growth and diversification in islamic finance

8/14/2019 Growth and Diversification in Islamic Finance

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Growth and Diversificationin Islamic Finance

F I N A N C I A L S E RV I C E S


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Contents

1 Introduction 12 Product and Market Diversification 2

3 Barriers to Growth 9

4 Conclusion 19


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Growth and Diversification in Islamic Finance 1

1 Introduction

The contemporary Islamic financeindustry is now in its fourth decadeand, during that period, has developedextremely rapidly. In the past fewyears, overall market growth has been

estimated at between 15-20 percentannually 1, although individual Islamicbanks have reported even fastergrowth. In 2006, for example, ArcapitaBank in Bahrain reported year-on-yearbalance sheet growth nearer to 40percent. Today, the sector hasestimated assets under managementof US$500bn 2.

Market dynamism has been felt in boththe t raditional Islamic finance centers

and a number of other markets.According to Bank Negara Malaysia (theMalaysian central bank), the number ofIslamic bank branches in Malaysiaincreased from 126 in 2004 to 766 in2005. Elsewhere, new Islamic financialinstitutions (IFIs) are being establishedrapidly in t he industrys t raditionalmarkets in the Gulf Co-operationCouncil (GCC) countries.

Islamic finance is also on the rise innew markets such as Syria, Lebanon,the U.K., Turkey and Canada. In theU.K., for instance, two new Islamicbanking licence applications arecurrently being considered by theFinancial Services Authority (FSA),following the authorization in the pastthree years of the Islamic Bank ofBritain and the European IslamicInvestment Bank.

Further, the recently proposed changesto U.K. tax law should help to removethe tax disadvantage which U.K.Sukuk issuance would have previouslysuffered. U.K. Sukuk issuance is now

looking like a valid financing option tobe explored by businesses which wantto be Shariah compliant as well as byother businesses which want todiversify their investor base or benefitfrom the ongoing infrastructureinvestments within the Middle east.More significantly these tax changeshelp to signify that Islamic finance canplay an important role in westerneconomies. The changes in the U.K.are very likely to be replicated in other

countries thereby creating an enablingframework for the rapid globaldevelopment of Islamic finance.

The prospects for Islamic finance havealso encouraged some conventionalbanks to embark on the process ofconverting to Islamic financialinstitutions. Two years ago, forexample, the Kuwait Real Estate Bank(KREB) announced that it wasconverting into a full-fledged Islamicbank. In December 2006, the CentralBank of Kuwait approved KREBsIslamic Banking license, complete withname change to Kuwait InternationalBank. The future is very exciting,says Sulaiman Al-Baqsami, assistantgeneral manager of KREB. If w e couldconvince our traditional client base, wecould solicit potential customers withother convent ional banks.

In the past five years, perceptions ofthe Islamic finance industry haveadvanced considerably. Originally, saysRichard Thomas, managing director ofGlobal Securities House U.K. Limited

(GSH), a wholly-owned subsidiary ofSecurities House Group of Kuwait, theglobal financial services companiessaw Islamic finance as a market forliquidity management and cheap short-term funding.

This perspective has changed. Theynow see opportunities across theboard from project finance to securitiesissuance, he explains. Five years ago,they saw a one-dimensional market;

now they see it as a multi-dimensionalmarket complete with opportunities infund, asset and wealth management.The result has been that moreinternational banks are setting upIslamic finance teams and one wouldbe hard-pressed now to find banks nothaving the capabilities to intermediatethe market.

The purpose of this report is to explorecurrent and future development ofIslamic finance and to examine ways inwhich the sector is predicted todiversify and grow in the years ahead.KPMG International commissioned theEconomist Intelligence Unit (EIU) toundertake a series of interviews inFebruary 2007 with leading figuresfrom the industry. Both the EIU andKPMG International would like to thankall respondents for their participation.

1, 2: Source: speech by Howard Davies, chairman of the Financial Services Authorityhttp://www.fsa.gov.uk/Pages/Library/Communication/Speeches/2002/sp103.shtml

2007 KPMG International. KPMG International provides no client services and is a Swisscooperative with which the independent member firms of the KPMG network are affiliated.


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2 Growth and Diversification in Islamic Finance

2 Product and Market Diversification

As IFIs consolidate in their home andregional markets and venture intocross-border start-ups and exposuresfurther afield, there is strengtheningevidence for market diversification. The

reason for this, explains Mr. Jaidahfrom QIB, is to allow surplus liquidityin the Islamic market to be employedwith different risk ratings; with differentasset classes; and with differentmarket exposures.

The general consensus within theindustry is that some of the key areasfor product innovation will be in theissuance and trading of asset-backedsecurities (Sukuk); project and

infrastructure financing to include newmarkets outside traditional ones suchas the West; structured financederivatives; private equity; retailbanking beyond the Islamic mortgage;and value added real estate products.

There is, however, some question as tohow much product innovation isactually needed at the moment, giventhat the industry is relatively young andthat many of its products are stillnascent. Indeed, some practitionersstress that the market is as much inneed of consolidation and refinementas it is of innovation and new products.

Duncan Smith, managing director andglobal head of Islamic finance at ArabBanking Corporation (ABC) in Bahrain,points out that, in the GCC andMalaysia, many of the retail needs ofthe market are probably being met. Hedoes not see any shortage of products,although in Western markets such as

the U.K. it will take longer to introducea wider range of Islamic consumerfinance products beyond the Islamicmortgage. Nonetheless, while

incremental changeconsolidation andproduct refinementwill remaincentral in the markets developmentover the short term, innovation willremain important.

Mr. Thomas of GSH believes that themain area for product diversification isTakaful (insurance). The Islamicinsurance (Takaful) industry is potentiallythe most lucrative of the Islamicfinancial landscape, simply becauseinsurance is a highly under-developedsector, especially in the conservativeGCC countries. Even in Malaysia,market penetration of Takaful is provingto be an uphill struggle.

He is more cautious about the future forhedge funds. They have been the nextbig thing in the Islamic finance space foryears, and I have not actually seen oneoperating properly yet, he explains.Exchange traded funds (ETFs), similarly,have been slow to take off, despite thefact that two leading Islamic equityindex providers, Dow Jones and FTSE,have been trying to promote them inthe past two years. Currently, there isonly one Shariah-compliant ETF, theDJIM Turkey Exchange Traded Fund,launched in Istanbul in January 2006 byTurkiye Finans (a merger between twoTurkish Islamic banks), and based on theDow Jones Islamic Market (DJIM)Turkey Index.

Barclays Capital and others are also inthe process of launching an ETF off theFTSE-SGX Asia Shariah 100 Index,launched in January 2006 by FTSE andThe Singapore Stock Exchange (SGX).

Progress has been slow, however,because of the unfamiliarity of Islamicinstitutional investors with ETFs.

the market is as much in

need of consolidation and refinement as it is of innovation and new products

Despite the real estate boom in theGCC and a warning from Standard &Poors in a report that IFIs may be overexposed to exposure to the real estatemarkets, bankers such as PeterPanayiotou, Deputy Chief Executive ofGulf Finance House (GFH) in Bahrainare convinced that analysts are readingthe situation wrongly.

Many people think the real estateboom is speculation, he asserts. It isntactually. It is catch-up. Weve seen in thepast three years, since the end of theGulf War, a concentration of initiativeswhich were suspended during the inter-Gulf War period, with the exception ofDubai, which halfway through thatperiod perked up and said We are going

to ignore that and carry on.



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HSBC Amanah Case StudyHSBC Amanah has not hidden its light

under a bushel. The Islamic financedivision of the worlds third-largestbank was set up in 1998 with thestated aim of becoming the globalleader of the nascent sector. It hasdevoted significant resources to thetask, hiring more than 100 dedicatedstaff - in addition to group-wideresources - across the Middle East,Europe, Asia-Pacific and the Americas.

Following an early focus on the MiddleEast, where most populations arepredominantly Muslim, HSBC Amanahhas now decided to expand intocountries where Muslims are in asizeable minority. The retail market inthe U.K., which has a Muslimpopulation of nearly 2m, w as identifiedas having the right attributes to t est thestrategy. Amjid Ali, Chief Executive ofHSBC Amanah in the U.K., says: Thereis very stringent regulation in the U.K.

so we thought if we could crack it here,we could succeed anywhere.

Mr. Ali, Senior Business DevelopmentManager, had worked for the U.K.sMidland Bank, which was bought byHSBC in 1992, for 17 years beforebeing appointed in 2003 as a businessdevelopment manager for the newlylaunched Islamic f inance division. Hehad encountered demand for Islamic

finance as long ago as the1980s. I rana pilot program in Bristol in 1987 andmany Muslims there said they wantedproducts in accordance with theirfaith, he explains.

In 2005, he was appointed chiefexecutive with a brief to developproducts in home finance, currentaccounts, pension funds, and buildingsand content insurance. The initial targetwas the mortgage market. HSBC says

Muslim families in the U.K. have taken

out 134,000 conventional mortgagesworth UK9bn and there are a further76,000 households with no mortgagesat all. Mr Ali believes a large proportionof households that already havemortgages could switch to Islamichome finance. About 200,000households in total match our targetprofile. These are m ainly second-generation Muslims who have someknowledge of f inance, he says.

So far, progress has been steady, if notspectacular. By mid-2006, HSBCAmanah had signed up 3,300 homefinance customers, providing 370m infinance to them. In addition, more than5,000 personal bank accounts hadbeen opened.

In part, growth has been held back bythe problem of convincing potentialcustomers that products meet the

demands of t heir faith. Few peoplequestion Halal meat, but they don tnecessarily accept Shariah-compliantproducts, explains Mr. Ali. Anotherissue is the higher cost of Islamicfinance. Products cannot be importedwholesale from the Middle Eastdivision - they must be approved by anindependent Shariah advisory board,pass regulatory tests and be adaptedso that they fit on HSBCs U.K. product

platform. The cost of this process isinevitably passed on to clients. Mostaccept that there is a marginal cost forpeace of mind, says M r. Ali.

In the early stages, the banks

marketing activity consisted ofexplaining Islamic finance throughhighly targeted seminars,presentations and meetings withcommunity leaders and scholars. Thisdirect approach was supplemented bysponsorship of local groups andorganizations. M r. Ali believes that nowis the right time to begin marketing inearnest. We had to build a knowledgebase and we feel that point has beenreached, he says. This year, HSBCAmanah will run radio and TVcampaigns, many channelled throughAsian and Arab TV and radio stations.

Marketing can also take more subtleguises. HSBC Amanah recruits heavilyfrom the Muslim community to buildcultural knowledge at each branch. M r.Ali says: We employ people whowant financial rewards but also want tohelp fellow Muslims.

Of course, creating a U.K. retail marketfor Islamic f inance is not down toHSBC alone. Competitors such asLloyds TSB and the Islamic Bank ofBritain share the responsibility and, fornow, there is a feeling of fraternityrather than rivalry between them. Butas the market matures, competition islikely to intensify and, in readiness forthis, HSBC Amanah is preparing to roll

out new products in areas such assavings, student finance and the smallbusiness sector.

These plans depend, of course, onwhether consumers buy into theconcept. Mr. Ali is confident: Thirtyyears ago, if you wanted Halal meat youslaughtered a live chicken. Now evenTesco sells Halal meat. Things change.



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GFH, w hich is leading landmark Islamicreal estate projects in India, Morocco,Jordan, Qatar and Bahrain, expectsconsiderable opportunities for value-added Islamic real estate investments,especially in the GCC countries, wherea young demography and robust year-on-year population growth shouldmaintain demand for housing,shopping complexes and leisurefacilities.

Mr. Panayiotou believes that the keyproduct segments include assetmanagement, wealth management,insurance, consumer finance,investment banking and private equity,but concedes that there is still muchwork to do in the sector. Ourinvestment banks need to roll intoproper investment banks, he explains. Most of them are focused on one line

of business. There is a lot of room togrow; a lot of new products to develop.The derivatives industry alone is ahuge business if we can crack themore complex structures beyond the

vanilla products that dont breachShariah rules. There is a whole newindustry that sits on top and that iscompletely untapped.

Mr. Jaidah of QIB agrees that Shariahscholars have an important role to playin product innovation. The bankersgive the explanations and theclarifications regarding the basic formatfor the products. But, it is the scholarswho have to understand the structureand the sophistication that is neededfor these products to support the IFIsand to leverage their use, he says.

Many GCC-based Islamic bankers areaware that eventually they will have tobe more creative in product innovationand diversification, especially in thearea of exotics such as derivatives,swaps, options, Repos, ETFs, hedge

funds and even Sukuk. But many ofthem doubt whether these productsare the right ones for a market which isstill at the lower end of a steeplearning curve.

What happens if the oilprice goes down?

Some economists stress that the realtest for the Islamic finance marketwould be its ability to absorb shocks inan era of low oil prices and budgetdeficits. Many Islamic bankers,however, are bemused at suggestionsof a negative impact on the sector, ifthe price of oil were to drop to ahistorical mean.

Why would we have to focus on theIslamic finance sector if such a thingoccurs? asks Salah Jaidah, ChiefExecutive of Qatar Islamic Bank (QIB). Such a scenario is going to affect thefinancial markets as a whole.

Bankers such as Mr. Jaidah stress thatGCC governments have budgeted for

various oil price scenarios. Many of theGCC states, for inst ance, have cateredfor a stabilization of the oil price toUS$50 per barrel. Several Saudieconomists predict that the average



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US$50 per barrel scenario is the mostlikely for the next few years. If theprice of crude oil drops below US$18per barrel, then everyone will be in achaos, let alone the banks, addsMr. Jaidah.

Low oil price scenarios are not new.In fact, several Islamic bankersinterviewed stressed that the sectordid go through oil price downturns inthe1980s, 1990s and early 2000s, andit successfully weathered the storm.At QIB, we have seen the ups anddowns of oil prices, and we managedour portfolios. We have short, mediumand long-term maturities, explains Mr.Jaidah. We also have differentresources we can utilize such as interbank and Murabaha liquiditymanagement lines. We could supportany immediate needs or run on

deposits that occur in the market.

Mr. Thomas of GSH concurs that aslump in oil prices is not going to affectthe Islamic finance market materially.He is more concerned about theimpact on asset quality and their abilityto comply w ith the capital and riskmanagement provisions of Basel II.

There is so much cash around even ifthe oil price goes down, he explains. The key is the asset quality of theportfolios of the Islamic financialinstitutions (IFIs), and that they remainrobust. It would be much harder todeal with credit problems than withliquidity problems. There will always beliquidity. The question remains on theliability side, whether the assets arerated or not .

Sukuk Proliferation

Sukukthe Islamic finance worldsequivalent of a traditional bondhastaken the Islamic finance industry bystorm over the past t wo years, w ithmost of the origination in Malaysia andthe GCC countries. In 2006, some 80percent of the burgeoning GCC bondmarket was accounted for by Sukuk,up from just 26 percent in 2005,according to City law firm Trowers& Hamlins.

The global Sukuk market is still relativelysmall the estimated volume ofoutstanding Islamic securities (includingMalaysian issuances) totaled just someUS$70bn at the end of 2006, accordingto Business Times, Malaysia. Themarket has thus far been dominated byMalaysia. Saudi Arabia currently has

only four Sukuk issuances to date,although Bryan Kraty, acting generalmanager of Gulf Islamic ClearingCompany (GICC) in Bahrain, predictsthat, in the future, some 90 percent ofthe Sukuk issuances will originate from



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the Kingdom. The biggest market foropportunities has to be Saudi Arabia,he explains. Other GCC markets arealso starting to catch up. Dubai IslamicBank and Abu Dhabi Islamic Bank, forexample, have respectively launchedUS$10bn and US$5bn Sukuk programs.

Thus far, there have been only twoSukuk originations in traditional westernmarketsthe Saxony-Anhalt Sukuk inGermany, and the East CameronPartners Sukuk in the U.S.. Nevertheless,there is significant potential for Sukukorigination in these markets, and inEurope in particular. Mr. Thomas of GSHprojects that Sukuk origination andissuance by European corporates andgovernments will be the next big stepforward in the market, with the U.K.leading the initiative.

Ed Balls, the Economic Secretary to theU.K. Treasury, confirmed in February2007 that the Treasury is currentlylooking at how the U.K. tax systeminteracts with the Sukuk market; thebarriers to establishing a secondarySukuk market in the U.K.; barriers in theway of U.K. origination and issuance;and taxing of U.K. Sukuk certificateholders. Market players are keen for theU.K. to issue a benchmark debutsovereign Sukuk and to spearhead thedevelopment of a Euro-Sukuk marketdominated by U.K. and EU corporateissuances. Many IFIs privately stressthat sovereign issuances aboveUS$250m by highly rated countries maybe needed as liquidity managementinstruments by banks.

The U.S. and Europe are not the onlyglobal markets entering the sector.Reports in the Middle East EconomicDigest and elsewhere suggest that theJapanese government is preparing a

debut sovereign Sukuk issuance ofover US$500m in 2007. Indonesia,Turkey and Saudi Arabia are alsocontemplating debut sovereignbenchmark issues.

To Badlisyah Abdul Ghani, head ofIslamic finance at Malaysias CIMBGroup and Chief Executive of CIMBIslamic Bank, more issuance will beone of the keys to the growth of aglobal Islamic capital market. Thedevelopment of a global Islamic markethas been slow because people areunwilling to take the necessary steps,he says. The more players thatarrange issuance in the market, thebetter. You cannot have an activesecondary market until you have wellin excess of 100 issuances.

Research done by GICC suggests thatthe tipping point would be when themarket attains a US$400bn poolcomprised of about 270 issuances. Bythat time you will have enoughinstruments and people will starttaking off-the-shelf products and start

trading. The truth is that there are notenough alternative Islamic investmentinstruments to further stimulatetrading, says Mr. Kraty.

Mr. Panayiotou of GFH agrees thatmore work needs to be done tostimulate a secondary trading. If therewas a secondary market we would feelmore comfortable, he explains. If thepeople who buy the Sukuk have noway to sell them apart from holdingthem to maturity, there is not muchincentive to buy the certificates. To bea market maker you need an institutionwith a very strong balance sheet, andthe institutions with that sort ofbalance sheet are not really in our[Islamic finance] industry.

He goes on to express surprise that themajor global banks have not beenquicker to enter the Sukuk market. TheIslamic finance sector has actually giventhem a new line of business, he

explains. I dont understand why theyhave not jumped in.

in 2006, some 80 percent of the burgeoning GCC

bond market was accounted for by Sukuk , up from just 26 percent in2005, according to City law firm Trowers & Hamlins



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Unicorn Case StudyTo date, no Islamic investment bank

has developed a brand with truly globalreach. Some have made significantinroads but sometimes encounterresistance from Muslim businessesand investors who do not wish to dealwith western banks.

Unicorn Investment Bank was set upin an attempt to f ill the void. Itsfounder and Chief Executive, Majid AlSayed Bader Al-Refai, believes he has

the background and industryexperience to create a dominantIslamic brand. Mr. Al-Refai comes froma distinguished Kuwaiti family, wasbrought up and educated in the U.S.and learned his early banking in SaudiArabia. He set up Unicorn in 2004 withUS$113m of his own and friendsmoney and with advisory support fromUBS Warburg, a global investmentbank. A further US$113m was raisedfrom high net w orth investors in the

middle of 2006.

Mr. Al-Refai says the rationale forlaunching the bank needs littleexplanation. Asking me why we setup is like asking why we shouldbreathe. Its because there are 1.5bnMuslims in the w orld and they don thave choice and they don t haveservice. He says that about 35percent of Muslims have always

avoided all forms of all interest-bearinginvestments and have had little choiceother than to put their savings undertheir mattress. Wit h a furtherestimated 30 percent of moderateMuslims also potentially open toIslamic finance, Unicorn has a potentialuniverse of 975m people and all thebusinesses they own and manage.

Cultural reasons explain why anindependent Islamic investment bankof scale has not yet emerged, says Mr.Al-Refai. Arabs are traders by nature.The concept of a global institution is

just not in their blood. To achieve

global reach, Mr. Al-Refai decided to

domicile Unicorn in Bahrain rather t hanin his native Kuwait. Bahrain iscosmopolit an and has been a bankingcenter for 30 years, he explains. Ithas strong relationships around theworld, including with the Bank ofEngland. It is a strict financial

jurisdiction but friendly at the sametime. In a short period, Unicorn hasmade strides to expand internationally.It now has a U.S. office, as well as a

presence in Dubai, Kuwait andMalaysia. In January, it acquired a 75percent stake in a Turkish brokerage.

Whereas many Middle East state-controlled banks have limited businesslines, usually participating in propertyrelated deals, Mr. Al-Refai has createda sophisticated model, based on theactivities of U.S. bulge bracketbanks. Unicorns six business linesare: corporate finance and advisory;

capital markets and t reasury; globalprivate equity; asset management;strategic mergers and acquisitions; andtakaful, or insurance. In each, Unicornscompetitive advantage is bothchallenged by the constraints imposedby Shariah law and enhanced by itsaccess to Islamic businesses that areoff-limits to many western banks.

the biggest market for

opportunities has to be Saudi Arabia

For example, rare access to Muslim-run private companies has allowedUnicorn to arrange the largest everprivate bond sale in Saudi Arabia,which closed in February at US$600m.On the other hand, it is not yet able tolaunch fully-fledged hedge funds.Instead it has created balancedinvestment funds using a mixture ofequities and bonds. It believes thiskind of innovation will attract high networth investors who may otherwise

head for the Swiss private banks. Ive

never met a billionaire who told me hewas satisfied with Islamic services,says Mr. Al-Refai.

But to win high-margin businessrequires high-caliber bankers whomight otherwise work at westerninvestment banks. Unicorn also has tocompete for talent with state-ownedregional banks, such as Dubai IslamicBank, Abu Dhabi Islamic Bank and the

UAE Emirates Islamic Bank. Unlikeothers in the region, says M r. Al-Refai, we have put in place international paystandards. At the same time, he doesnot employ bankers for their specialistknowledge of Shariah finance. We

just w ant expert bankers, he says. Few people have Shariah expertiseand, in any case, we have a wholedepartment to structure deals.

In 2006, Unicorn made a net profit ofUS$30m but it is considering a stock

market flotation, possibly next year, togrow at a faster rate. We will likelyseek a listing in Bahrain first and thenon the Alternative Investment Marketafter t hat, says Mr. Al-Refai. Theproceeds would enable Unicorn toacquire more businesses and alsogrow organically by, for example,launching new private equity funds.

After the investment banking productrange is filled out, Mr. Al-Refai plans totackle the consumer market. At somestage we will have retail branchesaround the world, he says.



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3 Barriers to Growth

the current lack of qualified Islamic bankers looks set to hamper the

development of the sector should it not be addressed

The prospects for the growth ofIslamic finance look bright.Nonetheless, there are severalobstacles currently preventing fasteruptake of Islamic financial products.

These include the issue of regulatorycapital and relative risk weightingsunder Basel II and the Islamic FinancialServices Board (IFSB) guidance; a lackof human capital; piecemeal financialand legal architecture; w eaknesses infinancial reporting and transparency;and the overarching problem of a lackof Shariah convergence.

Risk weighting

In 2006, the IFSB issued two standards the Capital Adequacy Standard (CAS)and the Guiding Principles of RiskManagement for Institutions offeringIslamic Financial Services. CAS offersguidance on the requirements forminimum capital adequacy to cover forcredit, market and operational risks ofIFIs that is equivalent to the Basel IICapital f ramework for conventionalbanking institutions.

According to the IFSB, the keydifference bet ween CAS and Basel IIprovisions is the computation of aninstitutions risk-weighted capital ratio(RWCR). In Islamic banking, given thatthe risks on assets financed by profit-sharing investment account holders donot represent risk to the capital of theinstitution, the CAS allows risk-weighted assets that are funded by theaccount holders to be deducted fromthe institutions total risk-weighted

assets in the calculation of RWCR. Inaddition, the assets of IFIs often havedifferent risk characteristics toconventional products, and hencecalculating their risk weights may not

necessarily be as straightforw ard as theBasel II proposals. It is the intention ofthe IFSB to bridge this gap.

To ABCs Mr. Smith, the process of

calculating regulatory capital andrelative risk w eightings under Basel II isvery important for the Islamic bankingindustry. The Islamic finance industryis no longer the small or insignificantmovement of say ten years ago. It hasmoved a long way. There areresponsibilities in being a bigger part ofthe world financial movement.Calculation of regulatory capital andrelative risk weight ings under Basel IIare some of them, he explains.

Human capital

Human capital development is crucial,as the current lack of qualified youngIslamic bankers looks set to hamperthe development of the sector shouldit not be addressed. In part, this lowinvestment in the industry stems fromthe fact that the sector lacks a globalindustry body to overseestandardization of continuouseducation and training.

The lack of human capital in the sectoraffects all regions, including nascentmarkets such as the U.K.. Training ofIslamic bankers has not kept pace withthe rapid growth of the sector and, asa result, there are shortagesthroughout the industry.

The two centers for training have beenKFH and Bank Islam M alaysia, which

between them have been responsiblefor training many Islamic bankers. Buthigh turnover remains a problem. They come, they learn and they leavefor better prospects, says Mr. Al-Ghannam of KFH.



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There is some progress being madein particular, Malaysia and Bahrain aretaking the human capital challengeseriously. In 2006, for example, BankNegara set up an RM500m endowment

fund to support The International Centrefor Education in Islamic Finance(INCEIF), with the main objectives ofmaking Malaysia the leading center forIslamic finance education anddeveloping human capital for the globalIslamic finance industry. Similarly in2006, The Central Bank of Bahrain setup a US$4.6m Islamic FinanceEducation scheme in cooperation w itheight IFIs based in Bahrain.

Regulation and legalframeworks

While rising demand for Islamic financehas helped lead to handsome returnsfor key players, some experts in theindustry are concerned that the rapidproliferation of IFIs has not beenmatched by development in the Islamicfinance regulatory and supervisoryarchitecture and infrastructure,especially in the GCC states.

One thing that w orries me, explainsAli Al-Ghannam, Head of InternationalReal Estate at Kuwait Finance House(KFH), is that t he IFIs should becontrolled better to avoid any bubble inthe industry. There are a huge numberof new IFIs being established in themarket. Many banks and traditionalcompanies are converting to Islamicfinance. Islamic banking windows atglobal majors are proliferating. Many of

these institutions are not going afterthe concept itself, but are following theflow of money.

Professor Rifaat Abdel Karim, secretarygeneral of the IFSB, also agrees thatsystemic weaknesses present a bigrisk. Muslim member countries needto beef up their financial systems, he

explains. If you are going to haveIslamic banks operating in yoursystem, one of the most importantissues is to have a high qualityregulatory framework and goodsupervisory standards. That is thesafety net. It is good for market playersto know what is required from them.There is still a lot to be done given thegrowth and developments that aretaking place in the global Islamicfinance indust ry.

Many Muslim countries still do nothave enabling legislation in placecovering the authorization of Islamicbanks; issuance of Sukuk andsecuritization; establishment of trustsand special purpose vehicles (SPVs);the introduction of Takaful (Islamicinsurance) products, and other suchissues. Additionally, and of equalconcern, many countries have not yetconsidered putting it on the agenda.Changing the law or introducingenabling legislation takes a lot ofpersuasion and time, says one Islamicbanker interviewed. In fact, the U.K.has to date introduced more enablinglegislation to facilitate access for U.K.Muslims and others interested inIslamic ethical finance to productsconsistent with Islamic principles thanmost of the Islamic Development Bank(IDB) member countries.

rising demand for Islamic finance has led to handsome returns for key players

changing the law or introducing enabling legislation takes a lot of persuasion and time, says one Islamic banker



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Some notable issues include the lackof a dedicated Islamic banking law inSaudi Arabia; few laws relating tocorporate governance in many MENAcountries; the lack of Islamic deposit

insurance schemes (only Malaysia andTurkey have such schemes in place);and a dearth of laws governingsecuritization, t rusts and SPVs.

Issam Al-Tawari, CEO of RasameelStructured Financethe first companyin Kuwait to be licensed to carry outasset securitization (Tawreeq), financialengineering and advisorystressesthe need for stronger regulatoryinfrastructure. We need to develop

legislation on trusts; leasing; and SPVs both to facilitate Sukuk issuancesand the development of a capitalmarket in Kuwait, he explains.

we need to develop In this regard, the IFSB has started to

legislation on trusts; establish prudential regulations togovern the IFIs. Beside the CAS andleasing; and SPVs risk management guidelines for IFIs,

the IFSB has released prudentialregulations on corporate governanceand an exposure draft on disclosureand transparency. These prudentialregulations should now be consideredand adopted by the various countriesoffering Islamic finance.

Financial reporting

The quality and transparency of financialreporting and disclosure in the Islamicfinance industry differs significantly

from one regulatory jurisdiction toanother. There is a general concern inthe market and among thoseinterviewed that IFIs, with the notableexceptions of those operating in theU.K., Malaysia, Bahrain and perhapsTurkey, should have more rigor in theirdisclosure and financial reporting,especially to the general market.

The international rating agencyStandard & Poors, in a report last year

entitled Enhancing Financial Reporting and Transparency: Keys to the Future of Islamic Finance , warned that financialdisclosure practices among IFIs fallwell short of international bestpractice. Standardisation of financialreporting is a key challenge for therapidly growing Islamic financeindustry, said the report, in order toavoid fragmentation and ultimateghettoisation at a time when Shariahcompliant investment vehicles as anasset class are coming of age.

The International Financial ReportingStandards (IFRS) constitute the mainreporting framework for IFIs, butdomestic regulation has alsoencouraged heterogeneity overuniformity. Frameworks in place in theleading IFI countries include IFRS,AAOIFI (Accounting and AuditingOrganisation for Islamic FinancialInstitutions); Malaysian AccountingStandards; and some local GAAPs

which are influenced by a combinationof IFRS, AAOIFI and local central bankreporting guidelines.



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Women in Islamic FinanceIslamic finance, like conventional

financial services, remains a largelymale-dominated industry. A womanhas yet to be appointed as chiefexecutive of an Islamic bank anywhere,even though several women haveexcelled in the industry.

Empowering women in the sector willlargely depend on the existing role ofwomen in a particular country oreconomy a role that ranges widely

across different markets.

In Saudi Arabia, for instance, saysSamra al-Kuwaiz, managing director ofthe Womens Division of OsoolBrokerage Company in Jeddah: Welive in a male-dominated society, whichis only now viewing women as apossible economic force. Saudi Arabiais a special case. We are different fromother GCC countries. We havecomplete segregation. We have lets

say, Islamic challenges , which aremore evident in the Kingdom.

The difficult position women face inSaudi Arabia is exemplified in the caseof Dr. Nahed Taher, former chiefeconomist of The National CommercialBank (NCB), one of the largest banksin Saudi Arabia. She spearheaded theconversion of NCBs retail bankingbusiness to an Islamic consumer

finance businessa process which isstill ongoingbut left the bank to beappointed chief executive officer ofFirst Gulf Bank in Bahrain, a positionthat would not be possible for awoman in her native Saudi Arabia.

There is, however, little doubt thatwomen have huge financial impact inthe Kingdom and the other GCCcountries. Women, for instance, ownbetween 10 percent - 30 percent ofbrokerage accounts in Saudi Arabia. Theyalso own some 40 percent of family-runcompanies, often as silent partners.They have some SR10bn in deposits inbanks and financial institutions 3.

In the rest of the GCC, despite fewer

formal restrictions on women in theworkplace, very few women are involvedin the Islamic finance sector, this may, inpart, be due to a strong conservativeundercurrent in these societies.

In many respects, it is Malaysianwomen who have set the pace inIslamic finance. But even in Malaysia,while women head the authorities thatregulate Islamic f inance and capital

markets, no Malaysian woman hasrisen to head an Islamic bank.

Dr. Zeti Akhtar Aziz is the celebratedGovernor of Bank Negara Malaysia (theMalaysian central bank) under whosewatch the Islamic banking sector hasflourished, and who brought forwardthe liberalization of the MalaysianIslamic banking market by three yearsby awarding licenses to three foreignoperators: Alrajhi Bank; Kuwait Finance

House; and Asia Finance Bank. Similarly,Dato Zarinah Anwar is the Chairman ofthe Securities Commission, havingpreviously worked for the RHB Group,where she was responsible forintroducing the Dow Jones RHB IslamicEquity Index in 2006.

Several non-Muslim women are alsoseasoned Islamic bankers. One of themost experienced is Stella Cox,

managing director and head of Islamicfinance at Dawnay Day CAP, the London-based Islamic finance commodity andintermediation entity, whose Islamiccommodity finance book business is inexcess of US$3bn. As the market forIslamic finance becomes moreestablished in non-Muslim countries,including the U.K., the role of women inthe sector w ill undoubtedly becomestronger, and the experience gained bywomen in the U.K. and elsewhere willbe exported to other countries.

Women are also coming to the fore inthe Islamic finance departments ofinternational law firms, rating agencies

and advisory firms. Currently, women

are also working in senior positions inthe Islamic banking sectors in Brunei,South Africa and the U.K..

Malaysia has gone one step further inan area that has been virtually closedto women elsewhere. Dr. Eg RabiahAdawiah Binti Engku Ali, an academicat the International Islamic Universityof Malaysia, is the first registeredfemale Islamic finance Shariah advisor,

a development that could change theface of the Shariah advisory businessover the next decade.

The rising involvement of women inIslamic finance has some potential toplay a role in tackling the humanresources bottleneck in Islamic finance.However, for this to happen, manyMuslim countries would have tointroduce enabling legislationguaranteeing gender equality and equal

opportunities in the workplace.

women in Islamic finance has some potential to play a role in tackling the human resources bottleneck in Islamic finance

There is also a straight business case

for an increasing role for women inIslamic finance: they can unlock majornew market segments for Islamicbanks. The emergence of the Sukuk,according to Ms. al-Kuwaiz representsa significant market opportunity. Women are risk averse, shesuggests. The best kind of investmentopportunity for them would be adiversified portfolio based on bonds,Sukuk, equities and real estate.

3: Sources : MENA FN(http://www.menafn.com/qn_news_story_s.asp?StoryId=1

093146765)

Jeddah Chamber of Commerce and Industry 2007 KPMG International. KPMG International provides no client services and is a Swisscooperative with which the independent member firms of the KPMG network are affiliated.


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AAOIFI, with its voluntary adoptionethic, faces a challenge to convince theIFI countries. Of the 56 membercountries of the Islamic DevelopmentBank, for instance, fewer than ten haveadopted the AAOIFI framework. Clearlymore effort is needed to promoteconvergence on this front.

Each convention has its pros and cons.While much good work has gone intoproducing the AAOIFI standards, it ishighly unlikely, according to severalIslamic bankers interviewed for thisstudy, that Europe would adopt thesestandards. In well-regulated markets,such as the U.K., people do not talkabout Islamic financial products butalternative investment products. Assuch, say some Islamic bankers, t alkabout adopting AAOIFI standards couldsimply create more confusion in the

U.K. market. Nevertheless, they agreethat the value of AAOIFI is forregulators to have a reference point forbetter understanding risk.

Mr. Smith of ABC argues that the mainissue is that one standard is adopted ina particular market. Its horses forcourses, he explains, as long as thereis some recognized standard thatpeople can conform to. In Bahrain ithappens to be AAOIFI. They do a good

job. I say go for AAOIFI.

Part of the issue with lack ofstandardization of accountingstandards is the variation betweenproducts offered by different IFIs. Forexample, a mortgage product could bestructured differently from one IFI toanother, which could give rise to adifferent accounting treatment. Hence,a broader approach to establishingaccounting standards needs to beconsidered for Islamic finance.



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Shariah Convergence

There are significant differences in theShariah interpretation of Fiqh Al-Muamalat (Islamic law relating tofinancial transactions). This can applynot only to products, but also tooperations and systems, becausecompliance can depend on certainprocesses being undert aken. Thesecan cause problems, but it is importantto remember that while harmonizationof contracts, documentation andstandards is a desired objective,equally diversity in Shariah opinions(Fatwas) is enshrined in Islamic legalhistory, and will thus remain a featureof the market by definition.

The lack of Shariah convergence is notonly a phenomenon between Malaysiaand the GCC countries. It also applies

within the GCC markets. Much workhas been done to bridge the gapbetween Malaysia and the GCCcountries and to promote greaterShariah convergence in general. But

such effort s have probably reachedtheir limits. The Islamic financeindustry would be wise, in the wordsof one banker interviewed, to live andcome to terms wit h this scenario.

KFHs Mr. Ali Al-Ghannam welcomesgreater convergence but doubts that itis achievable in the short term. Hecomments that Shariah scholars donot always communicate clearly witheach other. It is this and not the[theological] differences that is creatingthe variances. Our scholars also lack abackground in f inance, and most alsohave a language barrier. This is a hugechallenge for the indust ry.

For institutions in the West, issues ofShariah convergence are an issue,although not one that should beoverplayed. In general, bankers in non

traditional markets such as the U.K.tend to side with the GCC model,simply because this is where thegreatest liquidity resides.



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Measuring Performance

Given all these complexities, theprocess of measuring the performanceof Islamic financial products can be

tough. Nonetheless, Basel II demandsthat banks allocate risk by rating,meaning that the rating of IFIs andinstruments such as Sukuk will growsignificantly in importance over thenext few years. Whether setting themargin in a transaction or the pricingfor commercial paper, lendinginstitutions and institutional investorswill scrutinize balance sheets andcorporate structures.

Ratings for bonds and Sukuk, especiallysovereign issuances, are important toset a benchmark for individualinstitutions pricing of a specificinstrument. However, the major westernrating agencies, such as Standard &Poors, Moodys and Fitch, have beenslow to adapt their processes andframeworks relative to the rapid rise ofthe Islamic finance world.

[The Islamic finance sector needs] atailor-made rating agency to rate theperformance of IFIs using amethodology and nomenclature that isconsistent with the specificities ofIslamic finance, says Mr. Al-Ghannamof KFH. The measurement ofperformance differs even though thestart and end result of Islamic financeis the same as conventional financing.However, in the middle, there is a hugedifference. It remains to be seenwhether the nascent InternationalIslamic Rating Agency (IIRA), set up

inter alia by the Islamic DevelopmentBank, can assume this role.

The Western rating agencies have sofar declined to develop a specific ratingmethodology and criteria for IFIs andinstruments based on their uniqueShariah-compliant structures, arguing

that their current methodology andcriteria for rating conventionalinstitutions and instruments suffice.

To fill this gap, in Malaysia both theRating Agency of Malaysia (RAM) andthe M alaysian Rating Corporation(MARC) have pioneered newmethodologies and criteria specificallyfor rating IFIs and instruments suchas securities.

Nevertheless, institutions such as KFHare prepared to give the Western ratingagencies the benefit of the doubt,stressing that performancemeasurement is a two-way educationprocess, and that the Westernagencies are learning just as muchfrom us.



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The Role of Advisory OrganizationsThere is a broad understanding within

the Islamic finance sector of the needfor advisory organizations in theIslamic finance industry. Suchorganizations can provide assistancewith a range of issues including tax,regulatory compliance, risk procedures,reporting issues and addressingshortages in human capital. Theconsensus, however, is that advisoryorganizations need to be wellresourced, and have a clear separation

of advisory and auditing servicesshould the company offer both.

Advisory organizations, according toMr. Thomas, can help offset the humanresources bottleneck in the industry,and complement research anddevelopment (R&D) especially instructuring and policy init iatives. Thebanks themselves, he says, simply donot have the time for long, drawn-outprocesses because they must make

money to justify such an allocationof resources.

Practitioners stress that advisory

organizations have themselveslearned much from the experience ofIFIs. Over the past three decades,many of the primary Islamic financetools such as Murabaha, Mudarabaand Ijara were explored and reworkedthrough the process of collaborationbetween the banks, advisoryorganizations and law firms.

Mr. Smith of ABC, however, warns that

from the industry point of view, only afew of the largest advisoryorganizations are resourced for thiskind of activity on a global scale.Nonetheless, he agrees that retaininga leading advisory or consultancyorganization is essent ial for IFIs thatare contemplating entering newmarkets, given the resources andexpertise that these organizationscan bring.



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4 ConclusionThe Islamic finance industry is here tostay. In the space of three decades ithas transformed from a peripheralactivity to a sizeable alternativefinancial management system.Compared to the conventional financialsystem, it is relatively young. Industrypractitioners are constantly learningfrom the experience of theconventional system, but the learningcurve remains steep.

There is a real potential for expansion

in retail banking and consumer finance,especially in populous Muslimcountries. Non-traditional markets arealso expected to become increasinglyimportant, as is the provision of Islamicfinancial products to non-Muslimcustomers. The challenge here is toachieve a suitable level of support fromthe governments and regulators inthese markets towards the sector.

The growth and diversification of

Islamic finance, along with thegeopolitical environment in which itoperates, means that it would beunthinkable for the global Islamicfinance industry to go it alone.Institutions such as the U.S. Treasury,the U.K. Treasury, the InternationalMonetary Fund, the World Bank, andthe Basel Committee of the Bank ofInternational Settlements, are allengaging with the sector in an attemptto demystify it and to promote globaland industry best practice through theintroduction of universal prudential andsupervision standards. In addition, withmany global banking majors enteringthe market, there is a real impetus inthe West to promote the orderlydevelopment of the sector.

Muslim countries also want Islamicfinance to be part of the globalfinancial system, and are keen to adoptmany of the more innovative practicesand products as long as they complywith the principles of Fiqh Al-Muamalat(Islamic law relating to financialtransactions). On these principles therecan be no compromise, otherw ise thevery ethos and raison detre of faith-based Islamic f inancial managementwould be undermined.

As such, regulators such as Dr. ZetiAkhtar Aziz, Governor of Bank NegaraMalaysia, see much greaterconvergence of Islamic finance withthe global financial system as a nichealternative financing sector.

Muslim countries themselves,however, should seek to address theirIslamic financial architecture. Theyneed to establish which model theywould prefer to follow the dual

banking model as in Malaysia wherethe Islamic system operates side-byside with the conventional system,cooperating but not interacting; or theIslamization of the banking system asin Iran, Pakistan and Sudan.

The latter has to a large extent beendiscredited because of thefundamental anomalies that persist,especially in dealing with thecorrespondent banking relations of theIslamic banks. Sudan, Iran and Pakistanhave all introduced exceptions to therule allowing Islamic banks to engagein interest-based banking toaccommodate these relationships outof necessity.

Conversely, many GCC countrieseffectively follow a de facto dualbanking model, which many bankersincluding those interviewed stress isthe model to emulate.

As Islamic f inance continues itsexpansion and diversification into newmarkets and products, there is a realimpetus to understand more clearlyhow it can fit into the global bankingsector. As our int erviewees indicate,there is a strong appetite for growth

and diversification both amongregional Islamic banks and globalmajors. At present, however, t hereremain a number of barriers toovercome, including human capitalshortages, differences in Shariahinterpretation, and a lack ofconsistency in financial reporting.While the prospects for growth anddiversification look good, it appearsthere is still much work to be done tofulfil the core ambitions of the sector.



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Contact

Brendan NelsonGlobal Chairman, Financial ServicesKPMG LLP (U.K.)Tel: +44 (0) 20 7311 5390

Middle East RegionJaafar Al QubaitiPartner, Financial ServicesKPMG in BahrainTel: +973 (1) 722 4807

Andrew JacksonPartner, Financial ServicesKPMG in Saudi ArabiaTel: +966 (1) 291 4350

Munther DajaniPartner, Financial ServicesKPMG in Abu DhabiTel: +971 (2) 632 3476

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Darshan BijurDirector, Islamic Financing AdvisoryKPMG LLP (U.K.)Tel: +44 (0) 20 7311 4527

Samer HijaziSenior Manager, Financial ServicesKPMG LLP (U.K.)Tel: +44 (0) 20 7694 2807

Asian Sub-Continent RegionReyaz MihularPartner, Financial ServicesKPMG in IndiaTel: +94 (0) 11 2426 401

Africa RegionAhmed JafferPartner, Financial ServicesKPMG in South AfricaTel: +27 (11) 647 7030

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2007 KPMG International. KPMGInternational is a Swiss cooperative.Member firms of the KPMG network ofindependent firms are affiliated with KPMGInternational. KPMG International providesno client services. No member firm has anyauthority to obligate or bind KPMGInternational or any other member firm vis-vis third parties, nor does KPMGInternational have any such authority toobligate or bind any member firm. All rightsreserved. Printed in United Kingdom.

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Designed and produced by KPMG LLP(UK)'s Design ServicesPublication name: Growth andDiversification in Islamic FinancePublication number: 306-328Publication date: March 2007

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