Banking on piety


There is no such thing as an Islamic Sukuk; these are conventional bonds that are coated with an Islamic shell." To say Hassan Heikal, the CEO of the leading home-grown investment bank in the Middle East, EFG-Hermes, is sceptical about Islamic finance is an understatement. On the other side of the spectrum, Dr Abdul Moman Al-Olaby, a professor who was one of the pioneers in the industry agrees that some Sharia-compliant structures are questionable, but says "Sharia-compliant finance is our jewel, and even in its infancy, it is well positioned to compete among global banking giants."

Dr Ibrahim Warde, a professor of international business at Tufts University in the USA, and author of Islamic Finance in the Global Community, has been studying the industry for the past decade. As an academic, he takes a more nuanced approach, and tells Arabian Business "the initial hope of the sector was that it would be a completely different approach to finance and it would have many economic and social benefits, and would be based on the principle of sharing profits and losses." Critics today claim that "it evolved into a mimicking of conventional finance" and some question if it is a "new model", but supporters defend the approach on the grounds that they are leading the much needed modernisation of the financial sector.

We had to devise modern financial structures that were based on accepted trades that Muslims conducted in the past.

While the debate will undoubtedly continue, it is undeniable that the cat is out of the bag. Sharia-compliant finance is a growth sector all over the world, and has now become a US$600bn industry. Given the immense wealth of the Arab world and the billion-plus global Muslim population, market dynamics forced the creation of Sharia-compliant finance. From Singapore to London, from Doha to New York, bankers are developing new products, chasing new clients, and laying the groundwork for global expansion.

In this report, Arabian Business examines the origins of Sharia finance, modern banking products, and the rise in corporate finance. We also speak to some of the players behind the burgeoning Takaful (insurance) market, see the Qatari innovation of Sharia-compliant private equity, and look at the scholars and boards endorsing the various structures.

Creating a financial system without interest

First, a quick primer on Islamic finance. The underlying principle of Islamic finance is that it complies with the religion's ban on interest (Riba), and that all structures must be studied and approved by a religious authority. It goes without saying that no Islamic company can be involved in illicit drugs, gambling, and alcohol.

Muslims throughout the world take immense pride in the complete set of legal and moral norms that was revealed to the Prophet Mohamed (PBOH). While previous religions proscribed specific codes for personal conduct, and the mechanism of worship to a deity, Islam augmented these by adding a layer of rules to organise the government and economy.

The question of riba (interest/usury) was among the last verses to be revealed to the Prophet, yet the words were clear: "Allah permits trading and forbids riba" {The Holy Koran 2:275}. Sharia, or Islamic law, is derived from three main sources: the Koran, the Sunnah and Hadith (the Prophet's recorded words and deeds), and the accepted work of scholars. This system of jurisprudence has been effective to adjudicate conflict and sharpen ambiguity over the past 1400 years, but the question of interest remains unresolved. The main reason for this is that the Prophet Mohamed (PBOH) passed away shortly after the riba verse was revealed, and did not clarify the application of the prohibition. Muslim scholars over the centuries have tried to narrow this question. Even Omar bin Al-Khattab, one of the early Muslim leaders and a companion of the Prophet, acknowledged that the issue is not clear and instructed Muslims to abstain from the practice.

All scholars today accept that usury is forbidden, while trade is permitted. The Islamic world historically thrived on trade, but as economies became more complex, financial institutions were not capable of adapting. Dr Abdul Momen Al-Olaby, one of the early economists who worked on Sharia-compliant finance in Kuwait in the 70s, tells Arabian Business "we had to devise modern financial structures that were based on accepted trades that Muslims conducted in the past".

Dr Al-Olaby explains the principle that forms a basis for many Islamic finance structures: Murabaha (rough translation: profit). "Say you want to buy a refrigerator, but you don't have enough funds to buy it in cash. The seller or a bank agrees to buy the refrigerator for you at its current price of 100 dinars, and then sells it back to you in installments over a period of time at the higher price of 120 dinars.

The seller books a profit. This may appear to be an interest rate, but the structure is in fact Sharia-compliant." Murabaha, along with Ijira (leasing), and Mudaraba (alliance of capital and labour), are the main principles used in Sharia-compliant financial engineering. From these simple concepts, an Islamic finance empire is emerging, covering retail banking, corporate banking, alternative investments, and insurance. Of course, anything that is based on religion is open to interpretation, and in the case of Islamic finance, dissent comes from the highest authority.

In 1993, Dr Muhammad Sayyid Tantaway, the Grand Sheikh of Al Azhar University in Cairo - one of the pre-eminent Islamic schools in the world, conducted an in-depth study of the interest in Islam, and asked a now famous question: ‘Riba (interest) is haram (forbidden), but what is riba?'

He went on to explain that riba in Islam is closer to usury (excessive interest rates common in loan sharking and predatory lending practices), but interest rates that modern banks use to determine the cost of money is closer to profit rates.

This is a main cause for Egypt's relative dormancy in Islamic finance, and also explains why many consumers and scholars view the growth in Islamic products as little more than a clever manipulation of language and consumer behaviour.

Dr Warde, believes that Egypt's lag in the development of the Islamic finance sector is mainly the result of a number of "small companies that claimed they were Islamic" that popped up between 1984 and 1988. This had a "huge impact on the Egyptian economy - where about 15% of the GNP evaporated."

Dr Warde suspects that the crisis (and fraud) was the catalyst for Dr Tantaway's fatwa on interest rates.
Your friendly Islamic investment banker is at your service

While many Muslim scholars have reservations about Sharia-compliant finance, the Islamic finance industry has been expanding by 15% a year, according to accounting firm KPMG, and is set to reach the US$1 trillion by 2009. Islamic banks form the crux of the industry, controlling assets estimated to exceed US$400bn.

Dubai Islamic Bank opened its doors in 1975, and now has a market capitalisation of US$8bn. Its success has been emulated all around the Muslim world and, more recently, beyond. This July, Bank of London and the Middle East (BLME), a UK-based institution with a large Kuwaiti shareholder base, launched one of the first Sharia-based banks in Europe. Nigel Denison, the head of markets at BLME says: "The market is growing rapidly, and it is growing quicker than the conventional market."

There are a lot of traditional banking and financing opportunities [in Western Europe] that fits very well with the spirit and ethical framework of Sharia finance.

If you try to imagine an Islamic banker, you wouldn't think of Denison. Islamic banking is no longer the under the purview of scholars and pious quant types; conventional bankers from around the world have taken an interest. Denison admits that he is a newcomer, but being new doesn't put him or his team at any knowledge disadvantage. BLME puts all new hires through a rigorous course of study, the IFQ (Islamic Finance Qualification), a test that is run in tandem by the University of Beirut and the Securities Investments Institute in London. Getting your employees to know Sharia is a matter of education, but operating an Islamic bank in London has other less noticeable challenges.

Denison recalls that the simplest of tasks require extra diligence. A Sharia-based institution cannot have penalty interest clauses in its lease, so the lawyers have to amend the documents, and convince landlords that the Islamic substitute will adequately protect them. Even photocopier leases have to be Sharia-compliant. While the growth of Islamic banking remains unquestioned, expansion into London may seem odd. Denison points out that the Kuwaiti backers of BLME are looking towards Europe to diversify their revenue streams from financing property in the GCC, and enter untapped markets. "There is a much broader potential for Islamic finance than just assets from the GCC. We are looking to do business away from the GCC. We will focus on Western Europe, North Africa, Turkey, Kazakhstan and Central Europe."

The main challenge that this seasoned banker sees is the lack of standardisation in products, procedures, and documentation. Ambitious strides have been made in this realm, because the cost incentive is strong. There is no way to reduce the number of documents necessary for a certain transaction, and as we have shown with the typical murabaha deal, multiple contracts must be drawn up to ensure compliance. Standardising these documents will lower costs, and bring the price of Islamic finance products in line with conventional banks.

"Although we all use documents that are similar, they're all slightly different as they are all approved by our respective Sharia boards all of whom have a slightly different take on things. Once we get to a point where there is one single document that is universally accepted, as it has with the derivatives, and that will improve standards and increase liquidity."

BLME is only one example of the proliferation of Sharia-compliant banking across the globe. Takaful, or Sharia-complaint insurance, is the newcomer to the scene, and the insurance pioneers are dealing with a far more difficult set of problems, but are also entering an exciting underdeveloped playing field.

The cost of complyingIf you want to provide an Islamic financial service but don't have the three scholars required by the Dubai Financial Services Authority to ensure your product is Sharia-compliant, you may want to use an external consultant. But with fees comparable to those of lawyers, it might cost you dearly.

As CEO of one of the few consultancies in Dubai servicing the relatively young and rapidly growing Islamic finance industry, Majid Dawood knows he is onto a good thing. "It's a great industry", the self-confessed entrepreneur tells Arabian Business. "It's just fabulous that so much is going on. And to be part of that industry, contributing to the development, you get a buzz out of it".

One can see why. Behind Dawood's chair in an office in the Dubai International Financial Centre is a stack of empty boxes: the debris of an upgrade to more spacious premises. Occupying a lucrative niche market, Sharia advisors are able to earn as much as US$1m a year, growth for Yasaar is swift.

But it hasn't always been easy. Originally set up in London in 2001 Yasaar suffered in the aftermath of the terrorist attacks of 9/11. What followed were hard times for Dawood, "for three years I had no income". In 2004 and 2005 things picked up, "and this year has gone nuts," he laughs.

Things have come a long way since Dawood attended his first Islamic finance conference in 1997. "I saw a great opportunity in that there was no Islamic asset management company. So I followed that route". However, an agreement with his first client, Morgan Stanley, soon propelled him into the role of a Sharia consultant, using his network of contacts in the city.

But despite the "slight default" in his career he has "no regrets".

Indeed, here is a man who enjoys considerable job satisfaction: "I'm very happy because I get to work with the scholars although I'm not one myself. My background is in economics".

Dawood explains: "We provide the services of scholars", doing the work of a Sharia board. This ensures institutions structuring Sharia-compliant financial mechanisms adhere to Islamic principles.

So what of the obvious conflicts of interest inherent in the work of such organisations? Dawood is quick to address this point. Scholars employed by directly by banks "must ask themselves if they are just stamping a fatwa or not," he asserts. On the contrary, "we are a consultancy where the scholar is one step removed from that, which makes the conflict of interest issue less, if at all".

Another critical factor is speed. Internal Sharia boards may meet once every two or three months. According to Yasaar's CEO "that's not enough in today's world. Finance can't hang around".

Neither can Dawood. With Islamic finance conferences taking place around the world in the coming months he will be busy bulking out his contacts book.

You don't need a background in economics though to see that the numbers add up nicely. "We don't make as much as lawyers" claims Dawood, "I wish we did. But the prices are going up for the simple reason of supply and demand. Why would somebody do something for 100 pounds when somebody else is willing to pay 500 for it? You do it, but it's going to go to the back of the queue. The 500 pound one gets done first". And why wouldn't it?


Taking the gamble out of insurance

"That's the thing, what is a gamble?" asks Islamic banking and finance consultant Dawood. "It's not like you're putting some money on a horse or on a particular number turning up. That's a gamble".

Smiling across a desk littered with copies of the latest news stories on Sharia-compliant finance he has just posed the one million dollar question. To be more precise, it is closer to being the two billion dollar question.

The discussion concerns takaful, the Sharia-compliant insurance industry that is estimated to be worth more than two billion dollars, a figure that reflects the total premiums paid in 2005. According to Moody's, total takaful premiums are expected to reach US$7.4bn by 2015, building on impressive growth rates of around 20% since 2000. Moussa Al-Rubaian, chairman of the National Insurance Committee of the Saudi Arabian Chamber of Commerce confirms, "we are seeing much more interest now and very fast growth".

Abdullah Kubursi, regional vice president of Dubai-based AIG Takaful enthusiastically describes "a very steep learning curve and this is by no means finished. We will see takaful develop and mature over the next five years".

The [takaful] industry is constantly evolving and it is impossible to standardise a very infant market. You also have to take into account cultural differences.

Admittedly, the sector may be small relative to the size of the conventional insurance industry, yet the potential market for Sharia-compliant mechanisms is enormous. So how does an industry that conventionally bets on the occurrence, or non-occurrence of certain events to price risk, avoid gambling? This is the fundamental contention at the heart of developing takaful in which gambling, maisir, is prohibited. Conventional insurance mechanisms also involve excessive elements of risk and uncertainty, gharar, and the accumulation of interest, riba, is inherent in the investment strategies of traditional insurance companies.

A substantial portion of the investment portfolios of these companies, often more than 80%, is typically committed to interest bearing fixed income securities. These reduce risk on the asset side of the balance-sheet and maximise available capital to support liabilities. Asset risk is an important factor in determining an insurer's credit rating.

The problem is that along with maisir both gharar and riba are out of line with Islamic principles. So how does takaful work? Although commercially the sector is relatively young, Yavar Moini, executive director of Morgan Stanley Global Capital Markets in Dubai, insists that "takaful is a well-defined industry". He tells Arabian Business that one way in which it can be understood is as an "aggregation of a community's resources in a fund given to an investment manager or operating company". Surplus from the investment of the fund may be distributed to its members and/or the operating company according to the selected operating model and is used to provide the necessary financial support to contributors when required.

Dawood maintains that takaful is "more or less" based on what insurance is all about historically. "It is a pooled interest. If anything unforeseen should happen we will all undertake to share the loss. This time it will be your turn, next time it will be my turn. We help each other. It's a communal project if you like".

According to Moini the emphasis in the takaful process is on the contracts or operating models that underpin the products offered. There are three basic types that seek to define the relationships between the contributors to a fund and its managing agent. These different models ensure that the product offered is operating within Sharia concepts.

"It is the structuring of the operating model that is of concern to scholars" says Moini. "You may end up with the same economic result but the structures, the operating models are of critical importance".

This is what makes takaful "a whole ecosystem," he asserts. "It is not just putting a wrapper or Arabic sounding word on something. Documents are actually drafted within the tenets of Sharia".

Despite the tempting success story however, the development of the takaful industry is not without its obstacles, disagreement between scholars among them. In particular Moini mentions that "GCC scholars feel the Malaysian method is far too close to that of the conventional insurance industry".

Yet Kubursi argues that this difference is essential to the sector's development. "It's about flexibility if you really want this concept to work" he insists. "The industry is constantly evolving and it is impossible to standardize a very infant market. You also have to take into account every single cultural difference".

These are reflected in jurisdiction specific legal and regulatory frameworks, where they exist. Something Al-Rubaian identifies as a potential obstacle. "The regulatory environment is somewhat different from one area to the other and this is going to be a very big challenge" he tells Arabian Business. "We need regulators to work closer with each other and we are seeing this. We are working towards an association of Arab regulators".

Kubursi agrees: "Although very few countries actually have official regulations for takaful others are taking a proactive approach now".

The education of the client base, accessibility to suitable investments, the recruitment of qualified staff and the availability of affordable retakaful capacity all need addressing. Yet according to Fitch Ratings, the takaful industry's potential is strong despite the challenges it faces. Indeed, Kubursi believes the fact that rating agencies such as Fitch and Moody's are developing approaches to analysing takaful companies "brings legitimacy to the industry".

GDP levels in the GCC are growing but insurance penetration levels remain low. The Middle East in general is under-insured, reflected in the strong demand for takaful from indigenous populations. This demand is replicated across the Islamic world. Muslim countries account for only 5% of the global insurance markets but represent 25% of the world's population.

An abundance of industrial and infrastructure projects in the Gulf region have also stimulated the requirement for takaful. Even geography plays its part. It has not been lost on some analysts that many Muslim countries sit on earthquake zones. Finally as the industry grows the innovative products it develops will be increasingly able to compete with those available on the conventional market.

A key market in the region is Saudi Arabia. Previously dominated by the National Company for Co-operative Insurance and Bahrain-based insurance providers competition is growing among a variety of participants. These now include the UK's Prudential plc in collaboration with Saudi Arabia's Bank Aljazira, and reinsurance companies Munich Re and Swiss Re. Organisations which, according to Al-Rubaian, have been "very supportive of takaful operations". Kubursi believes these international giants of the insurance industry, including AIG, Allianz and Hanover "add a significant contribution to the growth of the sector not only in the region but globally".

Critically they provide the technical expertise to bridge the gap between the theology and the practice in a sector that suffers from "a lack of skilled personnel" in the Middle East.

Moini concludes that "all countries recognise the importance of takaful" despite "different approaches of how to offer it".

If current interest in the sector is an indication of what is to come he believes "there is a lot to look forward to in the future". It seems good times are ahead for the takaful industry. You might want to bet on that.
Sukuks - the rise of Islamic corporate finance

The genesis for our examination is not just a chance to look at the Islamic finance market in general; it was to shed light on the most visible, and arguably the fastest growing sector: Sukuks. A Sukuk is roughly equivalent to a bond. Like its conventional finance counterpart, Sukuks come in a wide array of structures, and innovations in financial engineering have caused phenomenal growth of the instrument.

Malaysia has the world's largest Sukuk market, making up about two-thirds of the estimated US$70bn. This dynamic is fast changing. GCC companies (and sovereigns) are catching up to the Far East, and financial centres around the globe are vying for the lucrative market - projected to reach US$100bn next year. While this pales with the US$43 trillion conventional bond markets, the growth is undeniable and is attracting both institutions and young bankers.

Dr Warde has seen a steady growth in the size of his classes on Islamic finance in the US. He says the reason for the increased interest in Sharia structuring is the growth of the market. The various methods involved in financial engineering and its main goal of finding ways to get around legal and regulatory matters is very similar to the problem that Islamic finance poses, albeit "it is all about getting around religious barriers".

The structures, however, are getting more complex. Moody's recently released a report explaining just two types of Sukuk, the Ijara Sukuk and the Mudarabah Sukuk. Although the report is a great effort to explain the various structures, many Islamic scholars are questioning the newer structures on the grounds that Sukuks are becoming too much of a mirror of conventional bonds. The competition between conventional and Islamic finance has led to an alignment of pricing. "A lot of Islamic deals are benchmarked to LIBOR (London Interbank Offered Rate), and obviously LIBOR is a setting for interest rates, it is not an interest rate, and that is why it is justified as a benchmark... the fact that your Murabaha cost is LIBOR + x, that's fine," says Denison. This linkage between the finance worlds increases ambiguity over their separation, and validates the charges of reverse engineering.

But this is set to change. As the Sukuk market grows and more sovereigns and corporates issue paper, an Islamic benchmark is bound to emerge. Once the market achieves a certain size, secondary markets will develop and trading in Sukuks is expected to be the next growth market.

However, Sharia-compliant finance will solve the maze of bond and derivative trading and structure it according to Islamic principles.

Misplaced fear Islamic finance post 9/11

Some say the lawsuit filed by the relatives of victims of the September 11 2001 terrorist attacks is worth as much as US$116 trillion. The list of defendants reads like a who's who of well-known figures in the world of Islamic finance, with some of the biggest names in Middle Eastern banking topping the list.

Many of the original defendants have successfully had their names removed from the list and the charges against them dropped.

Others are waiting for responses to their motions to dismiss the allegations leveled against them. All have been forced to spend millions of dollars in legal fees to try to clear their names.

But is this lawsuit is a persistent reminder of an all too ready tendency to associate the businesses of successful Islamic financiers to the funding of extremist organisations?

This was highlighted by the protest in the US over whether DP World, a Dubai-based port operator, should run terminals in America. The clash over DP World's managerial acquisition of the ports saw anti-Muslim sentiment in the US swell. By some estimates mistrust of the Arab world rose to levels comparable to those in the immediate aftermath of the 9/11 attacks.

In July Marianne Pearl, the wife of Wall Street journalist Daniel Pearl, sued one of Pakistan's largest banks. Her lawsuit alleges the bank knowingly provided financial services to charities associated with terrorist organisations. Daniel Pearl was kidnapped and killed in Karachi in February 2002. At the time he was investigating extremist groups in Pakistan and was actively seeking interviews with Islamic extremists.

The plaintiffs in the 9/11 lawsuit include more than 600 family members, firefighters and rescue workers. Their mission is to "bankrupt the terrorists" that have caused so much pain and suffering. This is a brave and noble effort. Yet there is little concrete evidence on which to convict many of the entities identified.

Now, with oil prices high and money pouring into, and out of, the Middle East, are latent prejudice and a renewed hatred of the petrodollar driving a misconceived fear of the Islamic investor?


Private equity: the financial next frontier?

In May this year, an interesting development came out of Qatar. Corecap, a new investment firm, launched a US$150m Sharia-compliant private equity fund. This came as a surprise to many observers. How can a business model based on acquiring companies through a small portion of cash and huge amounts of debt comply with Sharia?

Omar El Maghawry, the managing director at Corecap, tells Arabian Business: "If you look at the industry itself you will find it is actually a perfect fit to the Sharia principles." He views that the alliance between private equity firms and their portfolio companies adheres to the core principle of participation in profits and losses, and of risks. The development of Islamic finance as a sector is what enabled Corecap to structure its fund. El Maghawry explains that in the past, when Islamic companies sought to raise debt, "people would question your English language, they wouldn't understand how Islamic and debt could be in the same sentence." This has changed today. A variety of products can be used to provide Sharia equivalents of conventional structures. "The minimum investment in Corecap is set at US$3m, and that is for a good reason. Only the most sophisticated investors can wrap their minds around the company's core offering.

We have failed our children in every way, in education, and in our dysfunctional bureaucracies. Sharia-compliant finance is our jewel, and even in its infancy, it is well positioned to compete among the global giants.

With a minimal internal return rate target of 25% per year, and the impressive track record of the fund managers, there is no real mystery why the Corecap is on track in their fundraising. While the esoteric structure is very difficult to understand, the Sharia scholars have approved the model. Corecap may be the first on the Islamic private equity field, but scores of managers are likely to follow suit.

No looking back

It is undeniable that all facets of the Islamic finance industry are growing and will continue to grow.

But the debate among scholars rages on. It is clear that the average investors, or those who are in doubt, are never going to have a final answer that assuages all doubts and mollifies apprehensions. The Sharia finance scholars are churning out fatwas, bankers are engineering new structures, and investors are flocking, cash in hand. Two strong camps will define future developments.

Heikal, adds: "With all due to respect to everyone [working in the industry] there is no such thing as an Islamic bank or an Islamic loan... Sukuks do not differ from bonds that have a predetermined yield, and this applies on the rest of the Islamic finance products."

Dr Al-Olaby, one of the pioneers in the industry, agrees that some of the Sharia-compliant structures appear to be reverse engineered, but believes the intention was to create a solution that complies with Islamic principles.

As a staunch pan-Arab movement ideologue, he sees another function of the rise of Islamic finance. "Supporting Islamic banking and takaful is a duty for Muslims, not just because it strengthens the religion, it defines modern Islamic identity."

With a quiver in his voice he concludes "We have failed our children in every way, in education, and in our dysfunctional bureaucracies.

"Sharia-compliant finance is our jewel, and even in its infancy, it is extremely well positioned to compete amongst the global banking giants."

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