Islamic Banking Bulletin

September 2006

Prepared By Mr. Imran Ahmad

Ms. Sumera Baloch Islamic Banking Department

State Bank of Pakistan

Islamic Banking Sector

State Bank of Pakistan

September 2006

Islamic Banking Bulletin

Islamic Banking Bul-letin gives an over-view of the Islamic Banking Industry and provides information regarding the develop-ments taking place in this industry locally and internationally. An article pertaining to Islamic Banking & Finance is also pre-sented as an annexure (Annexure-II) with this report.

Inside this issue:

Bank in Focus 2

Book in Focus 3

Product in Focus 3

Issues in Islamic Banking

5

Upcoming Events 6

Developments at IBD 7

Local News 8

International News 9

IERS 7

Structure of the Islamic Banking

Sector

The Islamic Banking Sector continued to grow which is reflected by the increasing branch network of the Islamic Banking Institutions. The network details can be seen in the Annexure-I.

Balance Sheet Structure

The Balance Sheet footing of the Islamic Banking Industry kept on increasing. The total assets portfolio in the Islamic Banking Sector expanded by 0.59% to Rs. 89.350 billion in August 2006 from Rs. 88.828 billion in July 2006. Total loans and advances, net of provi-sions comprised of 57.18% of total assets and stood at Rs. 51.093 billion in August 2006 compared with Rs. 50.748 billion or 57.13% of total assets in July 2006. Advances as a percentage of total assets have increased by a nominal percentage. Total assets have increased due to substantial increase in other assets. Deposit liabilities increased by 1.56% % to Rs. 62.188 billion as at the end of August from Rs. 61.231 billion in July 2006. Due to the dominant position of advances on asset side, the credit to deposit ratio was 82.15%. a high credit to deposit ratio exposes industry to a fairly high degree of credit risk. Islamic Banking Sector equity and Islamic Banking Fund increased by 0.14% to Rs. 12.591 billion from Rs. 12.574 billion.

Cash and Li-quidity Position

Cash held by Islamic Banking Institutions at the State Bank of Paki-stan increased by 0.71% to Rs.9.494 billion from Rs. 9.427 billion. It averaged 15.27% of deposit liabilities in August 2006 which was 15.40 % in the month of July 2006. Cash Reserve Requirement (CRR) for the Islamic Banking Institutions is 7% as per BSD Circular No. 10 dated July 22, 2006. Islamic Banking Institutions on the li-quidity front are consistently meeting their CRR and SLR require-ments and significant amount is kept as cash and balances with other banks.

Profitability Unappropriated / unremitted profit for the month of August in-crease by 1.42% to stand at Rs. 1.042 billion compared to last month which was at Rs. 1.027 billion. Due to higher volume of business, profitability indicators have also improved. .

Meezan Bank Ltd is the First Islamic Bank to be given Islamic Banking License in Pakistan. The license was issued on 31.01.2002. First Branch of the Meezan Bank opened on 17.04.2002 at Ground Floor, Block B,FTC Building Sharah-e-Faisal , Karachi. Following Product Range is being offered by Meezab Bank Limited Deposit Products

Mudarabah based Deposit Products TRANSACTIONAL ACCOUNTS – Rupee Saving accounts - Karobari Munafa Account - Dollar Saving accounts - KMA Plus - MIIDA ISLAMIC TERM DEPOSITS Riba Free Certificates of Islamic Investments COIIs Monthly Mudarabah Certificates Dollar Mudarabah Certificates Meezan Amdan Certificates - Long term deposit product for Pension & Gratuity Funds Meezan Providence Certificates (MPCs) RETAIL ASSET PRODUCTS First Islamic Car Financing scheme – Car Ijarah (New & Used Cars as well as Motorcycles) First Islamic Housing Finance scheme – Easy Home (with 4 variants: Buy, Build, Renovate & Replace ) CORPORATE & SME

Corporate Murabaha (PKR & USD) – for Short Term Financing Diminishing Musharakah- Long Term Financing for Plant & Machinery, Commercial Premises Corporate Ijarah- Long Term Financing for Fixed Assets Shariah Compliant Schedule of Charges

STRUCTURED FINANCE Pakistan’s first Musharakah Term Finance Certificates – Sitara MTFCs Fayzan Manufacturing Mudarabah with ICI Govt. of Pakistan’s Global Sukook

TRADE FINANCE Import Financing through “Import Murabaha & Musharakah” Sight & Usance LCs - Shariah Compliant alternative Shariah Compliant alternative of Bill Discounting Islamic Export Finance Scheme – based on Musharakah Meezan Islamic Institution Deposit Account (MIIDA)

TREASURY OPERATIONS Exchange Risk Hedging – through Forward Promise FX dealings under Bai Salam & Bai Surf rules

LIQUIDITY MANAGEMENT Special Mudarabah based account for other Islamic banks for short term liquidity mgmt. Pakistan first Shariah compliant Musharakah & Mudarabah based solutions for Acceptance of funds from

Inter-bank Money Market Special Musharakah based Deposits for banks & Corporate sector.

MUTUAL FUND: Shariah Compliant Screening Criteria for Investment in Stocks

Meezan Islamic Fund – Largest Shariah Compliant Mutual Fund of Pakistan Meezan Balanced Fund – First Islamic Balanced Fund.

TAKAFUL Pakistan’s first Shariah compliant Islamic way of Insurance- FIRST TAKAFUL-A joint venture of Meezan Bank and Pak Kuwait

Bank in Focus: Meezan Bank Limited

Page 2

Mission: “To be a premier Islamic Bank offering a one-stop shop for innovative value-added products

and services to our customers within the bounds of Shariah,

while optimising the stakeholders’ value through an organizational

culture based on learning, fairness, respect for individual enterprise and performance.”

Core Marketing Functions of Meezan Bank • Achieve strong and continuous brand awareness in the market. • Highlight MBL as a full-fledged commercial bank. • Effectively support core product lines to enhance acquisition. • Promotion of key distribution channels. • Reinforce our key USP of absolute Shariah Compliance through market education.

Human Resource Capacity Building

• Special focus on Islamic Banking training of Meezan Bank staff • Special module developed for • Islamic banking, Product training, documentation & Shariah Standards • Full day advance workshop are organized for Branch Manager, Corporate RMs etc • 4-month Islamic Banker Certification Program have been launched • Regular training sessions & seminars with NIBAF, EPB, IBP, NIPA, CIE etc • Developed graduate level courses for IBA, IQRA, LUMS and other universities

Future Plan • Establishment of full fledge International Training Institute for Islamic banking - to provide training to MBL Staff,

other Islamic banks & general public

The term “Islamic Modes of Finance”’ is defined as follows: “The systematic and detailed Shariah rules that govern the contractual relationship of an in-vestment activity that can be applied for attracting money capital” (Fahmy & Sarkar). Bai-Murabaha Meaning of Murabaha The terms "Bai-Murabaha" have been derived from Arabic words Bai and Ribhun. The word 'Bai' means purchase and sale and the word ‘Ribhun’ means an agreed upon profit. “Bai-Murabaha" means sale for an agreed upon profit. Bai-Murabaha may be defined as a contract between a buyer and a seller under which the seller sells certain specific goods permissible un-

Islamic Modes of Finance: Murabaha

Book in Focus: An Introduction to Islamic Finance, Muhammad Taqi Usmani

Page 3

Surat Al-Baqarah, (Verses 278 & 279), what can be translated as, "O you who believe! Fear Allah and give up what remains (due

to you) from riba (from now onward), if you are truly believ-ers. And if you do not do it, then take a notice of war from Allah and His Messenger but if you

repent, you shall have your capi-tal sums. Deal not unjustly, and you shall not be dealt with un-

justly."

Islam does not deny the market forces and market economy. Even the profit motive is acceptable to a reasonable extent. Private ownership is not totally negated. Yet, the basic difference between capitalistic and Islamic economy is that in secular capitalism, the profit motive or private owner-s h i p a r e g i v e n u n b r i d l e d p o w e r t o m a k e e c o n o m i c d e c i s i o n s . Their liberty is not controlled by any divine injunctions. If there are some restrictions, they are imposed by human beings and are always subject to change through democratic legislation, which accepts no authority of any super-human power. This attitude has allowed a number of practices, which cause imbalances in the society. Muham-mad Taqi Usmani writes about these imbalances and tries to provide a cure using Islamic con-cepts of finance.

Islamic Shariah and the Law of the land to the buyer at a cost plus an agreed upon profit payable today or on some date in the future in lump-sum or by installments. The profit may be either a fixed sum or based on a percentage of the price of the goods.

Types of Murabaha In respect of dealing parties Bai-Murabaha may be of two types: • Ordinary Bai-Murabaha, and • Bai-Murabaha order on and Promise. Ordinary Bai-Murabaha is a direct transaction between a buyer and a seller. Here, the seller is an ordinary trader who pur-chases goods from the market in the hope of selling these goods to another party for a profit. In this case, the seller under-takes the entire risk of his capital investment in the goods purchased. Whether or not he earns a profit depends on his abil-ity to find a buyer for the merchandise he has acquired. Bai-Murabaha order on and Promise involves three parties - the buyer, the seller and the bank. Under this arrangement, the bank acts as an intermediary trader between the buyer and the seller. In other words, upon receipt of an order and agreement to purchase a certain product from the buyer, the bank will purchase the product from the seller to fulfill the order. There are some important features of Bai-Murabaha as given below. Important Features of Murabaha

• A client can make an offer to purchase particular goods from the bank for a specified agreed upon price, includig the cost of the goods plus a profit.

• A client can make the promise to purchase from the bank, that is, he is either to satisfy the promise or to indemnify any losses incurred from the breaking the promise without excuse.

• It is permissible to take cash/collateral security to guarantee the implementation of the promise or to indemnify any losses that may result.

• Documentation of the debt resulting from Bai-Murabaha by a Guarantor, or a mortgage, or both like any other debt is permissible. Mortgage/Guarantee/Cash Security may be obtained prior to the signing of the Agreement or at the time of signing the Agreement.

• Stock and availability of goods is a basic condition for signing a Bai-Murabaha Agreement. Therefore, the bank must purchase the goods in accordance with the specifications of the client, thereby taking ownership of the goods before signing the Bai-Murabaha agreement with the client.

• Upon acquiring the goods, the bank assumes the risk of ownership. In other words, the bank is responsible for damages, defects, and /or spoilage to the merchandise until such time that it is actually delivered to the buyer.

• The bank must deliver the goods to the client at the date, time, and place specified in the contract. • The bank sells the goods at a price above the cost to obtain a profit. The sale price that is charged by the bank is agreed

upon in the Bai-Murabaha. The profit can be stated in terms of a flat dollar amount or on a percentage of the purchase price. If a percentage is used, the percentage shall never be expressed in terms of time, in order to avoid confusion that the price is a form of interest (Riba), which is not allowed.

• The price agreed to in the agreement is binding on both parties. • It is permissible for the bank to contract with a third party to buy and receive the goods on its behalf. This agreement

must be a separate contract. These features make Bai-Murabaha distinctive from all other modes of Islamic Investment.

Application of Bai-Murabaha Murabaha is the most frequently used form of finance in Islamic banking throughout the world. It is suitable for financing the different investment activities of customers with regard to the manufacturing of finished goods, procurement of raw materials, machinery, and other required plant and equipment purchases.

Page 4

In a conventional banking system, the treasury has to manage the bank’s cash flow to maximise the profit generating po-tential of the front lines, and to protect the balance sheet and P&L statement from erosion due to market risk. To achieve this all current and future cash flows are to be identified and priced at market levels. The excess liquidity is to be managed through mainly four ways; (1) Lending the surplus in the inter-bank network, (2) Invest in government securities, (3) Lend to corporate customers, (4) Keep the excess funds at 0 percent return. The first three ways involve interest and Islamic Banks cannot utilise these options. From a liquidity management perspective, Islamic banking have to come a long way. Today, many more multinational companies (MNCs) are exploring the potential to optimise their liquidity across the globe and are making useful improve-ments in the management of their day-to-day liquidity problems. Liquidity risk encompasses risks arising out of gaps in applications and available resources, mismatching of tenors of sources, and application of funds, not meeting prudential liquidity requirements, lack of access to the market etc. For this, the conventional bank’s treasuries used to place the excess funds overnight in money market but the Islamic banks cannot do this because of Shariah constraints. Surplus liquidity with Islamic banks cannot be easily transferred to conventional banks since the Islamic banks do not ac-cept interest, however there is room for exchange of surplus funds among the Islamic banks on a Mudarabah / Musharakah basis. The greater the number of Islamic banks and wider their activities, the greater will be the scope of cooperation in this field. In general, to manage liquidity effectively, you need visibility of your cash positions, good forecasting, a way to concentrate your funds, and the ability to negotiate FX and get it done before cut-off times. The challenges, with liquidity management in Islamic Banks, are not just regulatory ones. It may currently be difficult to manage the excess liquidity but it will soon be possible as steps are being taken to make a liquidity management structure for Islamic banks / divisions . Investments will be made in equity or mutual funds and in any Shariah compliant Islamic product available in the market at that particular time or to invest the excess funds with other Islamic banks. An ‘Islamic Collective Investment Scheme’ can then be introduced to collectively manage the problem of excess liquidity. State Bank of Pakistan has formed a Task Force to map out a plan for introducing short term and medium term liquidity management products based on innovative Islamic Structures that would enable Islamic Banking Institutions in Pakistan to manage liquidity matters. Terms of Reference of this task force includes structuring of Islamic Instruments for short term liquidity management, comparative study of such Islamic Instruments issued by other countries, practices of IIFS in meeting SLR by Central Banks, structuring of Shariah compliant instruments for money market operations, introduction of Islamic instruments using securitization techniques, examination of these instruments from regulatory, legal and operational requirements, preparation of recommendations on modes and methods for issuance of these instruments, reporting mechanism of these instruments, identifying instruments which can be used by the Government of Pakistan, etc.

Issues in Islamic Banking: Liquidity Management

Page 5

Upcoming Events & Training

Page 7

Title Islamic Real Estate Asia 2006 Organisation Finance IQ - A Division of IQPC Worldwide Location of Organisation Singapore Event Dates From: 11/9/2006 to: 12/9/2006 Location of Event Grand Copthorne Waterfront Hotel, Singapore Event Details

Finance IQ is proud to bring you the first and only Islamic Real Estate conference to take place in Asia. Taking place 11-12 September the conference brings together leading experts in Islamic finance and real estate not just from Asia, but from all over the world. For more information please contact Andrew Thake at (65) 6722 9388, email – en-quiry@iqpc.com.sg or log on to www.iqpc.com.sg/AS-3378

Title Fundamentals of Islamic Banking & Finance Organisation Islamic Finance Training Location of Organisation Malaysia Event Dates From: 11/9/2006 to: 14/9/2006 Location of Event Jakarta Event Details

The 4-day programme will explain the background and most important characteristics of Islamic finance. The course will go on to examine the most commonly structured products, including capital markets instruments. http://www.islamicfinancetraining.com/fibf.php

Title World Islamic Infrastructure Finance Conference Organisation MEGA Location of Organisation United Arab Emirates Event Dates From: 5/11/2006 to: 6/11/2006 Location of Event Doha, Qatar Event Details

The 1st Annual World Islamic Infrastructure Finance Conference will bring together Investors, Project Developers, Conventional & Islamic Financial Institutions with key Government agencies in order to fast-track infrastructure de-velopment. The theme of this major world conference will tackle how conventional and Islamic institutions can better collaborate in order to meet the huge demands for project finance.

Title Islamic Financial Engineering & Advanced Products Organisation Islamic Finance Training Location of Organisation Malaysia Event Dates From: 6/11/2006 to: 9/11/2006 Location of Event Dubai Event Details

The course will enable delegates to develop a detailed understanding of core products such as Sukuk and Ijarah, as well as requisites for Islamic financial engineering and the contracts involved. The course will also cover in detail contracts for project financing and Islamic swap structures and uses. http://www.islamicfinancetraining.com/feap.php

Title Third International Business Conference Organisation World Business Institute Location of Organisation Australia Event Dates From: 20/11/2006 to: 22/11/2006 Location of Event Melbourne, Australia Event Details

Papers, abstract and case studies relating to all areas of Islamic Banking, Islamic Finance, Islamic Insurance (Takaful), Islamic leasing, Islamic Ethics, Islamic Economics, Islamic concepts of Management, Marketing and Accounting are invited from the researchers, students and practitioners. There are outstanding doctoral research awards and best paper awards. Please visit www.worldbizconference.com for more information.

IFSB Task Force Meeting The Islamic Financial Services Board (IFSB) is an international-standard setting body of regulatory and supervi-sory agency having vested interest in ensuring the soundness and stability of the Islamic financial services indus-try. To strengthen and streamline the statistical information on the Islamic financial services industry (IFSI) worldwide, IFSB Task Force on “Prudential Islamic Finance Database” had its first meeting at Hotel Sheraton, Ka-rachi on Wednesday August 23, 2006 under the patronage of State Bank of Pakistan which is a founding member of the IFSB.

Business Review Meeting •A Business Review Meeting was conducted on 17th August 2006 at the Board Room of the Learning Resource Center of the State Bank of Pakistan, Karachi for the purpose of reviewing the performance of Islamic Banking Business of Meezan bank. In the meeting following points were in focus: •Products being offered •Performance Review •Marketing Plan •Human Resource Capacity Building •Service Standards •Charity Fund Projects submitted by the Internees Internship of the five Internees assigned to the Islamic Banking Department completed on 16th August 2006. They presented the following projects:

• Micro Finance in context of Islamic Banking • Marketing & Promotion of Islamic Banks in Pakistan • Importance of Corporate Governance in Islamic Banking • Comparative Analysis of Islamic Banking Industry

Developments at State Bank of Pakistan

Page 7

The State Bank has been striving to ensure that the credit requirements of the genu-ine exporters from the banking system are not effected. In order to ensure smooth flow of credit to the genuine exporters the SBP has already put in place necessary mechanism under its Export Finance Scheme (EFS), which has been in operation since 1978. The recent developments relating to the introduction of specialized Is-lamic banking institutions have made it imperative for us to formulate a Scheme to enable the exporter to avail SBP’s refinance through the newly established Islamic Commercial Banks against eligible commodities. Accordingly, we have designed a new Scheme styled as Islamic Export Refinance Scheme (the Scheme). Islamic Ex-port Refinance Scheme was initiated in 2002 through Board approval. The said Scheme shall also be utilized by the dedicated branches of the commercial banks that would work as stand alone branches for providing the Islamic Banking Products and Services, for availing refinance against financing facilities provided by them to exporters for eligible commodities.

Islamic Export Refinance Scheme

Islamic banking in foreign currencies soon Bank Negara will issue new conditional licenses under the Islamic Banking Act and Takaful Act to allow qualified local and foreign lenders and even takaful operators to conduct the full range of Islamic banking and takaful busi-ness in foreign currencies, said governor Tan Sri Dr Zeti Akhtar Aziz. The move, she said, would augment Malaysia’s position as it strengthened itself as an international Islamic finan-cial hub and, at the same time, “enhance the capabilities of foreign players that have identified Malaysia as a cen-tre to serve the regional markets.” “Islamic financial products and services that are transacted in international currencies may now be conducted from anywhere in Malaysia,” Zeti said in her opening address at the Malaysian Islamic Finance Forum 2006. StanChart, Bank Islam seal world's first Islamic hedging tool

Standard Chartered (StanChart) Malaysia Bhd and Bank Islam Malaysia Bhd have introduced the world's first Is-lamic financial hedging tool to facilitate their in-house risk management. The two banks can now better manage their portfolio of risks by benefiting from lessened exposure from either fixed or floating rates stemming from a Wiqa Forward Rate Agreement (WFRA). WFRA enables a floating rate-based profit payment to be exchanged for a fixed profit payment for a specific time period, or vice versa. Under the deal signed between the two banks on August 15, Bank Islam will hedge RM130 million worth of fi-nancial assets over three years, using StanChart's Islamic hedging facility.

Bank Negara: Need to resolve Shariah matters Bank Negara plans to launch initiatives for the harmonisation of different Shariah interpretations and called for the stepping up of dialogue among scholars around the globe. “Let us debate, confront the issues and hopefully come out with solutions to these long outstanding issues,” deputy governor Datuk Mohd Razif Abdul Kadir said in his closing address. “We are assembling a group of prominent scholars across the globe to confront issues concerning Islamic banking and finance. So now is the time for us to take these Shariah issues seriously,” Razif said. The harmonisation of syariah interpretations would greatly enhance the markets, products and liquidity of the Islamic banking and fi-nance sector, he said. BIBD, BLNG to issue first corporate Islamic bonds In realising the first-ever corporate issue of Islamic bonds or 'Sukuk Al-Ijarah', Bank Islam Brunei Darussalam Berhad (BIBD) as an integral part of the financial community in the country is proud to be working together with Brunei LNG Sdn Bhd (BLNG) and the Ministry of Finance. The first syariah-compliant financial instrument based on the Sukuk Al-Ijarah concept in collaboration between BLNG and BIBD was launched in a signing ceremony held at the BIBD Headquarters in the capital.

International News

Page 9

Japan set to enter Islamic banking The government-backed JBIC said it was studying the possibilities of issuing Islamic bonds to help Japanese busi-nesses diversify their fund raising Japan is looking to become the first major industrialized nation to issue Islamic bonds in hopes of attracting money from oil-rich Muslim countries, a bank official said yesterday. Islamic financial practices ban the payment or receipt of interest or any transactions that include alcoholic bever-ages or gambling, which are banned by the Koran. "The bank is studying the possible issuance of the bond with Malaysia," said Hiromi Inukai, a spokeswoman of the government-backed Japan Bank for International Cooperation (JBIC). "The bank has had talks with the central bank of Malaysia with the intention to attract ample petro-dollars not only to Japan but also to the whole of Asia," she said. She declined to give further details such as how much of the bond JBIC officials, with the support of the finance ministry, would place with Bank Negara Malaysia, the Malaysian central bank, and when. Japanese news reports have said that the JBIC has formed an advisory board of Islamic legal scholars to study Is-lamic financial practices. Moscow bank wins $20m Murabaha facility The UK-based global trade finance group CCH International, through its German subsidiary, CCH Europe GmbH, has arranged a debut Dh73.45 million ($20 million) Murabaha facility for Globexbank in Moscow financed by an unnamed GCC-based Islamic bank. This is the first Murabaha facility extended to a Russian institution by an Islamic bank, said a report in the Arab News quoting managing director of CCH International Eren Nil. "Islamic financial institutions have virtually no exposure to Russian risk and therefore the market is of great inter-est to CCH. Given the size of the Russian market and its need for liquidity, we are confident of arranging further Shariah-compliant transactions for Russian institutions in the future," Nil is quoted to have said. The facility, which is guaranteed by Globexbank, is being used to supply and sell goods at an agreed price, plus a profit markup, to a client of the bank, the report added.

Page 10

For any query please contact: Imran Ahmad Joint Director imran.ahmad@sbp.org.pk 2453711 Sumera Baloch Regulating Officer sumera.baloch@sbp.org.pk 2453724

Mission To Make Islamic Banking the banking of first choice for the providers

and users of financial service Islamic Banking Department was established on 15th September, 2003 and has been entrusted with the huge task of promoting & developing the Shariah Compliant Islamic Banking as a parallel and compatible banking system in the country.

Annexure-1

Page 11

Number of Licensed Islamic Banks and IBBs as at 08.09.2006

Bank's Name No. of Branches

A) Islamic Banks 1 Meezan Bank Limited 42 2 Albaraka Islamic Bank 9 3 BankIslami Pakistan Limited 6

4 Dubai Islamic Bank Pakistan Limited 8

5 Emirates Global Islamic Bank Limited* -

6 First Dawood Islamic Bank* - Total of A 65

B) Islamic Banking Branches

1 Muslim Commercial Bank 5 2 Bank of Khyber 5 3 Bank Alfalah Limited 19 4 Habib Bank AG Zurich 2 5 Standard Chartered Bank 3 6 Metropolitan Bank 1 7 Bank Al Habib Ltd.* 1 8 Habib Bank Ltd.* 1 9 Soneri Bank Limited 2

10 Prime Commercial Bank 2 11 Askari Commercial bank 4 Total of B 45 A+B 110

* These two banks are expected to start operations soon.

Islamic banking flourishing in country The Islamic banking has captured 2 percent market share in only three-year period in the country due to rapid growth of this industry. This was stated by Pervez Said, director, Islamic Banking Department, State Bank of Paki-stan (SBP), while speaking at a seminar on "Efficiency, Diversity and Competition in Islamic Banking and Insur-ance Industry", organised by the Institute of Business and Technology at a local hotel on Saturday. He said that four full-fledged Islamic banks are operating in the country, while a couple of license applications of Islamic banks are in pipeline. Pervez said the Islamic banking operation was started in Malaysia in 1983 where the market share of Islamic banking is 11.6 percent while in Indonesia Islamic banking operation was launched in mid-90s and its market share is 1.34 percent. In Pakistan, its operation was started in 2003, he said, adding the Islamic banking has captured 2 percent market share in only three years, which is good achievement. He said that the growth of Islamic banking was resulted due the attractive policies of the present government. Pervez said the central bank wants to run a parallel Islamic banking system with the conventional system and provide opportunity to the people to choose any system, which they like. SBP governor opens Dubai Islamic Bank branch State Bank of Pakistan (SBP) Governor Dr. Shamshad Akhtar inaugurated Dubai Islamic Bank's Karachi branch at Cloth Market. "Given Dubai Islamic Bank's international stature and regional presence, we anticipate that the bank will bring to Pakistan the required technology, instruments and institutional framework, so as to set the standard for other Is-lamic banks to follow", said the SBP Governor after inaugurating the branch premises. "We have observed phenomenal growth in the Islamic banking industry in a short period of time as Islamic bank-ing has evolved as an institution to help achieve financial sector growth in a Muslim country as Pakistan", she added. Later, the SBP Governor and Advisor to the SBP Governor on Islamic banking, Pervez Said, were given a tour of the branch premises by a delegation of Dubai Islamic Bank, including Chief Executive Officer (CEO) Saad Zaman and Deputy CEO M. A. Mannan; during which network expansion plans of the bank were discussed. Dow Jones Indexes and JS Group to Launch Islamic Index for Pakistan Dow Jones Indexes, a leading global index provider, and JS Group, Pakistan's premier financial group, today an-nounced the launch of the Dow Jones-JS Pakistan Islamic Index. The index measures the performance of compa-nies in the Pakistani stock market that pass screens for compliance with Islamic principles. The Dow Jones-JS Pakistan Islamic Index is designed to serve as an underlying index for investment products such as mutual funds, exchange-traded funds (ETFs) and other investable products. This is the first time that a dedi-cated Islamic Index for Pakistan has been launched by a major global index provider.

Page 8

Local News

5

Islamic finance

Emerging Islamic

CAPITAL MARKETS -a quickening pace and new potential

by Zamir Iqbal and Hiroshi Tsubota, The World Bank

Describing the Islamic financial system simply as ‘interest-free’ doesnot do justice to the system. Promotion of entrepreneurship,preservation of property rights, transparency and the sanctity ofcontractual obligations, which are crucial to any sound financialsystem, describe its essence. Today, Islamic financial and bankingactivities have reached an impressive size of over US$250bn, ascompared to a meagre US$6bn in the early 1980s. Market participantsand policy makers are increasingly paying attention to its potentialand how to take advantage of the opportunities presented.

The term ‘Islamic finance’ or ‘Islamic financial system’1

is not as uncommon today as it was two decades ago

when financial institutions in several Muslim countries

started exploring ways to operate a banking system

prohibiting the payments and receipts of interest. Islamic

modes of financing have been in practice in some form

or other since the early history of Islam. Throughout the

Middle Ages, Islamic merchants became indispensable

middlemen for fostering trade through development of

sophisticated credit instruments in Spain, the

Mediterranean and Baltic states.

In modern banking history, an interest in the revival of

Islamic modes of financing emerged in several Muslim

countries, during their post-colonisation period. In the early

1960s, independent but parallel attempts in Egypt and

Malaysia led to the establishment of financial institutions,

which were designed to operate on a non-interest basis so

as to comply with Islamic principles. But it was not until

the first wave of oil revenues in the 1970s and the

accumulation of petro-dollars which gave momentum to

this idea, that the Middle East saw a mushrooming of small

commercial banks competing for surplus funds. At the same

time, interest grew in undertaking theoretical work and

research to understand the functioning of an economic and

banking system without the institution of ‘interest.’

Continuing demand throughout the 1980s led to

sustainable growth and, by the 1990s, the market for

Islamic financial products had attracted the attention of

several western commercial banks, which started to offer

specialised financial services to high net worth

individuals and later at the retail level through ‘Islamic

windows.’ Today, there are more than 240 financial

institutions operating on the basis of non-interest based

instruments in more than 40 different countries.

6

Islamic finance

BASICS OF ISLAMIC ECONOMIC AND FINANCIAL

SYSTEMS

An Islamic economic and financial system is a rule-based

system comprising a set of rules and laws, collectively

referred to as Sharia’ governing economic, social,

political and cultural aspects of Muslim societies. Sharia’

originates from the rules dictated by the Quran, from the

practices of the Prophet Muhammad, and further

elaboration of the rules by scholars in Islamic

jurisprudence through the process of deduction (Qiyas)

and consensus (Ijma’). Over time, four different schools

of thought – Hanafi, Maliki, Shafei and Hanbali have

emerged with some variations on the rules depending on

respective interpretations.

The central tenet of the financial system is the

prohibition of ‘Riba’ – a term literally meaning “an

excess” and interpreted as “any unjustifiable increase of

capital whether through loans or sales.” More precisely,

any positive, fixed, predetermined rate tied to the

maturity and the amount of principal (i.e., guaranteed

regardless of the performance of the investment) is

considered Riba and is prohibited. The general consensus

among Islamic scholars is that riba covers not only usury

but also the charging of “interest” as widely practiced.

This prohibition is not to be confused with a rate of

return or profit on capital, as Islam encourages the

earning and sharing of profits, because profit,

determined ex post, symbolises successful

entrepreneurship and the creation of additional wealth;

whereas interest, determined ex ante, is a cost that is

accrued irrespective of the outcome of business

operations and may not create wealth if there are

business losses.

Undoubtedly, prohibiting the receipt and payment of

interest forms the nucleus, but it is supported by other

principles of Islamic doctrine;

• advocating risk sharing;

• promotion of entrepreneurship;

• discouragement of speculative behaviour;

• preservation of property rights;

• transparency; and

• the sanctity of contractual obligations.

The system can be fully appreciated only in the context

of Islam’s teachings on the work ethic, wealth

distribution, social and economic justice, and the

expected responsibilities of the individual, society, the

state and all stakeholders.

EMERGING ISLAMIC CAPITAL MARKETS

During the 1980s and 1990s, Islamic financial institutions

were able to mobilise funds successfully through deposits

invested in a handful of financial instruments, dominated

by trade financing. Activities on the asset side of Islamic

financial institutions included

• cost-plus-sale or purchase finance (Modaraba’);

• leasing (Ijara’);

• trust financing (Modaraba’); and

• equity participation (Musharika’).

Due to market conditions, lack of liquid assets and

other constraints, the composition of Islamic financial

institutions’ assets stayed fairly static and heavily focused

on short-term instruments (mainly commodity finance).

By the late 1990s, there were many calls for the

introduction of new products and the promotion of

financial engineering.2 Main areas of concern were the

lack of liquidity, a lack of portfolio and risk management

tools and the absence of derivative instruments.

One of the impediments to growth was the lack of

understanding the fast changing landscape of modern

financial markets as well as the intricacies of rules

demanded by the Sharia’. The task was further

complicated by the different schools of Islamic thought

in various parts of the globe. Nevertheless, by the late

1990s, Islamic financial institutions had realised that the

development of capital markets was essential for their

survival and further growth. Meanwhile, deregulation

Islamic finance

7

and liberalisation of capital movements in several

countries led to close cooperation between Islamic

financial institutions and conventional financial

institutions in order to find solutions for liquidity and

portfolio management. The result was two distinct

developments – the introduction of equity funds which

were compatible with Sharia’ and the launch of Islamic

asset-backed securities more commonly known as Sukuk.

Whereas Islamic equity funds became popular with

investors who had a risk appetite for equity investment,

Islamic financial institutions, driven by the nature of their

intermediation, kept demanding securities which could

behave like conventional fixed-income debt securities but

also comply with Sharia’. In addition, Islamic financial

institutions wanted to extend the maturity structure of

their assets beyond the typical short-term maturities

provided by trade-finance instruments. This led to the

creation of Sharia’ compliant asset-backed securities,

Sukuk, which have risk/return characteristics similar to

conventional debt securities. The result is that within a

short span of less than five years, the market for Sukuk

have reached an impressive size of US$30bn which

includes several sovereign and corporate issues (see

Exhibit 1 - notable transactions in the first half of 2005).

WHAT IS A SUKUK?

The idea behind a Sukuk is simple. Prohibition of interest

virtually closes the door for a pure debt security but an

obligation which is linked to the performance of a real

asset is acceptable. In order words, Sharia’ accepts the

validity of a financial asset which derives its return from

the performance of a real asset. The word Sukuk (plural of

the Arabic word Sakk meaning certificate) reflects

participation rights in the underlying assets. The design of

the security is derived from the conventional securitisation

process in which a special purpose vehicle is set-up to

Exhibit 1Notable transactions in the first half of 2005

Source: Compiled from various market sources

Issuer Country Issue date AmountMaturity(year) Type Manager(s)

Government of Bahrain Bahrain February-05 BD30m 5 Ijara’ (Leasing) Bahrain Monetary Agency

Government of Pakistan Pakistan January-05 US$600m 5 Ijara’ (Leasing) Citgroup, HSBC Amanah

Islamic Development Bank Supranational organisation June-05 US$500m 5 Sukuk HSBC Amanah, Deustche Bank, CIMB, Dubai Islamic Bank

Ammercchant Bank Berhad, RHBSakura Merchant Bhd, MIMB,

The World Bank Supranational organisation April-05 M$760m 5 Bai’ Bithaman Ajil (BBA)(deferred-payment sale)

CIMB, ABN Amro Bank Bhd

PLUS Expressways Bhd Malaysia June-05 M$2,410m 11 - 14 Bai’ Bithaman Ajil (BBA)(deferred-payment sale)

CIMB

Jimah Energy Ventures Malaysia May-05 M$405m 6 - 16.5 Istisna’ (purchase order)

Commercial Real Estate Company Kuwait May-05 US$100m 5 Ijara’ (leasing) Kuwait Finance House, Liquidity Management Centre

Time Engineering (MusyarakahOne Capital Bhd)

Malaysia April-05 M$566.55m 1 - 5 Musharika’ (profit andloss-sharing

CIMB

Durrat Sukuk Company BSC Bahrain January-05 US$152.5m 5 Istisna’ and Ijara’ Sukuk Kuwait Finance House

Sovereign

Supranational

Corporate

8

acquire assets and to issue financial claims on the asset.

Such financial claims represent a proportionate beneficial

ownership for a defined period when the risk and the

return associated with cash-flows generated by an

underlying asset, is passed to Sukuk holders (investors).

The core contract utilised in the process of securitisation

to create a Sukuk is an Islamic contract of intermediation

known as Modaraba’ (trust financing), which allows one

party to act as an agent (manager) on behalf of a principal

(capital owner) for an agreed fee or profit-sharing

arrangement. The contract of Modaraba’ is used to create a

Special Purpose Modaraba’ (SPM) entity, similar to the

conventional Special Purpose Vehicle (SPV), to play a well-

defined role in acquiring certain assets and issuing

certificates against the assets. The underlying assets

acquired by SPM need to be Sharia’ compliant and can

vary in nature. Depending upon the nature of underlying

assets and the school of thought, the tradability and

negotiability of issued certificates is determined.

The majority of Sukuk issued to date are based on two

classes of assets. The first class of assets fall into financial

claims created out of a spot sale (Salam) or a deferred-

payment sale (bay’ mu’ajjal) and/or a deferred-delivery sale

(bay’salam) contract, whereby the seller undertakes to

supply specific goods or commodities, incorporating a

mutually agreed contract for resale to the client and a

mutually negotiated margin.

Salam-based Sukuk have proved to be a useful

investment vehicle for short-term maturity since underlying

commodity financing tends to be for a short-term tenor

ranging from three months to one year. However, due to the

fact that the Sukuk results in a pure financial security and

is somewhat de-linked from the risk/return of the

underlying asset, Sharia’ treats it as a pure debt security.

Consequently, many investors, including those in the GCC

countries cannot trade these Sukuk in the secondary

market, either at a discount, or at a premium. Trading will

introduce a mechanism to indulge in Riba or interest in the

Islamic finance

Exhibit 2Anatomy of a Sukuk

Source: Iqbal, 1999

Fund mobilising entity

Pool of assets(Ijara’/leases)

Credit enhancement Guarantor

Special purpose Modaraba’SPM/SPV

Assets Liabilities

Ijara’ assets(leases)

Servicing

Investors: Islamic,conventional institutional investors,

pension funds, etc.

Sukukcertificates

transaction. Due to this restriction, investors tend to hold

Salam-based Sukuk up to the maturity of the certificate.

In order to provide longer-term maturity and limited

tradability and negotiability to investors, a second class

of Sukuk is based on leasing (Ijara’). An Ijara’

instrument is one of the instruments which bears the

closest resemblance to a conventional lease contract and

offers flexibility of both fixed and floating-rate payoffs.

The cash-flows of the lease including rental payments

and principal repayments are passed through to

investors in the form of coupon and principal payments.

Ijara’-based Sukuk provide an efficient medium-to

long-term maturity mode of financing.

CURRENT MARKET ENVIRONMENT

Islamic capital markets are now gaining the momentum to

grow into a vibrant marketplace, especially for emerging

market borrowers in the regions of the Middle-East,

South-East Asia, South Asia and North Africa.

On the supply side, the volume of Islamic investments

– with a preference for Sharia’ compliant instruments –

has grown to form a critical mass that can support a

well-functioning and efficient capital market. It is

evolving into a truly international market. Not only

highly rated borrowers such as the Multilateral

Development Banks (for example, the World Bank), but

also developing country borrowers with lower credit

ratings, such as Pakistan, have successfully raised a

considerable volume of funds in this market.

On the demand side, countries in the developing world,

especially the middle-income countries, will require a

significant volume of investments in infrastructure over

the next decade. To illustrate, for Indonesia alone,

additional infrastructure investments of US$5bn (2% of

GDP) are required annually, to reach a 6% medium-term

growth target, as estimated by the World Bank.3

Because the domestic capital markets of these borrowers

are often not deep enough to satisfy their large

investment needs, they would have to access external

sources of financing.

Furthermore, Muslim stakeholders in middle-income

countries are increasingly expressing their preference for

Sharia’ compliant financing. Borrowers, especially public-

sector institutions, are starting to reflect their stakeholders’

voices in the implementation of financial operations. In

turn, financial intermediaries, including private-sector

commercial and investment banks, as well as development

finance institutions, are likely to start paying more

attention to such ‘non-financial’ needs of their clients - in

addition to satisfying these borrowers’ funding needs, in

order to stay successful in the marketplace.

For the Multilateral Development Banks (MDBs), such as

the World Bank, the development of Islamic capital

markets will be a highly relevant topic. Firstly, MDBs are

deeply involved in infrastructure finance in their

borrowing member countries and would therefore naturally

be interested in the emerging Islamic capital market as a

new and alternative source of financing. Secondly, by

channeling the funds available in Islamic financial markets,

which are mostly based in the countries with high savings

such as the GCC countries and Malaysia, to finance

investments in developing countries, MDBs can create a

new model for international development cooperation

while responding to the stake-holders’ voices on both sides.

Thirdly, MDBs can promote financial stability by

encouraging the development of Islamic capital markets to

enhance liquidity, and enabling Islamic financial

institutions to have more diversified portfolios and sound

risk management. Furthermore, this could also provide the

momentum to integrate the Islamic financial markets

within the framework of the international financial system.

GOING FORWARD: CHALLENGES AND POLICY

ACTIONS NEEDED

In the near future, it is most likely that structures which

provide investors with a pre-determined return as well as

9

Islamic finance

10

full recourse to the obligor (such as Ijara’ and

Murabaha’) would have more market potential than other

structures. As discussed earlier, this will be driven

primarily by investor preferences, but a large proportion

of potential borrowers would also prefer to lock-in their

borrowing costs rather than engage in pure profit

sharing schemes.

While the overall market background appears

promising, certain obstacles and constraints may lie

ahead and market participants and regulators need to

take concrete steps to support market take-off.

Firstly and most importantly, market development

requires a strong sponsorship and leadership of the host

country government, especially on legal and regulatory

issues. For example, for an Ijara’ transaction, the owner of

operating assets needs to enter into a leasing transaction.

While the owners of operating assets are often the

government itself or its related public-sector bodies, the

relevant laws and regulations in the host country may not

allow these public-sector bodies to pledge or lease assets

needed to structure an Ijara’ transaction. This is a

fundamental point; the host country’s policy actions to

promote such Islamic finance will be a key prerequisite for

the market to develop further.

Furthermore, borrowers, investors as well as

intermediaries need to nurture the market patiently. As of

now, Islamic transactions often face a competitive

disadvantage to conventional bond issues in terms of

cost-efficiency. Each new issue incurs higher levels of

legal and documentary expenses as well as distribution

costs; and involves examining structural robustness in

addition to evaluating the credit quality of the obligor.

Also, since the terms available in Islamic capital markets

are mostly derived from the pricing levels in the more

liquid conventional bond markets, there is no inherent

funding cost advantage for borrowers tapping Islamic

markets. Borrowers, therefore, would need to formulate a

comprehensive, long-term and strategic view on how to

reduce the overall funding cost by tapping Islamic

markets, rather than focusing on a single transaction.

Investors, on the other hand, can significantly support

market development by expressing their preference for

Sharia’ compliant instruments more concretely, namely

in terms of their bid prices. For intermediaries, they can

lead the process to reduce transaction costs, perhaps

through further standardisation of transaction schemes

and instruments.4

Sharia’ scholars can also play an important role. It is

essential that multi-disciplinary expertise, covering topics

ranging from theological interpretation to financial

structuring, be developed through knowledge-sharing,

cross-training and acquiring an understanding of the

functioning of markets. To stimulate cross-border

activities in the primary as well as secondary markets,

the acceptance of contracts across regions and across

schools of thought and markets will also be helpful.

CONCLUSION

In the wake of the current wave of oil revenues and

increasing demand for Sharia’-compliant products,

Islamic capital markets are emerging at a quickening

pace and stakeholders are starting to realise the potential.

Development of institutional infrastructure in the

international fora, such as establishment of accounting

standards and regulatory bodies, are all steps in the right

direction.5 However, for the market to grow further, it

also needs strong leadership and constructive policy

actions of host governments, to enable market

participants to originate Islamic finance transactions.

Well-developed Islamic capital markets will not only be

beneficial for borrowers and institutional investors, they

can also further enhance the stability of Islamic financial

institutions, providing them with improved portfolio,

liquidity and risk management tools. Ultimately, all these

developments will contribute to integrating Islamic

financial markets, as well as the people who form these

markets, into the framework of the broader conventional

international financial system.

Islamic finance

Notes:

1. For a further description of Islamic financial systems refer to Iqbal (1997).

2. See Iqbal (1999) and Iqbal and Mirakhor (2002).

3. Indonesia – Averting an Infrastructure Crisis: A Framework for Policy and Action, The World

Bank, 2004.

4. For example, in the Malaysian market, market participants have developed a few well

standardised structures, such as Bai’ Bithaman Ajil. Structuring as well as distribution costs for

these standardized Islamic deals in Malaysia are now reduced to a competitive level, making

them a viable alternative to conventional debt instruments.

5. These institutions include Islamic Financial Service Board (IFSB), Accounting and Auditing

Organization of Islamic Financial Institutions (AAOIFI), Liquidity Management Center (LMC),

International Islamic Financial Markets (IIFM) and International Islamic Rating Agencies (IIRA).

References:

Iqbal, Zamir (1997) Finance and Development, International Monetary Fund,

Washington, D.C. June, http://www.imf.org/external/pubs/ft/fandd/1997/06/pdf/iqbal.pdf

Iqbal, Zamir (1999), “Financial Engineering in Islamic Finance,” Thunderbird

International Business Review, Vol 41, No. 4/5, July-October 1999, pp. 541-560.

Iqbal, Zamir and Abbas Mirakhor (2002), “Development of Islamic Financial

Institutions and Challenges Ahead,” in Simon Archer and Rifaat Abdel Karim (eds.)

Islamic Finance: Growth and Innovation, Euromoney Books, London, UK.

The World Bank Jakarta Office (2004), “Indonesia – Averting an Infrastructure Crisis: A

Framework for Policy and Action”, Jakarta, Indonesia.

Hiroshi Tsubota and Zamir Iqbal

Zamir Iqbal and Hiroshi Tsubota are

Principal Financial Officers in Quantitative Strategies,

Risk and Analytics (QRA), and Banking, Capital Markets

and Financial Engineering (BCF) departments of the

World Bank Treasury in Washington, DC.

For further information,

please e-mail: ziqbal@worldbank.org or

htsubota@worldbank.org

11

Islamic finance

Views expressed in the article are of the authors and do not reflect views of the Board of Directors and of the World Bank Group. Authors wish to thank Hennie Van Greuning, Doris Herrera-Pol, andKenneth Lay for their comments.