deferred further intothe future than with a conventionalpurchase where the finance cost of £100 isdeducted over the first two years. Overall,the Islamic transaction would be treated lessfavourably than the conventionaltransaction.

Having illustrated the problem, Amin thenwent on to explain how UK tax law hasbeen modified with the goal of equalisingthe tax treatment. He explained that, strictlyspeaking, the UK has no tax law for Islamicfinance. Instead, the legislation reveals afundamental principle that the same tax lawshould apply to all citizens, regardless ofreligion, and that the tax treatment of atransaction cannot be allowed to depend onwhether or not it is Shari’ah-compliant.

Instead, UK law now defines certain typesof transactions, carefully using languagethat is completely neutral regarding religion.Amin illustrated this with the text ofFinance Act (FA) 2005 s.47, which defines atransaction called ‘purchase and resale’ thathappens to correspond to murabaha. Thelegislation then separates the mark-up in thetransaction (£100 in the example above)and treats it in the same way as interest istreated for tax purposes.

The table below sets out the UK tax lawconcepts Amin covered, and the Islamictransactions to which they correspond:

After covering the tax rules in more detail,especially those for alternative financeinvestment bonds (sukuk), Amin addressedsome of the remaining problem areas. Heillustrated one problem with the Diagram 3below:

In this example, a customer already owns aproperty now worth £100, but which wasoriginally acquired, perhaps some years ago,at a cost of £20. With conventional finance,the customer could simply borrow moneysecured on the property. However, if thecustomer wants to raise finance in a Shari’ah-compliant way using the property, he willneed to sell the property to the bank, rent itback, and then eventually repurchase it.

The stamp duty land tax rules (SDLT) forIslamic finance ensure that no SDLT arises on such an Islamic refinancing, provided it is carried out with a financial institution asdefined for tax law. However, there has beenno equivalent development of the capitalgains tax rules. Accordingly, the sale of theproperty to the bank for any price above £20will trigger a taxable capital gain, even

Tax law Islamic finance

Purchase and resale Murabaha

Deposit Mudarabah

Profit share agency Wakala

Diminishing shared ownership Diminishing musharakah

Alternative finance investment bond Sukuk

Diagram 3 Islamic refinancing

October preview: Surviving thecredit crunch – Shari’ah-compliantretail investment opportunities

The love affair with bricks and mortar hasbeen especially pronounced within the UKMuslim community, who have historicallyembraced property as a low-risk ‘Shari’ah-compliant’ alternative to conventionalinvestments. The credit crunch and resultingproperty market price fall have dramaticallyunderlined the need for investors to hold adiverse range of assets. Bashir Timol, directorof 1st Ethical, a UK-based independentfinancial advisers firm, will analyse whatShari’ah-compliant investments are currentlybeing developed by retail product providers inlight of current market conditions and assesswhich existing conventional investments canbe adapted to meet Shari’ah requirements.

The lecture will take place on 16th October at 6.30 pm at:British Bankers’ AssociationPinners Hall 105–108 Old Broad StreetLondon EC2N 1EX

There is no charge to attend the lecture butyou must register. To register, please visit: www.islamic-banking.com


NEWHORIZON October–December 2008IIBI WORKSHOP

Structuring Innovative Islamic Financial Products

Mohammad Shafique, IIBI editor of NewHorizon and programme development coordinator,presents a summary of the second annual three-day residential workshop organised by theInstitute and held on 8th–10th August 2008 at Clare College, University of Cambridge, UK.

The recent turbulence caused by the sub-prime crisis and resulting credit crunch hasnot settled down. The flush of liquidity inthe Middle East, due to high oil prices, andthe problems in the conventional financialsector is mainly driving the increasinginterest in Islamic finance. As Islamicfinance continues to consolidate its positionin the financial world, it inevitably comesface to face with many issues that needimmediate attention. A key issue is thedearth of professionals well versed in thestructuring of Shari’ah-compliant products.The demand for Islamic financial productsand services will continue to be highestwhere Islamic financial institutions are ableto offer a diverse range of instruments tomeet their clients’ needs, and also utilisetheir liquidity in an effective way foroffering optimal returns to the investors.Those organisations that have competentteams in Shari’ah-compliant productstructuring will always have a competitiveadvantage.

In this backdrop, IIBI organised its secondannual three-day workshop, ‘StructuringInnovative Islamic Financial Products’. Theworkshop, which was held at Clare College,University of Cambridge, was supported byPath Solutions, one of the leading systemsproviders for Islamic finance industry, andBank Islam Brunei Darussalam (BIBD), aShari’ah-compliant bank striving to offerinnovative Islamic financial products andservices to the public in Brunei.

The workshop was run by Dr HumayonDar, chief executive officer of BMB Islamic(an international Shari’ah advisory firm)and member of IIBI editorial advisory panel.Dr Dar was assisted by Dr Adnan Aziz, Ms Haliza Abd Rahim and Ms ZainebSefiani from BMB Islamic, and Kamran

Khalid Sherwani from Dubai Islamic Bank(DIB).

After the introduction and overview of theworkshop, Dr Dar discussed the essentialingredients of Islamic financial innovation,such as knowledge of cutting-edge financialtechnology, deep understanding of Islamiccommercial law and awareness of the needsand trends in the industry.

In the next session, on working capitalproducts, Dr Dar elaborated on theemerging trends in Islamic trade financewith examples of some existing productsfrom the industry. As two key markets inIslamic finance development are the GCCcountries and Malaysia in South East Asia,he discussed the variations in Islamic tradefinancing practices in these two markets.Rahim followed with a discussion on aninnovative overdraft facility based onmudarabah contract, which mimics theeconomic effects of a conventional overdraftfacility while complying with Shari’ahprinciples of profit-and-loss sharing (PLS).

In the following session, Sefiani explainedthe evolution of Islamic private wealthmanagement, the concept of Islamic privatebanks, various products available in themarket and the level of innovation theyemploy, and the institutions that offer suchservices. She also mentioned the availableasset classes, the future growth potentialand challenges.

Dr Adnan followed by providing a briefoverview of sukuk (Islamic bonds) as anIslamic capital market instrument, how itworks with the example of the genericstructure of sukuk, its progress and thesecondary market prospects. He cited someexamples of innovative sukuk issued so far,

such as DP World exchangeable sukuk, DPWorld’s PCFC convertible sukuk, AbaarPetroleum sukuk, Tamweel’s sukuk,Khazanah exchangeable sukuk andTabreed’s mandatory exchangeable sukuk.He also described Shari’ah-compliantcontracts used in structuring such bonds,their key features and innovative ways touse such contracts to structure products thatmeet the requirements of the diverse set ofinvestors and clients.

Then, Dr Dar provided an overview ofpersonal finance products. Broadly theseproducts are of two types: one offering cashto the clients and other financing purchasesof the clients. After that, Dr Aziz explainedthe cash-based products which arestructured with underlying contracts ofeither bai al-ina or tawaruq. Bai al-ina refersto sale of an asset by one party (financer) atan higher price to other party (client) ondeferred payment basis and then purchasingback same asset from the client at lowercash price (and vice versa); as a result, theclient gets cash. This contract is mainly usedin Malaysia while tawaruq (reversedmurabaha), which involves at least threeparties (bank, client and brokerage house),is widely used in the GCC and other Islamicfinance markets. For example, in the UKtawaruq is applied by the Islamic Bank ofBritain, the country’s first fully-fledgedShari’ah-compliant retail bank.

The following session was taken bySherwani, who provided an analysis ofasset-based personal finance productsoffered by DIB and Emirates Islamic Bank(EIB). These products cover a wide range offinancing, from travelling, education andhealthcare to household and auto finance.He pointed out that commonly usedcontracts in such transactions are murabaha


NEWHORIZON Shawwal–Dhu Al Hijjah 1429 IIBI WORKSHOP

and ijara, whereas salam (not currently usedby either DIB or EIB) may also be used inthe future.

Afterwards, Dr Dar provided an overviewof structures used in Islamic credit cards,such as widely used bai al-ina (mainly inMalaysian market) and tawaruq (GCC andother markets apart from Malaysia). Healso explained some other less commonstructures of ujrah (fee), ijara (leasing),murabaha (cost plus mark-up), and acombination of wakala (agency) and kafala

(guarantee). Dr Dar also proposed aninnovative structure of a credit card basedon the contract of istijrar (purchasing goods on ongoing basis without explicitoffer/acceptance each time).

In the next session, he discussed innovationsin Islamic depository/savings schemes withan example of Wataniyya sukuk with a viewto seeking implications for further productdevelopment of this kind. Wataniyya sukuk

is a savings product offered by National Bond Corporation, UAE, in which depos-itors act as investors and place their moneywith the manager (mudarib), NBC; profit-sharing ratio is defined from the outset.Mudarib may, at its sole discretion, offer partof its earned profit to the capital providers/sukuk holders (arbub-al-maal) in the form ofprizes based on a draw system. He outlinedthe comparison between premium bonds inthe UK and Wataniyya sukuk, and comment-ed on the commercial and Shari’ah relatedissues in this type of structure.

In the ensuing session, Rahim elaborated onthe Shari’ah and legal issues in structuringIslamic mortgages, which included ownershiptransfer and law of the land in the context ofthe UAE, Malaysia and the UK, and stampduty treatment for Islamic mortgages fromthe UK market perspective. She explainedvarious models used for Shari’ah-compliantmortgages, such as bai bithamin ajil (alsoreferred to as bai mu’ajal), ijara, diminishingmusharakah and istisna. She concluded that

various underlying contracts in Islamicmortgage products will impact on a bank’sbalance sheet, cost of financing and otherrights such as securitisation of receivablesand therefore must be considered at thestart of product development.

Then, Sherwani outlined the recentcontroversies in sukuk structuring from the Shari’ah perceptive. These includedownership in underlying assets of sukuk andpurchase undertaking by obligor to sukukholders in Islamic bonds with underlying

contracts of mudarabah, wakala andmusharakah (which is tantamount to capitalprotection or guarantee). Profit distributionmechanism between a special purposevehicle (SPV) issuing sukuk and the sukukholders, the liquidity facility of the obligorand the incentive payment to the managerwere also discussed by Sherwani. Heproposed a number of remedies, particularlyin the filed of structuring mudarabah andmusharakah sukuk.

Cambridge workshop participants


NEWHORIZON October–December 2008IIBI WORKSHOP/NEWS

After that, Dr Dar briefly discussed theShari’ah-compliant options contracts withunderlying structure based on arboun orwa’ad. He highlighted how some simpleShari’ah tools such as wa’ad (which means‘promise’) can be used to develop somesophisticated financial products. He thenwent on to discuss Shari’ah perspective on financial swaps and how a Shari’ah-compliant swap structure based on wa’admay be developed and its implications in structuring other Islamic products,particularly Islamic derivative instruments.He also commented on related controversiesin swap structures and how these may betaken care of under the ‘law of necessity’ in Shari’ah in prevalent circumstances.

Dr Dar also explained Islamic hedge funds,analysed the available products in themarket, pointed out the contentious issuesin Islamic hedge funds from the Shari’ahperspective emphasising the ‘shorting’techniques using arboun and salam.Shorting refers to borrowing a stock andthen selling it with the expectation that itsprice will fall and then buying the samestock from the market at lower price andpassing it to broker or institution fromwhom it was initially borrowed thus makinga profit representing the difference of theinitial higher selling price and lowerpurchasing price. He also touched upon the liquidity management issues in Shari’ah-compliant hedge funds. While there areplenty of short-term money marketinstruments available for conventionalhedge funds, there is dearth of suchinstruments in Shari’ah-complaintframework and it is a key area of concern in Islamic hedge funds. He pointed out that recent innovation by Deutsche Bankproviding daily/weekly liquidity usingShari’ah-compliant certificates and a similarrange of products by HSBC Amanah willremove this hurdle to considerable extent.

In the final session on innovation andproduct development in Shari’ah-compliantframework, there was heated debate about‘substance over form’ principle. Thiscovered whether, for the sake of wideningthe product range and offering a Shari’ah-complaint alternative to conventional

financial products, the Islamic financeindustry should mimic conventional product structures or embark on developingproducts which, in essence, reflect true spirit of PLS. Some argued that as today’sfinancial markets are highly sophisticated,discriminating and competitive, and demanda whole range of products and services, theIslamic finance industry must move forwardquickly to meet the demands of the marketand realise its full potential. It would beunrealistic for it to rely for business on thegoodwill and aspirations of the people ashas been happening to some extent so far. Itwas also pointed out that there are stillconsiderable hurdles to be overcome interms of enabling the taxation, legal andregulatory framework, even in some Muslimmajority countries, which discourage the use of mudarabah and musharakah-basedproducts, and instead push the Islamicfinancial institutions to use contracts suchas murabaha and ijara in their productofferings, although they are not consideredto carry the genuine spirit of Shari’ah bymany. However, there are expectations that

IIBI is assisting the UK Financial ServicesSkills Council (FSSC) with thedevelopment of National OccupationalStandards (NOS) to standardise skillsrequirements for providing Islamicfinancial services. Mohammad AliQayyum, IIBI director general, hasrecently attended a meeting at the FSSCto draw up an initial scope ofrequirements for this project. The firstmeeting of a working group, whichcomprises leading professionals andconsultants in Islamic finance in the UK,is scheduled for early October.

The group will guide the project team tosign off the structure and, ultimately, thedetails of the draft standards. Thefinancial services standards consist of anumber of units grouped under twelve

main suite headings. The exercises willinvolve identifying the units containingbanking and insurance competences thathave no need for amendment or re-writing to meet Shari’ah requirements.Then the group will single out the setsthat need to be modified.

Since a number of qualifications relatingto Islamic finance already exist, it is likelythat consideration will be given to placingsome of them in the Qualifications andCredit Framework. In addition, thedevelopment of NOS in this area meansthat various awarding bodies willconsider the development of newqualifications and/or training courses toenable banking and insurance staff togain competence and knowledge inShari’ah-compliant finance.

National Occupational Standards for Islamic finance

with the increasing internationalisation ofthe Islamic finance industry and ongoingdevelopment of standards, switching tomusharakah and mudarabah would be morewidely adopted.

Richard T de Belder, a lead partner in theLondon Islamic finance team of DentonWilde Sapte, an international law firm,delivered the closing address. Heemphasised the need for innovativestructures for taking the Islamic financeindustry forward and to keep its momentumof growth. He added a note of caution thatbasic Shari’ah principles should not becompromised at the expense of businessrationality. His concern is that whileconcessions may be needed in certaincircumstances, it should not become thenorm.

At the close, de Belder handed overcertificates to the participants who camefrom Australia, Brunei, France, Hong Kong,Kuwait, Mauritius, Saudi Arabia,Switzerland, Singapore and the UK.

IIBI 35www.newhorizon-islamicbanking.com

NEWHORIZON Shawwal–Dhu Al Hijjah 1429 IIBI NEWS

iPods for IIBI’s knowledge test winners

Everyone was welcome to test theirknowledge of Islamic finance at the IIBI’s stand during Islam Expo 2008exhibition, Europe’s largest celebration of Islamic culture, arts and innovation,held in London earlier this year. Theexhibition’s primary purpose was ‘to build bridges between Britain’sMuslim communities and the rest of

society’, according to Ismail Patel, directorof Islam Expo.

Islam Expo visitors were invited to take aknowledge test and win an Apple iPod in aprize draw of correct entries.

‘A few days after participating in the IIBI’sknowledge test at Islam Expo I received anemail with a subject line “Congratulations –winner of Apple iPod”’, recalls BatoulMaraqa (left), one of the two winners. ‘And although the prize was supplementaryto the benefits I earned from myparticipation in the exhibition, it was apleasant surprise.’

‘Though I have studied finance as one of my core subjects, I haven’t read aboutIslamic finance before,’ she admits and addsthat one of her friends assisted with findingthe right answers. ‘I would like to thank theIIBI for its distinguished effort to introduceus to Shari’ah-compliant finance.’

IIBI members making waves

Muhammad Ismail(left), financialcontroller of SonyMarketing Europeand member of theIIBI, received SonyEurope’s prestigious‘Luca Pacioli’ award.Prior to joining Sony,he was head of

finance function of the Pepsi Plant at Baku,Azerbaijan. His responsibilities includedsetting up and training the plant’s financeteam. Before this he worked at Siemens.Ismail is a chartered accountant andcompleted his audit training atPricewaterhouseCoopers member firm; healso holds MBA in marketing and MSc inaccounting and finance degrees.

Robert Gray (right),chairman of the debtfinance and advisorydivision of HSBC andmember of the IIBI,has been appointedlead representative for Qatar by the UKTrade and Invest-ment’s FinancialServices Sector Advisory Board. He joinedHSBC in May 1994 as chairman of HSBCMarkets Limited. Prior to joining HSBC, he was head of JPMorgan’s capital marketactivities in Europe. Gray was appointedvice chairman, client development of HSBC Investment Bank plc in September1999, and took his current role in March2001.

‘I enjoyed talking with staff at the IIBI stand and took the quiz. I take a keeninterest in Islamic finance and was glad forthe opportunity to test my knowledge,’ saysthe other winner, Lamaan Ball (above). ‘Iwas really pleased to be told that I had won the iPod. Thank you very much for it,much appreciated. I wish you great successfor the ongoing work, Masha Allah.’

IIBI Membership aims to create a fraternity of Islamic finance

professionals and other people withinterest in the Islamic economic

principles. It fosters cooperation in the exchange of information and ideas,as well as advances the knowledge andpractices of Islamic finance worldwide.IIBI Membership provides a wide range

of exclusive benefits to individual and corporate members, includingcontinuing professional education,

training and original researchemphasising the Islamic ethical valuesthat are neither time-bound nor biased

by the whims of human beings.

www.newhorizon-islamicbanking.com36 IIBI

NEWHORIZON October–December 2008IIBI NEWS

IIBI awards post graduate diplomas

IIBI’s Post Graduate Diploma (PGD) coursein Islamic banking and insurance, offeredsince 1994 and updated in early 2008, ishighly regarded worldwide. UK-basedDurham University has accordedrecognition to this course as an entryqualification to the University's ResearchMA as well as its modules on Islamiceconomics and Shari’ah-compliant finance.

To date, students from 77 countries haveenrolled in the PGD course. In July andAugust 2008, the following studentssuccessfully completed their studies:

❏ Amirali Bakirali Nasir, managing partner, Nasirs, Hong Kong

❏ Faisal Ali Bugshan, France❏ Farooque Ahmed Siddiqui,

assistant vice president and principal auditor, Union National Bank, UAE

❏ Gabriela Brust, UK ❏ George Andrew Wattley, lead control

systems engineer, Fluor Ltd, UK❏ Kamran Iftikhar, branch operations

manager, NIB Bank Ltd, Pakistan❏ Khalid Mehmood Ghaiba, Pakistan

❏ Mamdouh Yassin, Switzerland ❏ Mubeen Zafar, Pakistan ❏ Mohomad Shamail Annam, senior

business development executive, Amana Takaful Plc, Sri Lanka

❏ Mohammed Zubair Butt, chair, Al Qalam Shari’ah Scholars Panel, UK

❏ Momin Ebaad Vaqar, associate director, IIFL Wealth, UAE

❏ Nafay Al-Alam Choudhury, Canada❏ Rahat Nadeem, vice president, Allied

Bank Ltd, Pakistan❏ Said Ali, manager, audit and assurance,

Deloitte Kosova sh.p.k., Kosovo ❏ Sameer Mohammad Saeed, Pakistan❏ Samer MHD DIB Mardini, UAE❏ Sami Saeb Matraji, deputy manager,

structured and international finance, Qatar Islamic Bank, Qatar

❏ Sumaya Bakhsh, UK ❏ Syed Shameem Raza, internal control

unit officer, NIB Bank Ltd, Pakistan ❏ Tarik Rashid, CEO, Tarik Rashid

(Private) Ltd, Pakistan ❏ Yusuf Patel, project manager, Ummah

Welfare Trust, UK.

Although I would not regard myself as a beginner in this field, I found the course both interesting andthought-provoking. It is an excellent course for beginnersas well as those who have a good understanding ofIslamic finance because it contains the right balancebetween basic information and objective analysis of theinteraction between Shari’ah principles and conventionalbanking and insurance. I would recommend the course tofinanciers, lawyers, bankers, insurers, accountants and academics seeking knowledge in a different principle.In short, an enjoyable learning experience for which Iwould like to thank my tutor and the management of theIIBI.

Amirali Bakirali Nasir, Nasirs

Sami Saeb Matraji

Mohammed Zubair Butt

George Andrew Wattley

Said Ali

Momin Ebaad Vaqar

Kamran Iftikhar

Tarik Rashid

Mohomad ShamailAnnam

IIBI 37www.newhorizon-islamicbanking.com


October

Diary of events endorsed by the IIBI

14: The Rise of Islamic Finance and EthicalInvestments, London Conference to discuss the burgeoning growth of Shari’ah-compliant and ethicalinvestments, strategies for attracting fundsand the key selling points of these importantasset classes, as well as multinationalcorporate investments, and the implement-ation of necessary regulatory changes. Contact: Cordelia Ekeocha Tel: +44 (0) 20 7309 7705 Email: [email protected]

28: The World Islamic Infrastructure Finance Conference (WIIFC 2008), DohaConference to explore the latest develop-ments and opportunities for the next gene-ration of Islamic finance structures; deter-mine which sectors offer the most potential;and examine the collaboration of Islamic andconventional banks to deliver innovativefinancing solutions to project developers. Contact: Andrew ChopraTel: +971 4 343 1200 Email: [email protected]

CALENDAR

November

4–5: Islamic Capital Markets, LondonConference to focus on critical marketissues, explore product innovations, assessthe impact of regulatory developments and analyse practical issues around pricing,risk management, relative value, liquidity,buyside diversification, and the extent towhich Islamic capital markets need to apeconventional funding solutions.Contact: John Woodward Tel: +44 (0) 20 7369 7317 Email: [email protected]

11–12: Hedge Funds Review Middle EastSummit, BahrainSummit to focus on the key issues of thehedge fund industry in the Middle East,including the opportunities the recent global credit crunch created for managersand investors, and an update on the recent CIU (collective investmentundertaking) regulatory framework andhow this has affected the alternativeinvestment landscape in Bahrain. Contact: Sarika Mehta Tel: +44 (0) 20 7968 4551 Email: [email protected]

23–25: The World Islamic Banking Conference (WIBC 2008), BahrainNow in its 15th year, conference to discuss the fundamental issues andchallenges of Islamic finance worldwide;

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10–11: Middle East Insurance Forum (MEIF 2009), BahrainForum to focus on the crucial issues ofunlocking new growth opportunities in the Islamic and conventional insurancemarket of the Middle East, includingassessing key regional (and global) industrytrends, pinpointing real growth potential incrucial market segments, and looking atopportunities in the emerging captives andtakaful markets.Contact: Andrew ChopraTel: +971 4 343 1200 Email: [email protected]

28: Middle East Finance Forum 2008, DubaiForum to assess the trends in regionalfinance centres and to focus on structuresand evolving regulation, including practicalideas on post-AAOIFI sukuk and the bestways to structure equity offerings in theregion.Tel: +44 (0) 20 7779 8999Email: [email protected]

to focus on seizing new market oppor-tunities and creating the next generation of Islamic finance solutions; to examineharmonisation of Shari’ah rulings anddevelopment of efficient regulatoryframeworks and governance.Contact: Andrew ChopraTel: + 971 4 343 1200 Email: [email protected]



of 150 branches and outlets nationwide,with further plans to double it in the nextyear. The bank’s paid up capital is expectedto rise from the current $565 million to$700 million in the coming months and to$3 billion in five years’ time. ‘Such a growthrate is unique in Iran,’ says Daneshgar.

As Fanap was established around the sametime as Pasargad, the bank had no optionbut to turn to a third party vendor for acore system, and wait until Fanap’sdevelopment was ready. It opted for one ofthe main core system suppliers for bankingand insurance sectors in Iran, Kishware.

After about two years of intensive work,Fanap came up with its own stand-alonesolution suitable for Pasargad, as well asother Iranian banks. ‘We are alreadymarketing our system to other banks,’ notes Daneshgar. ‘It is a universal system,centralised, scalable and flexible,’ hecontinues. ‘It is parameter-based and can be used in different environments. We’vetried to achieve functional and non-functional requirements in this solution, in terms of flexibility, scalability, perfor-mance and so on.’ The solution is modularand is based on SOA (service orientedarchitecture). It uses Oracle (although thesystem is compatible with other databasemanagement servers) and Java J2EE. Thesystem’s international operations modulecommunicates with Swift, and currencyrates are based on Reuters. In conformitywith the country’s legislation, the system isShari’ah-compliant. It is worth noting that it is Shia-based (Iran has a dominant Shiapopulation) and thus differs from Islamicsystems in some other countries withprevailing Sunni population.

After a lengthy dormant period, the Iranianbanking market has started gathering pace,with privately-owned financial institutionsgaining a strong foothold in the formerlyentirely state-owned banking sector. In2000, the Iranian government ratified alaw allowing the establishment of non-governmental banks as part of the country’sThird Economic, Social and CulturalDevelopment Plan. With the increasingcompetition, banks are facing the need toupgrade their technology – an area which isnow actively developing in parallel with thebanking sector.

One corporation, Pasargad FinancialGroup, decided to combine the best of bothworlds and established an IT subsidiary that not only services the companies withinthe group, but also markets its software toother financial institutions in Iran. DubbedFanap, ‘the IT arm of Pasargad’ takes careof the technology of the group’s 23members, ranging from insurance operatorsto leasing firms to a banking institution,says Seyed Ali Daneshgar, project managerat Fanap.

Bank Pasargad is at the heart of the group’sbusiness. Launched in 2005 by a number ofprominent Iranian bankers, including aformer governor of the Central Bank of theIslamic Republic of Iran (CBI) and somesenior ex-directors of state-owned banks,Pasargad is the fastest growing private bankin Iran today. It is mainly retail-oriented,although it also offers some corporate andwholesale services (particularly globalbanking, such as letters of credit andvarious currency-related operations).Daneshgar describes it as a ‘retail bank andmore’. At present, Pasargad has a network

Iran: technology focusWith international banking systems vendors struggling to find a foothold in Iran, it’s up to thelocal suppliers to fill a wide gap in modern banking technology. Tanya Andreasyan,NewHorizon’s editor, reports.

A team of 20 software engineers –‘graduates from top universities in Iran’ – is involved in this venture. ‘We had someinitial help from the consultants in thebanking field, particularly during therequirements collection and analysis phase,’recalls Daneshgar. ‘But the actualdevelopment has been done by us.’

‘Our project is bigger than core banking,’ he states. ‘We are creating a comprehensivesolution for banking.’ Fanap has alreadydeveloped a payments suite, a cardmanagement system (CMS) and a remotebanking solution (internet, telephone andSMS). The next stage is developinganalytical reporting (specifically businessintelligence) and AML (anti moneylaundering) modules. The only thing that ismissing is a name for the system – an issuethat Fanap hopes to resolve soon. It hasannounced a group-wide competition forthe best name but, in the meantime, thesystem is referred to as Fanap CoreBanking.

The solution is currently being implementedat Pasargad and is expected to go live in thenext three to six months. It is equipped with Weblogic application server and isimplemented on HP machines. ‘We are nowin a very difficult phase of data conversionand migration,’ says Daneshgar. Due to analleged lack of cooperation (and therefore,information) with the current core systemprovider, a lot of additional work isrequired for successful data conversion. TheUAT (user acceptance test) is also alreadyunder way.

Despite some setbacks, Daneshgar isoptimistic about the project at Pasargad, as

ANALYSIS


NEWHORIZON October–December 2008ANALYSIS

well as the system’s success in the Iranianmarket. ‘Our system has the newesttechnology, while other solutions in themarket do not have this benefit,’ he states.‘We are sure our solution will sell well. Idon’t know how much time it will take, butI am confident it will be well received.’

He acknowledges that the company hasbeen ‘rather late in finishing the product’,but points out that the reason for this is thegroup’s recent inception. The core systemdevelopment started as soon as the companywas launched. Meanwhile, the competitionhas already been selling its software forseveral years, and therefore ‘has someadvantage in this situation’.

Fanap and its parent, Pasargad FinancialGroup, are also eyeing foreign markets forselling the new core system, provided it iswell received in the domestic market first.‘We have a far reaching view, and ourapplication is flexible enough to be sold inother countries,’ says Daneshgar.

Meanwhile, the afore-mentioned Kishwareis keen to expand abroad, too. Syria is themarket where the vendor is planning to takeits first international step, according toOmid Torabi, banking product manager atKishware. About a year ago, the companymade a presentation of its software for theFinance Ministry of Syria. Other MiddleEastern countries with Islamic banks arealso on Kishware’s agenda. ‘Islamic bankingis our competency,’ he says. ‘Our other areaof expertise is interface for the Persianlanguage, Farsi, so we can go to countrieslike Tajikistan and Afghanistan, or anyother country that uses this language.’However, going abroad is not easy for anIranian company, observes Ahmad Mirzaei,Kishware’s virtual banking manager. TheUN-imposed sanctions hinder theinternational expansion of Iran-based firms,and also prevent foreign companies enteringthe Iranian market.

So, domestic financial institutions remain apriority for Kishware. The vendor hasheadquarters in Tehran and a number ofoffices scattered across the country for‘implementation, support and

troubleshooting’. It employs 250 people.‘Iran is a big country and a big market,’ saysMirzaei. ‘The majority of the banks herestill have in-house solutions, but are nowstarting to turn to specialists for moderncore software.’

He describes the banking market as ‘veryactive’, citing the plastic card business as anexceptional area of growth. ‘Every day wesee new services and new requirements forcard-related operations,’ he says. Witharound ten million cards in circulation inIran, there is a high demand for cardmanagement systems. Kishware providescard payments software, which can beimplemented as an independent solution orpart of a suite dubbed Negin (based on theOracle platform). The complete packageconsists of 32 different applications in fourdifferent arenas: core (covering all majoractivities of a universal Islamic bank – retail,corporate, loans/deposits, trade financeaccounting/general ledger and knowledgemanagement), remote banking, enterpriseresource management and the afore-mentioned cards.

Negin was originally developed nearly tenyears ago as a standalone system, withSaman Bank being the first taker. The bankremains a user of Negin today. Over time,more financial institutions joined Kishware’scustomer list, bringing the total number to15. A handful of clients come from thestate-owned banking sector, such as, forexample, Bank Mellat, which operates thevendor’s card management system, or thelatest addition, Postbank of Iran, which is in the process of acquiring Kishware’s retailoffering and branch POS software. ‘We arecurrently negotiating a contract,’ saysMirzaei. This is a large-scale project for the vendor as the bank, owned by thecountry’s Ministry of Information andCommunications Technology, has beenspecifically set up to cover rural areas, withthousands of outlets in virtually everyvillage in Iran.

However, the main bulk of Kishware’scustomers are private banks, such asEqhtesad Novin Bank and Sinabank. Themost recent addition is Parsian Bank, the

largest private bank in the country. Theimplementation project here is currentlyunder way with ‘setting up the system’,according to Torabi. It will be deployed atthe bank’s head office and the entire branchnetwork of 150 offices across Iran. The deal for the total Negin package was signedaround six months ago, and Kishware will replace some home-grown applicationsand a core system from its major rival,Khadamat. In contrast to Kishware, which

is privately-owned, Khadamat is a statecompany and has a natural stronghold inthe state banking sector, whilst its share ofnon-governmental banks is quite small. Kishware’s biggest customer to date is anon-banking financial institution, AnsarFinancial and Credit Association. ‘It hasbeen our client for six years,’ says Mirzaei.The complete Negin suite operates inAnsar’s 600 branches and supports its 300ATMs and 10,000 POS terminals.

In parallel with implementation projects,Kishware is also continuously developingthe functionality range of Negin. ‘We are currently working on the AML andbusiness intelligence modules, such as MIS [management information system],’confirms Torabi. The vendor is also devisinga new version of its core system that can use IBM DB2 on the mainframe, scheduledfor completion by the end of this year. Mirzaei and Torabi are confident that atpresent, domestic vendors have advantage

Tehran, Iran


NEWHORIZON Shawwal–Dhu Al Hijjah 1429 ANALYSIS

over their foreign counterparts in Iran. TheShari’ah law difference between Shia Iranand Sunni Middle Eastern countries is aconsiderable obstacle in the way of asuccessful implementation for internationalsuppliers.

Meanwhile, local specialists have in-depthknowledge of the legislative requirementsfor banking operations in Iran. ‘Some banks have tried Misys [UK-based] and

System Access [Singapore-based], but later switched to our solutions because of theIslamic specifics and amount of work andcost involved in changing and adapting the systems,’ claims Torabi (System Access’acquisition by a US company, Sungard, iscited by this company as the reason).Nevertheless, one bank is persevering with a foreign implementation – state-owned Keshavarzi, Iran’s agricultural bank.It is implementing the Bancs core systemfrom an Indian vendor, TCS FinancialSolutions (NewHorizon, January–March2008 issue).

French supplier, Delta Informatique, also attempted to enter the Iranian market, albeit unsuccessfully. According to Georges Ayoub, Delta’s sales manager, the company carried out an extensivemarketing campaign there and found areliable local partner (a company that used to collaborate with System Access).Together with this firm, Delta signed a

deal to replace System Access’ solution atZamin Bank, but the implementation neverwent ahead. Ayoub admits there was justtoo much customisation involved – inaddition to different Islamic rules, there was also the issue of a Farsi calendar, whichis nothing like a conventional one. The bank ‘wanted to start very quickly’, but the work required would have beenimmensely time-consuming. Ayoub regretspulling out. ‘It’s a pity, because it is a nice

place. I visited six months ago and I loved itthere. You don’t have to follow the press,you have to go there and meet people.’ Headds that he would like Delta to go back to Iran, but realises that ‘the market isdifficult’ for the company to gain a strongfoothold.

Despite the challenges, Iran could prove tobe a hotbed for core banking systemsactivity in the years to come.

© Klaas Lingbeek-van Kranen iStockphoto.com

Iran is a big country and a big market. The majority of the bankshere still have in-house solutions, but are now starting to turn tospecialists for modern core software.

Ahmad Mirzaei,Kishware



Given modern technological advances, riskis now a separate managerial decision, andrisk transfer innovations increase theefficiency of risk diversification. A potentialfor growth in Islamic finance, identified byProfessor Robert C. Merton, is in utilisingavailable conventional market innovationsin a Shari’ah-compliant manner. A challengefor the industry is to further probe Shari’ah-compliant derivatives for risk-mitigatingstrategies. Merton illustrated the benefits of derivatives by building a hypotheticalexample, noting that Taiwan’s heavy directinvestment in the electronics industry maybe diversified if it contracted with othercountries to exchange similar returns from unrelated industries. This wouldeffectively increase the risk-weighted returnwithout requiring a long-term change ininfrastructure. Furthermore, the contractmay be enacted, as well as reversed,virtually overnight, thereby causing nodisruptions to the country. The result wouldbe the same amount of exposure in grossreturns, yet a lower overall risk profile. Thisflexibility in risk mitigation and industrydiversification was contrasted with moredisruptive diversification strategies such asbuilding new industries and infrastructuresfrom scratch, which require a longertimeframe, and are harder to reverse.Applying risk to an Islamic finance context,innovation is often limited by structuralimpediments, and the task remains tobalance the tension between the benefits of innovation and maintaining theinfrastructural quality of Shari’ah.

Innovation is indispensable, as it isnecessary for a society to move forward toprevent stagnation and decline. However,rapid developments have created a globalfinancial system plagued by crises over the

Innovation and authenticityDr Nazim Ali, director of Islamic Finance Project at Harvard Law School, US, recaps thedebates held by international academics, Shari’ah scholars and practitioners during the EighthHarvard Forum on Islamic Finance.

last 30 years. As the lack of adequatemarket discipline in the overall financialsystem causes excessive lending and highleverage, risk-sharing on an Islamic financemodel can curb lax lending and instillgreater market discipline. Islamic financecan help raise the share of equity inbusinesses and of profit-and-loss sharing(PLS) in projects and ventures through themudarabah and musharakah modes offinancing. To make such a system workable,Muslim countries should develop unifiedfinancial institutions such as a centralisedShari’ah board or a Shari’ah clearance andaudit, and a secondary market for Islamicfinancial instruments. How Islamic financestruggles with authenticity and innovationraises significant questions about howMuslims choose to live by fiqh and Shari’ahin the modern era.

In a world dominated by non-Islamic capitalmarkets, the challenge for Muslims is topractice their religious tradition in thecontext of a conventional western capitalmodel. While there are many instanceswhere the Islamic solution is only modestlydifferent from that of a conventionalwestern contract, the importance of findinga halal solution is the person’s intent toconform to religious principles, not simply a sleight of hand to get around rulesimposed by Shari’ah boards. According toSamuel Hayes (professor emeritus, HarvardBusiness School), what motivates Muslims isnot the effort to westernise Islamic conceptsbut rather to maintain a relationship withGod and invest in a way that they find to bemorally in line with God’s plan.

There are continuing debates on who hasauthority to speak on authenticity. Forabout a thousand years this authority has

OVERVIEW

Dr Nazim Ali,Harvard Law School


NEWHORIZON Shawwal–Dhu Al Hijjah 1429 OVERVIEW

been in the hands of Islamic scholars of fiqh(fuqaha) practicing ijtihad according to the age-old science of usul al-fiqh; and itremains with them today. Should greatertransparency as to fiqh decisions now beadopted so that the public can better maketheir decisions? Are fatwas issued toindividual financial institutions byindividual scholars or by small Shari’ahboards a sufficient guarantee of authenticity,or must institutions in the industry becreated to evaluate individual fatwas andfortify them through reviews and votes bylarger groups of scholars, among them non-fuqaha? An important issue is howbroadly or narrowly authenticity is to bejudged. Is Islamic finance’s compliance withtraditional fiqh a question to be addressedsolely within the relatively micro sphere ofcommercial law? Or is Islamic finance to bejudged by broader, more macro objectivesbelieved to be maqasid al-Shari’ah, such asstrengthening Muslim economies, aiding theunderprivileged, or better distributingwealth?

The dilemma concerning authenticity andinnovation is central to Shari’ah. Frank E. Vogel (founding director, Islamic LegalStudies Programme, Harvard) has pointedout that the authenticity of a proposed lawdepends on its grounding in the Quran and Sunnah. However, only a few Quranicverses deal with the issues in question andinnovation becomes necessary. In moderntimes the tension between authenticity andinnovation has grown sharper becausecolonialism’s sweeping legal reformulationsdestroyed fiqh’s capacity for organicadaptation to change at the very time when modern societies began to transformrapidly. The normal balance betweenShari’ah authenticity and social changeevaporated and created a gulf betweenmodern daily life and the provisions ofIslamic law.

According to Adnan al-Bahar, chairman andCEO of The International Investor (TII), an investment banking and non-bankingfinancial services company in Kuwait, thereare two distinct forms of innovation. Onetype is through the repackaging of existingtools to serve a new need or more efficiently

serve an existing need. These include thehedging of currency positions with a swap-like transaction achieved through asimultaneous purchase and sale of the samecommodity (deferred payment murabahacontract) denominated in two differentcurrencies. The second type is through newfatwas and breakthroughs in Shari’ahthought, such as in the fatwa defining theShari’ah-compliant listed shares and theassociated formula of dividend cleansing.

While many share a vision of innovation,whether something is legally correct may beeasy to answer, but questions of authenticityper se remain open to discussion, and thismay be more about how an idea sounds and feels rather than its sheer legality. Aminority assert that authenticity oftencomes down to ideas, products and conceptsthat are legally correct by the letter ofShari’ah while also having both scholarlyand consumer (market) acceptance.

Neil Miller, partner at Norton Rose, aLondon-based law firm, believes thattension exists in providing legal advice while giving Shari’ah guidance. Productdevelopment occurs along a spectrum, andissues of innovation and authenticity runthroughout that spectrum. As such, it maybe best to move away from the idea ofinnovation and toward evolution, a morecomprehensive concept that betterencompasses the manner in whichconventional products are made Shari’ah-compliant.

Shari’ah scholars’ perspectives

Shari’ah scholars agree that there needs to be a balance between innovation andauthenticity, while stressing that Shari’ahwelcomes innovation within boundaries. Aview is that the room and the opportunityfor innovation are infinite. Esam Ishaq, aShari’ah scholar from Manama, Bahrain,says that ‘there is no need to cut corners andnot to observe what the Shari’ah requires,because the whole world is open for you.Just keep away from what is forbidden andessentially they are the contracts thatcontain gharar, maysir or riba.’ HussainHassan, a Shari’ah scholar of Dubai Islamic

Bank, believes, as do others, that the task of developing new products lies betweenbankers, Shari’ah scholars and lawyers, and that the greatest potential for useful,Shari’ah-compliant innovation lies withindividuals who have dual knowledge infinance from a commercial and Islamicperspective. The key is cooperation betweenShari’ah scholars and bankers.

The sub-prime mortgage crisis

According to Umer Chapra, well known for his scholarship in the field of Islamiceconomics, currently an adviser to theIslamic Development Bank research arm,Islamic Research and Training Institute inJeddah, the crisis is a reflection of excessivelending. Although securitisation is a usefulinnovation, it allowed mortgage originatorsto pass the risk of default to the ultimatepurchaser of the loan security. This createdless incentive to undertake carefulunderwriting, and, consequently, loanvolume gained priority over quality. Thecheck that market discipline could haveexercised on self-interest therefore did notcome into play. A lack of market disciplineleads first to excessive lending and then tofinancial crises. With the US Federal Reservelowering interest rates to increase liquidityand avoid a recession, a risk is createdexacerbating the vicious cycle of loosefunding followed by further financial crisis.The solution, instead, exists in finding aneffective way of introducing greaterdiscipline into the financial system with anobjective to check excessive and looselending. This is the direction in whichIslamic finance wishes to make a valuablecontribution to the international financialsystem.

Law, policy and supervision

Islamic finance can be compared to othersocially responsible forms of investment,such as socially or ethically oriented funds,in an effort to elucidate the common agendabetween socially responsible investment andIslamic finance. The difference between thetwo industries is that the latter focuses onrules while the former focuses on values and principles. Kilian Bälz (visiting fellow,


NEWHORIZON October–December 2008OVERVIEW

Islamic Legal Studies Programme, Harvard)believes that regulatory arbitrage betweenShari’ah and local laws may be permissible,but formalistic adherence to Islamic legalrules may not be the only correct wayforward. When addressing whether Islamicfinance would enhance emissions trading,an issue that would arise is whether theright to pollute can be considered propertyin Shari’ah. Abdul Kadir Barkatulla, aShari’ah consultant in London, questionswhether the Islamic finance industry canmove from the current model of usingconventional product structures and simplyadjusting them to gain Shari’ah approval, to creating original Shari’ah-based productsfor any market’s benefit. Lines of productscarrying high Shari’ah risk could includecertain capital protected structuredproducts, money markets, linked notes,hedge funds and exchange-traded funds.Abdurrahman Y. Habil, senior vicepresident at Abu Dhabi Islamic Bank, viewsauthenticity of Islamic finance in light ofmaqasid al-Shari’ah (the higher objectives

of Shari’ah). He opines that the definitionsof riba and gharar are too broad to formany solid basis for agreement. The role ofal-maslahah al-Shari’ah in contemporaryIslamic finance discourse needs to examinehow to determine the Shari’ah objectives inthe modern age; the pursuit of human goalsand the principle of utility based on humanreason is not necessarily what is meant bymaslahah or maqasid al-Shari’ah.Furthermore, maslahah may or may not be

in compliance with commonly held beliefsof human reasoning, thereby addressing thetopic of whether there is a need for aneconomic justification for the prohibition ofriba.

When furthering a country’s financestructures, much room for improvement stillexists in developing products and models,with an eye to sustainability in the modernworld, and, especially, with regard toindustry transparency and access. Accordingto Shamshad Akhtar, governor of the StateBank of Pakistan, the process of Islamicfinancial development is in its infancy inPakistan, and the country is still developinga model of Islamic finance that serves itspopulation’s needs while remaining true tothe principles of Islamic law.

Conceptual directions in Shari’ah

The wisdom of some current Islamicbanking and finance practices that seek their legitimacy from adherence to only

formalistic contractual requirements, asopposed to looking into the contractualsubstance and content, needs to bequestioned. A more open-ended view onShari’ah-compliant financial stability shoulddeal with the application, interpretation,and impact of Shari’ah compliance in theIslamic financial services industry. Applyinga more theoretical perspective, the renewalof waqfs as a pivotal player in the creationof a distinctively Islamic conception of

development balances socioeconomicobjectives with religious concerns. Thesubject of loans, or qard, is still seen asproblematic in Shari’ah-compliant financebecause they, at times, can be easilyassociated with riba. The boundaries ofinvestment risk in Islamic finance alsorequire analysing financial risk in terms of gain, temporality, and moral engagementin order to determine permissibleinvestments under Islamic law.

Debt and equity modes offinancing

Most Shari’ah scholars agree thatmudarabah and musharakah as equity-based contracts can be used in many areasof financing and investment, includingdeposit-taking kinds of products, venturecapital and sukuk. According to DaudBakar, Shari’ah scholar from Kuala Lumpur,Malaysia, the problem with sukuk, inparticular, arises as we strive to strike abalance between authenticity and inno-vation for Islamic fixed income investors. Aminority opinion is that this is a non-issue.Since the comparison is between a Shari’ah-approved product and a Shari’ah-compliantproduct, there is little room for differen-tiation. The relevant issue is risk manage-ment and mitigation; thus we must look tothe structuring of the instrument so that theinstrument or the product retains its originalpurpose, remaining validly as mudarabah ormusharakah. Nizam Yaquby, a Shari’ahscholar, urges caution in giving blanketpronouncements for such a wide range ofproducts. To avoid Shari’ah-compliantproducts becoming disadvantaged whencompared to conventional products, Islamicbanks must be able to provide sophisticatedtools to hedge against currency and interestrate fluctuations. On the other hand, Seif el-Din Tag el-Din of Markfield Institute ofHigher Education, UK, asserts that thetension is not between conventional bankingand Islamic finance, but rather between risk management and its proximity to astructured sort of gambling. As such,modern Islamic finance has yet to trulyaddress the problem of risk assurance andavoidance in a Shari’ah-compliantframework.

Eighth Harvard Forum on Islamic Finance

very nature, has a responsibility to enactpreventative measures that are specific to its unique structure.

A mismatch in the role ofcorporate governance

According to the Organisation forEconomic Cooperation and Development(OECD), corporate governance is ‘thesystem by which companies are directed and controlled, in the interest ofshareholders and other stakeholders, tosustain and enhance value’. Conventionalgovernance standards seek to address theseparation of ownership and management –known as the ‘agency problem’ or‘principal-agent problem’ – by ensuring that the actions of the management are kept in line with the interests ofshareholders and stakeholders. WithinIslamic finance, too, the fundamentalteachings of the Quran and the Sunnah,which form the basis of the Shari’ah andIslamic jurisprudence that governs theindustry, emphasise the importance ofhonesty, transparency, documentation,accountability and ethics. The conventionalgovernance standards can therefore bepaired with Shari’ah requirements to createa corporate governance structure that issuited to Islamic finance.

However, there is a difference betweenconventional and Islamic finance that addsanother dimension to corporate governanceand relates to the equally weightedimportance of ‘other stakeholders’. In IFIs there are two types of owners, theshareholders, as in conventional institutions,and the investment account holders, or



Liquidity – a catalyst for growth

Over the past three decades Islamic financehas successfully carved out a niche withinthe global financial system. It has done so by reconciling the financial andtheological needs of an expanding piousMuslim population. One of the largestconcentrations of this growth has been inthe Middle East region, where the industryhas been invigorated by liquidity owing toinflows of petrodollars from record high oilprices.

Excess liquidity has thus far been a majorcontributor to the success of Islamic financein the Middle East and investor confidencehas correspondingly grown. This confidence has in turn ensured relative financialstability in an emerging market place that is still considered politically unstable.However, Islamic financial institutions (IFIs)

Playing catch-up While excess liquidity has driven the growth of Islamic finance, investor confidence has growncorrespondingly. Mark Stanley, assistant manager of the Islamic Financial Services Group (IFSG)at Ernst & Young, Bahrain, considers how the implementation of the right corporate governanceprocedures can ensure the long-term sustainability of Islamic finance.

should remain conscious of the economicboom-and-bust cycles that have historicallyplagued development in a region thatcontinues to rely heavily upon petroleum for much of its GDP. Liquidity cannot beindefinitely relied upon as a foundation forgrowth and Islamic finance must insteadfocus on fundamentals if it is to offset theeffects of an economic downturn.

The long-term sustainability of Islamicfinance must therefore be based upon thepublic’s trust and confidence and aim toavoid systematic risk through theestablishment and implementation ofregulatory frameworks that embracetransparency, accountability andenforceability. Major corporate scandals inthe past have had a detrimental effect onconventional finance (the Bank of Creditand Commerce International scandal is afamous example). Islamic finance, by its

ACADEMIC ARTICLE

Figure 1 Collective investment schemes and IFIs



depositors. The relationship between theinvestment account holder and IFI can becompared to that of a collective investmentscheme, in which participants (the invest-ment account holders) have authorised theirfund manager (the IFI) to manage theirinvestments.

This is because the mudarabah contract, onwhich the relationship between the invest-ment account holder and IFI is based,specifies that investment account holders, as owners of capital (rab-al-maal), have anagency (mudarib) relationship with the IFI.The depositors are risk/reward-sharing andtherefore provide quasi-equity to the bank,albeit under restrictions delineated by thenature of the account (i.e. unrestrictedinvestment accounts (URIA) and restrictedinvestment accounts (RIA), see Box 1 formore details).

As a result, investment account holders areliable to incur unexpected losses in the same way as shareholders because there iseffectively no cushion, as is in conventionalinstitutions, provided by equity from theshareholders. To counter such uncertainties,IFIs, in some jurisdictions, have adopted aprocess of smoothing out returns to theirunrestricted investment account holderthrough the use of a profit equalisationreserve (PER). This reserve aims to offsetpoor performance and maintain a rate ofreturn that is consistently competitive, evenwhen the IFI’s earnings are below themarket rate (IFIs are competing against theguaranteed returns offered by conventionalbanks). However, the transparency of such practices is somewhat questionable,particularly with regard to risk and reward.

Corporate governance in IFIs must thereforebe customised to address such issues andprotect the rights and needs of theinvestment account holders.

Tailoring corporate governance tosuit Islamic finance

In response to the issues set out above, theIslamic Financial Services Board (IFSB) inMalaysia and the Accounting and AuditingOrganisation for Islamic Financial

Box 1 Restricted and unrestricted investment accounts (RIA and URIA)

RIAs will, as their name suggests, allow investors to impose restrictions on the way inwhich their funds are invested. The bank will act as a non-participating mudarib(agent) and the investment account holder is therefore liable for all potential lossesincurred (providing the bank has not acted negligently). Investors in the URIAs willauthorise the IFI to invest their funds in any way the IFI sees as appropriate. Theinstitution is also permitted to commingle the funds with its own (thus constitutingthe equity portion in Figure 2) and any others available to it (e.g. current accounts).

Institutions (AAOIFI) in Bahrain have bothissued guiding principles on corporategovernance for IFIs. These recommend-ations examine issues beyond the scope ofthis discussion, but also focus on bothShari’ah compliance and the importance of investment account holders.

Shari’ah compliance

Both organisations mentioned aboveemphasise the need for IFIs to attainShari’ah advisory and supervisory functionsthat can guide their business operations. Tothis end, AAOIFI states that every IFI shallhave an independent Shari’ah supervisoryboard, recommended by the board ofdirectors and appointed by its shareholders,consisting of at least three specialised juristsin Islamic commercial jurisprudence (fiqhal-mua’malat). Together, these jurists (oftenreferred to as Shari’ah scholars) are taskedwith directing, reviewing, supervising andproviding rulings (fatwa) on the activities ofthe IFI to ensure compliance with Shari’ah

Figure 2 Bearers of risk in conventional institutions and IFIs

committee, to implement governance policyframeworks that will protect the interests of the investment account holder. Such acommittee will be established by the boardof directors and comprise three members: a member of the audit committee, a non-executive director (selected based uponexperience and the ability to contribute) and a Shari’ah scholar (possibly from the supervisory board). IFSB argues that of particular concern to the governancecommittee will be the commingling of funds(relating to unrestricted investmentaccounts) from investors with differing riskexpectations. Investment account holdersare generally perceived as requiringprotection of their funds, whereasshareholders, who have provided equity, will expect high returns – the result, forcommingled funds, is a conflict of interests,with investment account holders restrictedin their control over investment strategy.The investment account holder is thereforeexposed to the same risk as the shareholder,but is not expected to receive proportionaterewards.

This problem is then further exacerbated bythe arguably controversial practice of

utilising a PER, which effectively obscuresthe actual return on investments andprevents the unrestricted investment accountholder from properly assessing theimplications of the IFI’s investment strategy.

Moreover, the PER is subject to what IFSBrefers to as inter-generational problem, inthat a build-up of reserves during periods of above average profits may leaveunrestricted investment account holderswith forgone and unrealised benefits if theywithdraw their investment before such atime when reserves are utilised. It is thisambiguity, surrounding the rights of theinvestment account holder, which thegovernance committee will seek to address.The committee will provide the board ofdirectors with reports and recommend-ations, closely liaise with the management,the audit committee, and the supervisoryboard, and ensure disclosure and the proper implementation of investmentcontracts.

In light of the requirements and suggestionsoutlined above, an indicative corporategovernance structure for an IFI shouldinclude the following (Figure 3):


NEWHORIZON October–December 2008ACADEMIC ARTICLE

jurisprudence. The IFSB emphasises theneed for these scholars to address both exante and ex post aspects of financialtransactions, thus ensuring an effectivereview process.

Furthermore, it is recommended that IFIsconduct an internal Shari’ah review of allactivities, executed by a dedicated internaldivision/department or as part of theinternal audit department, depending on the size of the institution. According toAAOIFI, the main purpose of this function,referred to as the internal Shari’ahcompliance unit, will be to ensure themanagement of an IFI discharges itsresponsibilities in relation to implementingrulings made by the supervisory board. Thecompliance unit is therefore an internal andindependent function that assists theShari’ah supervisory board and contributesto ensuring the IFI’s Shari’ah compliance.

Investment account holders

As previously discussed, the investmentaccount holder is considered a stakeholderin an IFI. As a result, IFSB has argued forthe creation of a separate governance

Figure 3 Corporate governance in IFIs


Addressing gaps in corporategovernance

Maintaining customers’ confidence in anIFI’s Shari’ah compliance is of vitalimportance. It is the fundamentaldifferentiator between conventional andIslamic finance and there has subsequentlybeen significant progress in establishingcorporate governance structures thatsupport Shari’ah compliance. Thesupervisory board has become anindispensable aspect of corporate govern-ance for IFIs and the demand for reputableShari’ah scholars has consequently grown.However, structures that address internalcontrols and ex post aspects of Shari’ahcompliance have not been as comprehens-ively implemented as the predominantly exante role played by the supervisory board.The role of the compliance unit is to addresssuch failings and its establishment shouldtherefore be considered essential.

It is, however, arguably the lack ofcorporate governance aimed at ensuring therights and addressing the risk exposure ofinvestment account holders that requiresimmediate attention. The recommendationsput forward by the IFSB are commendableand IFIs should acknowledge and respondto the need for corporate governance thataddresses these shortcomings. Theestablishment of a governance committeemay not be the only solution; onealternative would be a board withindependent directors that have dualresponsibilities to the shareholders andinvestment account holders, another wouldrequire structures that ensure themanagement is held accountable toinvestment account holders. Nevertheless,the structure that is implemented must notbe subservient to the board of directors,must be allowed to operate independentlyand must be enforced in order to influencedecision making processes that affect theinvestment account holders.

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The way forward

The enactment and implementation ofrelevant corporate governance structures isessential if trust and confidence in Islamicfinance is to be maintained. External shocksmay occur and if they do, the bufferprovided by a solid corporate governancestructure, supported by regulatoryauthorities, will help to ensure continuedstability. Islamic finance is becomingincreasingly competitive and clients arebecoming increasingly sophisticated, awareof available product offerings and lesscompelled to remain loyal to any giveninstitution. The ambiguity that affectsaspects of the industry will have to beaddressed if respective IFIs are to retainmarket share and remain competitive. Islamic finance as a whole must not rest onits laurels. It must be resolute and embrace a proactive, instead of reactive, strategytowards corporate governance if long-termsustainability is to be assured.


NEWHORIZON October–December 2008GLOSSARY

arbounA non-refundable down payment for attaining the right to buy goods at a certain time and certain price in future;if the right is exercised, it becomes part of the purchaseprice.

bai al-inaThis refers to the selling of an asset by the bank to thecustomer on a deferred payments basis, then buying backthe asset at a lower price, and paying the customer in cash terms.

bai bithaman ajil Sale of goods on a deferred payment basis – credit sale;another term used for such sales is bai mu’ajjal.Equipment or goods requested by the client are bought by the bank which subsequently sells the goods to theclient at an agreed price which includes the bank’s mark-up (profit). The client may be allowed to settlepayment by instalments within a pre-agreed period, or as a lump sum at a future date.

fatwaA ruling made by a competent Shari’ah scholar on aparticular issue, where fiqh (Islamic jurisprudence) isunclear. It is an opinion, and is not legally binding.

fiqhIslamic jurisprudence. The science of the Shari’ah. This isan important source of Islamic economics. Islamicscholars of fiqh are called fuqaha.

fiqh al-mua’malatIslamic commercial jurisprudence, jurisprudence oftransactions.

HajjAn annual pilgrimage to Mecca and other holy places.The fifth pillar of Islam, Muslims have the duty toperform Hajj at least once in their lifetime.

halalActivities which are permissible according to Shari’ah.

haramActivities which are prohibited according to Shari’ah.

ijaraA leasing contract under which a bank purchases andleases out a building or equipment or any other facilityrequired by its client for a rental fee. The duration of the lease and rental fees are agreed in advance. Owner-ship of the equipment remains in the hands of the bank.

ijara wa iqtinaThe same as ijara except the business owner is committedto buying the building or equipment or facility at the endof the lease period. Fees previously paid constitute part of the purchase price. It is commonly used for home andcommercial equipment financing.

ijtihadLit: effort, exertion, diligence. Technically, endeavour of ajurist to derive/formulate a rule of law on the basis ofevidence found in the various sources of Shari’ah.

istijrarA master agreement which facilitates purchasing ofgoods on ongoing basis without explicit offer andacceptance each time; the price is fixed either upfront orconcluded after a predetermined period which is subjectto certain conditions.

istisnaA contract of acquisition of goods by specification ororder, where the price is fixed in advance, but the goodsare manufactured and delivered at a later date.Normally, the price is paid progressively, in accordancewith the progress of the job.

kafalaLit: responsibility or suretyship. In kafala, a third partybecomes surety for the payment of debt. It is acovenant/pledge given to a creditor that the debtor willpay the debt or any other liability.

mudarabahA form of business contract in which one party bringscapital and the other personal effort. The proportionateshare in profit is determined by mutual agreement at thestart. But the loss, if any, is borne only by the owner ofthe capital, in which case the entrepreneur gets nothingfor his labour.

mudaribIn a mudarabah contract, the person or party who actsas entrepreneur.

murabahaA contract of sale between the bank and its client for the sale of goods at a price plus an agreed profit marginfor the bank. The contract involves the purchase ofgoods by the bank which then sells them to the client at an agreed mark-up. Repayment is usually ininstallments.

musharakahAn agreement under which the Islamic bank providesfunds which are mingled with the funds of the businessenterprise and others. All providers of capital are entitledto participate in the management but not necessarilyrequired to do so. The profit is distributed among thepartners in predetermined ratios, while the loss is borneby each partner in proportion to his contribution.

musharakah, diminishingAn agreement which allows equity participation andsharing of profit on a pro rata basis, but also provides amethod through which the bank keeps on reducing itsequity in the project and ultimately transfers theownership of the asset to the participants.

qard hasanAn interest-free loan given for either welfare purposes orfulfilling short-term funding requirements. The borroweris only obligated to pay back the principal amount of theloan.

rab-al-maalPl: arbub-al-maal. In a mudarabah contract, the personwho invests the capital.

ribaLit: increase or addition. Technically, it denotes anyincrease or addition to capital obtained by the lender asa condition of the loan. Any risk-free or ‘guaranteed’rate of return on a loan or investment is riba. Riba, in allforms, is prohibited in Islam. Usually, riba and interestare used interchangeably.

salamSalam means a contract in which advance payment ismade for goods delivered later on.

Shari’ahRefers to laws contained in or derived from the Quranand the Sunnah.

sukukSukuk (pl. of sakk) is often referred as Islamic bonds orIslamic investment instruments, which represent theirholders’ undivided ownership interest in the underlyingassets and their entitlement to the revenue from thoseassets.

SunnahIt refers to the sayings and actions attributed to ProphetMuhammad (PBUH).

takafulA form of Islamic insurance based on the Quranicprinciple of mutual assistance (ta’awuni). It providesmutual protection of assets and property and offers jointrisk sharing in the event of a loss by one of its members.

tawaruqA sale of a commodity to the customer by a bank ondeferred payment at cost plus profit. The customer thensells the commodities to a third party on a spot basis andgets instant cash.

wa’adA promise to buy or sell certain goods in a certainquantity at a certain time in future at a certain price. It isnot a legally binding agreement.

wakalaA contract or agency in which one person appointssomeone else to perform a certain task on his behalf,usually against a certain fee. The agent (wakil) is allowedto generate an income for himself in excess of theminimum agreed upon returns as agreed with rab-al-maal (investor of the capital).

waqfAn appropriation or tying-up of a property in perpetuityso that no propriety rights can be exercised over theusufruct. The waqf property can neither be sold norinherited nor donated to anyone.

zakatAn obligation on Muslims to pay a prescribed percentageof their wealth to specified categories in their society,when their wealth exceeds a certain limit. Zakat purifieswealth. The objective is to take away a part of thewealth of the well-to-do and to distribute it among thepoor and the needy.

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