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Islamic Banking and Finance

Islamic Banking and Finance

By

Mondher Bellalah

Islamic Banking and Finance, by Mondher Bellalah

This book first published 2013

Cambridge Scholars Publishing

12 Back Chapman Street, Newcastle upon Tyne, NE6 2XX, UK

British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library

Copyright © 2013 by Mondher Bellalah

All rights for this book reserved. No part of this book may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or

otherwise, without the prior permission of the copyright owner.

ISBN (10): 1-4438-4770-4, ISBN (13): 978-1-4438-4770-4

It is with a considerable sense of pride and honour that I dedicate this book to the “Yasmine revolte” of the young people of the Tunisian Republic. This book is written to improve understanding about Islamic economics and the international Islamic community, and to convey the importance of both particularly during these days of crisis. I am delighted to note the unique efforts of the Tunisian Ministry of Higher Education and Scientific Research to enhance Islamic studies; these efforts are expansive and cover all fields of Islamic studies, including economics.

TABLE OF CONTENTS Preface ......................................................................................................... x Adnan Ahmed Yousif, President and CEO of Albaraka Banking Group, Chairman of the Board of Directors, Union of Arab Banks Introduction ............................................................................................... xii Chapter One ................................................................................................. 1 Introduction to Islamic Finance and Islamic Banking: From Theory to Innovations

Section 1: From a Conceptual Idea to an Evolving and Fast Growing Reality

Section 2: An Overview on the Framework of Islamic Finance and Banking13

Section 3: Islamic Financial Contracts and Products Conclusion: On the Challenges and Issues of Structuring Innovative

Shariah Compliant Products Chapter Two .............................................................................................. 71 Productivity Growth in the GCC Banking Industry 1999–2007: Conventional Versus Islamic Banks

Section 1. Introduction Section 2. Revue of Literature Section 3. Methodology Section 4. Data and Variables Section 5. Empirical Results and Analysis Conclusion

Chapter Three .......................................................................................... 109 An Analysis for the Growth and Rise of Smaller Islamic Banks in the Last Decade

Section 1. Introduction Section 2. Literature Review Section 3. Islamic Banking: an Overview Section 4. Methodology Section 5. Empirical Analysis Conclusions

Table of Contents viii

Chapter Four ............................................................................................ 126 Development and Scope of Islamic Bank Bonds (Sukuks)

Section 1. Introduction Section 2. Aims and Objectives Section 3. Cases of Non-Muslim Sukuk Issuers and Investors Section 4. Britain and Islamic finance Section 5. Islamic Home Financing Section 6. Methodology Section 7. Results Section 8.Discussion Conclusion Recommendations

Chapter Five ............................................................................................ 159 Iran’s Islamic Banking Experience and Future

Section 1. Introduction Section 2. The Islamic Banking Law—Did the Banking System

Implement It? Conclusion

Chapter Six .............................................................................................. 169 Islamic Banking Structure and Growth in the Sudanese Islamic Banking Sector

Section 1. Introduction Section 2. Sudanese Banking Industry Section 3. Research Methodology Section 4. Data Analysis and Findings Conclusion

Chapter Seven .......................................................................................... 196 Islamic Mortgages

Section 1. Introduction Section 2. Major Principles of Islamic Finance Section 3. The Islamic Mortgage Market in UK Section 4. Empirical Analysis Conclusion

Islamic Banking and Finance ix

Chapter Eight ........................................................................................... 221 Role of Islamic Mortgages in the UK

Section 1. Introduction Section 2. Uk Sharia-compliant Market Analysis Section 3. Islamic Modes of Financing Section 4. The Growth of Islamic Financial Instittions Section 5. Comparison between Islamic and Conventional Mortgages Conclusion

Chapter Nine ............................................................................................ 244 The “Islamic Bank of Britain”: Case Study Analysis

Section 1. Introduction Section 2. Objectives of thе Study Section 3. Islamic Banking in the United Kingdom Section 4. The Islamic Bank of Britain Section 5. Methodology Section 6. Results and Analysis Section 7. Author Findings Summary and Conclusions Recommendations

Chapter Ten ............................................................................................. 261 Growth of Islamic Banking and Employee Satisfaction in Bangladesh

Section 1. Introduction Section 2. Aims and Objectives Section 3. Literature Review for Bangladesh Section 4. Methodology Conclusions Policy and Recommendation

PREFACE Islamic banking has seen rapid growth during the last two decades. There are many contributory factors for such growth, most notable of which are the liberalisation of financial regulation; the globalisation of financial markets; changes in technology; product innovation; the birth of several new Islamic states; and the growing Islamic presence in the West. Product innovations have helped economists and religious scholars to bring new products to almost all areas of banking and insurance, some of which were previously thought to be extremely controversial. There is no accurate data on the extent and volume of Islamic banking. Islamic banking assets are currently estimated at being between USD 500 and 800 Billion, and there are nearly three hundred Islamic Financial Institutions worldwide, including “Islamic windows” of conventional banks. The Islamic sukuk, (equivalent to bonds in Western finance) are the fastest growing product on the financial market, and the sukuk market has increased at an average annual rate of 40 per cent, with a current size of more than USD 82 billion. In Pakistan and Malaysia, Sharia-compliant funds have exceeded over 50% of total market capitalization. Today, Islamic banking is growing at approximately 15% per annum, as a result of economic expansion in the Islamic world, fuelled primarily by oil wealth. This growth has created a expanding middle-wealth segment and hence made banking a necessary service to a larger segment of the population rather than a service for a minority, as had been the case for the preceding ten to fifteen year period. The Islamic banking system is popular with not only Islamic banks themselves, but also well-known international and other conventional banks. Presently the majority of international banks are adopting Islamic banking to serve their new clients and their specific needs. Examples of such banks are Citibank and HSBC, both of which have started Islamic operations worldwide to expand their businesses.Although interest in Islamic banking has grown considerably during the last decade, Islamic banking today continues to evolve as an industry. The financial world has set conventional banking as a standard practice driven mainly by the profit maximisation principle. However, Islamic banking principles have attracted attention from academic researchers and regulators both in developing and developed countries as a result of their distinguished micro-operating fundamentals. The prohibition of interest payments by Islamic Sharia (Islamic law) has instead made equity and profit sharing the

Islamic Banking and Finance xi

cornerstones of its operational structure activities. This ban on interest does not mean that capital is costless in an Islamic system; in fact, it recognises funds as a factor of production but does not allow the fund-providers to make a prior or pre-determined claim in the form of interest. This risk-sharing principle provides theoretically better long-term allocation of funds to investments with higher risk-return profiles and subsequently greater economic growth.

This book addresses the main issues of concern within Islamic banking, namely the conceptual framework and viability of interest-free banking and the assessment of its performance and future. In a world where conventional interest-based finance is the dominant framework, Islamic banking faces many challenges that must be addressed. This book discusses the contemporary issues and challenges confronting the Islamic banking system and was written for both researchers and practitioners. It analyses the past experiences of Islamic banks worldwide and provides an objective assessment of their successes and failures.

Adnan Ahmed Yousif President and CEO of Al Baraka Banking Group President of Union des Banques Arabes

INTRODUCTION

General Introduction

What distinguishes Islamic finance and banking from the conventional financial system is based on a comprehensive system of ethics and moral values stemming from the Islamic religion. Unlike conventional finance, Islamic finance is founded on overarching principles that constitute the guidelines governing any Islamic economic or financial dealings.

The principles that underline the distinguishing features of Islamic finance and banking as well as Islamic economics as a whole stem from the Sharia of Mu’amalat or Islamic law governing human relationships. Islamic Law refers to the divine injunctions in the Koran and the prophet’s (PBUH) traditions that regulate the conduct of human beings in their individual and collective lives. In this regard, it is worth pointing out that Islam does not refer only to the Islamic religion but encompasses a comprehensive social system where people live in accordance with divine guidance.

Islamic finance was developed from a conceptual idea in regard to an evolving and fast reality. With the involvement of many actors in the industry and the culmination of economic, political and demographic factors, Islamic Finance has shown a strong growth.

Basic Sharia-compliant contracts have been used innovatively in structuring various Islamic financial and deposit products for banking, project finance, capital market, insurance products and risk management instruments. The structuring of innovative finance and derivative Sharia-compliant instruments plays an important role in the enhancement of Islamic financial markets and Islamic risk-management practices.

For future challenges, the immediate need is to develop instruments that enhance liquidity, and to develop secondary, monetary and inter-bank markets; and to perform asset liability and risk management.

My personal view is that it is a “huge mistake” to use the LIBOR as a benchmark. The benchmark must be the “real cost”’ or “Actual costs” incurred by Islamic banks and mainly information costs to which a margin must be added. These costs are well known in the literature (the reader can refer to Bellalah [2008, 2009]). These costs are defined in Appendix 1 of Chapter 1.

Islamic Banking and Finance xiii

This Book is organized as follows. Chapter one draws attention to the important development that Islamic

Finance and banking have known from a conceptual idea to an evolving and fast reality. It deals with the different principles governing Islamic financial dealing and transactions and gives an overview of the added value of Islamic finance to the international financial system. The chapter covers the main Sharia-compliant structured project finance solutions and the sukuk market, and presents new practices in the industry such as sukuk restructuring, credit enhancement, redemption and convertibility.

Chapter two studies the productivity growth in the GCC Banking Industry for the period 1999-2007. It compares conventional versus Islamic banks. This study examines the impact of financial liberalization on banking productivity growth in the Gulf Cooperation Council (GCC) countries during the period 1999–2007. Employing a non-parametric approach (DEA), productivity change has been measured by computing total factor productivity index for two groups of banks: conventional and Islamic. The findings indicate that during the period of deregulation, GCC banks have experienced a gain in productivity change of about 1.8%, attributed mainly to the progress of technical change rather than increase in efficiency change. We also found that conventional banks tend to outperform Islamic banks in most productivity measures. In this chapter, we also investigate the determinants of bank productivity. The results show that bank size has a positive impact on productivity growth for all models, while capitalization is related negatively to efficiency change for the model of Islamic banks only. Finally, the regression findings also demonstrate the strong links of macroeconomic and financial sector indicators with bank productivity.

Chapter three presents an analysis for the growth and rise of smaller Islamic banks in last decade. Chapter four studies the development and scope of Islamic bank bonds (known as Sukuks).

Raising finance through investment Sukuks is becoming more and more popular in the Middle East, Europe and the Far East. Sukuk is a thriving new market in many Islamic Economies, especially in GCC countries and Malaysia This is attracting a lot of interest from European countries like the UK, Portugal and some other major countries like Japan and Singapore.

Given their novelty and unique characteristics and varieties, Sukuks can be researched extensively and discussed from various angles. However, under this heading, the focus will be on the definition of Sukuk types, nature and salient features distinguishing each type of Sukuk from

Introduction xiv

others, and consequently offering a critical appraisal of Sukuk as Islamic alternatives to conventional Bonds or securitization.

The other chapters investigate Islamic banking and finance in several countries.

Chapter five develops Iran’s Islamic banking experience. The practice began in Iran in 1984, and the transformation from a conventional form of banking has been a subject of debate among scholars. Analysis of Islamic modes of financing shows that bank authorities and economic policy makers have followed the same path of traditional banking and switch their funds towards a more profitable type of contract. This chapter describes that due to the heavy concentration of the banking assets on short term deposits, and the private sector’s reluctance to commit funds for long term financing, bank loans were also utilized to mainly finance short-term trade transactions, for example hire purchases, forward purchases and service contracts. Long-term partnerships for project financing and direct investment by the banking system in the long term undertakings constituted a small percentage of the total operation.

Chapter six studies the Islamic banking structure and growth in the Sudanese Islamic banking sector. Goes back to 1977 when the Faisal Islamic bank of Sudan was established in the country. With the introduction of Sharia law in 1984, the entire banking industry converted to Islamic Sharia principles. The Sudanese Islamic banking industry now encompasses more than thirty banks, and some of them, like the Faisal Islamic bank of Sudan, have twenty-eight branches alone.

This chapter seeks to analyze the financial performance of selected Sudanese Islamic banks and highlight their growth using financial statement analysis (FSA). The procedure involves calculating numerous financial ratios and categorizing them into five key groups in order to examine profitability, earning potential, liquidity, credit risk, and assets activity.

Findings revealed that the Sudanese Islamic banks are doing very well in terms of generating reasonable profits. In addition we discovered that the liquidity earning performance and assets activity performance of the three selected bank was satisfactory. Finally, while analyzing credit risk we found that Sudanese Islamic banks are taking excessive risks.

Chapter seven looks at Islamic mortgages. Mortgages are considered to be a major determinant factor not only for the UK, but for other Western economies as well. Therefore, we thought it fit to conduct an empirical study on Islamic mortgages in the UK. In this chapter, we critically analyse the Islamic mortgage system in the UK and also find out if it might help to create a stable financial environment. The chapter gives a

Islamic Banking and Finance xv

preliminary empirical assessment of role of Sharia board and corporate governance with reference to the UK. The information was gathered through a well-designed questionnaire assessing a professional banking point of view on Islamic mortgage. This study also sought two important answers to: (1) whether Islamic banking is based on Islamic economic principles or is just a replica of conventional banking, and; (2) if we would still be facing a financial crisis if the market was regulated by Islamic Sharia.

Chapter eight investigates the role of Islamic mortgages in the UK. Mortgages are considered a major determinant factor not only for the UK, but for other Western economies as well. Therefore, we thought it fit to conduct an empirical study on Islamic mortgages in UK. In this chapter we study and elaborate principles behind the overall Islamic banking system, main focus in the role of Islamic mortgages in the UK. This chapter gives a preliminary empirical assessment of the role of sharia board and corporate governance with reference to the UK. This study also sought to find out whether Islamic banking is based on Islamic economic principles or just a replica of conventional banking.

Chapter nine studies the “Islamic bank of Britain” in a case study analysis. There is no specific difference between Islamic and conventional banking on a functions basis. Both provide and perform almost the same functions. The only difference between them is for the Islamic bank to follow the rules and principles of Islam in all their transactions (Henry and Wilson 2004; Iqbal and Mirakhor 2007). Many conventional banks also have started to open branches, which operate in accordance with Islamic Sharia principles. The Islamic banking system is expected to face strong competition not only from the Islamic banks but also from well-established conventional banks offering Islamic products and services. In this study, we focus on the Islamic Bank of Britain, the only indigenous bank of its kind in United Kingdom. An assessment of the degree of customer awareness satisfaction is made, as well as selection criteria. A sample of two hundred respondents took part in this study. The responses show a certain degree of satisfaction, and a few respondents also expressed their dissatisfaction with some of the Islamic bank's services. Chapter ten studies the growth of Islamic banking and employee satisfaction in Bangladesh.

Twenty-five years ago, Islamic banking was virtually unknown. Now, fifty-five developing and emerging market countries have some involvement with Islamic banking and finance. In Bangladesh, the Islamic banks are in a minority and operate alongside conventional banks. The objective of this research is to provide a brief analysis of the performance

Introduction xvi

of Islamic banks in Bangladesh. The Islamic banks in Bangladesh show strong growth. The products range from consumer credit to long-term finance for big investment projects using Islamic modes of financing such as Marahaba, Bia-Muazzal and Ijarah. Currently, in Bangladesh, the higher import cost of commodity prices, price hike in international oil market as well as money and credit growth resulted in higher inflation. As a result, the economy of the country showed every sign of recession. Despite numerous adversities, Islamic banks made significant pre-tax profit in the last few years. Islamic banks maintained and achieved a strong position in the key areas like capital adequacy, liquidity, assets quality, management and earnings. Moreover, Islamic banks in Bangladesh are keeping pace with the advancement of information technology by providing online banking, debit card facilities and money transfers. The research is based on primary data collected through a questionnaire to the employees of four selected banks on a random basis.

CHAPTER ONE

INTRODUCTION TO ISLAMIC FINANCE AND ISLAMIC BANKING:

FROM THEORY TO INNOVATIONS

Islamic finance is founded on overarching principles that constitute the guideline governing any Islamic economic or financial dealings. The reader can refer to the cited websites. This chapter is organized as follows. The first section tries to draw attention towards the important development that Islamic finance and banking have known from a conceptual idea to an evolving and fast reality. The second section deals with the different principles governing Islamic financial dealings and transactions and gives an overview of the added value of Islamic finance to the international financial system. The third section starts with a summary on the different basic Islamic financial contracts and points out the importance of financial innovation. We shed light on the main Sharia-compliant structured project finance solutions. Moreover, we focus on the sukuk market and present new practices in the industry such as sukuk restructuring, credit enhancement, redemption and convertibility. We point out the importance of the Waad as an interesting instrument, leading to the development of Islamic derivatives and innovative hedging and financing Sharia-compliant structures. We present the main Sharia-compliant derivative based on instruments along with recent Sharia-compliant portfolio insurance practices. Finally, we highlight the major challenges facing the development of Islamic capital market standing from the need for liquidity and risk management-innovative structures to the urgent need to an international central regulatory body ensuring international standardization and uniformity.1

1 This chapter is written partially by Chayeh Zeineb.

Chapter One 2

Section 1: From a Conceptual Idea to an Evolving and Fast Growing Reality

1.1. Islamic Finance Industry Growth

The infancy of the Islamic finance and banking was in Egypt and Malaysia during the 1960s. The establishment of the first Islamic bank, pioneered by the Mit Ghamr Local Saving Bank, can be traced back to 1963 in Egypt. In the same year, the first Sharia-compliant fund was established in Malaysia known as the Pilgrim’s Savings Corporation. According to the 2009 Banker report, the number of Islamic financial institutions worldwide is about 626 in approximately fifty countries in 2009, compared to 525 in 2007, with total balance sheet assets estimated to be about $822 million in 2009 compared to $500 million at 2007. The global total of Islamic assets grew at rate of 28.6% in 2009 for the preceding year. The Middle East and North Africa region accounts for the largest share at 81.3% of total global Islamic assets in 2009.

Islamic banking had a real boom at the beginning of the twenty-first century with an increasing number of Islamic banks and Islamic windows (see table. 1.1 above) and exponential growth of its geographical spread (see fig. 1.2 above). The top twenty banks in the GCC countries have seen their combined assets grow by 24% in 2008. The diversification of market players in the Islamic bank resulted in a growth of geographical reach and the emergence of new financial centres for Islamic banking, different from the historical ones such as Dubai, Bahrain and Kuala Lumpur. The emergence of an increasingly broad range of retail products and services has largely contributed to make Islamic banking as competitive as the conventional method.

The Takaful or Islamic Insurance industry, introduced in the 1990s, is expected to reach $8 billion by the end of 2012 at an annual growth rate of 35%, especially for the life takaful industry. The Gulf Countries council represents 60% of the market size followed by Malaysia with 21%. Gross takaful contributions have grown from $1.4 billion in 2004 to over $3.4 billion in 2007. There still exists a large, expanding and untapped Muslim population on almost every continent (the World Takaful Report 2009).

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Chapter One 6

choice of asset type with 40–60% depending on the region of the total assets.4 Several Islamic Equity funds emerged during the equities market boom of the 1990s and the introduction of the Islamic stock index in the 1999, the Dow Jones and FTSE Sharia index has largely contributed to this industry.

Conscious of the rapid growth and dynamic of the Islamic Finance sector, many large Western financial institutions including Citibank, Barclays Capital, Morgan Stanley, Merrill Lynch and HSBC have established subsidiaries that provide financial Islamic products. Moreover, the major French banks have also actively developed Islamic banking activities, mainly in the Gulf but also at a lesser scale on French territory. BNP Paribas, Credit Agricole and Societe Generale are the most advanced in this field. Today, the number of conventional financial institutions with Islamic windows is about 191 worldwide (The banker, 2009). Western regulators, investors and other agents have also shown a greater interest in and a receptive attitude towards Islamic banking and finance (M. Khan et al. 2008). It is interesting to note that among the top twenty-five countries by size of Sharia-compliant assets include such non-Muslim countries such as the United Kingdom in ninth place with $19.4 million and Switzerland in twentieth place with $4.6 million. Recently, France is gaining momentum in its bid to become a centre for Islamic finance. In fact, the French government has taken a comprehensive approach to understanding how to seamlessly assimilate Sharia-based finance into the existing regulatory and legislative structures. An amendment to article 2011 of the French Civil Code, passed on by the French National Assembly, shows the determination to adjust French legislation to the requirements of Islamic finance.

Many important players from both the conventional and Islamic finance stream have pooled their expertise and knowhow to devise more ethical and efficient Islamic financing and hedging solutions. For instance, the launch of the Tahawut (Hedging) Master Agreement (TMA) in March 2010 by the Bahrain-based International Islamic Financial Market (IIFM), in cooperation with the International Swaps and Derivatives Association, Inc. (ISDA), gives the global Islamic financial industry the ability to trade Sharia-compliant hedging transactions such as profit rate and currency swaps, which are estimated to represent most of today's Islamic hedging transactions.

While the first steps toward the materialization of the idea to pursue an Islamic mode of economic and financial dealings were taken by a minority community of Muslims in India in the early twentieth century (Interest 4 Ernst and Young 2009

Introduction to Islamic Finance and Islamic Banking 7

Credit Society 1923), real state sponsorship of the establishment of an interest-free institution can be traced back to the 1970s, mainly in Egypt and Iran when a presidential decree in 1971 in Egypt gave birth to the Nasir Social Bank. The introduction of President Zia UlHaq in 1977 was an important step in the process of establishing interest-free banking in Iran. These initiatives were followed in the 1980s by the Islamization of economies in the Islamic Republics of Iran, Pakistan and Sudan where banking systems are converted to interest-free banking systems. The GCC countries and Malaysia worked for the promotion of Islamic banking parallel with the conventional banking system. The Malaysian Islamic banking industry has seen the most spectacular expansion with the enactment of the Islamic banking act in 1983 and the establishment of the Bank Islamic Malaysia as well as important government involvement.

In 1974, the first Islamic modern commercial bank, the Islamic Dubai bank, was established. The Islamic Dubai bank, one of the earliest private initiatives in the UAE, could be considered one of the first proofs of the feasibility and efficiency of an Islamic banking system. The bank continues to prosper and be involved in the development of Islamic finance. The IDB is not a unique example in this regard, as the major Islamic banks have proved to be as efficient and profitable as conventional banks.

One year later, in 1975, the Islamic Development Bank was established in Jeddah. This institution has played a crucial role in expanding Islamic modes of finance and in fostering interesting research in Islamic economics, finance and banking.

In 1977, the Kuwait Finance House was founded as the first Islamic bank in the country. Recently, the KFH accounted for about a quarter of all deposits in the Kuwaiti market and continues to expand its overseas dealings.

1.2. Determinants of Islamic Finance and Banking Spread

Many factors have contributed to the development of Islamic finance and the spread of Islamic banking. The growth in Islamic financial services may be attributed to the important growth that the GCC countries and Asian economies have seen as well as the increasing numbers in the Muslim community. (IMF 2009) has investigated the determinants of the pattern of Islamic bank diffusion around the world using country-level data for 1992–2006. It was argued that the huge influx of petrodollars from the late 1970s, as well as the consistently high oil prices in international markets, has provided a strong impetus for the development of several Islamic banks in the Middle East. Islamic banking is spreading

Chapter One 8

wherever there is a sizable Muslim community and is not restricted to Muslim countries. The probability for Islamic banking to spread in a given country rises with the share of the Muslim population, income per capita, and whether the country is a net exporter of oil. Trading with the Middle East and economic stability are also conducive to the diffusion of Islamic banking. Proximity to Malaysia and Bahrain, the two Islamic financial centres, does matter. The interest rates’ decrease enhances the development of Islamic banking because they reduce the opportunity cost for less pious individuals to put their money in a conventional bank. According to the authors, the terrorist attacks of September 2001 were not important to the spread of Islamic banking. However, they coincided with rising oil prices, which are the real drivers of Islamic banking growth. Moreover, because the Islamic banking is guided by Sharia law, the quality of institutions, which traditionally count for conventional banking, is not important for the diffusion of Islamic banking.

In addition, the major determinants of the development of Islamic banking and finance include the continuation of serious conceptual and theoretical work both in academic and professional circles. The involvement of international institutions in the development of serious research in Islamic finance and banking was of great interest to the industry. Many well-regarded academic institutions in both Western countries such as Harvard University, Durham University, La Sapienza University & ISME and in Muslim countries such as the Cass Business school, the Faculty of Islamic Studies (Qatar), Effat Women’s University (Saudi Arabia), Bahrain Institute of Banking and Finance, International Institute of Islamic Finance Incorporated (Malaysia) organized seminars and conferences and offered degree programs and scholarships in postgraduate Islamic finance study.

1.3. Research Breakthrough

The emergence of an opposition and reluctance to the interest rate started in Egypt in the late nineteenth century when Barclays Bank was established in Cairo to raise funds for the construction of the Suez Canal (Iqbal at al. 1998, 2001). Several formal critiques have been conducted to highlight, on the one hand, the main critical areas where the conventional economic system conflicted with Islamic values, and on the other to lay out alternatives to interest-based financial systems and banking that have started to gain momentum in Muslim countries. The contributions of Qureshi 1967, Siddiqi (1983, 1985, 1988), were considered important in this regard. Their works focused on studying how Islam could propose a


framework to organize an economy and providing a formal definition of Riba, as well as explanations and rationales behind the prohibition of interest. The main studies proposed a comparison framework between the economies based on Islamic tenets, socialism and capitalism and emphasized the operational and organizational model of an Islamic bank based on partnership.

Interest grew in undertaking theoretical work and research to understand the functioning of an economic and banking system designed to be an interest-free system, in line with the tenets of Islam, with the first international conference on Islamic economics held Saudi Arabia in 1976. The involvement of institutions and governments led to the application of theory and resulted in the establishment of the first interest-free banks. The Islamic Development Bank, an inter-governmental bank established in 1975, was born of this process. Parallel to the research initiatives taken by Islamic international institutions such as the IDB and its research arm the Islamic Research and Training Institute established in 1981, the World Bank as well as the International Monetary fund were among the first conventional institutions initiate research on understanding the macroeconomic efficiency and financial stability of an interest-free economic system as well as the financial implications of a loss and profit sharing mechanism (Khan 1986, Khan and Mirakhor 1990). There has also been an outpouring of continuous research on the nature and operation of interest free banks by Muslim economists such as Siddiqi (1983), Bashir (1983, 2000), Chapra 1982, 1985). By exploring the different Islamic contacts, these researches led to the laying out of alternatives to the conventional banking system. In fact, the main results of their efforts were to provide a framework to the early theoretical models of Islamic banking based on the concept of Profit and loss sharing through the Musharakah and Mudarabah contracts. The two-tier Mudarabah financial intermediary model was thus designed and its efficiency and performance assessed.

While academic research on Islamic economics has taken back seat and interest has increased toward the Islamic finance and banking field due to the growing demand for Islamic products and services and the important spread of Islamic banks all over the word, research on corporate governance, Islamic accounting, asset liability management, risk management, capital adequacy and regulation of Islamic banking as well as Islamic financial engineering and innovation in Sharia-compliant derivatives have drawn attention to what Islamic financial institutions and academic researchers need to watch out for in the rapidly changing and competitive financial world.

Chapter One 10

Chapra (1995) initiated discussions on corporate governance in Islamic financial institutions. They underlined that Sharia compliance in Islamic banks will lead to differences in governance mechanisms in Islamic banks compared to conventional banks. They pointed out that the core element of corporate governance framework for Islamic banks is the Sharia Supervisory Board (SSB) and the internal controls which support it. Chapra provided an overview of corporate governance from an Islamic perspective, focusing on the Islamic financial institution and presented a model defining stakeholders in Islamic banks. They argued that, in contrast with the conventional bank’s corporate governance mechanism where in the depositors’ interest does not receive much attention, Islamic banks’ corporate governance should give emphasis to protect depositors’ interest in their business. Z. Hasan (1996) brought out the basic elements of Islamic corporate governance with the Western counterpart in the aspects of conceptual definition, episteme, corporate objective, nature of management and corporate structure.

There is some need for special regulations for Islamic banks for special capital adequacy framework. Drawing from the specific features of Islamic finance and its inherent features of risk sharing, questioned the relevance of the Basle norms and d certain modifications and alternative ways to compute capital adequacy measures for Islamic financial institutions.

As Islamic financial institutions endeavour to cope with the challenges of globalization, efficient risk management has assumed particular importance. This requires the development of not only a more suitable regulatory framework, but also new financial instruments and institutional arrangements to provide an enabling operational environment for Islamic finance. The recent establishment of the Islamic Financial Services Board, facilitated by the International Monetary Fund, addresses this need.

han (2001) highlighted the unique risks of the Islamic financial services industry and the main regulatory concerns with respect to risks and their treatment. They identified a number of Sharia-related challenges concerning risk management.

As far as the asset liability management is concerned, interest toward the development of Sharia-compliant derivative, securitized and structured based instruments has gained momentum. Iqbal (1999) pointed out that the Islamic system of contracting allows for designing risk management solutions using the framework of financial derivative products. The paper analyzes and discusses the case of a specific Islamic contract, istijrar, and highlights its possible use in managing certain forms of risk. Iqbal (1999) argued that Islamic finance provides the basic building blocks that can be used to construct more complex financial instruments that will enhance


liquidity and offer risk management tools. With the introduction of asset securitization and swap transactions conforming to Islamic principles, the issues of secondary markets and risk management can be addressed.

1.4. Regulating and Supervising Islamic Finance and Banking Industry

The Institutional Development

For the sake of supporting the development of Islamic banking and finance, an institutional infrastructure has been evolving since the emergence of the Islamic Development Bank in 1975 as one of the major actors in the enhancement of the Islamic financial industry.

The rapid expansion in the breadth and depth of Islamic banking and capital market activity as measured in terms of the number of institutions as well as by the variety, complexity and sophistication of products and services has triggered a strong awareness among scholars, professionals and regulators about the necessity to institutionalize Islamic finance through the establishment of international regulating and supervising organizations.

Undoubtedly, one of the biggest challenges for the Islamic financial system is the development of a framework for governing, supervising and regulating Islamic finance. For instance, Islamic banks have to be subject to a supervisory and regulatory regime of central banks that is entirely different from that of conventional banks as well as conventional central banks in order to promote a true and fair view of Islamic financial transactions.

The Islamic Development Bank

In this regard, it is meaningful to highlight the important role played by the Islamic Development Bank in developing internationally acceptable standards and procedures and strengthening the sector's architecture in different countries. The IDB was established in pursuance of the Declaration of Intent issued by the Conference of Finance Ministers of Muslim Countries held in Jeddah in December 1973.

Moreover, several other international institutions are working to enhance the regulatory framework and standardization of the Islamic finance and banking industry. These include the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), the Islamic Finance Service Board (IFSB), the International Islamic Financial Market

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(IIFM), the Liquidity Management (LMC), the International Islamic Rating Agency (IIRA), the Islamic Research and Training Institute (IRTI) and the International Sharia Research Academy for Islamic Finance (ISRA).

Auditing Organization for Islamic Financial Institutions

Thanks to the effort of the Islamic Development Bank, the Accounting and Auditing Organization for Islamic Finance was established and registered in 1991 in Bahrain as an international, autonomous self-regulation for the industry. The main objective of the organization is to prepare and develop accounting, auditing, governance and ethical standards relating to the activities of Islamic financial institutions, taking into consideration international standards and practices and the need to comply with Sharia rules.

The Islamic Finance Service Board

With the growth of the market, the IFSB was established in 2000 as a dedicated regulatory agency. The IFSB, together with the AAOIF, aims to promote the development of a prudent and transparent Islamic financial services industry and provides guidance on the effective supervision and regulation of institutions offering Islamic financial products. The IFSB has recently finalized standards on capital adequacy and risk management and has made progress in developing standards on corporate governance. Once developed and accepted, these international standards will assist supervisors in pursuing soundness, stability and integrity in the world of Islamic finance.

The Liquidity Management Center

As Islamic financial transactions increasingly become global in nature, there are concerns over the sufficiency of supply of appropriate instruments to address the global liquidity management needs of Islamic financial institutions. These concerns led to the establishment of the Liquidity Management Centre (LMC) in February 2002. The LMC is based in Bahrain and is part of a larger project to create an International Islamic Financial Market (IIFM). The LMC facilitates investment of the surplus funds of Islamic banks and financial institutions into quality short- and medium-term financial instruments. It aims to enhance the creation of


an Islamic interbank money market that would enable Islamic financial institutions to manage their liquidity.

The International Sharia Research Academy for Islamic Finance

The International Sharia Research Academy for Islamic Finance was established by the Malaysian Central Bank in Mei 2008 with the vision and mission of Integration of Sharia experts and industry practitioners as well as synergizing total human capital development in Islamic Finance. Furthermore, the academy contributes to the study of the potential market needs and innovation in research findings.

Section 2: An Overview on the Framework of Islamic Finance and Banking

Referring to Islamic banking or Islamic financial system as simply an interest-free system does not reflect the real image of the Islamic financial system. Undoubtedly, prohibiting the receipt and payment of interest is the nucleus of the system, but is supported by other principles of Islamic doctrine advocating social justice and risk sharing.

Islam recognizes the role of Markets and freedom of individuals and trade. History cannot deny, as expressed by Gordon Brown, that: “it was mainly through peaceful trade that the faith of Islam arrived in different countries.” The profit motive and private ownership are acceptable, but to a reasonable extent. In fact, the Islamic finance defines this extent regarding the Islamic Law, which upholds the principles of integrity, transparency, justice, fairness, solidarity and good corporate governance in financial dealings.

2.1. Materiality and Validity of Economic and Financial Transaction and Dealing

2.1.1. Asset Backed or Based Finance

One of the most important features of Islamic finance, of which the economic crisis has demonstrated relevance, is that Islamic finance is based on an asset-backed financing principal. In fact, Sharia law, which grounds the principles of Islamic finance, encourages business and trade activities that generate fair and legitimate profit through which business dealings must be accompanied by an underlying genuine trade and business-related activity. Any transaction in the financial sphere must

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necessarily reflect a transaction in the economic sphere. The two spheres must increase or decrease in terms of value overall. This was not the case for the current financial crisis where the massive injections of money into the real economic sphere were not been able to cope with the enormous gap that stood between the two.

Thus, every financing mode5 in the Islamic financial system enforces the close link between financial and productive flows and hence ensures that funds are channelled into real financial business activities, thus entailing the appropriate due diligence. It is worth noting that the asset-backed financing principal has widely contributed to insulating the Islamic financial system from the risks associated with excessive financial leveraging and speculative activities that have characterized the recent crisis.

2.1.2. The Three Main Prohibitions in Islamic Finance: the Prohibition of Riba (interest), Gharar (uncertainty) and Maysir (gambling)

Islamic finance does not deny that the transfers of credit and risk are at the heart of finance, without which an economic system cannot function. However, it is wise to state that these two vehicles are a double-edged sword. Although they can be used judiciously to reduce risk and enhance welfare, they can easily entice otherwise cautious individuals to engage in ruinous gambling behaviour, such as what we have seen with the current financial crisis.

According to El-Gamal, the two main prohibitions of Riba as well as Gharar and its subsequent Maysir, in Islamic law, are best characterized as trading in unbundled credit and trading in unbundled risk, respectively. In this respect, Islamic jurisprudence uses those two prohibitions to allow only for the appropriate measure of permissibility of transferring credit and risk to achieve economic ends. Moreover, while financial secular regulators seek to limit the scope of credit and risk trading to prevent systemic failures, Islamic law provides injunctions that also aim to protect individuals from their own greed and the potentially addictive nature of living beyond one’s mean or addictive behaviour of gambling and corrupting intelligently.

5 The Islamic financing mode will be discussed in the next section, pointing out this prominent feature and how in spite of the fact that such financing modes as Murabaha and Leasing are not believed to be ideal they remain a real guarantee to keeping the two economic spheres synchronized.


2.1.2.1. The Prohibition of Riba (Interest) or Trading in Credit One of the main features of the Islamic financial system is the

prohibition of the payment and receipt of Riba, which refers to any conditional increase in the principal of a loan or a debt in return for deferred payment. Generally, Riba includes all gains from loans and debts and anything over or above the principal of loans and debts, and covers all forms of interest on conventional commercial or personal loans. This does not mean by any means that Islamic finance does not recognize that time has a strong influence on economic activity and decisions. In fact, the juristic consensus permits the possibility of increasing the item’s price for deferred payment in the case of sale contract. However, the Islamic perception of the role of time differs from sale contract to loan or debt contract. This dual perception of time in financial transactions governed by Islamic law seems contrary to the uniform treatment of time in conventional finance that considers an instalment sale as a dual operation of sale-cum-loan.

2.1.2.1.1. The Concept of Time in Islam

In this regard, it is worthwhile to enlighten this different dual time perception and point out the rationale behind it.

On one hand, Islamic Law establishes the legitimacy of price increase in credit sale dealing by admitting that time has a value and recognizes the innate human preference of what is in hand to what is loaned and immediate to the deferred. In this respect, the justification of increasing price when payment is deferred is that the intervening time between passing on commodity and receiving its price involves possibilities of opportunity benefits which are waived in the interest of the buyer. Furthermore, the credit sale does not involve a contract or agreement to pay an equivalent to time as in the case of the credit loan. It is rather a contract to sell a commodity where time is observed as a factor in fixing the price. Here, time is dependent on the commodity and its presence contributes to the determination of the price, but is not, in itself, paid for. The equation in such a sale consists of a commodity tied to a time frame and a price which includes an element to compensate for time and that cannot be perceived as unjust as the dealing, concluded by mutual consent.

On the other hand, Islamic law bans dealing with Riba in the case of a loan contract. It is clear to see that the interdiction holds to the unproductive aspect of lending money for itself and adds an interest factor to it. Money, in Islam, is by no means a commodity and ought mainly to serve a productive means, the lender having to participate in the profit/losses from the money injection for a particular investment.

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(2.275) "Those who eat Riba (usury) will not stand (on the Day of Resurrection) except like the standing of a person beaten by Shaitan (Satan) leading him to insanity. That is because they say, "Trading is only like Riba or usury, whereas Allah has permitted sales and forbidden Riba. So whosoever receives an admonition from his Lord and stops eating Riba shall not be punished for the past; his case is for Allah (to judge): but whoever returns to Riba, are dwellers of the Fire - they will abide therein.”

From the above verse, we can touch the severity of the sin of Riba and to what extent Muslims are instructed by the Holy Qur’an to shun it. At the same time, however, they are encouraged by the Holy Qur’an to pursue trade. Furthermore, the word Riba, meaning “prohibited gain,” is explained in the Holy Qur’an by juxtaposing it against (profit form) sale. It explains that all income and earnings can be categorized either as profit from trade and business along with its liability or return on cash or a converted form of cash without bearing liability in term of the result of deployed cash or capital. The former kind of return is permitted and well encouraged in the Islamic financial framework and the latter is severely prohibited.

2.1.2.1.2. Rationale behind Interest Rate Prohibition 2.1.2.1.2.1. Ethical and Religious View

The rationale behind the ban of the interest is well clarified by Al-Razi in his exegesis of the Qur’an, considering Riba as a cause of injustice that consists in the unbalanced equation linked to the interest-based loan: the increase, on one hand, and the opportunity cost, on the other. The variance in certitude between the interest over the principal which is certain and its amount is known, and the yield resulting from investing the loan by the creditor, who is not sure it will materialize or its amount is not certain in advance constituting the essence of the injustice of imposing interest on loans. Justice requires that the provider of money capital should share the risk with the entrepreneur. Thus, there is a basic difference between principals of the Islamic economic system and the conventional one in regard to the treatment of money capital as a factor of production. Whereas in the conventional system, money is treated on a par with labour and land, each being entitled to return irrespective of profit or loss, this is not so in the Islamic system which treats money capital on a par with enterprise. Hence the interest of highlighting, in the next section, the prominent feature of loss profit sharing that distinguishes the Islamic financial system from the conventional one.


Moreover, the prohibition of Riba aims to substantively protect individuals from getting excessively indebted and overwhelmed by interest payment, as well as paying for receipt or the extension of credit. Compared to the conventional regulators who also strive to prevent individuals from borrowing excessive amounts, or falling prey to unfair predatory lending, they care primarily about the general health of the financial system, and their concern about the financial health of specific individuals is secondary at best. Furthermore, this aim is among the interests of conventional bankers who work primarily for financial corporations that care little about systemic or individual financial health and care mostly about their own profitability. Thus, they generally permit customers to borrow excessively if the expected rate of repayment remains sufficiently high to ensure profitability.

As a whole, socio-economic and distributive justices as well as intergenerational equity are considered the basis of prohibition under Islamic law.

Al-Razi states that the illegality of Riba is proved by the text of Holy Qur’an, the real wisdom from the prohibition of Riba is known to God and we only apply our minds to deduce this Historically, interest was opposed on the grounds of the social divisions it creates. The Old Testament recommended loans without interest. Lending on interest is blame-worthy action and is often equated with the exploitation of those in need. According to Dar & Presley (1999), Judaea-Christianity recognizes economic brotherhood and the sharing of risks. Christianity teaches to “love thine enemies,” which is compliant with the prohibition of interest. Brunner (1937) regarded interest as encouraging a “parasitical existence” literature. Aristotle considered money as only a medium of exchange and not a store of value, as seen by Western literature.

2.1.2.1.2.2. On the Theory of Interest

While the original basis of the prohibition of interest was divine authority, Muslim economists and scholars have recently emphasized the lack of theory to justify interest. Existing theories of interest are attempts to rationalize an institution deeply entrenched in modern economies and brought out through a study of several theories of interest developed since Adam Smith of which there has been no satisfactory explanation of the fixed and predetermined rate of return. He stated that:

… leaving out some notable exceptions, like Bohm Bawerk’s Capital and Interest, significant parts of Keynes’ General Theory and parts of Harrod, Hawtey and Kurihara, questioning the validity of interest, bulk of the effort of economics has been to justify it, yet not a single argument

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advanced in favour of this institution has a leg to stand on. All theories of interest evolved till the time of Bohm Bawerk, including those resting on productivity, abstinence and demand and supply concepts, were unanswerably repudiated by him. Yet economics continues whipping these dead horses, without evolving any persuasive answers to his criticism.

In this respect, Muslim economists consider three main arguments in response to the typical justification for interest in conventional finance. Table 1.2 below presents the opposing arguments.

Western economists who had questioned the validity of interest and its consequences on economy and financial system held a reasonably strong conviction that a fixed and predetermined rate of interest constitutes a hurdle to economic development and financial instability. They shed light on the strong relationship between interest rates and the instability of economy through the inflation, unemployment, negative growth and blamed interest rates and associated bank credit expansions and contractions for many of the economic issues.

A bulk effort attempted to explain cyclical fluctuations in terms of a divergence between the natural and the market rate of interest. The difference between market and natural interest rates is that the former is determined by monetary forces in loanable funds market, e.g. money supply growth and bank credit creation, and the latter is determined by the profitability of investment and could be associated with profit rate at the microeconomic level. If market and natural rates of interest do not coincide over time, some claim that cyclical fluctuation must result.

Keynes (1931) criticized the role of interest rates and bank credit in cyclical process and emphasised the role of interest rates in promoting economic instability.


Justification for interest Justification against interest Interest is a reward for saving Such a reward could only be

rationalized if savings were used for investment and to create a real additional value. Abstention from consumption is not entitled to a return.

Interest is considered as marginal productivity of capital

Interest per se has no relation with the productivity of capital. Interest is paid as a charge for the use on money and not as a yield from the investment of capital. Money is not capital. Money is potential capital needed to be invested. To transform money into capital requires the application of enterprise, that is risk taking and the knowledge required to bring factors of production together to create profit (or loss).

Interest is the time-value of money

Even if the basis for time preference is the difference between the value of commodities this year and the next, it seems more reasonable to allow next year’s economic conditions to determine the extent of the reward.

Interest is a reward to cost opportunity

As for the modern capital-holder, who has their capital deposited in a bank, money is available to them anytime they want. Lost opportunity is an illusory argument. Not only did they not lose any opportunity, their money was earning interest even when they had no opportunities. Moneylenders such as banks are generally not businessmen on the lookout for business opportunities that involve risk. The argument of opportunity cost is an unreal argument.

Table 1.2. Opposing arguments regarding interest rates and Money

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2.1.2.2. The Prohibition of Gharar and Maysir, or Trading in Risk 2.1.2.2.1. The Prohibition of Gharar (Uncertainty)

A second feature that is banned and severely condemned by Islamic law is economic dealings entailed uncertainty or Gharar. The latter includes ambiguity about the end result of a contract and the nature, quality and specification of the subject matter of the contract or the rights and obligations of the parties, possession and delivery of the item of exchange. Generally, it relates to uncertainty in the basic element of any agreement.

The prohibition of Gharar in Islamic economic transactions promotes business ethics and enforces justice among participants dealings, limits deception and leaves no space for speculation and asymmetry of information that contribute to the lack of confidence as well as to the deterioration of moral values, elements that were noticed during the current financial crisis. The injustice that underpins such prohibited transaction comes from the fact that the latter may lead one side to impose a burden on another or may cause a vendor to erode the property of others unlawfully.

Although Islamic law strongly denies the uncertainty related to the essential pillars of contract, it accepts its presence in some cases. In fact, scholars distinguish between excessive uncertainty that invalidates contracts and minor uncertainty, which is tolerated as a necessary evil. A canonical example to the latter situation is the Sharia law acceptance of the Salam and Istisna’a contract (prepaid forward sale), wherein the object of sale does not exist at contract inception, but since the contract allows for the financing of agricultural and industrial activities that cannot be financed otherwise, it is allowed despite this Gharar.

2.1.2.2.2. The Prohibition of Maysir (Gambling)

The rationale behind the prohibition of Gharar in Islam is by no means far from that for the forbidding of Maysir or gambling, as the former was often characterized by prominent scholars in the light of its similarity to gambling. In this respect, the forbidden trading in risk is defined as the sale of probable items whose existence or characteristics are not certain, the risky nature of which makes the transaction akin to gambling. In fact, the latter is a form of Gharar because the gambler is ignorant of the result of the gamble. A person puts their money at stake wherein the amount being risked may bring huge sums of money or may be lost

(5.90–91) In this regard, the Prohibition of Maysir or gambling constitutes another major principals of the Islamic Finance, as it is explicitly stated in the Holy Qur’an: “O ye who believe! Wine and


gambling, (dedication of) stones, and (divination by) arrows, are an abomination, of Satan's handwork: eschew such (abomination), that ye may prosper.”

It uses the word Maysir for games of hazard, derived from Usr (ease and convenience), implying that the gambler strives to amass wealth without effort, and the term is now applied generally to all gambling activities. In Islamic jurisprudence, all kinds of gambling are strongly banned, from explicit forms of gambling to any business activities entailing any element of gambling, such as the conventional insurance contracts in which the uncertainty element is persistent, as well as futures and options contracts that are settled price differences only covered under gambling.

In this regard, it is worth noting the alternative given by Islamic finance to conventional insurance. This alternative is Takaful, which means guaranteeing each other. The takaful system embodies the element of shared responsibility, common benefit and mutual solidarity as well as avoiding the prohibited uncertainty in respect of rights and liabilities of the economic parties In practice, every policyholder pays their subscription or premium, considered as a donation or Tabarru, in order to assist those who need it. The collected premiums constitute the Takaful fund from which any damage giving rise to claim is covered. Indeed, at the end of each financial year, after the deduction of expenses, the remaining cash surplus will be returned to the policyholders in the form of dividends. In this respect, the conception of Islamic insurance is far from the conventional one in which the policyholders, rather than the shareholders, benefit from the surplus generated from the business and investment assets.

2.1.3. The Screening of Sector Activities

All activities in Islamic finance are permitted except those specifically forbidden by Sharia due to their harmful and destructive implications. The most fundamental pillar of this evolving but extensive industry is the concept of Sharia-compliance. This dictates that the financial approach of Muslims should be governed by two major sets of rules. Firstly, unlike conventional finance, Muslims are strictly prohibited from investing in or dealing with economic activities that involve interest, uncertainty and speculation, regardless of their form or shape or the pretexts often used to justify them. Furthermore, Muslims are not only discouraged but forbidden from investing in businesses engaged in illicit activities, such as the production and the distribution of goods and services that stand against

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the tenets of the Islamic value system such as alcohol beverages, pork-related products, drugs, gambling, conventional insurance and banking, war industry and indecent entertainment.

2.2. Mutuality of Risk Sharing

2.2.1. The Principal of Profit and Loss Sharing

This is also the essence of the principle of no profit sharing without risk sharing al-ghunm bi-‘l-ghurm6 (“no pain no gain”), and the earning profit is legitimized only by engaging in an economic venture and thereby contributing to the economic development. In this regard, the assumption of business risk is a precondition for the validity of entitlement to any profit over the principal. Profit has to be earned by sharing risk and reward of ownership through the pricing of goods, services or usufruct of goods.

Investment in the Islamic context is not merely a financial or monetary transaction in which transfer of funds is the only activity. Investment is considered only if it is a part of real activity or is itself a real activity. This is because money has the potential for growth when it joins hands with entrepreneurship. It is not recognized as capital and therefore it cannot earn a return.

The principle of fairness is also reflected in the risk and profit-sharing characteristics of Islamic financial transactions. This requirement must be clearly defined at the onset, and serves as an additional in-built mechanism that promotes the adoption of sound risk management practices by Islamic financial institutions. In particular, these features demand the exercise of appropriate due diligence and higher standards of disclosure and transparency to be observed by the Islamic financial institution, which in turn enforces market discipline and minimizes informational asymmetries. Terms and conditions need to be honestly and clearly laid out; ambiguity based on future events cannot be part of Islamic transactions to avoid potential conflicts in future.7

Thanks to this mechanism, Islamic banks are more involved in financed project profitability than conventional banks. The latter focus mainly on receiving interest payments as its profitability is directly linked to this payment. However, Islamic banks are concerned about the real rate of return and focus in the long term in their relationships with their clients. This partnership engagement obliged the Islamic bank to oversee and monitor projects as closely as possible. 6 A Shariah maxim. 7 Financial Stability and Payment Systems Report 2007.


2.2.2. Business Ethics of Islamic Finance

Islamic Finance is a model "based on themes of Community Banking, Ethical and Socially Responsible Investments and Affinity Marketing."

2.2.2.1. Social Sphere

Kamla et al. (2009) argue that the philosophical reasoning underlying the principles of the Islamic financial system is the implementation of a financial system (wealth accumulation and wealth distribution) that is fair, just and unbiased towards the rich minority at the expense of the poor majority. The holy Qur’an and the Sunna refer to a number of norms and principals which govern the rights and obligations of parties to the contracts. Principles enunciating justice, mutual help, free consent and honesty on the part of the parties to a contract, transparency, fraud avoidance, mispresentation and misstatement and negation of injustice or exploitation provide grounds for actual sound governance. Indeed, the ultimate aim of Islamic law is to spread socio-economic justice amongst all people regardless of their whereabouts. Sharia-compliant debt financing and equity mode proposes a comprehensive moral guideline for dealing with money. Creating money, therefore, has to be in line with the prospects of real growth in the economy in order to provide a sustainable development and more equitable distribution of wealth.

Furthermore, it is worth noting that each of the Islamic finance principals demand the real exercise of appropriate due diligence by Islamic financial institutions and economic agents along with higher norms of disclosure and transparency which could enforce market discipline and mitigate informational asymmetry.

Collectively, these intrinsic features of Islamic finance act as natural stabilizers and restraints against the risks and excesses associated with excessive leverage, financial speculation and mis-selling that can threaten the effective functioning of financial systems.

The Zakat System—Income Redistribution Mechanism in Islam

According to the Holy Qur’an, God owns all wealth, and private property is seen as trust from God. Property has a social function in Islam and must be used for the benefit of society. Moreover, there is a divine duty to work. Social justice is the result of organizing society on Islamic social and legal precepts, including employment of productive labour and equal opportunities, such that everyone can use all of their abilities in work and gain just rewards from that work effort. Justice and equality in Islam means that people should have equal opportunity and does not imply that they should be equal either in poverty or riches (Chapra 1985).

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However, it is incumbent on the Islamic state to guarantee a subsistence level to its citizens in the form of a minimum level of food, clothing, shelter, medical care and education (Holy Qur’an 58, 11). The major purpose here is to moderate social variances in Islamic society and to enable the poor to lead a normal, spiritual and material life in dignity and contentment.8

A mechanism for the redistribution of income and wealth is inherent in Islam so that every Muslim is guaranteed a fair standard of living (nisab). Zakat is the most important instrument for the redistribution of wealth. This almsgiving is a compulsory levy, and constitutes one of the five basic tenets of Islam. The generally accepted amount of Zakat is a one-fortieth (2.5%) assessment on assets held for a full year (after a small initial exclusion), the purpose of which is to transfer income from the wealthy to the needy.

2.2.2.2. Environmental Sphere

In this regard, Al-Qaradawi9 (2000) elucidates that safeguarding, protecting and caring for the environment scarcely constitutes a new Western concept; rather, such concerns are deeply rooted in all fields of Islamic value. Furthermore, Islamic law has enunciated a set of principles that provide a basic framework for the conduct of economic activities in general, and financial and commercial dealings in particular. The most salient values of Islamic finance are fairness, socio-economic justice and its uncompromising commitment towards the well-being of future generations through caring for the environment and preserving earth's valuable resources. 10

8 Handbook Islamic banking (2007). 9 Al-Qaradawi, Y. (2000). “Safeguarding the environment in Islamic Shariah”. Al-Khaleej. 10 For further details, see Kamla et al. (2009) “Islam, nature and accounting: Islamic principles and the notion of accounting for the environment” point out that such concerns for the environment are deeply rooted in all fields of Islamic teaching and culture.


2.3. The Added Value of Islamic Finance Principles to the Financial System

2.3.1. The Inherent Stability of Islamic Finance: Controlling Excessive Credit and Risk Trading in the System and Enhancing Real Economic Sphere

Over investment is important but would have far less serious results if it was financed by equity, as opposed to financing from borrowed money and leverage. Easy money that usually causes over indebtedness followed by deflation is one of the main factors of financial instability. Friedman et al. (1963) considered that faster money expansion resulting from unchecked credit expansion is the dominant cause of financial instability. Some authors prescribed the rule of setting fixed targets for the growth of monetary aggregates in line with economic growth. Through the expansion of money and credit supported by financial deregulation, speculation gathers speed and reinforces financial crisis. Moreover, unbacked credit expansion and money creation is conceived to be one of the main factors responsible for financial instability. Financial instability emerges when there are not sufficient real savings to support lending. These main factors are found to cause financial instability and are exactly the contrary of what distinguishes Islamic finance. Islamic finance fosters equity-based financing and investing instruments and enhances profit- and risk-sharing mechanisms. Islamic finance prohibits interest as well as speculation and promotes an important aspect often missing in conventional finance, which is asset backing.

Maurice Allais held the view of the inevitability of the current structural global economic crisis and warned against its consequences. He considered structural reforms that go far beyond addressing the symptoms of the crises by devising an efficient monetary system, capable of preventing such crises from happening in the future as the unique solution. The two basic components at the heart of the proposed system are adjusting the rate of interest to 0% and revising the tax rate to about 2%. Incidentally, these are the core elements of Islamic economics. Islam prohibits interest (Riba) and requires all Muslims who possess minimum net worth above their basic needs (Nisab) to pay Zakat (2.5% of their assets a year). Zakat is a major economic instrument premeditated to spread socio-economic justice amongst Muslims. Unsurprisingly, the US Federal Reserve announced the cut in lending rate to be between 0 and

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0.0025%, and the demand for meaningful tax cuts has also been building up.11

Khan (1987) investigated the stability of Islamic banking in comparison to the conventional system based on a mathematical approach and found that the Islamic system may turn out to better suit for adjusting to shocks that result in banking crises and disruption of the payments mechanism. The authors compared the application of the balance sheet characteristics of Islamic PLS banks with traditional banks. The balance sheet of the Islamic bank has no fixed liabilities and deposits are considered as shares. Any shock on the asset’s side would automatically be absorbed and adjusted on the liability side. This can lead to stability in Islamic banks. However, in conventional banks, when a crisis arises on the asset’s side the banks turn to liability management and this leads to instability. Bankruptcy is less likely to happen in Islamic banks, because PLS and mark-up operations are based on the solvency and trustee of partners. In the Islamic financial system, the term and structure of the assets and liabilities of the financial intermediary, as we will bring out the latter in the section which deals with Islamic banking, are closely matched through the profit sharing system and hence Islamic finance offers a “pass through” of risk to investors and depositors.

On the microeconomic level, all Islamic modes of trade financing are asset-backed and thus involve money on the one hand and goods or services on the other. Monetary flows would have to be tied directly to commodity flows. Changes in spending would be reflected in the supply and demand of goods and services, causing the quantities of output produced to respond more quickly to market forces. Islamic finance removes the dichotomy between financial and real activities.

2.3.2. Resource Allocation Efficiency

In this regard, Friedman (1969) conceived zero nominal interest as a necessary condition to achieve optimal allocation of resources. In general equilibrium models, a zero interest rate is both necessary and sufficient for allocative efficiency.

Instead of proposing an institutional monetary policy based on steady deflation, Islamic finance propose an alternative restructuring based on replacing interest rate with rate of profit and risk sharing framework through the profit and loss sharing mechanism. In fact, the cornerstone of the Islamic financial system is that any financial development should cause investment alternatives to be compared to one another, based only 11 Hassan (1998).


on their productivity and rates of return. Such a condition is bound to produce improved allocation.

2.3.3. Velocity of Money in Islamic banking

Introducing interest-free banking in Iran and Pakistan in the last two decades has improved or at least did not hamper their overall macroeconomic performance. These structural changes have led to a smoother behaviour of money velocity, have provided policymakers with a more controllable monetary environment and strengthened the linkage between policy instruments and the main policy goal of price stability.

Section 3: Islamic Financial Contracts and Products

The application of the different Sharia principles seen above, which are prominent features in Islamic finance, has contributed to the emergence of a panoply of Islamic financial products and instruments. These latter are developed by applying or combining the appropriate Islamic financial contracts to cater to the financial needs of the investors and consumers. The range of Islamic financial products has broadened considerably in recent years thanks to financial engineering; however, much more effort is needed in this way. The Islamic economic system has a set of basic and core contracts which constitute pillars for designing more sophisticated financial products. Sharia-compliant contracts have to obey the bans on Riba, Gharar, Maysir, illicit activities and ignorance.

For the sake of responding to the more diverse and differentiated requirements of investors and clients, Islamic financial institutions have developed three kinds of Islamic financial instruments—derivative-based instruments, securitized-based instruments and structured-based instruments—by utilizing the set of basic Sharia-compliant contracts.

This section deals firstly with the set of core and basic contracts which are deemed legal and lawful by the Sharia as they are free from any prohibitions detailed above. Further attention will be paid to intermediation contracts in order to well understand how the function of intermediation is performed mainly by Islamic banking and to point out the nature of Islamic financial intermediation and its importance in designing the landscape of the Islamic financial system. As far as the critical role of the capital market in promoting an efficient financial system and enhancing the development of the financial intermediation by improving the resource allocation, providing liquidity and diversified investment opportunities, is considered, the second subsection focuses on

Chapter One 28

the main developed and implemented securitized and derivative Sharia-compliant financial instruments and sheds light on the main features of Islamic equity-based securities.

Islamic financial contracts can be subdivided into four categories: transactional contracts, intermediation contracts, financing contracts and social welfare contracts. Transactional contracts concern transactions that deal with exchange and trading in goods and services and deals mainly with terms linked to the subject of the transaction or the underlying asset as well as to the delivery mode. The financing contracts include contracts which seek to define the terms relating to payment and financing mode of economic activities. The intermediation contracts promote the efficient and transparent execution of these transactional and financing contracts. The Islamic intermediation contracts offer a regulatory framework to propose fee-based service contracts based on the concept of trust and security, partnership-based contracts and takaful or insurance-based contracts. The social welfare contracts include gratuitous loans (Qard Hasan). Qard Hasan is an interest free loan and a kind of gratuitous loan given to the needy people for a fixed period without requiring the payment of interest or profit. The receiver of Qard Hasan is only required to repay the original amount of the loan. These contracts aim to promote the wellbeing of people in need. The institutionalizing of welfare contracts could be developed by intermediary institutions.

3.1

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Chapter One 30

Future Transactional Contract We can distinguish two transactional contracts where the general

condition under which the existence of the object of the contract is required to validate the latter, infringed in order to finance some activities as agriculture or industry that cannot be financed otherwise:

Bay Salam or advanced purchase is an ancient form of forward sale contract wherein the full price was paid in advance at the time of making the contract for prescribed goods to be delivered later. Salam has been permitted by the Sunna. The rationale for this permission is the concept of genuine need as clarified by Zaman (1991), both for the seller and the buyer. The basic difference between the bay Salam and the conventional forward is that in the former the payment of the full negotiated price is paid at the time of contract conclusion, which is not compulsory for the latter.

Istisna’a or Purchase order is a sale contract where the sale of commodity is transacted before the commodity comes into existence. In other words, it is an agreement culminating in a sale at an agreed price whereby the purchaser places an order to manufacture, assemble or construct anything to be delivered in the future. The Istisna’a contract has been legalized on the basis of the benefit analysis.12 It is very similar to the Salam contract as it shared with the latter the function of financing the production of non-existent items. However, it differs from Salam in a few points. Indeed, scholars did not require price in Istisna’a to be fully paid at contract inception to facilitate the financing of multistage manufacturing or construction projects, wherein the buyer may pay for each phase separately. Moreover, the term of deferment in an Istisna’a contract does not need to be fixed in the contract inception. Although the object of a Salam sale is a natural resource, the object of an Istisna’a contract is non-natural and is required to be manufactured or constructed (a public or corporate infrastructure).

Bay’al Muajjil (Deferred payment sale) refers to a sale contract wherein the payment is deferred in instalments or in a lump sum payment.

Al-Mousawamah is a sale by mutual consent reached by negotiations between the seller and the buyer. No reference to the good’s original price is made. Therefore, the cost of the good and the profit made is not known by the buyer.

At-Tawliyyah refers to the sale of goods at its real cost without any surplus.

Al-Wadiah refers to the sale between two parties who agree to trade at a marked-down price. 12 Islamic Fiqh Council of the OIC, resolutions No.65.

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Chapter One 32

The partnership financing contracts are a large range of financing or investing contracts in which two or more parties combine their financial and/or human capital to develop a new commercial project or participate in an existing business. Karich (2005) subdivides this range of contract into two types of partnership:

Musharakah or capital partnership contract; with unequal capital contribution Al-Inan or equal capital contribution Al-Moufawada, characterized by a long- to medium-term and a high risk based on profit and loss sharing. The Musharakah contract entails that every partner enjoys equal rights in all respects and could participate actively in the affairs. The ratio of sharing profit should be predetermined and no fixed amount can be pre-agreed. The losses should be borne based on ratio of capital contribution. Upon this basic contract, Islamic financial intermediary has developed other forms of partnership to manage mobilized funds known as the consecutive Musharakah or to cater other financing needs such as housing finance. In order to provide housing or property mortgages, Musharakah Mutanaqisah or Diminishing Musharakah was developed. This contract is initially a Musharakah contract on property ownership between the financier and the person or the company in need. The special feature of this form of partnership contract is in the fact that the financier ownership will diminish over time as the second partner buys the financer ownership shares with each payment instalment until acquiring complete ownership. The former kind of Musharakah used to manage mobilized funds from depositors in Islamic bank named the consecutive Musharakah will be detailed in the next section when dealing with Islamic banking.

Mudarabah (profit sharing) or capital and labour based partnership; this kind of partnership is actually a partnership in the profit rather than its capital. One party provides the financial capital; it is called the RabElmalior financer/investor. The other party provides its work; it is called the Mudharib or the entrepreneur who acts as an agent of the investor to invest the money based on his skill. Only the profits are shared between them at a predetermined ratio, any losses are exclusively borne by the lender. Before the activity starts, the user of funds is considered as trustee on the capital of the owner, and after activity starts he is considered as a proxy for the owner of capital. The two parties become partners. The capital should be in the form of money and must be well defined by its amount. It should also be delivered to the entrepreneur in full to enable him to trade freely with it. The Mudarabah contract is usually limited to a certain period of time at the end of which profits are distributed at a pre-agreed proportion. Profits stand as a guarantee for the capital, mean that profits are given to


the entrepreneur only if they refund the total amount of principal. There are some activities that the entrepreneur is not allowed to do without the approval or permission from the owner of capital, e.g. to establish a new company or a new Mudarabah with others. To cancel the Mudarabah contract, the Sharia scholars see that it could be cancelled by any of the two partners at any time. Thus, capital should be liquidated.

Many forms of Mudarabah contract exist: Mudarabah can be restricted or unrestricted. In restricted Mudarabah,

the owner of capital specifies to the entrepreneur the type of commodity to use, and the time and place of trade. In this case, Mudarabah is similar to the Wakalah contract seen later. However, in unrestricted Mudarabah, the user of funds is free in their choice of circumstance of trade.

Non-contractual Mudarabah (Mudarabah Mutlaq) and contractual Mudarabah (Mudarabah Muqaiadah)

Single Mudarabah (there is one entrepreneur and one financier) or compound Mudarabah (there are more than a Mudharib [entrepreneur] and more than a provider of funds)

Limited-term Mudarabah where profits are accounted for at the time the work is terminated, or continuous Mudarabah where profits are accounted for on a periodical basis.

Commingled Mudarabah in which there are two providers of funds Mudharib and a financier, but only the Mudharib can participate in the work, or non-commingled Mudarabah in which there is only one financier.

The Debt Based Financing Contract

Murabaha refers to a sale financing contract wherein the subject of the contract is sold at a price which includes a profit margin as agreed by both parties. Such a sales contract is valid on the condition that the price, other costs and the profit margin of the seller are stated at the time of the agreement of sale. With a short-term and low-risk, this contract has become a common financial product offered by the majority of financial institutions to cater to the ascending consumer’s or investor’s need of financing. It involves a profit mark-up. The latter, in practice, can consist of remuneration for the service and administration cost, the credit risk and the use of the financed commodity. Compensation for inflation is also charged. This kind of transaction contract is often used as an alternative to the interest debt granting by conventional banks. It guarantees, first of all, the asset-based principal of Islamic finance and thus the financing of real economy. The Murabaha transaction involves three parties in practice: the financier, the seller and the entity in need. The transaction takes place over four phases. The first step is a need expression, wherein the financier or

Chapter One 34

the bank’s client details their request in terms of product quality, quantity and quoted price to be purchased by the Islamic bank. The next step involves a spot-sale contract between the bank and the vendor and thus the bank becomes the owner of the product. Before the bank purchases the product required by the client, it reaches an agreement with them on the resale price and delivery terms. The resale price is composed of two elements: the original price paid by the bank plus a profit or a mark-up to be agreed upon between the bank and the client. Generally, the customer is responsible for the product’s delivery and storage, although the product is still under the ownership of the bank. The last step involves a Murabaha contract between the client and the bank which is a credit sale contract in instalments or lump sum payment where the two compounds of the resale price, the original cost and the mark-up are precisely indicated. The ownership transfer from the bank to the client is thanks to this contract.

Bay’ Bithamanin Ajil contract is a well-used contract in Malaysia in trade financing. It is similar to the Murabaha contract as the payment is made after the delivery and in instalments. However, the BBA contract is usually used in long-term financing and the profit margin is not usually communicated to the buyer.

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Chapter One 36

contract, the funds of the depositors, especially those deposited in an investment account, will be invested by Islamic banks thanks to its expertise in Sharia-compliant investment, both in financial markets and identifying profitable projects. The contract is usually limited to a certain period of time at the end of which profits are shared based on a predetermined profit sharing ratio. Any losses are borne only by depositors provided they are not due to bank negligence and professional error.

Trust Contracts

The Wikalah contract (representation or agency) refers to a contract that gives to the Wakil (mandatory) the right to act on behalf of the principal and the power to perform certain tasks according to principal instructions. This contract is widely used in Islamic financial intermediary such as in Islamic banking, the brokerage and asset management institutions. The Wakalah contract is used as an alternative to Mudarabah contract when the principal would limit the freedom of the mandatory to the given instructions. Despite the fact that Mudarabah and Wikalah are both principal agent contracts, the Mudarabah contract gives the agent the full control and freedom to invest the principal funds based on their expertise which constitute the main difference between the two contracts. The Wakalah contract may generate cost beyond the administration fees.

The Amanah contract involves the custody and safekeeping of someone’s property. This contract is widely used in Islamic financial intermediation. Based on this contract, the Islamic bank’s depositors deposit their funds in special account in order to safe keep them. The bank has no right to use these funds in any way which constitutes the basic difference between the Amanah and the Wadia contract.

The Wadia contract is a contract of safekeeping wherein the first party deposits money or goods in the second party’s hands as a trust. The latter is liable to compensate any loss if the contract involves service fees. Upon the owner agreement, the trustee could utilize the trust in a different manner (pledge, lend) and must return it upon the owner’s demand.

The Jawala contract refers to an agreement wherein one party undertakes to pay a predetermined commission or to offer specified compensation to the second party able to realize a specific service or uncertain required result. The Jawala is a relevant and useful contract to offer advisory, asset management, consulting and trust services as well as a large scope of feeearning financial services. The Jawala contract may be used by Islamic banks for the recovery of overdue debts and where the entitlement to compensation is contingent upon collection of defaulted debts. The Jawala contract may also be used by a financial intermediary to


offer custodial services for customers in the securities market. This contract offers a large scope of innovative financial products and structures by opening up several fee based financial services.

Security Contract

The Kafalah (Suretyship) is a contract by which a third party guarantees the debt of the actual debtor. The debt responsibility is vis-à-vis the creditor incumbent to the two counterparties.

The Rahn (Pledge) is a contract wherein the lender takes an asset as collateral to make sure that the borrower will repay back the debt.

Takaful Contract

This kind of contract is used in Islamic insurance companies, more commonly known as takaful or mutual guarantee companies. These are contractual saving institutions that mobilize funds through a Mudarabah or Wakalah contract based on a variety of takaful policies. The funds mobilized, in turn, are invested in Sharia-compliant avenues.

3.1.2. On Critics of Debt Similar to Islamic Financing Contracts

We can highlight through the previous development on Islamic contracts, that although Islamic finance is considered equity or partnership finance structured through profit and loss sharing and risk sharing, thanks to the two widely developed financial instruments of Musharakah and Mudarabah, debt has to remain a part of Islamic finance. The Islamic debt-financing, structured through contemporaneous underlying contracts of exchange such as sale and purchase contracts, creates debt that is genuinely backed to real asset, as opposed to a mere debt system in conventional finance. It is worth stating that the two further financing contracts, Murabaha and Ijara, have sometimes been criticized on the grounds that their net result is often the same as that of interest-based borrowing. This criticism is justified to some extent. In fact, in the absence of a suitable profit-rate benchmark, compatible with the principles of the Islamic financial system, Islamic banks have often resorted to the use of interest-based benchmarks such as LIBOR and conventional profitability theories in order to determine mark up rates and returns in advance (Homoud 1980; Haron et al. 1993, 1994). Such reliance on conventional instruments is due to the shortage in Sharia-compliant financial engineering and the poor record in financial research and development in Islamic banks. Sharia Scholars are unanimous on the point that Murabaha and Ijara contracts are not ideal modes of financing and that they should

Chapter One 38

be used only in case of need in some sector where partnership-based finance is not workable for many reasons. Therefore, scholars have to guarantee sound measures to control the use of these instruments to reach both the form and the substance of Islamic law.

3.2. From Basic Financial Instruments to Structured, Securitized and Derivative Instruments

These different kinds of Islamic contract have been used innovatively in structuring various Islamic financial and deposit products for banking, project finance, capital market and insurance sectors. Indeed, Islamic financial products have progressed and grown in sophistication, as can be seen from the offering of a wider range of products with various product structures, multiple categories of service providers and a different mix of consumer composition. Islamic banking products have evolved from basic contracts into a full range of deposit and investing product offers under various Islamic contracts.

The range of Islamic financial products has diversified to include structured financing products, securitized equity and asset-backed land –based, as well as derivative-based instrument as hedging instruments.

In order to cater to the different kinds of Sharia-compliant financing, demand ranging from the short term to the long term and from the cash demand to the financing of huge projects, innovative structured financing products have been developed in this respect.

Although Islamic capital markets are at a rather early stage of growth, the development of Sharia-compliant securitized and derivative financial products has largely contributed to the improvement of the risk management ability of the Islamic financial institutions. For Islamic financial institutions, a financial engineering challenge is to introduce new Sharia-compliant products that develop much needed money and capital markets and enhance liquidity, risk management, and portfolio diversification (Iqbal 2001). In its early days, financial engineering was limited to the development of a product for Islamic banking, but with the development of the capital market the focus of product innovation has shifted more towards the development of marketable securities such as Sharia-compliant bond or Sukuk, stocks, funds, equity indexes and derivatives.


3.2.1. Islamic Financing Structured Products

3.2.1.1. Debt Financing Structured Products These products are grey areas since they are considered the most

important disputed financial instruments among scholars. These products are seen as a case of legal stratagem to circumvent the payment of interest. Chapra (2007) argued that such instruments differ from the conventional as Islamic finance debts are not created by borrowing and lending money, but as by-products of real transactions, and Gharar is not involved as the debtor is often a well-known company with a high credit rate. However, when focusing on the main cause of the recent financial crisis we understand the real danger of such trading. According to Chapra, these products would improve the Islamic secondary market which would give banks the opportunities for liquidity management and securitization. Basically, we can distinguish two main debt financing structured products:

Tawarruq refers to a structured financing transaction of borrowing cash by undertaking two separate transactions. The first transaction involves a basic Murabaha or Bay’ Bithamanin Ajil contract between two parties: the Islamic bank and the client. The second transaction involves a spot sale contract of the same product subject of the Murabaha contract to a third party, for instance a bank. The two transactions are formally Sharia compliant, but in substance they are deemed not compliant by a few scholars as it is alike the creation of a zero coupon loan where the interest rate is the same at which the original seller might be charging to defer the payment. The scholars permit such a product on the grounds of darura, or necessity. For the sake of managing their liquidity, Islamic bank resort to Tawarruq and for large transactions use metal as the underlying asset trade in the London Metal exchange market.

Bay Inah is the same as the Tawarruq as it entails the same two transactions. However, the unique difference is that the third party is the same as the first, which means that the first seller who sold the product on credit to the second party in need of cash repurchases it. Although this transaction is widely used in Malaysia and accepted by Malaysian and south-east Asian Scholars, it is deemed unlawful by gulf scholars.

It is worth noting that Sharia scholars have considered this structure in compliance with Islamic law in case the difference in time between the entry into the first sale transaction and the second is one year minimum.

40

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Istisna’a and Forward Ijarah Structure

In order to mobilize the required funds, the project company involves the financing services of an Islamic bank. Under an Istisna’a contract, the latter undertakes to finance the project with agreed specifications for a fixed price to be paid on a deferred instalment. However, to avoid any involvement in the engineering, construction or building, the Islamic banks enter into an investment agency agreement with an Islamic facility agent acting on behalf of the Islamic bank. The investment agent may either enter into an Istisna’a contract with the project company in which the project specifications are set up or appoints the project company to act as a Wakil under a Wakalah agreement, and procures the construction and delivery of the project assets. The investment agent and the project company may also enter into a Musharakah agreement and mutually provide funds to construct the project.

Under the Istisna’a contract, the project company usually subcontracts the construction tasks to engineering, construction and building contractor. In both agreements, the Islamic bank continues to disburse funds as long as the project company is satisfied with the construction milestones. In parallel with the Istisna’a contract, the investment agent on behalf of the Islamic bank enters into a forward leasing or an Ijarah mawsufah al dhimmah agreement with the project company to allow a return during the construction phase of the project. The forward Ijarah differs from the basic Ijarah contract as the assets matter of the leasing will come into existence once the project is completed. As a lessee, the project company pays advance periodic rental to the investment agent as profit payment date. Along with the forward Ijarah, the project company signed a purchase undertaking of the project in favour of the investment agent through the payment of the total sum minus the paid rentals. In return, the investment agent grants a sale at a pre-agreed price.

The Doraleh Container Terminal (DCT) project constitutes a real example of implementation of such Islamic Project financing structure. The project involves the development, design, construction, management, operation and maintenance of a new container port terminal in the city of Doraleh, Republic of Djibouti. The government of Djibouti grants a thirty-year concession to the DP World Djibouti and Port Autonome International of Djibouti. The Doraleh Container Terminal S.A. (DCT) was developed as a project company via their joint-venture vehicle. The project financing structure was executed by combining three basic Sharia-

42

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Chapter One 44

resemble a conventional fixed income debt security. Sukuk are considered to be the catalyst that put Islamic finance on the global capital markets map. A developed primary and secondary sukuk market widens investment and financing opportunities and provides liquidity management tools to Islamic intermediation.

The AAOIFI has defined investment sukuk in Standard 17 as certificates of equal value representing undivided shares in ownership of tangible assets, usufruct and services or in the ownership of the assets of particular projects or special investment activity. The Sukuk are financial asset that derive their return from the performance of an underlying real asset or a pool of real assets.

The table below points out the main differences between Sukuk and Conventional bonds:

Sukuk Bond Sukuk involves beneficial ownership of the underlying asset or project

Bonds involve debt obligations due from the issuer

Asset underlying the sukuk involves ownership rights either physical or usufruct

Asset backing structure in some conventional bonds takes the form of collateral rights, not ownership rights

The sukuk would be tied to eligible Sharia-compliant contracts such as an Ijara, Murabaha, Musharakah, Mudarabah, Salam, Istisna’a, Wakalah contract etc.

The underlying contract is a contract of loan that generates interest

The purpose for sukuk issuance must be Sharia-compliant

Bonds can be issued to finance almost any purpose which is legal in its jurisdiction

Trading in sukuk represents trading in shares of an asset

Trading in conventional bonds represents trading in debt

Sukuk value depends on the market value of the underlying asset and do not actually depend on the obligor’s or the issuer’s creditworthiness

The value of bonds depends solely on the creditworthiness of the issuer

Asset-related expenses may attach to Sukuk holders

Bond holders are not concerned with asset-related expenses

Table 1.3. main differences between Sukuk and Conventional bonds Source: Author’s contribution


The IFSB (2005) categorized the sukuk into two broad types: The asset based or backed sukuk, where the underlying assets offer fairly

predictable returns to the sukuk holders, such as in the case of Salam, Istisna’a and Ijarah. The assets in question may be held by a Musharakah or Mudarabah which is securitized. This is not the same as the equity sukuk.

The equity-based sukuk or partnership-based sukuk, namely the Musharakah and Mudarabah Sukuk, where the returns are determined on profit and loss sharing in the underlying investment which does not offer predictable returns

Under the first type of sukuk, the IFSB (2009) distinguishes three different sukuk structures:

Asset-backed Sukuk structure which involves actual ownership rights in the underlying asset.

Asset-based Sukuk structure wherein the ownership rights over the underlying asset may not reliably result in an effective right of possession in case of default given the applicable legal environment, and in consequence the sukuk holders need to have a right of recourse to the issuer.

Pass-through Asset-based Sukuk structure which is the typical structure of sukuk when a SPV is involved in the purchase of the underlying assets from the originator, in the packaging of them into a pool and in the issuance. This SPV requires the originator to give the holders recourse, but provides Sharia-compliant credit enhancement by guaranteeing repayment in case of default by the originator.

Usually, the sukuk transactions involve three general key players except for the equity-based sukuk:

The Issuer of Sukuk is the originator who sells its assets to the SPV and to whom funds are collected from subscribers of sukuk. By transferring the asset to this SPV, the asset is taken off the issuer’s balance sheet and is therefore immune to any financial distress the issuer may face in the future.

The Special Purpose Vehicle (SPV) is formed as a separate legal entity based on the Mudarabah contract for the only purpose of managing the securitization process and the issue. The SPV plays the role of agent who acts on behalf of sukuk holders. The purchase of the asset from the originator is funded by issuing sukuk. Depending on the nature of the asset, usufruct of assets or services involved, sukuk can be structured to be designed as Ijara sukuk, Murabaha Sukuk Salam Sukuk and Istisna’a Sukuk. Investment sukuks are structured on the principal of partnership such as Musharakah sukuk and Mudarabah or Muqaradah Sukuk. The existence of an SPM provides confidence to investors about the certainty of cash flows on the certificates and thus their credit rating.

Chapter One 46

The Investors or sukuk holders who subscribe to sukuk issued by the SVP. The rate of return on sukuk could be either variable in the case of Musharakah or Mudarabah sukuk or quasi fixed in the case of Ijara sukuk, Murabaha, Salam or Istisna’a Sukuk.

Fig. 1.12. Basic Sukuk Structure Basic Sukuk Structure

Sukuks are Sharia-compatible for trading in the secondary market, except for the Salam, Istisna’a and Murabaha sukuk as they involve debt trading or Bay Dayn at negotiated price. Sharia considers that the sale of debt other than at face value entails dealing with interest. Salam, Istisna’a and Murabaha contracts create debt as the result of credit sale.

Below, we distinguish the main known and used kinds of sukuk depending on what the basic contracts are tied to.

Ijara Sukuk

Ijara sukuks are certificates of ownership of leased asset, and held by investors who lease the asset underlying the certificate to the originator after purchased it from them. Funds collected through sukuk issuance are used to purchase the asset from the originator. After the transfer of ownership, the SPV lease the asset to the originator. During the course of the life of the Ijara sukuk, periodic payments which are made by the originator (lessee) are transferred to the investors through the SPV. At maturity, the SPV sell the asset back to the originator at a pre-determined price and then pay back the sukuk holders. Most of the sukuk issues are


based on the Ijara contract as Ijara sukuks are distinguished by several advantages such as flexibility in the time of inflows and outflows and the maturity length. The maturity of the Ijara sukuk can be of any length as long as the asset can be subject to the Ijara contract. According Sharia, the transfer of ownership is possible during the leasing period. Such criterion is important for a developed secondary market for Ijara sukuk. From the fact that the asset underlying the Ijara contract is always a physical asset, the Ijara contract could be widely negotiated in the secondary market.

Fig. 1.13. Salam Sukuk Salam Sukuk

The SPV purchase the asset based on the Salam contract. It pays the

price thanks to proceeds from the sukuk certificates. The sukuk holders are the owners of the asset purchased. Subsequently to the Salam contract, the originator promises to buy the asset from the SPV when it will be delivered at a predetermined price with a profit margin. The rate of Return on the Salam Sukuk is fixed to the margin profit. The Salam Sukuk resembles a zero coupon. In countries with large public sectors or where the government has a substantial deposit of natural resources, they can issue certificates for the future delivery of such products, which are fully paid for on the spot by investors, who receive certificates of purchase in

Chapter One 48

return. The Salam purchaser can choose to hold onto the Salam contract and receive the shipment on the designated date, or elect to sell the goods involved in the contract through parallel Salam.

Istisna’a Sukuk

The SPV which acts as an agent on behalf of sukuk holders in the Istisna’a sukuk issue process becomes the seller and contractor-manufacturer of an asset to the buyer who is the originator. The sukuk sold to investors may have different maturities to match the instalment plan agreed upon by the SVP and the originator. The Istisna’a sukuk, along with the Salam sukuk, are not allowed to be traded in the secondary market except at its nominal value.

Murabaha Sukuk

The SVP purchase the asset needed by the originator and resells it to them under a Murabaha contract. The return of the Murabaha sukuk is a steady stream of income based on the mark up of the Murabaha contract.

Mudarabah or Muqaradah Sukuk

This kind of Sukuk is very suitable to finance infrastructure projects or the development of great projects. The relationship between the originator and the investors represented by the SPV is based upon a Mudarabah contract. The originator is the Mudharib or the entrepreneur, and the Mudarabah sukuk holders are the capital investors. The rate of return of the sukuk Mudarabah depends on the profit rate realized by the financed projects and the return to sukuk holders is based on the profit sharing rate pre-agreed between the SPV/ investors and the originator. At sukuk maturity, investors may sell their sukuk on the secondary market. Musharakah Sukuk

The Musharakah and Mudarabah sukuk are very similar as they are both based on risk and profit sharing. However, in the case of the Musharakah sukuk, the sukuk holders and the SPV or the originator are partners as well, as the latter plays the role of the entrepreneur.

Both are generally used for financing public or corporate developed projects that need large funds or real estate. They are not well-spread as their development requires a high level of transparency and monitoring.

Table 1.4 below deals with some differences and similarities between Partnership Sukuk, Bond as well as Sharia-compliant stocks.


Mudarabah and Musharakah Sukuk

Bonds

Sharia-compliant stocks

Nature

Not a debt but undivided ownership shares in assets/ projects with defined or undefined maturity.

Debt of Issuer With defined maturity.

Ownership share in specific company deemed Sharia-compliant. With undefined maturity.

Asset Backed

A minimum of 51% tangible assets (or their contracts are required to back issuance of Sukuk)

Generally not required

Liquidity test: the amount of account receivables divided by twelve- month average M.Capita <33%

Claims

Ownership claims on the specific underlying asset or project.

Creditors’ claims on the borrowing entity, and in some cases liens on assets

Ownership claims on the company

Security

Secured by ownership rights in the underlying assets or projects in addition to any additional collateral enhancements structured

Generally unsecured debentures except in cases such as first mortgage bonds, equipment trust certificates and so on

Unsecured

Principal and Return

Not guaranteed by issuer and returns depends on the return rate of the project and the pre-agreed sharing rate. Returns are variable. Sukuk are backed by the revenue generated by the project funded.

Guaranteed by issuer and returns do not depend on the profit of the project. Returns are fixed income. Bonds are backed by the revenue generated by the project funded.

Not guaranteed by company and return depends on the company profits. Returns are variable. Shares are backed by the revenue generated by the company.

Purpose

Must be issued only for aan Islamically-permissible purpose.

Can be issued for any purpose

The core business activity of the company should be consistent with the Islamic law.

Chapter One 50

Responsibility of holders

Responsibility for defined duties relating to the underlying assets/projects limited to the extent of participation in the issue.

Bondholders have no responsibility for the circumstances of the issuer.

Responsibility for the affairs of the company limited to the extent of holding in the company.

Table 1.4 Source: Author’s contribution Combined Sukuk

Combined or Hybrid Sukuk are the combination of different kinds of sukuk: Ijarah, Istisna’a, Salam and Murabaha. They are conceived to be tradable as generally the share of the Ijara sukuk represents more than 50% of the hybrid sukuk basket.

3.2.2.1.2. Redemption and Convertibility of Sukuk Redemption of Sukuk

The resolution adopted by the Sharia Board of the AAOIFI in February 2008 provides that it is not permissible for the Mudarib (investment manager), sharik (partner), or wakil (agent) to re-purchase the assets from Sukuk holders or from one who holds them, for its nominal is, however, permissible to undertake the purchase on the basis of the net value of assets, its market value, fair value or a price to be agreed, at the time of their actual purchase. In case the assets of Sukuk of al-Musharakah, Mudarabah, or Wakalah for investment are of lesser value than the leased assets of Forward Leasing, then it is permissible for the Sukuk manager to undertake to purchase those assets, at the time the Sukuk are extinguished, for the remaining rental value of the remaining assets, since it actually represents its net value.

Convertibility of Sukuks

Convertible Sukuks are those that can be converted at the option of the holder into shares of the issuer at a pre-agreed price through a sale undertaking. From the obligor's perspective, convertible Sukuks offer the prospect of obtaining finance with the prospect of the payment being converted into the issuer's shares at a premium to the market value of the shares at the time of issuance. From an investor’s perspective, a convertible sukuk typically has a low yield but offers the investor the prospect of participating in any significant increase in the issuer's share

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Credit enhancement techniques are designed to protect the investors from losses incurred in the underlying assets. Many techniques are already used in the industry and considered as Sharia-compliant sukuk credit-enhancement mechanisms, mainly the subordination, the overcollateralization, cash reserves, recourse and takaful insurance. Discussions over the compliancy of the tranching techniques to Sharia law are undertaken between scholars.

Subordination is the limitation of the rights of certain creditors to the full satisfaction of the rights of other creditors, which means that upon any distress event, the trustee’s claim an owing by the originator in respect of any obligations is subordinated to the claim of senior creditors, in that all claims of senior creditors must be paid in full before any other claim is paid.

Overcollateralization is another credit enhancement technique indicating an allocation of assets in amounts exceeding the size of the Sukuk issuance.

Cash reserves are based on allocation of certain amounts whether funded from the outset of a transaction or built over time to pay investors in case of default or delinquencies.

Under the recourse techniques, the shareholder rights to the collateral are subordinated to the rights of the Sukuk holders.

Takaful Insurance is also considered as a credit enhancement mechanism. In fact, on Sharia Standard No. 5 in respect of guarantee, it is permissible to subscribe to Islamic insurance coverage as security for debt obligations and is not permissible that debts be insured on a conventional insurance basis.

3.2.2.2. The Islamic Equity Market Sharia-compliant Stocks

The first catalyst to the development of the Islamic equity investment based on investing in Sharia-compliant stock market was a Fatwa or ruling legislated by the Islamic Fiqh Academy of the Organization of Islamic conference in 1987, whereby shares in a company where defined as being an undivided portion of the company assets. Prior to this, there had been much debate about whether investing in shares was allowable under Sharia law. The ruling, however, opened up the sector to the millions of Muslims throughout the world who wanted to invest their surplus earnings or savings in accordance with Sharia law.

What distinguish Islamic stocks from their conventional one is that the stocks are screened to ensure that each of which is in keeping with Sharia or Islamic law requirements for acceptable business activities, debt level, interest income and liquidity. Sharia screening takes place mainly at two levels. The first level deals with business activities and the second level has to do with financial ratios.

Chapter One 54

Sharia screening process starts with the analysis of the revenue allocation of companies. The core business activity of the company should be consistent with Islamic Law and companies with the following core business are excluded: conventional financial and insurance services, gambling, casino, manufacture or sale of illicit products such as pork, tobacco, alcohol and arms and adult entertainment deemed as unethical.

The second step of the screening process consists of driving three financial ratio screens. The first concerns leverage. Companies with total debt over the twelve-month average market capitalization beyond 33% are excluded. Hence, the first characteristic beyond sector allocation that distinguishes companies included in the Islamic equity index is the low leverage feature. The second ratio refers to the liquidity test which consists in keeping only the companies with a minimum level of liquid asset. In fact, the amount of account receivables divided by twelve-month average market capitalization must be less than 33% to retain the stock. The rationale behind this lies in the principal of money that cannot be traded and generate returns. If company’s assets are in a liquid form as money, shares represent money that are forbidden to be purchased and sold except at par value. The last ratio concerns interest earnings. Earnings from interest are generally forbidden. Yet, since all companies are cooperating with banks and this relationship might generate interest, Islamic Scholars defined thresholds indicating to which extent interest is permissible. Interest permissibility is measured in two different ways: either the amount of the interest income generated, or the amount of liquid assets (cash and short-term investments) that could generate interest income is limited. The ratio sum of a company‘s cash and interest bearing securities over market capitalization must be kept under the threshold of 33%.

3.2.2.3. Sharia-Compliant Derivative Based Instruments

The introduction of derivatives in Islamic finance has been highly objected. Options, futures, forwards and swaps, as they are currently used and traded in conventional finance, are unlawful according to Islamic law as they involve Gharar (uncertainty), Maysir (speculation) as well as the sale and purchase of debts. In fact, apart from their hedging function, conventional derivatives have actually been used for speculation objectives, deemed impermissible under Islamic law. However, the reduction and prevention of risks by lawful mechanisms is not only permissible but praiseworthy as it contributes to preserving wealth, one of the objectives of Sharia.

Due to the need to manage increasing kinds of risk exposures, the development of Sharia-compliant hedging instruments becomes crucial for


Islamic financial institutions. Sharia-compliant derivatives would promote Islamic international business deals and increase the trading volume and liquidity of Islamic securities, thus reducing transaction costs and rendering Islamic capital markets less risky and more attractive. 3.2.2.3.1. Key Concepts in Structuring Derivative Based Products

The Islamic basic instruments considered as key concepts in developing Islamic derivatives include Murabaha, Salam, Istisna’a, Urbun, and Waad, or promise. Sharia-compliant derivative products include istijrar, Islamic profit rate and currency swaps, currency option and Sharia-compliant short selling. Some of these are being further developed, and some are already used in Islamic finance.

Salam and Istisna’a

Salam and Istisna’a contracts are considered as both transactional ownership sale contracts with future delivery and as Islamic-derivative instruments used to hedge some financial risks. With respect to their hedging feature, they are very similar to forward contracts whereby the price of an asset is paid up-front at the time of contract or in margin based payments. Before delivery of the asset, the risks lies with the seller and upon delivery and are transferred to the buyer. The latter may enter into similar contract with a third party in a parallel Salam, which must be independent of the first. The Salam is widely used to generate working capital.

Urbun

Urbun is a conditional purchase contract which refers to an advance deposit that forms part of the asset or service price, but will be forfeited in the event that the buyer decides not to proceed with the purchase and thus considered a gift to the seller. Many scholars have considered such an undertaking as a void contract as it makes a gift (the advance deposit) conditional upon a sale, considered as repugnant to Sharia. The OIC Academy based on the Hanbali school opinion has endorsed Urbun only if a time limit is specified for exercising the option. It is interesting to note the similarity between this and the modern European call option, except that in the call option the down payment or premium is not subtracted from the purchase price if the buyer chooses to exercise the Urbun. The concept of the Bermudan option is of great interest in this respect, offering more flexibility.

56

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Chapter One 58

3.2.2.3.2. Sharia-Compliant Derivative Based Structures 3.2.2.3.2.1. Sharia-Compliant Swaps

The common types of Islamic swap structures used are the Islamic Profit Rate Swap (IPRS)14 and the Islamic Currency Swap (ICS).15 The former instrument is used to swap or exchange floating payment liabilities with fixed payment liabilities or vice versa for the purposes of hedging. Islamic Currency Swap is used to hedge against fluctuations in currency rates by a series of profit payments in one currency with another currency. The common underlying Islamic contracts used by the banks in Islamic swaps are Tawarruq, commodity Murabaha and Waad. We will also develop the structure of another kind of Sharia swap, the Sharia Total Return Swap.

Islamic Profit Rate Swap

An Islamic Profit Rate Swap is an agreement to exchange profit rates between a Fixed Rate Party and a Floating Rate Party (or vice versa) implemented through the execution of two transactions, each of them structured in two contracts, a spot sale contract and a Murabaha contract. It is a bilateral agreement between Islamic financial institutions or investors seeking to match funding rates with return rates or to match assets with liabilities. A Sharia-compliant profit rate swap could also be used to achieve a lower cost of funding, to restructure an existing debt profile without raising new finance. This swap is utilised to alter the structure of the balance sheet and to manage exposure to interest rate movement as Islamic financial institutions still compete with conventional banks for market space. The profit rate swap is structured around two basic stages. The first stage has generated a fixed profit rate and is structured around a sole Murabaha contract at a fixed profit rate. Within the second stage of the swap transaction, simultaneous Murabaha contracts are undertaken by the two parties in order to generate floating profits. The different secondary Murabaha contracts are based on different fixed rates. The determination of each fixed rate depends on a floating interest rate such as the LIBOR. In the first stage, the fixed-rate payer sells commodities to the floating rate payer under a Murabaha contract. Hence,

14 The first usage of the IPRS traces back to 2006. The Standard chartered Saadiq, along with the Kuwait based Aref Investment Group, entered into $150 million three year profit rate swap. (www.ameinfo.com). 15 The first usage of the ICS traces back also to 2006. The Dubai Investment Group entered into a Sharia-compliant currency swap designed by the Citigroup bank In order to hedge its currency position linked to its 828 RM million equity investment in Bank Islam Malaysia (www.gata.org).

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Under the conventional Total Return Swap contract, the first swap-party pays all revenue linked to the reference asset, plus any positive price changes of the asset over the payment period to the second swap-party. Furthermore, the latter pays LIBOR plus a spread as well as any negative price changes of the asset. In case of a default of the underlying asset, the asset is valued to zero and the protection seller has to pay the full initial market price of the asset, which was valid at the start of the contract. The interest in using such a contract stemmed from the fact that it allows investors to derive economic benefits and gain exposure to an asset which it does not necessarily hold on its balance sheet. Moreover, it permits the protection buyer to be hedged against any upside or downside of the reference asset value. The Sharia-compliant Total Return Swap was introduced in 2007. It is based on a double Waad structure or two mutually exclusive unilateral promises. The structure of such a product needs the creation of a special purpose vehicle issuer. The SPV issues Murabaha or Salam certificates in order to acquire a pool of Sharia-compliant assets from the market. The certificate holders gain exposure to the underlying assets referenced by the swap mechanism through a double mutually-exclusive Waad agreement between the SPV and an Islamic bank. The first Waad consists of a promise given by the SPV to sell the Sharia-compliant assets to the bank at a price based on the performance of the underlying asset. Under the second Waad, the bank promises to buy the Sharia-compliant assets at a pre-agreed strike price. Both undertakings are mutually exclusive which means that only one promise will be enforced at maturity. The exercise of each promise depends on the performance of the Sharia-compliant assets in comparison to the underlying assets matter of the swap. In fact, at maturity, if the underlying assets outperform Sharia-compliant assets and the strike price is better than the Sharia-compliant assets’ market value, then the issuer enforces the second Waad, and conversely if not. This structure allows certificate holders to benefit from the opportunity to swap the returns of an investment basket generated from the Sharia-compliant assets performance with another investment basket generated from the underlying assets. DeLorenzo16 (2007) has severely criticized this structure and considered it as non-Sharia compliant in case the underlying assets were not Islamic. He points out the difference between that reflects a prohibited transaction in terms of its characteristics such as Murabaha or Salam based on LIBOR mark up, and an investment that reflects a prohibited transaction by actually having its returns determined by that transaction.

16 www.dinarstandard.com/finance/DeLorenzo.pdf

62

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Sharia-Compliant Short Selling Based on the Urbun

The structure of Sharia-compliant short selling based on the Urbun was introduced in 2008 with the launch of the first Islamic hedge fund17 on the Al Safi trust alternative investment platform. Within the Urbun, even if the contract is not completed when the buyer provides the non-refundable deposit, the sale is considered as concluded and ownership is transferred. The transaction is structured on two steps. On the first step, the investor sells an Urbun to a buyer upon which they promise to deliver the asset at a precise date and pre agreed price. At maturity, if the buyer chooses to exercise the call option and to buy the asset, the buyer pays the remainder of the purchase price. Following the exercise of the Urbun, the investor will be under obligation to purchase and deliver the assets to the buyer. The buyer pays the investor at maturity, following which the investor purchases the assets from the market at a price that is expected to be lower than the pre-agreed price. The investor may hedge its risk exposure from the Urbun agreement by entering into a parallel Urbun contract with a third party. The difference between the Urbun strike prices and the purchase price at maturity gives rise to the investor’s profit. In practice, a prime broker intervenes to facilitate the exchange between investor and buyer.

17 Barclays Capital and the Dubai Multi Commodities centre authority were among the first active agent in the development of the first Shariah compliant hedge fund replicating shorting in a Shariah framework.

64

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66

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Conclusion: On the Challenges and Issues of Structuring Innovative Sharia-compliant Products

Innovation and financial engineering today constitutes one of the most critical needs of Islamic financial institutions, as it represents the forces that will drive Islamic finance toward continuous growth and efficiency. The structuring of innovative financing and derivative Sharia-compliant instruments plays an important role in the enhancement of Islamic financial markets and the Islamic risk management practices. Combining basic Sharia-compliant financial instruments within Sharia-compliant structures to cater to precise identified needs defines the financial engineering process in Islamic finance. Such a process is very sensitive and complex as it requires multidisciplinary considerations involving deep knowledge of finance, economy, Sharia law and commercial law. The approval of innovative products by Sharia law scholars constitutes one of the main steps in the whole process as it gives the product its legitimacy. Despite the effort inside the industry to harmonize the opinions towards new different products, Sharia compliance is carried out mostly at the micro level, with Islamic financial institutions appointing their own Sharia boards. Divergence of opinions among different Sharia scholars and boards as well as the absence or lack of effectiveness of a central regulatory body is perceived as an obstacle to the growth of investment confidence in Islamic finance. Hence, Innovation along with greater uniformity is the order of the day to make Islamic finance as an international financial system, luring a wider customers share. While innovation and financial engineering are very important, attention must be drawn to the fundamental feature of Islamic finance, which is socio-economic and distributive justice, and this aim has to be kept in mind when developing new products.

References

Ariff, M. (1982), 'Monetary policy in an interest free Islamic economy nature and scope' in M. Ariff, (ed.), Monetary and Fiscal Economics of Islam, International Centre for Research in Islamic Economics, Jeddah.

—. (1988), “Islamic Banking in Southeast Asia”, Institute of Southeast Asian Studies, Singapore.

Bellalah Mondher, Gestion Quantitative du Portefeuille et nouveaux marchés financiers, 1990, Editions Nathan

—. Real option valuation with information costs: a synthesis” With G. Pariente, International Journal of Business, vol 12, (2), 2007

Chapter One 68

—. “Merton H. Miller: Our Socrates”, International Journal of Business, 2008,

Bellalah Mondher, Zhen Wu “An Intertemporal Capital Asset Pricing Model with Incomplete Information”, International Journal of Business, 2009, Vol 14, N 2

Bellalah Mondher, A simple model of corporate international investment under incomplete Information and taxes, Annals of Operational Research, special issue, vol 165, 2009 , pp. 123-143

Beshir A. (1993), "Equity Capital, Profit Sharing Contracts, and Investment: Theory and Evidence" Journal of Business and Accounting, 20(5) Sept. 1993

—. (1994), "The performance of Islamic Banks: The case of Faisal Islamic Bank" a paper presented at the International workshop on Islamic Political Economy in Capitalist Globalization, December 12-14, Penang, Malaysia

—. (1999). "Risk and Profitability Measures in Islamic Banks: The Case of Two Sudanese Banks “Islamic Economic Studies, Vol. 6, No. 2: 1-24.

—. (2000), “Assessing the Performance of Islamic Banks: Some Evidence from the Middle East”;

Chapra (1970), "The Economic System of Islam: A Discussion of its Goals and Nature", The Islamic Quarterly (quatre articles), vol 14, Londres 1970.

—. (1982), “Money and banking in an Islamic economy”. —. (1985), “Toward a Just Monetary System: The Islamic Foundation”,

Leicester. Dar and Presley (1999), « Islamic Finance: A Western Perspective »,

International Journal of Islamic Financial Services 1(1), 3-11. Haron, S., N. Ahmad et S. Planisek (1994), « Bank Patronage Factors of

Muslim and Non-Muslim Customers », International Journal of Bank Marketing 12(1), 32-40.

Haron S. (1993), " The effects of management policy on the performance of Islamic banks" Asia Pacific Journal of Management Vol 13, NO 2: 63-76.

Hasan, I., Weill, L. (1998),”Competitive environment, market structure, and performance: A review of European experience”, paper presented at the VII Tor Vergata Financial Conference, Rome, 26-27 November 1998.

Hasan Y.D. (1996), “al-Riqabah al-Shari yyah fi al-Masarif al-Islamiyyah, Cairo, Egypte: International Institute of Islamique Thought.


Iqbal, Z. (1997), “Islamic financial systems” Finance & Development, Vol. 34, Issue 2, pp. 42-45.

Iqbal et al. (1998), "Challenges Facing Islamic Banks", Jeddah: IRTI. Iqbal Z. (2001) , “Profit and loss sharing ratios a holistic approach to

corporate finance”, International Journal of Islamic Financial Services, Volume 3, Number 2.

Iqbal, Z. et A. Mirakhor (1987), Islamic Banking International Monetary Fund Occasional" Paper no 49, W.C.

Kahf Monzer (1982), "The Islamic Economy: An Analytical Study of the Functioning of the Islamic Economic System", Muslim Student Association of the United States and Canada, Indiana, 1982.

—. (1982a), 'Saving and investment functions in a two sector Islamic economy', in M. Ariff (ed.) .

—. (1982b), ‘Fiscal and monetary policies in an Islamic economy', in M. Ariff (ed.).

Karsten, I.. (1982), 'Islam and financial intermediation', IMF Staff Papers, March, 29(1):10842

Khan et Mirakhor, (1987), "Theoretical Studies in Islamic Banking and Finance", The Institute for Research and Islamic Studies, Houston, Tex.

Khan M.-S. (1986), "The Framework and Practice of Islamic Banking", Finance and Development, New-York, V.23, 1986

—. (1986), "Islamic Interest-free Banking: A Theoretical Analysis", International Monetary Fund Staff Papers, No. 33, pp. 1-27.

Khan, A. J. (1986), 'Noninterest banking in Pakistan: a case study', paper presented to the Seminar on Developing a System of Islamic Financial Instruments, organized by the Ministry of Finance Malaysia and the Islamic Development Bank, Kuala Lumpur.

Khan, M. F. (1983), 'Islamic banking as practised now in the world' in Ziauddin, Ahmad et al. (eds.).

Khan, M. S. (1987), 'Principles of monetary policy in an Islamic framework', paper presented to the International Institute of Islamic Economics, Islamabad, Pakistan, July.

Khan, M. S. and Mirakhor, A. (1988)., “'The financial system and monetary policy in an Islamic economy', Journal of Research in Islamic Economics.

Khan, M. A. (1968), “'Theory of employment in Islam', Islamic Literature, Karachi, XIV (4): 5l6.

Khan, W.M. (1985), "Towards an Interest Free Islamic Economic System", The Islamic Foundation, Leicester.

Chapter One 70

Khan (1983), “Comments on Volker Nienhaus: Profitability of Islamic Banks Competing with Interest banks”, Journal of Research in Islamic Economics, Vol. 1, N° 2 (Winter), pp. 73-78

Siddiqi, M.N. (1982), 'Islamic Approaches to Money, Banking and Monetary Policy: A Review', in M. Ariff (ed.), above.

—. (1983a), "Banking Without Interest", The Islamic Foundation, Leicester.

—. (1983b), "Issues in Islamic Banking", Islamic Foundation, Leicester. —. (1985), "Partnership and Profit Sharing in Islamic Law",

Islamic Foundation, Leicester. —. (1988), "Banking without Interest", Leicester: The Islamic

Foundation.

Selected readings: Websites

www.ameinfo.com www.gata.org Islamic Finance - cfapubs.org, www.cfapubs.org Islamic Finance, www.islamic-finance.com Islamic Financial Services Board (IFSB), www.ifsb.org World Database for Islamic Banking and Finance, www.wdibf.com International Islamic Financial Market, www.iifm.net Islamic Finance News, www.islamicfinancenews.com Global Islamic Finance Magazine, www.globalislamicfinancemagazine.com Islamic Finance - Deloitte, www.deloitte.com/xd Islamic Finance News - Bloomberg, topics.bloomberg.com/islamic-finance Islamic finance: Banking on the ummah, www.economist.com Islamic Finance, www.islamicfinance.de Islamic Finance WIKI,

wiki.islamicfinance.de/index.php/Islamic_financial_institutions IslamicFinance Overview - Islamic Finance - FNB, https://www.fnb.co.za/

islamic-finance/islamic-finance.html Islamic banking - Wikipedia, the free encyclopaedia,

en.wikipedia.org/wiki/Islamic banking International Shari'ah Research Academy for Islamic Finance (ISRA),

www.isra.my Islamic Finance News, www.islamicfinancenews.com Ethical Institute of Islamic Finance™, ethicainstitute.com/ Islamic Banking & Finance Institute Malaysia, www.ibfim.com/ IIUM Institute of Islamic Banking and Finance (IIiBF)

www.iium.edu.my/iiibf

CHAPTER TWO

PRODUCTIVITY GROWTH IN THE GCC BANKING INDUSTRY 1999–2007:

CONVENTIONAL VERSUS ISLAMIC BANKS

Section 1. Introduction

Market conditions in the banking sector have undergone profound and extensive changes over the last two decades.1

The liberalization of financial markets, the increasing use of new and advanced technology, financial innovations, the change in customer preferences, and the information revolution have put competitive pressure on banking institutions and modified the technology of bank production (Carvallo and Kasman 2005; Al-Jarrah and Molyneux 2007). In response to these changes and rapid globalization, Arab countries, following developed economies, have, from the 1980s, introduced a series of financial reforms in their banking sector. The economic growth in this region depends on the banking industry, which constitutes the main financial intermediary to manage funds and to channel savings and investment (Iimi 2004). Indeed, in emerging markets, banks remain the principal suppliers of credit to private and public investment projects besides financing government deficits.

The Gulf cooperation council (GCC) which includes six Arab countries, namely Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates is a region where the processes of financial liberalization and deregulation have recently accelerated as part of the GCC countries’ overall strategies to free their economies. Over the last decade, the financial and monetary authorities in GCC countries have undertaken several changes with the intention of promoting financial market development and increasing the competitiveness of their banking sector. According to Al-Obaidan (2008) and Srairi (2009b) these measures include liberalizing trade, encouraging foreign direct investment (FDI), 1 This chapter is written initially by Samir Abderrazek Srairi.

Chapter Two 72

liberalizing interest rates, allowing entry of both domestic and foreign new private banks,2 strengthening the central bank’s supervisory capacity, and implementing regulations that helped in progressively moving the Gulf states toward market-based economies. We estimate that these economic and financial reforms encouraged competition in the GCC banking sector, which will improve the quality of services offered, diversify products and reduce costs, and in turn increase the efficiency and productivity of banks. To test this hypothesis, we assessed the impact of financial sector reforms on the productivity growth of GCC banking industry over the period 1999 to 2007. By employing a non-parametric method, data envelopment analysis (DEA) developed by Fare et al. (1985), we measured the productivity change of commercial banks operating in six Gulf countries using the Malmquist productivity index (MPI). In addition, the sampled banks are categorized into two sub-groups: conventional banks and Islamic banks. This enables us to examine the effect of environment changes on productivity by organizational type. To our knowledge, this is the first study to apply this approach in the comparison of productivity change between conventional and Islamic banks in GCC countries.

Established in 1981, the GCC countries as a regional economic block share many common features, notably the similarities in their political, economic, social, demographic and cultural structures (Peterson 1988). These traits, especially the role of oil in their economies, are important factors in facilitating economic and financial development and growth (Saab 2007). Despite many efforts to diversify their economies, the energy sector continues to dominate the GCC countries’ revenues. On average, oil represents more than 80% of export receipts and budget revenues respectively. The non-oil sector is dominated by trade and financial and business services.

Early in their economic development, the GCC countries (unified by economic agreement in 1981) liberalized their trade and exchange rates regimes, which are pegged to the US dollar (with the exception of Kuwait which opted in 2007 for a basket of currencies), opened their capital markets and imported foreign labour. Over the last decade, there have increasingly been attempts to reform and liberalize the financial and capital market in this region. In order to integrate their banking systems, the resolution of the 18th summit of GCC countries held in Kuwait in December 1997 allowed each member state to open branches of its national banks in the other council’s countries. The economic agreement 2 For example, Saudi Arabia in the last few years has granted licenses to ten branches of Gulf countries’ banks and international banks (e.g. BNP Paribas, JP Morgan and Deutsh bank).

Productivity Growth in the GCC Banking Industry 1999–2007 73

signed in 2001 added other areas of economic cooperation. It allowed GCC citizens and businesses to own and trade shares of joint companies in other GCC countries, and to establish companies as well. According to this economic agreement, the six Gulf countries adopted a common customs tariff in 2003 (reducing it to 5% of all imported goods) and created the Gulf customs union where trade barriers, taxes and related procedures are reduced or eliminated among them. In addition, a common market was launched in 2008 and GCC states decided to establish a monetary union and to have a single currency before 2010. However, some technical problems may delay the realization of this union in the target date. Moreover, since 2005 all GCC countries became members of the World Trade Organization (WTO), and in consequence are also members of the General Agreement on Trade in Services (GATS). On the other hand, the degree of openness in the banking system in GCC states varies from one country to another. In Bahrain, Oman, Qatar and the UAE, several international banks have been operating for many years without any restrictions. However, Saudi Arabia and Kuwait started receiving branches of foreign banks only from 2004.

The GCC region has been an important financial centre for decades. The GCC banking sector is well developed and banks continue to play a major role in economic development. In recent years, GCC banks have witnessed a growth in both size and sophistication as a result of the very favourable economic environment. Since 2002, the GCC economies have been in a relatively strong position and continue to benefit from the sustained rally in oil prices as well as from the healthy performance of the non-oil sector (8% growth between 2002 and 2005 in real terms). Nominal GDP, which was $349 billion in 2002, has more than doubled and raised to $828 billion in 2007. In real terms, economic growth averaged a solid 7% a year during the period 2002–2008. The total assets of banks, which amounted to $310 billion to 2001, have also more than doubled to reach over $854 billion in 2007. Gulf banks are still small compared to the big international banks, but they are financially strong, well capitalized and have adopted modern banking services (Srairi 2009a). Their operations can be characterized by satisfactory asset quality, adequate liquidity and high levels of profitability (Islam 2003). Local banks follow International Account Standards (IAS) and the central monetary authorities of Gulf countries have strengthened prudential norms in line with Basel 1 and 2 requirements. They have also amended their banking regulations to include internal corporate governance, such as establishing transparency and disclosure in financial statements, establishing board level audit, nomination and compensation committees and improving risk management

Chapter Two 74

(Saidi & Kumar 2007). In addition, the participation of foreign banks through joint-ventures with local banks and the development of the financial sector in this region3 have enhanced the performance and competitiveness of the GCC banking sector. Moreover, international institutions such as the International Monetary Fund, World Bank and BIS have played a role in providing technical assistance and building knowledge and capacity to the GCC financial market. According to international ratings agencies, most GCC banks are expected to continue with robust financial performance in the medium term.

GCC countries have also succeeded in implementing a dual banking system. Indeed, an important number of Islamic banks are operating side by side with traditional banks. In 2007, the financial sector represented about 18% of the region’s financial system and captured about 36% ($178 billion) of global Islamic financial assets. Islamic institutions are focused on financing and leasing operations. They also manage wide-ranging portfolio of equities in companies and businesses whose activities are compatible with Islamic rules (Elton 2003). In addition, many conventional banks, especially in Saudi Arabia, Bahrain, UAE, and Kuwait, have added Islamic banking services to their regular banking operations either through a separate Islamic window or through a subsidiary.

The GCC banking sector is expected to become more liberalized, open, transparent and better governed. However, with globalization, consumerism, economic diversification, increased Islamic banking activities, deregulation and the explosion of technology, GCC banks are under greater pressure to be more productive and efficient and to respond quickly to more sophisticated customer needs (Srairi 2009b).

Against this background, this study empirically examines whether financial liberalization has improved the productivity growth of the GCC banking sector and contributes to the debate about the link between productivity and deregulation. The literature review related to this question has presented mixed results. Empirical studies suggest decrease (see, for example, Elyasiani & Mehdian 1995 for US banks; Grieffell-Tatjé & Lovell 1996 for Spanish banking; Avkiran 2000 and Sathye 2002 for Australian banks), or increase (see, for example, Casu et al. 2004 for Italian and Spanish banks; Rezitis 2006 for the Greek banking industry; Park & Weber 2006 for Korean banks; Tortosa-Ausina et al. 2008 for Spanish savings banks) of bank productivity growth in a deregulated period.

3 There are three financial centres in this region: the first off-shore banking centre established in Bahrain in 1974, the Dubai International financial centre created in 2004 and the Qatar financial centre founded in 2005.


By using a sample of seventy-one commercial banks (forty-eight conventional and twenty-three Islamic banks), our empirical analysis of productivity change is done in three steps. In the first, we estimate total productivity change of GCC banks over the eight-year period using the output-oriented Malmquist index based on a comparison of adjacent years. To analyse the sources of productivity, this index is unpacked into technical change, efficiency change, scale change and pure technical change. According to Maniadakis & Thanassoulis (2004, 396): "such decompositions promote the understanding of the determinants of better performance and provide valuable information for managers and planners in both the private and the public sector." Moreover, we compare these Malmquist indices between the two sub-periods 1999–2003 and 2003–2007, since 2003, with the economic agreement and the Gulf customs union, the process of liberalization in GCC countries has increased and been reinforced. As a second stage in this chapter, we compare the five Malmquist indexes between the two types of banks and across countries. The first comparison allows us to answer the question if conventional banks are more productive than Islamic banks during the deregulation period in this region. In addition, we contrast the Malmquist indexes and its decompositions between the six Gulf States to explore the effect of economic and financial reforms on bank’s productivity growth in each country. Finally, in order to investigate the determinants of banking sector productivity, we regress total productivity change, and technical and efficiency change, on a number of variables including bank-specific, macroeconomic and financial industry indicators and using the fixed-effect model. In addition, we complement this analysis by identifying factors that explicate revealed differences in productivity changes across conventional and Islamic banks.

The present chapter is organized as follows. In section 2, we briefly review the relevant literature on productivity changes in financial institutions. We present methodology related to the Malmquist index in section 3 and describe data and variables used in the study in section 4. Section 5 discusses the empirical findings by comparing productivity indices across country and between conventional and Islamic banks. Section 6 provides the conclusions and recommendations.

Section 2. Revue of Literature

The empirical literature related to the analysis of productivity growth in financial institutions has developed tremendously over the last two decades using both parametric and non-parametric approaches (Goddard et

Chapter Two 76

al. 2007). Most of these studies were focused on developed countries. Notable and recent among them are Daniels et al. (2005) for US banks, Asmild et al. (2004) for Canadians banks, Fukuyama and Weber (2002) for Japanese banks, Avkiran (2000) for Australian banks, Tortosa-Ausina et al. (2008) for Spanish banks, Casu and Girardone (2004) for Italian banks and Drake (2001) for United Kingdom banks. More recently, there have been a number of research studies that examine banks productivity in other regions, mainly in Asian and European countries (Dogan and Fausten 2003 for Malaysia; Chiou 2009 for Taiwan; Rezvanian et al. 2008 for India; Sufian 2009a for China; Isik 2008 for Turkey; Rezitis 2006 for Greece; Rebelo and Mendes 2000 for Portugal).

Another strand of the productivity research has concerned a panel of countries. For instance, Pastor et al. (1997), using the DEA technique and Malmquist index with value-added approach, compared the productivity, efficiency and differences in technology of several banking systems in different countries for 1992 (US, Spain, Germany, Italia, Australia, United Kingdom, France and Belgium). They found that banks in France have the highest efficiency level followed by banks in Spain, while the selected banks in U.K were found to be the least efficient in the sample. Casu et al. (2004) employed parametric and non-parametric approaches to estimate the productivity change in five principal European banking sectors (France, Germany, Italia, Spain, UK) between 1999 and 2000. Overall, the findings suggested an increase of productivity growth for all countries, especially in the Italian (9%) and Spanish (9.5%) banks. The decomposition of total factor productivity index showed only an improvement in technological change. In general, the two approaches used in this study yield the same results related to the main components of productivity growth. Jaffry et al. (2007) examined changes in productivity and technical efficiency levels in the banking sectors of India, Pakistan and Bangladesh over the period 1993–2001. The results indicate that technical efficiency has generally increased across countries (especially in Indian and Bangladeshi banks) in response to reform. Using Tobit regression, the study also revealed that the main internal variable which has a positive impact on efficiency was the type of business each bank is engaged with. The sizes and ages of banks were not found to have any effect. Finally, the authors also found a slight upward trend in TFP index. Bangladesh presented the highest levels of Malmquist index, while India registered low levels of TFP. Recently, Delis et al. (2009) analyzed the relationship between regulatory and supervisory framework and the productivity growth of 533 banks operating in 22 transition countries over the period 1999–2006. They found that regulations related to the market discipline


(the third pillars of Basel 2) and restrictions on banks’ activities have a positive impact on productivity.

Coming to the Arab Gulf countries, despite considerable development in their banking sector during the last decade, only a few papers have explored the productivity growth of banks in this region. For example, Ariss et al. (2007) employed the DEA approach to calculate Malmquist productivity index of forty-five banks operating in GCC countries. The results show that between 1999 and 2004, these banks have experienced a decline in the productivity of their banking system, even though with different degrees. The decline in productivity of banking in Kuwait, Oman and Qatar was due to both technological regress and decline in overall technological efficiency. However, for Bahrain, Saudi Arabia and UAE, the decline in MPI was the net result of technological regress and improvement in overall technical efficiency. Ramanathan (2007) examines nearly the same sample (in nine banks), in the same period (2000–2004), and uses the same approach (MPI and DEA) as that adopted by Ariss et al. (2007). He finds that all GCC countries have registered reductions in productivity in terms of technology change (a similar result was reached by Ariss et al. [2007]). However, banks in four of the six GCC countries (Bahrain, Kuwait, Saudi Arabia and the UAE) registered progress in terms of MPI during 2000–2004. The highest improvement in MPI (1%) is registered by the selected banks in Bahrain, while the selected banks in Qatar have presented the highest reductions (4%) in productivity during the same period. Using data from fifty-two banks over ten years (1993 to 2002), Al- Muharrami (2007) employed the same technique as the other two studies. Findings show an overall decrease in total factor productivity of 5% attributed simultaneously to a decline in technical efficiency (3%) and technological regress (3%). However, in 2002 banks in this region exhibited a high productivity growth of 6% due mainly to an increase in technological change rather than efficiency change.

To fill the gap in the literature related to productivity in GCC banking, the present study complements the three studies cited above and differs from them in several ways. First, we update the period of analysis from 1999–2004 to 1999–2007. Second, we include in our sample Islamic banks which are omitted in the above papers. Third, we undertake a comparison of productivity growth between conventional and Islamic banks. Fourth, we examine the sources of efficiency change by separating this index into two other indices: pure technical efficiency change and scale efficiency change. Fifth, our specification of inputs and outputs completely differs from these studies by using the profit-oriented approach of Drake et al. (2006). Finally, in the second stage of our analysis, we

Chapter Two 78

attempt to explore the effect of a number of variables on productivity change for the two groups of banks: conventional and Islamic.

Section 3. Methodology

In order to investigate productivity change in the banking industry of the GCC countries during the period 1999–2007, we use a two-stage procedure. In the first stage of analysis, we employ a non-parametric frontier approach4 to calculate the Malmquist productivity index (MPI) and its components. In the second stage, we examine the determinants influencing the conventional and Islamic banks’ productivity changes.

In the banking literature, the Malmquist index, first introduced by Caves et al. (1982), was frequently used to evaluate productivity change. According to Grifell-Tatjé and Lovell (1997), the Malmquist index, as a measure of change in total factor productivity (TFP) from year to year, presents several advantages relative to the other index numbers (Fisher 1922; Tornqvist 1936). First, it does not make any assumptions on the economic behaviour of production unity such as cost minimization or profit maximization. Second, it does not require information about prices of input and outputs. MPI uses only quantity information. Finally, the Malmquist index provides further information about the sources of productivity change. Hence, if panel data is available, it can be decomposed into several components: technical change (shifts in the frontier), efficiency change (catch up to the frontier), pure technical efficiency change (improvements in management practices) and scale efficiency change (improvements toward optimal size).

In this section, we briefly describe the theoretical details5 to calculate the output-oriented6 Malmquist productivity indexes. Let (xt, yt) represent the observed input and output vectors of a bank at time period t = 1,2,…..T. Following Fare et al. (1994), the Malmquist index (M) based on

4 It is possible to measure changes in productivity by employing an econometric method. This requires the estimation of a production, cost or revenue function. 5 For a more detailed explanation see Fare et al. (1992) and Grifell-Tatjé and Lovell (1996). 6 In this approach, we estimate the frontier in terms of the maximum level of outputs that can be achieved with a given set of inputs. The Malmquist index can also be defined by an input-oriented approach where the frontier is the minimum set of inputs required for a given level of outputs.


ratios of output distance functions7 between periods t (the reference technology period) and t+1 (the base technology period) can be defined as:

),(),( 11

ttt

tttt

yxDyxDM

++

= (1)

Where ),( 11 ++ ttt yxD represents the distance from the period t+1

observation to the period t technology. This distance measures the maximum proportional change in outputs required to make

),( 11 ++ tt yx feasible in relation to the technology at t (Casu et al. 2004). In the case that t+1 is the reference technology period, equation (1)

becomes:

),(),(

1

1111

ttt

tttt

yxDyxDM +

++++ = (2)

To avoid the choice of arbitrary benchmark, the Malmquist TFP index

can be calculated as the geometric mean of Mt and Mt+1:

2/1

1

11111

),(),(

),(),(

⎥⎦

⎤⎢⎣

⎡= +

+++++

ttt

ttt

ttt

ttt

yxDyxDx

yxDyxDM (3)

Alternatively, in the assumption of constant return to scale (CRS), the

equation (3) can be written as:

2/1

1111

11111

),(),(

),(),(

),(),(

⎥⎦

⎤⎢⎣

⎡= ++++

+++++

ttt

ttt

ttt

ttt

ttt

ttt

yxDyxDx

yxDyxD

yxDyxDM (4)

The first term in equation (4) represents the efficiency change or the

catching-up effect (EFFCH) and shows how much closer a bank gets to the efficient frontier (Isik and Hassan 2003). The index inside the brackets (geometric mean of the shift in technology between two periods) denotes the technical change effect or the frontier shift effect (TECCH), and indicates whether the best practice relative to the evaluated bank compared is improving, stagnating or deteriorating (Tortosa-Ausina et al. 2008). 7 An output distance function is defined as the reciprocal of the maximum proportional expansion of the output vector, yt, given input vector, xt, under period t technology (Shephard 1970).

Chapter Two 80

These shifts in the production frontier could be due to the change of market structure (bank merged, increased competition), the change of government policy (financial liberalization or deregulation), and the innovations in management (customer relationship management systems) or in production processes (Angelidis and Lyroudi 2006; Chiou 2009). Thus, the total factor productivity change (TFPCH) can be defined as the product of technical efficiency change and technical change:

TFPCH = EFFCH x TECCH (5). A TFP index value which is greater than one implies increases in

productivity, while a value of less than one indicates productivity deterioration, and a value concentrated around one indicates no productivity change. The same interpretation applies to others Malmquist indices.

In the assumption of variable return to scale (VRS), Fare et al. (1994) showed that there are two additional sources of productivity growth. Thus, the efficiency change (EFFCH) calculated under CRS can be further decomposed into two components:8 the pure technical efficiency change (PEFFCH) and the scale efficiency change (SECH). These two indexes can be formulated as:

)/,()/,()(

111

VRSyxDVRSyxDVRSPEFFCH ttt

ttt +++

= (6)

2/1

111

111

)/,()/,(

)/,()/,()( ⎥

⎦

⎤⎢⎣

⎡= +++

+++

VRSyxDCRSyxDx

CRSyxDVRSyxDVRSSECH ttt

ttt

ttt

ttt (7)

Hence, we have: EFFCH = PEFFCH x SECH (8) The PEFFCH measures the changes in the proximity of banks to the

frontier. According to Chiou (2009), this index represents the manner that banks manage input resources more efficiently between two periods. The SECH indicates improvements towards the optimal scale in terms of cost control (Isik & Hassan 2003).

Finally, the complete decomposition of Malmquist TFP index becomes:

8 This decomposition has been subject to a number of criticisms (see for example, Ray and Desly 1997; Coelli 2005).


TFPCH = TECCH x PEFFCH x SECH (9) The above five Malmquist indexes (TFPCH, TECHH, EFFCH,

PEFFCH, SECH) are defined with a set of distance functions which can be estimated using DEA approach (see, for instance, Charnes et al. 1994). More specifically, to calculate these indices, a total of six different linear programming problems have to be solved (see Coelli et al. 1998 for details) corresponding to six output distance functions: Dt(xt, yt), Dt+1(xt+1, yt+1) , Dt(xt+1, yt+1) , Dt+1(xt, yt), Dt+1(xt+1, yt+1/VRS), Dt(xt, yt/VRS). Each of these distance measures presented in equations (4), (6) and (7) are computed for each bank in each adjacent pair of time periods ((t, t+1),………, (T-1, T)).

Once the Malmquist productivity indices are calculated,9 we run regressions in order to explain the variations in the TFP, efficiency and technical change. In particular, by using the fixed-effect model,10 we examine the effect of bank specific characteristics and economic and financial environmental factors on the productivity changes of conventional and Islamic banks.

The general form of this model is: M = αR + ßE + ε (10) Where M is the Malmquist productivity index (TFPCH, EFFCH,

TECCH), R represents the vector bank specific, B is the set of external factors, α and ß are the vectors of parameters to be estimated, and the error term ε.

Section 4. Data and Variables

4.1. Data

To construct the productivity frontiers, we use annual data from the balance sheet accounts and income statements of seventy-one commercial banks (forty-eight conventional and twenty-three Islamic) operating in six Gulf Arab countries (fourteen in Bahrain, eleven in Kuwait, five in Oman, eight in Qatar, eleven in Saudi Arabia and twenty-two in the United Arab Emirates). The number of banks during the sample period varies between 9 All Malmquist indices are computed using the program Deap version 2.1 (Coelli 1996). 10 Using panel data, this technique produces unbiased and consistent estimates of the coefficients.

Chapter Two 82

sixty and seventy-one, due mainly to the new entry in the sector. We have collected data from Bankscope Database of Bureau Van Dijk’s Company. The macroeconomic variables and financial industry indicators required to analyze the determinants of banks’ productivity changes are sourced from annual reports published by central banks in each GCC country and from the International financial Statistic (IFS).

Since all countries have different currencies, all annual financial values are converted to US dollars using appropriate average exchange rates for each year. In addition, to ensure comparability of data across countries, all values are deflated to the year 1999 using each country’s consumer price index (CPI).

4.2. Specification of Inputs and Outputs

As indicated in several research studies, there has been a lack of agreement over what banks produce and over what resources banks consume in the process of production (Berger & Humphrey 1992). Two alternative approaches, namely the intermediation approach and the production approach, are adopted extensively in the most efficiency banking studies to define the inputs and outputs of a financial institution. The intermediation approach, which treats a bank as intermediary between savers and borrowers, defines loans and other earning assets as outputs, while various funding sources (deposits and other liabilities), labour and physical capital are treated as inputs. On the other hand, in the production approach the bank utilizes capital and labour as inputs to produce loans and deposit accounts as outputs. This approach measures outputs in terms of the number of account services, whereas in the intermediation approach outputs are measured in value terms (see Berger & Humphrey 1997 and Mester 1987 for a comprehensive discussion of these two approaches). In the last years, Berger & Mester (2003) and Drake et al. (2006) have proposed the profit-oriented approach, which treats revenue components as outputs and cost components as inputs. According to Berger & Mester (2003, 80), this approach takes into account unmeasured changes in the quality of banking service by including higher revenues paid for the improved quality, and helps to capture the profit maximization goal by including both the costs and revenues. Furthermore, the profit-oriented approach has the advantage to better understand the strategies banks use to respond to the changes in environment (Pasiouras 2008).

Following Drake et al. (2006), Pasiouras (2008a) and Sturm & Williams (2004), among others, we adopt the profit oriented approach in this study to define inputs and outputs. Accordingly, three inputs and two


outputs are selected to estimate Malmquist indexes. Hence, the vector of inputs comprises: employee (x1), other operating expenses (x2) and loan loss provisions (x3). The third input is chosen to capture the cost of risk-taking in lending (Leightner & Lovell 1998). Since Gulf commercial banks have been more engaged in non-traditional activities in recent years, we include the variable non-interest income in our model to proxy these business activities.11 Rogers (1998) argue that models which ignore off-balance sheet activities understate bank efficiency. Thus, the two outputs concern net interest income (y1=interest income-interest expense) and other operating income ( y2= fee and commission).

Table 2.1 (panel A) below reports sample means and standard deviations of each input and output for the entire sample as well as for conventional and Islamic banks. All variables are measured in millions of US dollars. Two important features of the banking sector in GCC countries are revealed by observing the summary statistics. First, it is apparent that there is a significant difference in the inputs and outputs of the two types of banks. This indicates that conventional banks are significantly larger than Islamic banks. Second, the data in Table 2.1 also shows that the standard deviations of all variables are relatively very large, implying both groups of banks contain very large and very small banks.

11 In some studies (Casu et al. 2004; Pasiouras 2008a; Sufian 2009b) off-balance sheet items are used as a proxy to non-traditional business.

Chapter Two 84

Variables/ type of bank

Full Sample

Islamic banks

Conventional Banks

Mean Std. D. Mean Std. D. Mean Std. D.

Panel A: inputs and outputsa - Employee expenses (x1) - Other operating expenses (x2) - Loan loss provision (x3) - Net interest income (y1) - Other operating income (y2)

57.92 46.30 23.03 175.43 87.65

92.13 75.65 80.50 255.06 131.38

31.84 28.61 15.91 138.60 55.53

54.60 51.11 42.32 290.99 126.28

67.79 52.96 25.68 189.11 99.75

101.16 82.14 90.80 238.17 131.28

Panel B: Bank-specific variablesb - Total assets (US$ Millions) - Equity to total assets - Non interest income/Total income - Other operating expenses/Assets - Loan/Total asset

7188 20.01 22.48 0.99 53.35

11207 17.94 15.57 1.24 19.04

3198 28.46 23.00 1.31 55.14

5521 23.86 20.01 1.21 24.90

8759 15.13 22.73 0.74 53.25

12418 9.81 11.85 0.64 14.79

Table 2.1. Summary statistics of dataset used in the study by type of bank (average values) Notes: a: variables in US$ million, b: all variables are in percentage, except where indicated.

4.3. Determinants of Productivity

In addition to computing Malmquist indexes, we conduct regression analysis in the second stage of this study to examine the effect of a number of variables on the bank productivity growth. The vector of explanatory variables comprises five bank-specific characteristics, three macroeconomic indicators, and three financial industry determinants.


Following several studies that examine productivity change in the banking sector (Chiou 2009; Sufian 2009b; Jaffry et al. 2007; Isik & Hassan 2003), we select in our model of regression (equation 10) the following variables related to the internal factors of bank: size, capitalization, diversification, quality of management and loan intensity.

We use the logarithm bank asset as a proxy for bank size. Empirical studies present mixed results. Mukherjee et al. (2001), Isik and Hassan (2003) and Sufian (2009b) found that larger banks have more productivity growth. However, other researchers report no significant (Sathye 2002; Chiou 2009) or negative (Dogan & Fausten 2003) relationships between size and productivity scores. Capital adequacy is measured as equity divided by total assets. The results of many studies (Mukherjee et al. 2001; Sufian & Haron 2008) show that higher capitalization is associated with lower productivity growth. In contrast, some research (Esho 2001; Kaparakis et al. 1994) found that capital adequacy is positively related to productivity change. According to Chiou (2009), bank with capital strength has more capacity to prevent insolvency and to control managers to improve performance; in consequence, the productivity of banks can be increased. To capture the effect of diversification on productivity, we follow Wu (2005) and include in our model the ratio non-interest income to total income as a measure of diversification of business.12 In the literature, the effect of this variable is ambiguous. Dogan & Fausten (2003), in the case of Malaysian banks, found that specialization has a negative effect on productivity change while several studies (Mukherjee et al. 2001 and Fung 2006 concerning the US banking industry; Chan & Liu 2006 and Chiou 2009 for Taiwanese banks) reveal that more specialized banks are associated with higher productivity growth. A fourth variable, other operating expenses in total asset, is included as a measure of bank management quality and is expected to be negatively related to productivity. The last measure of banks concerns the proxy of loans intensity, which is calculated as loans to total assets. According to Mukherjee et al. (2001, 933): "loans are the most risky and least liquid of assets." Consequently, this ratio also measures some of this risk. Generally, since loans are the principal source of the bank’s income, higher lending could be transformed into higher efficiency and productivity.

Table 2.1 (panel B) also contains some descriptive statistics of these variables. It is apparent from this data that the average value of total assets varies greatly among the two groups of banks. Conventional banks ($8759 12 The variable of diversification or specialization can also be measured by the Herfindahl index of outputs which is calculated as a sum of the squared shares of each output in total output.

Chapter Two 86

million) are approximately three times bigger than Islamic banks ($3198 million). Another interesting observation is that Islamic banks (28%) are better capitalized than conventional banks (15%). For other indicators (diversification, quality of management, loan intensity) there are minor differences between both types of banks.

To isolate the effect of bank-specifics on productivity change, we also control this study for cross-country differences in the microeconomic conditions and structure of financial industry. Three macroeconomic variables are chosen: per capita GDP, degree of monetization and inflation rate. Per capita GDP is used as an index of country economic development. Many studies (Jaffry et al. 2007; Fries & Taci 2005) suggested that higher growth in macroeconomic conditions is translated into higher demand for credit and higher efficiency and productivity. The degree of monetization is the ratio of money supply (M2) to the gross domestic product (GDP). This economic indicator is also expected to have a positive impact on bank productivity. The rate of inflation is proxied by the growth of CPI. Banks obtain higher profits in higher inflationary countries and should be more efficient and productive (Jaffry et al. 2007).

As in Srairi (2009a) and Pasiouras (2008b), among others, we also examine the impact of the development of the financial sector in each country on productivity by using three indicators: banking sector development, financial market development and banking concentration. The credit to the private sector divided by GDP represents the proxy of banking development. This variable is also used to measure the importance of bank financing in the economy. Financial market development is calculated as a stock market capitalization to GDP. It indicates the importance of stock market in financing the economy. Bank productivity may be also affected by the concentration ratio which is computed as the assets of the three largest banks divided by the total assets of the sector. All these indicators are expected to be positively related to productivity growth. Table 2.2 gives the summary statistics of these variables in each country. First, we can observe that there are large differences in all macroeconomic measures across GCC countries. Second, the banking development ratio is still far below the comparable levels which exceed 100% in developed countries. Thus, the banking sector in Gulf countries has ample room for growth. A third feature of the data is the variation in financial market development between countries. This index ranges from 38% in Oman to 115% in Kuwait. Finally, the ratio of concentration is relatively high and differs widely across countries (UAE 42%; Bahrain 87%).


Variables/country U.A.E Saudi Arabia

Bahrain Kuwait Qatar Oman

- Per capita GDP (US$) - Degree of monetization - Inflation rate - Banking sector development - Financial market development - Concentration ratio

24041 64.59 5.05 43.18 100.14 42.52

11193 41.11 0.57 30.81 87.01 50.41

15009 74.62 1.04 27.29 104.56 87.21

20229 70.68 2.26 55.72 115.42 60.88

34908 43.83 5.18 31.14 99.18 78.08

10074 33.91 1.00 37.39 38.08 80.73

Table 2.2: Descriptive statistics of country-specific variables (average values) Note: All variables are in percentage, except where indicated.

Section 5. Empirical Results and Analysis

First, we estimate the productivity changes for 71 commercial banks operating in GCC countries using output-oriented Malmquist index. Then, we divide our sample into two groups, conventional banks and Islamic banks, to analyze the relationship between productivity growth and type of bank and to explore the sources of productivity change in each group. We also compare Malmquist indexes between different countries in the Arab Gulf region to examine the impact of liberalization and deregulation on productivity. Finally, we attempt to identify internal and external factors that explicate differences in productivity changes between conventional and Islamic banks.

Chapter Two 88

Scale Efficiency Change (SECH)

Pure Technical Change (PEFFCH)

Technical Efficiency Change (EFFCH)

Technical Change (TECCH)

Total Factor Productivity Change (TFPCH)

Bank type/years

1.007 1.018 0.946 0.951 1.049 0.983 1.013 0.993 0.980 1.009 0.994

0.962 0.990 1.101 1.013 1.001 1.024 0.996 1.002 1.015 1.006 1.010

0.968 1.007 1.032 0.962 1.049 1.008 1.009 0.995 0.992 1.015 1.003

0.976 0.960 0.949 1.079 1.029 1.036 1.072 1.060 0.983 1.049 1.015

0.944 0.967 0.979 1.009 1.074 1.044 1.082 1.055 0.975 1.064 1.018

Panel A: All banks 1999–2000 2000–2001 2001–2002 2002–2003 2003–2004 2004–2005 2005–2006 2006–2007 1999–2003 2003–2007 Geometric average

1.016 0.952 0.951 0.915 1.072 0.992 1.008 0.990 0.958 1.015 0.986

0.938 1.041 1.115 1.031 0.988 1.015 0.988 1.020 1.029 1.003 1.016

0.953 0.990 1.020 0.944 1.052 1.007 0.996 1.010 0.976 1.016 0.996

0.975 0.943 0.923 1.105 1.036 1.057 1.106 1.086 0.984 1.071 1.027

0.930 0.934 0.941 1.044 1.087 1.065 1.102 1.097 0.961 1.088 1.022

Panel A: Conventional banks 1999–2000 2000–2001 2001–2002 2002–2003 2003–2004 2004–2005 2005–2006 2006–2007 1999–2003 2003–2007 Geometric average

0.968 0.985 0.927 1.068 0.993 0.963 1.026 0.999 0.986 0.995 0.990

1.057 1.032 1.052 0.954 1.032 1.048 1.014 0.995 1.023 1.027 1.022

1.023 1.017 0.976 1.019 1.025 1.010 1.041 0.995 1.009 1.018 1.013

0.977 0.997 0.971 0.999 0.993 0.998 0.993 1.010 0.986 0.998 0.992

1.001 1.013 0.948 1.019 1.017 1.007 1.035 1.004 0.995 1.016 1.005

Panel C: Islamic banks 99–2000 2000–2001 2001–2002 2002–2003 2003–2004 2004–2005 2005–2006 2006–2007 1999–2003 2003–2007 Geometric average

Table 2.3. Malmquist productivity indexes in GCC banks, consecutive years and by type of bank 1999–2007 Notes: All indexes are geometric averages, TFPCH = TECCH X EFFCH, EFFCH = PEFFCH X SECH.


5.1. Estimation of Malmquist Productivity Indices in the GCC Banking Sector

Table 2.3 summarizes the annual geometric means of five types of Malmquist indices (TFPCH, TECCH, EFFCH, PEFFCH, and SECH) for the entire sample (Panel A) and for conventional banks (Panel B) and Islamic banks (Panel C). It also reports the Malmquist indexes for both pairs of consecutive years and the two sub-periods 1999–2003, 2003–2007 and the whole sample period 1999–2007. All indices are calculated for adjacent periods instead of the fixed based periods.13 A value of one for the Malmquist index and its components indicates stagnation in productivity growth; a value >1 indicates productivity gain, and a value <1 indicates productivity decline.

Over the sample period, the results in Table 2.3 (panel A) indicate that, on average, the annual productivity growth rate of banks in GCC countries grew by 1.8% as a result of improvement in technical change (1.5%) and a smaller increase in efficiency change (0.3%). The latter in turn is due to the improvement in pure technical efficiency (1%) rather than in sale efficiency (-0.06%), implying perhaps the improvement in management practices of the GCC banking sector during the period 1999–2007. Looking at changes through the years, it is also apparent from panel A of Table 2.3 that commercial banks in GCC countries have experienced a productivity loss between 1999 and 2002. However, since 2003 the total factor productivity has exhibited a progress that ranges between about 4% and 8%. Hence, in the second sub-period (2003–2007), the average annual productivity increased by 6.4%, while productivity decreased by 2.5% in the first sub-period (1999–2003). The deterioration of productivity in this period is dominated by the decline in technical change (1.7%) and a small decrease of efficiency change (0.8%). These findings are in line with those of Ariss et al. (2007) and Al-Muharrami (2007) who found an overall decrease in TFP of Arab Gulf banks during the period 1999–2004. However, the main source of productivity gain in the second sub-period was technical change (4.9%) rather than efficiency change (1.5%). Indeed, this period witnessed heavy investment to introduce advanced technologies in the GCC banking sector such as ATMs, credit and debt cards, points of sale network (POS), home banking, and telephone and 13 Two methods are used in literature to construct the Malmquist index. The adjacent method calculates Malmquist index for each period (e.g. adjacent periods t+1, t, adjacent periods t+2, t+1,…). In the second approach, the fixed based period, Malmquist index is computed for all periods relative to a fixed base period (for details see Grifell-Tatjé and Lovell 1996).

Chapter Two 90

online banking.14 In addition, the high growth of productivity in the second period of study (after 2003) can be explained by the increase of competition between banks due to the accelerated liberalization and deregulation of the banking system in GCC countries and by the very favourable economic environment in this region as a result of the considerable increase in oil prices. During the last six years, commercial banks in GCC countries have been forced to operate more efficiently and utilize new technologies in order to compete with foreign banks and other financial companies whose number has increased considerably in this period.

5.2. Productivity Growth Vis-à-vis Conventional Islamic Banks

We now turn to an analysis of productivity change relative to conventional and Islamic banks in GCC countries. A comparison of panels B and C of Table 2.3 reveals some important differences between the two groups of banks. Under the sample period, for both conventional and Islamic banks, the average annual total productivity change is constantly positive except in the first years of study (2000, 2001 and 2002). However the productivity growth rate in conventional banks (2.2%) was significantly higher than in Islamic banks (0.5%). It appears that conventional banks are more exposed to competition in the period of liberalization than Islamic banks. The source of productivity gains for conventional banks was mainly technical progress (2.7%). On the contrary, the productivity growth of Islamic banks is attributed to enhancement in efficiency change (1.3%) rather than improvement in technological efficiency (regress of 0.8%). These findings suggest that the major differences between conventional and Islamic banks are related to technical change. It is apparent that Islamic banks have experienced some difficulties in improving their production technologies in the period of study. Furthermore, the decomposition of efficiency change into two components (PEFFCH and SECH) shows that both conventional and Islamic banks enjoyed improvement in pure technical efficiency (1.6% vs. 2.2%) and decline in scale efficiency (1.4% vs. 1%). According to Sufian (2009a, 123), this result implies that these banks are relatively efficient in managing their operating costs but have been operating at a non-optimal scale of operations.

14 For example, in Saudi Arabia, the number of ATMs increased by 240% to 7,531 in 2007 compared to 2,222 in 2000. In addition, the number of POS has multiplied by three in the same period.


While substantial changes and reforms were taken in the GCC banking industry after 2003, it is interesting to compare the productivity change and its components of the two groups of banks in the two sub-periods 1999–2003 and 2003–2007. As can be seen from Table 2.3 (panels B and C), in both cases of conventional and Islamic banks, the productivity growth rate is higher in the second sub-period than the first one. For conventional banks, the TFPCH increased by around 8.8% in the second period as a result of an increase in both efficiency change (1.6 %) and technical change (7.1%). The enhancement in efficiency change seems to be due to a slight improvement of pure efficiency (0.3%) and higher-scale efficiency increase of 1.5%. In the case of Islamic banks, the rate of productivity change (0.5%) as well as technical change (1.4%) are also negative in the first sub-period, like in conventional banks (TFPCH=-3.9%, TECCH=-1.6%) indicating their difficulties to better exploit new technologies. However, in the second sub-period, the TFPCH for Islamic banks has improved (1.6%) as liberalization and deregulation have proceeded. The source of this improvement is attributed to an increase in technical efficiency (1.8%) and a lower deterioration in technical change (0.2%). Most of the efficiency gains in Islamic banks throughout the second sub-period result mainly from the improvement in pure technical efficiency (2.7%).

In order to determine whether differences in the Malmquist indexes between conventional and Islamic banks have statistical significance, we use the non-parametric Mann-Whiney test. The results show that there were significant differences between the two groups of banks at 5% in TFPCH (Z=4.631, prb>Z=0.001), EFFCH (Z=-2.687, prb>Z=0.028) and TECCH (Z=2.641, prb>Z=0.021). In contrast, the other Malmquist indices PEFFCH (Z=1.213, prb>Z=0.276) and SECH (Z=0.057, prb> Z=0.198) are not statistically significant. In consequence, we can conclude that conventional banks in GCC countries outperformed Islamic banks in terms of total productivity change. While the productivity gain is mainly driven by technical change in conventional banks, it is dominated by efficiency change in Islamic banks.

5.3. Analysis of Productivity Growth Measures by Country

The mean annual values of Malmquist productivity index and its components of each country in the Gulf region are provided in Table 2.4 for the whole period and for the two sub-periods 1999–2003 and 2003–2007.

Chapter Two 92

Scale Efficiency Change (SECH)

Pure Technical Change (PEFFCH)

Technical Efficiency Change (EFFCH)

Technical Change (TECCH)

Total Factor Productivity Change (TFPCH)

Country/years

0.996 0.985 1.007 0.997 1.004 0.990 0.993 0.990 0.996 0.991 1.001 0.981 0.980 0.964 0.996 0.994 0.998 0.990 0.994

0.995 0.994 0.998 1.012 1.008 1.014 1.007 1.016 0.998 1.022 1.024 1.019 1.010 1.002 1.017 1.013 1.004 1.021 1.010

0.992 0.980 1.005 1.009 1.013 1.004 1.000 1.004 0.995 1.013 1.025 1.000 0.990 0.967 1.013 1.007 1.001 1.011 1.003

1.038 1.010 1.063 0.998 0.993 1.003 1.015 1.012 1.018 0.982 0.962 1.002 1.031 1.014 1.044 1.029 0.993 1.065 1.015

1.030 0.990 1.069 1.007 1.006 1.007 1.015 1.017 1.013 0.995 0.986 1.003 1.021 0.981 1.058 1.037 0.992 1.077 1.018

Bahrain All period 1999–2003 2003–2007 Kuwait All period 1999–2003 2003–2007 Qatar All period 1999–2003 2003–2007 Oman All period 1999–2003 2003–2007 Saudi Arabia All period 1999–2003 2003–2007 UAE All period 1999–2003 2003–2007 All countries Table 2.4. Malmquist productivity indexes in GCC banks, sub-periods and by country 1999–2007

Overall, as can be seen in Table 2.4, on average all GCC countries with the exception of Oman have exhibited high TFP change during the sample period 1999–2007. In particular, the United Arab Emirates (3.7%), Bahrain (3%) and Saudi Arabia (2.1%) have the highest TFP growth rate, while Qatar (1.7%) and Kuwait (0.7%) presented much lower TFPCH. The results indicate that selected banks in UAE, Bahrain and Saudi Arabia have reacted more quickly than other banks in response to the liberalization and deregulation of their financial system. It appears that reforms undertaken in these countries have positively affected the productivity growth of banks. Indeed, with a rapid growth of the economic situation in these countries during the last seven years, commercial banks


have made heavy investments in technology to develop their communication networks and information systems. The improvement of TFPCH in the banks of these countries is mainly attributed to technical progress which ranges between 2.9% (UAE) and 3.8% (Bahrain) and is due less to efficiency change. However, Kuwait and Oman suffered from negative technical change and exhibited on average a positive EFFCH of 1% owing to an increase in pure technical efficiency (1.2% and 2.2% respectively for Kuwait and Oman). Furthermore, as observed in Table 2.4 below, the dominant source of efficiency change increase in most GCC countries was related to improvements in managerial practices (PEFFCH) rather than scale related (SECH).

Regarding the Malmquist productivity indexes in the two sub-periods 1999–2003 and 2003–2007, we note first that the TFP growth of most GCC countries in the second sub-period is positive and larger than in the first period. Only in Kuwait and Qatar are the differences between TFPCH large. The growth in this second period is mainly due to the implementation of new technologies (TECCH ranges between 0.2% and 6.5%) and less due to the improvement in efficiency change (EFFCH ranges between -0.5% and 1.3%). On the contrary, during the first sub-period, we observe a decrease in TFPCH in countries such as Bahrain (-10%), Oman (-14%), Saudi Arabia (-19%) and UAE (-8%), whereas banks in Kuwait (0.6%) and Qatar (1.7%) experienced a smaller increase in TFPCH. The major source of productivity loss in UAE, Kuwait and Oman was technical regress while it was an efficiency decrease for Saudi and Bahraini banks. Overall, the pattern of productivity growth in this first period is characterized by a decline in productivity and technical change. Our findings related to this period are generally in conformity with those found by Ariss et al. (2007) and Al-Muharrami (2007).

5.4. Determinants of GCC Banks’ Productivity Growth

In the second stage of this analysis, we regress three Malmquist indexes—TFPCH, EFFCH and TECCH—on a number of variables including bank-characteristics, macroeconomic indicators and financial structure measures by employing the fixed effect model. The regression results concerning the determinants of banks’ productivity change for the full sample and for conventional and Islamic banks are reported in Table 2.5 below.

Cha

pter

Tw

o 94

Type

of B

ank/

Ex

plan

ator

y V

aria

bles

All

Ban

ks

Con

vent

iona

l Ban

ks

Isla

mic

Ban

ks

EFFC

H

TEC

CH

TF

PCH

EF

FCH

TE

CC

H

TFPC

H

EFFC

H

TEC

CH

TF

PCH

Bank

-ch

arac

teris

tics

Size

C

apita

lizat

ion

Div

ersif

icat

ion

Qua

lity

of

man

agem

ent

Cre

dit r

isk

Fina

ncia

l and

ec

onom

ic

vari

able

s Pe

r cap

ita

GD

P D

egre

e of

m

onet

izat

ion

0.03

6 (0

.46)

0.

230

(0.2

4)

-0.6

29

(-1.

79)

-0.7

41**

(-

2.59

) -0

.544

(-

1.52

) 0.

119

(1.3

0)

0.03

5 (0

.50)

0.12

7*

(3.0

1)

0.13

5 (1

.04)

-1

.734

**

(-2.

33)

0.43

6 (1

.06)

-1

.959

**

(-2.

73)

0.03

2 (0

.47)

0.

253

(0.2

2)

0.13

1**

(2.0

3)

0.11

9 (1

.20)

-1

.582

* (-

3.73

) -0

.039

(-

0.96

) -0

.327

(-

1.13

) 0.

847*

**

(1.9

7)

0.46

2***

(2

.15)

0.03

9 (0

.43)

1.

005

(0.4

3)

-0.3

48

(-0.

65)

-0.7

33**

(-

2.47

) -0

.780

(-

1.76

) 0.

138

(1.2

9)

0.07

4 (0

.95)

0.66

1**

(2.9

8)

0.05

4 (0

.99)

-3

.270

* (-

2.72

) 0.

785

(1.8

4)

-2.2

90**

(-

2.25

) 0.

171

(0.8

5)

0.41

2 (1

.46)

0.11

7**

(2.1

8)

1.19

1 (0

.94)

-1

.864

* (-

3.05

) -0

.910

(-

1.21

) -0

.380

(-

0.73

) 0.

699*

**

(2.1

3)

0.56

2 (2

.31)

0.06

3 (0

.50)

-2

.491

**

(-2.

95)

-1.2

40**

(-

2.27

) -0

.948

**

(-2.

39)

0.53

3 (1

.23)

0.

367

(0.5

0)

0.25

3 (0

.22)

0.10

6 (1

.09)

0.

117*

* (2

.18)

-0

.094

(-

0.20

) -0

.061

(-

0.97

) 0.

075

(0.2

5)

0.04

2 (0

.82)

0.

084

(1.1

3)

0.07

7 (0

.43)

-1

.000

(-

1.42

) -1

.634

**

(-2.

65)

-0.0

33

(-0.

37)

0.45

4 (0

.67)

0.

033

(0.2

6)

0.04

9 (0

.22)

In

flatio

n ra

te

Ban

king

se

ctor

de

velo

pmen

t Fi

nanc

ial

Mar

ket

deve

lopm

ent

Con

cent

ratio

n ra

tio

Adj

uste

d R

2 N

b. o

f ob

serv

atio

n

0.04

1 (0

.78)

0.

167*

(2

.59)

0.

103

(0.6

2)

-0.0

93

(-0.

95)

0.21

5 52

3

0.13

4 (0

.91)

0.

674

(0.7

5)

0.02

2 (0

.05)

-0

. 861

(-

1.48

) 0.

272

523

0.06

9 (1

.27)

0.

158

(1.4

7)

0.03

3 (0

.20)

-0

.025

(-

1.53

) 0.

311

523

0.09

2 (0

.81)

0.

387*

(2

.66)

0.

090

(0.4

7)

-0.4

23**

* (-

1.98

) 0.

246

381

0.25

4 (0

.36)

0.

668

(0.9

9)

0.01

4 (0

.15)

-0

.148

(-

1.02

) 0.

271

381

0.05

7 (0

.48)

0.

064

(0.2

6)

0.02

8 (0

.94)

-0

.033

(-

0.25

) 0.

258

381

0.61

3 (0

.85)

0.

956*

(2

.42)

0.

615

(1.0

2)

-0.0

23

(-0.

02)

0.33

7 14

2

0.01

5 (0

.23)

0.

072

(1.7

2)

0.07

7 (0

.37)

-0

.067

(-

0.59

) 0.

148

142

0.07

3 (1

.20)

0.

042

(1.2

5)

0.33

0 (1

.15)

-0

036

(-0.

39)

0.12

2 14

2

Tabl

e 2.

5. R

egre

ssio

n re

sults

on

the

dete

rmin

ants

of b

ank

prod

uctiv

ity c

hang

e N

otes

: t- s

tatis

tics

are

betw

een

pare

nthe

ses.

*, *

* an

d **

* in

dica

te s

tatis

tical

sig

nific

ance

at 1

%, 5

% a

nd 1

0%, r

espe

ctiv

ely.

TEC

CH

: te

chni

cal c

hang

e, E

FFC

H: t

echn

ical

eff

icie

ncy

chan

ge, T

FPC

H: t

otal

fact

or p

rodu

ctiv

ity c

hang

e.

96 Chapter Two

Regarding bank-specific variables, the results indicate that the coefficient of size has a positive and statistically significant effect on productivity (TFPCH at 5%) and technical change (TECCH at 1%) for all banks and conventional-bank models. This finding which is supported by several studies (Worthington 1999 for Australian credit unions; Mukherjee et al. 2001 for US commercial banks; Sufian & Haron 2008 for the Malaysian Islamic banking sector) implies that productivity improvements are higher for large banks than for smaller. The positive relationship between size and productivity growth can be explained by the fact that large banks have the capacity to invest and better utilize new technologies, to hire a qualified team and have more diversified products and services (Kyj & Isik 2008; Sufian 2009b). Furthermore, the results suggest that conventional banks have benefited from a higher productivity growth due to their size (conventional banks are three times bigger than Islamic banks) and improvement in technical change compared to Islamic banks.

The proxy of capital adequacy (equity/total assets) for the Islamic bank model reveals a significant negative relation to efficiency change (EFFCH) and a significant positive relation to technical change (TECCH), a finding consistent with the studies of Sufian & Haron (2008) and Chiou (2009). While Islamic banks in GCC countries are better capitalized than conventional banks, our results mean that banks which held a higher level of equity have difficulty in generating scale economy (Islamic banks experienced a SECH decline of 1% during the period 1999–2007) and as a consequence have a negative technical efficiency (Chiou 2009). In addition, banks with higher equity tend to exhibit technical progress. The regression model results for all banks and conventional banks show an insignificant positive relationship between capital adequacy and productivity measures.

The ratio of diversification is statistically significant and negatively related to the most Malmquist indexes (especially TFPCH and TECCH) in all models. It seems that specialized banks are more productive than diversified banks. Although the higher level diversification of banks decreases the risk, it causes banks to be less professional and increases information asymmetry, so that the productivity of banks can be decreased (Chan & Liu 2006; Chiou, 2009).

As expected, the indicator of management quality is associated negatively with technical efficiency change (EFFCH) in all models. Similar results are reported by Das and Ghosh (2006) and Sufian (2009b), who argue that a decline of technical efficiency is caused essentially by poor senior-management practices which concern the use of inputs, daily

Productivity Growth in THE GCC Banking Industry 1999–2007

97

operations, and loan portfolio management. Their explanation is based on the bad management hypothesis of Berger & De Young (1997).

Finally, as shown in Table 2.5, the loan to asset ratio exhibits a negative relationship with all Malmquist levels for all banks and conventional banks models, even though this is not statistically significant (only for TECCH). Dogan & Fausten (2003) and Sufian & Haron (2008) have also found in the case of Malaysian banks a negative association between productivity growth and loan intensity. Our results support the view that banks with a higher level of loans undertake additional costs and contain more non-performing loans. In contrast, Wu (2005) reports regarding the Australian banking sector that banks with a large share of loans have experienced greater TFP change and technological progress. It is interesting to note that in the regression results of Islamic banks, the ratio of loan intensity is insignificant but positively related to productivity change. This result can be explained by the nature of Islamic products which present less bad loans and consequently need less reserve for these loans compared to conventional banks.

Turning to the macroeconomic indicators, two of these variables display the expected signs. Per capita GDP and degree of monetization have a significant positive impact on TFPCH in all banks and the conventional banks model. This finding provides additional support for the strong association between economic growth and the performance of banks. Indeed, in countries with higher income the demand for financial products and services increases substantially and generates more revenues for banks (Grigorian and Manole 2005; Sufian 2009b). Since the inflation rate was largely moderate in GCC countries during the period 1999–2007, this variable had an insignificant effect on Malmquist indices.

Regarding the financial structure variables, Table 2.5 suggests that banking sector development (credit to private sector/GDP) entered the EFFCH all regression models positively and is statistically significant at a 5% level. This implies that banking development increases the productivity growth of a bank, a result which is supported by several studies (Jaffry et al. 2007; Pasiouras 2008b). On the other hand, the financial market development variable (stock market capitalization/GDP) is positively related to all productivity measures, but not statistically significant. On the contrary, some studies (Grigorian & Manole 2005) indicate that the development of the stock market can reduce the efficiency and productivity of banks, which is mainly attributed to the decrease of the demand of loans by the best borrowers on the market. Finally, we find a negative and significant relationship between the concentration indicator and efficiency change only for conventional banks. According to Maudos

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et al. (2002), banks which operate in a concentrated market can charge higher prices and experience less pressure to control their costs. Accordingly, high concentration decreases the productivity growth of banks, a finding which is in contradiction with market power hypothesis.

Conclusion

During the last decade, the process of liberalization and deregulation of the GCC financial system has been realized at an accelerated pace. Indeed, to support economic growth in Gulf countries and to transform their economies into international financial and trade centres, decisions makers and monetary authorities have implemented several important reforms in their banking sectors. These measures included liberalizing interest rates, according new licenses to domestic and foreign banks, implementing progressive legal and regulatory reforms, and reducing the direct government control (Srairi 2009b).

In this chapter, we have investigated the effects of these reforms on the productivity growth of the GCC banking sector by comparing conventional and Islamic banks. Our sample consisted of a panel data of seventy-one commercial banks from six Gulf States. By employing a DEA based Malmquist productivity index, we have computed total factor productivity change and its components for each GCC bank in adjacent years during the period 1999–2000 and 2006–2007. Additionally these Malmquist indices are contrasted between two sub-periods (1999–2003 and 2003–2007), two groups of banks (conventional and Islamic banks) and countries. Finally, we have examined the factors influencing bank’s productivity change for all banks and for each type of bank.

Overall, empirical results suggest that GCC banks during the period 1999–2007 have on average experienced productivity progress of about 1.8% per year, driven essentially by improvement in technical change (1.5%) more than by an increase in efficiency change (0.3%). This smaller catching-up with best practice was only due to the improvement in management practices (PEFFCH = 1%, SECH= -0.06%). It is interesting to note that the productivity growth was much lower or negative in the first years of deregulation (TFPCH= -2.1% and 0.09% in 2001 and 2002 respectively), but with the acceleration of financial and economic reforms, productivity change of GCC banks has rapidly improved (8% and 6% in 2006 and 2007 respectively). Indeed, a comparison of Malmquist indices between the two sub-periods reveals that all GCC banks in the second sub-period had higher TFP change (6%), while this index decreased by 2.5% in the first sub-period (1999–2003). The increase of productivity change in


99

the second sub-period is also attributed solely to technological progress (4.9%) rather than efficiency increase (1.5%). The results clearly indicate that the productivity of banks has improved significantly in a period of financial liberalization of the GCC banking sector especially after 2003. We estimate that this fact can be explained by the increase in competition between GCC banks in this period and also by the very favourable economic conditions in these countries. Our findings are in accordance with other recent studies conducted in emerging countries (Leightner & Lovell 1998 for Thai banks; Isik & Hassan 2003 for Turkish banks; Koutsomanoli-Filippaki et al. 2009 for the banking industries in ten countries of central and Eastern Europe) which found that deregulation increased the productivity growth of the banking sector.

Furthermore, the empirical findings also show an improvement in productivity of the two types of banks, with conventional banks exhibiting higher productivity change (2.2%) than Islamic banks (0.5%). The most important sources in determining the level of productivity appear to be technical progress (2.7%) for conventional banks, whereas it is due to the enhancement of efficiency change (1.3%) in the case of Islamic banks. This indicates that conventional banks have benefited from expanding their productivity through capital investment in technology while Islamic banks did not make sufficient investment to take advantage of the new technologies. Moreover, the decomposition of efficiency change into two components indicates that the increase in efficiency change of both conventional and Islamic banks were attributed to the improvement in pure technical efficiency (1.6% vs. 2.2%) rather than scale efficiency which declined by 1.4% and 1% respectively. This means that all GCC banks are more efficient in managing their input resources than in operating at optimal scale operations.

Concerning the comparative analysis of Malmquist indices in different GCC banking sectors, the results during the sample period suggest clear high productivity change in the Emirati (3.7%), Bahraini (3%) and Saudi banks (2.1%), whereas Qatari (1.7%) and Kuwaiti (0.7%) banks presented lower productivity and a decline in productivity growth for Omani banks (-0.3%). The productivity gains are higher if we consider only the second sub-period (7.7%, 6. 9% and 5.8% for the UAE, Bahrain and Saudi Arabia, respectively). Moreover, productivity increases in the UAE, Bahrain, Saudi Arabia and Qatar were due to technical change progress, while Kuwait and Oman suffered from negative technical change and exhibited a small improvement in efficiency change owing to the increase in pure technical efficiency. In view of these results, it appears that the selected banks in UAE, Bahrain, and Saudi Arabia and to lesser extent

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Qatar have reacted more quickly to the new competitive environment in the Gulf region resulting from financial reforms than other banks in Kuwait and Oman. Indeed, The UAE, Bahrain and Qatar have the most open financial sectors as their total banking assets exceed the size of their GDP (167%, 114% and 113% in 2007 respectively for these countries).

We have also investigated the effect of a set of bank-specific, macroeconomic and financial variables on GCC banks’ productivity growth. The results suggest that bank size has a positive impact on total productivity change and technical change for all banks and for conventional bank models. This implies that large banks are more productive than smaller ones because they have greater capacity to invest and utilize new technologies (Kyj & Isik 2008). Our findings are in line with the recent study on the cost efficiency in GCC banks of Srairi (2009b) which also concluded that the larger the size of the bank, the higher the efficiency. We also find that the ratio of equity to total assets is positively related to technical change and negatively to efficiency change for only the Islamic banks model. This finding could be explained by the fact that banks which hold a higher level of equity have a difficulty in generating scale economy while they tend to experience technical progress (Sufian & Haron 2008 and Chiou 2009). The ratio of diversification has a negative effect on the most Malmquist indices for all models. This result is in agreement with the opinion that specialization increases the risk but stimulates the productivity growth of banks (Mukherjee et al. 2001; Chan & Liu 2006). According to Chiou (2009), in a liberalization and competitive environment, specialization is a better strategy for a bank manager who cannot operate too many operational revenue items. Consistent with our expectations, the proxy of management quality and the ratio of loan intensity are associated negatively to efficiency and technical change in most models. These findings, in accordance with several studies (Dogan & Fausten 2003; Das & Ghosh 2006; Sufian & Haron 2008) mean that banks with poor management practices and a large share of loans generate additional costs and in consequence are less productive. In contrast, the regression result of Islamic banks reports a positive relationship between Malmquist indices and the ratio loan to asset. Indeed, Islamic banks provide financing on a partnership and, in turn, their products contain less bad loans compared to traditional banks. Thus, the higher level of loan intensity may increase the productivity change of the type of bank.

Regarding the macroeconomic and financial indicators, our findings suggest that the degree of monetization, the per capita GDP and the variable of banking sector development are significantly and positively


101

related to some Malmquist indexes (especially TFPCH and EFFCH) while the inflation rate and the financial market development measure do not have any impact on productivity change in all models. Finally, the empirical results show that the concentration indicator has a significant and negative effect on conventional banks’ efficiency change. As the banking sector becomes more concentrated, competition becomes low, intermediation margins are relatively wide, there is less pressure on costs and banks are likely to experience low productivity growth rates. Overall, these results confirm the strong association between the performance of banks and the characteristics of the environment and the sector in which they are active.

In conclusion, many policy implications and recommendations may follow from the findings of this research. First, since there is an improvement in productivity growth across most of the GCC banking sector over the period of deregulation and liberalization, legislators and regulators in the Gulf region should increase economic integration between their countries, contemplate further liberalization of their financial market, and improve participation of the private sector. Second, the results indicate that large banks are more productive than smaller and provide a justification for further mergers among GCC banks. In addition, with the rapid expansion of the GCC economies and the entry of foreign banks and, due to the limited size of the GCC markets, commercial banks in this region should gradually move toward national, regional and international consolidation in order to be more competitive and efficient. Such a strategy allows banks to expand their services, improve the quality of their assets, increase their scale of operation and facilitate transfers of new skills and technology. Finally, according to several international ratings agencies (e.g. Standard & Poor’s), it is expected that in ten years Islamic banks will account for 40–50% of the total savings for the Muslim population, and the potential market for Islamic products is estimated to be $4,000 billion. Thus, Islamic banks have to improve their efficiency and productivity to satisfy the large needs of the market and to compete with conventional banks. Accordingly, while the study shows that Islamic banks have experienced a lower level of productivity growth both in technical change and technical efficiency compared to conventional banks, it is necessary for this group of banks to increase the size of investment in information technology and to utilize specialized and automated systems to measure, monitor and control market credit and operational risk as indicated in Basle 2. Furthermore, to improve their technical efficiency, Islamic banks also have to extend their size via mergers and acquisitions

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with other Islamic financial institutions, create and design new Islamic products and services, and rationalize their operating costs.

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CHAPTER THREE

AN ANALYSIS FOR THE GROWTH AND RISE OF SMALLER ISLAMIC BANKS

IN THE LAST DECADE


What are the reasons behind the recent growth in Islamic finance? Why is Islamic finance developing at a remarkable pace? What are the determinants of the profitability of the Islamic banking sector over the last decade? There are many reasons which can be attributed to the rise in Islamic banking, such as the strong demand from a large number of immigrant and non-immigrant Muslims for Sharia-compliant financial services and transactions, the growing oil wealth creating soaring demand for suitable investments in the Gulf region, the competitiveness of many of the products attracting Muslim and non-Muslim investors, and finally the fact that Islamic banking has so far been spared a serious financial crisis, with the exception of a few minor instances (such as the Dubai Islamic Bank in 1998 and Ihlas Finans in Turkey in 2001.)

Since their inception three decades ago, the number of Islamic financial institutions worldwide has risen from one in 1975 to over 300 today in more than seventy-five countries. They are concentrated in the Middle East and Southeast Asia (with Bahrain and Malaysia acting as the biggest hubs), but are also appearing in Europe and the United States. Total assets worldwide are estimated to exceed $250 billion, and are growing at an estimated 15% a year (although cross-border data remains scarce).

Due to the lack of literature, very few articles have been written on governance structures in Islamic banking, despite the rapid growth since the mid-1970s and the increasing presence of Islamic banks in the world financial markets. There are now over 180 financial institutions worldwide which adhere to Islamic banking and financing principles. These banks operate in forty-five countries encompassing most of the Muslim world, along with Europe, North America and various offshore locations.

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How have conditions in Islamic Banking changed banking and regulations overall in the last decade? In the scope of this chapter, we answer this question by using econometric techniques to provide a cross-country empirical analysis of the rise of smaller Islamic banks.

Islamic banking represents a radical departure from conventional banking. From the viewpoint of corporate governance, it embodies a number of interesting features, since equity participation, risk and profit-and-loss sharing arrangements form the basis of Islamic financing. Because of the ban on interest (riba), an Islamic bank cannot charge any fixed return in advance, but rather participates in the yield resulting from the use of funds. The depositors also share in the profits according to a predetermined ratio, and are rewarded with profit returns for assuming risk. Unlike a conventional bank, which is basically a borrower and lender of funds, an Islamic bank is essentially a partner with its depositors on the one hand, and a partner with its entrepreneurs on the other, when employing depositors' funds in productive direct investment.

The motivation behind our research is the limited literature tackling the market structure of the Islamic banking sector. This study contributes to the literature on market structure in Islamic banking systems by using a larger sample of banks over a significant amount of time. We collected our dataset from thirty dominant banks in the Islamic banking sector for the period 1998–2008. The aim of this research is to analyze the reason and factors for the rise and growth of smaller Islamic banks and Islamic finance over the last decade. The previous studies for the Islamic banking sector mainly concentrate on the rise of Islamic banking as a whole, and very little literature is focused on the significance and impact of smaller Islamic banks or Islamic finance (e.g. Yudistira, 2004).

The chapter is divided into five sections. Section 1 will give the literature review, followed by Section 2, which will give a brief overview of Islamic banking. Section 3 demonstrates the methodology used in the chapter. Section 4 will give our empirical findings and Section 5 finally concludes with a short summary

Section 2. Literature Review

Choong and Liu (2006) argue that Islamic banking, practiced in Malaysia, deviates from the PLS paradigm, and in practice is not very different from conventional banking. The authors therefore suggest that for purposes of financial sector analysis, Islamic banks should be treated similarly to their commercial counterparts. A large part of the literature contains comparisons of the instruments used in Islamic and commercial banking,

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and discusses the regulatory and supervisory challenges related to Islamic banking (e.g. Sundararajan and Errico 2002; The World Bank and The IMF 2005; Ainley et al. 2007; Sole 2007; Jobst 2007).

A lot of the literature focuses on interrogating risks in Islamic financial institutions. However, this is done so in theoretical terms instead of through analysis of data. Empirical papers on Islamic banks focus on issues related to efficiency (e.g. Yudistira 2004; Moktar, Abdullah and Al- Habshi 2006).

Hasan et al. (2003) investigated the relative efficiency of the banking industry of Bahrain by applying a panel data of thirty-one banks for the years 1999–2000. They employed non-parametric data analysis to estimate efficiency measures, finding that the dominant source of inefficiency of Bahrain banks is due to technical efficiency rather than the allocative efficiency. Hasan et al. also examined differences in efficiency measures in Bahrain between domestic and foreign banks. They found that both categories of banks differ only in scale efficiency. Recent studies by Ozkan Gunay (1996, 1998), Mahmud & Zaim (1998), Yildirim (1999), and Mercan & Yolalan (2000) concluded that liberalisation increased the efficiency of the banking sector. Mahmud & Zaim (1998) focused on private commercial banks, while Cingi & Tarim (2000) studied the efficiencies of twenty-one commercial banks (some state-owned and some private) with a deposit share of more than 1% in the banking sector.

Favero & Papi (1995) found that their results were not sensitive to specifying deposits as an output rather than as an input. However, Heffernan (2005) indicates that deposits may be treated either as inputs or as outputs. Brown & Skully (2004) stated that the use of deposits has been used more as output rather than input in most bank efficiency studies that apply the DEA technique. Berger et al. (1993) argued that the chosen approach has an impact on the levels of efficiency scores, but does not imply strong modifications in their rankings.

A research of Islamic financial institutions in twenty-eight countries by Khan & Ahmed (2001) found that credit risk is highest in Musharakah (3.69 from a score of 5) followed by Mudarabah (3.25). Their findings highlight that the bankers perceive profit and loss sharing (PLS) modes to have a higher credit risk. Mark-up risk is found to be highest in the product-deferred contracts of Istina (3.57). Sundararajan & Errico (2002) opine that while PLS modes may shift the direct credit risk of Islamic banks to their investment depositors, they may also increase the overall degree of risk of the asset side of banks’ balance sheet, since the assets under this mode are uncollaterized. Their deductive intuition is that, in

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principle, the ratio of riskier assets to total assets should typically be higher in an Islamic bank than in a conventional bank.

Samad & Hassan’s (1999) study on Malaysian Islamic banking reveals that Bank Islam performance of risk from 1984–1997 in risky business measured by debt-equity ratio (DER), debt to total Assets (DTAR) and Earning Multiplier (EM), increased over the years. DER and EM are significantly related to profitability. In comparison with two conventional banks, Bank Pertanian and Perwira Affin Bank, Bank Islam risk indicators are lower. The reason for the low risk of the Islamic bank is that its investment in government securities is much larger than conventional banks.

Berger & Mester (1997) argue that profit efficiency is more superior to cost efficiency, since the profit efficiency accounts for the errors on the output side, i.e. revenues, as well as the input side, i.e. cost. Berger & Mester further argue that the bank may be more successful in minimizing cost than another firm, but it still makes less profit than other firms because they make poor choices on output mix.

Hasan & Marton (2001) proposed that the non-US studies found that foreign banks are more efficient than domestic banks, for instance Hungarian banks. Similar results were found by Zaim (1995) and Isik & Hassan (2002) for Turkish banks, whereas Sathye (2001) reveals that there is no comparative advantage accruing to foreign banks. In their study, Al-Jarrah & Molyneux (2003) included banks in Bahrain, Egypt, Sudan and Saudi Arabia, and found that the Islamic banks were the most efficient in their sample. They observed that this was due to the fact that the cost of funds for Islamic banks is relatively cheaper than the cost of funds for other financial institutions. Hussein et al. (2004) found that the Islamic banks outperform their conventional counterparts; Islamic banks are found to gain 75% for their profit, while the same measure for conventional banks is 66%. They also proposed that the difference between the profit efficiency of Islamic and conventional banks is due to the difference in performance of commercial rather than investment banks.

Islam has a high regard for efficiency, but there are very few examples in the literature which focus on this aspect of the Islamic banking system, while a bulk of production efficiency studies of banks have been undertaken upon conventional banks.

Section 3. Islamic Banking: an Overview

Islamic banking must obey a different set of rules—those of the Holy Qur’an—and meet the expectations of the Muslim community by providing Islamically-acceptable financing models. These profit and loss


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sharing methods, in turn, imply different relationships than interest-based borrowing and lending. Islamic organisations must serve God. They must develop a distinctive corporate culture, the main purpose of which is to create a collective morality and spirituality which, when combined with the production of goods and services, sustains the growth and advancement of the Islamic way of life (Janachi, 1995). Interest-free banking is based on the Islamic legal concepts of shirkah (partnership) and mudarabah (profit-sharing). An Islamic bank is conceived as a financial intermediary, mobilising savings from the public on a mudarabah basis and advancing capital to entrepreneurs on the same basis.

More than two thirds of Islamic finance business currently originates in the Middle East. The GCC countries, with the exception of Oman, are all major markets for Islamic finance. Bahrain is regarded as the hub for Islamic finance. Other major non-GCC markets for Islamic finance include Egypt, Malaysia, Turkey, Indonesia and Pakistan. Malaysia operates a dual banking system promoted by the government. This allows conventional financial institutions, investment banks, commercial banks and finance companies to launch separate Islamic banking divisions, competing alongside two Islamic banks—Bank Islam Malaysia and Bank Muamalat Malaysia. Bank Negara Malaysia (the central bank) has its own Sharia Advisory Board, which sets the rules for the entire Islamic banking sector, ensuring the uniformity of products and services.

Over 150 Islamic financial institutions now operate in over forty countries around the world, from commercial banks, investment banks, investment companies to leasing and insurance companies.

The Islamic financial system employs the concept of participation in enterprise, utilising the funds at risk on a profit and loss sharing basis. This by no means implies that investments with financial institutions are necessarily speculative. This can be excluded by careful investment policy, diversification of risk and prudent management by Islamic financial institutions. It is possible that investment in Islamic financial institutions can provide potential profit in proportion to the risk assumed to satisfy the differing demands of participants in the contemporary environment and within the guidelines of Sharia.

Islamic banks around the world have devised many financial products based on the risk-and profit-sharing principles of Islamic banking. For day-to-day banking activities, a number of financial instruments have been developed that satisfy the Islamic doctrine and provide acceptable financial returns for investors. Broadly speaking, the areas in which Islamic banks are most active are in trade and commodity finance, property and leasing. Almost every Islamic bank has a committee of religious advisers whose

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opinion is sought on the acceptability of new instruments and services and who have to provide a religious opinion of the bank's activities for year-end accounts.

Central to the framework of corporate governance for an Islamic bank is the Sharia Supervisory Board (SSB). The SSB is vital for two reasons. First, those who deal with an Islamic bank require assurance that it is transacting with Islamic law. Should the SSB report that the management of the bank has violated the Sharia, it would quickly lose the confidence of the majority of its investors and clients. Second, some Islamic scholars argue that strict adherence to Islamic religious principles will act as a counter to the incentive problems outlined above. The argument is that the Islamic moral code will prevent Muslims from behaving in ways which are ethically unsound, so minimizing the transaction costs arising from incentive issues. In effect, Islamic religious ideology acts as its own incentive mechanism to reduce the inefficiency that arises from asymmetric information and moral hazard.

An investment account operates under the mudarabah al-mutlaqah principle, in which the mudarib (active partner) must have absolute freedom in the management of the investment of the subscribed capital. The conditions of this account differ from those of the savings accounts by virtue of: (a) a higher fixed minimum amount; (b) a longer duration of deposits, and most importantly; (c) the depositor may lose some or all of their funds in the event of the bank making losses.

Special investment accounts also operate under the mudarabah principle, and are usually directed towards larger investors and institutions. The difference between these accounts and the investment account is that the special investment account is related to a specified project, and the investor has the choice to invest directly in a preferred project carried out by the bank.

If the paying and receiving of interest is prohibited, how do Islamic banks operate? It is necessary to distinguish between the expressions “rate of interest” and “rate of return.” Whereas Islam clearly forbids the former, it not only permits but rather encourages trade. In the interest-free system sought by adherents to Muslim principles, people are able to earn a return on their money only by subjecting themselves to the risk involved in profit sharing. As the use of interest rates in financial transactions is prevented, Islamic banks are expected to undertake operations only on the basis of Profit and Loss Sharing (PLS) arrangements or other acceptable modes of financing. Mudarabah and musharakah are the two profit-sharing arrangements preferred under Islamic law.


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A mudarabah is a contract between at least two parties whereby one party, the financier (sahib al-mal), entrusts funds to another party, the entrepreneur (mudarib), to undertake an activity or venture. This type of contract is in contrast with musharakah. In arrangements based on musharakah there is also profit sharing, but all parties have the right to participate in managerial decisions. In mudarabah, the financier is not allowed a role in management of the enterprise. Consequently, mudarabah represents a PLS contract where the return to lenders is a specified share in the profit/loss outcome of the project in which they have a stake, but no voice.

Under musharakah, the entrepreneur adds some of their own capital to that supplied by the investors, so exposing them to the risk of capital loss. Profits and losses are shared according to pre-fixed proportions, but these proportions need not coincide with the ratio of financing input. The bank sometimes participates in the execution of the projects in which it has subscribed, perhaps by providing managerial expertise.


4.1. Estimation of Bank Stability

In this section, we use z-score as the measure of bank risk. The z-score has recently become a popular measure of bank robustness. However, there are very few examples in the literature of using this methodology to measure bank risks, e.g. Boyd and Runkle (1993), Maechler, Mitra and Worrell (2005) and Martin Čihák & Heiko Hesse (2008). The z-score can be summarized as z ≡ (k+μ)/σ, where k is equity capital and reserves as per cent of assets, μ is average return as per cent of assets, and σ is standard deviation of return on assets as a proxy for return volatility. The z-score measures the number of standard deviations a return realization has to fail in order to deplete equity, under the assumption of normality of banks’ returns. A higher z-score corresponds to a lower upper bound of insolvency risk, and a higher z-score therefore implies a lower probability of insolvency risk.

The z-score applies equally to banks that use a high risk/high return strategy and those that use a low risk/low return strategy, provided that those strategies lead to the same risk-adjusted returns. If an institution “chooses” to have lower risk-adjusted returns, it can still have the same or a higher z-score if it has a higher capitalization. In this sense, the z-score provides an objective measure of soundness.

A large portion of Islamic banks’ financial liabilities consists of investment accounts that can be viewed as a form of equity investment (generally based on the principle of Mudarabah). Investment accounts are

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offered in different forms often linked to a pre-agreed period of maturity. The profits and returns are distributed between the depositors and the bank, according to a pre-determined ratio, e.g. 80% to the depositors and 20% to the bank (Iqbal & Mirakhor 2007).

4.2. Regression Analysis

Using the regression of z-score as a function of a number of variables, we test the stability of smaller and larger Islamic banks. We estimate a general class of panel models of the form:

Where the dependent variable is the z-score z i,j,t for bank i in country j

at time t B i,j,t-1 is a vector of bank-specific variables I j,t-1 containing time-varying industry-specific variables; Ts I j,t-1 are the type of banks and the interaction between the type and some of the industry-specific variables; M j,t, Cj and tDt are vectors of macroeconomic variables, country and yearly dummy variables, respectively; finally, εi,j,t is the residual.

A negative sign for the interaction of the Islamic banks’ market share and the Islamic bank dummy would indicate that a higher share of Islamic banks reduce their soundness (their z-scores). We want to examine the Islamic banks’ impact on other banks and the hypothesis that the presence of Islamic banks lowers systemic stability; hence, we calculated the market share of Islamic banks by assets for each year and will interact it with Islamic banking dummies.

The regression includes a number of other control variables for bank-level differences in size, asset composition and cost efficiency, including the bank’s asset size in billions of USD, loans over assets, and the cost-income ratio. In addition, to control for differences in the structure of the bank’s income, we calculate a measure of income diversity. This enables us to determine the degree to which banks diversify from traditional lending activities from other activities. For Islamic banks, the net interest income is generally defined as the sum of the positive and negative income flows associated with the PLS arrangements. We also measure differences of Islamic banks in their business orientations, and interact the income diversity variable with the Islamic bank dummy. Controlling for these variables is important because there are differences in these variables between various Islamic banks.


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To account for cross-country variation in financial stability caused by differences in market concentration, we include the Herfindahl index, defined as the sum of squared market shares (in terms of total assets) of all major Islamic banks. The index can have values from zero to 10,000. The macroeconomic and bank specific variables, the Herfindahl index, and the Islamic banks’ market share and its interaction with the Islamic and commercial bank dummies are lagged to capture the possible past effects of these variables on the banks’ individual risk. We also tested for the robustness of the lagged effects by restricting the explanatory variables to contemporaneous effects.

We tested for the regression analysis by the pooled ordinary least squares (OLS) technique. To test the sensitivity of the results with respect to the estimation method, we also estimated fixed effects and median least squares regressions. We also assessed the robustness of the results with respect to the selected sample. Specifically, we estimate the regressions separately for sub-samples of large Islamic banks. We categorized the large Islamic banks as those having total assets worth more than $2 billion USD and all others as small Islamic banks.

The complete list of all the variables used for the regression analysis is given in Table 3.1 below.

4.3. Data

The data used in this chapter was collected from thirty key Islamic banks functioning in different countries of the world in the period from 1998 to 2008. The Islamic banks whose data was collected are ABC Islamic Bank (E.C.), Abu Dhabi Islamic Bank, Al Baraka Bank (South Africa), Al Baraka Islamic Bank B.S.C. (E.C.), Al Rajhi Bank, Albaraka Turk Participation Bank, Arcapita Bank B.S.C., Bahrain Islamic Bank B.S.C., Bank Al-Jazira, Bank Asya, Bank Islam Malaysia Berhad, Bank Muamalat, Boubyan Bank, CIMB Islamic Bank Berhad, Faisal Islamic Bank of Egypt, Faysal Bank (Pakistan), Hong Leong Islamic Bank, International Islamic, Islamic Bank Bangladesh Limited, Islamic Bank of Britain, Islamic International Arab Bank, Jordan Islamic Bank for Finance and Investment, Kuwait Finance House, Kuwait Turk Participation Bank, Meezan Bank, Qatar Islamic Bank, RHB Islamic Bank, Sharjah Islamic Bank, Tadhamon International Islamic Bank, Turkish Finance Participation Bank.

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Variable Description

Z-score Defined as z ≡ (k+μ)/σ, where k is equity capital as per cent of assets, μ is average return as per cent of assets, and σ is standard deviation of return on assets as a proxy for return volatility. Measures the number of standard deviations a return realization has to fall in order to deplete equity, under the assumption of normality of banks’ returns

Total assets The total assets of the bank in USD

Loans/assets Ratio of loans to assets (per cent).

Exp._inc . Ratio of total expenditure to total income

Income Diversity 1- |(Net operating income – other operating income)| Total operating income

Islamic Bank Dummy Equals 1 for large Islamic banks; 0 otherwise

Market Share The share of the bank amongst various

Par amount Islamic banks in the dataset

Herfindahl Index Sum of squared market shares of banks in the dataset

Table 3.1. Description of individual variables used in regression analysis. Source- Čihák and Hesse (2008)

The pooled data was made by combining the datasets from all the

banks. The regression analysis was performed on this pooled data to obtain the results mentioned in the next section. The mean square and double accounting techniques were also used on the dataset, wherever required.

Section 5. Empirical Analysis

The summary statistics on the data sample for Islamic banks in 1998–2008 are shown in Table 3.2.


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Large Islamic banks Small Islamic banks

Z-score 10.68** 29.21**

Z-score excl. outliers 09.53 15.52

Loans/assets 0.79* 0.66*

Income diversity 0.41 0.39 Table 3.2 Summary statistics of the data sample ** and * denotes significant at 1% and 5 % respectively The 1st percentile of the distribution of the income diversity variable is excluded. The z-score without the outliers excludes the 1st and 99th percentile of its distribution The z-score without the outliers excludes the 1st and 99th percentile of its distribution

The basic data analysis suggests that smaller Islamic banks are found

to be more stable than larger Islamic banks, as higher z-scores indicate higher stability. A pairwise comparison of means suggests that in both cases the difference is significant at the 1% level. The table also illustrates that the treatment of outliers is important. Furthermore, even with the outliers we found that the smaller Islamic banks have higher z scores. The large Islamic banks have, on average, higher loan-to-asset ratios than smaller Islamic banks, reflecting the fact that Islamic banking prohibits investment in non-lending operations such as regular bonds or T-bills in Islamic banking.

We then turn to regression analysis, and the results of our tests are shown in Tables 3.3 and 3.4. Table 3.3 gives the results for the OLS estimation, whereas Table 3.4 shows the results of a robust estimation technique, which assigns lower weights to observations with large residuals. This makes the estimation less sensitive to outliers.

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Variable All banks Large banks Small banks

Islamic dummy

-1.563 (0.151) -13.771(0.011) 5.929 (0.007)

Loan/assets -2.503 (0.284)** -2.003 (0.332)** -3.475 (0.023)**

Exp_inc -0.029 (0.007)** -1.153 (0.636)** -2.969 (0.449)

Assets 0.192 (0.001) 0.281 (0.003) -2.112 (0.011)

Income diversity

3.487 (0.474)** 17.734 (0.001)* -4.873 (0.295)**

Market share

-0.575 (0.064) 0.011 (0.717)

Herfindahl Index

-0.001 (0.006)* -0.005 (0.001)* -0.001(0.013)*

R-square 0.177 0.295 0.198

Constant 64.872 88.981 29.326 Table 3.3 Regression Results—Ordinary Least Squares (Dependent variable z-score) p-values are in parenthesis ** and * denotes significance at 1% and 5% respectively

The regression results show that smaller Islamic banks are more stable than larger Islamic banks. We observe that for larger Islamic banks, the Islamic dummy is negative while it is positive for smaller banks. We also observe that banks with higher z scores tend to have low z scores. Moreover, we found that z scores tend to increase with bank size for large Islamic banks, but decrease in size for the small Islamic banks.

Our results show that the larger banks have greater income diversity than the smaller banks. This suggests that they do not rely much on income bearing assets. Similarly, higher expenditure-to-income ratios have a consistently negative link to the z-scores; the sign is consistently significant except for regressions for small banks.

We found that the Herfindahl Index had a negative impact on Islamic banks; hence our findings are in accordance with previous studies, such as those of Schaeck, Čihák and Wolfe (2006) and Čihák & Hesse (2008), who also found higher concentration to be associated with lower stability.


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Variable All banks Large banks Small banks

Islamic dummy

-0.22 (0.431) -6.256(0.048) 1.235 (0.019)

Loan/assets -5.727 (0.004)** -12.026 (0.002)** -3.292 (0.051)**

Exp_inc -0.039 (0.009)** -0.112 (0.001)** -0.229 (0.009)

Assets 0.082 (0.239) 0.155 (0.047) -4.571 (0.020)

Income diversity

-1.635 (0.128)** -2.946 (0.038)* 0.321 (0.295)**

Market share

-0.368 (0.027) 0.019 (0.545)

Herfindahl Index

-0.001 (0.104)* -0.003 (0.153)* -0.001(0.262)*

R-square 0.272 0.259 0.181

Constant 55.783 45.357 16.399 Table 3.3. Regression Results—Robust estimation (Dependent variable z-score) p-values are in parenthesis ** and * denotes significance at 1% and 5% respectively

The robust regression results confirm our earlier findings that smaller Islamic banks are more stable than larger banks, as the Islamic dummy is again negative while it is positive for smaller banks.

The difference in the results of income diversity of larger and smaller banks is important because there are significant differences in these variables between Islamic banks. We observe that the smaller Islamic banks correspond to a higher degree of diversification than the larger banks.

Moreover, we observe that the expenditure to income ratio is smaller for smaller Islamic banks than larger Islamic banks in both the OLS regression results and the robust regression results. This can be seen as the major factor for the rise and growth of smaller Islamic banks and Islamic finance in the last decade, even after the prohibition

of investment in non-lending operations such as regular bonds or T-bills in Islamic banking.

The robust regression results for the Herfindahl Index show similar results to the OLS regression, as it is still negative and significant for both

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the smaller and the larger Islamic banks. We conducted several additional checks to test the robustness of our results, and tested for the robustness of the lagged effects by restricting the explanatory variables to contemporaneous effects, again finding no substantive change in the main results.

Conclusions

This chapter investigates the factors responsible for the rise and growth of smaller Islamic banks in the last decade. Using regression of z-score as a function of a number of variables, we test the stability of smaller and larger Islamic banks. We then tested for the regression analysis using the pooled ordinary least squares (OLS) technique. Furthermore, we also assessed the robustness of the results with respect to the selected sample on our pooled dataset for the period 1998–2008.

Our results show higher z-scores for smaller Islamic banks; hence we conclude that smaller Islamic banks are found to be more stable than larger Islamic banks over the last decade, as higher z- scores implies higher stability. We found that, even with the outliers, the smaller Islamic banks have higher z-scores. The larger Islamic banks have, on average, higher loan to asset ratios than smaller Islamic banks, reflecting the fact that Islamic banking prohibits investment in non-lending operations such as regular bonds or T-bills. We also observed that z scores tend to increase with bank size for large Islamic banks, but decrease with size for the small Islamic banks.

The OLS regression results obtained confirms our previous finding; that smaller Islamic banks are more stable than larger Islamic banks. Our findings suggest that larger banks have greater income diversity than the smaller banks. We also found that expenditure-to-income ratios were negative and significant for larger Islamic banks. Furthermore, the Herfindahl Index was found to have a negative impact on Islamic banks.

Our robust regression results prove that the smaller Islamic banks correspond to a higher degree of diversification than the larger banks, which is also responsible for the growth of these smaller Islamic banks. We found significantly low expenditure to income ratio values for smaller banks than in larger banks, which can be regarded as one of the paramount factors responsible for the growth and rise of smaller Islamic banks.


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CHAPTER FOUR

DEVELOPMENT AND SCOPE OF ISLAMIC BANK BONDS (SUKUK)


According to Khan & Bhatti (2008), sukuk constitute about 85% of the Middle Eastern capital market, and US $13bn of them have been issued with an average growth rate of over 45% during the period 2002–2007 (Islamic Finance News 2006b). The Middle East and Asian regions will primarily rely on sukuk to meet their US $1.5 trillion infrastructure needs over the next five years (Khaleej Times 2007).

Therefore, the interest in sukuk is definitely growing as demand for Islamic products is rising and enjoying a period of sustained growth. Islamic finance is developing at a remarkable pace. Since its inception three decades ago, the number of Islamic financial institutions worldwide has risen from one in 1975 to over three hundred in more than seventy-five countries. They are concentrated in the Middle East and Southeast Asia (with Bahrain and Malaysia being the biggest hubs), but are also appearing in Europe and the United States. Total assets worldwide are estimated to exceed $250 billion, and are growing at an estimated 15% a year (although cross-border data remains scarce).

Islamic financial products are aimed at investors who want to comply with the Islamic laws (Sharia) that govern a Muslim's daily life. These laws forbid giving or receiving interest (because earning profit from an exchange of money for money is considered immoral); they mandate that all financial transactions be based on real economic activity, and prohibit investment in sectors such as tobacco, alcohol, gambling and armaments. Islamic financial institutions are providing an increasingly broad range of financial services, such as fund mobilization, asset allocation, payment and exchange settlement services, and risk transformation and mitigation. However, these specialized financial intermediaries perform transactions using financial instruments compliant with Sharia principles.

What are the reasons behind the recent growth in Islamic finance? One is the strong demand from a large number of immigrant and non-

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immigrant Muslims for Sharia-compliant financial services and transactions. A second is growing oil wealth, with demand for suitable investments soaring in the Gulf region. A third is the competitiveness of many of the products, attracting Muslim and non-Muslim investors. Yet despite this rapid growth, Islamic banking remains quite limited in most countries and is tiny compared with the global financial system. For it to take off and play a bigger role, especially in the Middle East, policymakers must tackle enormous hurdles, notably on the regulatory front. Islamic banking has so far been spared a serious financial crisis, with the exception of a few small cases (such as the Dubai Islamic Bank in 1998 and Ihlas Finans in Turkey in 2001). Nevertheless, building confidence in a new industry is fundamental for the development of Islamic finance.

Despite the increasing popularity of Islamic banking, corporate governance in banking has been analysed almost exclusively in the context of conventional banking markets, and this is mainly attributable to many countries not being Muslim and therefore not really being interested in adopting an Islamic banking system. For example, there has recently been some discussion of the role that “market discipline” exerted by bank shareholders and depositors in constraining the risk-taking behaviour of bank management. At the same time, there is growing interest in, and analysis of, banks as stockholders in companies themselves playing a central role in corporate governance, especially in Germany and other countries with universal banking structures of the traditional type.

By contrast, little is written on governance structures in Islamic banking, despite the rapid growth of Islamic banks since the mid-1970s and their increasing presence on world financial markets. There are now over 180 financial institutions worldwide which adhere to Islamic banking and financing principles. These banks operate in forty-five countries encompassing most of the Muslim world, along with Europe, North America and various offshore locations. Islamic financing is increasingly a market segment of interest of Western banks, and the latest addition to the list of Islamic banks in October 1996 is the Citi Islamic Investment Bank, Bahrain, a wholly owned subsidiary of Citicorp.

Islamic banking represents a radical departure from conventional banking, and from the viewpoint of corporate governance it embodies a number of interesting features since equity participation, risk and profit-and-loss sharing arrangements form the basis of Islamic financing. Because of the ban on interest (riba), an Islamic bank cannot charge any fixed return in advance, but rather participates in the yield resulting from the use of funds. The depositors also share in the profits according to a predetermined ratio, and are rewarded with profit returns for assuming

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risk. Unlike a conventional bank, which is basically a borrower and lender of funds, an Islamic bank is essentially a partner with its depositors on the one hand, and a partner with entrepreneurs on the other, when employing depositors' funds in productive direct investment.

The Islamic bank is subject to an additional layer of governance since the suitability of its investment and financing must be in strict conformity with Islamic law and the expectations of the Muslim community. For this purpose, Islamic banks employ an individual Sharia Advisor and/or Board.

My examination of corporate governance in Islamic banking begins by comparing governance structures in the Islamic bank and will continue with the principles of Islamic banking. This study compares the Islamic banking financial model and its implications for governance structures with the intention of discovering whether Islamic bonds are viable options to replace conventional bonds. Therefore, this research is concerned with investment sukuk in the banking industry, in both retail and investments banks. Hence, it does not include sukuk issued directly by financing companies since these are still in their early beginnings. It takes into consideration those bonds and sukuk that have been practiced/issued in the last few years until now, not taking into consideration historical forms of both. This research will deal with sukuk that have been issued in or through Middle Eastern banks, especially UAE. Bonds, however, are handled more extensively in Western countries, such as Europe and USA. Thus samples will be taken as most useful to the comparison, whether from Western countries or the Middle East as well.

Section 2. Aims and Objectives

The researcher has noted a distinct lack of existing literature on the topic of Islamic sukuk, while there exists a multitude of existing studies, academic papers and books on conventional banking instruments including bonds.

Almost all banking systems abide by the conventional banking system. Islamic banking, by contrast, is a new equity-based financial system that has only been implemented in its modern form, serving the present day markets’ needs, over the last twenty-five years. investment sukuk (i.e. Islamic bonds) are a fairly new addition to Islamic banking. The literature available on it is based on the classical reference materials on Islamic Fiqh. Furthermore, there has not been enough educational material in comparison with conventional banking material.

Therefore, there is an obvious gap in comparing conventional bonds to investment sukuk, with the objective to assess the potentiality of sukuk as


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substitutes to conventional bonds, at least in the Muslim world. This research seeks to address this gap, and look at whether sukuk are a viable option to the banking customer.

The primary hypothesis here is that investment sukuk are a better economic, commercial and legal substitute to conventional bonds. This will be tested by a comparison analysis between conventional bonds and investment sukuk. It seeks to identify similarities, dissimilarities and important economic and financial issues, both in principle and practice.

2.1. Literature Review

This chapter will seek to provide a solid background of information on Islamic banking and its underlying principles. It will fully identify the characteristics and qualities of Islamic sukuk, as well as outline the nature of a conventional bond.

2.2. The Islamic Bank

Governance structures are quite different from those under Islamic banking because the institution must obey a different set of rules—those of the Holy Qur'an—and meet the expectations of the Muslim community by providing Islamically-acceptable financing modes. These profit-and-loss sharing methods, in turn imply different relationships than under interest-based borrowing and lending.

Fig. 4.1 sets out the key stockholders in an Islamic bank. There are two major differences from the conventional framework. First, and foremost, an Islamic organisation must serve God. It must develop a distinctive corporate culture, the main purpose of which is to create a collective morality and spirituality which, when combined with the production of goods and services, sustains the growth and advancement of the Islamic way of life. To quote Janachi (1995, 42):

Islamic banks have a major responsibility to shoulder … all the staff of such banks and customers dealing with them must be reformed Islamically and act within the framework of an Islamic formula, so that any person approaching an Islamic bank should be given the impression that he is entering a sacred place to perform a religious ritual, that is the use and employment of capital for what is acceptable and satisfactory to God. There are equivalent obligations upon employees: “The staff in an

Islamic bank should, throughout their lives, be conducting in the Islamic way, whether at work or at leisure” (1995, 28).

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Further, obligations also extend to the Islamic community:

Muslims who truly believe in their religion have a duty to prove, through their efforts in backing and supporting Islamic banks and financial institutions, that the Islamic economic system is an integral part of Islam and is indeed for all times … through making legitimate and Halal profits (1995, 29).

Second, interest-free banking is based on the Islamic legal concepts of shirkah (partnership) and mudaraba (profit-sharing). An Islamic bank is conceived as a financial intermediary, mobilising savings from the public on a mudaraba basis, and advancing capital to entrepreneurs in the same way. A two-tiered profit-and-loss sharing arrangement operates under the following rules:

The bank receives funds from the public on the basis of unrestricted mudaraba. There are no restrictions imposed on the bank concerning the kind of activity and the duration and location of the enterprise, but the funds cannot be applied to activities which are forbidden by Islam.

The bank has the right to aggregate and pool the profit from different investments and share the net profit (after deducting administrative costs, capital depreciation and Islamic tax) with depositors according to a specified formula. In the event of losses, the depositors lose a proportional share or the entire amount of their funds. The return to the financier has to be strictly maintained as a share of profits.

The bank applies the restricted form of mudaraba when funds are provided to entrepreneurs. The bank has the right to determine the kind of activities, the duration and location of the projects and monitor the investments. However, these restrictions may not be formulated in a way which harms the performance of the entrepreneur, and the bank cannot interfere with the management of the investment. Loan covenants and other such constraints common in conventional commercial bank lending are allowed.

The bank cannot require any guarantee such as security and collateral from the entrepreneur in order to insure its capital against the possibility of an eventual loss.

The liability of the financier is limited to the capital provided. On the other hand, the liability of the entrepreneur is also restricted, but in this case solely to labour and effort employed. Nevertheless, if negligence or mismanagement can be proven, the entrepreneur may be liable for the financial loss and obliged to remunerate the financier accordingly.


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The entrepreneur shares the profit with the bank according to a previously agreed division. Until the investment yields a profit, the bank is able to pay a salary to the entrepreneur based on the ruling market salary.

Many of the same restrictions apply to musharaka financing, except that in this instance the losses are borne proportionately to the capital amounts contributed. Thus, under these two Islamic modes of financing, the project is managed by the client and not the bank, even though the bank shares the risk. Certain major decisions such as changes in the existing lines of business and the disposition of profits may be subject to the bank's consent. The bank, as a partner, has the right to full access to the books and records, and can exercise monitoring and follow-up supervision. Nevertheless, the directors and management of the company retain independence in managing the affairs of the company.

These conditions give the finance many of the characteristics of non-voting equity capital. From the viewpoint of the entrepreneur, there are no fixed annual payments needed to service the debt as under interest financing, while the financing does not increase the firm's risk in the way that other borrowings do through increased leverage. Conversely, from the bank's viewpoint, the returns come from profits—much like dividends—and the bank cannot take action to foreclose on the debt, should profits not eventuate.

2.3. The Markets and the Players

More than two-thirds of Islamic finance business originates from the Middle East. The GCC countries, with the exception of Oman, are all major markets for Islamic finance. Bahrain is regarded as the hub for Islamic finance. Other major non-GCC markets for Islamic finance include Egypt, Malaysia, Turkey, Indonesia and Pakistan.

Malaysia operates a dual banking system promoted by the government. This allows conventional financial institutions, investment banks, commercial banks and finance companies to launch separate Islamic banking divisions, competing alongside two Islamic banks: Bank Islam Malaysia and Bank Muamalat Malaysia. Bank Negara Malaysia (the central bank) has its own Sharia Advisory Board, which sets the rules for the entire Islamic banking sector, ensuring uniformity of products and services.

Over 150 Islamic financial institutions now operate in over forty countries around the world, from commercial banks, investment banks, investment companies to leasing and insurance companies.

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2.4. Principles of Islamic Banking

An Islamic bank is based on the Islamic faith and must stay within the limits of Islamic law or Sharia in all of its actions and deeds. The original meaning of the Arabic word Sharia was “the way to the source of life” and it is now used to refer to the legal system in keeping with the code of behaviour called for by the Holy Qur'an.

Islam not only prohibits dealing in interest but also in liquor, pork, gambling, pornography and anything else which the Sharia deems haram (unlawful). Islamic banking is an instrument for the development of an Islamic economic order. Some of the salient features of this order may be summed up as follows:

While permitting the individual the right to seek economic well-being, Islam makes a clear distinction between what is halal (lawful) and what is haram (forbidden) in pursuit of such economic activity. In broad terms, Islam forbids all forms of economic activity which are morally or socially injurious.

While acknowledging the individual's right to ownership of legitimately acquired wealth, Islam makes it obligatory for the individual to spend their wealth judiciously and not to hoard it, keep it idle or to squander it.

While allowing an individual to retain any surplus wealth, Islam seeks to reduce the margin of the surplus for the well-being of the community as a whole, in particular the destitute and deprived sections of society, through participation in the process of Zakat.

While making allowances for human nature and yet not yielding to the consequences of its worst propensities, Islam seeks to prevent the accumulation of wealth in a few hands to the detriment of society as a whole, by its laws of inheritance.

Viewed as a whole, the economic system envisaged by Islam aims at social justice without inhibiting individual enterprise beyond the point where it becomes not only collectively injurious but also individually self-destructive.

The Islamic financial system employs the concept of participation in the enterprise, utilising the funds at risk on a profit-and-loss sharing basis. This by no means implies that investments with financial institutions are necessarily speculative. This can be excluded by careful investment policy, diversification of risk and prudent management by Islamic financial institutions.

It is possible that investment in Islamic financial institutions can provide potential profit in proportion to the risk assumed to satisfy the


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differing demands of participants in the contemporary environment and within the guidelines of Sharia.

The concept of profit and loss sharing, as a basis of financial transactions, is a progressive one as it distinguishes good performance from the bad and the mediocre. This concept therefore encourages better resource management.

Islamic banks are structured to retain a clearly differentiated status between shareholders' capital and clients' deposits in order to ensure correct profit-sharing according to Islamic law.

Four rules govern investment behaviour: The absence of interest-based (riba) transactions; The avoidance of economic activities involving speculation (ghirar); The introduction of an Islamic tax (zakat); The discouragement of the production of goods and services which contradict the value pattern of Islamic (haram) In the following section, I explain how these four elements give

Islamic banking its distinctive religious identity.

Riba

riba refers to the addition in the amount of the principal of a loan according to the time for which it is loaned and the amount of the loan. While earlier there was a debate as to whether riba relates to interest or usury, there now appears to be consensus of opinion among Islamic scholars that the term extends to all forms of interest.

In banning riba, Islam seeks to establish a society based upon fairness and justice (Qur'an 2.239). A loan provides the lender with a fixed return irrespective of the outcome of the borrower's venture. It is much fairer to have a share of the profits and losses. Fairness in this context has two dimensions: the supplier of capital possesses a right to reward, but this reward should be commensurate with the risk and effort involved and thus be governed by the return on the individual project for which funds are supplied.

Hence, what is forbidden in Islam is a predetermined return. The sharing of profit is legitimate and that practice has provided the foundation for Islamic banking.

Ghirar

Another feature condemned by Islam is economic transactions involving elements of speculation, ghirar. Buying goods or shares at a low cost and

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selling them for a higher price in the future is considered illicit. Similarly, an immediate sale to avoid a loss in the future is condemned. The reason is that speculators generate their private gains at the expense of society as a whole.

Zakat

A mechanism for the redistribution of income and wealth is inherent is Islam, so that every Muslim is guaranteed a fair standard of living (nisab). An Islamic tax, Zakat (a term derived from the Arabic zaka, meaning "pure"), is the most important instrument for the redistribution of wealth. This tax is a compulsory levy, one of the five basic tenets of Islam, and the generally accepted amount of the zakat is one-fortieth (2.5%) of a Muslim's annual income in cash or kind from all forms of assessed wealth exceeding nisab.

Every Islamic bank has to establish a zakat fund for collecting the tax and distributing it exclusively to the poor directly, or through religious institutions. This tax is imposed on the initial capital of the bank, on the reserves and profits as described in the Handbook of Islamic Banking.

Haram

A strict code of “ethical investment” operates. Hence, it is forbidden for Islamic banks to finance activities or items forbidden in Islam, haram, such as trade of alcoholic beverages or pork meat.

Furthermore, as the fulfilment of material needs assures the religious freedom for Muslims, Islamic banks are required to give priority to the production of essential goods which satisfy the needs of the majority of the Muslim community, while the production and marketing of luxury activities, israf wa traf is considered unacceptable from a religious viewpoint.

In order to ensure that the practices and activities of Islamic banks do not contradict the Islamic ethical standards, Islamic banks are expected to establish a Sharia Supervisory Board, consisting of Muslim jurisprudence, who act as advisers to the banks.

2.5. Profit-sharing Agreements

Although the restriction against the use of interest might seem to be a binding constraint upon expansion, Islamic banks and financial institutions have in fact grown rapidly. Table 4.1 below sets out the number of banks,


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paid up capital, total deposits and total assets of these Islamic banks, classified by region. It shows that the total assets of these reporting banks amounted to US $155 billion in 1994, with employment in excess of 220,000 (data supplied by the International Association of Islamic Banks).

If the paying and receiving of interest is prohibited, how do Islamic banks operate? To answer this, it is necessary to distinguish between the expressions “rate of interest” and “rate of return.” Whereas Islam clearly forbids the former, it not only permits but encourages trade. In the interest-free system sought by adherents to Muslim principles, people are able to earn a return on their money only by subjecting themselves to the risk involved in profit sharing. As the use of interest rates in financial transactions is prevented, Islamic banks are expected to undertake operations only on the basis of Profit and Loss Sharing (PLS) arrangements or other acceptable modes of financing. Mudaraba and musharaka are the two profit-sharing arrangements preferred under Islamic law.

Mudaraba

A mudaraba can be defined as the contract between at least two parties, whereby one party, the financier (sahib al-mal), entrusts funds to another party, the entrepreneur (mudarib), to undertake an activity or venture. This type of contract is in contrast with musharaka. In arrangements based on musharaks there is also profit-sharing, but all parties have the right to participate in managerial decisions. In mudaraba, the financier is not allowed a role in management of the enterprise. Consequently, mudaraba represents a PLS contract where the return to lenders is a specified share in the profit/loss outcome of the project in which they have a stake, but no voice.

In interest lending, the loan is not contingent on the profit or loss outcome, and is usually secured so that the debtor has to repay the borrowed capital plus the fixed interest amount regardless of the resulting yield of the capital.

Under mudaraba, the yield is not guaranteed in profit-sharing and financial losses are borne by the lender. The entrepreneur as such loses only the time and effort invested in the enterprise. This distribution effectively treats human capital and financial capital equally.

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Musharaka

Under musharaka, the entrepreneur adds some of their own to that supplied by the investors, exposing themselves to the risk of capital loss. Profits and losses are shared according to pre-fixed proportions, but these proportions need not coincide with the ratio of financing input. The bank sometimes participates in the execution of the projects in which it has subscribed, perhaps by providing managerial expertise.

Mudaraba and musharaka constitute, at least in principle if not always in practice, the twin pillars of Islamic banking.

The two methods conform fully to Islamic principles, in that under both arrangements lenders share in the profits and losses of the enterprises for which funds are provided and shirkah (partnership) is involved. The musharaka principle is invoked in the equity structure of Islamic banks and is similar to the modern concepts of partnership and joint stock ownership.

Two-tiered mudabara

For banking operations, the mudaraba concept has been extended to include three parties: the depositors as financiers, the bank as an intermediary, and the entrepreneur who requires funds. The bank acts as an entrepreneur when it receives funds from depositors and as financier when it provides the funds to entrepreneurs. In other words, the bank operates a two-tier mudaraba system in which it acts both as the mudarib on the saving side of the equation and as the rubbul-mal (owner of capital) on the investment portfolio side. Insofar as the depositors are concerned, an Islamic bank acts as a mudarib, which manages the funds of the depositors to generate profits subject to the rules of mudaraba. The bank may in turn use the depositors' funds on a mudaraba basis in addition to other lawful (but less preferable) modes of financing, including mark up or deferred sales, lease purchase and beneficence loans. The funding and investment avenues are discussed below.

2.6. Sources of Funds

Besides their own capital and equity, Islamic banks rely on two main sources of funds: (a) transaction deposits, which are risk free but yield no return, and; (b) investment deposits, which carry the risks of capital loss for the promise of a variable return. In all, there are four main types of accounts:


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Current Accounts

Current accounts are based on the principle of al-wadiah, whereby the depositors are guaranteed repayment of their funds. At the same time, the depositor does not receive remuneration for depositing funds in a current account, because the guaranteed funds will not be used for PLS ventures. Rather, the funds accumulating in these accounts can only be used to balance the liquidity needs of the bank and for short-term transactions on the bank's responsibility.

Savings Accounts

Savings accounts also operate under the al-wadiah principle. Savings accounts differ from current deposits in that they earn the depositors income; depending upon financial results, the Islamic bank may decide to pay a premium, hiba, at its discretion, to the holders of savings accounts.

Investment Accounts

An investment account operates under the mudaraba al-mutlaqa principle, in which the mudarib (active partner) must have absolute freedom in the management of the investment of the subscribed capital. The conditions of this account differ from those of the savings accounts by virtue of: (a) a higher fixed minimum amount; (b) a longer duration of deposits, and most importantly; (c) the depositor may lose some or all of their funds in the event of the bank making losses.

Special Investment Accounts

Special investment accounts also operate under the mudaraba principle, and are usually directed towards larger investors and institutions. The difference between these accounts and the investment account is that the special investment account is related to a specified project, and the investor has the choice to invest directly in a preferred project carried out by the bank.

2.7. Uses of Funds

The mudaraba and musharaka modes, referred to earlier, are supposedly the main conduits for the outflow of funds from banks. In practice, however, other important methods applied by Islamic banks include:

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Murabaha (mark up). The most commonly used mode of financing seems to be the “mark-up” device. In a murabaha transactions, the bank finances the purchase of goods or assets by buying them on behalf of its client and adding a mark-up before reselling it to the client on a “cost-plus” basis profit contract. Fig 4.4 illustrates the sequence. Bai' muajjal (deferred payment). Islamic banks have also resorted to purchase and resale of properties on a deferred payment basis. It is considered lawful in fiqh (jurisprudence) to charge a higher price for goods if payments are to be made at a later date. According to fiqh, this does not amount to charging interest, since it is not a lending transaction but a trading one. Bai'salam (prepaid purchase). This method is really the opposite of the murabaha. There the bank gives the commodity first, and receives the money later. Here the bank pays the money first and receives the commodity later, and is normally used to finance agricultural products. Istissanaa (manufacturing). This is a contract to acquire goods on behalf of a third party, where the price is paid to the manufacturer in advance and the goods are produced and delivered at a later date. Ijara and ijara wa iqtina (leasing). Under this mode, the banks buy the equipment or machinery and lease it out to their clients who may opt to buy the items eventually, in which case the monthly payments will consist of two components, i.e. rental for the use of the equipment and instalment towards the purchase price. Qard hasan (beneficence loans). This is the zero return type of loan that the Holy Qur’an urges Muslims to make available to those who need them. The borrower is obliged to repay only the principle amount of the loan, but is permitted to add a margin at their own discretion.

2.8. Islamic Securities

Islamic financial institutions often maintain an international Islamic equity portfolio where the underlying assets comprise ordinary shares in well-run businesses, the productive activities of which exclude those on the prohibited list (alcohol, pork, armaments) and financial service based on interest income.


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2.9. Islamic Bonds (Sukuk)

Sukuk have become a very hot topic and are increasingly one of the most sought-after Islamic financing vehicles (Bijur, 2007). Sukuk can be defined as “asset-backed, Sharia-compliant trust certificates” (Bijur 2007) that give the owner rights to owning part of the asset, the cash that arises from the asset and the responsibilities that go with it (MIFC 2008).

The conventional instrument closest in similarity to sukuk in the conventional financial system is a bond (mainly those issued in relation to a securitization). However, these bonds lead to usury interest and it is therefore forbidden for a Muslim to partake in such a thing under Islamic law (Bijur 2007).

Based on a range of Islamic values, sukuk can be structured in a number of ways to offer the issuing entity greater financial flexibility and options to meet its funding needs (MIFC 2008). Sukuk can be structured based on the principles of:

- Contract of exchange such as bai’ bithaman ajil (BBA), murabaha, istisna’ and ijarah; or

- Contract of participation such as musharakah and mudharabah. (MIFC 2008).

Most commonly, Sukuk are backed by assets and tend to be used in conjunction with an Ijara structure (that is mentioned earlier on)—where the rental income from the lease earns a profit for the Sukuk holder. Other Sukuk forms use the Musharaka structure, in which the profit share provides the holder with a decent return (Bijur 2007).

Having a Sukuk signifies that the holder has a positive and valuable interest in the asset, as they partly own the underlying asset as well as the income that it produces (Bijur 2007).

Bijur (2007) also asserts that the sukuk bonds come with additional and tedious responsibilities, as the Sukuk holder is also responsible for the maintenance of the asset, while in a conventional bond the investor has no such responsibility, and can only receive interest. Therefore, these additional responsibilities can be classed as a disadvantage of the sukuk.

However, advantages are also high with sukuk, as according to MIFC (2008) they are exempt from incurring any stamp duty.

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Section 3. Cases of Non-Muslim Sukuk Issuers and Investors

It was originally the domain of sovereign issues, but more recently corporates in the domestic markets have begun to tap into the Sukuk market. Emirates Airlines, for example, launched a $500 million Sukuk issue. The Sukuk market is now no longer confined to predominantly Islamic countries, nor is it the sole domain of Islamic finance institutions. Increasingly, Sukuk linked to assets based in the UK, continental Europe and the United States are being structured, since Islamic investors want to include securities with such profiles in their portfolios. Furthermore, non-Islamic issuers are currently seeking to capitalize on the increased liquidity in the Islamic world. For example, the German Federal State of Saxony-Anhalt issued a $100 million Sukuk in 2004, for which the regional minister said the rationale for issuance was twofold: “… On the one hand [for] economic reasons. There are investors out there and it makes sense to provide them with a product. On the other hand, it is a matter of international courtesy. We want to send out a message of respect for other cultures that have different regulations on investing.”

Sukuk investor demographics are becoming increasingly diverse with non-Islamic investors increasingly participating in the market. Middle Eastern credit risk, for example, has increasingly become appealing for offshore investors. In a recent Sukuk, conventional investors purchased 48% of the issue (24% institutional investors, 13% central banks and government institutions, and 11% fund managers).

3.1. The Products and Structures

Islamic banks around the world have devised many financial products based on the risk- and profit-sharing principles of Islamic banking. For day-to-day banking activities, a number of financial instruments have been developed that satisfy the Islamic doctrine and provide acceptable financial returns for investors. Broadly speaking, the areas in which Islamic banks are most active are in trade and commodity finance, property and leasing. Almost every Islamic bank has a committee of religious advisers whose opinion is sought on the acceptability of new instruments and services and who have to provide a religious opinion of the bank's activities for year-end accounts.


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Section 4. Britain and Islamic finance

4.1. Community Banking

Muslims in Britain and throughout the world aspire to carry out their financial matters in accordance with the principles of Islamic law. Muslims are forbidden from obtaining the various conventional banking and insurance products and services in the forms currently offered due to their incompatibility with the principles of Islamic law.

It is estimated by various surveys that over two million Muslims are permanent residents in the UK. The community is predominantly composed of people from the Indian sub-continent who settled in Britain during the 1950s. Beside them, there are also Muslims of Middle Eastern and North African origin. Additionally there is a growing population of indigenous Muslims.

The UK Muslim community has now reached the “second-generation” stage; with the first wave of immigrants having settled down, the second-generation Muslims are now slowly penetrating the different strata of British society. It is not uncommon to find successful Muslim lawyers, chartered accountants, bankers, businessmen and even Members of Parliament, both at the House of Lords and the House of Commons.

Third generations of Muslims are also emerging from the educational system and are projected to increase the Muslim presence in all strata of British society, especially the educated middle class.

The vast majority of Muslims are either living in rented houses or have taken conventional interest-based mortgages. The total number of Muslim households as estimated by the Muslim Council of Britain is around five hundred thousand. Of these, it is estimated by various market researchers that approximately forty thousand families seek financing for home purchases each year.

We have regularly received enquiries regarding the availability of Islamic finance products, in particular Islamically-compatible finance to purchase both residential and commercial properties. It is believed that a large number of Muslims have abstained from taking conventional mortgages because of their incompatibility with Islamic principles. The needs of these Muslims need to be served immediately.

Besides the market represented by Muslims living in Britain, there is potential for the introduction of overseas investors by HSBC. We understand that a considerable number of Muslims living abroad (mainly in the Middle East) have expressed their desire to own properties in Britain (mainly as a holiday residence) but have been reluctant to embark into an

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interest bearing financing facility. For these investors, an Islamic home financing scheme will offer the opportunity to own a property in Britain.

Section 5. Islamic Home Financing

Structure The potential customer, having identified the property, will approach the bank to finance the purchase of the property. The transaction structure will be as follows:

The customer chooses the property for purchase and agrees the purchase price with the owner of the property (“seller”). The bank buys the property from the seller at the agreed price. The customer will be requested to provide a deposit against the purchase price, but the bank will remain the sole registered owner.

The customer signs a lease agreement with the bank. The lease will be for a period of up to twenty-five years with the lease rentals to be reviewed annually to reflect the capital repayment. The terms of the lease agreement will stipulate that in the event of a default the bank will have the right to repossess and sell the property.

The customer/lessee will give an undertaking that in the event of a default under the lease agreement, the bank/lessor will have the right to compel the customer to purchase the property for the purchase price (which shall equal the amount of principal outstanding).

There will also be an undertaking whereby the bank/lessor promises to sell the property to the customer/lessee at the end of the agreed lease period (i.e. when the whole of the principal portion has been repaid). There will also be a provision for certain other specified instances including when the customer desires to sell the property.

The above structure would allow British Muslims to get access to home financing without forcing them to choose between their religion and home ownership. It allows British Muslims to purchase homes without violating Islamic prescriptions on borrowing money on which interest is charged. Further, this initiative is consistent with the well-established public policy of encouraging home ownership and making Muslim stakeholders in Britain.

Islamic Home Financing: Current Impediments 1. Risk Weighting A key element, which impacts the pricing, is the FSA's approach to risk weighting for this product. The FSA has provisionally ruled that the product is to be 100% risk weighted. This is essentially because the


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transaction is equivalent to a lease and leases are weighted 100%. This assumes that the house remains the property of the bank throughout the term of the transaction and is treated as a fixed asset on its balance sheet. If we are obliged to weigh at 100% then pricing will be significantly higher than the conventional mortgage rate. Good Muslims should not be penalised for being good Muslims. The Muslims in the United States have approached the Comptroller of the Currency Administration of National Banks (“OCC”) to seek the approval for Islamic home finance based on the above leasing structure. The OCC had in 1997 approved the Islamic home financing based on the above leasing structure and ruled, inter alia, that the banks' risks under the Islamic leasing structure are similar to the risks on traditional mortgage loans (see the OCC's Interpretive Letter #806). We hope that a similar approval will be granted in Britain. 2. Taxation The transfer of ownership from vendor to bank at the commencement of the lease, and from bank to customer at the end of the lease, may attract the payment of two sets of stamp duty. The second set would arise at the end of the term of the lease at the rate of stamp duty then applicable. The second set of stamp duty needs to be exempted because the true effect of the transfer is similar to the redemption of a conventional mortgage or charge—when the property finally vests with the customer without any encumbrance. If the second set of stamp duty is not exempted, its' uncertain cost would make Islamic home financing unattractive and cost prohibitive. 3. Legal Fees Unlike the conventional mortgage, the proposed product would require the appointment of two sets of solicitors, thereby making the product more expensive. It is suggested that the law society should consider a general exemption as for the mortgage product.

5.1. Current Islamic Finance Efforts in the UK

In the past three years, several major banks have entered the Islamic finance effort in the UK, offering a variety of Sharia-compliant products including current accounts, cash generating arrangements, mortgages, pension funds, savings and stock broking.

The Islamic Bank of Britain, the first of its kind in the UK, opened in 2004, offering current and savings accounts and cash-generating arrangements which take the place of borrowing. The bank uses what

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would otherwise be interest on customers’ savings balances to buy commodities, mostly metals, and sell them on at a profit, a share of which goes to the client monthly. Instead of guaranteed savings income, it offers a target amount. There are rules on the way profits are split and redistributed, including a cap on how much the bank can take. Cash-generating arrangements work with the bank buying commodities and selling them to customers at a mark-up. The customer sells them on to a broker, who releases the cash by selling the commodities on to the market. The customer repays the bank over a set term.

Islamic mortgages, offered by the likes of HSBC Amanah Finance, the Islamic Bank of Britain and the independent financial adviser Destini, obey Sharia law because the bank buys the home for the customer. He or she pays the price of the house in monthly instalments plus a rent-type payment, eventually buying out the bank, with ownership then passing to the customer.

Lloyds TSB has launched an Islamic current account, which does not pay interest or provide overdrafts. The bank heralded it by announcing that Islamic banking was coming into the mainstream.

In April 2005, HSBC’s Amanah arm became the first UK bank to offer trustees a pension fund aimed at Muslims. It does not hold shares in firms mainly involved in areas that create religious problems, including alcohol, gambling, pornography, pork products, tobacco, or conventional financial services. It tracks an index that includes the top one hundred companies engaged in Sharia compliant activities. Dividends generated by unacceptable business, for example, part of an advertising agency's profits from an alcohol account, are given to charity.

The Fyshe Group offers a tailored stock broking service which advises Muslims on whether an investment complies with Sharia law, as well as providing stock broking services, while HSBC Amanah offers portfolio management.

Major UK high street banks have also invested in research and development of Sharia-compliant products, including HSBC, Lloyds TSB and NatWest, as well as smaller providers and foreign players.

The UK Securities and Investment Institute and Lebanon's Ecole Supérieure des Affaires have launched the Islamic Finance Qualification, which will initially be offered in the UK and Lebanon. It is designed specifically for providers of financial advice in the Islamic community. It is thought that it may become part of the FSA's requirements for advisers in the UK working with Islamic clients.


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Financial Product

Fyshe Group

HSBC Amanah Finance

Islamic Bank of Britain

Lloyds TSB

Destini

Current accounts X X X

Cash generating arrangements

X

Mortgages X X X

Pension funds X

Savings X

Stock broking X X Summary of current Islamic finance products offered in the UK HSBC Islamic Mortgages In July 2003, HSBC launched their new Amanah Home Finance product with the backing of the Muslim Council of Britain and the blessing of several world-renowned Islamic scholars. At that time, there were thousands of mortgage products on the market, but prior to that, no high street bank offered one that was acceptable to Britain's Muslims. Launched on July 14, 2003 in just four locations, the product attracted more than six thousand enquiries in its first two months and is now offered across Britain in around twenty-five centres.

The HSBC solution to the Sharia prohibition on interest works as follows:

HSBC buys the property and leases it back to the customer over an agreed term, typically twenty-five years.

The customer makes monthly payments of rent and payments towards the purchase price. HSBC owns the property until the customer has made their final payment.

The customer can arrange for the property to be sold at any time and the rent rate will be reviewed on July 1 and January 1 every year.

In Islamic terms, the rent paid to the bank on top of the monthly payments towards the purchase price is not classified as interest; it is seen as a fair payment for use of the property rather than a charge for borrowing money.

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Lease Back Under the HSBC scheme, the bank buys the property and leases it back to the customer over an agreed term.

The customer makes monthly payments made up of rent and contributions towards the purchase price.

HSBC owns the property until customers have made their final payment.

Crucially, at no stage is the customer paying interest⎯the paying of 'rent' is seen as a fair payment for use of the property rather than a charge for borrowing money.

In addition, HSBC is launching an Islamic law-compliant current account, which has no overdraft or credit card facility.

Money paid into the current account will be administered in accordance with Islamic law and not used for generating interest.

The current account and mortgage products are to be introduced in selected HSBC branches.

Huge Market Previously, only relatively small institutions such as the National Bank of Kuwait and the West Bromwich Building Society have offered tailored Islamic financial products for UK customers.

Last year a report from market analyst Data monitor estimated that demand for Islamic mortgages in the UK was so strong that gross advances could reach £4.5bn ($7bn) in 2006.

Halalmortgage.com is an online firm mortgage provider whose primary service is to assist you in finding and selecting available Halal mortgage options that meet Muslims’ personal needs in line with their beliefs. Halalmortgage.com provides the necessary information on the available Halal mortgage products and assists with the application process.

Being the first website in the United Kingdom solely dedicated to Halal mortgages, it provides convenient online services and e-finance solutions. The site is easy to use, enabling advantageous knowledge in a quick and convenient manner twenty-four hours a day, seven days a week. These state-of-the-art technology solutions ensure easy accessibility of up-to-date information.

The company’s full-service specialised agents can be contacted through online enquiry, email or by telephone. They are experienced in the Islamic finance industry and are kept up to date on the latest terms available for Halal mortgages and are just a phone call or a keystroke away.


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Unlike most online financial services, HalalMortgage.com is a technology-focused company with a human face. This encourages the customer to phone for a free one-to-one consultation with a professional. Agents are available to give impartial information and a person can be assured that they will be under no pressure or obligation by using this free service.

Therefore, this change towards Islamic finance shows that there are already strong Islamic finance initiatives underway both in Islamic countries and the UK, and this should be considered when trying to ascertain whether sukuk Islamic bonds would be a suitable alternative to conventional bonds, both in a Muslim country setting and a non-Muslim country such as the UK.

Governance Structures These structures are a framework of corporate governance for Islamic banks. Central to such a framework is the Sharia Supervisory Board (SSB) and the internal controls which support it. The SSB is vital for two reasons. First, those who deal with an Islamic bank require assurance that it is conforming to Islamic law. Should the SSB report that the management of the bank has violated the Sharia, it would quickly lose the confidence of the majority of its investors and clients. Second, some Islamic scholars argue that strict adherence to Islamic religious principles will act as a counter to the incentive problems outlined above. The argument is that the Islamic moral code will prevent Muslims from behaving in ways which are ethically unsound, thus minimising the transaction costs arising from incentive issues. In effect, Islamic religious ideology acts as its own incentive mechanism to reduce the inefficiency that arises from asymmetric information and moral hazard.

Such matters are obviously important for the successful operation of Islamic modes of finance, and are assessed in the next section when I examine the principles of Islamic banking.

According to Directgov (2008), corporate bonds are sold by companies as a way of raising money for their firm. They have a nominal value (usually £100), which is the amount that will be returned to the investor on fixed future date (the redemption date) (Directgov 2008). Similarly, they also pay out an interest rate annually and the rate is usually fixed. Corporate bonds are bought and sold on the stock market and their price can go up or down (Directgov 2008).

Gilts are bonds issued by the government, which pay a fixed rate of interest to the bond holder two times a year. They are considered safe, low

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risk investments, as the government is unlikely to go bust or try to avoid the interest payments (Directgov 2008).

However, you are not guaranteed to get all your capital back as gilts, like corporate bonds, are also bought and sold on the stock market where their price can go up or down (Directgov 2008).

A reason why a bond may be used if a business wants to expand is that one of its options is to borrow money from individual investors. The company issues bonds at various interest rates and sells them to the public. Investors purchase them with the understanding that the company will pay back their original principal plus any interest that is due by a set date (this is called the “maturity”).

The interest a bondholder earns depends on the strength of the corporation. For example, a blue chip is more stable and has a lower risk of defaulting on its debt. When companies such as Exxon Mobile, General Electric etc. issue bonds, they may only pay 7% interest, while a much less stable start-up pays 10%. Usually, when investing in bonds it is well known that “the higher the interest rate, the riskier the bond.”

Conventional bonds can be issued from governments, municipalities, corporations and a variety of institutions.

Obviously, as they are based on interest this is one of the main reasons why they are rejected by many Muslim customers, as interest or usury is prohibited in Islam.


This section seeks to identify similarities, dissimilarities and important economic and financial issues in both principle and actual practice. In this regard, the study will utilise the following methods:

Secondary data was the first step in obtaining data for the research. This secondary data came in the form of the literature review and the use of pre-existing case studies which cover of the most common forms of bonds issuance and Sukuk, with at least one case study in each type of Sukuk and bonds. The comparison will refer to the underlying financing mode of Sukuk, the mode of issuance (discussing the possible issuer of each type), structure, documentation, return, tradability, listing, collaterals, redemption, risks and risk mitigation thereof.

The first phase of this research relies mainly on secondary data collected from existing published literature on the subject, and largely found in published scholarly journals concerned with Islamic finance and the sukuk field, and reliable internet sources. Gharry & Gronghaug (2002) have defined secondary data as that which has been collated by other


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parties for specific reasons, which may not necessarily be for the same reasons as another researcher. This secondary data will provide valuable and important initial information and a summary on the subject area of sukuk, and serve to highlight which areas from within the literature have been highlighted by authors and analysts as being a cause for concern, and will allow me to specifically direct my research at areas that have been highlighted as needing attention or improvement. Logically, it makes sense to begin with secondary data as Churchill (1999) recommends embarking on research by using secondary data, and only when the secondary data begins to become scarce or irrelevant does he recommend moving onto primary data sources. The advantage of this is that this will reduce the amount of time spent on the research, and will also help to ensure that the research topic and methodology is relevant (Ghauri & Gronhaug 2002). However, secondary data is not without its problems, as it is not written specifically with the researcher’s topic in mind, and the researcher may therefore find it difficult to make the secondary data both relevant and applicable to their own research aims, so caution needs to be exercised when utilising secondary sources. Furthermore, only reliable internet sources (such as official websites) were used in order to preserve the integrity and validity of this research.

Section 7. Results

7.1. Case Study of Sukuk Issuance in Malaysia

Malaysia operates a dual banking system promoted by the government. This allows conventional financial institutions, investment banks, commercial banks and finance companies to launch separate Islamic banking divisions, competing alongside two Islamic banks—Bank Islam Malaysia and Bank Muamalat Malaysia. Bank Negara Malaysia (the central bank) has its own Sharia Advisory Board, which sets the rules for the entire Islamic banking sector, ensuring the uniformity of products and services.

Malaysia’s impressive record in issuing sukuk is well known, as it has taken pioneering steps since its inception in 1990. This got the ball rolling for more sukuk issuances, especially in the last few years where Malaysia achieved several awards and recognition for being the first to do certain things in the sukuk field. As of 2007, the Malaysian sukuk market is the biggest such market in world, dealing in more than 68.9% or US $62 billion of the global outstanding sukuk. Similarly, a Malaysian firm was the first to issue the largest sukuk amount in the world, which was to the sum of approximately US $4.7 billion, and demand for this was so high

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that they were oversubscribed twofold (MIFC 2008). The development of the sukuk market in Malaysia is supported by a sophisticated and all-inclusive infrastructure including the reporting, trading and settlement system for all sukuk transactions, and this has led to an active primary sukuk market with an average growth of 22% from 2001–2007 (MIFC 2008).

Looking at the dynamic development of Malaysia’s sukuk market and infrastructure, it is evident that the country offers one of the most viable options for participation in this fast growing asset class. Coupled with Malaysia’s more than thirty years of experience in Islamic finance and its overall comprehensive domestic sector, Malaysia offers several value propositions for local and foreign sukuk issuers and investors.

Taken from MIFC (2008b), Table 4.1 below details the major sukuk issuances which Malaysia has overseen:

Issuer Amount Year Transaction Highlights

Shell MDS RM 125 million (USD 33 million)

1990 World’s first ringgit sukuk issuance by foreign-owned, non-Islamic company

Kumpulan Guthrie Bhd

USD 150 million

2001 World’s first global corporate sukuk

Government of Malaysia

USD 600 million

2002 World’s first global sovereign sukuk

International Finance Corporation (World Bank)

RM 500 million (USD 132 million)

2004 First ringgit sukuk issuance by supranational agency

Cagamas MBS Bhd RM 2.05 billion (USD 540 million)

2005 World’s first Islamic residential mortgage-backed securities

PLUS RM 9.17 billion (USD 2.86 billion)

2006 Complex and innovative structure conversion of existing debts of PLUS info Islamic financing

Khazanah Nasional (Rafflesia Capital Limited)

USD 750 million

2006 World’s first exchangeable sukuk


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AEON Credit Services

RM 400 million (USD 125 billion)

2007 First Japanese-owned company issuing sukuk

Nucleus Avenue (Malakoff corporation)

RM 8 billion (USD 2.5 billion)

2007 First hybrid sukuk in the world

Khazanah Nasional (Cherating Capital)

USD 850 million

2007 Largest equity-linked sukuk issuance and record highest over-subscription

Maybank Berhad USD 300 million

2007 World’s first international subordinated sukuk

Binariang GSM RM 15.35 billion (USD 4.8 billion)

2007 Largest-ever sukuk issue in the world

Table 4.1. The Malaysian government’s inaugural sukuk issue in 2002 marks the

beginnings of a market that has grown to somewhere in the region of $8 billion.

Malaysia is able to attract many foreign investors to its sukuk market because of it has many incentives to encourage them to trade, as it provides tax exemption for non-Malaysian residents, and also exempts sukuk holders from stamp duty (MIFC 2008).

Malaysia has not only attracted external customers by incentives, but foreign investors are also extremely impressed by Malaysia’s organized framework (MIFC 2008), which makes the whole process of buying sukuk much clearer and easier. Malaysia can also issue sukuk in their own local currency (the ringgit) and other foreign currencies. Below is an excerpt taken from the MIFC website (2008) regarding the Malaysian framework for sukuk issuance:

Malaysia provides a facilitative framework for sukuk issuance for both local and international issuers. In addition to issuing ringgit sukuk, the current issuance framework allows for issuers to issue a non-ringgit sukuk in Malaysia.

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• Facilitative approval process for issuance of Ringgit denominated sukuk: o Deemed approval granted to sovereigns, quasi-sovereigns,

Multilateral Development Banks (MDBs) and Multilateral Financial Institutions (MFIs) rated “AAA.”

o Fourteen working days for foreign Multi-National Corporations (MNCs) and foreign corporations.

• Facilitative approval process for issuance of non-ringgit denominated sukuk: o Deemed approval granted to sovereigns, quasi-sovereigns,

MDBs and MFIs rated "BBB" on foreign rating scale. o Governing laws of Malaysia, the UK or the United States may

be used for bond documentation. • For both ringgit and non-ringgit denominated sukuk:

o Both resident and non-resident issuers are free to utilise proceeds from the issuance onshore and offshore.

o The issuers are also free to hedge to the full amount of the underlying commitment.

Malaysia's sukuk framework has a proper infrastructure platform which

involves the use of an electronic platform and real-time technology that enables the transferring of funds and securities. This helps investors and issuers alike to have transparency, and also helps to ensure that the sukuk market can remain liquid (MIFC 2008).

8. Discussion

The findings from both the literature review and the case studies examined appear to suggest the validity of sukuk in today’s marketplace. The Malaysian government is known to be a Muslim country and has proven the success of sukuk. It made it a success by using the most up-to-date technology and by having an organized framework and system in place to oversee all sukuk transactions. This has led to Malaysia being the market leader in issuing sukuk, and for this they are reaping immense rewards. With a long history in Islamic banking, it is clear that they have seen a big opportunity and tapped into the demand for Sharia-compliant bonds with a great degree of success.

Furthermore, those who believe that a sukuk bond will only be attractive to Muslims is clearly mistaken, as throughout the course of this research it has been highlighted that the non-Muslim issuers (such as a small state in Germany) are also cashing in on the financial gains to be


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had. By referring to Table 4.1 above, which shows sukuk issuances made by Malaysia, it becomes clear that many of the companies who are also issuing sukuk are non-Muslim, such as Shell. Similarly, the investor base for sukuk is clearly a diverse range of Muslims and non-Muslims, as Malaysia itself has attracted much foreign investment in sukuk by offering incentives such as tax and stamp duty exemption, and therefore clearly shown that sukuk have the potential not only to replace the common bond in Muslim countries, but also that there is definitely a place for them in non-Muslim and European markets as well. London is one of the main wholesale transacting centres outside the Middle East for this market. Yet, it is ironic that little in the way of Islamic financial products are available to Muslims in the UK. This community of between 1.5 and 2 million, and some 350,000 households is a sizeable market which is unlikely to be ignored for long.

However, this research has highlighted that sukuk bonds are not 100% fool-proof and this may be why many still prefer conventional bonds.

However, despite there being a lot of demand for such products, perhaps the countries of banks themselves are not properly prepared to launch sukuk on a massive scale, as according to Sole (2008) there are many limitations to the development of a sukuk market in the Middle East, as there is increasing interest by local investors and companies alike in the creation of a sukuk market as a potential alternative to conventional bonds. However, the use of sukuk may not be straightforward for entities unfamiliar with the legal underpinnings of these instruments. For instance, the issuance of sukuk certificates must be unequivocally linked to one or more underlying assets. These assets, in turn, are typically transferred to a special purpose vehicle (SPV) for a period equal to the maturity of the sukuk. Although there is no explicit legal restriction on the creation of SPVs, Kuwait does not possess an unambiguous framework for the establishment, management and accounting procedures of these vehicles. According to Sole (2008), the lack of a proper set of rules introduces a serious element of uncertainty into sukuk transactions, and thus severely limits the attractiveness of these Islamic instruments, as they are considered to be high risk.

Therefore, putting in place an explicit framework governing sukuk issuances and their management would certainly encourage their use by companies and investors alike. In a similar vein, an additional step that would bolster the sukuk market even further would be the introduction of a framework for the securitization of these instruments, to make them less risky (Sole 2008).

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Therefore, in order to make sukuk more secure and encourage more corporations to obtain them, Sole recommends that the authorities consider:

Developing a clear legal framework for the establishment, management, and accounting of SPVs, underpinning the issuance of sukuk; and

Developing a legal framework for sukuk securitization (pool/funds of sukuk).

If these problems are to be overcome in the Middle East, then it appears that there is no explicit reason why sukuk cannot be used as a replacement for normal interest bearing bonds. Similarly, this research also seems to suggest a positive reception of sukuk in non-Muslim countries such as the UK.

A number of recent developments point to significant changes in the marketplace. Indications have emerged from the UK regulators that they do not have any objections in principle to Sharia-compliant financial products, and major high-street players like HSBC and some building societies are seriously considering entering the market with an array of products. They have teamed up with Muslim institutions to address the regulatory issues which have so far discouraged the launch of Islamic housing finance and other products. A working party, comprising of practitioners and representatives of the Muslim Council of Britain (MCB) and Union of Muslim Organisations (UMO) has been formed with the blessing of the Governor of the Bank of England. This party has prepared a report on the issues of concern and has met several of the officials, regulators, departments and ministries to work out acceptable solutions.

In the meeting of representatives of the working party, the issue of levying of stamp duty was discussed. The way Sharia-compliant housing finance product is structured would mean that stamp duty would be levied twice on a single property purchase. This additional levy would obviously make the product uncompetitive. The government is considering making changes to the stamp duty legislation to recognise this problem and facilitate the levying of a single charge on what is in effect a single purchase. In a similar way, many other issues have been taken up with different departments and officials to enable a like-for-like competitive product to be launched.

In fact, recent changes made to legislation in 2007 have meant that the unfair taxation of sukuk is no longer a problem, as the government in the UK has removed the tax disadvantage to UK sukuk transactions (Bijur 2007), which is another reason why sukuk bonds have the potential to also work in non-Muslim countries.


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Indeed, as one or two major institutions who lead the launch of these products make headway and gain market share, other institutions should follow to protect their market. Thus, if successful, in a short space of time one may see a plethora of Sharia-compliant financial products on the UK high street.

Many people have argued that Muslims have availed of existing products and are unlikely to abandon them for the new Sharia-compliant products. However, anecdotal evidence suggests that many people would switch to Sharia-compliant products if they are properly structured and competitively priced. Certainly, new buyers would seriously explore these facilities. As the range and scope of these products builds, the whole saving and borrowing patterns of UK Muslims is likely to change. In addition, as the volume of financing builds up, the underlying ethical base of Islamic financial products would begin to make its mark on the market. At that point, many non-Muslims would also be attracted to these products. In time, these products may provide a valuable bridge between different communities and interest groups in the UK.

Conclusion

This research positively supports the notion that sukuk can be used as a suitable replacement for conventional bonds, both in a Muslim region such as the Middle East and also in a non-Muslim country such as the UK. However, this is no easy feat, and this research has identified that in order for this to happen there are some recommendations that can help to make sukuk issuances successful and prosperous so they can form a viable replacement to conventional non-compliant interest bearing bonds.

Recommendations

(1) Using the latest and most up-to-date technology to create a framework or system will help sukuk transactions to be easy to buy and sell, create transparency and reduce the risks of any bad business deals tainting the name of the noble sukuk tradition. This has been proven to be highly successful in Malaysia and has consequently led to it being the key sukuk issuer in the world. (2) Countries need to set up a special task force or regulatory body for overall sukuk transactions and dealings, which will be specially assigned to sukuk issuance, and these task forces will liaise with countries/companies who wish to issue sukuk so they can also educate regulatory bodies to help make the whole process more streamlined and ensure that sukuk are not

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unfairly taxed in comparison to conventional bonds, as this will inevitably put sukuk in a weak position and discourage their uptake. Furthermore, having a regulatory body or task force will help to ensure that only reputable providers are issuing sukuk. This will help to reduce the risk of the sukuk holder losing their investment or assets which their sukuk is assigned to. They will ensure that all sukuk sellers meet a criterion and are legitimate, and this will help to protect sukuk holders and give them credence.

In addition, the Islamic finance markets within the United Kingdom and the United States are showing significant growth and promising futures. However, the obstacle of complex regulatory environments presents a difficult challenge to the development of Islamic finance products. Nevertheless, Deutsche Bank, as an innovator and leader in the structuring space, is clearly best positioned to design creative products that overcome regulatory obstacles. As such, the United Kingdom and the United States represent significant business opportunities for Deutsche Bank in the Islamic finance arena.

References

Bijur, D. (2007). “Islamic Finance—From Niche to Mainstream.” http://news.bbc.co.uk/1/hi/business/6483343.stm (accessed November 11, 2008).

Churchill, G.A. (1999). Marketing Research: Methodological Foundations, 7th Edition. Dryden, Fort Worth.

Directgov. (2008). “Corporate Bonds and Government Bonds.” http://www.direct.gov.uk/en/MoneyTaxAndBenefits/ManagingMoney/SavingsAndInvestments/DG_10013986 (accessed November 15, 2008).

Ghauri, P., & Gronhaug, K. (2002). Research Methods in Business Studies: A Practical Guide 2nd Edition, prentice hall, Harrlow, 76–78.

Khan, M. M., Bhatti, M. I. (2008). “Development in Islamic Banking: a New Risk-Allocation Approach.” Journal of Risk Finance 9 (1): 40–51

MIFC. (2008). “Sukuk Overview.” http://www.mifc.com/index.php?ch=cat_int_sukuk&pg=cat_int_sukuk_over date (accessed October 10, 2008).

—. (2008b). “Notable Sukuk Issuances.” http://www.mifc.com/index.php?ch=cat_int_sukuk&pg=cat_int_sukuk_iss# date (accessed November 11, 2008).


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Sole, J. (2008). “Prospects and Challenges for Developing Corporate Sukuk and the Bond Market.” International Journal of Islamic and Middle Eastern Finance and Management 1 (1): 20–30.

Bibliography

Abdul Gafoor, A. L. M. (1995). Interest-Free Commercial Banking. Groninigen, The Netherlands: Apptec Publications.

Ahmed, Z., lqbal, M., and Khan, M. F. (1983). Money and Banking in Islam. Jaddah: International Centre for Research in Islamic Economics, King Abdual Aziz University.

Algaoud, L. M. and Lewis, M. K. (1997). “Bahrain as an International Centre for Islamic Banking, Proceedings of International Conference on Accounting, Commerce & Finance.” , The Islamic Perspective, University of West Sydney, Macarthur.

Arrif, M. (ed.), (1982). “Monetary Policy in an Interest Free Islamic Economy: Nature and Scope.” In Ariff, M. (ed), Monetary and Fiscal Economic of Islam. Jaddah: International Centre for Research in Islamic Economics.

Handbook of Islamic Banking, 1977–86. Published in Arabic by the International Association of Islamic Banks, 6 Vols., Cairo.

“Islamic finance: Turning the Prophet's profits”. Economist 340 (7980): 58 Janahi, A. L. (1995). Islamic Banking, Concept, Practice and Future, 2nd

edition. Manama: Bahrain Islamic Bank. Khalaf, Roula. (1995). “Banking the Islamic way.” World Press Review 42

(1): 35. Khan, M. S. (1986). “Islamic Interest-Free banking: A Theoretical

Analysis,” IMF Staff Papers 33 (1): 1–25. Kuran, T. (1986). “The Economic System in Contemporary Islamic

Thought: Interpretation and Assessment.” International Journal of Middle Eastern Studies 18: 135–154.

—. (1995). “Islamic Economic and the Islamic Sub Economy.” Journal of Economic Perspectives 9 (4): 155–173.

Lewis, M. K. (1996). “Universal banking in Europe: The Old the new.” International Symposium on Universal banking, Korean institute of Finance, Seoul, January.

Mannan, M. A. (1986). Islamic Economics: Theory Practice. Cambridge: Hodder and Stoughton.

Siddiqi, M. N. (1988). Banking Without Interest. Leicester: The Islamic Foundation.

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Ul-Haque, N. U. and Nirakhor, A. (1986). “Optimal Profit-sharing Contracts and Investment in an interest-free Islamic Economy.” IMF Working Paper, No. 12, Washington: international Monetary Fund.

Abdi, Sameer, Survival of the Fittest: The future of Shari’a Complaint Retail Banking in the GCC

Alhi United Bank, http://www.iibu.com/ http://www.redhotcurry.com/money

Islamic Banking, http://www.islamic-banking.com/aom/ibanking/ia_khan.php The Banker, http://www.thebanker.com/news/fullstory.php/aid/1000/

Islamic_Bank_of_Britain_launch_imminent.html International Financial Law Review, Islamic Finance Market Turns to

Securitization. International Herald Tribune, http://www.iht.com/articles/2005/09/08/

news/sp-pri-05.php Islam Online, http://www.islamonline.net/English Khan, Iqbal, 4th Euromoney Islamic Finance Conferece 2005 Dr. Said Al Shaikh: Market Review & Outlook, Volume 15 Issue 6, April

2005, National Commercial Bank —. Market Review & Outlook, Volume 15 Issue 7, May 2005, National

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Commercial Bank Salaam.co.uk, http://www.salaam.co.uk/ Taylor, John. Speech Given at the Forum on Islamic Finance at Harvard

University. May 8, 2004.

CHAPTER FIVE

IRAN’S ISLAMIC BANKING EXPERIENCE AND FUTURE

Introduction The process of Islamization of the banking system in Iran had gone through two phases. In the first (1979–82), the banking system was nationalized and reorganized in order to remove the weakness of the previous system. However, internal and external developments in this phase did not allow the policymakers to build an adequate plan for the Islamization of the banking system. The second phase began in 1982 and lasted until 1986. In this phase, the law of riba-free banking (i.e. no interest) was passed in 1983, which went into effect on March 20, 1984. The new banking law had as its main objectives the following: (i) the proper issue of money and credit for the creation of a just, healthy and progressive economy; (ii) The use of monetary tools to promote the national objectives of the country (including the elimination of poverty and attainment of national self-sufficiency), and; (iii) the preservation of the national currency value and promotion of balance of payments stability.

With the passage of the Islamic banking law the Council of Money and Credit set the “minimum guaranteed profit return” (interest) for savings and time deposits at 7–8%. No interest was to be charged on loans and credits to private borrowers. Instead, a service fee and a contribution to the guaranteed profit were to be received, the rate differing according to the purpose (for example, 4% for housing, farming and manufacturing and 8% for services). Despite drastic changes in economic conditions in the years after the 1979 revolution, there were no major changes in the monetary and credit policy. While private deposits with the banking system increased more than 90% between 1979 and 1982, bank loans to the private sector rose by about 40% due to stagflationary tendencies in the economy. To deal with the problem, in 1982 the Council on Money and Credit raised the legal reserve requirement from 12% to 17% and placed

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ceilings on bank loans to various sectors. Nevertheless, the excess reserves of the commercial banks continued to mount due to government budgetary deficits, the expansion of private deposits, and depressed conditions in the private sector. The fear of rising prices led the monetary authorities to raise the minimum reserve requirement on sight deposits from 17% to 27% in 1983. Private sector liquidity was brought down to an annual growth rate of 17.2% (CBI 1985).

The central feature of the Iranian monetary system in the 1980s was that the Money and Credit Council administered the interest rates. The underlying purposes of such an administered structure of interest rates were the mobilization of savings and the provision of funds for productive activity to the preferred sectors at concessional rates of interest. Monetary policy was also influenced by the need to raise the domestic savings rate. If there is a larger proportion of savings in the form of financial assets, there is a need to offer depositors a positive real rate of interest.1 The monetary authorities of Iran realized that low interest rates might not generate savings, so they geared policy towards encouraging deposits with long maturities.

The Islamic banking law gave the banks additional and more specific regulatory power. First the CBI (Central bank of Iran) had the power to set the minimum rate of return (i.e. interest charged by banks) in regular or limited partnerships in each sector. These rates effectively eliminated marginal and sub-par projects. Second, by determining the profit sharing ratio between the banks and their clients in each sector of the economy, the CBI could influence the amount of credit allocated by banks to various sectors. Third, by regulating and changing the rate of services fees (i.e. interest) charge by banks on forward transactions, installment sales and lease-purchases, the CBI could regulate the allocation of credit financing for these traders. Fourth, the CBI had the power to establish minimum limits for participation by banks in the capitalization of long-term investment projects; it thus had the power to influence the allocation of

1 If deposits rates rise over the course of loan because of financial liberalization then the bank may bring about a loss because it cannot increase the interest rate on the loan. Banks usually reduce this risk associated with maturity mismatching by lending at floating interest rates. Nevertheless, where banks have been subjected to directed credit allocation, they naturally have a large proportion of their loans on a fixed interest rate basis, leaving them vulnerable in the period following deregulation.

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investment funds to different sectors of the economy.2 The problems of the slow growth of the banking sector deposits worsened in the mid-1980s when the conversion of all operations to the new interest-free banking was completed, partly due to the lack of familiarity of lenders and borrowers with the new system. The sectoral loan rates, set administratively by the Council on Money and Credit, were upwardly revised.3.

The priority sectors, like agriculture, had the lowest loan rates and those for domestic commerce had the highest. The deposit rates were also upwardly revised and certificates of deposit with different maturities were introduced. These changes were meant to reduce constraints on the banking system and increase its lending capacity by raising financial savings. This policy was successful in reducing cash holdings relative to

2 For the proper functioning of the monetary and credit system, Iran Central bank is empowered to intervene in, and supervise, the monetary and banking activities through the following instruments: (a) Fixing a minimum and /or maximum ratio of profit for banks in their joint venture and mozarebeh activities; these ratios may vary for different fields of activity. (b) Designation of various fields for investment and partnership within the framework of the approved economic policies, and fixing of a minimum prospective rate of profit for the various investment and partnership projects; the minimum prospective rate of profit may vary with respect to different branches of activity. (c) Fixing a minimum and maximum margin of profit as a proportion to the cost price of goods transacted for banks in installment and hire-purchase transactions. (d) Determination of types and the minimum and maximum amounts of commissions for banking services (provided that they do not exceed the expense of service rendered) and the fees charged for putting to use the deposits received by the bank. (e) Determination of the types, amounts, minimum and maximum bonuses subject of article (6) and the establishment of guidelines for advertisement by the banks in the cases referred to. (f) Determination of the minimum and maximum ratio in joint venture, mozarebeh, investment, hire-purchase, installment transactions, buying or selling on credit, forward deals , mozarebeh, mosaqat, joalah and gharz –al – hasaneh for banks or any thereof with respect to various fields of activity; also, fixing the maximum facility that can be granted to each customer. 3 Under Islamic banking, interest-paying deposits with the banking system are viewed as participation in investment activities. Such deposits are subject to two profits rates. An initial rate, known as the provisional rate, which is announced at the time deposits are placed with the banks; and a final rate which is computed on the basis of the bank operations at the end of the of the year. However, in practice the provisional and actual returns are very close (Pourian 1995).

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deposits, increasing non-sight deposits and term-investments in the banking system. Nevertheless, fiscal and monetary policies were inconsistent with the new deposits and loan rates. With a sharp increase in the rate of inflation in the early to mid-1990s, the real rate on five-year deposits began to decline substantially. The real return on five-year deposits had became again from 1999. However, short-term deposits have not enjoyed a positive real return for years. Perhaps the principal contributing factor to the weakness of Iran’s financial reforms was the government’s inability to produce definitive, rational and cohesive policies in the financial and monetary sectors.

The Islamic Banking Law—Did the Banking System Implement It?

The act of usury-free banking operations was ratified on which basis the executive by-laws and directives were formulated and after a lapse of three decades from having put the act into effect, the phenomenon of interest still possesses the state monetary and banking system. Under the Islamic banking system there are ten separate ways through which banks can make use of resources (such as deposits) in financing personal needs, trade and business requirements, and longer-term investment. Table 5.1 shows various methods of financing envisaged for each line of activity. The fact is that the performance of Islamic banking in Iran has not been much different from the former Western-style banking. There has been an upward trend for installment sale since the early 1980s. Therefore, this share had raised to one third of credits. Conversely, table 5.1 also indicates that other types of contract such as civil partnership, the share of mozarebeh, and qharz al- hassanh4 were 29.4% in 1984 and had reduced to 11.1% in 2006. Article 1 of law of usury however emphasizes the creation of necessary facilities for the extention of co-operation and gharz-al-hassanh among the pepole. The share of civil and legal partnership

4 Mozarebeh ( limited trade partnership) whereby the bank provides initial capital to commercial traders, both individuals and companies, preferably cooperatives , who engage in trade and business (other than imports). Profits from the undertaking are divided under specified terms at the end of the contract.

Gharz-al-hassaneh are interest free loans to individuals for the purpose of meeting the objective of paragraph (b) and (i) of article 43 of the 1980 constitution (e.g. providing tools of trade for workers who lack these means; meeting urgent and unexpected needs of individuals; and facilitating the production of agricultural, livestock, and industrial goods). The expenses of making such loans are borne by borrowers as fees or charges.


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experienced a steady growth. However, for the last decade this share has dropped to almost half of the previous amount, so that the share of civil and legal partnership reached 12.5% in 2006. Table 5.1. Islamic Modes of financing in Iran ( 1984-2006)

Year

Gha

rz-a

l-ha

ssan

eh

Moz

areb

eh

Forw

ard

Tra

nsac

tions

Civ

il Pa

rtne

rshi

p

Joal

eh5

Inst

allm

ent S

ale

Hir

e Pu

rcha

se

Leg

al

Part

ners

hip

Dir

ect

Inve

stm

ent

debt

pur

chas

e

prop

ertie

s un

der

isla

mic

co

ntra

ct

1984 10.8 18.5 3.7 15.0 0.3 34.0 1.8 3.6 0.6 11.7 0.2 1985 10.8 15.9 3.2 13.2 1.4 32.6 0.9 7.3 3.6 10.1 1.2 1986 11.6 15.5 3.9 13.9 1.4 35.7 0.8 6.6 2.7 6.4 1.7 1987 10.6 12.6 3.9 13.9 1.8 42.7 0.8 7.1 1.7 3.1 1.8 1988 9.7 11.0 4.9 11.7 2.8 47.1 0.8 7.1 1.3 1.0 2.6 1989 7.5 10.7 6.7 12.8 5.1 46.8 0.5 5.8 1.3 0.6 2.2 1990 5.7 10.2 5.3 14.5 6.6 49.0 0.4 4.6 1.3 0.3 2.1 1991 4.2 9.7 5.0 17.8 7.0 47.0 0.7 4.8 1.3 0.1 2.4 1992 3.6 8.5 6.7 17.6 6.0 46.5 0.5 5.2 1.9 0.1 3.5 1993 4.6 7.5 6.9 17.4 6.0 45.0 0.7 4.8 2.6 0.1 4.3 1994 4.4 7.3 6.2 18.1 6.6 45.8 0.8 3.6 2.4 0.1 4.7 1995 4.7 6.8 5.5 19.4 7.0 45.0 1.0 2.7 1.7 0.0 6.2 1996 4.5 6.7 5.0 19.6 6.6 43.4 1.1 3.8 2.8 0.0 6.5 1997 4.6 6.4 5.2 11.6 1.6 56.0 0.8 4.7 2.5 0.0 6.4 1998 5.9 6.0 6.2 9.7 1.4 58.0 0.7 3.1 1.8 0.0 7.4 1999 4.6 6.3 6.7 10.3 1.7 28.3 0.6 2.7 1.5 0.0 0.9 2000 4.2 6.2 7.0 9.9 1.6 28.8 0.6 2.2 1.2 0.0 0.8 2001 4.5 5.5 7.5 8.6 1.6 31.4 0.7 1.6 0.9 0.0 0.5 2002 7.2 5.7 6.7 6.4 1.4 33.0 1.1 1.3 0.8 0.0 0.6 2003 5.8 6.2 6.1 6.7 1.6 35.5 1.2 1.6 0.9 0.1 0.6 2004 4.7 6.2 5.8 7.0 2.1 36.9 1.5 2.4 1.0 0.1 0.5 2005 4.4 6.9 5.2 7.5 1.7 33.6 2.4 2.5 1.0 0.1 0.4 2006 3.4 7.7 4.8 10.7 1.8 30.7 2.0 1.8 1.0 0.2 0.7 Source: Central Bank of Iran, Annual and Economic Reports, Various Years

5 Joaleh (service contract), or an undertaking by the bank or the customer to pay a specific sum or service fee in return for a service as specified in a contract. Thus, the bank providing customary banking services (money transfers, cashing commercial paper, or handling other transactions) is entitled to a service fee.

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On the basis of Usury –free banking Act in Iran, the fiscal resources concerned with giving loans by way of mozarebeh contract necessarily must be provided by term investment deposits and these are entrusted to banks by people for utilization and banks are authorized to insure the principal deposits and disburse the profit (which has not been specified in advance), accruing from permissible banking operations to the depositors after deducting the costs and advocate fees. According to this approach, the profit and principal deposit must not be guaranteed because the profit takes an interest nature.

In effect, the purpose of the partnership contract with its Islamic tenor is to benefit from investor’s cash capital, and the mozarebeh agent’s expertise and management in commercial affairs without the principal and profit thereof is ensured by the agent in the mozarebeh contract. Indeed, in this kind of agreement, the party of the mozarebeh agent incorporates their work with the capital owner’s cash capital, and if any profit accrues the two parties have it divided between themselves as per the agreement, but if the trade incurs loss the capital owner is not entitled to demand profit or compensation from the opposite party. In this event, in this sort of dealings and agreement interest is not received or disbursed. However, based on the by-laws and directives concerned with executing the mozarebeh contract, the contract between banks and loanees is drawn up in such a way that a phenomenon emerges without direct reference made to its name. In order to comprehend the argument behind this contention it suffices to pay attention to the tenor of two articles associated with the mozarebeh contract between persons and bank—the agent transfers to the bank the sum of expenses that they pay out of their own properties and resources in return for IRR6 1,000, and while concluding the transfer contract (solh contract), the object of this article, they accept all terms and obligations inserted in any of the prior and prospective articles of this agreements.

According to article 15, while concluding the transfer contract, the object of Article 8, the agent necessarily accepts and undertakes to make up for any loss or decline inflicted on bank principal out of their own properties if any arises. Thus, apparently as the party in the mozarebeh contract has transferred to the bank all the amounts that one should pay on account of principal and profit expected by bank (even under the circumstances that the agent incurs loss in their trade), disbursement of the amounts is not tantamount to interest and usury because it has belonged to the bank itself. All contracts through which the bank resources confer a

6 The rial is the monetary unit of Iran


165

Fig 5.1. Distribution facilities to different economic activities in the non-public sector (1984–2006).

loan to natural or legal persons out of the credit of investment deposits partake of the same attribute are based on interest through which the rubric of interest has changed into bank profit. With regard to interest-free saving deposits (gharz-al-hassaneh), by declaring various and precious prizes which are given to the winners via drawing lots, the bank paves the way

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for attracting financial resources to these accounts, which is in turn a certain sort of deviation from the usury-free banking principle.

As a part of the implementation of the new banking law, the council on money and credit established the “minimum expected profit” in various economic sectors for lending or direct investment by the banks. Rates of charges on bank loans were determined by central bank according to type of project and sectoral priorities. Thus, the rates in the agriculture sector were set at 4–8% and services at 10–12% (CBI 1991). Beginning in 1990, these rates were raised to a minimum of 6–9% for agriculture and a maximum of 17–19% for trade and services. As of early 1991, the rates for the latter two sectors were allowed by market. In 1993, these rates again raised to 12–16% percent for agriculture and 18–24% for trade and services (CBI 1994). The rates of 9–16% for other sectors also represented the minimum payable and were calculated retroactively after the end of year according to market condition.

As Fig. 5.1 above shows, there has been a highly uneven expansion of credits to the service sector. The share of service sector as a percentage of total credits paid to the economic sector experienced an upward trend from the late 1980s. Since 2000, this registered an increasing trend which continued for the whole period. The aim of Islamic banking was to change the pattern of consumption and production in the economy through reduction of credits to the service sector and increased credit availability to the agriculture sector. However, as Fig. 5.1 indicates, the share of agriculture as a percentage of total credits was the lowest. The share of agriculture rose from 14.2% in 1984 to 20.4% in 1989, but since then it had registered a declining trend for a decade. It was only between 1996–2000 that the agriculture share experienced signs of improvement.

Under Islamic banking, the lender and borrower share the profits of enterprise (and associated risk) according to some previously agreed upon share. Thus, the actual size of the profit to the lender is determined only after completion of the projects. An increase in risk sharing, as entailed by Islamic banking, encouraged borrowers to adopt more risky projects. Naturally, this made the loan portfolios of banks more risky. Hence, banks were persuaded to ration credit more strictly and to divert a large proportion of their assets away from long term investment loans to commercial and short-term ones.


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Conclusion

Under Islamic banking, the lender and borrower share the profits of enterprise (and associated risk) according to some previously agreed upon share. Thus, the actual size of the profit to the lender is determined only after completion of the projects. An increase in risk sharing, as entailed by Islamic banking, encourages borrowers to adopt more risky projects. Naturally, this has made the loan portfolios of banks more risky. Hence, banks were persuaded to ration credit more strictly and to divert a large proportion of their assets away from long-term investment loans to commercial and short-term ones.

Generally speaking, the record of Iran’s banking system is unimpressive. Far from achieving the three-fold objectives of the 1983 Banking Act, namely stimulating economic growth, promotion of social justice, and protecting the national currency, the sector has been plagued by slow growth, a large portfolio of non-performing assets and a narrow range of products and services.7 As was mentioned, after the 1979 revolution stress was laid on the Islamization of the system, and policy makers of the economic system somehow had to eliminate the rubric of interest from the banking operations. However, most of the people in charge of economic affairs, influenced by the Neo-classical approach, regarded interest as an objective of non-allowable phenomenon instead of probing into the real causes of interest and working out appropriate devices to eliminate it. For instance, in a mozarebeh contract, the bank and an agent agree to engage in some commercial activity and earn a profit, which will be shared between the bank and the agent (customer). However, the bank has received interest from the agent of the mozarebeh contract and both parties treat the amount excess to the principal as a certain sort of interest. The advocates of Islamic banking had exaggerated expectations of the benefits from proposed law. Even if there was agreement among policy makers about the elements of a program of policies, the transmission mechanism through which the adoption of policies leads to outcomes was complicated. There were steps in that process of Islamization which was subject to uncertainty and delay with the probability of adverse results. The adverse implications of poorly conceived policies exacerbated economic distortions.

7 For instance, in 1987, 62.4% of all lending by the banking system to the private sector was for short-term ventures (Mazarei 1995, 300).

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References Al-Rifaee.S.S, www.arabinsight.org/articles/190 Baizaee, S. E. (2006). Money, Foreign Exchange and Banking. nor-e elem

press, Tehran Central Bank of Iran. Annual Report. Various Years. Central Bank of Iran. (2008) The Law for Usury (Interest) free Banking Mirakhor, A. & Khan, S. M. (1990). “Islamic Banking: Experiences in the

Islamic Republic of Iran and Pakistan.” Economic Development and Cultural Change 38: 353–375.

Mazarei, A. (1997). “The Iranian Economy under the Islamic Republic: Institutional Change and Macro Economic Performance (1979–1990).” Cambridge Journal of Economics 20 (289): 289–313.

Pourian, H. (1995). “The Experience of Iran’s Islamic Financial System and Its prospects for Development.” In Development of Financial Markets in the Arab Countries, Iran and Turkey. Economic Research Forum for Arab Countries, Iran & Turkey, Cairo.

Zangeneh, Hamid. www.financeinislam.com/article/1_35/8/287

CHAPTER SIX

ISLAMIC BANKING STRUCTURE AND GROWTH IN THE SUDANESE ISLAMIC BANKING SECTOR

Section 1. Introduction The Islamic banking industry of Sudan is the backbone of Sudanese economy. It emerged in 1977 with the establishment of the Faisal Islamic Bank. In 1981, both the Islamic Bank of West Sudan and the Tadamon Islamic Bank set up their first branch in Khartoum, the Sudanese capital, followed by the creation of the Islamic Co-operative Development Bank in 1982. In 1984, after the application of Islamic Sharia as official law, the Sudanese government made it compulsory for all the banks in Sudan to conform to Islamic Sharia principles. Since then, the entire banking system has converted to Islamic Sharia principles and many banks have started to offer products and services that comply with Islamic Sharia law.

In the 1940s and 1950s, many unsuccessful attempts were made to create an Islamic banking system as an alternative to conventional banking. However, the first Islamic bank was announced by Egypt in 1963, followed by the formation of the Dubai Islamic Bank (DIB) and the Islamic Development Bank (IDB) in 1975. After this initial period, Islamic banks were announced by many Muslim countries including Pakistan, Saudi Arabia and Iran. Shortly after Malaysia’s independence in 1963, the Malaysian government issued Tabung Hajji as the first Islamic product designated to help Muslims perform pilgrimage (hajj) in Mecca and Medina. Up to the late 1970s there was only a limited range of Islamic products, but now with the estimated population of 1.6 billion Muslims, the interest-free Islamic banking industry is expanding rapidly with annual growth rates of 15% to 25% and around 250 to 300 establishments operating from East to West. In the early 1990s, Islamic banks started offering their services (which are driven by the principle of profit-and-loss sharing) to Western countries including the UK, USA and Germany with a large selection of products for both Muslim and non-Muslim investors.

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This chapter seeks to analyze the financial performance of three main Sudanese Islamic banks (The Faisal Islamic Bank of Sudan, Tadamon Islamic Bank, and the Al Baraka Bank) for the period 2005 to 2008, and highlight the banks’ financial position using financial statement analysis (FSA). To this end, numerous financial ratios were calculated and categorized into five key groups examining profitability, earnings, liquidity, credit risk, and assets activity. Thirteen different financial ratios including gross profit margin, networking capital to sales, return on equity, and fixed assets turnover, were used under the five main groups reached.

The factors that affect the decision of customers when they are choosing whom to bank with starts with the bank’s performance in terms of low service charges, followed by the bank’s reputation and recommendations made by friends and family. Choosing their bank according to their faith is normally the least-effecting factor of all. Hence, Islamic banks must not rely solely on the fact that they are Islamic banks in order to market their products, but must also take certain measures to improve their efficiency and performance in order to survive in a highly competitive environment.

A large number of researchers in Islamic banking performance areas such as Sabi (1996), Abdus Samad & M. Kabir Hassan (1997) Akkas (1996), Arif (1989), Samad, (2004) and Libby (1975) have used financial ratios to determine the changes occurring in the financial positions of these institutions, mainly because it is simple to understand and can be used for different sized banks or to match a bank to an industry average to assist investment decisions. Rosly & Abu Bakar (2003) measured the performance of the Malaysian Islamic banking scheme (IBS) with Malaysia’s mainstream banks during the period 1996 to 1999. They compared the performance of the banks’ profitability using financial ratios such as return on asset (ROA), return on deposit (ROD), asset utilization (AU) and operating efficiency ratio (OER).

According to Elliott & Elliott (2006), the use of financial ratios while measuring performance has many advantages when investigating low performance areas and the changes which occurred during a specific period of time. Siddiqu (2008) used the financial ratios analysis to investigate the performance of two Pakistani banks, namely Al-Baraka Bank and Meezan Bank, for the years 2003–2004. It was discovered that due to their unique nature, Islamic banks are generally more liquid than their conventional rivals. Two effective financial ratios to determine the liquidity position were identified as current ratio and quick ratio, relating to the size of both assets and liabilities.

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Belkaoui (1998) argued that due to the characteristic of the financial ratio in explaining links among the different financial statement entries, the analysis of financial statement accounts is much more complex than the analysis of financial ratios. This useful analysis involves comparing calculated ratios with the industry averages, or with previous similar ratio analysis. The classification of financial ratios can be categorized into five key groups: (i) the business’s capability to pay its immediate commitments; (ii) the business’s capability to meet its long-term commitments; (iii) the business’s mixes of funds; (iv) the business capital profitability and effectiveness, and; (v) the effective usage of its assets.

In this chapter we measured the financial performance of selected Sudanese Islamic banks (Faisal Islamic Bank of Sudan, Tadamon Islamic Bank and Al Baraka Bank), and stressed their growth using the financial statement analysis (FSA). The procedure involved calculating numerous financial ratios and categorizing them into five key groups to identify profitability, earnings potential, liquidity, credit risk and assets activity. The number of the financial ratio used under the five main groups reached thirteen further ratios, which helped in calculating gross profit margin, networking capital to sales, return on equity, and fixed assets turnover.

Using the ratios calculated, we made a significant contribution to the literature. First, we found that the Sudanese Islamic Banks are cost-effective in terms of generating reasonable profits. Secondly, the liquidity performances of all three selected banks were also found to be satisfactory with an average current ratio figure of 1.0 to 2.0. Moreover, the assets activity performance of three Sudanese Islamic Banks measured by net assets turnover suggested that all three banks are efficiently utilizing their net assets to generate profits. Finally, the credit risk performance analysis implies that Sudanese Islamic banks are taking excessive risks.

The rest of the chapter is organised as follows. In Section 2, we present a brief review of the Sudanese banking industry. Sections 3 describe the methodology, research approach and the use of the financial statement analysis (FSA). Section 4 presents the empirical results & findings and Section 5 concludes.

Section 2. Sudanese Banking Industry

Said et al. (2003) suggested that prior to the application of Islamic Sharia and the discovery of Sudanese oil, the Sudanese banking industry suffered a severe shortage of large profitable projects. Brutal civil war in many parts of Sudan led to a food crisis and economic deterioration. Although Sudan is the largest agricultural country in Africa, the immigration of

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farmers from rural to urban areas resulted in low production and loss of job opportunities. Other factors such as political and economic instability also reduced local and foreign trade. All of these reductions had a direct effect on the Sudanese Islamic banking sector.

Recently, after the oil discovery in the last decade, large infrastructure projects were undertaken by the government, including building bridges, roads and airports in order to link the production areas with local and foreign markets and to improve the efficiency of the internal trade between various states. All these efforts by the Sudanese government resulted in large foreign investments and a considerable flow of liquid funds in the banking sector, creating more job opportunities. Although the entire banking industry in Sudan is Islamic, competition is fierce. According to the Central Bank of Sudan (CBOS), there are over thirty Islamic banks currently operating. All these banks are functioning within the rules and regulations of CBOS, which conform to the principles of Islamic Sharia.

In an effort to improve Islamic banking performance and efficiency recognised in CBOS policies (Annual Report 2007), the central bank of Sudan motivated banks to retain 8% cash in balance from the total deposits (local and foreign currency) and 3% of central bank Ijara as a legal reserve requirement. The current level of liquidity held by the banks is considered to be about 10%. This also resulted in an increase of banks’ internal liquidity, which rose from 13.2% in 2006 to 18.5% in 2007, and also in 2006, BASEL II guidance for minimum capital adequacy was put into practice.

Section 3. Research Methodology

The annual reports of the Sudanese Islamic banks (the Faisal Islamic Bank of Sudan, the Tadamon Islamic Bank, and the Al Baraka Bank) are the main source of the secondary data for this research. Unfortunately, the annual reports for Sudanese banks are not available for a period of more than one or two years at a time. The financial performances of the Faisal Islamic Bank of Sudan for the years 2005−2008 are compared with the financial performances of Al Baraka Bank and Tadamon Islamic Bank for the years 2005–2007 and 2006–2008 respectively.

For the purpose of this research, we have used five major types of ratios to measure profitability, earnings potential, liquidity, credit risk and assets activity.


3.1. Profitability Performance Ratios

The assessment of bank’s earnings related to particular sale volume, assets size or stake-holder’s speculation can be achieved through using profitability ratios. There are several profitability measures, but we have considered four major ratios below: 3.1.1 Gross Profit Margin Ratio (GPM) Gross profit margins point out the proportion of each sale per pound outstanding after paying the cost that the bank would consider efficient and gainful if the ratio is on its highest level. The ratio can be calculated using the formula:

Gross profit margin ratio = Gross profit * 100 / Sales 3.1.2 Cost of Sales Percentage Ratio (COS) Cost of sales percentage ratio assesses the bank’s efficiency in producing sales. The bank would consider it efficient if the ratio is at its lowest level. Cost of sales percentage ratio can be calculated using the formula:

Cost of sales percentage = Cost of sales * 100 / Sales 3.1.3 Net Profit Margin Ratio (NPM) Net profit margin points out the efficiency and the financial position of the bank. The bank would consider it efficient and profitable if the ratio is on its highest level. This ratio can be calculated using the formula:

Net profit margin formula = Net profit * 100 / Sales 3.1.4 Operating Profit Margin (OPM) Operating profit margin determines the profit produced through bank operations, being the pure profit after paying tax and Zakat (PBTZ) for the Islamic Bank. Operating profit margin can be calculated using the formula:

Operating profit margin = Net profit before tax and Zakat / Sales

3.2. Earning (Principal) Performance Ratios

Earning or principal ratios measure the effectiveness of a bank in relation to the bank owner’s equity level, and total net assets. For the purposes of

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this research, we have considered this using the two major earning (principal) ratios below. 3.2.1. Return on Equity Ratio (ROE) Return on equity ratio simply appraises the return received by the bank’s shareholders. The bank would consider it efficient and profitable if the ratio is at its highest level compared to the market value. This ratio can be achieved by using the formula:

Return on equity ratio = Net profit after tax and Zakat / Shareholders book value

3.2.2. Return on Net Assets (RONA) Return on net assets measures the effectiveness of bank management and how the existing resources have been utilised to produce reasonable earnings. The bank would consider it effective if the ratio is at its highest level. This ratio can be calculated by using the formula: Return on asset formula = Net profit after tax and Zakat / Total assets

3.3. Liquidity Performance Ratios

According to Shim & Siegel (2000), liquidity is the lifeblood of business. It is extremely important to maintain the correct level of liquidity for any business in order to survive in the long term. While a lower level of liquidity may expose the business to financial and operational risks, a higher level is not always a good thing as this may lead to minimum returns. For the purpose of this research, we will be considering the two major liquidity ratios below. 3.3.1. Current Ratio (CR) Current ratio examines the bank’s safety margin to meet short-term obligations, the optimal ratio being achieved when the total liabilities are less or equal to half the total assets. This ratio can be calculated using the formula:

Current ratio = Current asset / Current liability

3.3.2. Networking Capital to Sale Ratio (NCTS) Networking capital to sale ratio assesses the bank’s outstanding balance after deducting the short-term commitments. This ratio can be calculated using the formula:


Networking capital to sale Ratio = (Current assets – Current liabilities) / sales

3.4. Credit Risk Performance Ratios

Solvency can also be described as the ability of a corporation to meet its long-term fixed expenses and to accomplish long-term expansion and growth. The better a company's solvency, the better it is financially. We have considered three major credit risk ratios below. 3.4.1. Equity to Asset Ratio (EQTA) Equity to asset ratio measures the balance between the owner’s total equity, and the size of the total assets. This ratio can be calculated using the formula:

Equity to asset ratio formula = Total Equity / Total Assets

3.4.2. Equity to Net Loan Ratio (EQL) This ratio measures the balance between the owner’s total equity and their total loans. It can be calculated using the formula:

Equity to net loan ratio formula = Total Equity / Net Loans

3.4.3. Debt to Equity Ratio (DER) Debt to equity ratio or gearing ratio compares the owner’s capital to borrowed funds. It can be calculated using the formula: Debt equity ratio formula = Debt / Equity capital.

3.5. Assets Activity Performance Ratios

Asset activity ratios give details on how effective a business is in utilising their different types of assets (fixed and current). Moreover, it simplifies the link between total income and the existing level of assets. A bank would be considered effective if the ratio is on its highest level. For the purpose of this research, we have considered using the two major assets activity ratios below. 3.5.1. Fixed Assets Turnover Ratio (FATR) Fixed assets turnover ratio measures the efficiency of the bank, and how the bank makes use of its total fixed assets to produce income. This ratio can be calculated using the formula:

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Fixed asset turnover formula = Sales / Net fixed asset 3.5.2. Net Assets Turnover Ratio (NATR) Net assets turnover ratio measures the efficiency of the bank, and how the bank makes use of its total net assets to produce income. This ratio can be calculated using the formula:

Total asset turnover formula = Sales / Net asset

Section 4. Data Analysis and Findings

In order to analyse the data collected and draw the research findings, thirteen ratios were calculated and divided into five groups to access profitability, earning, liquidity, credit risk, and assets activity ratios for the period between 2005–2008.

4.1. Profitability Ratios

Fig. 6.1 Gross profit margin

The Faisal Islamic Bank’s gross profit improved during the year 2005–06. During the period 2006–07, the bank’s gross profit figure remained almost the same with only a marginal drop of 0.13%. This went to a huge drop of 12.22% during 2007–08 due to a large increase in the bank’s total expenses, which went up by 64.29%.


Although the Tadamon Islamic Bank’s profit growth rate reached 13% in 2006–2007 from SD 37.3 million to SD 42.3 million, a 16% increase in the bank’s general expenses led to an overall reduction in the gross profit ratio by 1.16%.

The Al Baraka Bank shows a reduction in the gross profit margin during 2005–2006 and 2006–2007. This is due to the massive increase in the bank’s general expenditure by 38% from SD 2700 million to SD 3729 million in order to make use of the latest banking technology. In addition, the bank’s efforts to strengthen its financial situation lead to an increase in the bank’s share of particular provisions, which include staff termination, reward provision, finance risk provision, and bad debt provision. The increase in general expenditure and provisions resulted in bringing profit down by 13% from SD 1056 million to SD 920 million.

Fig. 6.2 Cost of sales percentage.

The Faisal Islamic Bank of Sudan showed a reduction in the bank cost

of sale during 2005–06 when total expenses declined from 45.90% to 16.12%. This went up again during the periods of 2006–2007 and 2007–08 by 0.13% and 10.37% respectively as expenses increased.

The Tadamon Islamic Bank’s cost of sales increased in the year 2006–2007, but reduced by 4.59% during 2007–2008 due to the bank’s total expenses declining from 16.33% to 9.34%.

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The Al Baraka Bank showed a continuous increase in the cost of sales percentage from 2005–2007, increasing its expenses in an effort to adopt latest banking technology, and building up adequate provision.

Fig 6.3. Net profit margin

The Faisal Islamic Bank’s net profit ratio continuously increased

during 2005–2006, and 2006–2007 due to the bank’s decline in sales from 76.20% to 15.99%, leading to a decline in bank net profit from 119.12% to only 19.94% respectively. During 2007–2008 the bank net profit ratio declined by 11.85% as the result of sales increasing from 15.99% to 48.86%.

The Tadamon Islamic Bank’s net profit ratio reduced from 2006–2007, but increased by 2.75% in 2007–2008 due to the bank sales declining from 14.76% to 14.61%, as well as the increase in bank net profit from 13.51% to 17.76%.

The Al Baraka Bank’s net profit ratio continuously reduced during 2005–2006, and from 2006–2007 due to the bank’s increase in general expenditure and provision.


Fig. 6.4. Net Operating Profit Margin

The Faisal Islamic Bank operating profit increased from 2005–2006 due to the bank sales declining from 76.20% to 15.99%. From 2006–2007 the bank’s ratio reduced by as little as 0.13%, but from 2007–2008 the bank ratio reduced again by 12.22% as a result of the bank’s sales increasing from 15.99% to 48.86%, compared with the massive increase in expenditure from 16.12% to 64.29%.

The Tadamon Islamic bank net operating profit ratio from 2006–2007 reduced by only 0.85%, and in 2007–2008 the bank ratio started to increase by 3.99%.

The Al Baraka Bank net operating profit ratio continuously reduced from 2005–2006, and again in 2006–2007 due to the bank’s uncompensated general expenditure increasing in relation to the bank’s total sales level.

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4.2. Earning (Principal) Ratios

Fig 6.5. Return on Equity Ratio The Faisal Islamic Bank of Sudan’s return on equity continuously increased from 2005–2008.

The Tadamon Islamic Bank’s return on equity declined from 2006–2007 due to the bank owner’s equity increasing in 2006–2007 by 43% from SD 97.2 to 193, and from 2007–2008 the bank shareholder’s equity increased by 25% from SD 139 million to SD 175 million.

The Al Baraka Bank’s return on equity declined from 2005–2006 due to the reduction in net profit before tax and Zakat, and the increase in the bank shareholder’s equity by 11.01% and again from 2006–2007 due to the bank’s severe decline in net profit by 51.93%, compared with the bank’s equity growth of only 4.23%.


Fig. 6.6. Return on Net Assets Ratio

The Faisal Islamic Bank’s return on net assets increased from 2005–2006, and from 2006–2007, the bank’s ratio reduced due to the bank’s net assets growth by 43.78%, compared with 19.94% growth in the bank’s profit after tax and Zakat. From 2007–2008, the bank ratio reduced again due to the huge bank growth in net asset by 50.29%, compared with a 31.21% growth in the bank’s profit after tax and Zakat.

The Tadamon Islamic Bank’s return on asset reduced from 2006–2007, and from 2007–2008 due to the bank’s net assets growth of 24.87%, and 23.04% respectively, compared with growth in the bank’s net profit after tax and Zakat of 13.51%, and 17.76% respectively.

The Al Baraka Bank’s return on assets continuously reduced from 2005–2006 due to the bank’s reduction in profit after tax and Zakat by 12.92% from 1,056,263 to 919,735, and the bank’s total assets increased by 8.48% during 2006–2007.

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4.3. Liquidity Ratios

Fig. 6.7. Current Ratio The Faisal Islamic Bank’s current ratio reduced from 2005–2006, and from 2006–2007 due to the current liabilities increasing by 75.20%, and 47.90% compared with current asset growth of 66.42% and 44.31% respectively. From 2007–2008 the bank’s current ratio increased dramatically by 71.14% due to the current assets increasing by 51.75% compared with the current liabilities growth of 34.37%.

The Tadamon Bank’s current ratio reduced during 2006–2007, but in 2007–2008, it started to increase again.

The Al Baraka Bank’s current ratio increased from 2005–2006 due to the bank’s current liability increasing by 33.65% compared with the current asset growth of 9.02%. During 2006–2007, the bank’s ratio reduced due to the bank’s current assets growth by 14.25% compared with 17.25% growth in current liabilities.


Fig. 6.8. Networking Capital to Sale Ratio

The Faisal Islamic Bank’s networking capital to sale reduced during 2005–2006 due to the superior current liabilities growth of 74.12%, compared with 47.90%, and 34.37% from 2006–2007 and 2007-2008 respectively.

The Tadamon Islamic Bank’s networking capital to sale continuously increased in 2006–2007 and 2007–2008.

The Al Baraka Bank’s networking capital to sale ratio increased from 2005–2006 due to the bank’s reduction in total revenue from 21.82% to 14.32% in 2006–2007, when the ratio started to reduce.

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4.4. Credit Risk Ratios

Fig. 6.9. Equity to Assets Ratio The Faisal Islamic Bank’s equity to assets continuously reduced from 2005–2007 due to the bank’s equity reduction from 18.26% in 2005–2006 to 15.70% in 2006–2007, and from 2007–2008 the bank’s ratio reduced due to the bank’s total assets increasing from 34.78% in 2006–2007 to 50.29% in 2007–2008, compared with a 15.70% and 21.54% increase in bank equity from 2006–2007 and 2007–2008.

The Tadamon Islamic Bank’s equity to assets ratio increased from 2006–2007 and 2007–2008 due to the bank’s total assets increasing from 23.03% to 24.93% respectively.

The Al Baraka Bank’s equity to assets ratio increased from 2005–2006, and from 2006–2007 the bank’s equity to assets ratio reduced due to the bank’s equity reduction from 11.01% in 2005–2006 to only 4.23% in 2006–2007.


Fig. 6.10. Equity to Net Loan Ratio

The Faisal Islamic Bank’s equity to net loan reduced continuously during 2005–2007 due to the bank’s equity reduction from 18.26% to 15.70% in 2005–2006 and 2006–2007 respectively, and from 2007–2008 the bank’s ratio increased due to the bank’s equity increasing from 15.70% to 21.54%.

The Tadamon Islamic Bank’s equity to net loan increased during 2006–2008 due to the bank’s reduction in net loan level from 30.22% to 5.68%, in 2006–2007 and 2007–2008 respectively.

The Al Baraka Bank’s equity to net loan ratio increased during 2005–2006 due to the bank’s reduction in net loan level from 49.12% to 3.78% in 2005–2006, and from 2006–2007 the bank’s ratio reduced due to the bank’s increase in net loan level.

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Fig. 6.11. Debt to Equity Ratio

The Faisal Islamic Bank’s debt to equity ratio increased from 2005–2008 due to the bank’s equity reduction from 18.26% in 2005–2006 to 15.70% in 2006–2007, and from 2007–2008 the bank’s ratio increased due to the bank’s debt increasing from 88.75% to 91.33%.

The Tadamon Bank’s debt to equity ratio reduced from 2006–2007, and from 2007–2008 the bank’s ratio increased due to the bank’s debt increasing from 13.25% to 45.91% as well as the bank’s reduction in equity from 42.91% to 26.02%.

The Al Baraka Bank’s debt to equity ratio increased from 2005–2006, and from 2006–2007 the bank’s ratio increased due to the bank’s equity reduction from 33.64% to only 4.23%.


4.5. Assets Activity Ratios

Fig. 6.12. Fixed Assets Turnover The Faisal Islamic Bank’s fixed assets turnover increased during 2005–2006, and during 2006–2007, the bank’s ratio reduced due to the bank’s sales reduction from 65.03% to 15.99%. From 2007–2008 the bank’s ratio increased due to the reduction in fixed assets from 44.10% to 34.50%, and in addition, the bank’s sales increased from 15.99% to 48.85%.

The Tadamon Islamic Bank’s fixed assets turnover reduced during 2006–2007 due to the bank’s sales reduction from 22.46% to 18.01% as well as the increase in fixed assets from 1.45% to 61.34%. From 2007–2008 the ratio reduced due to the bank’s sales reduction from 18.01% to 14.61%.

The Al Baraka Bank’s fixed assets turnover ratio increased during 2005–2006 and 2006–2007 due to the bank’s fixed assets reduction from 2.11% to -2.44%.

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Fig. 6.13. Net Assets Turnover

The Faisal Islamic Bank’s net assets turnover increased during 2005–2006 due to the bank’s net assets reduction from 76.20% to 43.78% during 2006–2007. During 2007–2008, the bank’s ratio reduced due to the bank’s sales increasing from 15.99% to 48.85%.

The Tadamon Islamic Bank’s net assets turnover reduced during 2006–2007 and 2007–2008 due to the bank’s sales reduction from 18.01% to 14.61%.

The Al Baraka Bank’s net assets turnover continuously increased during 2005–2006 and 2006–2007 due to the bank’s net assets superior reduction from 60.04% to only 8.48%.

Performance Measures Tables 6.1, 6.2 and 6.3 below present calculations of all the financial ratios mentioned above for the three Sudanese Islamic banks (Faisal Islamic Bank, Tadamon Bank, and Al Baraka Bank).


Performance Measures 2005 2006 2007 2008

A Profitability

1. Gross profit margin (GPM) 45.976 34.757 45.915 40.306

2. Cost of sales (COS) 54.024 65.243 54.085 59.694

3. Net profit margin (NPM) 42.490 34.167 43.936 38.730

4. Operating profit margin (OPM) 45.976 34.757 45.915 40.306

B Earning or principal

1. Return on Equity (ROE) 31.200 16.800 32.300 32.900

2. Return on Assets (RONA) 4.000 3.000 3.300 2.900

C Liquidity

1. Current ratio (CR) 1.113 1.165 1.095 1.874

2. Networking capital to sale ratio (NCTS) 1.024 1.507 1.085 5.950

D Credit risk

1. Equity to Asset (EQTA) 0.128 0.179 0.103 0.089

2. Equity to Net Loan (EQL) 0.151 0.222 0.119 0.173

3. Debt to equity( DER) 1.770 0.921 2.940 4.520

E Assets activity

1. Fixed assets turnover (FATR) 1.779 1.410 1.487 1.797

2. Net assets turnover (NATR) 0.094 0.088 0.076 0.075 Table 6.1. Financial ratios of the Faisal Islamic Bank of Sudan from 2005–2008.

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Performance Measures 2006 2007 2008

A Profitability

1. Gross profit margin (GPM) 54.145 53.519 55.655

2. Cost of sales (COS) 45.855 46.481 44.345

3. Net profit margin (NPM) 52.563 51.990 53.420

4. Operating profit margin (OPM) 53.979 53.519 55.655


5. Return on Equity (ROE) 38.300 30.500 28.500

6. Return on Assets (RONA) 4.500 4.100 3.900

C Liquidity

7. Current ratio (CR) 2.016 1.916 2.236

8. Networking capital to sale ratio (NCTS) 5.657 5.791 7.201

D Credit risk

9. Equity to Asset (EQTA) 0.118 0.136 0.139

10. Equity to Net Loan (EQL) 0.246 0.270 0.322

11. Debt to equity( DER) 3.380 2.687 3.101

E Assets activity

12. Fixed assets turnover (FATR) 2.879 2.048 2.012

13. Net assets turnover (NATR) 0.086 0.079 0.074 Table 6.2. Financial ratios of the Tadamon Islamic Bank from 2006–2008.


Performance Measures 2005 2006 2007

A Profitability

1. Gross profit margin (GPM) 30.866 21.613 11.375

2. Cost of sales (COS) 69.134 78.387 88.625

3. Net profit margin (NPM) 27.046 19.333 8.128

4. Operating profit margin (OPM) 30.866 21.613 11.377


5. Return on Equity (ROE) 14.500 11.400 5.200

6. Return on Assets (RONA) 2.200 1.800 00.800

C Liquidity

7. Current ratio (CR) 1.267 1.332 1.298

8. Networking capital to sale ratio (NCTS) 2.378 2.510 2.310

D Credit risk

9. Equity to Asset (EQTA) 0.153 0.156 0.144

10. Equity to Net Loan (EQL) 0.210 0.255 0.200

11. Debt to equity( DER) 0.789 0.950 0.934

E Assets activity

12. Fixed assets turnover (FATR) 1.042 1.244 1.457

13. Net assets turnover (NATR) 0.082 0.092 0.93 Table 6.3. Financial ratios of the Al Baraka Bank from 2005–2007.

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Fig. 6.14. Faisal, Al Baraka and Tadamon Financial Ratios 2005–2008

4.6. Findings

The Tadamon Islamic Bank is the most efficient in terms of generating profits as well as being cost effective, followed by the Faisal Islamic Bank of Sudan and the Al Baraka Bank, which continuously reduced its gross profit margin, net profit margin, and operating profit margin.

The deterioration in the selected Sudanese Islamic banks profitability mainly emerged in 2007–2008, possibly because the central bank of Sudan’s (CBOS) policy to increase bank deposits, combined with a lack of confidence in the international banking system.

The Tadamon Islamic Bank’s return on net assets is better than that of the other two banks, apart from the Faisal Islamic Bank’s performance in 2005–2006.


In term of the liquidity ratio performance, all three Sudanese Islamic banks are performing satisfactorily, ranging from +1 to +2. The Tadamon Islamic Bank’s liquidity level reached +2.24 in 2007–2008.

The equity to assets level of the three Sudanese Islamic banks is adequate with percentages from 4.59% to 10.30% of the total assets.

The three Sudanese Islamic banks maintained different approaches on how much debt is to be used compared with their equity levels, with the Al Baraka Bank using debt of less than one times its equity to generate profits, while the Faisal Islamic Bank used debt of between 1.00 to 4.5 times of its owner’s equity.

The three Sudanese Islamic bank net loans level compared with the bank equity levels range from two to seven times. It is usually recommended to keep loans at an equity level below three times, which shows that the banks are taking excessive risks.

Credit risk performance (equity to assets, equity to net loans, and debt to equity) of the three Sudanese Islamic banks confirmed that there is no big difference in the bank’s equity to assets and equity to net loans. The Faisal Islamic Bank of Sudan and the Tadamon Islamic Bank debt to equity suggests that both banks are more risky than the Al Baraka Bank, since the bank debt to equity ratio fluctuates between 0.5 -1.0.

Conclusion

The financial performance investigation into the profitability of the three major Sudanese Islamic banks revealed that the Faisal Islamic Bank of Sudan and the Tadamon Islamic Bank are performing more efficiently than the Al Baraka Bank. The latter planned to improve its banking service by using the latest in banking technologies⎯such as cash machines and electronic cheques clearance⎯and assigning considerable provision for different purposes. These efforts led to the deterioration in profit after tax and Zakat from 12.92% in 2005–2006 to 51.93% in 2007–2008. All three banks are efficiently utilising their net assets to generate profits. The Tadamon Islamic Bank and the Al Baraka Bank have more liquidity to meet their short-term liabilities than the Faisal Islamic Bank of Sudan, although the latter maintained its current ratio range between 1–2 times. Apart from the risk taken by the Sudanese Islamic banks, if higher risk always means higher return, the overall performance of the three selected banks is satisfactory regarding their size and authorised capital. The current banking crisis that started in 2007 also affected the profitability performance of Islamic banking and finance, to some extent.

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http://www.aaoifi.com/objectives-acc.html http://www.albarakasudan.com/english/branches.htm


http://www.cbos.gov.sd/ http://www.fibsudan.com/en/ http://www.tadamonbank-sd.com/about_us.php

CHAPTER SEVEN

ISLAMIC MORTGAGES


With economies encountering the effects of failed conventional banking practices, experts have already begun to look for alternatives to rectify this situation and to ensure it does not recur in the future. Against this backdrop of financial crisis and economic recession, world economies are increasingly attracted to Islamic banking practices as an alternative financial and mortgage system due to its unique element of interest-free transactions. There is a great deal of interest presently in Islamic mortgages, with many seeing it as just what the Western world needs. The current credit crisis is a result of excessive lending and pure speculation and many financial analysts believe it would not have occurred if Islamic financial principles had been followed.

The UK now has five fully Sharia-compliant banks and another seventeen financial institutions offering the Islamic mode of home finance mortgage. This includes the Qatar Islamic Bank (QIB), with its London-based European Finance House in Berkeley Square, and the Islamic Bank of Britain, with its headquarters in Birmingham, answering the former Prime Minister Gordon Brown’s call for Britain to become the global centre for the international Islamic finance system. A report by the International Financial Services London even states that Britain’s Islamic finance sector is now bigger than that of Pakistan (Alex Wade, 2008). However, before we present Islamic finance as an alternative to conventional banking it is very important to determine the primary cause of the current crisis.

The ongoing subprime mortgage crisis constitutes a financial market failure because financing a home for a subprime borrower poses a dilemma in an efficient capital market (Fama, 1970, 1991). The ingenious mortgage bankers figured out an innovative method (which turned out to be disastrous, as explained below) to get financially-strapped individuals to qualify for a home loan using lax underwriting standards. This way of awarding loans was through the use of “exploding” adjustable rate mortgages

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(ARMs) with unusually low introductory (i.e. “teaser”) interest rates, which later climbed to a much higher rate once the introductory period expired (Gapper, 2007). This was supposed to facilitate access to a home for borrowers and to help them establish some credit history before qualifying for refinancing with a fixed rate mortgage. The implicit assumption was that the eventual appreciation of the home would bail out the borrower prior to the expiration of the “teaser” rate, as they would be able to refinance and not be exposed to the shock of higher mortgage payments. Unfortunately, the opposite happened, and not only did payments increase drastically but home prices also fell. This made it difficult for borrowers to keep up with their payments. In addition, they could not refinance (or sell) their homes, as their values were significantly below their mortgage balance (leaving them with negative equity), leaving them with no option but to default. It is estimated that more than 2.4 million American families have lost their homes through foreclosures (Economist, 2007a; Paletta, 2007; Mason & Rosner, 2007).

According to Aziz Tayyebi (2008), “Islamic finance is any finance that is compliant with the principles of Islamic [Sharia] law.” In terms of finance, Sharia explains in detail the ethical concepts of money and capital, the relationship between risk and profit and the social responsibilities of financial institutions.

El-Qorchi (2005) envisaged Islamic finance—financial institutions, products and services designed to comply with the central tenets of Sharia—as one of the most rapidly growing segments of the global finance industry. Starting with the Dubai Islamic Bank in 1975 (and operations in the United Arab Emirates, Egypt, the Cayman Islands, Sudan, Lebanon, the Bahamas, Bosnia, Bahrain and Pakistan), the number of Islamic financial institutions worldwide now exceeds three hundred, with operations in seventy-five countries and assets in excess of US $400 billion. Financial transactions are one of the more important dealings controlled by Sharia, ostensibly to ensure the more equitable distribution of income and wealth among Muslims in Islamic economies:

As opposed to conventional finance, where interest represents the contractible cost for funds tied to the amount of principal over a pre-specified lending period, the central tenet of the Islamic financial system is the prohibition of Riba, whose literal meaning “an excess” is interpreted as any unjustifiable increase of capital whether through loans or sales. The general consensus among Islamic scholars is that Riba covers not only usury but also the charging of interest and any positive, fixed, predetermined rate of return that are guaranteed regardless of the performance of an investment.

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Since only interest-free forms of finance are considered permissible in Islamic finance, financial relationships between financiers and borrowers are governed by shared business risk (and returns) from investment in lawful activities (Halal). Islamic law does not object to payment for the use of an asset, and the earning of profits or returns from assets are indeed encouraged as long as both lender and borrower share the investment risk together. Profits must not be guaranteed based on assumption and can only accrue if the investment itself yields income. Any financial transaction under Islamic law assigns to investors clearly identifiable rights and obligations for which they are entitled to receive commensurate return. Hence, Islamic finance literally “outlaws” capital-based investment gains without entrepreneurial risk. In light of these moral impediments to “passive” investment and secured interest as a form of compensation, Sharia-compliant lending in Islamic finance requires the replication of interest-bearing, conventional finance via more complex structural arrangements of contingent claims (Mirakhor & Iqbal, 1988).

Section 2. Major Principles of Islamic Finance

The general principles are as follows:

(i) The prohibition of Riba (usury or excessive interest) and the removal of debt-based financing from the economy;

(ii) The prohibition of Gharar, encompassing the full disclosure of information and removal of any asymmetrical information in a contract;

(iii) The exclusion of financing and dealing in sinful and socially irresponsible activities and commodities such as gambling and the production of alcohol;

(iv) Risk-sharing; the provider of financial funds and the entrepreneur share business risk in return for shares of profits and losses;

(v) Materiality; a financial transaction needs to have a “material finality,” that is a direct or indirect link to a real economic transaction; and

(vi) Justice; a financial transaction should not lead to the exploitation of any party to the transaction (Gait & Worthington, 2007).

The rest of this chapter is divided into five sections. In Section 2, we

review the literature on Islamic banking, Islamic mortgages and the

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principles of Murabaha. In Section 3, we present the Islamic mortgage market in the UK and factors limiting the uptake of Islamic mortgages. A comparison between conventional and Islamic mortgages is also provided in this chapter. The fourth section describes data collection techniques and methodology. Section 5 presents the findings from primary and secondary sources and Section 6 concludes.

A number of theoretical works have examined the implications of preferred Islamic modes of finance in the contemporary world. In their theoretical work, Siddiqui & Zaman (1989a, 1989b) have shown how the application of Mudarabah and Musharakah techniques of finance have the potential to enhance investment and could also generate a more equitable income distribution pattern. Their models confirm the intuitive point that compared to a debt arrangement, both under deterministic and probabilistic framework, Mudarabah and Musharakah finance could lead to a higher level of investment as new (marginal) projects would be undertaken as long as they are expected to give a positive rate of return, however small those rates might be.

It also shows that under these Islamic techniques of finance, compared to a debt management system, a greater portion of profits is allocated to the providers of funds if the economy is doing well. On the other hand, in bad conditions, the providers of the fund receive a lower return and in extreme cases may get a negative return. This has a stabilising effect on the economy.

Siddiqui (1994) further discusses how an economy based on the institution of interest is inherently unstable (a proposition elegantly presented and championed by prominent post-Keynesian economist Hyman Minsky) and how the Islamic techniques of finance based on profit-and-loss sharing have the potential to provide financial stability.

It emphasises the point that Mudarabah finance is particularly capable of attracting those potential entrepreneurs who are unable to provide any collateral. This possible increase in the supply of entrepreneurs would decrease the power of existing entrepreneurs and lead to a desirable distribution of income by discouraging the concentration of wealth in fewer hands. Siddiqui (1994) also addresses the problems one would face under Islamic techniques of finance and argues that those problems are not insurmountable. He points out that any serious attempt to implement profit-sharing financing would require, at the initial stages, commitment and often supervision and intervention by the government (Assad, 2007).

Islamic banks do not charge interest but rather participate in the yield resulting from the use of funds; investors also share in the profits of the bank according to a prearranged ratio. Hence, there is a partnership

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between Islamic banks and their depositors on one side, and between the bank and its investment client on the other, as one who manages depositors’ resources in a productive way. This is quite different from what happens in conventional banks, which mainly borrow funds at interest on one side of the balance sheet and lend funds at interest on the other. In other words, an Islamic bank is an institution whose scope of activities includes all currently-known banking activities, excluding borrowing and lending on the basis of interest. On the liabilities side, it mobilizes funds on the basis of a mudarabah or wakalah (agent) contract. It can also accept demand deposits which are treated as interest-free loans from the clients to the bank and which are guaranteed. On the assets side, it advances funds on a profit-and-loss sharing or a debt-creating basis, in accordance with the principles of the Sharia (Mabid & Munawar, 2007).

Housing plays a vital role in any economy (Sheng, 1997). This is due to its following attributes: First, a home is both a consumption as well as an investment (Malpezzi, 1990). The investment aspect of homeownership helps to increase wealth (Buckley, 1994; Englehardt, 1994; Sheng, 1997; Haurin et al., 2002). Second, homeowners support their neighbourhood more than renters, as they participate in crime prevention and support public schools. They are better citizens and vote at a higher rate (Haurin et al., 2002). Homeownership fosters investment in local amenities and social capital, thus enhancing the status and quality of the community (DiPasquale & Glaeser, 1999).

As Sharia law regards the practice of paying or receiving interest (Riba) as unacceptable and forbidden, a Sharia home loan provides a Halal (permissible) alternative to an interest-based mortgage by allowing individuals to purchase their own homes without having to pay interest. Case analyses by Matthews et al. (2003) show that the principle differences between an Islamic and conventional mortgage is that the former is equity based and the latter is debit based. In an Islamic mortgage situation, both the bank and the client share ownership [equity] and therefore share the risk of equity ownership. In conventional banking the client owns all the equity and the bank’s loan to the client is secured on the value of the property.

According to Kuran (1995), Murabaha is the most commonly used method of finance by interest-free banks. It is based on the use of a mark-up or profit margin, which does not seem to differ much (in its calculation or application) from interest charges used by conventional banks (Brown, 1994). This has subjected the interest-free banks to severe criticisms.

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2.1. Murabaha Contract (Mark-ups on Sale)

Murabaha is an Islamic instrument for buying and reselling the purchase or import of capital goods and other commodities by institutions, including banks and firms. Under the Murabaha contract, the customer provides the bank with the specifications and prices of the goods to be purchased or imported. The Islamic bank studies the application and collects information about the specifications and prices of the goods, focusing especially on the price and conditions for payment. When the bank and its client agree on the terms of the deal, the bank purchases goods or commodities and resells them to the customer. The profit that accrues to the bank is mutually agreed upon as a profit margin (mark-up) on the cost of purchase (Metwally, 2006).

The fundamental principles attached to Murabaha can be summarised as follows:

(i) Goods must be classified and clearly identified according to

commonly accepted standards and must exist at the time of sale; (ii) Goods for sale must be in the ownership of the bank at the time

of sale; (iii) The cost price must be known at the time of sale and this should

be declared to the client. This is especially the case when the bank succeeds in obtaining a discount where the profit margin is calculated on the net purchase price (this means discounts also provide benefits to the client); and

(iv) The time of delivery of the goods and the time of payment must be specified (Iqbal & Molyneux, 2005; Lewis & Algaoud, 2001; Kahf, 1997).

The Murabaha contract is merely a two-party buying and selling

contract between bank and customer involving no financial intermediation or financing. In other words, the bank offers this service to clients who should pay the cost of the goods plus a profit margin to the bank immediately following receipt. In addition, the client can pay for the goods and the bank’s profit margin by deferred instalments or a deferred lump sum without an increase over the original value. This type of contract is referred to as Bai muajjall-Murabbah or Baibithaman ajja. Fig. 7.1 below shows how the Murabaha contract is conducted.

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Fig. 7.1. Murabaha Contract Source: Islamic finance (Matthews et al. n.d.).

2.2. Murabaha versus Interest

There is no unfairness involved in murabaha-financing as far as the relationship between the financier and the entrepreneur-buyer-on-credit is concerned. On that count, it is superior to the financing arrangement based on interest. The financier is financing not a venture of uncertain results but the acquisition of a commodity of acknowledged utility and known current price. The mark-up on current price is tacked on the commodity, whereas in interest-based borrowing it is tacked onto money capital (the principal). By converting money capital into a commodity, the financier has already given up liquidity and taken the risks associated with owning a real asset, e.g. a fall in its market price, destruction due to natural causes or theft, etc. They also take the risks associated with relying on the other party’s promise to buy, like the risk of bankruptcy of the would-be buyer or backing down on their promise to buy. In addition, by selling on credit, the financier is taking the risk of default by the buyer as well as forgoing any other opportunities of using the money that could have arisen as time passes. Time, which is not recognized by Sharia as a basis of claiming an

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excess over principle when making a money loan, becomes part of the justification for a mark-up in credit sale (Khan, 1995). The fact that Sharia does not allow any further increase in the contracted price, should more time elapse before the actual payment is made, clearly demonstrates that there is no price for the mere passage of time involving a sum of money.

The twin norms of justice in transactions, equivalence and reciprocity, which we found to be violated in interest-based lending, are not violated in sale on credit with a mark-up on current price. There is a perceived equivalence between the commodity received by the buyer and the price received by the seller, as is the case in voluntary exchanges between commodity on one side and money on the other. Reciprocity inheres in the seller’s advantage of a mark-up (attached to which are the risks mentioned above) being matched by the buyer’s advantage of getting the time and opportunity of using the commodity ahead of paying the price. As we have already seen above, no such claim can be made about exchanging money now for more money in future. The perception of equality is acceptable in place of objective equality in exchange of dissimilar things, as money and commodity, but it cannot be acceptable between the same things, i.e. the exchange of money for money. It has to be measurable equality as there is no room for perception, and there is also no reciprocity. What the lender gets is definite and known but what the borrower gets is neither definite nor known, should we consider the point of time at which the loan is repaid (Siddiqi, 2004)

Section 3. The Islamic Mortgage Market in the UK The UK Islamic mortgage market has seen impressive growth over the last five years, yet the market is still in its infancy and faces many obstacles. The Islamic mortgage market is now worth £164 million and is growing at an average rate of 68.1% per annum since 2000, in comparison to the total mortgage market growth of 16.2%.

With the Muslim community representing a substantial portion of the UK population, it is predicted that by 2009 the Islamic mortgage market will be worth £1.4 billion. In 2003, the Islamic mortgage market began to accelerate further with the abolition of the payment of double stamp duty. Today there are at least five lenders in the market actively offering Islamic products including institutions such as HSBC and Lloyds TSB. The problem is that the Islamic mortgage market does not offer any real alternatives for customers unless they have a large amount of equity in a property or a substantial deposit. Islamic lenders recently increased their deposit requirements on

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products such as Alburaq to 35% and HSBC Amanah to 40%. Both these organisations are leaders in the market, with many innovative products.

Nevertheless, the Islamic mortgage market remains positive, with all lenders investing in marketing initiatives to drum up business. The Islamic Bank of Britain remains competitive and continues to develop its product portfolio, recently expanding into the Scottish market. However, the average Islamic mortgage customer will still struggle to get a mortgage, with a minimum property value requirement of £150,000.

The trend for Islamic mortgages is broadening the home ownership base, particularly amongst Muslims. However, you do not need to be a Muslim to take advantage of the existing Islamic mortgage schemes. Muslims make up 5% of the UK population and it is predicted by Datamonitor that the Islamic mortgage market could be worth £4.4 billion within the next two years. Islamic mortgages are one of the most rapidly growing segments of the Islamic financial industry, though it still has a huge market waiting to be fully explored. There are approximately three million Muslims permanently resident in the UK with estimated savings of around £1 billion, while over half a million Muslims visited Britain in 2001, spending nearly £600 million.

Cumbo (2005), points out that one factor that appears to be limiting the uptake of Islamic mortgages is that the cost is higher than for conventional mortgages. For Islamic financing worth £135,000 from Lloyds TSB over a period of twenty-five years, the monthly repayments were £883 plus £21 a month for buildings insurance in March 2005. This comprised a rental payment of £693 plus a capital repayment of £190. The total monthly payment was over £100 per month more than the cost of a Lloyds TSB conventional mortgage. This was further supported by Hassan and Lewis (2007), who state that with HSBC Amanah, for the same loan of £135,000 over twenty-five years, the monthly repayments were £857, only £7 per month more than the bank’s conventional mortgage, but the buildings insurance of £34 per month was obligatory with the Islamic financing as the property itself is owed by the bank, unlike the case of a conventional mortgage where the bank simply has a charge on the property so that it can be repossessed in the case of payment default. According to information from a publication of New Millennium Publishing (2004), a survey of 503 Muslims in ten cities throughout England undertaken by Dr Humayon Dar of Loughborough University showed that many respondents had little knowledge of Sharia-compliant finance, but those who had enquired about Islamic home finance were deterred from proceeding because of higher costs (Hassan and Lewis, 2007).

Of course, the cost of mortgages is not the only factor determining the level of business, as those Muslims who have signed contracts for Islamic

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finance are prepared to pay a premium. A further factor inhibiting the uptake of Islamic home finance is that a significant proportion of the Muslim population in the UK is in a low socioeconomic position and cannot afford to buy property. This applies in areas such as East London where many of those in the Bangladeshi community are quite poor, but property prices are relatively high. One solution might be co-ownership through Islamic housing associations, with the tenant, association and bank all owning a share in the property, but at present, this does not exist in the UK.

Fig.7.2. Source: Islamic finance (Matthews et al. n.d.)

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3.1. Data Collection and Methodology

People used for the research were banking professionals with in-depth knowledge of the banking industry. A total of 190 banking professionals completed the questionnaire. Initially, a test sample of fifty was carried out. The pilot questionnaire enables it to be initially evaluated for its design, format and clarity in content, relevant to the research question and structure. This is because it would be impossible to exactly predict how respondents would interpret the questions. After a favourable initial response, we proceeded to survey 190 individuals. The first part of the questionnaire was related to views on the mortgage system, consisting of six questions based on a five scale ranging from SA (strongly agree) to SD (strongly disagree). The purpose of this part was to assess the perception of banking professionals about the type of mortgage system they want in relation to interest, fees, choices, insurance etc. The second part consisted of questions concerning demographic, including age, income, marital status, and for the finance professionals, number of years in the profession. In total, ten questions were asked to analyse the bankers’ views and expectations regarding the significance of the Islamic mortgage system (a copy of the questionnaire can be found in the Appendix section).

The questionnaire included a two-line paragraph explaining the purpose of the study. Confidentiality, and to some extent secrecy, were assured to respondents so that they could give more honest and open answers. A guarantee was also given that the collected data would only be used for academic purposes.

As this study aims at providing an insight into the significance of the Islamic mortgage to the UK finance industry and the practical view of those in industry, the returned questionnaire was analysed using various software packages with good analytical capabilities. The analysis of the questionnaire offers insight into the conception of banking professionals with regard to their perception of the Islamic mortgage system and it principles.

Section 4. Empirical Analysis A total of 190 questionnaires were used and the researcher calculated this as an appropriate sample. Data provided in Tables 7.1, 7.2 and 7.3 divides and presents respondents according to their income, age and years of experience in the banking industry.

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Less than £15,000£15,000-£20,000£20,000-£30,000£30,000-£40,000No Answer

Table 7.1. Income

Income Level No. of Respondents Percentage

Less than £15,000 10 5.26%

£15,000-£20,000 50 26.3%

£20,000-£30,000 73 38.4%

£30,000-£40,000 47 24.7%

No Answer 10 5.26%

Total 190 100%

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18- 2425-3435-4950-6465 and above

Table 7.2. Age

Age Group No. of Respondents Percentage 18-–24 32 16.8% 25–34 43 22.6% 35–49 65 34.2% 50–64 38 20% 65 and above 12 6.32%

Total 190 100%

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1-9years10-20years21-30years31-40years41years or more

Experience No. Of respondents Percentage 1–9 years 38 20% 10–20 years 42 22.10% 21–30 years 59 31.05% 31–40 years 41 21.58% 41years or more 10 5.26% Total 190 100% Table 7.3. Length in Banking Industry

Table 7.4 below shows that forty-five respondents (23.7%) of 190 strongly agree that a non-interest based mortgage is better than interest based, while eighty respondents (42%) agree, forty-eight respondents (25.3%) neither agree nor disagree, twelve respondents (6.32%) disagree, and five respondents (2.63%) strongly disagree. The results below indicate that the majority of the respondents believe non-interest based mortgages to be better than interest based. This might be because an interest based mortgage system can be fundamentally unstable; the recent subprime mortgage crisis witnessed in the US, which had a strong impact on the global economy, is a good example of this. Just 2.63% of the respondents strongly disagreed.

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Options No. of Respondents Percentage SA—Strongly agree 45 23.70% A—Agree 80 42% N—Neither Agree nor disagree

48 25.30%

D—Disagree 12 6.32% SD—Strongly disagree 5 2.63% Total 190 100% Table 7.4. Non-Interest Based Mortgages are Better than Interest Based

Fig. 7.3. Non-Interest Based Mortgages are Better than Interest Based Table 7.5 below indicates that from the 190 respondents, 120 strongly agree that Islamic mortgages are less risky than conventional mortgages (63.16%), 50 agree (26.32%), 15 neither agree nor disagree (7.89%), five disagree (2.63%) and none strongly disagree. This result points towards the widely held view that the Islamic mortgage is less risky than the conventional mortgage and many financial analysts believe the credit crisis would not have happened if Islamic finance principles had been followed.

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Table 7.5. Islamic Mortgages are Less Risky than Conventional Mortgages

Figure 7.4. Islamic Mortgages are Less Risky than Conventional Mortgages Options No. of Respondents Percentage SA—strongly agree 25 13.16% A—Agree 75 39.47% N—Neither agree nor disagree

40 21.05%

D—disagree 37 19.47% SD—Strongly disagree 13 6.84% Total 190 100% Table 7.6. Its Ethical Foundations Make the Islamic Mortgage an Increasingly Serious Alternative to the Conventional Mortgage

Options No. of Respondents Percentage SA—strongly agree 120 63.16% A—agree 50 26.32% N—neither agree nor disagree

15 7.89%

D—disagree 5 2.63% SD—strongly disagree - - Total 190 100%

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Table 7.6 demonstrates that 25 of the 190 respondents strongly agree that the ethical foundation of the Islamic mortgage makes it an increasingly serious alternative to the conventional mortgage (13.16%), 75 agree (39.47%), 40 neither agree nor disagree (21.05%), 37 disagree 19.47%, and 13 strongly disagree (6.84%). Thirty-nine per cent agree that because Islamic principles of interest are concerned with issues of fairness and justice rather than narrowly defined efficiency, they allow a more equitable distribution of income and wealth and an increased equity participation in the economy. These principles focus on the necessity of sharing risk in a fair and stable society, and upon problems of exploitation in markets where power is asymmetric, and this is the real Riba (interest) issue. Options No. of Respondents Percentage SA—Strongly agree 103 54.21% A—Agree 37 19.47% N—Neither agree nor disagree

5 2.63%

D—Disagree 30 15.79% SD—Strongly disagree 15 7.89% Total 190 100% Table 7.7: The Islamic Mortgage Has a Market outside the Muslim Community

Fig. 7.5. The Islamic Mortgage Has a Market Outside the Muslim Community

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Options No. of Respondents Percentage SA—strongly agree 3 1.58% A—agree 7 3.68% N—neither agree nor disagree

25 13.16%

D—disagree 58 30.53% SD—strongly disagree 97 51.05% Total 190 100% Table 7.8: There is a great awareness in the UK about the Islamic mortgage and its principles

Table 7.8 points out that 97 of the 190 respondents (51.05%) strongly disagree that there is a great awareness in the UK about the Islamic mortgage and its principles, 58 disagree (30.53%), 25 neither agree nor disagree (13.16%), 7 agree (3.68%), and 3 strongly agree (1.58%). While Wilson (2000) argues that the level of knowledge of Islamic finance methods is generally low among individual consumers as compared to the need, the Islamic finance industry is utilising only a fraction of its true potential. A more professional approach has been recommended to penetrate the untapped market, as the most accessible part of the market has already been covered.

Fig. 7.6. There is great awareness in the UK about the Islamic mortgage and its principles

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Options No. of Respondents Percentage SA—strongly agree 76 40% A—agree 57 30% N—neither agree nor disagree

34 17.89%

D—disagree 14 7.37% SD—strongly disagree 9 4.74% Total 190 100% Table 7.9: There is little or no difference between the choices offered in conventional and Islamic banks

Fig. 7.7: There is little or no difference between the choices offered in conventional and Islamic banks

Table 7.9 above shows the responses when asked if there is little or no difference between the choices offered in Islamic and conventional banks, to which 76 respondents (40%) strongly agree, 57 agree (30%), 34 neither agree nor disagree (17.89%), 14 disagree (7.37%), and 9 strongly disagree (4.74%). This result is based on the fact that Islamic finance has been free-riding on financial theories and instruments developed within the context of the conventional debt and interest-based system. Unless Islamic finance develops its own genuinely Islamic financial instruments, it cannot achieve the dynamism of a system that provides the security, liquidity and diversity needed for a globally-accepted financial system which could prove to be a genuine alternative to the present interest-based international financial system.

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According to evidence from both the primary and secondary data obtained, it can be ascertained that there is no real difference between Islamic and conventional banking in terms of organisational set-up and choice of product. It is quite clear that a disaster of a certain magnitude could not occur in markets governed by Islamic Sharia because of the way transactions are made. Islamic law forbids usury and outlaws the selling of what you do not own, except under strict conditions such as the selling of commodities where the full price is paid in advance, whilst that which is valuated (the product) is postponed, thus reducing the risks in the transaction. Islamic Sharia also forbids the postponement of buying and selling (forward contracts), which is the case with derivative contracts and debt trading, except under certain conditions that prevent usury manipulation and deceit. The above-mentioned facts also explain why Islamic institutions were not affected by the crisis.

Conclusion

After a detailed study of the available literature and analysing responses from respondents, the researcher concludes that Islamic finance is convincing the world that it not only covers the ethical aspect of the society but also gives economic benefits. However, it is not a justified argument to portray Islamic finance as a real competitor of conventional banks, because the Islamic banking industry is in its infancy and will take more time to prove itself against its conventional counterpart.

Islamic principles of interest are concerned with issues of fairness and justice rather than narrowly defined efficiency. These principles focus on the necessity of sharing risk in a fair and stable society, and upon problems of exploitation in markets where power is asymmetric, which is the real Riba (usury) issue.

Our survey shows that the principle differences between Islamic and conventional housing finance is that the former is equity based and the latter is debit based. In an Islamic mortgage situation, both the bank and the client share ownership (equity) and therefore share the risk of equity ownership. In conventional banking, the client owns all the equity and the bank loans to the client are secured on the value of the property.

Putting aside the penetrating comment by Ahmed (1992)—“It’s not clear whom we are cheating”—regarding hypocrisy in the current practice of Islamic banks, let us deal with the realm of the ideal. Consider an ideal situation in which Islamic principles of interest are adhered to by a substantial proportion of the world financial system. What they have in common is a prohibition of usury, or excessive interest rates. Could such

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an idealized system conceivably survive as a foundation of banking in a hypercompetitive global financial environment? Pure logic would dictate that this is not possible in a profit-maximizing world; that is, if excessive interest rates reflect high-risk situations or situations of capital shortage, both of which would require high interest rates that might be considered usurious. We remarked at the beginning of the chapter on the recurrent crises in the financial sector.

Maladministration, deception and ethical behaviour lie at the root of many of these problems, and Enron and WorldCom are just two examples of this. The Islamic approach emanates from a foundation of ethical principles. Therefore, discussion of Islamic finance in connection with global financial practices introducing an ethical dimension is welcome. In addition, as Khan (2002) points out, an Islamic system of finance might create a more stable world financial market.

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Iqbal, Zamir & Hiroshi Tsubota. (2006). “Emerging Islamic Capital Markets: Islamic Finance Review.” Euro money Handbook, and Euro money Institutional Investor PLC, London, p. 5–11.

Kahf, M. (1997). “Instruments of Meeting Budget Deficit in Islamic Economy.” Research Paper N.42, Islamic Research and Training Institute, Islamic Development Bank, Jeddah.

http://www.irtipms.org/PubAllE.asp (accessed May 2009). Khan. I. (2005). “Revisiting the value proportion of Islamic finance.” Euro

money 4th Annual Islamic Finance Summit, London, February 22–23. Lewis, M. & Algaoud, L. (2001). Islamic Banking. Edward Elgar,

Cheltenham. Mason, J. R. & Rosner, J. (2007). “How Resilient are Mortgage Backed

Securities to collateralized Debt Obligations Market Disruption?” Working Paper, Hudson Institute, Washington, DC.

Malpezzi, S. (1990). “Urban Housing and Financial Markets: Some International Comparisons.” Urban Studies 27: 971–1022.

Mirakhor, Abbas & Zaidi Iqbal. (1988). “Stabilization and Growth in an Open Islamic Economy.” IMF Working Paper No. 88/22, International Monetary Fund (IMF), Washington, DC.

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Metwally, M. (2006). “Economic Consequences of Applying Islamic Principles in Muslim Societies.” Journal of Islamic Banking and Finance 23 (1): 11–33.

Obaidullah, M. (2005). “Islamic Financial Services.” Islamic Economics Research Centre, Jeddah.

Paletta. (2007). “Obama Lays Out Plan to Stem Defaults in U.S. Housing Market.” Wall Street Journal Europe (February 19, 2007), Issue 12.

Syed. Assad. (2007). Islamic Banking & Finance, Macroeconomics Term report.

Sheng, A. (1997). “Housing Finance and Asian Financial Markets.” Speech by the Deputy Chief Executive of the Hong Kong Monetary Authority, delivered to the International Union for Housing Finance in Thailand on October 27, 1997.

Siddiqi., M. N. (2004), “Riba, Interest and the Rationale of its Prohibition, Visiting Scholars.” Research Series. Jeddah- Saudi Arabia

Siddiqui, M. N. (1983). Banking without Interest. Leicester: The Islamic Foundation.

Tayyebi, Aziz. (2008). “Islamic Finance: An ethical alternative to conventional finance?” ACCA Discussion Paper, London.

http://www.accaglobal.com/pubs/general/activities/library/financial_reporting/other/tech_tp_if6pp.pdf (accessed November 2009).

Wade, Alex. (2008). “Crossing Over to Islamic Banking.” Times Online http://business.timesonline.co.uk/tol/business/law/article5889624.ece (accessed November 2009). Zaher, T. Hassan, M. (2001), “A Comparative Literature Survey of

Islamic Finance and Banking.” Financial Markets, Institutions and Instruments 10 (4): 155–199.

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Appendix Questionnaire

Part A Please use a (√) to indicate how strongly you agree or disagree with each of the following statements. Please make sure that you only check one response for each question. Remember that there are no right or wrong answers so please be honest. Possible responses are: SA—strongly agree A—agree N—neither agree nor disagree D—Disagree SD—strongly disagree 1) Interest based mortgages are better than non-interest based. _____ SA _____ A _____ N _____ D _____ SD 2) Islamic mortgages are less risky than the conventional mortgage. _____ SA _____ A _____ N _____ D _____ SD 3) Its ethical foundations make Islamic finance an increasingly serious alternative to conventional finance. _____ SA _____ A _____ N _____ D _____ SD 4) Islamic mortgage has a market outside the Muslim community. _____ SA _____ A _____ N _____ D _____ SD 5) There is great awareness in the UK about Islamic mortgage and it principles. _____ SA _____ A _____ N _____ D _____ SD 6) There is little difference between the mortgages offered by conventional and Islamic banks. _____ SA _____ A _____ N _____ D _____ SD

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Part B We require some background information in order to classify your responses. I would like to remind you that all the information collected will remain confidential and will be used only for academic research purposes. A) Which age group do you fall in: _____ 18 to 24 years _____ 25 to 34 years _____ 34 to 49 years _____ 50 to 64 years _____ 65 years or more B) What is your total household income (before tax): _____ Less than £15,000 _____ £15,001 to £20,000 _____ £20,001 to £30,000 _____ £30,001 to £40000 _____ No Answer C) How long have you been in the banking industry? _____ 9 years or less _____ 10 to 20 years _____ 21 to 30 years _____ 31 to 40 years _____ 41 years or more Thank You

CHAPTER EIGHT

ROLE OF ISLAMIC MORTGAGES IN THE UK


Islamic banking is only three decades old but its growth has been phenomenal. Islamic financial institutions globally have risen from one institution in just one country in 1975 to over three hundred institutions in more than 75 countries. The activities of these institutions have an effect on between 20% and 30% of the world's population, and in certain countries, they handle more than 20% of financial flows.

In the early days, when Islamic banking appeared with its ethical values, it was deemed impracticable by the world’s financial circles. However, the attitudes gradually changed and over the last few years, many new Islamic banks have started operating, while conventional banks have opened separate sections for Islamic banking services in order to attract more customers (Haqiqi & Pomeranz 2000).

The Islamic financial system employs the concept of participation in the enterprise, utilizing the funds at risk on a profit-and-loss-sharing basis. This by no means implies that investments with financial institutions are necessarily speculative. This can be excluded by careful investment policy, diversification of risk and prudent management by Islamic financial institutions. Islamic finance as a concept is based on themes of community banking, ethical and socially responsible investments and affinity marketing. These themes are based on core ideas, which include individual responsibility, reliance on market mechanisms, commitment to economic and social justice and mandatory care for the environment.

At a time when international financial markets have been rattled by the sub-prime crisis, Islamic banks have witnessed no effect as yet. While many experts and bank officials have confirmed that Islamic banks have been untouched by the global financial crises, more and more people are moving towards ethical banking. This can be credited to the ethics and values inherent within the Islamic banking system (Ahmed, 1992).

The Middle East Online website explained that there are two main reasons why Islamic financial institutes have remained unaffected by the

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global crisis. The first is due to their security from the liquidity problem, due to interbank lending in the money markets, merger and re-sales of debt companies. The second reason can be attributed to the rating of complete investment risks instead of mere credit risks. Owing to this, liquidity related problems could be avoided because inter-bank transfers are not permitted by Islamic banking.

According to the rating of investment risks, Islamic finance has no problem with fluctuation in asset values; instead, it diverges according to actual business trends. Thus, there is no fear of sub-prime mortgages under Islamic banking principles; rather, it counters the cutthroat competition in the financial sector to get more credit shares. In this way, Islamic banks offer stability and insulation in the financial market. However, if the right information and data were available to the consumer, the demand of justly motivated consumers for Islamic banking would be significant.

However, the Islamic economic principles of sharing risks and rewards and participating in the activity of wealth creation via equity rather than debt has provided a solution that eliminates debt in its existing interest-based form, while continuing to promote entrepreneurship and creativity in the economic cycle. This requires equity participants to actively benchmark proposed projects against moral standards (social analysis) in addition to the financial parameters (risk analysis) leading to a clear comprehension of the wealth creation process at an individual level. In the Islamic economic model, each individual is involved in economic activity. In comparison, the debtor tends to be only individual remotely involved in scrutinizing the business proposal in the debt bond model, broadly content with earning interest on the loan regardless of the social and financial implications of the project.

Section 2. UK Sharia-compliant Market Analysis

According to the International Association of Islamic Banks (IAIB), by 1998 there were 176 Islamic banks and financial institutions operating in 38 countries. These institutions had total assets of $148 billion, paid up capital of $7.3 billion, and generated $1.2 billion in aggregate net profits in the latest year of operation. Sir Howard Davies, chairman of the Financial Services Authorities in the UK, said that: “there was a gap in the market for retail sector Islamic banking products, which would cater to nearly two million UK Muslims.” There are approximately three million Muslims permanently resident in the UK (i.e. 50% of all UK ethnic minorities) with an estimated saving of around £1 billion, while over half a million Muslims visited Britain in 2001, spending nearly £600 million.

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The five thousand richest Muslims in the UK have liquid assets of over £3.6 billion, according to wealth analysts’ Datamonitor.

HSBC, the UK-

listed bank, has £2 billion of assets under management and three Islamic funds, and is predicting growth of assets under management of up to 40% for the year 2002. The Datamonitor (1999) research indicates that out of their 1.65 million estimate, three hundred thousand Muslim adults in the UK have annual incomes in the range of £30000 and above. This means that approximately 25% of all adult Muslims are excellent targets for Islamic banking and financial products.

Section 3. Islamic Modes of Financing

Islamic modes of financing are designed in such a way that they affect both the assets and liabilities of a bank’s balance sheet and are divided into two major categories. They are based on PLS (profit-and-loss sharing, which is a core mode) principle and NPLS (non-profit and loss sharing, which is a marginal mode). Fig. 8.1 below provides a summary of the two modes of financing. These modes are central to formulating, designing and structuring all financial products and instruments of banking, insurance and capital markets within the Islamic financial industry. From the offset, one can observe that they are both performing tremendously different actions; this is because Islamic banking is based on Islamic law, and hence all transactions, product features, business approaches, investment aims and responsibilities are based purely on Sharia principles, which are completely different from conventional banking.

The reminder of this chapter is organised into five sections. Section 2 reviews the literature related to the Islamic mortgage and finance market. Section 3 describes Islamic financial infrastructure and the role of corporate governance. Section 4 reveals comparisons between Islamic and conventional mortgages. The conclusion of the study is in Section 5.

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Fig. 2.1 Mode of Finance Source: Yaqubi (2006)


Islam is a complete way of life that has a set of goals and values encompassing all aspects of living (Al Tamimi et al., 2004). In order to understand Islamic finance and banking, it is necessary to have certain knowledge of the history and tenets of Islam. It is not easy for individuals who are used to Western traditions to understand the teachings of Islam (Ibrahim 2000).

According to Dar & Presley (2000), Islamic banks (IB) act as an intermediary and trustee of people’s money just like conventional banks, but the reimbursement to all depositors is done on a profit and loss sharing basis. This basic difference establishes an element of mutuality in a wider socio-economic context and provides the right of ownership to its customer. However, in practice Islamic banks are similar to their conventional counterparts in terms of their organisational set-up.

Khan (1986) has noted that the abolition of interest-based transactions is not a subject alien to Western economic thought. Fisher (1945), Simons (1948) and Friedman (1969) have all argued that the current one-sided liability, interest-based financial system can be fundamentally unstable. There are many such examples, such as the German hyperinflation of the 1920s, oil shock inflations in 1970s the banking crises in Japan, East Asia,


Russian and Argentina, and the Enron bankruptcy. The occurrence of

crises is the result of the combination of a number of factors including over-exuberance, greed, underestimation of risk, overexposure, currency failures, asset depreciation, faulty regulation, illiquidity, macroeconomic shocks and accountancy maladministration. Zarqa (1983), Khan (1986), Chapra (2000), El-Gamal (2000) and Abdul Gafoor (1997) have illustrated the macroeconomic stability that can form a profit and loss sharing system, an Islamic form of banking that would replace the interest-based transactions that characterize Western transactions.

Islamic finance is based on Sharia principles (Islamic laws and rules) which are also called Islamic jurisprudence:

“Shariah is not a codified body of commandment. It is a conceptual form of rule competent of adaptation, advancement and interpretation. Shariah supervision may be thought of as the single most important distinction between a conventional and a truly Islamic financial venture, for it has no way certifying that its services, products and operations are actually Shariah compliant.” (DeLorenzo 2003) Sharia manages all aspects of matters including socio-economical,

political and cultural aspects of Islamic societies. The main sources of Sharia are the Holy Qur’an (the holy book of Muslims), Hadith (a narrative relating the deeds and statements of Prophet Mohammad S.A.W.), Sunnah (the practice of Prophet Mohammad S.A.W.), Ijtihad (the reasoning of Sharia scholars), Qayas (the use of assumption by analogy to provide a judgment on a case not referred to in the Qur’an or Sunnah) and Ijma (the consensus among religion scholars about explicit issues not envisaged in the Qur’an or Sunnah).

The central feature of the Islamic financial system (IFS) is the elimination of the payment and receipt of interest (or Riba). One of the verses from the Holy Qur’an regarding “interest” is given below. The strong condemnation of interest by Islam and the fundamental role of interest in modern commercial banking systems led Muslim thinkers to discover ways and means by which banking could be prepared on an interest-free basis. Sharia mortgages are considered to be the only counterpart of conventional mortgages. Islamic home financing is the standard method for commercial and residential real estate financing without paying the full value of the house upfront. In developed countries like the UK and USA, house prices are above average personnel reach (to pay the full value upfront). Similarly, according to the Office of National Statistics, there are around 1.8 million Muslims living in the UK, so owning a house could be made possible by compromising on religious

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belief, as a Muslim concept of a conventional mortgage, based on interest and debt-based financing, is in conflict with Islamic principles and Sharia.

In its early days, Islamic mortgages were considered to be painstaking, and there was a real dearth of Halal mortgage providers in the UK; up until 2002 there were only two—the United Bank of Kuwait (formerly known as Ahli United Bank) and the West Bromwich Building Society. A major development in the market was seen in 2003 after the removal of double stamp duty and the emergence of HSBC Amanah Finance and United National Bank, followed in 2004 by Lloyds TSB and Alburaq Home Finance in the Islamic mortgages sector.

Section 4. The Growth of Islamic Financial Institutions

According to the reports of Maris Strategies and Karina Robinson (2007), the growth of Islamic financial institutions increased significantly from 2006 to 2007. Table 8.1 shows the total figure of regional and global growth of Islamic financial institutions in different regions and demonstrates the growing appeal of Islamic financing to non-Muslim institutions and investors. £ million 2007 2006 %change GCC 89064.78 63913.28 39.35% Non-GCC MENA 88411.10 68078.82 29.87% MENA total 177475.86 131992.09 34.46% Sub-Saharan African 2353.99 1519.66 54.90% Asia 59673.23 49534.78 20.91% Australia/Europe/America 10737.86 10150.12 5.79% Global Total 250240.94 193016.65 30.88% Table 8.1. Regional and Global Growth Totals (Maris Strategies and The Banker 2007)

4.1. Islamic Financial Infrastructure

The most significant sign of the development of Islamic financial institutions is the completion of infrastructure at the international level. Although many Islamic banks are still at the initial stage of this process, they are progressing satisfactorily with the passage of time.


4.2. Sharia Governance

IB has the basic responsibility to make sure that all the products, instruments, operations, practices, management etc. comply with Sharia principles. Sharia governance is another constituent that is exclusive to IB and serves as the backbone of the IBF. It supports legitimacy and confidence in the general public and shareholders. The existence of non-Sharia compliant constituents in the IBF introduces several risks like fiduciary and reputation risks. Compliance with Sharia principles will be achieved by having a proper Sharia governance framework, which includes a Sharia board (SB), corporate governance, regulators (FSA), taxation and the role of auditors, which are discussed in later sections of this study. Principle 3.1 of the “IFSB Guiding Principles on Corporate Governance” states that suitable methods must be shaped to make sure of compliance with the Shariah principles. Similarly, Principle 7.1 of the “IFSB Guiding Principles on Risk Management” states that Islamic banks should have in place necessary systems and controls, including an SB/advisor to ensure compliance with Sharia principles (Hassan 2007).

4.3. The Role of the Sharia Board in Islamic Banking

“The Shariah board is not just a codified body of directives; it is a theoretical form of proficient adaption, improvement and a construal body” (DeLorenzo 2003). Practically, the major responsibility of the Sharia board is to review and verify the acceptability of Islamic contracts and products with reference to the Qur’an (the Holy Book) and Sunnah (the practices of Prophet Mohammad S.A.W.). Furthermore, this is divided into two dependent sources: Ijma (consensus) and Ijtihad /Qayas (individual reasoning by analogy).

The AAOIFI Standard requires at least three individuals but the legal/statutory requirement varies. In contemporary practice, most Islamic financial institutions appoint between three and six members to their board. With regard to the reporting structure, the SB reports functionally to the Board of Directors, which replicates the status of the Sharia Committee as an independent and autonomous body of IB.

4.4. The Role of Corporate Governance

Corporate governance is understood to mean accountability, transparency and fairness of a company’s management and board of directors to shareholders, depositors and other stakeholders, which includes financial

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institutions, financial market and supervisory authorities and other providers of finance.

The issues of corporate governance arise from the violation of the fulfilment of the promises. The basic issue is the principal/agent problem, because there is separation of management and finance or ownership and control. The principal/agent problem is very complex in banks because of high leverage and other systematic risks. The problem also lies in the Murabaha contract, where there might be a conflict of interests between financier and entrepreneur. Both parties want to enjoy the maximum share of profits, and this is only possible when the relationship is based on honesty, efficiency and equity. Therefore, in order to maintain wider benefits of all the stakeholders and the wider economy, effective corporate governance needs to be implemented in all Islamic financial institutions (Chapra & Ahmed 2002).

According to Al-Jarhi (2000), the corporate governance mechanism for Islamic banks is explained below.

Shareholders—IB acts as a corporate entity and thus they abide by the UK corporate law, which clearly defines the rights of shareholders to monitor the performance of IB through annual results, external auditing, the annual general meeting, as well as by sitting on the board of directors.

• Demand Depositors—regulators (FSA) always stand to ensure that

demand depositors are getting the guarantee of the value of their deposits and are able to transfer or withdraw their funds at reasonable costs.

• Investment Depositors—sit on the board of directors to monitor the banking operations to make sure that risks and other issues are managed with due care, scrutinizing deposits so that people can sell and buy certificates of deposits at will, and ensuring the rate of return on investment deposits is calculated on the basis of total performance so the whole pool can increase investor confidence.

• Regulators—the regulators of IB monitors three types of supervision: Sharia supervision to ensure that the bank is providing quality products, financial supervision representing the financial position and management of bank, and finally operational supervision which determines the applications of necessary procedures for the placement of funds.

• Financial Market Authorities—the authorities must ask a proper procedure for standardization of Islamic financial instruments and contracts and set measurements of transparency and disclosures, and the rules of Sharia-compliant trading must be recognized.


• Islamic Finance Community—standardisation of Islamic financial products, contracts and products as well as unified Sharia, accounting, regulatory and supervisory standards which are internationally acceptable, increasing the confidence of the Islamic financial community.

• Financial Community—high standards of transparency and disclosure with competitive behaviour increase the confidence of overall financial community in Islamic banking.

• The Public—the public is always interested in quality financial services and products at competitive prices.

According to Suleiman (2000), the corporate governance structure

shown in Fig. 8.2 below drafts an intangible framework of corporate governance for any Islamic bank. The Sharia Supervisory Board (SSB) and the internal controls are central to the framework. In promoting good corporate governance, IB is required to report their performance overview and corporate governance practices. The performance overview requires the IB to disclose their review on performance, measures, business plans and strategies, at the same time as the statement of corporate governance requires IB to disclose the composition and responsibilities of the board, internal audit and control activities and risk management strategies and policies. These report requirements are vital for providing additional information to users in appraising the performance and conduct of the bank.

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Fig. 8.2. Corporate Governance Framework Source: Suleiman (2000)

4.5. The UK Islamic Mortgage Market

Although the Islamic mortgage industry is still young and faces obstacles, it is growing at a phenomenal rate. With over 1.8 million Muslims living in the UK and conventional mortgages being hit by sub-prime mortgages, practitioners and academics predict that the Islamic mortgage industry will continue to grow. A survey conducted by Datamonitor suggests that the UK Islamic mortgage market could be worth approximately £1.4 billion by 2009. According to researchers, Islamic mortgages have grown at an


average of 68.1% per year since 2000; in contrast to the total mortgage markets, they have an average growth of 16.2%. The Islamic mortgage market is now worth GBP 164 million (allbusiness.com). Datamonitor (1999) research reveals that out of 1.65 million estimates, 300,000 Muslim adults in the UK have annual incomes in the region of £30000 and above. This means that approximately 25% of all adult Muslims have excellent prospects for Islamic mortgages.

One survey conducted by the CIA (Central Intelligence Agency) in 2007 estimated the total population of Muslims as being about 1.61 billion. Islam is the fastest emerging religion in Europe as well as the world (CIA 2007). There are about 1.8 million Muslims living in the United Kingdom and half a million are frequent visitors to the UK. Twelve million Muslims live in the EU, mostly in France, Germany and the UK.

4.6. Cost Involved in Sharia-compliant Mortgages

Up until 2003, double stamp duty was the biggest issue facing homebuyers. Double stamp duty was the tax implication of the house which is paid first by the financier and then by the mortgage holder. This leads to the payment of stamp duty twice where the final homeowner has to pay the cost. Thus, Islamic mortgages became more expensive than conventional mortgages. However, this tentative block has now been removed, with the then UK chancellor Gordon Brown announcing the change in his 2004 budget speech.

Another issue related to the cost of Islamic mortgages is related to legal costs, where it has not been clear whether a single solicitor can advise both the financier and the purchaser in the case of an Islamic mortgage, because the bank is acting as owner of the property.1

Another reason why the Sharia-complaint mortgages are costly is because the Islamic departments within the banks offering Islamic mortgages have had to allocate the funds in such a way that they were not raised through investments in non-Sharia industries, e.g. tobacco, drugs, pornography, gambling etc.2

According to Paul Sheeran, who is the head of Islamic financial services at Lloyds TSB, Islamic mortgages are costly because banks share more risk in a Sharia compliant mortgage, and to keep Sharia rates remaining competitive with lenders' standard variable rates is a tough job.

1 Fiscusmortgages.co.uk. 2 Mortgageman.co.uk

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There was a dearth of competition from 2003 and Islamic mortgages were charged at a premium to the interest-based mortgages in the market. However, now many high street banks have, over the last few years, introduced Sharia-compliant mortgages and therefore the cost of Islamic mortgages is competitive in the market. It is said by researchers and practitioners that with the passage of time, the removal of regulatory and supervision obstacles and with increasing competition, it will be more competitive and cheaper in the future.

4.7. Islamic Mortgage Structures in UK

According to Ainley et al. (2007), the Islamic mortgages in UK have been structured under two different Sharia-compliant contracts—Murabaha and Ijara. In Ijara-based contracts, Ijara and Diminishing Musharakah are the most commonly used methods in the UK for home financing. These are available to all consumers and not just Muslims. In both types, the financial institution receives a rate of return on its investment, although both models are designed and structured to avoid the use of interest payments. 4.7.1 Murabaha Contract In the case of home financing, the bank purchases assets/property at the request of a customer for a deferred price, which comprises an agreed profit added to the actual cost. The bank retains the property until the final instalments are paid. According to many ordinary Muslims, Murabaha-based mortgages are similar to interest-based mortgages, but the Murabaha is lawful by consent of Muslim scholars. However, to make this transaction lawful, two separate transactions should be met by the Islamic financial institution, and the bank must first own a property and sell it to the customer. Fig 8.3 below demonstrates the application of this method to mortgages.

Apart from the complexity in Islamic banking in each transaction, the issue of security is common to all, making sure that the advancement of money for sale in favour of the buyer is supported by sufficient security. Current Islamic banks require the client to provide security other than the contract subject matter.

4.7.2: Default and its Consequences in Murabaha In the case of default by the buyer in the payment of the price, at the due date, the price of the commodity cannot be increased. However, as


mentioned above, that seller can charge a certain amount or a certain proportion, such as 5% of rental for a charitable purpose.

Murabaha mortgages were offered by the Ahli United Bank Ltd. (UK) and referred to as Manzil Home Purchase Plans. For the Murabaha scheme, banks require a deposit of 17–25% depending on the value of the property and residential status of the customer, the payment term laying between five and fifteen years. Customers can repay the outstanding balance at any time and payments are fixed for the term of the arrangement (Islamicmortgageadvice.co.uk).

Fig. 8.3. Murabaha Contract Source: Lovells (2008)

4.7.3 Ijara contract Ijara literally means, “to give something on loan,” and in principle it narrates the “transferring the usufruct of a particular property to another person on the basis of a rent claimed from him” (Lewis & Algaoud, 2001). The person employing these services is called Musta’jir, and the person rendering their services is called A’jir. Ijara is the most attractive method of property finance according to Sharia scholars and practitioners. It is a more flexible than Murabaha, allowing the customer to repay the

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mortgage early with one payment, or to make additional “overpayments.” Ijara shares many characteristics with lease financing and hire-purchase arrangements. It involves a lessor (usually a bank) purchasing a property and renting it to a lessee (customer) for a specific period at an agreed rent.

There are two main types of model under the Ijara structure. The first model is Ijara wa lqtina, a longer-term lease that usually ends with the transfer of ownership of the property to the lessee, similar to a modern finance lease. The second model is Diminishing Musharakah, a shorter-term lease which usually ends with the financial institution keeping possession of the property, which is similar to an operating lease. According to the Ijara structure, the bank and customer jointly owns a property where the customer buys out the bank’s share over time. Fig. 8.4 below demonstrates both types of model.

Fig. 8.4. Ijara Contract Source: Lovells (2008)


4.8. The Regulatory Position of Islamic Mortgages

FSA chairman Callum McCarthy said in 2007 that: “Islamic finance is a fast growing force in the world economy and the FSA's open principle-based approach to regulation offers the right environment for it to flourish in the UK. There is huge potential for an expansion of Islamic offerings in the UK's financial markets, which will in turn boost London's position as an international financial centre.” The UK government and the FSA have taken crucial steps to create an even playing field for both institutions. The Finance Act 2007 was a breakthrough in which the government brought Ijara-based mortgages into the FSA regulatory framework, whereas before that, only murabaha were regulated by FSA.

According to the FSA,3 Ijara mortgages are a type of equity release product, and these products are generally designed for older homeowners to enable them to take advantage of the value of their home without moving from it. For regulatory purposes, these contracts are called Home Purchase Plans (HPP) and Home Reversion Plans (HRP). These two methods of financing home purchase are acceptable under Islamic law. The other is the Murabaha, which is already regulated under the FSA’s mortgage scheme from October 31, 2004.

According to Basel 1, Murabaha-based mortgages were considered to have the same risks as conventional mortgages, weighted at 50%. However, the Ijara-based mortgages were risk-weighted at 100%, which is another reason for the providers to make it slightly more expensive than conventional mortgages. Under the European Union Capital Requirements Directive, the risk weight of all three products (i.e. HPP, HRP and Murabaha) are the same in the UK, and are set at 35% under the standardized approach.

The FSA has now given clear frameworks to promote change in the market place. It is now the responsibility of Islamic Financial Institutions to bring innovative products, since there are no hurdles to the regulation as long as UK consumers are satisfied and receive the benefits.

3 www.Fsa.gov.uk/pages/library/communication/pr/2006/041.shtml

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Section 5. Comparison between Islamic and Conventional Mortgages

Conventional Mortgage Islamic Mortgage

The lender advances funds to the borrower and charges interest for the use of their money.

Based on trade [Murabaha] and leasing [Ijara], Islamic mortgages are interest free.

Credit references and sources of income make it possible to retune the loan before the age of sixty-five.

Credit references and sources of income make it possible to retune the loan before retirement age.

The lender has no lower limit to the property value.

The minimum property value is £50,000.

Up to 125% of the property value. Up to 80% of the property value

Life and building insurance are mandatory in most cases.

There is no compulsory life and building insurance is required.

The lender never owns the property. The bank puts itself in the position of owner of the property. This carries with it higher risks.

Payment term up to forty years. Murabaha up to fifteen years, minimum five years Ijara up to twenty-five years, minimum seven and a half years

Income multiples up to five times primary annual income of a sole applicant.

Murabaha 2.5 times primary annual income Ijara 3 times primary annual income of a sole applicant

Arrangement fee usually up to £500.

Arrangement fee of 0.75% of the property value, less the first payment.

Table 8.2.

5.1. Comparison Analyses

Islamic banking has the same purpose as conventional banking, except that it operates in accordance with the rules of Sharia known as Fiqh al-


Muamalat (Islamic rules on transactions). The basic principle of Islamic banking is the sharing of profit and loss and the prohibition of riba (usury). Common concepts used in Islamic banking include profit sharing (Mudharabah), safekeeping (Wadiah), joint venture (Musharakah), cost plus (Murabahah), and leasing (Ijara).

According to Dar & Presley (2000), Islamic banks (IB) act as an intermediary and trustee of people’s money just like a conventional bank, but the reimbursement to all depositors is done on a profit and loss sharing basis. This basic difference establishes an element of mutuality in the wider socio-economic context and provides the right of ownership to its customer. However, in practice Islamic banks are similar to their conventional counterparts in terms of organizational set-up.

5.1.1 Conventional Mortgage For example, if the price is £100,000 , the banks require a 10% deposit. If the bank agrees to give a thirty-year mortgage of £90,000 and at an annual interest rate of 8%, the monthly payments would be £660.39. Each payment will partly consist of interest due and partly the repayment of principal. The buyer will make 360 monthly payments, which add up to a total of £237,740.40 paid to the bank, accruing £147,740.40 in interest (see Table 8.3 below).

Table 8.3. Conventional Mortgage

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5.1.2. Islamic Mortgage (Co-Operative Bank) Just as in the conventional arrangement, the bank will require some down payment, which will be the client’s initial equity share. If we assume the client makes the same down payment of 10%, or £10,000, and the co-op bank puts up the remaining £90,000, the client and the bank are now co-owners. If the client occupies the house, the client will be required to pay rent to the owners. However, the client is also allowed to increase their ownership share at any time by making additional payments to the co-op bank, in effect buying out the bank’s interest in the house. As the client does so, their proportionate share increases while the co-op bank’s share decreases and the distribution of the rent payments change accordingly.

The big question, of course, is what is a fair amount for the monthly rent? It might be reasonable to assume that it is equal to the monthly payments clients would have made under the conventional mortgage arrangement, in this case £660.39. At the outset, the client will receive 10% of that rent as their ownership share and the co-op bank will receive 90%. Let us also assume that the client applies their share of the rental payments to increasing their share of the ownership. Table 8.4 below is an abridged amortization table, which shows the respective returns to client and the co-op bank. Under this arrangement, the client will own 100% of the property after making the 350th payment. The client will have paid a total rent of £231,018.30. The bank’s total share will have been £141,018.30. This is a saving of more than £6,000.00 or 4.1% over the amount of interest paid on the conventional mortgage.


Table 8.4. Shared equity mortgage

5.2. Problems in the Provision of Islamic Home Financing in the UK

Discussions have been taking place with the Bank of England and the Financial Services Authority (FSA) on these issues. HSBC (Amanah Finance) offers Islamic financial products since 2003. It is not inconceivable that the provision for Islamic home financing in the UK exist, as the regulatory authorities have already approved Islamic mortgages in the US. Khan believes that Islamic finance has potential appeal for the mainstream as well as Muslim consumers because of its ethical basis: “Islam teaches us that money should be channelled toward the 'real' economy, the production of real goods and services and not the 'financial' economy such as hedge funds and derivatives,” he argues. “It keeps us in touch with the real economy and away from speculation.”

A document jointly prepared by the Barclays Group, HSBC, the Union Bank of Switzerland, Ihilal UK and the United Bank of Kuwait lists the following major barriers to the provision of Islamic home financing in the UK:

(a) Under current regulations on lease agreements, the product has to be

100% risk weighted. In other words, HSBC (Amanah Finance) says it has to set aside the full amount of the property to cover the full value

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of the house in case the buyer cannot afford to pay the rent, whereas a conventional mortgage has a risk weighting of only 50%.

(b) Another impediment for Islamic mortgages is the prospect of double stamp duty. The first would arise when ownership is transferred from the seller to the bank at the start of the lease. The second would occur at the end of the lease. For an Islamic mortgage to be viable for a bank, the bank needs to be exempt from the second set of stamp duty. Former Barclays boss Andrew Buxton chairs a working party on Islamic mortgages set up by the Bank of England, and believes that a change in stamp duty rules could result in 500,000 more mortgages.

(c) Unlike a conventional mortgage, the proposed product would require two sets of solicitors. Islamic institutions would also want an exemption from a second set of solicitors.

(d) A final issue is the inability to obtain financial assistance from the state in cases of financial hardship.

Conclusion

The future is definitely dazzling and glorious for Islamic banking and its financial products such as mortgages, Sukuk and Takaful. After this detailed study of IB, the researcher concludes that IB is currently convincing the world that as a system, it not only covers the ethical aspect of society but also gives an economic benefit. However, it is not a justified argument to position IB as a real competitor of conventional banks because the industry is in its infancy and will take more time to prove itself over its conventional counterpart.

Corporate governance provides effective tools in IB, and financial institutions are internal control systems, providing the facilitation of the risk management culture, enhancing the transparency of banking operations, and allowing for the proper selection and use of accounting standards and disclosure about credit quality, external audit, Sharia clearance and Sharia audit (Chapra & Ahmed 2002).

As far as Islamic mortgages are concerned, among the methods discussed above, Diminishing Musharakah seems to be the solution to the problems faced by Muslims when buying a home because it is closer to the principle defined in Islamic jurisprudence.

Islamic principles of interest are concerned with issues of fairness and justice rather than narrowly defined efficiency. These principles focus on the necessity of sharing risks in a fair and stable society, and upon problems of exploitation in markets where power is asymmetric, which is the real Riba (usury) issue.


Our case analyses show that the principle differences between Islamic and conventional home finance is that the former is equity based and the latter is debit based. In an Islamic mortgage situation, both the bank and the client share ownership (equity) and therefore share the risk of equity ownership. In conventional banking, the client owns all the equity and the bank loans to the client are secured on the value of the property.

Putting aside the penetrating comment by Ahmed, (“It’s not clear to whom we are cheating …”) regarding hypocrisy in the current practice of Islamic banks, let us deal with the realm of the ideal. Consider an ideal situation in which Islamic principles of interest are adhered to by a substantial proportion of the world financial system. What they have in common is a prohibition of usury, or excessive interest rates. Could such an idealized system conceivably survive as a foundation of banking in a hypercompetitive global financial environment? Pure logic would dictate that this is not possible in a profit-maximizing world; that is, if excessive interest rates reflect high-risk situations or situations of capital shortage, both of which would require high interest rates that might be considered usurious. We remarked at the beginning of the chapter on the recurrent crises in the financial sector. Maladministration, deception and ethical behaviour lie at the root of many of these problems, and Enron and WorldCom are just two examples of this. The Islamic approach emanates from a foundation of ethical principles. Therefore, discussion of Islamic finance in connection with global financial practices introducing an ethical dimension is welcome. As Khan (2002) points out, an Islamic system of finance might create a more stable world financial market.

References

Abdul, Gafoor. (2004). Interest, Usury, Riba, and the Operational Costs of Banks. AS Noordeen UK.

Ahmad, Ziauddin. (1994). “Islamic Banking: State of the Art.” Islamic Economic Studies 2 (1): 1–34.

Ahmed, Habib & Chapra, M. Umer. (2002). Corporate Governance in Islamic Financial Institutions (Translated into Arabic). Jeddah: Islamic Research and Training Institute, Islamic Development Bank Group.

Ahmed, S. (1992). Towards Interest-Free Banking. New Delhi: International Islamic Publishers.

Al-Jarhi, Mabid Ali and Munawar Iqbal. (2000). Islamic Banking: FAQS, Jeddah: IRTI. Occasional Paper # 4.

Al Tamimi & Company. (2004) “The Development of Shariah Compliance Services.” Islamic Banking Seminar Series.

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Aryan, Hossein. (1990). “Iran: The Impact of Islamisation on the Financial System.” In Rodney Wilson (ed.), Islamic Financial Markets, Rutledge, London, 155–70.

Calhoun, C. A. & Deng, Y. (2002). “A dynamic analysis of fixed and adjustable-rate mortgage Terminations.” Journal of Real Estate Finance and Economics 24 (1/2): 9–33.

Campbell, J. & Cocco, J. (2003). “Household Risk Management and Optimal Mortgage Choice.” Quarterly Journal of Economics 118: 1449–1494.

Chapra, M. The Future of Economics: An Islamic Perspective. Leicester, UK: The Islamic Foundation, 2000.

ChinTiong Tan & Christina Chua. (1986). “Intention, Attitude and social influence in Bank selection: a study of oriental culture.” International Journal of Bank Marketing 4: 88–27.

Council of Mortgage Lenders (2004), Annual Mortgage Surveys, carried out for CML by NOP/MINTEL, February 2004.

Dar, A. H. & Presley, J. R. “Islamic Finance: A Western Perspective.” International Journal of Islamic Financial Services 1 (1) (2000): 1–6.

Dar, A. Islamic House Financing in the United Kingdom: Problems, Challenges and Prospects. London, 2002.

Datamonitor. (1999). http://datamonitor.com censes report. Davies, Ross. (2002). “Super-rich Ranks Growing Again.” Evening

Standard (London), February 8, 2002; http://www.thisismoney.com/20020208/nm44034.html

Druckers, John. (2002). Birmingham Post, September 21, 2002. Fisher, I. (1945). The Theory of Interest. New York: Macmillan. El-Gamal, M. (1997). “Can Islamic Banking Survive a Micro-

Evolutionary Prospective?” International Journal of Islamic Financial Services.

El-Qorchi, Mohammed. (2005). “Islamic Finance Gears Up.” Finance and Development 42 (4): 46–50.

Erol, C., Kaynak, E. & EL-Bdour, R. (1990). “Conventional and Islamic banks: partronage behaviour of Joordanion customers.” International Journal of Bank Marketing 8: 25–35

Friedman, M. (1969). “The Monetary Theory And Policy Of Henry Simons.” In Friedman, M., ed., the Optimum Quantity of Money and Other Essays, 16–23. Aldine, Chicago.

Hassan, K. (2007). “Islamic Financial Services.” Presentation at KPMG Insurance Industry Leadership Conference, November 2007.

Haqiqi, A. W. & Pomeranz, F. (2005). “Accounting Needs of Islamic Banking.” http://islamic-finance.net/islamic-ethics/artcile12.html


(accessed retrieved October 16, 2005). Islamic finance research paper By Robin Matthews, Issam Tlemsani,

Aftab Siddiqui James, Mawson. (2002) Financial Times, February 25, 2002 Khan, M. (1986). “Islamic Interest-Free Banking: A Theoretician

Analysis.” Staff Papers of the IMF, 33, 1–27. —. (1999). “Financial Modernization in 21st

Century and Challenge for

Islamic Banking.” International Journal of Islamic Financial Services 1 (3).

—. “Monetary Policy and Central Banking in an Islamic Context.” Paper presented at the Islamic Banking Conference, London, May 7–8, 2002.

Lewis, M.K. & Algaoud, L.M. (2001). Islamic Banking. Cheltenham, UK: Edward Elgar.

McDoughall, G. & Lévesque. (1994). “A Revised Review of Service Quality Dimensions: an Empirical Investigation.” Journal of professional service Marketing 11 (1): 189–210.

Naser, K. (1988). “Comprehensive of Discolour of Non Financial Companies Listed on the Amman Financial Market” International Journal of Commerce and Management 2: 56–65.

Norwood, G. “The Housing Boom that Forgot Muslims.” The Observer, June 16, 2002. http://money.guardian.co.uk/homebuying/mortgages/story/0,1456,739195,00.html.

Robinson, Karina. (2007). “Islamic Finance is Seeing Spectacular Growth.” Banking Matters, Monday, November 5, 2007

Simons, H. Economic Policy For A Free Society. Chicago: U. Chicago Press. 1948.

Sudin Haron, Norafifah Ahmad, (1994) “Bank patronage Factors of Muslim and non-Muslim customers.” International Journal of Bank Marketing 13: 74–34.

Wilson, R. (1997). “Islamic Finance and Ethical Investment.” International Journal of Social Economics 24 (11): 1325–1342.

Yaqubi (2006) International Islamic Financial Market launches several industry-building new initiatives, News Updates Centre (IFM).

Zarqa, M. (1983). “Stability in an Interest-Free Islamic Economy: A Note.” Pakistan Journal of Applied Economics 2: 181–88.

CHAPTER NINE

THE “ISLAMIC BANK OF BRITAIN”: CASE STUDY ANALYSIS


Late in the nineteenth century, when Muslim countries and their populations were politically and economically at low ebb, a modern banking system was introduced. In order to have regular exports and imports from the countries concerned, the main banks in the home countries of the royal powers established local branches in thе capitals of the subject countries. As a result, the local population remained largely untouched by this new banking system. This led to a situation where local business communities started to avoid these “foreign” banks’, both for patriotic and religious reasons. This system worked for a short period, and as time went on it became difficult to engage in trade and other activities without making use of commercial banks. Even then, many confined their involvement tо transaction activities such as current accounts and money transfers. Borrowing from banks and depositing savings into banks was strictly avoided so as tо keep away from dealing in interest, which is prohibited by Islam (Zechmeister, 2007).

Preventing interest on all sorts of personal, commercial, industrial and agricultural loans led to the formation of Islamic banking. Islamic banking follows strict Islamic laws which prohibit interest in all sorts of business. Islamic banking is based on certain codes which prohibit them from paying or receiving any interest in their business. These codes led to the formation of profit and loss sharing. Through this approach, Islamic banking attracts both the lender and borrower to work with each other under certain limits. Profit and loss sharing allows both lender and borrower to share any loss and profit on a sharing principle. This profit and loss sharing principle is the only basis upon which Islamic banking leads in the modern era (Metwally, 1997).

The “Islamic Bank of Britain”: Case Study Analysis 245

Section 2. Objectives of thе Study

This chapter’s two major features are first to analyse the financial performance and growth of the “Islamic Bank of Britain,” and second to use survey methodology to obtain primary data and assess the degree of customer satisfaction towards Islamic banking in the UK. Furthermore, the chapter reports on the extent to which Muslims in the UK are aware of the Islamic bank's products and services. The chapter also discusses the implications for the Islamic bank in the UK.


The last two decades have witnessed the Islamic banking system as gaining worldwide momentum, a fact which is quite clear from the 180 Islamic banks and other financial institutions based on Islamic principles operating in Asia, Europe, America and Africa. Collectively they have 8,000 branches throughout the world with an estimated worth of $170 Billion (Alford & Sherrell, 1996).

Regular growth along with modernization is going to convert a large number of customers from the conventional banking system to the Islamic banking system (Shepherd, 1996). Through Islamic windows, Citibank, ANZ, HSBC and other big names from conventional banking are now providing various Islamic financial services. Islamic banks are now no longer the only institutions to provide Islamic financial services; even conventional banks provide them. This creates a lot of competition between the two financial institutions (Cunningham, 1994).

Islamic banks are currently going through a developmental stage. Concurrently, conventional banking is at a boom. This makes it more difficult for Islamic banks to compete with the conventional banking system in all fields (Nienhaus, 1986). In addition, it is easy for conventional banks to attract more customers compared to Islamic banks. The main reason for this is that they are serving customers in various fields. This gives them the opportunity to present their products and services to the customer very easily (Al-Omar & Abdel-Haq, 1996). The counterargument, however, is that the conventional banks' movement into Islamic banking is advantageous, since its wide-scale practice will make customers more aware and diminish any apprehension toward it (Al-Omar & Abdel-Haq 1996). It is necessary for the conventional and Islamic banking systems to co-operate with each other to create more profit from their products. This will also allow them to present their products in good shape (Kutty, 1995).

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A new study reveals that the growth rate for the world’s largest one hundred Islamic banks was 26.7 % as compared to the conventional banks growth rate of 19.3%. The growth reported by Islamic banks was $350 billion (March 2008). The outstanding growth shown by Islamic banks is also demonstrated in non-Muslim countries. The breakdown for growth in Islamic banks is shown in Fig. 9.1.

Fig. 9.1. Breakdown of the world’s one hundred Islamic banks

Section 3. Islamic Banking in the United Kingdom

The number of Muslims residing in the UK is about 1.8 million, constituting 3% of the population. Fifty per cent of these are estimated to reside in the London area. The number of Muslims visiting the UK on a regular basis is about half a million. Apart from these, twelve million Muslims are living in the EU, the majority in France and Germany (Moyer, 2000).

The United Bank of Kuwait and HSBC in London are banks with Islamic banking divisions. Both banks, irrespective of their locations, regularly receive enquiries regarding the availability of Islamic finance products. The main enquiry is about Islamic compatible finance to purchase both residential and commercial properties. It is believed that а large number of Muslims abstain from taking a conventional mortgage because of its incompatibility with Islamic principles. The needs of these Muslims need to be served immediately (Gamblіng, 2004).


Many banks in the UK offer Islamic financial products. Their products range from savings accounts to home finance in the form of Ijara. The FSA in the UK authorized the first retail bank based on Sharia under the name of the “Islamic Bank of Britain,” thus making the UK the first country in the West to officially start Islamic banking under Sharia principles. A wide range of growth later forced the FSA to authorize the European Islamic Investment Bank.


The bank selection criteria are expected to affect a customer’s overall satisfaction towards their bank (Levesque & McDougall, 1996). Various studies have investigated bank selection criteria or the reasons behind customers selecting specific banks. These studies identified a number of factors influencing customer’s decisions regarding bank selection criteria, such as. competitive interest rates, recommendations, the reputation of the bank, their credit facility, the co-operation of bank staff, convenient banking hours, quick services, the availability of ATM, parking arrangements, service charges, special services and quality of service on the checking of accounts. The significant importance of these factors varies from country to country depending on the age, gender, income, material status, occupation and cultural background of customers. For example, research in the Canadian Bank expresses that key factors in this decision seem to hinge upon lower borrowing rates and higher interest rates on deposits as well as better overall customer service. In spite of the trend of banks towards “one-stop-banking centres,” Hegazy (1995) investigated bank selection criteria for both Islamic and conventional banks located in Egypt. He concluded that the selection attributes for the former are different than for the latter. For Islamic banks it was found that the most important factor was advice and recommendations made by relatives and friends.

Anderson et al. (1976) and Laroche & Taylor (1988) report that convenient location is one of the significant factors influencing the choice of bank by customers. However, Tan & Chua’s (1986) findings show that being located conveniently was not an important factor for Singapore respondents; rather, it was courteous service, since Singapore is a small city and most banks are conveniently located. From these results, bank marketers can develop advertising that stresses the concept of family or friends. On this basis, Tan & Chua (1986) argued that, in an oriental culture, customers desired a more intimate interaction with bank personnel. Ta & Har (2000) made a study of bank selection decisions in

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Singapore using the analytical hierarchy process. The findings indicate that undergraduates place a high emphasis on the pricing and product dimensions of bank services.

The study of Erol & El-Bdour (1989) deals with the attitude of Jordanian people towards interest-free banks. Their findings show that religiosity was not the main determinant of bank selection criteria. Sudin et al. (1994) undertook a study to determine the factors considered important by customers in selecting their financial instruments as well as other products. They used a sample of Muslims and non-Muslims living in three medium-sized towns in Malaysia. The three most important criteria in bank selection for Muslims were the provision of fast and efficient service, the speed of transactions and the reputation and image of the bank.

Kaynak et al. (1991) reported differences in bank selection criteria according to gender, age and educational background of bank customer in Turkey. They reported that factors such as the bank’s reputation and its image, business hours, parking facilities, range of services offered, recommendation of friends and relatives, fast and efficient services, ability to pay utility bills and provision of financial counselling services were considered more important by male than female customers in their selection. Furthermore, the bank locations played a more important role for customers under forty, as compared to other age groups studied. Kaynak et al. (1991) also reported that bank customers who had a higher than primary school education considered the friendliness of bank employees, a fast and efficient service, the bank employees, the bank location and availability of credit more important than the customers who had only a primary school education.

Denton & Chan (1991) investigated multiple banking behaviour in Hong Kong and found statistically significant differences in the evaluation of the relative importance of these factors on multiple banking behaviour based on sex, age, marital status, income and education discriminators. Levesque & McDougall (1996) looked into the major determinants of customer’s satisfaction in the retail banking sector in Canada. They collected information from 325 respondents who rated their respective banks on various aspects such as service quality, service problem recovery, service feature, product usage, and satisfaction and future intentions. Their study found that customer satisfaction in retail banking was driven by a number of factors. These factors included service quality, the bank’s features (such as location), the competitiveness of the bank‘s interest rates, the customers’ judgement about the bank employees’ skills and whether the customer was a borrower or not. The study also found that whether the customer was a single or multiple bank user was not a


significant factor. The study confirmed and reinforced the idea that unsatisfactory customer service would reduce willingness to recommend the service to a friend. This could result in increased switching by customers.

In the study by Metawa & Almossawi (1998), the banking behaviour of Islamic customers in Bahrain was investigated with a sample of three hundred. The study reveals that there are two most important bank selection criteria: adherence to Islamic principles and the rate of return. Almossawi (2001), in an empirical analysis on bank selection criteria employed by college students in Bahrain, suggests that it may be necessary to deal with male and female students as distinctive segments with different priorities in their bank selection process. Naser et al. (1999) found that the most important bank selection criteria for customers of Islamic banks was “the image of the bank” followed by compliance to Islamic principle. The study by Erol & El-Bdour (1989) deals with the attitude of Jordanian people towards interest-free banking. For this aim, the author designed nine questions and/or statements that were published in the appendix of their article. It appears from the said study that religiosity was not the main determinant of bank selection, whereas the level of profitability (return on investment) was one of the main factors in Jordan. The above studies were conducted almost a decade ago and not in the United Kingdom, and therefore it was considered appropriate and timely to investigate the bank selection criteria adopted by the “Islamic Bank of Britain,” being the only indigenous bank of its kind.

Section 4. The Islamic Bank of Britain

The motive to form an Islamic bank based in the UK came from one of the non-executives from the Middle East in 2002. Initially, under the name of the Islamic House of Britain, the company started negotiations with the FSA to start its operations in the UK. With a start-up capital of £14 million in August 2004, the FSA granted permission to the bank to operate under the name of the Islamic Bank of Britain (IBB).

The IBB has grown vigorously with the passage of time, showing enormous growth in the majority of fields. The number of customers for 2007 was 42,000, as compared to 30,814 for 2006, a growth rate of 36.30%. The number of customer deposits in 2007 was £135 million, showing a growth of 60.91% as compared to the customer deposits of £83.9 million for the year 2006. The number of customer financing for 2007 was £15.8 million, showing a growth rate of 51.92% as compared to 10.4 million for 2006. The number of account holders for 2007 was 64,000, showing a

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growth of 27% as compared to the 51,032 bank customers for 2006. With the passage of time, the bank has also started using modern technology to attract different customers. This has resulted in a quite reasonable increase in bank customers using the internet banking facility. The number of customers using online internet banking for 2007 was 10,200, showing a growth rate of 91.66% as compared to the figure for 2005. 2007 2006 2005

No of customers 42,000.00 30,814.00 14,023.00

36.30 % ↑ 119.74 % ↑

Customer deposits 135,000,000.00 83,900,000.00 47,700,000.00

60.91 % ↑ 75.89 % ↑

Customer financing 15,800,000.00 10,400,000.00 4,500,000.00

51.92 % ↑ 131.11 % ↑

No of accounts 64,000.00 51,032.00 25,403.00

25.41 % ↑ 100.89 % ↑

Online banking customers 10,200.00 8,641.00 5,322.00

18.04 % ↑ 62.36 % ↑

Total assets 164,936,827.00 118,012,095.00 89,289,500.00

39.76 % ↑ 32.17 % ↑ Table 9.1. Islamic Bank of Britain—Analysis and Projection


The primary data for this research was collected from two hundred customers of the Islamic Bank of Britain in early 2008 using face-to-face structured questionnaires. The methodology is in the spirit of studies based on questionnaires and personal interviews by Royal & Althauser (2002) on key indicators and performance drivers in the investment banking industry; Collins (2002) and Bassi et al. (2001) on human capital and the future financial performance of the firm; and Beaulieu (1994, 1996) on


bank loan officers in relation to bank’s commercial lending. Hussey (1997) also used questionnaire data collected from 12,000 customers. Data was gathered on a division basis as different divisions in the bank had different pricing, regulations and tools for customer satisfaction.

The main objective of this study was to investigate customers of the Islamic Bank of Britain, the only indigenous Islamic bank in the UK). The questionnaire focused on reason-selection criteria, customer awareness of different Islamic banking products, as well as the quality of the customer service experience. The personal, face-to-face questionnaire has been shown to be effective for survey as makes it possible to gather and quantify qualitative information (Gray 2004). It was also initially important to analyse the “demographic” characteristics of the respondents. In total, two hundred questionnaires were randomly distributed outside different branches of the bank throughout the United Kingdom.

Section 6. Results and Analysis

By using primary and secondary data, this section of the research will evaluate the findings and offer explanations. The results are shown in Appendix I and Appendix II. The focus was to get an answer to the research questions by using the findings from the research work. With the emergence of conventional banks offering Islamic financial products and services, the success and performance of banks depends on the satisfaction level of customers involved. For a country where both a conventional and Islamic banking system is operated, it is advantageous to understand the factors that motivate customer’s bank selection. Furthermore, one also wants to know the level of customer satisfaction while dealing with Islamic banks, conventional banks or both (Anderson 1976).

By collecting primary and secondary data, we conducted this study with the objective of knowing the extent of customer satisfaction for Islamic financial products within the UK. Research also focuses on the awareness level of customers towards different Islamic products. While keeping in view the customer satisfaction level, this also seeks to discover the factors on which customer make their banking selection, either to keep their business with Islamic banks, conventional banks or a combination of both within the United Kingdom.

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Frequency % Cumulative % Gender Male 96 48.0 48.0 Female 104 52.0 100.0 Age 20 or Less 9 4.5 4.5 20–30 30 15.0 19.5 31–40 87 43.5 63.0 41–50 39 19.5 82.5 51 or More 35 17.5 100.0 Religion Muslim 109 54.5 54.5 Non-Muslim 82 41.0 95.5 Marital Status Single 117 58.5 58.5 Married 74 37.0 95.5 Education Up to Foundation 9 4.5 4.5

Up to Intermediate 13 6.5 11.0

Graduate 87 43.5 54.5 Postgraduate 65 32.5 87.0 Professional 17 8.5 95.5 Job Type Professional 13 6.5 6.5 Management 43 21.5 28.0 White Collar 26 13.0 41.0 Blue Collar 26 13.0 54.0 Business 79 39.5 93.5 Table 9.2. Respondents’ Profiles

The United Kingdom was chosen for a number of reasons. The number of Muslims resident within the UK is 1.8 million. The population of Muslims within the UK is almost 3% of the total population. The large number of Muslims based in the UK forced the financial institutions to


start thinking about the specific financial needs of the Muslim community. This led the FSA to authorize the Islamic Bank of Britain, the first of its kind in the West to provide basic Islamic financial products. Keeping in view the increasing demand for Islamic financial products, many conventional banks in the UK started providing Islamic financial products through the Islamic window system. Frequency % Cumulative % Low Service Charges

Strongly Agree 74 37.00 37.00

Agree 39 19.50 56.50 Uncertain 26 13.00 69.50 Disagree 35 17.50 87.00

Strongly Disagree 26 13.00 100.00

Recommendation




Bank based on Religion




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Based on Fast Service




Based on Friendly Staff




Based on Unique Products




Bank Reputation





Parking Facility




Location




Table 9.3. Respondent’s selection criteria

Section 7. Author Findings

• The findings show that bank service charges come first when the customer makes a bank selection.

• The second finding regarded bank reputation. This means that in the UK, customers put bank reputation as the second most important selection criteria after low service charges. This may be because in a country like the UK where there is strong competition among banks, the customer is always looking for a bank with a good reputation both in the market and according to customer views.

• Recommendations from friends and relatives to select an appropriate bank came third according to the research.

• The author found that customers put their religion fourth when selecting their bank.

• The survey shows that respondents put fast and efficient services as their fifth selection criteria.

• The author also found that customers put bank staff as their sixth priority in selecting a bank.

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• The author found that customers put unique products offered from the bank, bank location and parking facility as seventh, eighth and ninth respectively as their selection criteria.

Respondent’s Bank

Frequency % Cumulative

% Islamic Bank 48 24.00 24.00 Conventional Banks 122 61.00 85.00 Both Islamic and Conventional Banks 30 15.00 100.00

Table 9.4.

As per Table 9.4 above, only 24% of respondents held accounts in an Islamic bank. However, a majority of 61% revealed that they held accounts in conventional banks, while 30% indicated that they held accounts with Islamic as well as conventional banks.

Summary and Conclusions

The reason for this study is the intensive competition and variety of products provided by conventional banking systems and the introduction of Islamic finance banks. In the United Kingdom, the competition is due to many reasons, and this contributes towards this situation. Many new players like the Islamic banking system and others like Tesco and Sainsbury’s have entered the banking market. This strong competition from various suppliers has forced the banking sector to pay serious attention to customer satisfaction and methods for attracting customers.

The finding of this study indicates that irrespective of the bank’s nature and its products, customers always prefer to select banks which provide services with low charges. This selection is mainly based on an economic point of view, meaning that bank selection has nothing to do with demographic factors. The result also shows that in a country like the UK, where a number of financial service organisations provide financial services to their clients, bank reputation plays an important role. The study also shows that friends and relatives play an important role in bank selection. This further suggests that word of mouth is the best source of


advertisement in communities, such as the Muslims in European countries, who interact on a frequent basis resulting in influencing and inspiring each other in their daily life decisions. Therefore, financial advantages from banking decisions are frequently communicated within the community and motivate others to adopt them accordingly. Decisions are rarely made wholly on the basis of religion; however, this study revealed that it is the fourth most important factor which affects the decision to select a bank. At the pace of life today, any bank with good and fast services will be highly appreciated; however, the study reveals that customers rate fast and efficient services in fifth place. The study also clarifies that bank staff have an important role in attracting new customers to the bank. When asked about their ranking, the respondents placed friendliness of the bank staff as their sixth selection criteria. The study also clarifies that customers put the availability of unique products, bank location and parking facility as their seventh, eighth and ninth criteria respectively.

It is quite clear from the study that to attract more customers, banks have to keep their service charges at a minimum level. In today’s society, where the credit crunch is coupled with other financial crises, like soaring prices in the food market, a record decline in job availability, a worsening mortgage market and a continuous increase in energy prices, the consumer is incentivised to look for cheaper services and products. The second factor to attract more customers from the vast field of customer service industry is for banks to secure good reputations, both in the minds of customers and clients. This will lead them to attract more customers, which will in turn increase their business and hence ensure their survival. The third most important factor is the role played by the world of advertising, particularly spoken word. This is the main factor customers always use to select their financial service providers.

Recommendations

Islamic banks will only survive today if they can provide good and reliable services to their clients. Islamic banks are very new in the market and they have to compete with conventional banks, which have served their clients for a long time and have strong reputations. Islamic banks cannot only rely on religion to attract their customers, as our study shows that customers prioritise low charges, not religious convictions, as a priority. In order to attract more customers to the Islamic banking system, Islamic banks have to do more work than conventional banks, which are already stable in the financial market. The main area Islamic banks should focus on is in making their reputation appealing to the customer. Islamic banks can take

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a number of steps in this regard, including creating strong advertising in a range of media and hiring educated and friendly staff, in order to attract more customers and retain their existing ones.

References

Ahmad, A. (2002). Development and Problems of Islamic Banks. Ahmad, Ziauddin. (1994). “Islamic banking: State of the Art.” Islamic

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Bristоn, R. & El-Ashker, A. (2002). "Religious Audit: Could it Happen Here?" Accountancy, October: 120–1.

ChinTiong Tan & Christina Chua. (1986). “Intention, Attitude and Social Influence in Bank Selection: a Study of Oriental Culture.” International Journal of Bank Marketing 4: 88–27.

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Hussey, Jill, & Roger Hussey. (1997). Business Research—A Practical Guide For Undergraduate And Postgraduate. London: Macmillan Press Ltd.

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004.pdf

CHAPTER TEN

GROWTH OF ISLAMIC BANKING AND EMPLOYEE SATISFACTION

IN BANGLADESH

Section 1. Introduction Bangladesh is the third largest Muslim country in the world with around 139 million people, of which 90% are Muslim. The Islamic banking system started operating in Bangladesh in 1983 with the establishment of Islami Bank Bangladesh Ltd (IBBL). Five more fully-fledged Islamic banks and twenty Islamic banking branches of ten conventional banks have since begun operating in the private sector according to the principles of Islamic Sharia. In spite of some operating issues, they boast approximately two decades of successful Islamic banking operations in Bangladesh.

Section 2. Aims and Objectives

The aim and objectives of this chapter are to explain the basic elements of interest-free banking and the performance of such banking in developing countries such as Bangladesh. The problems and future prospects of Islamic banking in Bangladesh will also be discussed.


The modern banking system was introduced into the Muslim countries at a time when they were politically and economically at low ebb, in the late 19th century. The main banks in the home countries of the imperial powers established local branches in the capitals of the subject countries and they catered mainly to the import export requirements of the foreign businesses. L. M. Abdul Gafoor, 1995)

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According to the website for HSBC’s Islamic Financial Solutions (www.hsbcamanah.com), the first modern Islamic financial institutions emerged in the 1960s and 1970s. Since then, Islamic banking has extended to a large number of Muslim countries, including the GCC and the Arab world at large, South and Southeast Asia, and even Muslim communities in the West. Islamic banks operate in over sixty countries worldwide. The entire banking system has been converted to Islamic banking in Iran, Pakistan and Sudan. Bahrain is considered a centre for Islamic banking, with significant activity also taking place in Malaysia and the UK. Islamic financial institutions have taken the form of commercial banks, investment banks, investment and finance companies, insurance companies and financial service companies. They pursue different banking models, such as private institutions in a conventional economy (as in the GCC and the West), attempts at national Islamic banking systems (as in Sudan, Iran and Pakistan), and dual banking models (as in Malaysia). They also take different forms, such as wholly Islamic institutions, Islamic subsidiaries of conventional banking groups, and Islamic banking windows within conventional banks.

Islamic banking was first successfully operated in Egypt, when the Mit Ghamr Village Bank established a model for Islamic banking, leading to the subsequent establishment of the Nasser Social Bank. During the seventies, a number of Islamic banks emerged in the Muslim world at a national level, along with the Islamic Development Bank (IDB) at the international level. A number of entrepreneurs were actively working towards the introduction of Islamic banking. Two professional bodies⎯ the Islamic Economics Research Bureau (IERB) and the Bangladesh Islamic Bankers Association (BIBA)⎯took practical steps to impart training on Islamic Economics and banking to a group of bankers and arranged a number of national and international seminars/workshops to mobilize local and foreign investors. Their professional activities were streamlined by a number of enthusiastic businessmen in Bangladesh. They concentrated mainly on mobilizing equity capital for the prospective Islamic bank. Due to the continuous and dedicated endeavour of the above groups and individuals and active support from the government, Islamic banking was established in the early eighties.

According to Nienhaus (1986), the welfare principle of Islam should focus on the disadvantaged classes of the society by channelling their loans and advances with a view of making them self-reliant. Currently, these banks offer facilities in the same segment of the economy as the conventional banks.

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Khan & Mirakhor (1989) and Iqbal (1997) state that Islamic banks are theoretically better poised than conventional banks to absorb external shocks because the banks’ financing losses are partially absorbed by the depositors. Similarly, the risk-sharing feature of the profit and loss sharing (PLS) paradigm in theory allows Islamic banks to lend on a longer-term basis than projects with higher risk-return profiles, and thus promotes economic growth (Chapra, 1992; Mills & Presley, 1999).

According to Khan, a primary advantage of PLS banking is that it leads to a more efficient allocation of capital, because the return on capital and its allocation depend on the productivity and viability of the project (Khan, 1986).

The Islamic banking industry today stands at several hundred billion dollars and consists of more than three hundred financial institutions inside and outside of the Muslim world. It is the product of the collective effort of bankers, economists and Islamic legal scholars over the past several decades to develop financial solutions that meet the religious requirements of Muslims (Philipp, 1990).

Section 3. Literature Review for Bangladesh

Of Bangladesh’s over-sized population of nearly 150 million, 85% are Muslim with a firm belief in Islam. This is reflected in the culture, customs, perception and economy of the country, as well as the banking arena. Today, there are a number of Islamic banks providing Sharia-based banking services in Bangladesh, alongside many private and multinational banks which serve Islamic banking as a conjunction.

In the case of Bangladesh, Islamic banking was inherited from the period of the British regime as an interest-based banking system, and employment of Muslims in banks was more or less restricted. During the period 1947–1971, when the country was a part of Pakistan, banking came under Muslim control but the system did not change (Haque, 1994). After the liberation war of 1971, Bangladesh faced new development in the banking sector, both at home and abroad. Today, there are around sixty private commercial, nationalized, multinational and Islamic Sharia-based bank and financial institutions in Bangladesh. Among them, there are five commercial banks that operate on the basis of Islamic law, while some of the other banks offer Islamic banking to their customers as a conjunction. The banking system of Bangladesh is composed of various types of banks, such as nationalized commercial banks, private banks, foreign banks and development banks. Currently, 28 out of 50 banks are private, among which six banks are private Islamic banks like Islami Bank Bangladesh

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Ltd, Shahjalal Bank Ltd, EXIM Bank, Al-Arafah Islami Bank Ltd, Social Investment Bank Ltd and ICB Islamic Bank.

In the 1970s, the Islamic Development Bank began successfully operating at a international level, along with nationalized Islamic banks in several other countries. Later in Bangladesh, the Islamic Economics Research Bureau (IERB) and the Bangladesh Islamic Bankers Association (BIBA) took practical steps to impart training about Islamic economics and banking on a group of bankers, in order to mobilize both local and foreign investors. In Bangladesh, multinational banks exist alongside several private Islamic banks such as Bank Al-Falah, which mobilize deposits and provide loans like other traditional banks. Islamic banks have been operating in Bangladesh for about 15 years alongside traditional banks. Besides the Islamic banks, Prime Bank Ltd. opened Islamic banking branches in both 1995 and 1997.

3.1. Islamic Banks in Bangladesh

There are four fully-fledged Islamic banks originated in Bangladesh: (1) Islami Bank Bangladesh Ltd. (2) Al-Arafah Islami Bank Ltd. (3) Exim Bank Ltd. (4) Shahjalal Islami Bank Ltd.

3.1.1 Islami Bank Bangladesh Ltd. Islami Bank Bangladesh Ltd., which was the first of its kind in South-East Asia, was established on March 14, 1983 and introduced a full package of banking services in August 1983. The Islami Bank Bangladesh Ltd. (IBBL) began a joint venture multinational bank with 63.92% of equity, which was contributed by the Islamic Development Bank and financial institutions such as Al-Raji Company for Currency Exchange and Commerce of Saudi Arabia and Kuwait. The Islami Bank Bangladesh Ltd runs through 42.63% of local shareholders and 57.37% of foreign shareholders.


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(Amount in Million Taka) Islami Bank Bangladesh Ltd 2004 2005 2006 2007 Authorized Capital 3,000.00 5,000.00 5,000.00 5,000.00 Paid-up Capital 2,304.00 2,764.80 3,456.00 3,801.60 Reserves Fund 4,329.92 5,450.94 6,551.23 8,039.74 Total Deposits 88,452.18 10,8261.00 132,814.00 166,812.78 Investment 83,893.63 102,145 123,959.00 174,365.55 Import Business 59,804.00 74,525.00 96,870.00 137,086.00 Export Business 29,151.00 36,169.00 51,133.00 66,690.00 Number of Employees 5,306 6,202 7,459 8,426 Number of Branches 151 169 176 186 Table 10.1. Source: islamibankbd.com

Table 10.1 above shows the growth of the Islami Bank Bangladesh Ltd. year on year. The figures reveal that total deposits and investments almost double over four years from 88,452.18 million Taka to 166,812.78 million Taka, and 83,893.63 million Taka to 174,365.55 million Taka respectively. The figures also reveal that though there is only an 18.81% increase in the number of branches over those four years, there is a 37.02% increase in the number of employees. This shows great employee satisfaction in the Islami Bank Bangladesh Ltd. 3.1.2 The Al-Arafah Islami Bank Ltd. The Al-Arafah Islami Bank Ltd. was incorporated on June 18, 1995 and started operation as the third Islamic bank in the private banking sector in Bangladesh from September 27, 1995. The bank is noted for its business acumen. The Al-Arafah Islami Bank Ltd. has forty-six branches and 1,033 employees (as of December 2007). Its authorized capital is Taka 2,500

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million and the paid-up capital is Taka 1,153.18 million. It has a reserve fund of BDT 1,091.95 million, deposits of BDT 23,009.13 million, investments of BDT 27,042 million, and 12,013 shareholders. The bank is managed by a twenty-three member board of directors. (Amount in Million Taka) Al-Arafah Islami Bank 2004 2005 2006 2007 Authorized Capital 1,000.00 1,000.00 2,500.00 2,500.00 Paid-up Capital 586.99 677.94 854.20 1153.18 Reserves Fund 488.00 542.22 835.98 1091.95 Total Deposits 10,108.28 11,643.66 16,775.34 23,009.13 Investment 8,150.16 11,474.41 17,423.19 22,906.37 Import Business 9,337.49 12,631.6 1,882.14 27,042.72 Export Business 3,639.34 49,32.9 914.27 12,714.91 Number of Employees 803 771 912 1033 Number of Branches 40 41 46 46 Table 10.2. Source: al-arafahbank.com

The above figures show the movement in the Al-Arafah Islami Bank in Bangladesh. Although Al-Arafah Islami Bank looks somewhat insignificant in comparison to Islami Bank Bangladesh Ltd., its growth more than doubled from 2004 to 2007. Figures reveal that the total deposits rose to 23,009.13 million Taka in 2007 from 10,108.28 million Taka in 2004. The table also shows that investment was twice the figure in 2004. Only a small number of new branches were opened in this four year period but the number of employees were increased by 22.26%, which is not as considerable as that demonstrated by the Islami Bank Bangladesh Ltd., where there was an increase of 37.03%. 3.1.3 Exim Bank Ltd Exim Bank Ltd. was established in 1999 in order to contribute to the socio-economic development of the country. This bank has earned a secure and distinctive position in the banking industry in terms of performance, growth and excellent management. The bank has migrated all of its conventional banking operations into Sharia-based Islamic banking since July 2004. The promoters and equity holders are aware of


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their commitment to their society. A large amount of profit is kept aside and/or spent on socio-economic development through trustees and patronization of the country’s art, culture and sports. (Amount in Million Taka) EXIM Bank Ltd 2004 2005 2006 2007 Authorized Capital 1,000.00 1,000.00 3,500.00 3,500.00 Paid-up Capital 627.80 879.00 1,713.80 2,142.20 Reserves Fund 357.30 570.00 810.90 1,134.60 Total Deposits 19,078.20 28,319.00 35,032.00 41,546.60 Investment 20,875.00 27,679.00 34,874.60 42,652.90 Import Business 26,781.00 41,432.00 49,596.70 61,399.40 Export Business 22,418.40 31,285.00 46,234.60 55,790.40 Number of Employees 768 934 1020 1104 Number of Branches 28 28 30 35 Table 10.3. Source: eximbankbd.com Exim Bank Ltd also shows a similar growth rate to that seen at the other banks. It is a small bank compared to the Islami Bank Bangladesh Ltd. and the Al-Arafah Islami Bank. Total deposits and investments have risen to 41,546.60 and 42,652.90 million Taka respectively; the number of branches has increased to thirty-five from twenty-eight in 2004, while the number of employees has increased to 1,104 in 2007 from 768 in 2004, a 30.43% increase. This shows a positive level of employee satisfaction. 3.1.4 The Shahjalal Islami Bank Ltd The Shahjalal Islami Bank Ltd was established on April 1, 2001. The total paid up capital is TK. 1,871.65 million; total capital is TK. 3,040,882,802; stationary reserve is TK. 510,392,155; investments are TK. 20,616,605,335; deposits are TK. 22,618,187,313 and total assets are TK. 28,346,996,395.

Every Islamic bank contains a standard Sharia council or Sharia board involved with advising and giving directives for all functions of the bank, including investment procedures carried out according to the principles of Islamic Sharia.

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3.2. Challenges and Problems of Islamic Banking in Bangladesh

Around the world, Islamic banks have been facing many problems. In Bangladesh, Islamic banks are also facing challenges. First, they have not yet been successful in devising an interest-free mechanism to place funds on a short-term basis, and they do not finance customers’ loans. Second, the risk is high in profit sharing. Third, the Islamic banks in Bangladesh do not have the proper legal support from the central bank in Bangladesh. In addition, they do not have the sufficiently trained workforce needed to appraise, monitor, and evaluate the projects, though they have enough unused liquidity. The performance of interest-free banking in banking raises a lot of questions and possible problems from both a micro- and macro-operational point of view in Bangladesh.

3.3. Monetary Policy and Islamic Banks

The central bank has the sole authority to issue currency and manage liquidity in the economy. One of the objectives of monetary policy is to ensure the stability of the value of the Taka and regulate the banking system prudently. The Bangladesh Bank, the central bank of Bangladesh, issued a license in 1983 for the establishment of the first Islamic bank in Bangladesh. The government participated in establishing the bank by subscribing a 5% share in the paid-up capital. The Bangladesh Bank granted some preferential provisions for smooth development in the growth of Islamic banks. Among the preferential provisions, the following are important:

Islamic banks have been allowed to maintain their Statutory Liquidity Reserve (SLR) at 10% of their deposit liabilities while it is 20% for conventional banks. This provision has facilitated Islamic banks to hold more liquidity and generate profits. Under indirect monetary policy regime, Islamic banks were allowed to fix their profit-sharing ratios and mark-ups independently, commensurate with their own policy and banking environment. This freedom in PLS ratios and mark-ups rates has provided the scope for the Islamic banks to follow Sharia principles independently in order to realize their goals.

There is no complete Islamic banking act for controlling, guiding and supervising Islamic banks in Bangladesh. Some Islamic banking provisions have already been incorporated in the amended Banking Companies Act, 1991 (Act No. 14 of 1991). The Bangladesh Bank did not set up a separate department at its head office to control, guide and supervise the operation of the Islamic banks. Inspection and supervision of


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Islamic banking operations are conducted by the Bangladesh Bank as per the general guidelines framed for conventional banks, therefore ensuring achievements of Sharia principles in the Islamic banks are conducted by their own Sharia Councils. The role of the Bangladesh Bank in controlling, guiding and supervising Islamic banks in Bangladesh in accordance with Islamic Sharia is minimal. In observing the Sharia implementation status of Islamic banks, the Bangladesh Bank examines only the report of the respective banks’ Sharia Councils. However, the inspectors and supervisors of the Bangladesh Bank are not equally familiar with the technicalities of the different operational methodologies of Islamic banking. This is because there is no separate department to look into this important matter.


Primary data is information collected only for the research being conducted, usually a current set of data. In this research, the primary data is that collected by surveying bank employees by means of a questionnaire. Secondary data is data regarding the organisation, collected previously for any other purpose. The report will be prepared using primary and secondary information. The primary information will be collected by interviewing bank officials, while the secondary information will be collected from annual reports and websites.

The primary data was collected through a questionnaire given out to two hundred officials in the following four Islamic banks: the Islami Bank Bangladesh Ltd., the Al-Arafah Islami Bank Ltd., EXIM bank and the Shahjalal Islami Bank. This sample of employees was chosen randomly from among different job titles. A qualitative research method was followed to construct this questionnaire, consisting of a set of “rank according to preferences” questions, a set of “scale” questions and a set of three open-ended questions. Secondary data was collected from the bank websites and annual reports. Financial management theories provide various indexes for measuring a bank's performance.

4.1. Results and Analysis

The author has used the eleven motivating and hygiene factors mentioned by Herzberg (1987) for the employees to rank according to their preference (the questionnaire can be found in Appendix 1). The factor ranked as 1 will be the most important to that particular employee, with 5 as the least important. All of these factors affect employees’ satisfaction at

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work, directly or indirectly, which affects performance and is the reason they have been used in a single questionnaire.

1 2 3 4 5 Total Work Condition—Actual 67 47 33 27 27 200 Work Condition—Percentage 33.33% 23.33% 16.67% 13.33% 13.33% 100.00% Interpersonal Relationship—Actual 87 27 33 27 27 200 Interpersonal Relationship—Percentage 43.33% 13.33% 16.67% 13.33% 13.33% 100.00% Recognition—Actual 53 40 40 33 33 200 Recognition—Percentage 26.67% 20.00% 20.00% 16.67% 16.67% 100.00% Achievement—Actual 60 47 40 27 27 200 Achievement—Percentage 30.00% 23.33% 20.00% 13.33% 13.33% 100.00% The Work Itself—Actual 73 47 33 20 27 200 The Work Itself—Percentage 36.67% 23.33% 16.67% 10.00% 13.33% 100.00% Responsibility—Actual 40 33 33 40 53 200 Responsibility—Percentage 20.00% 16.67% 16.67% 20.00% 26.67% 100.00% Job Security—Actual 47 53 40 40 20 200 Job Security—Percentage 23.33% 26.67% 20.00% 20.00% 10.00% 100.00% Advancement —Actual 40 27 53 40 40 200 Advancement—Percentage 20.00% 13.33% 26.67% 20.00% 20.00% 100.00% Company Policy and Administration—Actual 20 27 20 40 93 200


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Company Policy and Administration—Percentage 10.00% 13.33% 10.00% 20.00% 46.67% 100.00% Salary—Actual 60 67 13 20 40 200 Salary—Percentage 30.00% 33.33% 6.67% 10.00% 20.00% 100.00% Supervision— Actual 40 20 33 33 73 200 Supervision—Percentage 20.00% 10.00% 16.67% 16.67% 36.67% 100.00% Table 10.4. Source: Questionnaire

From the questionnaire, it is found that more than 67 (33.33%) employees believe that work conditions are the most important factor, while 87 respondents (43.33%) revealed that interpersonal relationships are another. In response to the question of whether recognition contributes employee satisfaction, 53 respondents believe that it is the most important factor, while 33 consider this to be the least important factor. Thirty per cent of respondents rate achievements as most important and only 20% believe that responsibility at work contributes to employee satisfaction. Job security had a mixed response as 23% of respondents believed that it might contribute to employee satisfaction. Advancement and supervisions scored 20% each while salary was scored more than 63%. Most of the respondents (66.67%) believed that company policy and administration cause the most employee dissatisfaction at work.

Conclusions

The banking industry in Bangladesh is flourishing day by day. The superstition and prejudice of ignorant people towards banking is reducing as the banking service spreads into rural areas. As the major population of Bangladesh is Muslim, there is a vast opportunity for Islamic banks to excel. The Islamic banking industry has continued to show strong growth since its inception in 1983 in tandem with the growth in the economy, as reflected by the increased market share of the Islamic banking industry in terms of assets, finance and deposits of the total banking system. The products being offered by these banks range from consumer credit to long-term finance for big investment projects using Islamic modes of financing such as Marahaba, Bia-Muazzal and Ijarah.

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The four banks discussed are the most recognized and successful Islamic banks. If we look at the trend of deposit amounts of these banks over the years, we can see the popularity of Islamic banking in Bangladesh. Of these banks, the Islamic Bank Bangladesh has the highest asset, liability, shareholder’s equity, deposit, investment, and profit. These are the result of the bank having been in the industry for a long time and amassed a wealth of experience. However, if we look at the ratio analysis, Al-Arafah Islami Bank certainly heads the chart. Most of the results of the analysis suggest that Al-Arafah Islami Bank is an efficient and well-managed bank. If the bank can sustain its efficiency, it can become the market leader in the future. Exim Bank has shown very moderate features. They have the second highest amount of assets, deposits and investments. More efficiency in management is needed to make the bank perform better in the future. Shahjalal Islami Bank suffered a great loss in 2004 but its recovery has been remarkable, and for the last two years, it has shown promising improvement. If they can sustain this growth, they can be one of the front-running banks of Bangladesh.

The Islamic banks in Bangladesh started with a very limited resource base from the beginning. However, with the passage of time, they have shown strong performance in respect of mobilization of deposits as well as investments. The total deposits of the Islamic banks and Islamic banking branches of the conventional banks stood at Taka 232,981.00 million at the end of June 2006. This was 28.46% of the deposits of all private commercial banks and 9.67% of the deposits of the total banking system. Total investment of the Islamic banks and the Islamic banking branches of the conventional banks stood at Taka 210,493.80 million at the end of June 2006. This was 29.35% of all private banks and 14.88% of the total banking system of the country. The Statutory Liquidity Requirement (SLR) for Islamic banks has been fixed at 10% since the inception of the first Islamic bank in 1983. This has remained unchanged to date, while SLR for the traditional commercial banks has changed several times and is presently fixed at 18%. The low requirement of SLR for Islamic banks is due to the non-holding of interest bearing types of eligible securities. In order to overcome the situation, the Bangladesh Bank issued an Islamic bond on behalf of the government, namely the “Government Islamic Investment Bond (GIIB)” in October 2004, which is governed by Islamic Sharia. Excess liquidity of Islamic banks and Islamic banking branches stood at Taka 8,956.80 million as of the end of June 2006 (19.08% of private banks and 8.19% of all banks), which originated mainly due to the non-responsiveness of the good borrowers for investment demand, and the absence of adequate interest-free financial instruments and an organized


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Islamic money market in the country. However, efforts are underway to develop Islamic inter-bank market instruments to help banks manage their liquidities.

On top of everything, all Islamic banks in Bangladesh show a high level of increase in the number of employees, i.e. 37.03% for Islami Bank Bangladesh Ltd., 22.26% for Al-Arafah Islami Bank and 30.43% for Exim Bank, which also means a great level of employee satisfaction.

Policy and Recommendation

If Islamic banking is to grow in Bangladesh, people must be aware of the Islamic banking system and should know how it differs from the conventional banking system. The banks have to spread information that the profit-loss sharing policy of Islamic banks is supported, while the interest-based conventional system is prohibited by Muslim law. If people understand the religious as well as financial aspects of Islamic banks, they may consider Islamic banks when opening a bank account.

The government should also have to create an environment in which the Islamic Sharia-based banks can prosper. The government can create monitory and fiscal policies to support Islamic banks. As regards the supervision and inspection of the banks in Bangladesh, an equal treatment is being followed for all banks⎯including the Islamic ones⎯by the Bangladesh Bank. In some cases, the Bangladesh Bank has given some special provision for the Islamic banks. Yet, for the smooth development and operation of Islamic banking, the Bangladesh Bank should devise separate regulatory and supervisory guidelines for Islamic banks in Bangladesh, as well as the provision of financial assistance by the central bank in the form of Mudaraba deposits with the Islamic banks, by way of providing refinance to the Islamic banks under Mudaraba/Musharaka or any other Islamic mode of finance. These may include refinance facilities on the basis of PLS, the opening of current accounts at the central bank with occasional overdrawing facilities free of charge and participation in the clearing house, the regulation and supervision of Islamic banks, as applicable in interest-based banking in respect of permission for establishing banks, appointment of directors and auditors, foreign exchange regulations, etc., and lower liquidity requirements on deposits accepted by Islamic banks until such time as appropriate Islamic financial instruments which can be counted towards liquidity requirements become available. For inspection of the Islamic banks, the central bank’s personnel should be adequately trained in Sharia-based banking operations and the

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central banking authorities may consider preparing separate guidelines for inspection, keeping into view the special character of Islamic banks.

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New Horizon.

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