Egyptian Coptic Christian community banks like the high quality of service. In Malaysia, the good rates of return appeal to Chinese businessmen. And in Europe the socially aware may find the ethical credentials attractive. Islamic banking’s appeal is indeed as broad, if not broader, than that of secular commercial banking. Atif Abdulmalik is typical of the new breed of dynamic, innovative manager that is transforming Islamic banking. Abdulmalik, chief executive of First Islamic investment Bank, jets between such cities as Houston and the bank’s modern headquarters in Bahrain’s capital selling the bank aggressively.
In the past four years, he has helped stretch the boundaries of Islamic investment significantly. Now Gulf nationals can invest in private equity in the US. This has been deemed acceptable under the Sharia (Islamic) code of law since it involves holding physical assets.
Abdulmalik is tweaking the tail of Investcorp, a long-established and highly successful conventional firm that specializes in finding international private-equity investment from the Gulf for deals in Europe and the US. Abdulmalik and several senior executives left Investcorp in 1997 when First Islamic was set up. Their ability to tap this new market so quickly – First Islamic has nine ventures in the US to the value of $800 million and has already exited successfully from two projects – shows the enormous versatility of the business.
Islamic banking has grown from nothing to a $200 billion industry in little more than a decade. Adnan Al-Bahar, chief executive-elect of the newly merged Albaraka&The International Investor, says: “There are millions of customers in 75 countries and in some states it has a 30% market share. With annual growth of 15% it is outstripping the growth in conventional markets. In the face of globalization, consolidation and fierce competition, many Islamic banks now rank among the top three in their markets.”
Abu Dhabi Islamic Bank (ADIB), which is strong in the retail sector, is growing at 5% a month and now ranks at 12 among the UAE’s 47 banks.
Though the largest demand for Islamic finance comes from the Arab world, only 20% of the population presently use this type of banking. Already the world’s leading traditional banks, including Citibank, HSBC, BNP Paribas, and locally based institutions such as Arab Banking Corporation (ABC), have launched Islamic offshoots.
The development of new products has enabled Islamic banks to offer competitive rates. One banker says that “20 years ago those using Islamic banks just wanted somewhere to place their money and showed little concern about how much it earned. Today the younger generation of sophisticated investors wants to see a decent rate of return while keeping close to their Islamic principles.”
The new target is middle-class investors and high-net-worth individuals. “In the 1970s, Islamic banking was a concept and in the 1990s it became a business. It has thrived where there has been a large educated middle class,” says Iqbal Khan, chief executive of Amanah Finance, HSBC’s Islamic division.
Work in progress
But the sector is in danger of becoming a victim of its own success. Despite the growth spurt, the regulatory and accounting standards have yet to be standardized and the quality of management is patchy. Moreover there is not the range of financial instruments to meet the growing demands for short-term liquidity.
“There are shortcomings because our industry is in its infancy. We have developed products but our customers need more. Because of our growth the sector does not have enough trained staff,” says one Islamic banker.
One of the grimmest episodes in the sector came when Dubai Islamic Bank collapsed in 1998 after a multi-million dollar fraud. The Dubai authorities had to bail it out. There is a recognition that the industry now has no excuse for amateurism.
“All Islamic banks have to adopt international standards of management. They should not live off the spiritual side of the faith. They have to be transparent and operate to the best international standards – neither their shareholders nor their customers will accept anything less,” says a senior local banker.
But how do you define the tenets of Islamic banking? There are deep divisions between scholars and between regulators as to what exactly is acceptable for a banking system or specific products on offer, particularly on the fundamental question of whether interest can be levied and paid.
There are some jurisdictions, such as Iran and Pakistan, that are officially exclusively Islamic but where banks operate effectively as conventional banks. In Egypt the Islamic authorities have ruled that reasonable interest charges are acceptable.
Saudi Arabia remains ambivalent because recognition of the concept might imply acknowledgement that the rest of the banking system is non-Islamic. As a result, many Saudi investors have put their money into institutions in Bahrain, which has pioneered the development of the sector and tried to introduce uniform standards and structures.
Clear fundamentals
The founding principle is comparatively clear – Islam forbids usury, interpreted by scholars as the payment or receipt of interest. Investment is not allowed in specified industries, including armaments and alcohol, and in companies that have too high a level of borrowing.
But the interpretation of these rules is left to the Sharia courts of individual banks and their conclusions are frequently incompatible. For example, disagreement over what exactly is Islamically acceptable (halal) means that Bahraini and Malaysian Islamic banks do not trade with each other – Malaysian banks want to see more securitization but Bahraini Sharia courts say that it is not compatible with Islam.
Some conventional bankers argue that the entire concept is flawed and that behind it interest in effect exists. They point out that the management costs charged as an alternative to interest charges tend to rise and fall in line with what is happening in these markets. They say that the sale and repurchase of a commodity with a management fee cannot disguise the reality that it is usury by another name.
According to one western banker based in the Gulf: “If Islamic banking really was going to take off, it would have done so before now. When it comes down to it most Arab investors are content to take the higher returns available on offer from most conventional banking.”
That, though, is a minority view in the region. Islamic bankers counter that it is up to Sharia courts and individuals to decide whether transactions fit in with their religious principles and whether the rates of return are acceptable. However, they do accept there is a need for more widely applied standards.
At the recent World Islamic Banking Conference in Bahrain, a succession of speakers called for the creation of more universal standards. Bankers said that uniformity was essential if the Islamic sector was to gain any credibility. On idea is that the final decision should rest with one supreme Sharia court.
Few expect this to happen for some years. But some progress is being made. One important development is the expected creation of an Islamic Financial Services Organisation, comprising the central banks of south-east Asian, Middle East and north African states – the bases of most Islamic banks. Their task is to define common standards of measuring risk so it is possible to define prudential standards on capital adequacy, while maintaining standards on the 200 or more Islamic banks and financial institutions.
“There will be no question of lowering the standard of regulation. Both conventional and Islamic banks are subject to the same rigorous regulatory standards,” says Shaikh Ahmed bin Mohammed Al Khalifa, governor of the Bahrain Monetary Agency.
A key role in this process is being played by the Bahrain-based Accounting and Auditing Association for Islamic Financial Institutions (AAOIFI). This has already introduced accounting standards for the banks and has now produced five standards and four rules to define the basic Islamic contracts, an area formerly the preserve of Sharia courts.
At present various banks have adopted several clearly defined business strategies. First there are the international and regional banks. Citibank, for example, has set up totally independent Islamic institutions, arguing that this is the only way to ensure that conventional and Islamic funds have appropriate cultures.
Citibank’s offshoot, called CitiIslamic, based in Bahrain, has arranged a six-month oil financing facility and broke new ground by carrying out the first syndicated Islamic transaction. That deal, for the British subsidiary of a Korean company, was used to import oil from Saudi Arabia.
Others, such as HSBC, have opted for creating a division of the main bank. “You have to have a structure where you do not compete with the parent bank for business,” says Amanah Finance’s Khan. Meanwhile, HSBC is introducing a debit card and home loan package for Muslim customers in the US.
Saudi British Bank, in which HSBC has a minority stake, is launching an Islamic mortgage scheme in Saudi Arabia, a radical step because a way must be found round the problem of repossession when borrowers are in default. Islamic courts are very reluctant to allow lenders to repossess.
Some conventional Arab banks have also started to offer Islamic services. Saudi Arabia’s National Commercial Bank (NCB), for example, has chosen to do so through separate Islamic branches rather than windows in its existing branches. “We think it is important to keep the two operations entirely separate,” says Abdulrazak Elkhraijy, head of Islamic banking at NCB.
Another distinct group consists of large specialist Islamic retail banks, such as Al Raji Banking and Investment Corporation of Saudi Arabia, Abu Dhabi Islamic Bank and Bank Islam Malaysia. These banks are also looking at mortgage business and are expanding debit-card activities – conventional credit cards are not Sharia-compliant. Several banks, though, are launching cards that levy charges according to Sharia standards.
One significant development has been mergers that have for the first time created Islamic conglomerates by merging retail and investment institutions. The most recent was the link up between Albaraka and The International Investor to create a new institution with assets in excess of $3 billion and total equity of $350 million. A year earlier Shamil Bank of Bahrain was created by the merger of Faysal Bank of Bahrain and the Islamic Investment Company of the Gulf.
More consolidation may be on the way.
Developing new products
The main task for all these banks in the next five years will be to develop instruments to ensure short-term liquidity and develop investable instruments that will deliver comparable rates of return to those available in traditional markets.
There is little that can be done about profitability as the banks have to match short liabilities with assets. Traditionally money is placed through western banks into the London Metal Exchange to ensure that the funds are asset-backed. The banks only pay a return comparable to the London interbank market, which has to be set against a higher administrative cost.
The issue of short-term liquidity will eventually be resolved as more Islamically compatible products are developed. The BMA has led the way in the last year by issuing the first leasing (Ijara) securities and has begun to issue $25 million a month of Islamically structured short-term government bills. “Bahrain is also moving ahead with another pioneering project to establish a liquidity management company, which will create an international Islamic financial market to help provide short-term liquidity,” says Shaikh Ahmed.
Islamic bankers accept the need to develop more products but significant progress has been made in recent years to increase equity investment; until five years there were major doubts about whether it was Islamically acceptable.
There are strict rules. Investment in companies with core activities linked for example to alcohol, pork, insurance, gambling, tobacco, pornography and the arms trade are excluded. So too are conventional banks, which means most of the listings on the financial-sector dominated Arab stock exchanges.
Companies with a high debt to equity ratio are also excluded. Some leeway is allowed through dividend cleansing, where companies have a limited involvement in banned products – the dividend paid out from the shares of airlines that serve alcohol, for example, would be reduced, with the balance given to charity.
Islamic indices
A number of companies, including Kuwait’s TII, provide a growing body of information on shares that are Islamically acceptable, and the major development in the past year has been to establish Islamic indices that offer benchmarks for investors. Dow Jones has set up an Islamic market index of 600 stocks and FTSE International has put together a similar index in conjunction with TII.
The restrictions on investment have had several consequences. First, the exclusion of so many sectors meant that some funds became overexposed to information technology and internet shares. However, the block on investing in highly geared companies means that Islamic funds tend to do better in periods of slow economic growth when the emphasis is on finding stable, well-established companies to invest in.
Today there are several dozen equity funds, including global, market-neutral, emerging markets and leasing. Successful funds in recent years have included the Al Dar Islamic European Equities Fund, which has regularly outperformed the sector index. In the United States, there are a number of funds, including the Wafra-BBH Dow Jones Islamic Market Index Fund.
One of the first Arab institutions to get involved in fund management was NCB, which says it now has the largest Islamic funds. “We have an equity fund of just less than $1 billion as well as the largest commodity fund of SR8.8 billion [$7.7 billion],” says Elkhraijy.
It is evident that Islamic banking faces major challenges if it is to continue to modernize. Central bankers and senior bankers agree that there is no alternative to agreeing international reporting and accounting standards that can be properly enforced.
The prize is great. There are 1.2 billion Muslims ready to invest, so long as they can make a decent return.
Bahrain sets the pace
Bahrain is the capital of Islamic banking. There are already 18 banks, attracted by the sympathetic regulation, the presence of specialist auditing, training and rating organizations and measures by the Bahrain Monetary Agency (BMA) to make markets deeper and more liquid.
Bahrain is heavily involved in the establishment of the Islamic Financial Services Organization, which enables central banks to develop uniform prudential regulations and in the creation of the Islamic Financial Market (IFM). Bahrain’s role in this latter project is to set up a $50 million liquidity management company, which is intended to help Islamic banks find new sources of short-term liquidity.
The BMA has also pioneered a series of new short-term Sharia-compliant financial instruments, designed to fill a gap in the investment opportunities open to Islamic institutions.
“These new instrument will straddle the gap between secular finance and religious beliefs in an ethical way, providing Muslim investors with wider investment opportunities,” says BMA governor Shaikh Ahmed bin Mohammed Al Khalifa.
The first of these instruments is the Al Salam Sukuk (Islamic short-term securities), which is a monthly $25 million programme of three-month bills. With redemptions this will raise $75 million a year. Al Salam is essentially a transaction where two parties agree to carry out the sale and purchase of an underlying asset at a future date but at a price determined and fully paid for immediately.
The BMA’s contract is based on the sale and purchase of aluminium. The Bahrain government sells aluminium to the buyer with the Bahrain Islamic Bank (BIB) nominated to represent the other participating banks. The government agrees to sell a specified amount of aluminium at a certain date with the buyer appointing the government to market the aluminium. The government also offers an undertaking to market the aluminium at a price offering the banks a level of return equivalent to other short-term money-market instruments.
Medium-term and long-term investment opportunities for Islamic banks have also been limited. A second innovation by the BMA was a leasing contract (Ijara) with bond-like characteristics, through which the government of Bahrain raised $100 million with a “rental” return of 5.25%. The issue, which was open to all commercial banks and Islamic institutions, was fully subscribed.
Ijara is a method of finance where securities are issued in the capital market to develop identified long-term infrastructure projects, maintaining the principle of linkage to a specific asset.
Rental payments are guaranteed by the government, providing security and returns, and because the underlying assets are tangible and secured the instruments can be traded on the secondary market.
Key organizations based in Bahrain include:
The Accounting and Auditing Organization for Islamic Financial Institutions This sets Islamic accounting standards that are gaining influence across the industry and has also started to define Islamic trading contracts. It liaises with international organizations including the International Accounting Standards Association, the Basle Committee and the Financial Services Authority in the UK.
The International Islamic Ratings Agency This has been established to rate Islamic financial institutions. “It is designed to promote confidence for both investors and regulators in their dealings with Islamic institutions and investments,” says the BMA’s Shaikh Ahmed.
The General Council for Islamic Banks and Financial Institutions This provides information about the Islamic banking industry
Definitions of Islamic banking terms
Types of Islamic contract include:
Istisna: a contract to acquire goods with the price paid gradually as the work is completed.
Murabaha: a form of cost plus financing.
Mudarabha: trust financing, where one party provides all the capital, has no control over the management of the project and bears all the risk while the other party manages the project.
Musharaka: the most flexible arrangement, where both parties provide capital, share profits on a pre-agreed ratio and split losses on the basis of equity participation.
