Islamic banking and finance has clearly found its home in the Gulf. The region leads the industry by housing two thirds of global assets, worth roughly $350 billion. Also, the world’s leading Islamic financial institutions are all headquartered in the Gulf states and they routinely export their business model to Asia, Europe and Africa. Ninety percent of incremental retail-banking production in Saudi Arabia is Islamic, but Bahrain acts as the regional hub for Islamic finance. This is largely because the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) is based in Manama.

However, despite Bahrain’s role as a hub for Islamic finance, with 28 Islamic banks based in the island state, the market share for Islamic banks in the country is only 7%, according to a recent report by Moody’s. The other surprise in the study is that Oman is a Gulf state with no Islamic banks.

A closer examination of the regional sharia-compliant scene reveals that the largest Islamic commercial bank by total assets is Saudi Arabia’s Al Rajhi Bank, with more than $28 billion in assets. Second in line comes the historic Kuwait Finance House at $21.8 billion, followed by Dubai Islamic bank with $17.5 million.

Future Trends

It will be important to watch Noor Islamic Bank, based in Dubai. Started as a project of Sheikh Mohammed bin Rashid al Maktoum, Noor’s ultimate goal is to become the largest Islamic bank in the world. It only recently launched with ten branches in the UAE and intends to follow an Emirates Airlines model in order to solidify the market base, including a significant focus on customer service and innovative products.

When asked when Noor will break into the regional banking scene, a senior official at the bank remarked that this is confidential, but added: “I can say that whenever we are feeling very strong in the UAE, then we will look to the outside.” Considering who is backing the project, this will probably not take very long and one can expect an aggressive, regional Noor very soon.

Another bank to watch is the Abu Dhabi Islamic Bank, the second largest Islamic bank in the Emirates. ADIB recently entered the Egyptian market with the purchase of a 51% stake in Egypt’s National Bank for Development for $28 million. This was a bold move considering the poor reception Islamic banking is receiving in Egypt at the moment. Five years ago, a ruling by Mohammed al-Tantawi, one of Egypt’s highest-ranking Islamic scholars, essentially permitted earning a fixed amount of capital on an invested principle, largely seen as allowing interest. The move has been a large contributor to the crippled pace of development of Islamic finance in the country.

However, despite the current poor climate, the potential for Islamic banking in Egypt is huge, and one should expect more moves from Abu Dhabi Islamic Bank into Egypt, possibly in the form of a buyout.

A recent Middle East Business Intelligence report said it best, when it opined, “If Abu Dhabi Islamic Bank can make a success of offering Islamic products, the whole market will open up. We have already seen some of the local banks start to advertise their Islamic products in view of the competition for customers they see about to begin.”

Clearly Islamic banks in the Gulf are already anticipating the day when their home markets are saturated. And it appears that Egypt will be on the next front-line in the development of regional Islamic banking and finance.

The Islamic banking sector’s phenomenal growth in recent years has not been universally welcomed. Among some powerful and influential circles in the West, particularly the United States, there is an assumed association between the increased financial capacity of sharia-compliant financial institutions — with the roughly $500 billion in wealth currently under sharia-compliant management expected to grow to $2.8 trillion by 2015 — and an increased ability for those who follow radical interpretations of Islam to fund terrorist operations.

In April 2008 the Center for Security Policy (CSP) — a Washington, D.C. based organization describing itself as specializing in identifying policies, actions, and resources “vital to American security” — launched a national campaign to counter what the group describes as the “serious risks” sharia-compliant finance poses for US financial institutions “and the national security of the United States of America.” In CSP literature its President, Frank Gaffney, warned that “US financial institutions and businesses engaged in sharia-compliant finance may have criminal and civil exposure on the grounds of securities fraud, consumer fraud, racketeering, antitrust violations, material support for terrorism and aiding and abetting sedition.”

Among CSP directors, advisers and staff are R. James Woolsey, former head of the CIA, former and current congressmen and senators, high-level staffers at the White House, the Defense Department and Congress and numerous other US government departments, while during the past several months CSP said it briefed the U.S. Treasury, members of Congress, the Securities and Exchange Commission, law enforcement personnel and others on its legal memorandum regarding sharia-compliant finance.

Analyzing the risk

Is sharia financing such a threat to West? Are mechanisms within the Islamic banking system any more at risk of being used to finance terrorism than conventional banking methods?        

“The easiest way in which a terrorist group can move funds around is through the conventional banking system,” said Ganesh Sahathevan. The Australia-based counter-terrorism financing expert has researched extensively the support structures of terrorist groups in Southeast Asia and their links to Jihadist networks globally, and explained that services conventional banks have developed to better serve customers — correspondence banking, internet banking, Automated Teller Machines (ATM) able to access funds through worldwide banking networks, etc. — are conveniences that make the work of terrorism financiers easier as well.

He pointed to the example of Saudi millionaire Yassin al-Qadi, who Sahathevan has been tracking for several years and who is also a “Specially Designated Global Terrorist,” according to the U.S. Treasury, for his financing of al-Qaeda and other extremist Islamic groups.

“Two companies within his group — a futures trading company and a stock broking company — had wire arrangements with Clearstream Banking of Luxembourg,” explained Sahathevan. “There’s no evidence that money had been transferred, but had Yassin al-Qadi wanted to transfer money through to anyone in any part of the world, he could have easily used these two entities, and no one would have known because no one would have been looking.”

Another example he gave is of Malaysian-owned MBF Bank located in Tonga — a tiny South Pacific island — with only two known overseas branches in Rangoon, Myanmar (Burma) and Pyongyang, North Korea. MBF Bank also happens to have a correspondence banking arrangement with Bank of Wachovia in the US. “So it becomes extremely easy for someone in Pyongyang or Myanmar to circumvent all sanctions — deposit the money in Myanmar, and through Tonga, it gets transfer to the banking system in mainland US. And who would know? It would be simply lost in the daily transactions.”

Where Islamic banks may have a greater propensity for facilitating the financing of terrorist groups comes at the level of ownership, said Sahathevan, as “an Islamic bank is more often than not owned by Muslim shareholders who have a desire to promote Islamic banking as a form of Dawa [the prorogation and promotion of Islam].” And among those who believe in the promotion of the Islamic way, there are some for whom this may also include Jihadist leanings, “so then a bank in the ownership of shareholders who already have that inclination, it becomes an obvious tool through which to move funds through the international banking system [for terrorism financing].”

According to Jean-Charles Brisard, an international expert on terrorism financing, a characteristic unique to Islamic banking often cited as a means used to finance international terrorist operations is zakat. He described it in a report prepared for the UN Security Council as “a legal alms-giving required as one of the five pillars of Islam on current assets and other income… [and] takes three forms, depending on its recipients: feesabeelillah (in the way of Allah), lil Fuqara (for the poor) and lil Masakeen (for the needy).”

The first form of zakat — feesabeelillah — is money spent in fighting for the cause of God (jihad), where jihad can mean struggling for personal purification (i.e. becoming a better Muslim), social betterment, or armed struggle — i.e. “Holy war” — actual physical combat waged in self defense or in fighting oppression.

“There is a clear distinction between the Koran’s concept of a defensive Jihad and the usurped form of offensive Jihad developed by several scholars [mostly followers of the Wahabbism doctrine of Islam]… justifying zakat for un-legitimate violence against peaceful nations,” noted Brisard.   

Zakat past to present

Before Islamic banking, zakat would typically have been collected by the local imam or mosque, said Sahathevan. Given their localized base, these amounts of money remained relatively limited, and would typically be used towards local projects such as schools or orphanages, though small amounts could have ended up supporting violent Jihad.

“Once you have a banking system feeding into zakat, then it becomes quite different, because there you’re talking of a very large sums of money… feeding into zakat, and then the zakat can be distributed by that very same banking network,” explained Sahathevan, pointing out that once the money leaves the banking system through distribution to charities — which can then distribute it to other charities both locally and internationally — it becomes nearly impossible to trace. Should money originally earmarked for buying Qur’ans or building religious schools in Pakistan be diverted once it arrives to an al-Qaeda training camp across the border in Afghanistan, no one would be the wiser.

In Saudi Arabia alone, where zakat is enforced by law and levied much like a general taxation across the entire economy, figures from the early 2000s estimated total zakat funds even then at $10 billion annually. While the vast majority of this was undoubtedly spent in benevolent pursuits, it takes only an extremely small percentage of $10 billion to fund a major terrorist organization, as Brisard estimated pre-9/11 al-Qaeda revenue at $50 million annually — of which, interestingly enough, 90% was spent on organizational infrastructure, such as communication, networks, training facilities and protection, while only 10% was spent on operations, such as day-to-day money, terrorists attacks planning and execution.   

According to the US Department of State, since the 9/11 terrorist attacks American authorities have initiated a broad range of measures to counter terrorism financing including: designating some 400 individuals as “linked to terrorism” and freezing their US-based assets, passing counter-terrorism financing legislation at home and prompting the UN to adopt the Convention for the Suppression of the Financing of Terrorism; pushing the Financial Action Task Force (FATF), an inter-governmental body consisting of 32 countries, the European Commission and the Gulf Cooperation Council to expand and revise its mandate to

include counter-terrorism financing, while pushing for the formation of the Middle East and North Africa Financial Action Task Force (MENA-FATF) in 2005 — consisting of the 320-member Union of Arab Banks and governments across the Arab world.

By many accounts however these efforts, among others, have done staggeringly little to stem the flow of funds to terrorist groups.

“It is continuing unabated,” said Sahathevan. “No doubt people are more aware of it, there’s more discussion about it, more regulations, and certainly there have been some convictions in some places… but by and large it continues unabated.”

Lax regulation

Brisard said that the “MENA-FATF initiative has proven efficient in identifying the legal and structural weaknesses in the fight against terrorism financing. But many countries… still lack proper regulations and tools, as recently pointed out by the FATF.” He noted a number of Gulf countries have not ratified the UN anti-terrorism financing convention, while other 87 countries still had not criminalized terrorism financing by the end of 2007.

In particular Brisard named  Kuwait, Pakistan and Saudi Arabia as countries that “have failed to take legal action to prevent the misuse of charitable and other nonprofit entities that can be used as conduits for the financing of terrorism, while weak implementation of regulations is a cause of concern as to the potential for the financing of terrorism through the misuse of charities.” An example of this Brisard pointed to is the Saudi High Commission for Charities, announced in 2002 to oversee Saudi charities with foreign operations, yet six years on it is still to be formally established.

“At the same time, countries such as the UAE, have taken several important regulatory and conventional steps with the banking sector that obviously go in the right direction,” he adds.

Among the other difficulties in cracking down on terrorism financiers is the ability they have developed, especially in the case of al-Qaeda, to make and move money through legitimate, recognized financial institutions and businesses to fund illegal activities. This largely distinguishes terrorism financing from money laundering, where money is made through illegal means, then moved through businesses and financial institutions — both legitimate and fraudulent — to make the money appear “clean” for use in the normal economy.

And perhaps therein lies part of the reactionism motivating groups like the CSP against sharia-compliant financing and Islamic banking: not only have the huge amounts of resources poured into counter-terrorism financing efforts since 9/11 been relatively ineffective, but terrorist networks are showing incredible aptitude at using the same capitalist structures America and the West were build on to fund Jihad against the West.  

“By integrating themselves into the Western financial structure, proponents of this doctrine can essentially shield from regulatory mechanisms the transfer of millions of dollars in zakat, or charity payments, from wealthy Middle Eastern radicals to violent and/or subversive organizations in Europe and the United States,” wrote the CSP November 2007 in literature from it’s Sharia Risk Project. The CSP followed that statement with one that highlighted what may be the fear at the group’s core: “Advocates of sharia’s financing believe that they may have found an indirect way to begin imposing their obscurantist code upon the free peoples of the world.”

Assets managed within Islamic banking and finance are massive and growing rapidly in both monetary and geographic terms. In Sudan, Saudi Arabia, Iran and Malaysia, Islamic banking is the premier form of financial transaction. The industry also has a niche presence in the rest of the MENA region and many other countries around the world are toying with the idea of sharia-compliant banking.

On a technical level, analysts often separate the sector into four separate segments: commercial Islamic banks, investment Islamic banks, takaful institutions and Islamic finance houses.

But Abdel-Maoula Chaar, the Islamic finance project manager at the Beirut-based Ecole Supérieure des Affaires, applies what he considers a more important dichotomy. Chaar believes it is more helpful to view the industry in terms of “Islamic banks versus sharia-compliant banks.” He suggested that Islamic banks, like Dubai Islamic bank, have a moral underpinning to their operations. Banks of this nature tend to hold all of their products and actions under the microscope of sharia.

On the other side of the equation are sharia-compliant banks. Most of the time the big Western banks with Islamic windows, like Citi Islamic and HSBC’s Amanah, receive the attention in that category. Nevertheless, this group also includes conventional banks based in Arab countries, like the Arab Bank for Investment and Foreign Trade (ARBIFT). ARBIFT was established in 1976 as a joint venture between the federal government of the United Arab Emirates, the Libyan Arab Foreign Bank and Banque Exterieure d’Algerie. Reflecting the era in which it was born, the bank initially had a strong Arab unity character and the establishment stressed promoting the collective ownership of Arab capital funds in the international financial markets. This has, however, recently begun to change.

Just this year ARBIFT changed its name to Al Masraf. Furthermore, the bank has been steadily increasing the number of Islamic financial products it offers with an eye to capturing part of the growing Islamic finance market. According to Saeed Khan, Head of Corporate Banking at Al Masraf, the bank started offering sharia-compliant products in 2006 as “we had to cater to our customer’s needs. Our clients in the emirates were asking for Islamic products.”

He added that “the launch of Islamic products has yet to touch the corporate sector and that within the retail division Islamic products represent just five percent of the portfolio.” It seems that the most popular type of Islamic product at Al Masraf is murabaha. When compared to the counterpart conventional car loan offered by the bank, the products are almost identical. The repayment period is flexible up to 72 months, no down payment is required and there are no processing fees.

When one compares the cost, however, discrepancies appear. The conventional car loan interest rates start at 2.99%, while the profit rates for the vehicle murabaha start at 4.25%. The 1.26% difference in cost is significant when tacked on to the sticker price of a new car. Perhaps this factor is keeping interest in the bank’s new Islamic products low.

Khan said the existence of conventional, interest-earning products next to the newly established Islamic ones does not bother the bank’s customers. Khan said that his customers have “no concerns over the presence of both products,” and that this is normal in many banks in the region. Furthermore, he implied that the bank’s sharia-compliant offerings would only grow, saying that “Islamic finance is the future of banking” in the region.

Regulation

The Islamic banking and finance industry is predominantly regulated on the national level. In addition to the in-house sharia supervisory boards present in most Islamic financial institutions, those entities are also obliged to follow the standards set by the advisory board of their respective national central bank. The industry, and its strongest central bank supporters, have also recognized the importance of international regulation and have formed two strong self-regulatory bodies: the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) and the Islamic Financial Services Board (IFSB).

According to a handbook published by the Securities and Investment Institute, based in London, “AAOIFI is the autonomous entity responsible for the formulation and issuance of accounting, auditing, ethics, governance and sharia standards for the international Islamic banking and finance industry.” Despite the overarching and unifying image accorded to AAOIFI, the organization itself recently fell pray to the ubiquitous growing pains of the Islamic finance world.

Late last year, Sheikh Muhammad Taqi Usmani, chairperson of AAOIFI’s advisory board, declared 85% of sukuk to be un-Islamic. The specifics of the statement were not immediately clarified, throwing Islamic investors and institutions into a panic. After three months of debate, the organization issued a statement saying that any financial product with a buyback clause was un-Islamic because this effectively eliminated the risk-sharing aspect of the investment, a necessary part of sharia compliance.

The advisory board also declared that, in order to be considered Islamic, sukuk must be asset-backed, and not merely asset-based. This development will make things difficult for CFOs, as they will be forced to adapt to new structures. Under the new ruling it appears that those original 85% of sukuk are still un-Islamic and it is likely that the market will now bifurcate under the pressure of the ruling, with half of the investors adopting new asset-backed products, while the other half pursues new structures. The organization has taken a lot of heat for the ruling and AAOIFI’s leadership is reticent on the topic.

In an interview with Executive, Dr. Khairul Nizam, AAOIFI’s Assistant Secretary General, was quick to note that the standards of the body are five-fold: accounting, auditing, governance, ethics and sharia standards. Nizam stated, our “sharia standards have been adopted by most of the world’s Islamic financial centers. And in fact, all Islamic banks in the world follow our sharia standards.”

However, when asked about the AAOIFI ruling that would effectively make 85% of sukuk un-Islamic, Nizam took a different tack, saying that, “Although our standards are used by almost all of the banks around the world, each bank also has its own sharia supervisory board and has to decide for itself. And this may vary as different products are designed for different markets… We are part of the finance industry and we have to work with that industry.”

Given the massive amounts of capital at stake and the relative youth of the industry, more sukuk-style episodes are likely in the future. It is also likely that regulatory authorities will come under immense pressure to make the ‘right decision’ when it comes to controversial products.

All this is bound to make the future developments of Islamic financial product regulation a challenging and exciting process.

Abroad overview of the Islamic financial world shows that the phenomenon truly is global. From its humble beginnings in the Middle East of the 1950s, the sector has grown into a $500 billion industry, with $350 billion invested in the region itself. Furthermore, the Islamic finance sector in South Asia has broken the $100 billion mark and the infant Western markets are already worth a combined $30 billion. Around the world, there are over 300 Islamic financial institutions in more than 50 countries.

Industry overview

A breakdown of Islamic financial assets at the end of 2006 shows exactly how that capital is distributed. Roughly half of all capital managed under sharia rules resides on the balance sheets of Islamic financial institutions.

The next largest segment, at 40%, is placed at the Islamic windows of conventional banks, like Citi Islamic, HSBC Amanah and others. Sukuk not managed by banks check in at 6.9%, while takaful accounts for just one percent of the total. Although the takaful market is expected to grow, lack of emphasis on long-term planning in the Arab world has largely ham-strung the industry.

On the other hand, the sukuk market has been growing at a phenomenal pace and by 2007, global volumes had reached $97.3 billion, with the majority originating from Malaysia and states in the Persian Gulf. In a recent study, Moody’s noted that overall issuance volume of sukuk increased by 71% to $32.65 billion in 2007 within the Europe, Middle East, Africa (EMEA) region. The largest proportion of sukuk was issued in the financial services sector, accounting for 31% of total volume, followed by real estate with 25% and power and utilities with 12%.

While the sukuk market is growing rapidly, not all is well. Recently a dust-up over sharia compliance had the Islamic finance world’s main regulator, the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), claim that 85% of sukuk were un-Islamic. (See the Industry segment for more on this regulatory issue). The incident has prompted sharia scholars and Muslim investors alike to reexamine the basics of Islamic finance.

In this context, it is useful to consider some of the defining features of Islamic finance to better understand the markets. Of course, the most visible feature of Islamic finance is the prohibition on interest.

However, “the Islamic ban on interest does not mean that capital is costless in an Islamic system,” said Ghassan Chammas, an Islamic finance business consultant. “Islam recognizes capital as a factor of production but it does not allow it to make a prior or pre-determined claim… in the form of interest.”

Breakdown of Islamic financial assets at YE2006

Pillars of Islamic finance

Certainly, this prohibition on interest gets the most play in today’s mainstream media, but this is just one of the five distinguishing features of Islamic finance. In order for an investment to be sharia-compliant it should also be multi-purpose and not merely commercial. The idea is to remember that God and society are more important than the bottom line. One can think of it as built-in corporate social responsibility.

Furthermore, financial transactions should involve the sharing of risk. Any deal that is guaranteed to make a profit is unacceptable and falls into the same category as interest. Also, uncertain transactions are not allowed, meaning that goods for sale or the details of a contract must be clearly and completely understood before the transaction takes place.

Finally, sharia-compliant investments must not sponsor haram, un-Islamic, activities. This includes things like the armament industry, pork products, alcohol and the entertainment industry like gambling and nightclubs.

This final prohibition complicates due diligence procedures for Islamic funds, as every element of the fund must be investigated for sharia compliance by a sharia supervisory board.

Despite this inconvenience for funds, and the growing pains in the sukuk market, strong growth for both products is expected to continue for the near future. The sukuk market alone is expected to hit $100 billion by the end of this year.

Risk management is at the heart of banks’ financial intermediation process and has assumed utmost importance at a time when complexity and volatility in financial markets have become both differentiating factors building competitive advantages and sources of risk entanglement. Basel II and widespread write-downs have highlighted the importance of sufficient capital adequacy and, more importantly, set a framework for improving the overall risk management architecture in banks.

Islamic financial institutions (IFIs) are no exception. Similar to conventional financial institutions, they face many challenges in adequately defining, identifying, measuring, selecting, pricing and mitigating risks across business lines and asset classes. A number of specific financial risks at IFIs deserve closer examination. IFIs also face a series of non-financial risks, including sharia compliance, reputation, perception, and human resource risks, which are outside the scope of the following discussion, but equally important.

Risk entanglement within IFIs’ asset classes

In IFIs’ portfolios, it is often challenging to distinguish between risk categories. It is generally difficult to distinguish between the market and credit risks attached to a financial transaction abiding by the rules of sharia. In a large number of contracts, risk categories of a different nature are entangled. For example, in an ijara (lease) contract, the IFI buys an asset that is subsequently leased or rented to a customer against periodic rental payments. The IFI remains the owner of the leased asset throughout the duration of the lease contract, leaving the bank exposed to the residual value of the asset. The management of leased assets’ residual value is a feature that differs materially from credit risk management and assumes access to reliable market data as to asset-price volatility and behavior across business cycles, all the more so as IFIs tend to run a portfolio of asset inventories. Inventory management is another aspect that separates IFIs, from a risk management perspective, from their conventional peers.

Such constraints attached to the status of IFIs as sellers and buyers of tangible goods also have risk-mitigating benefits. In Islamic finance, any financial transaction should be backed by a tangible, identifiable underlying asset. This is a powerful way for the IFI to secure strong access to collateral. IFIs naturally have a high level of collateralization on their credit portfolios, and thus are in a position to somewhat reduce their exposures at default. This is helpful for sector diversification in credit, and somewhat mitigates IFIs’ concentration risks by name and geography.

IFIs evolving in balance-sheet management

Investment allocation and liquidity management continue to vex IFIs’ balance-sheet managers. The limited scope of eligible asset classes for IFIs increases concentration in investment portfolios, which is mitigated by a lower appetite for speculative transactions. Financial Islam forbids gharar (uncertainty) and maysir (speculation). Therefore, IFIs are naturally crowded out from the high-risk/high-return leveraged and/or structured investment asset classes. As such instruments tend to be based either on riba (interest) or derivatives, their technical eligibility is in most cases difficult to justify. IFIs thus limit the scope of their investment strategies to plain vanilla asset classes such as stocks, sukuk and real estate. A limited range of permissible asset allocations leads to concentration risks in IFIs’ investment portfolios, by asset class, legal sector and also usually by name.

Liquidity management is far from being an easy task for IFIs. There is still a great shortage of liquid instruments. Typically, Islamic banks would place their excess cash reserves into short-term interbank murabahas, at a cost compared to conventional banks. Indeed, short-term murabahas make it necessary for commodity brokers to be involved, triggering higher transactional costs for managing liquidity. IFIs are subject to the constant trade-off between profitability and liquidity in a binary way. IFIs at this stage of the development of the Islamic financial industry barely have an alternative: profitable but highly illiquid asset classes; or highly liquid short-term murabahas with investment-grade banks, but at a cost. In the future, as the industry matures, margins might come under pressure and the trade-off between liquidity and profitability might lead to an increase in IFIs’ risk appetite.

A limited range of possible funding sources leads to concentrated liabilities, imbalanced funding mixes and stretched capital management strategies

IFIs’ wholesale liabilities tend to be concentrated. IFIs are generally well entrenched in retail banking, which gives them access to a large pool of relatively cheap deposits, when these are not in the form of Profit-Sharing Investment Accounts (PSIAs).

Apart from retail accounts, which are in most cases both granular and stable across business cycles, IFIs also resort to wholesale creditors for funding. So far, sukuk have not served as the main term funding source. Instead, IFIs typically fund bank and non-bank customers, who tend to be price sensitive, relatively unstable and concentrated.

IFIs’ funding continuums remain imbalanced. Between deposits in their various forms and Tier 1 capital, IFIs have so far had access to a limited number of alternative funding sources. Only very few subordinated sukuk have been issued so far. Bank securitization, other Tier 2 instruments, Tier 3 short-term debt to cover the regulatory capital charge of market risk, as well as plain vanilla and innovative hybrid capital notes are inexistent in the Islamic financial industry. One of the reasons behind such a vacuum lies in the fact that a number of sharia supervisory boards have been uncomfortable so far with the concept of subordination.

Therefore, IFIs’ capital management strategies tend to be stretched. Allocation of economic capital to business units is barely applied. Capital allocation tends to be inefficient at this stage, although this is not disadvantageous as capitalization ratios are high and capital is not scarce in the geographies where IFIs are most active (typically in the Gulf region).

In the future, lower net returns directed towards more demanding shareholders could put pressure on IFIs’ capital positions. Funding would therefore attract less core equity and more alternative refinancing vehicles such as sukuk (including subordinated, convertible and exchangeable sukuk), hybrid instruments, securitization techniques, and various classes of PSIAs.

How specific should ALM be at IFIs?

Controlling margin rates is at the heart of IFIs’ ALM. Similar to interest-rate risk management at conventional bank, IFIs must manage maturity gaps and asset-liability profit-rate imbalances. However, unlike conventional banks, the charge attached to funding costs is supposed to be a function of asset yields, as per the core principle of profit sharing underlying Islamic banking and finance, which is at the heart of PSIAs.

Should there be no smoothing of returns to PSIA-holders, those IFIs that resort materially to PSIAs for funding would in theory be less profitable than conventional banks when the interest or profit-rate cycle is at its peak, because when conventional banks would face a predetermined cost of funds, IFIs would, on the contrary, be in such a position as to share more returns with the holders of PSIAs.

As well there is the fact that in some cases the opposite scenario would also be true: when the interest — or profit-rate cycle trends down towards its trough — IFIs would buffer the decline by distributing less profit to PSIA-holders, whereas conventional banks would have to absorb the same cost of funds at a time when net asset yields had shrunk, therefore reducing more substantially their margins.

Therefore, “displaced commercial risk” is always at stake, giving birth to various mechanisms of smoothing returns. “Displaced commercial risk” (DCR) is a term reflecting the risk of liquidity suddenly drying up as a consequence of massive withdrawals should the IFI’s assets yield returns for PSIA-holders lower than expected. Managing DCR efficiently, by smoothing returns, is a subtle, dynamic exercise.

Traditionally, there are three lines of defense against DCR. Investment risk reserves (IRRs) and the bank’s mudarib fee tend to absorb expected losses; profit equalization reserves (PERs) are used to cover unexpected losses of manageable magnitude. IRRs come as a deduction from the asset portfolio, in the same way that loan-loss reserves are deducted from conventional banks’ loan books. Reducing mudarib fees to protect returns to PSIA-holders remains a management decision.

In case asset yields deteriorate beyond levels absorbable by IRRs, the IFI’s management team, in line with the board’s formal approval, could reduce management mudarib fees ex post.

Finally, PERs are built based on the excess return to PSIA-holders in periods where assets have performed better than expected, and are subsequently distributed to depositors when the cycle reverses.

Anouar Hassoune is the Vice President – Senior Credit Officer of Moody’s France SAS

Islamic finance is becoming an increasingly attractive sector and financial players are seeking to take advantage of its development. The value of assets regulated by sharia principles has reached $500 billion and is expected to exceed $1 trillion by 2010. When compared to the $74 trillion of assets accumulated by the 1,000 top international banks, this number may seem insignificant. Yet, its implications are extremely important. It is indeed a significant indicator that Islamic finance is at a turning point. It is reaching a critical mass and changing from just a “niche market” to a main component of finance. This trend is reinforced by the phenomenal growth rate the field has been experiencing. Experts are talking about a yearly increase of 20-25% or even greater. Whatever the actual number is, it remains above the 11% average growth rate of the conventional financial sector. Furthermore, there are no signs indicating a slow down in the growth in the short term, on the contrary.

More than 78 new Islamic banks were created within the past three years. Competition is growing fiercer between two types of Islamic financial institutions: the sharia-compliant organizations and the sharia-based institutions. The former are usually Islamic windows, branches or subsidiaries used by conventional financial entities as an entry door to the Islamic market while the latter are fully fledged Islamic Banks. Both types of companies have the same purpose: offer their clients sharia-compliant financial products. To reach their goal, Islamic finance institutions apply a series of specific rules that insure the conformity of their operations to the fundamentals of sharia. They nominate a sharia supervision board that ensures that these regulations are respected and ascertains the sharia compliancy of the firm’s operations. Sharia-compliant institutions restrict their “Islamic” activity to these operational aspects and sharia has no further impact on the other activities of the organization. In fact, there is an evident decoupling between the bank’s main operations and its Islamic ones. On the other hand, in sharia-based institutions, the entity as a whole is in conformity with the sharia and all operations, on all levels, are sharia-compliant.

Furthermore, sharia can have a significant impact on the strategic behavior of these banks in that it can directly constrain some of their strategic options. Islamic finance institutions are limited to ‘halal’ (permitted) transactions. In fact, Sharia enacts a strategic environment where some elements of the ‘objective’ reality do not fit. This situation can be exemplified by the screening process used to choose the halal stocks an Islamic portfolio can integrate. The halal investment universe is therefore reduced from thousands of company stocks, used in conventional portfolios, to only hundreds that can be used in Islamic ones. Islamic financial institutions, of both types, are subject to these restrictions and the difference in their strategic behavior, if any, resides in the purpose underlying their activities.

Islamic banking and finance are often considered as a marketing tool or a subset of conventional finance in the case of sharia-compliant institutions. This is mainly the result of the strategic decision of conventional banks to open Islamic windows or branches that tap into the pool of wealth governed by sharia. In this respect, the sharia-compliant institutions are required to seek the main objective of the headquarters (conventional bank), i.e. the maximization of the shareholders’ return on investment.

It is important to note that this strategic objective creates tension between the actions of these institutions and the purpose of sharia. Indeed, the ethics of Islamic finance do not recognize the supremacy of individual interests according to the basic belief that man is a caretaker trusted by God to manage its creation. As such, man is meant to apply a set of moral guidances to ensure that the interests of all stakeholders are safeguarded.

The divergence between these stakeholder and shareholder approaches explains why most specialists consider that using Islamic rules in financial activities is banking under sharia constraints. The key word in this sentence is “constraints”, implying that there is a desired state of affairs that could not be reached due to a number of limitations. Within such a mindset, the strategist tries to get as close as possible to that desired state without breaching the restrictions imposed by the sharia. Consequently, sharia is considered as a constraining set of rules and guidelines. Institutions applying this view tend to mimic conventional finance operations and benchmark their performance on their conventional counterparts.

This is the case for sharia-compliant institutions designed to maximize stockholder return by mimicking conventional banks operations. It is surprising to see that it is also true for a number of sharia-based banks despite the fact that they fall in the core of Islamic financial ethics. This situation leaves the latter banks in a delicate strategic situation.

Islamic banks find themselves confronting, indirectly, conventional banks on their own territory despite the apparent disadvantage in resources. Banks such as UBS, Barclays Bank, BNP Paribas, Citigroup or HSBC have their own Islamic finance delivery vehicles and hold around $2 trillion of assets each. On the other hand, the total assets owned by the top 20 Islamic banks do not attain one quarter of that value — $338 billion to be exact. When institutions face such an intense competitive pressure from their opponent, they generally choose to apply a differentiation strategy. It allows them to avoid the confrontation by creating limited domains of operations where they can outperform their competitors. A number of Islamic banks opt for this kind of strategy but their actions have limited potential since they are based on the stockholder maximizing approach, ‘rule of the game’ of their opponent.

In fact, the real differentiation strategy would be a complete shift of the mindset replacing the “sharia as constrained” approach with an “enabling” vision of the role of sharia. This view would enlarge the scope of the sharia and its guiding principles making it possible to include a wider public other than Muslim communities and may result in an inversion of the strategic equation. Instead of being placid and defensive when facing the Islamic finance strategies of conventional banks, Islamic banks would have the possibility to be more active by looking for new markets in the realm of conventional finance.

Some banks have already begun to explore this approach. When it ‘Islamized’ its operations, a well-known bank in the GCC decided to create ethical products (sharia-compliant), to serve its non-Muslim clients given that the demand for ethical and socially responsible products is increasing worldwide.

Abdel-Maoula Chaar is Islamic Finance Projects  Manager at Ecole Supérieure des Affaires, Beirut

Global Islamic finance is growing at a fantastic rate with over half a trillion dollars currently under management. Conservative estimates put the growth rate at 20%, while more optimistic estimates set it at almost 30%. Wealth under management by Islamic financial institutions is expected to skyrocket over the coming years as the world’s 1.3 billion Muslims become increasingly well-off. It is anticipated that by 2015 the sector will be worth $2.8 trillion.

A big part of that wealth is coming in the form of petro-dollars, which have saturated the Gulf with liquidity over the past few years. That wealth, in turn, needs to be invested and Islamic financial products are rapidly becoming a popular option. But with Islam’s thirteen-hundred-year-old history, why is Islamic banking just now starting to make the headlines?

Historical perspective: product development

Beginning of the Islamic bank

The answer to that question is long and complicated, but to start it is useful to take a brief glance at the history of Islamic banking. For over 1,000 years the concept of Islamic banking remained rigidly fixed to the form it had held when the faith was in its formative years. Due in part to its prohibition on riba (usually translated as interest), Islamic banking was largely seen as incompatible with contemporary conventional banking methods. By the early to mid-twentieth century, however, attitudes were starting to change and small experiments with Islamic banking were taking places in countries like India, Malaysia and Pakistan.

But the first real Islamic bank worth mentioning got it start in Egypt. Ahmad al-Najjar was a young Egyptian graduate student in West Germany in the 1950s when the concept of an Islamic bank for Egypt’s poor, rural population first came to him. Inspired by the major role local savings banks played in West Germany’s reconstruction after World War II, al-Najjar became convinced that a similar scheme organized along Islamic lines could help to boost Egypt’s economy.

So al-Najjar returned home and launched his project in the tiny Nile delta town of Mit Ghamr in 1961. Although the Mit Ghamr Savings Bank fizzled after an initially modest success, the concept of Islamic banking had been born.

Islamic banking took on its contemporary form just over a decade later, in 1975, when the Islamic Development Bank (IDB) was established by the members of the Organization of the Islamic Conference. And although the Mit Ghamr Savings Bank had followed sharia (Islamic law) guidelines, it was in fact the IDB that was the world’s first purpose-built Islamic bank. In the same year, the Dubai Islamic Bank was founded. Just two years later the Faisal Islamic Bank in Sudan and the Kuwait Finance House were inaugurated.

Global Development in IBF

Expanding product base

The trend continued over the years with the launching of new Islamic banks and creation of new Islamic financial products. In terms of products, Islamic banking in the 1970s was rather limited and only the simplest services were available. The most basic of these is murabaha. This Islamic method of finance is defined as ‘cost plus financing’. Murabaha refers to contracts in which a bank purchases goods upon the request of a client, who then makes deferred payment that covers cost and an agreed upon profit margin for the bank.

In the 1980s, the hot item was takaful, Islam’s answer to conventional insurance. The 1990s saw the rise of Islamic equities and the sukuk market (the Islamic bond market now worth over $120 billion). Islamic scholars are still breaking new ground deep into the present decade with sharia-compliant structured alternative assets.

Islamic banking and finance continues to grow geographically as well. Malaysia has rapidly become a leader in terms of product development and London is now a major international Islamic financial center. With the West’s financial markets in disarray after the subprime crisis in the US and the collapse of the UK’s Northern Rock, it is very likely that interest in Islamic finance will continue to grow on the international scene.