ISLAMIC FINANCEFINANCIAL TIMES SPECIAL REPORT | Thursday June 19 2008

Grappling with problems of success

Islamic finance has notescaped unscathed from theglobal financial turbulenceof the past year. As the

credit crunch hit, the market forsukuk, or Islamic bonds, took apause, with new issues postponedand months going by without asingle dollar-denominated bondbeing sold.

Despite the setback, however,the pool of liquidity in the oil-rich states of the Gulf, and thestill-growing appetite for finan-cial products that comply withthe prohibition on the use ofinterest, have kept the $800bnIslamic finance industry march-ing on.

With experts predicting thatthe slowdown in the sukuk mar-ket will be temporary, the menuof Islamic-sanctioned financialinstruments has continued toexpand. More bankers, lawyers,and advisers have been flockingto the sector, bringing along newideas and structures that can rep-licate products available in con-ventional finance. After Islamicmortgages and Islamic insurance,the industry is now dabbling inhedging products, and expertssay derivatives are the next bigthing on the horizon.

Perhaps the most powerfulsign of progress in recent monthshas been the establishment,partly with state backing, oflarge Islamic banks, a trend thatshould take an industry domi-nated until now by hundreds ofsmall institutions a step closer tomainstream banking.

In January, Noor Islamic Bankwas launched with $1bn in capi-tal by the Dubai government. Itstarted operations through 10branches but also made clear itsambition for expansion, hopingto lift the share of Islamic bank-ing in the United Arab Emiratesto as much as 50 per cent. Theindustry now represents between15 per cent and 25 per cent of the

banking market across the Gulf.In April, it was the turn of

Saudi Arabia to launch InmaBank, raising $2.8bn in capital inan initial public offering. Now agroup of Gulf investors are look-ing to launch a $9bn Islamicbank and float it on the Bahrainstock exchange.

“The new banks add a lot ofcredibility to the market,” saysAfaq Khan, head of Islamic bank-ing at Standard Chartered Bank.“As big banks come in with size-able capital they will becomemainstream banks in their localeconomy and can bid for all thebig projects.”

Nabeel Shoaib, global head ofHSBC Amanah, says that despitechallenges in the sukuk market,the new banks underline thatIslamic finance business is stillpicking up. “It’s a reflection of

the potential available. And theoversubscription [of initial publicofferings for these banks] is areflection of the market and theliquidity that is available.”

Yet, an industry where everyproduct needs a religious stampof approval is also starting to

face some vital questions.The most important is the

extent to which it can create newproducts that provide the sameservice and give the samereturns as conventional instru-ments without deviating fromreligious tenets.

Over the past year, the indus-try was jolted by controversyafter a leading religious scholardeclared that the most populartype of sukuk was not at all inline with principles of sharia, orIslamic law. At stake were struc-tures that included a repurchase

undertaking in which issuerspromised to pay back the facevalue of the bond at maturity orin case of default.

For Sheikh Muhammad TaqiUsmani, head of the religiousboard of the Accounting andAuditing Organisation forIslamic Financial Institutions,the Bahrain-based standards set-ter, the guaranteed return vio-lated the key principle of Islamicfinance, which stipulates sharingin profits and losses. Despite anoutcry from the industry, MrUsmani’s views essentially pre-vailed when the sharia board ofthe AAOIFI subsequently met todiscuss the issue.

Given that the decline in thesukuk market has been blamedprimarily on the credit crunch,however, the full impact of theAAIOFI decision has yet to be

felt. Although the standardsbody’s views carry weight, theyare not binding, and some bank-ers and issuers are likely toignore them. Others, however,have gone back to the drawingboard, to try to make the sukukstructures more compliant.

“The AAOIFI opinion doesn’timpact existing sukuk but goingforward some people will ignorethe ruling,” says one leadingIslamic banker. “Others will findways to adhere to them butimpose other contractual obliga-tions.”

Some analysts have welcomedthe debate as a wake-up call,arguing that it will help stand-ardise religious decisions in anindustry that has no unifiedopinion. Others, however, say theattempt to regulate the market isdetrimental, stifling its growth.Customers, they say, want prod-ucts that can replicate debtinstruments but without obvi-ously appearing to deliver guar-anteed return.

“What AAIOFI is failing to rec-ognise is that investors and issu-ers need to have debt,” says theIslamic banker.

As the industry grapples withreligious interpretation, it is con-fronting another important issue– a shortage of staff.

There are perhaps up to 100religious experts who knowenough about finance and muchof the industry relies on the top12 scholars within that group.More broadly the fast-growingfinancial industry, Islamic andconventional, is struggling tokeep talent as salaries soar andforeign banks beef up their oper-ations. That is a particular con-cern in the Gulf.

While AAIOFI is helping totrain a generation of youngerreligious experts, Dubai Interna-tional Financial Centre and CassBusiness School are offering anexecutive MBA programme inIslamic finance.

“What’s limiting the ability ofbanks is the right people, theskilled bankers,” says Moham-med Amin, head of Islamicfinance at PwC. “The industryneeds new talent and it needs tore-skill bankers.”

The sector isexpanding in rangeand credibility –bringing new strains,says Roula Khalaf

Inside this issueA Scholar’s Blow a statementthat threatened to halt themarket has brought clarityinstead, writes David OakleyPage 2

Standard Setting FarhanBokhari profiles the IslamicFinancial Services Board Page 2

Experts Specialised bankers,

lawyers and technical staff are inshort supply, says Sharmila DeviPage 3

Ethical Insurance AndreaFelstead sees opportunities inthe Gulf and beyond Page 3

London Leads ShyamanthaAsokan finds the City has stolena march on global rivals Page 6

Rich oil­pool of liquidity: there is still a growing appetite for sharia­compliant financial products in the wealthy Gulf states Bloomberg

More on ft.comThe deals and howthey workPLUS: Neil Millerof Norton Rose

www.ft.com/islamicfinance

www.ft.com/islamicfinance2008

2 ★ FINANCIAL TIMES THURSDAY JUNE 19 2008

Islamic Finance

Contributors

Roula KhalafMiddle East Editor

David OakleyCapital MarketsCorrespondent

Farhan BokhariIslamabad Correspondent

Andrea FelstedInsurance Correspondent

Shyamantha AsokanFT Contributor

Sharmila DeviFT Contributor

Rohit JaggiCommissioning Editor

Steven BirdDesigner

Katie CarniePicture Editor

For advertising details,contact: Chris Nardi on+44 020 7873 4311, Fax+44 020 7873 4296,email: chris.nardi@ft.com,or your usual FinancialTimes representative.

Pioneer standards bodytries to spread the word

Rifaat Ahmed Abdul Karim,is in a self-confident mood.The director-general of theMalaysia-based IslamicFinancial Services Board(IFSB), says it has entered a“more meaningful phase” inits existence.

Up to 28 workshops areplanned by the board aroundthe world, mainly to trans-late research into training.

The move is in keepingwith its aims: the IFSB wasset up five years ago as theMuslim world’s first stand-ards body in the Islamicfinance industry. It describesitself as “an internationalstandard-setting organisa-tion that promotes andenhances the soundness andstability of the Islamic finan-cial services industry”. Itdoes this by issuing stand-ards and guiding principlesfor the industry, which itbroadly defines as includingthe banking, capital marketsand insurance sectors.

The IFSB has pronouncedon risk management, capitaladequacy, corporate govern-ance, supervisory reviewprocesses, transparency andmarket discipline, recogni-tion of ratings on sharia-compliant financial instru-ments, and the developmentof money markets.

Research under wayincludes examining opera-tions of takaful, or Islamicinsurance, and governanceof investment funds. Thetraining exercise involvesteams from the IFSB teach-ing courses in countries tokey people including centralbank officials and financialexperts.

The IFSB has set itself theobjective of becoming theIslamic world’s premierstandard-setting body. Itaims to be seen as theIslamic world’s equivalent tothe Basel Committee onBanking Supervision, theInternational Organisationof Securities Commissionsand the International Associ-ation of Insurance Supervi-sors all wrapped into one.

Mr Abdul Karim, a promi-nent Sudanese economicsprofessor who has built areputation as a leadingscholar on Islamic finance,says the IFSB’s could play acentral role in the evolutionof Islamic finance. “The glo-bal structure is there butyou have to adapt it toIslamic finance. Otherwise,if we did not have the IFSB,every institution wouldmake its own interpreta-tion.”

In some ways, the IFSB’stask may be easiest inMalaysia, its home base,which prides itself on host-ing the world’s largest mar-ket for sukuk – Islamicbonds – and where BankNegara Malaysia, the centralbank, has set an ambitioustarget of raising the propor-

tion of total banking assetsunder Islamic institutionsfrom 15 per cent now to 20per cent by 2010.

Much of the demand for itsservices comes from outsideits home country: there aremany entrants to the markethopeful of attracting moneyfrom Muslim investors in thecash rich Arab world.

Mr Abdul Karim says com-ing up with high-quality glo-bal standards and achievingtheir adoption is not easy.“Our biggest challenge is theimplementation side of ourwork. We don’t have thelegal right to impose stand-ards,” he says.

Many experts acknowledgethe value of IFSB’s work butalso note that the long-termfuture of the IFSB’s workdepends on assuring lendersand borrowers that itachieves globally-acceptedstandards.

Mr Abdul Karim believesthat attitudes are changing.“The industry has grownand has been demand-driven,” he says. “Thegrowth has brought about alot of things. One of the goodthings is that there are moreinstitutions now.”

Rafe Haneef, Malaysia-based Managing Director ofFajr Capital, a recentlyestablished internationalIslamic investment manage-ment company, says Islamicbanks “have to be as com-petitive as conventionalbanks. Muslims may notturn to an Islamic institu-tion unless they see value inthat decision.”

Expansion plan aims highSix months after Hussain AlQemzi led the initiativeto launch the United ArabEmirates’ Noor IslamicBank, the institution’s chiefexecutive is workingon ambitious expansionplans.

He is looking at ideas thatrange from targeting lower-income customers – by forthe first time using postoffices to offer Islamic bank-ing – to expanding the bankoutside the Gulf to parts ofAfrica and Asia.

The grand vision of thefuture for this Islamic bankis in sharp contrast to thedays when they were periph-eral and catered for only anarrow base of customers.

Several factors haveprompted Islamic banks tomatch international stand-ards.

They range from the largeamount of Middle Easternpetrodollars produced byrecent rises in the oil price,to customers seeking Islamicservices with global stand-ards.

Furthermore, there areplenty of untapped opportu-nities in the sector.

“We see plenty of areasthat are empty. North Africaand central Asia have nopresence of Islamic banking.Indonesia and Pakistan havea very small presence ofIslamic banking,” the chiefexecutive of Noor told theFT.

Mr Qemzi has had a distin-guished career as an Islamicbanker, with stints includinghis role in overseeingthe conversion of theNational Bank of Sharjah,

also in the UAE, to anIslamic institution.

Noor, which began takingdeposits from customers thisyear, is 25 per cent ownedby the Dubai government, 25per cent by Sheikh Moham-med bin Rashid Al Mak-toum, Dubai’s ruler, 5 percent by the UAE federalgovernment, with theremaining 45 per cent ownedby 17 UAE royals and busi-nessmen.

Some of the most promi-nent names in Dubai’s busi-ness elite sit on the bank’sboard.

Mr Qemzi is keen to stressthat concepts such as “qual-ity”, “creating value for cus-tomers” and “creating size”in a competitive environ-ment must all be central tothe success of banks enter-ing the Islamic markettoday.

“There are lots of Islamicbanks which don’t evencarry the Islamic name.Islamic banking could [even]be termed as alternativebanking. But the quality hasto be the top priority,” hesays.

To fulfill its plan ofexpanding outside the UAE,the bank must decidewhether its strategy shouldbe to acquire existing bankswith a view to convertingthem to Islamic institutions,or seek new licences to startfrom scratch.

Mr Qemzi notes that thecost of conversion of a regu-lar bank to an Islamic insti-tution is a factor that wouldhave to be considered.

While Noor seeks toexpand, it is also preparing a

novel concept.The bank is launching in

the UAE a bank servicedelivered through postoffices to target the 50per cent of the populationthat has no formalbank accounts, says MrQemzi.

“Post office banks arecommon around the world.It is time for an Islamic bankto try out this idea. We havesigned a contract with thepost offices [in the UAE] tocreate a post bank to caterto the poor.”

The idea of setting up apost office bank follows an

order from the UAE ministryof labour requiring compa-nies to pay workers bydepositing their pay in abank account, ruling out theoption of them being paid incash.

The new service isexpected to attract customfrom low-paid workers,including many expatriatesfrom countries such asIndia, Pakistan and thePhilippines, who representa significant part of theUnited Arab Emirates’ work-force.

For such workers, the keyattraction would be that thecharges levied by a post

NOOR ISLAMIC BANK

Farhan Bokhariprofiles a newinstitution in ahurry to grow

‘North Africaand centralAsia have nopresence ofIslamic banking’

Clarification of rules does market a favour

In November last yearSheikh Muhammad TaqiUsmani, a religious scholarnot widely known outside

the Middle East, sent shockwavesthrough the Islamic financialworld with a statement thatthreatened to bring the fast-growing sukuk market to astandstill.

Mr Usmani, head of thereligious board of the leadingbody that sets standards forIslamic financial products, said85 per cent of sukuk, or sharia-compliant bonds, had broken twokey principles of Islamic law.

He was specifically referring totwo types of bond structures thatbegan to dominate the markettowards the end of 2006. Thesestructures are known as mushar-aka, an Islamic joint partnership,and mudaraba, a form of trustfinancing.

Significantly, between Novem-ber and February not one size-able international, or dollar-denominated, sukuk was issued,suggesting his statement mayhave permanently damaged amarket that has grown dramati-cally since 2002 when the firstIslamic bond was issued by thegovernment of Malaysia.

However, most bankers andlawyers involved in the industrybelieve that the head of the reli-gious board of the Bahrain-basedAccounting and Auditing Organi-sation for Islamic Financial Insti-tutions (AAOIFI) may turn out tohave done the market a bigfavour by clarifying now ratherthan later what bonds are accept-able in the eyes of mainstreamscholars. Mr Usmani also made itclear that his guidance was forfuture reference and would notaffect the existing $80bn of out-standing sukuk.

Danie Marx, managing direc-tor, treasury and capital markets,at the European Islamic Invest-ment Bank, a London-basedIslamic bank, says: “This is apositive development as it pre-vents the market from goingdown a particular avenue that isnot universally perceived to be inthe spirit of sharia.”

Most bankers also believe thestall in growth is mainly becauseof the credit crisis.

Despite the compliance contro-versy and dislocations in the con-ventional financial system,$2.5bn of international Islamicbonds have been issued this year– respectable, even though justhalf that of the same period ayear ago.

In recent weeks, the markethas started to pick up. Two nota-ble issues came from the Bahraingovernment and the Bahrain-based Villamar Sukuk Company.

But, in a sign of the changinglandscape, these two bonds wereijara structures, which Mr Usm-ani had not criticised.

Mr Usmani said the musharakaand mudaraba structures were

breaking the rules because theyoffered investors a repurchaseundertaking where the issuerpromises to pay back the facevalue of the bond when itmatures or in the event of adefault.

This looks like a guaranteedreturn, which goes against thespirit of Islamic finance whereinterest is banned and buyersshould share risk and profit.These financial deals were alsocriticised as they did not always

transfer the assets from the bor-rower to the lender, again raisinga question-mark over who wastaking the risk in the transac-tion.

Ijara structures, which involvea sale and leaseback arrange-

ment, escaped the criticismbecause they use an asset, usu-ally a building, to raise money.

The building is placed in a spe-cial-purpose vehicle by the ownerfor a set amount, say $100m. TheSPV will raise the $100m from

investors to finance a businessproject. The SPV will then leaseback the building to the ownerfor a set monthly fee, which willbe paid to the investors.

As these are lease payments,no interest has been used to fund

SUKUK MARKET

A scholar’s blow tobonds is likely to turnout to be a favour, saysDavid Oakley

the project – in line with sharialaw. As a building does not usu-ally lose its value, the investorsare in effect guaranteed theirprincipal payment at par onmaturity, although no explicitguarantee is made.

In the case of a musharaka,where one partner, usually abank, puts the money into theventure and another, usually acompany, puts in assets, such asa plot of land to be developed,the principal payment on matu-rity is guaranteed at par eventhough the investment may fallbelow face value. This was thepoint objected to by Mr Usmani.

With a mudaraba, where agroup of investors appoints anagent to manage or develop theland or some other project, theprincipal payment is also guaran-teed at par.

Roger Wedderburn-Day, a part-ner at law firm Allen & Overy,says: “The scholars are insistingthat investors should be exposedto the risks associated with theperformance of the underlyingassets forming part of the invest-ment. This means that a pre-de-termined, or guaranteed, pricefor those assets should beavoided and so a balance isstruck between risk and reward.”

The debate started to intensifyonly last year as the musharaka

and mudaraba structures becamemore popular. Before 2005, theonly structure used was the ijara.By the end of 2007, the majorityof outstanding bonds weremudaraba or musharaka.

The rise in use of the mushar-aka and mudaraba structureswas because bankers wantedmore flexible forms of financethat did not rely on an asset orbuilding, which limited issuers tothose with property.

Neil Miller, a partner at lawfirm Norton Rose, says: “On theone hand, there are bankers thatwant to create instruments thathave the character of debt, andon the other hand there arescholars who do not want to seecertain characteristics, such asguaranteed payments, that havecrept into the new structuresbecause the economic paradigmthey seek requires more equita-ble profit and loss sharing.”

So where does this leave themarket?

Jawad Ali, a partner in the lawfirm King & Spalding based inDubai and London, says: “TheIslamic finance and sukuk mar-kets will continue to grow. Thereare over $1,000bn worth of infra-structure projects planned in theGulf over the next decade. A bigportion of these projects will beseeking sharia-compliant fund-ing. I have no doubt the issuessurrounding the sukuk marketwill be dealt with to facilitatefinancing these mega projects.”

‘There are scholarswho do not wantcertain characteristics,such as guaranteedpayments’

UBS sees a strong performance from the the Islamic bank it set up then brought back into the foldUBS, one of the world’s biggest banks, hasnot had a good year. The Swiss bank hasrecorded nearly $20bn in writedowns thisyear and plans to shed 5,500 jobs becauseof the credit crisis.

Yet one area of the bank continues togrow – the Islamic financing arm. Since2002, when it first moved into thisfast­growing arena, the bank has expandedoperations, creating new products andattracting more business, even in the faceof the worst financial crisis for decades.

Idayu Zainuddin, the head of the globalsharia solutions team, says: “We are seeinggrowing interest from investors in Islamicfinance across a range of equities, fixedincome, corporate finance, real estate,private equity, structured products andforeign exchange.”

Catharine Furrer­Lech, chair of the UBSGroup Islamic Finance Committee, adds:“We are able to draw on our strength as aglobal bank to develop and distribute ourproducts through our origination,structuring and marketing teams.

“We are able to develop Islamic productsby leveraging the capabilities of ourdifferent teams across UBS, whether that iswith the commodities agricultural team orthe equity structuring team.”

The bank, which employs 80,000 peopleworldwide, launched Noriba Bank as anIslamic bank in Bahrain in 2002, targetingprivate investors in the Middle East andsouth­east Asia.

In 2006, after four years of stronggrowth, helped by the increasing wealth inthe Middle East on the back of the soaringprice of oil, Noriba was integrated into UBSitself.

Ms Furrer­Lech says: “As our Islamicbusiness gained momentum, we found thatour clients’ needs would be better servedby an in­house team that could take fulladvantage of UBS’s global strength andcapabilities.”

Offices were set up in Dubai, seen as abetter location than Bahrain in the MiddleEast because of its dramatic growth,fast­developing financial services sector andmore appealing lifestyle to westernbankers. Its airport, with connections to themain financial centres around the world,was also a big attraction. The bank’s clientbase and products have evolved rapidlysince 2002.

Today its clients include some of the biginstitutional investors, such as pensionfunds and asset managers, and they arenow drawn from all over the world, not just

from the Middle East and Asia.The bank also helped arrange one of the

biggest international Islamic bond deals ofthe year – a $550m issue ofsharia­compliant exchangeable bonds forKhazanah Nasional, the investment arm ofthe Malaysian government.

Ms Zainuddin says: “The deal highlightedthe strength of demand for Islamic financialproducts. The bond was 13 timesover­subscribed, and was launched andpriced on the same night.”

Products include Islamic cross­borderstructured debt and equity transactions,sharia­compliant leveraged private equity

investments and leveraged real estatetransactions. The bank is creating morecommodity linked products, too, asinvestors want exposure to this boomingasset class.

Ms Furrer­Lech says: “Our Islamicfinance operation has grown and evolvedquite dramatically since 2002, when wefirst started out, in terms of the number ofproducts and services we offer, the regionscovered and the number and type ofinvestors we serve.

“We also increasingly rely on the breadthof our distribution networks and marketingteams around the world as more and moreinstitutional and private investors wantIslamic financial products. Our core team isbased in Dubai, but we can use offices asfar afield as Singapore and New York toserve our clients.”

Ms Zainuddin says: “We are definitelyseeing more and more activity in theIslamic finance space, and we believe thismarket can continue to grow. There aremany more investors who want exposureto Islamic financial products. Islamicfinance remains in a healthy state in spiteof the credit crisis.”

David Oakley

Sheikh Muhammad Taqi Usmani has shone a helpful light on bonds that are acceptable to scholars Bloomberg

MALAYSIA

The IFSB plans totarget key financepeople, writesFarhan Bokhari

office account would be sig-nificantly lower than thoselevied by traditonal banks.

This joint venture betweenNoor and the UAE postoffice is expected to includedebit cards, Islamic insur-ance, credit cards, microfi-nancing, salary payments,remittances and currencyexchange.

The post office and Noorsaid this year: “We under-stand that providing bank-ing services to the low-income segment may not belucrative.”

But the post office Islamicbank concept is set to helpNoor’s profile as an institu-tion willing to offer the typeof services covered by con-ventional banks.

A key challenge for suchconsumer-based expansion isfinding the right talent: it isnot easy to recruit bankerswho are as comfortable withconventional banking asthey are with Islamic con-cepts.

This is a common problemcited by top executives atIslamic banks, who struggleto retain some of their beststaff.

“We are in a situationwhere so much talent ischasing such few people,”says Mr Qemzi.

To ease this situation, heis urging Islamic institutionsto create a variety of humanresource development pro-grammes, including on-the-job training.

He is also proposing thatbanks build links with top-quality academic institu-tions to support research onIslamic banking and finance.

More clients and products

FINANCIAL TIMES THURSDAY JUNE 19 2008 ★ 3

Islamic Finance

Agencies struggle to give investors a frame of quality reference

“A fatwa, just like a rating,is an opinion. Investors areconstrained neither by rat-ings nor by fatwas and makedecisions from their ownperspectives,” says AnouarHassoune, vice-president andsenior credit officer atMoody’s international rat-ings agency in Paris.

The growth of analysisand indices tracking Islamicinstruments by agenciessuch as Moody’s and Stand-ard & Poor’s follows demandfrom Muslims and non-Mus-lims alike.

Many potential and even

current investors areunclear how best to judgethese new Islamic instru-ments, and have welcomedanalysis of their technicalfeatures. But these ratingsagencies make no attempt tojudge the sharia dimension –that aspect is approved by aboard of Islamic scholars.

While global investmentbanks and other institutionscan offer standardisation onthe commercial and techni-cal aspects of Islamicfinance, many differinginterpretations of shariaremain. “Fragmentation is afact of life,” says Mr Has-soune.

The ratings agencies,aided by scholars, have hadto come up with new meth-ods of analysis in the pastcouple of years to help toguide the growing number ofinvestors in Islamic finance.

Alka Banerjee, vice-presi-dent of index services atStandard & Poor’s in NewYork, says: “It was impera-tive that we work with anestablished board of scholarsbecause we don’t have credi-bility in the space of shariacompliance – we were nov-ices. The scrutiny was veryintense.”

Last year, S&P launchedthe GCC Shariah series ofindices – the name refers tothe Gulf Co-operation Coun-cil which groups Bahrain,Kuwait, Oman, Qatar, SaudiArabia and the United ArabEmirates.

The indices were screenedby Ratings Intelligence Part-ners, a Kuwait-based con-sulting company whoseresearchers work with asharia supervisory board.Companies considered non-compliant include those that

deal with alcohol, tobacco,pork, entertainment andfinancial services.

Companies with debt lev-els worth more than one-third of their assets are alsounacceptable.

Ms Banerjee discovered aninteresting statistical fact.No matter the total numberof western stocks in anygroup under consideration,whether 20 or 500, about50-60 per cent were alwaysfound to be Sharia-compli-ant. “It follows a consistentpattern and follows the nor-mal probability curve,” shesays.

However, classifying equi-ties according to sharia prin-ciples is more straightfor-ward than assessing otherinstruments, such as sukuk,or Islamic bonds, andIslamic banks.

“Profit-sharing accounts

found in Islamic financedon’t meet our normal crite-ria so we have adjusted theframework by which wejudge stability,” says PaulCoughlin, S&P executivemanaging director for corpo-

rate and government rat-ings.

Islamic banking bans thepayment of “riba” whichsome interpret as interest.Instead of conventional fixedinterest rates, payments onsukuk derive from the prof-

its of tangible assets. Theycan be structured to delivera fixed annual rate from aprofit-sharing investmentaccount (PSIA).

Moody’s makes a broaddivision in its classificationof sukuk. The first groupbenefits from a guaranteefrom the originator and iscalled asset-based sukuk.

The second group is sukukwithout such an explicitguarantee and is calledasset-backed “to reflect thefact that the most criticalratings factor lies in thecredit quality of the underly-ing assets”, according toMoody’s.

The first type of sukuk hasbeen the subject of contro-versy, with some Islamicscholars saying they adhereto only the letter and not thespirit of Islamic law.

Moody’s discovered an

additional advantage to thesecond type of sukuk. “Oneof the many benefits ofIslamic securitisation trans-actions giving birth tosecured asset-backed Sukukis the ability of the origina-tor to issue sukuk ratedhigher than the originator’s... credit ratings,” the agencysays.

This happened last Julywhen Tamweel, a Dubai-based property finance com-pany, launched the Gulf’sfirst rated Islamic securitisa-tion and transferred legalownership of residentialproperty and associatedfinancing contracts to inves-tors. Moody’s rated thepaper Aa2 while Tamweelitself is rated A3.

Analysts and ratings agen-cies say further growth insecuritisation and moresophisticated financing tools

in the Gulf will need greaterlegal and regulatory clarity.

For example, collateralforeclosure, inherent as arisk in property-backedPSIAs, has yet to be triedand tested in the Gulf wherereal estate has fuelled muchof the growth in sukuk.

The Islamic InternationalRatings Agency in Bahrainconducts analysis of shariacompliance as well as themore usual technical over-sight. “We are the only spe-cialised agency doing this,”says Jamal Zaidi, chief exec-utive officer.

“The sukuk market inMalaysia is developing veryfast and in more depth thanin the Middle East becauseregulatory actions have pro-vided support to the capitalmarkets. Sukuk in Malaysiamust have a rating and thisprovides a level of comfort.”

Scholars andharmony inshort supply

Barely five years ago, fewwestern investment bankerswould have believed thatthey would be following thefatwas or religious rulings ofMuslim scholars, some ofwhom do not use email offax.

But the spectacular rise ofIslamic finance in the pastfew years has left manywestern institutions rushingto acquire the knowledgeand expertise necessary tocompete – with a resultingscramble for skills.

Bankers’ scepticism aboutthe sector is expressed onlyprivately but some Islamicscholars have gone public intheir attacks on banks andthe judgments of other cler-ics.

Many analysts say suchdebate is simply part andparcel of a religion with noclerical hierarchy, and to beexpected in a sector asyoung as Islamic finance.

More of a threat to imme-diate growth is the shortageof skills – from the religiousscholars needed to approvesharia compliance to law-yers, bankers and technicalstaff needed to implementdeals.

Salaries are rising inaccordance with thedemand, say recruitmentconsultants.

There are only about 60Islamic scholars with expertknowledge of finance, whilean even smaller group ofaround 12 are highly sought-after by western institutions.

“The number of interna-tionally accepted scholars isstagnant and there is anacute shortage,” says QudeerLatif, head of Islamic financeat corporate law firm Clif-ford Chance in Dubai. Forone deal, he had to travel tofour countries to meet justone Islamic scholar.

It takes about 15 years totrain in Islamic jurispru-dence and become expert infinance.

But there is a pipeline ofpeople who have startedtraining, says Jamal Dar,an executive at PwC in Lon-don.

Mr Dar says the lack ofIslamic standardisationoffers opportunities for insti-tutions to offer a wide vari-ety of products and instru-ments to suit all levels ofreligious sensibility.

“There is agreement on 90per cent of the sector,” hesays. It gets complicated inthe other 10 per cent withinstruments such as deriva-tives, which affect the cross-border market, not thedomestic market.”

Malaysia is a long-estab-lished Islamic financial cen-tre but has been challengedin recent years by stronggrowth in the Gulf.

The Bahrain-basedAccounting and AuditingOrganisation for IslamicFinancial Institutions (AAO-IFI) is working hard todevelop common, regulatorystandards including shariaand training.

“There are more than 16jurisdictions that follow orconsult our standards,”says Khairul Nizam, assist-ant secretary-general atAAOIFI.

“The standards take into

consideration all the differ-ent Islamic schools ofthought – and there is a lotmore similarity than differ-ence among the schools.”

But AAOIFI standards arenot enforceable, and differ-ent scholars even within thesame jurisdiction are likelyto continue on their ownpaths.

“I’ve looked at AAOIFIand I think the problem isthat, with anything done bya committee, clarity andcrispness is sacrificed in get-ting a consensus,” saysHenry Thompson, legalcounsel at the Bahrain-basedArcapita investment firm.

“It will be hard to havestandardisation becauseeach board of scholars at allthe different firms will beloth to have their rulingsoverturned.”

Another area where AAO-IFI is likely to be ignored isremuneration.

The organisation saidscholars should not acceptcontingency fees and wherepay might depend on a dealgoing ahead as it creates aconflict of interest. Mostscholars, however, receive aset fee and observers say atop scholar can earn up to$250,000 on a typical capitalmarkets deal.

Another organisationstriving for standardisationis the Central Bank of Bah-rain, which examines regula-tion such as bank adequacyrules to ensure stability.

“We were the first todevelop such regulations

and we have been promotingthem worldwide,” says Kha-lid Hamad, an executivedirector at the Central Bankof Bahrain.

The International IslamicFinance Market (IIFM), alsoin Bahrain, is working onregulation of Islamic capitaland money markets in co-operation with the Interna-tional Capital Market Associ-ation.

“There is a generationalissue when it comes tostandardisation, with someolder people not feeling com-fortable giving judgment oncomplicated instruments,”says Ijlal Alavi, IIFM chiefexecutive.

Many analysts hope therewill be greater consensus onstandards as the sectormatures.

“The scholars have madegreat strides in recent yearsin establishing rules whichhave seen the developmentof mainstream products,such as profit-bearing depos-its, mortgage loans andother investment vehicles,”says Salim Nathoo, head ofIslamic finance for legal firmAllen & Overy.

“Selection of reputablescholars who command therespect of the market is criti-cal in developing some ofthese newer products.”

Covering risk puts a premium on growth

The development of theIslamic insurance market isat a crossroads. Many biginternational companieshave piled into Islamicinsurance over the past fewyears. But according toArthur White, partner atOliver Wyman, companiesthat have entered theIslamic insurance sector faceseveral challenges in orderto advance their businessesto the next stage of develop-ment.

“Big international compa-nies have now decidedwhether they want to be inthis market or out of it.Many of the big names haveestablished footholds. Thereal question now is how dothey make it work,” says MrWhite.

Sameer Abdi, partner incharge of Islamic financialservices at Ernst & Young,agrees: “International insur-

ance companies are cominginto this market becausethey see a huge potential forgrowth, but success will bepredicated on a number ofcritical factors such as mar-ket acceptance and scale.”

The reason internationalinsurers have flocked to thismarket is the potential forexpansion. The market forinsurance that complies withIslamic law, or takaful, isforecast to increase substan-tially over the next decade.

According to Moody’s, glo-bal takaful premiums couldrise from $2bn in 2005 to$7.4bn in 2015.

Ernst & Young estimatesthat global takaful premi-ums could reach $4.3bn in2010 excluding Iran, andalmost $15bn including Iran.

Much of the takaful mar-ket is focused on the coun-tries of the Middle East,where historically there hasbeen a low level of insurancepenetration. Malaysia alsohas a mature takaful mar-ket.

But according to SimonHarris, team managingdirector of European insur-ance at Moody’s, as people inGulf countries and otherMuslim nations grow richerand accumulate more assets,

they are increasing theextent to which they areinsured.

Takaful is expected to playa significant role in thesecountries. In the MiddleEast, E&Y points out,demand is high for financialproducts that comply withIslamic law. And some coun-tries, such as Saudi Arabia,are encouraging individualsto protect themselves bybuying insurance.

Indeed, the potential of theinsurance market in MiddleEastern countries is under-lined by the fact that about40 companies – includingmany big internationalnames, often in a joint ven-ture with a local partner –have applied to the SaudiArabian Monetary Agencyfor licences to sell insuranceunder a new regime. Underthese rules, insurers must beincorporated in Saudi Arabiaand listed on the Riyadhstock exchange.

They must also operateunder a co-operative model,whereby profits generatedfrom policyholders areshared with them, usuallyby granting them a discountwhen they come to renewtheir policies.

Saudi Arabia is particu-

larly attractive to insurersbecause of a combination oflow insurance take-up so far,high levels of economicgrowth and an expandingmiddle class. In addition, alaw requires most expatriateworkers to have health andthird-party motor liabilityinsurance.

While the Middle Eastoffers the potential forstrong growth, even morespectacular expansion could

come from offering takafulproducts to Muslims outsidethe region – and even to non-Muslims. Indeed, PrincipleInsurance, the first pureIslamic insurer in the UK,recently received authorisa-tion from the Financial Serv-ices Authority.

According to MohammadKhan, a director in PwC’sactuarial and insurancemanagement solutions prac-

tice, there are about 20mMuslims in Europe. Sellingtakaful insurance to theUK’s 2m Muslims would be asubstantial market in itself.

“If you can sell it as anethical product and pricecompetitively, your marketis far far greater,” says MrKhan.

“This is a terrific opportu-nity to sell a price-competi-tive ethical product to every-one. You have to market itcorrectly, but if I walk intothe supermarket, and I go tothe organic counter, I payfar more for my organiccheese than for my conven-tional cheese.

“Here, you have a productthat is ethically invested,gives you a share of the sur-plus if the company makes aprofit, has an independentbody confirming that thecompany is acting in theright way, and your motorinsurance premium is goingto be roughly the same.”

But the takaful insurancemarket is not without itschallenges.

Mr White says insurersmust decide which kind ofmodel to use to share profits.Options include the Wakalamodel, similar to a mutualwhere the operator takes

fees for service, and theMudharaba model, a profit-share arrangement betweenpolicyholders and operator.

Similarly, insurers need todecide which type of Islamiclaw they are to comply with:the Malaysian version,which is well-established butviewed as more lenient, orstricter interpretations fromSaudi Arabia or Qatar.

Other challenges in theMiddle East include how pol-icies are distributed to cus-tomers and how to deal withteething problems associatedwith a rapidly expandinginformation technologyinfrastructure.

With the takaful marketexpanding rapidly in theMiddle East, PwC’s Mr Khansays another challenge isrecruiting sufficient skilledstaff.

”Traditionally, insurancehas not been at the cuttingedge of attracting talent inthe region,” he says.

To ensure that companiesstay ahead, they will need toprice their products appro-priately, develop and distrib-ute innovative products, andmanage claims properly.

All this, says Mr Khan,“requires staff with talentand experience”.

INSURANCE

The companies thathave piled into thissector face a bigchallenge, saysAndrea Felsted

Propertyprice growthspurs rise ininstruments

Nakheel, the Dubai gov-ernment-owned propertydeveloper, might be mak-ing a splash in an arcane

area of Islamic finance after havingdefied nature to create palm-shaped islands off the UnitedArabe Emirates coast.

Nakheel wants to raiseDrh1.36bn ($1bn) for housing andinfrastructure projects via an ini-tial public offering of two realestate investment trusts (Reits).

These instruments have yet totake off in the Gulf Islamic financesector but are tipped as the nextbig thing as more institutionsexamine ways of managing andcapitalising on the recent realestate boom while abiding byIslamic restrictions.

Analysts say Reits are perfectlysuited to Islamic finance becausethey are based on underlying, tan-gible assets, such as rent on realestate, not on speculation.

“Reits have not yet taken off butit’s a question of when,” saysQudeer Latif, head of Islamicfinance at corporate law firm Clif-ford Chance in Dubai. “Real estategrowth in the last three years hasbeen phenomenal and there arelots of banks who have very highexposure to real estate assets.”

Hedging such exposure can bedifficult because sharia scholarsdiffer on whether derivatives arepermissible.

A Reit is a listed property com-pany that usually does not pay taxon its earnings as long as these aremostly distributed to investors inthe form of dividends.

“There’s a lot of demand in the

market for Islamic solutions,” saysJamal Dar, an executive at PwC inLondon. “It’s dependent on the leg-islative environment in theregion.”

Malaysia, a long-establishedIslamic financial centre, severalyears ago listed the first IslamicReits, which included hospitalsand palm oil estates as assets.

The Dubai International Finan-cial Centre, the free zone opened in2004 to attract institutions fromaround the world, is also hoping tocreate a Reit sector following arevamped regulatory framework.

“We’ve seen a number of Reits injurisdictions with a fairly maturereal estate market [such as Malay-sia]. They aren’t just limited tobuildings and they can be anythingtangible with an income stream –estates, plantations, even a powerplant with an off-take by a govern-ment entity,” says Nik Thani, exec-utive director of Islamic finance atthe DIFC.

“As long as there’s steady cash-flow, and the cashflow is notderived from interest-basedincome, anything can be mone-tised. And while sukuk [Islamicbonds] are for institutional inves-tors, Reits can be retailed to every-one thereby providing wider accesstowards investing in Islamicinvestment products.”

Institutions operating in theDIFC are regulated by the DubaiFinancial Services Authority,whose rules contain “hidden gems,particularly for Islamic finance”,that have yet to be utilised, saysMr Thani.

But Reits still need anotherimportant foundation stone – clearand concise property laws and, inparticular, land registration rules.In Dubai, for example, companiesoperating outside the DIFC’s freezone are subject to the regular civillegal framework, which is in theprocess of being adapted to keepup with the fast-paced economy.

“This makes sense for Dubaibecause there are a lot of massiveprojects here that are not currentlymonetised but are income-produc-ing,” says Mr Thani.

An updated legal and regulatory

framework is needed to boost secu-ritisation in general, not just Reits.Legal issues relating to bank-ruptcy, insolvency and ownershipneed to be clarified before inves-tors gain confidence.

The growth of Islamic securitisa-

tion also has been hampered byinvestor caution following thecredit crunch in the US. But manyanalysts believe the crisis serves tohighlight the benefits of Islamicfinance and its requirement to belinked to tangible assets.

Securitisation would allow inves-tors to buy bonds directly tied tomortgages, auto loans and otherincome-producing assets as long asthey comply with the Islamic banon trading debt and lending oninterest.

A report released in April byinternational credit ratings agencyMoody’s said the future structur-ing of sukuk was likely to moveincreasingly towards sharia-com-pliant securitisation and secured“asset-backed” transactions.

“Thanks to the slow but constantdevelopment of securitisation andcredit repacking in emerging Mus-

lim countries, asset-backed sukuk,with no explicit guarantee fromasset originators, should continueto gain market share but alsoremain dependent on the dynamicsof the global credit markets, espe-cially in securitisation,” said theMoody’s report Islamic Banks andSukuk: Growing Fast but Frag-mented.

Gulf Islamic financial activity isexpected to remain tied to the for-tunes of real estate, and analystssee property booming for at leastthe next couple of years.

“There will probably be a slow-down in the rate of growth of realestate because it can’t be 15-20 percent every year,” says Mr Latif.“But there probably won’t be acrash given the fact that govern-ments are behind so much of theactivity. From a political perspec-tive, they can’t allow it to fail.”

REAL ESTATE

Companies are lookingfor ways to capitalise onsurging prices, saysSharmila Devi

Shored up: Gulf Islamic financial activity is expected to remain linked to real estate AP

‘There are a lot ofmassive projects herethat are not currentlymonetised but areincome­producing’

EXPERTS

Sharmila Devifinds opportunitiesin the lack ofstandardisation

RATINGS

Regulators alsoneed to play theirpart, saysSharmila Devi

The sukuk marketin Malaysia isdeveloping veryfast and in moredepth than inthe Middle East’

‘This is a terrificopportunity to sella price­competitiveethical product toeveryone’

‘The number ofinternationallyaccepted scholarsis stagnant’

Qudeer LatifHead of Islamic finance,

Clifford Chance, Dubai

4 ★ FINANCIAL TIMES THURSDAY JUNE 19 2008

FINANCIAL TIMES THURSDAY JUNE 19 2008 ★ 5

6 ★ FINANCIAL TIMES THURSDAY JUNE 19 2008

Islamic Finance

The nextfrontier

The recent development ofIslamic derivative productsis making it possible forsharia-compliant finance toaddress risk-management.

From its modestbeginnings in the mid-1970sas a local, specialisedproduct, Islamic bankinghas grown into a globallyrecognised alternative. Ithas amassed assets of morethan $900bn and achievedgrowth rates far outpacingthe conventional market.

The past decade has seensignificant developments,with rapid growth in thenumber of Islamic financialinstitutions and expansionin product offerings andgeographic footprint.

Governments fromMalaysia and Pakistan tothe UK have introducedregulations that allowIslamic banks to operate onequal terms withconventional institutions inthese jurisdictions.

An example of this is thetradable sukuk – it providesliquidity, improveddisclosure via a regulatedrating process, and allowedissuers more flexibility inraising long-term capital atfloating rates, as well asenabling market-basedpricing of Islamic assets.

Meanwhile, the Islamicproduct investor base hasexpanded from local banksto global banks, privatebank customers, assetmanagers and, increasingly,private investors. This hasallowed issuers theopportunity to tap into newsources of capital andincrease investment andinnovation in products.

Islamic finance houses inmany jurisdictions nowdeliver complete retail,corporate and indeedinvestment bankingservices.

While the development inthe primary Islamic financemarket has been rapid,sharia-compliant riskmanagement for Islamicindustries has evolved at aslower pace.

The rate of change is nowaccelerating, for threereasons.

First, as Islamic industrybecomes part of national,regional and internationaleconomies, it is exposed tothe same vagaries of amarket-based economy. Thismeans Islamic financialinstitutions must have thetools to manage this risk.

Second, customers areincreasingly demanding

end-to-end solutions in asharia-compliant manner,rather than going to theIslamic industry only forcapital-raising.

Third, as Islamic financialinstitutions expand outsidetheir national borders toparticipate in some of thefastest-growing economiesof the world, they needmore sophisticated tools tomanage the associated risksof diversified portfolios andglobal customer servicing.

While derivatives mayseem out of line with a banon profit throughspeculative means, hedgingto mitigate risk or fixingthe cost of production isallowed.

These types of Islamicderivatives may provideanswers to many of theindustry’s risk needs andtherefore are beingaggressively pursued as akey risk-management tool.They should also improvethe revenues of the Islamic

banks, as they enable themto offer customers a broaderrange of services.

It would help maximisethe potential of theseproducts if standarddocumentation existed forIslamic hedging products -–and banks are working withglobal industry bodies tothis end.

Further ahead, Islamichedging solutions shouldenable the industry toexpand into such areas asasset management, privateequity, principal financeactivities and commodityfinance.

In a couple of years’ time,I believe that we will lookback on today as a rapidperiod of innovation in theIslamic finance industrymarking a milestone in itsdevelopment and its impactacross the world.

Afaq Khan is chief executiveof Standard CharteredSaadiq

Guest ColumnAFAQ KHAN

‘Islamic derivativesmay provideanswers to many ofthe industry’s riskneeds’

Afaq KhanStandard Chartered Saadiq

UK leads in sowingseeds for a sector

One Friday night in2006, London’sfinancial tradersshunned the flashy

wine bars for a room fur-nished with white cloths anddevoid of alcohol.

The City was hosting aceremony to break the Mus-lim fast of Ramadan. Part ofMansion House, usually usedfor meetings with financeministers, had been con-verted to a prayer room forthe night.

The event was widelyinterpreted as a sign of Lon-don’s eagerness to establishitself as a hub of Islamicfinance. This aim had beenexplicitly stated by the then

chancellor, Gordon Brown,who had that year spoken ofhis ambition to make the UK“the global centre” for thesector.

Almost two years on fromthat speech, the City is wellon the way to becoming athriving centre for Islamicfinance. There are fourlicensed wholesale Islamicbanks – the only ones in theEU – and 21 conventionalbanks offering Islamic serv-ices. London’s newestIslamic bank, Gatehouse,received its licence in lateApril. Principle Insurance,the first independent com-pany fully compliant withIslamic law in the UK,launched at the start of May.

The London StockExchange has admitted 16sukuk, or sharia-compliantbonds, to its markets, raising£5.5bn. The UAE companyTabreed issued the first LSE-listed sukuk, for £109m, inJuly 2006. The Kingdom ofBahrain registered the firstsovereign sukuk in London,

for £176m, this March.“If you want to talk to

anyone about Islamicfinance, and you’re not inthe Middle East or Far East,you come to London,” saysHumphrey Percy, head ofBank of London and theMiddle East, which waslicensed last year.

“It has the right timezone

for dealing with Asia andthe Middle East, a huge tal-ent pool, and a concentra-tion of diverse markets – thestock exchange, futures,metal, oil. Also, the govern-ment and the Bank of Eng-land have supported Islamicfinance.”

The UK government hasbeen introducing legislationto nurture Islamic financesince 2003. Sharia, or Islamiclaw, forbids interest on thegrounds that money shouldmeasure rather than createvalue. An Islamic invest-ment thus often uses severalpurchases and sales to cre-ate a comparable increase.

During the past five years,finance acts have containedlaws that try to ensure thatSharia-compliant transac-tions are not exposed to mul-tiple stamp duty or ineligiblefor the tax breaks granted tocertain kinds of interest inthe UK.

The government gives tworeasons for its zeal: to aidthe integration of Britain’s2m Muslims, and to main-tain London’s position as aglobal business centre.

“This isn’t just an altruis-tic gesture [for Musliminvestors],” says RichardThomas, who chairs the gov-ernment’s advisory board onIslamic finance. “This is a

way of keeping the City atthe forefront,

“This area is growing rap-idly and these new banksdraw activity to the UK.That money could go to Bah-rain, but we would like it tocome to London.”

Islamic banking assetshave been growing at a rateof just under 20 per cent,according to Moody’s, therating agency. The sectorstill accounts for just 1 percent of global bankingassets.

London has so far had lit-tle competition to becomethe west’s centre for Islamicfinance. New York, the onlypossible contender, struggleswith its timezone andremains ambivalent aboutthe sector after the Septem-ber 2001 terrorist attacks.

“US politicians still con-fuse Islamic finance with ter-rorist finance,” says Moham-med Amin, who overseesIslamic finance projects atPwC.

Meanwhile, in Asia, coun-tries such as Japan, HongKong and Indonesia havestarted to show an interestin the sector.

But the UK still has workto do. Some sharia-complianttransactions are more heav-ily stung by value-added taxthan conventional equiva-lents, but this area of legisla-

tion is EU-wide and difficultto modify.

City executives are alsocalling for the UK to issuesovereign sukuk as an alter-native to government bonds– it is thought this step willbe announced in next year’sfinance act.

The UK cannot yet boastan Islamic finance sector assophisticated as that ofMalaysia or Bahrain, oftenconsidered leaders in thefield. But it has madeimpressive progress in a fewyears.

As David Testa, head ofGatehouse, said when thebank received its Britishlicence: “What with theproblems of Northern Rockand the crackdown on non-doms [non-domiciled foreign-ers], this really is one areawhere the City got it right.”

LONDON

ShyamanthaAsokan says theCity has stolen amarch on many ofits global rivals

‘This isn’t analtruistic gesture.This is a way ofkeeping the City atthe forefront’

End of Ramadan in central London: the financial centre has also hosted its own ceremony Getty