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GLOBAL PERSPECTIVE ON ISLAMIC BANKING & INSURANCE ISSUE NO. 167 JANUARY–MARCH 2008 MUHARRUM–RABI AL AWWAL1429 KAZAKHSTAN: ON THE PATH OF DEVELOPMENT TAKAFUL: INSURANCE THE ISLAMIC WAY IIBI PARTNERS WITH AAOIFI FOR A NEW COURSE SHARI’AH AND BANKING: COMPATIBLE OR UNSUITABLE? ANALYSIS: BASEL II AND ISLAMIC BANKING IT CASE STUDY: BANK KESHAVARZI, IRAN PUBLISHED SINCE 1991

GLOBAL PERSPECTIVE ON ISLAMIC BANKING & … Previouse Issues... · 4 IIBI NEWHORIZON January–March 2008 Executive Editor’s Note EXECUTIVE EDITOR Mohammad Ali Qayyum, Director

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GLOBAL PERSPECTIVE ON ISLAMIC BANKING & INSURANCE

ISSUE NO. 167JANUARY–MARCH 2008

MUHARRUM–RABI AL AWWAL1429

KAZAKHSTAN: ON THEPATH OF DEVELOPMENT

TAKAFUL: INSURANCE THE ISLAMIC WAY

IIBI PARTNERS WITH AAOIFIFOR A NEW COURSE

SHARI’AH AND BANKING:COMPATIBLE OR UNSUITABLE?

ANALYSIS: BASEL II AND ISLAMIC BANKING

IT CASE STUDY: BANK KESHAVARZI, IRAN

PUBLISHED SINCE 1991

www.newhorizon-islamicbanking.com IIBI 3

NEWHORIZON Muharrum–Rabi Al Awwal 1429

Features

Regulars

CONTENTS

46 RATINGS & INDICESCredit ratings for Islamic financial institutions and financialinstruments monitored by Capital Intelligence.

47 CALENDARComprehensive diary of upcoming Islamic finance events from around the globe.

36 IIBI NEWSIIBI partners with AAOIFI to offer the CIPA programme. Report on the Islamic Banking Forum, held in London on 2nd February 2008.

38 IIBI LECTURESJanuary, February and March lectures reviewed.

05 NEWSRound-up of the important stories from the last quarter around the globe.

13 APPOINTMENTSSummary of appointments within the Islamic finance industry.

34 ACADEMIC ARTICLERisk management in murabaha.

10 Shari’ah and banking: compatible or unsuitable?Islamic finance specialists and representatives of the Muslim community debate on the subject of compatibility of Shari’ah and financial industry.

14 Islamic banking and Basel II: challenges ahead

24 Kazakhstan: on the path of development

Dr Natalie Schoon, head of product development at the Bank of London and The Middle East plc,provides an in-depth analysis of Basel II and its application in Islamic banks.

30 Insurance: the Islamic way

Case study on Iran’s agricultural bank, the first in the country to implement a new systems infrastructure.

Focus on Kazakhstan and its achievements in accommodating Shari’ah-compliant finance to cater forits largely Muslim population. An industry expert, who has initiated the idea of introducing takaful tothe country’s insurance market, reports from this ‘heart of Eurasia’.

Andrew Murray, senior director of Fitch Ratings’ insurance team in London, examines the key features,developments and challenges of takaful.

Joe DiVanna, managing director of Maris Strategies Ltd and the author of a series of books on Islamicbanking, explains why the underlying promise in Shari’ah-compliant finance is unique.

18 Islamic banking evolution: today’s achievements and tomorrow’s trendsInterview with a prominent figure within Islamic finance industry – Majid Dawood, CEO of YasaarLimited – on the input the industry can make to the world’s economy and the important contributionShari’ah scholars make to Islamic finance.

20 A cloud is a promise, fulfilment is rain

18

42 IT modernisation: reaping the benefits at Bank Keshavarzi

42

4 IIBI www.newhorizon-islamicbanking.com

NEWHORIZON January–March 2008

Executive Editor’s Note

EXECUTIVE EDITORMohammad Ali Qayyum,Director General, IIBI

EDITORTanya Andreasyan

IIBI EDITORMohammad Shafique

CONTRIBUTING EDITORSDon BrownlowLawrence FreebornMartin Whybrow

NEWS EDITORJames Ling

IIBI EDITORIAL ADVISORY PANELMohammed AminAjmal BhattyStella CoxDr Humayon Dar Iqbal KhanDr Imran Ashraf Usmani

DESIGN CONSULTANTEmily Brown

PUBLISHED BY IBS Publishing Ltd8 Stade StreetHythe, Kent, CT21 6BEUnited KingdomTel: +44 (0) 1303 262 636Fax: +44 (0) 1303 262 646Email: [email protected]: www.ibspublishing.com

CONTACTAdvertisingIBS Publishing LtdPaul MinisterAdvertising ManagerTel: +44 (0) 1303 263 527Fax: +44 (0) 1303 262 646Email: [email protected]

SUBSCRIPTION IBS Publishing Limited8 Stade Street, Hythe, Kent, CT21 6BE, United KingdomTel: +44 (0) 1303 262 636Fax: +44 (0) 1303 262 646Email: [email protected]: newhorizon-islamicbanking.com

©Institute of Islamic Banking and InsuranceISSN 0955-095X

This issue of NewHorizon, as always, strives to educateand update its readers across the globe on the newestreports of the ever evolving Islamic finance industry.

Despite the feelings of some within the Muslimcommunity that Shari’ah and finance are not compatible,more and more countries around the world are embracingthe concept of Shari’ah-compliant banking and insurance.There have been talks of issuing sukuk in South Korea.Ajman, one of the Arab Emirates, has announced theestablishment of an Islamic bank. News has emerged thatItaly is to host a Shari’ah-compliant bank in the course of this year. Islamic microinsurance has been launched in Indonesia. And Kazakhstan, the largest country (byterritory) with a majority Muslim population – overeleven million people – is vigorously developing Islamicbanking and insurance (takaful).

This NewHorizon puts takaful in the spotlight, featuringa comprehensive article on this type of protection – itsconcept, its structure and its products, with up to datedevelopments and impending challenges.

Basel II, a stumbling-block for Islamic banks, is alsoexplained in detail, and so is another highly topical issue,that of risk management.

There is also good news for those willing to study Islamicaccounting – IIBI has partnered with the Accounting andAuditing Organisation for Islamic Financial Institutions(AAOIFI) to offer those in the UK and Europe theCertified Islamic Professional Accountant programme (the CIPA programme) of this reputable organisation. We hope that the next step will be the introduction of theAAOIFI’s Certified Shari’ah Adviser & Auditors (CSAA)programme.

EDITORIAL

Deal not unjustly,and ye shall not be dealt with unjustly.

Surat Al Baqara, Holy Quran

This magazine is published to provide information on developments in Islamic finance, and not to provide professional advice. The views expressed inthe articles are those of the authors alone. The Publishers, Editors and Contributors accept no responsibility to any person who acts, or refrains fromacting, based upon any material published in the magazine. The Editorial Advisory Panel exists to provide general advice to the editors regardingmatters that may be of interest to readers. All decisions regarding the published content of the magazine are the sole responsibility of the Editors,and the Editorial Advisory Panel accepts no responsibility for the content.

Mohammad Ali QayyumDirector General, IIBI

www.newhorizon-islamicbanking.com IIBI 5

NEWHORIZON Muharrum–Rabi Al Awwal 1429 NEWS

NCB helps handicappedMuslims to worship

Saudi Arabia’s NationalCommercial Bank is to make 20 mosques accessible tohandicapped Muslims. Theproject has come out of anagreement signed with theCollaborative Charity, wherebythe bank has committed itself to the training and developmentof people with special needs inthe province of Makkah.

The programme has beendesigned to enable elderly andhandicapped Muslims toperform their prayers andworship. The mosques will be selected by the charity

based on location and thenumber of elderly andhandicapped visitors. Thecharity will also decide on theadjustments needed to make the mosques accessible.

The first site to be enhancedwill be in Jeddah. This will befollowed by similar projects inthe rest of the cities of theprovince.

This programme is part of thebank’s strategy to assist peoplewith special needs by trainingthem to work in the privatesector.

Maybank increases foreigncurrency product set

After launching Malaysia’sfirst Islamic foreign currencyproducts at the start of theyear (NewHorizon online,31st January 2008), Maybankhas now increased its offeringto include two furthertreasury products. Theproducts are foreign currency

deposit and placement, andthey work on the commoditymurabaha principle. Theproducts are aimed atcorporates and high net-worthindividuals, and have beendesigned to enable investors tomobilise surplus funds into theIslamic financial market.

HSBC Amanah Malaysia hasbeen formally incorporated by its parent bank as a fully-fledged Islamic bank in thecountry. HSBC has been anactive player in the Malaysianmarket on both theconventional and Islamic

sides (NewHorizon,July–September 2007), and wasthe first locally incorporatedforeign bank to receive a licencefrom the country’s regulator,Bank Negara Malaysia(NewHorizon online, 9thNovember 2007).

HSBC incorporates Malaysian Islamic subsidiaryThe bank will have a universalbanking scope, which it hopeswill give it better access toMalaysia’s growing Islamicfinance industry. The bankinggiant hopes that its newsubsidiary will make thecountry the regional hub for

its Amanah brand.

HSBC Amanah Malaysia willbe launched in the second halfof 2008. It will offer a fullsuite of Shari’ah-compliantproducts and services to bothretail and corporate clients.

Moody’s Investors Service, theglobal credit analyst, hasreleased a report entitled ‘2007Review & 2008 Outlook:Islamic Finance’, which paintsan encouraging picture for theIslamic finance industry.Authored by DominiqueGribot-Carroz, Moody'sassistant vice president in HongKong, and Faisal Hijazi, ananalyst in London, the reportcalculates that the Islamicfinance market grew by around15 per cent for each of the lastthree years, which can beattributed mainly to theincreased wealth of Islamiccountries thanks to the oil priceboom.

The report estimates Shari’ah-compliant finance to be worth$700 billion worldwide, withthe largest increase in valuecoming from the sukuk market.Within this market, the reportreckons that sukuk held inAsian currencies increased byaround half last year. Overall,the report expects the sukukmarket to grow by 30 to 35 percent this year, mostly in GCCcountries, North Africa andAsia Pacific.

The report affirms Malaysia’slead in the global sukuk market,quoting 66 per cent of all sukukas being issued in the Malaysianringgit.

Moody’s report rosy aboutIslamic finance market

Mosque in Jeddah

©iStockphoto jamjom

NEWHORIZON January–March 2008

www.newhorizon-islamicbanking.com

NEWS

6 IIBI

Energy boom spurs Islamic banking interestGulf Finance House, Bahrain-based financial servicescompany, has announced theformation of the region’s firstShari’ah-compliant bank to be tailored to the energysector.

First Energy Bank has beengranted ‘in principle’ approvalfrom the Central Bank ofBahrain, and is now underformation with a plannedpaid-up capital of $750million. It will focus on oiland gas upstream anddownstream, transportation,petrochemicals, power, andindependent water and powerproduction.

The new bank is designed tocater to the huge anticipateddemand for investment in theglobal energy industry; theenergy infrastructure for theMiddle East and North Africa(MENA) region alone requiresapproximately $56 billion a year according to theInternational Energy Agency(IEA). This suggests a require-ment for $280 billion in invest-ment in the next five years.

The investment will be timely due to IEA estimates of anannual increase in globaldemand for energy of 1.8 percent until 2030, which equatesto a need for global investment

City Council leader pledges support for Islamic Bank

The Islamic Bank of Britain(IBB) and Birmingham CityCouncil are to work together tobring economic opportunities to entrepreneurs in the UK’ssecond city. The bank was thefirst Shari’ah-compliant retailbank in the country, and began

its operations in Birminghammore than three years ago. The announcement came out of a meeting between the leader ofBirmingham City Council, MikeWhitby, and the chairman anddirectors of the IBB in February(above). Whitby pledged to

work with the bank to bringnew economic opportunity topotential entrepreneurs in thecity. The meeting discussed ‘theway Islamic financial institu-tions may be of specific interestto communities in the city, andcould be part of a way to en-courage entrepreneurship anddevelopment’, says head of Lo-cate in Birmingham, MichaelLoftus. The Council wants towork with the bank to ensurethat its presence in the citytranslates into business growthin communities that may feel excluded from other financialavenues.

The meeting was also a way forthe City Council to acknowl-edge the bank’s commitment tobuilding its brand in Birming-ham. The city prides itself on itscultural diversity and has a large

Muslim population, but thiswas only part of the reason whythe IBB decided to locate itsheadquarters there, says Loftus,it was also because ‘it is a goodplace to do business from’.

Also discussed was a way forthe City Council and the bankto work together to explore mu-tual opportunities. ‘The finan-cial initiative that underpins theIBB came out of the Gulf, andthe Gulf is a source of otherkinds of investment around theworld,’ says Loftus. ‘We’re verykeen on encouraging that inter-est and awareness around Birm-ingham.’ He hopes to create anenhanced profile for the cityamongst sovereign wealth fundsand believes ‘the bank and itsconnections, and its own degreeof recognition can be very usefulto the city’.

of $4.3 trillion in the oil sect-or alone between now and2030. Esam Janahi, chairman of the founding committee forFirst Energy Bank, has referredto the opportunity that theincreasing global demand forenergy presents for investors, and is proud that First EnergyBank will be the first Shari’ah-compliant bank devoted tothe industry.

Peter Panayiotou, acting chiefexecutive of Gulf FinanceHouse, believes that First EnergyBank can fulfil the needs of anumber of private developers for capital and developmentexpertise.

Similarly, the bank will consideracquiring regional energycompanies which currently lack resources to fully exploitthe growth of this sector. FirstEnergy Bank plans a variety of investment activities, such as energy development projects,co-investment, acquisitions andmezzanine capital. The bankwill be established in asso-ciation with strategic partnersTasameem LLC, EmiratesIslamic Bank, KuwaitInvestment Co, CapitalManagement House, BahrainIslamic Bank, QINVEST,Energy City Qatar, KhaleejiCommercial Bank and PFCEnergy International.

IIBI 7www.newhorizon-islamicbanking.com

NEWHORIZON Muharrum–Rabi Al Awwal 1429 NEWS

Indonesia-based PT AsuransiAllianz Life has permanentlyincluded an Islamic micro-insurance product line in itsportfolio after the successfulcompletion of a two year pilot.The product range is dubbed‘Payung Keluagra’, which means ‘Family Umbrella’ and isspecifically tailored to meet theneeds of low income customers.

According to Jens Reisch, CEOof Allianz Life, the companywas ‘the first internationalinsurer to offer a micro-insurance product that complieswith Islamic law’. The companyhas already been offeringtakaful products in Indonesiasince April 2006, and now the range has expanded toincorporate Shari’ah-compliantmicroinsurance.

The majority of the Indonesianpopulation is Muslim (over 88per cent), so ‘ensuring that theproducts they buy do not goagainst the principles of theQuran is an importantconsideration for many,’ notedReisch, ‘and that applies topotential microinsurancecustomers, too’.

Allianz Life is currentlycollaborating with sevendomestic microbanks that offerthe company’s microinsurancepolicies to the Indonesianmarket. However, Reischexpects to increase thecooperation network in future,citing around 600 microbanksin the country that ‘are largeand modern enough to be viablepartners’. He also sees

considerable potential in largecommercial banks, ‘more andmore of which are entering themicrofinance sector’.

At present, the company hasaround 42,000 microfinancepolicyholders, the overwhelmingmajority of whom are women,who own and run smallbusinesses. Allianz Life has a far reaching aim to sell a total of 100,000 policies in the course of 2008, increasing this numberthree fold by 2010. ‘Our initialexperiences have encouraged us greatly,’ said Reisch. Thecompany has been able to buildup a sustainable customer baseand ‘is in the black’.

A new distribution concept hasalso been announced. To makeits products more accessible, the company is going tointroduce specialist micro-finance service providers,representatives and brokers atmicrobanks. The next step,according to Reisch, is tofurther diversify the productportfolio. Health insurance andchildren’s education, which are‘important considerations forlow income families’, as well asproperty insurance are amongthe new planned policies.

Allianz Life is part of AllianzGroup, an insurance, bankingand asset management servicesprovider with a global reach.Outside Indonesia, the Group’slocal subsidiaries currently offermicroinsurance products inIndia and Egypt, with 250,000and 30,000 takers in eachcountry respectively.

Islamic microinsurancelaunched in Indonesia

First Ajman-based Islamicbank announced

The city of Ajman will becomethe latest Arab Emirate to hostthe headquarters of a Shari’ah-compliant bank. In February,Ajman Bank held an initialpublic offering (IPO) for tendays, with the aim of raisingAED550 million ($149million) on the DubaiFinancial Market. The sumequates to 55 per cent of itstotal capital. Of the rest, 25per cent will be owned by thegovernment of Ajman, and 20per cent will be set aside forinternational investors.

The IPO was the most heavilyoversubscribed in the UAE forover a year, with investorsoffering more than 80 times the anticipated amount.‘Investors have clearly seen theopportunity that the creationof Ajman Bank offers,’ saidAjman Bank’s chairman,Sheikh Ammar bin Humaid al-Nuaimi. Yousif Saleh Khalaf

(above), who has a wealth ofexperience in the bankingsector in the region andabroad, has been appointedCEO of the bank.

The bank plans to offer a rangeof Shari’ah-compliant services,and seeks to tap into thegrowing market for Islamicbanking in the UAE. It hopes to open ten branches in the first two years, with the statedaim of becoming the favouritefinancial services brand in theUAE and the region.

A Shari’ah-compliant bank is to be established in Italy in thecourse of 2008, which will bethe first Islamic bank in thecountry. This was announced at a recent meeting betweenbankers from the Middle Eastand Italy.

Adnan Yousif, chairman of theUnion of Arab Banks, notedprogress on the plans to set up afully-fledged Islamic financialinstitution, worth $147 million.Although no details are beingdisclosed at present, there is a

Italy to get an Islamic bankpossibility that the new entitywill be incorporated under theumbrella of the EuropeanIslamic Investment Bank (EIIB).London-based EIIB is itself apioneer – it was the firstShari’ah-compliant investmentbank to be launched in the UK.Yousif stated that the deal is togo ahead in the course of thisyear. Initially, the bank willtarget the Muslim population of Italy, however once settled, it hopes to expand its customerbase to include non-Muslims as well.

The service was launched inFebruary, and is available forIslamic mortgages in the UK.

www.newhorizon-islamicbanking.com

NEWS NEWHORIZON January–March 2008

8 IIBI

eConveyancer launches Islamic mortgage panel

The online conveyance servicesplatform from the UnitedGroup, eConveyancer, haslaunched an Islamic mortgagepanel. The eConveyancerservice enables financialintermediaries, estate agentsand lenders to select andappoint a conveyancer(someone required to look afterthe legal interests for everymortgage in the UK) on behalfof their clients, and then trackprogress of a specific case. ‘Thecompany has now decided toenhance its service by launchinga specialist panel of solicitors

capable of managing Islamicmortgage applications on behalfof clients,’ explains sales andmarketing director, VanessaBlount (right).

The new service focuses on law firms that understand therequirements of Shari’ah-compliant mortgages. Blountbelieves there is a growingdemand for Islamic home finance in the UK, and that this is driving the need forconveyancers with anunderstanding of the specificrequirements of Islamic law.

‘The benefit for borrowers is that they will be dealing withconveyancers that understandtheir specific needs,’ she explains.

The service works by an adviserinputting basic client andinstruction details intoeConveyancer. This will produce a list of quotes that can be sorted by fee, distance or performance rating fromwhich the client will select theirconveyancer. Once selected, the conveyancer will commencework and update eConveyanceron a daily basis.

Sukuk in Korea?A strategic alliance betweenMalaysia-based CIMBInvestment Bank, and DaewooSecurities Co. Ltd, the largestsecurities firm in South Korea,has raised the prospect of asukuk market being nurtured on the peninsula.

CIMB will provide expertise asan established Islamic bank tothe regional footprint, andDaewoo will supply its brandname, which is prominent in the South Korean market.

The two entities are going to set up an Alliance InitiativeCommittee that will includerepresentatives from CIMB and Daewoo. The group willresearch, negotiate, strategise,

Switzerland-based ICBFinancial Group Holdings AG has become the newmajority owner of OrientalBank, a Bangladeshi Shari’ah-compliant bank with a recenttroubled history of corruption.

Oriental Bank has a widefootprint in Bangladesh, with 30 branches. However,Bangladesh Bank, thecountry’s central bank andregulator, dissolved OrientalBank’s board in 2006, andObaidul Karim, a keyindustrialist, was served a life sentence for mis-appropriating 67 million taka (around £50,000) fromthe bank in December.

The bank was also bannedfrom conducting many of itsservices for much of 2007

by the army-backed interimgovernment.

ICB, which is looking toexpand into emerging Asianeconomies, has seen a positiveopportunity to overhaul theoutfit, with the aim of itbecoming one of the mostefficient banks in the countryin five or so years, under thenew name of ICB IslamicBank, according to DrHadenan Bin A Jalil, chairmanof the ICB Group.

Emphasis will be placed onimproving the technology and infrastructure of the bank, as well as retrainingemployees, with a view toproviding an improved rangeof competitive products for the country’s hundred million-plus Muslims.

Overhaul for BangladeshiIslamic bank operate and manage the

financial products and servicesto be offered.

Dato’ Nazir Razak, group chiefexecutive of CIMB Group,states that ‘this alliance will giveKorean investors easier access to South East Asian stocks and will also give our clients accessto the Korean market. [This is] a region we believe holds greatpotential for the financialservices sector.’

The estimated number ofMuslims in Korea varies, and itis thought unlikely that manyreside in North Korea; however,the number of Muslims in SouthKorea is probably between40,000 and 100,000.

To stay up to date with all the news in the Islamic financial sector,visit the Breaking News section of the NewHorizon website at

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and demanded that the CMHC abandon its study. The MCC essentially makes fourpoints concerning Islamic banking: that itneedlessly ‘scares’ Muslims into payingmore than they should for banking; that it charges interest by another name; that the scholars, who gain financially bydetermining what is and is not Shari’ah-compliant, often use the position topromote the products of their employers,and are therefore incentivised to preachagainst conventional banking; and thatIslamic banking marginalises those Muslimswho use it by separating their bankingactivities from the mainstream of society.

The MCC also calls into question how theQuran should be interpreted on the subjectof Islamic finance, particularly on thedistinction between usury and interest. Thedebate centres on the concept of ‘riba’ fromthe Quran and the Hadith. Farzana Hassan,president of the MCC and also a women’srights activist, has denied that the Quranmentions the concept of interest at all,saying, ‘what it does talk about is usury and the two are completely different’.

Dr Humayon Dar, a well-known economist,an expert on Shari’ah-compliant productstructuring, and CEO of BMB Islamic (theShari’ah advisory and structuring arm ofBMB Group) agrees that the concept of‘riba’ is confusing. The IIBI’s perspective isthat the concept of ‘riba’, which comes fromthe Arabic root meaning ‘to increase’ or ‘to gain’, is much wider than its commontranslation as ‘usury’. Today, riba is

10 IIBI www.newhorizon-islamicbanking.com

NEWHORIZON January–March 2008

Shari’ah and banking: compatible or unsuitable? A recently announced study by the Canadian federal mortgage insurer has reignited debatewithin the Muslim community and among Islamic finance specialists about whether the conceptof Islamic banking is acceptable. NewHorizon’s contributing editor, Lawrence Freeborn, talks toindustry experts to get the full picture.

Governments in the West are increasinglytaking note of the growth of Islamicbanking across the world. In the UnitedStates, the treasury has recently appointedan Islamic finance specialist, and an IslamicFinance Information Program at HarvardUniversity has lately attracted mediainterest. In Britain, the government hasrecently announced its plans to consider theissuing of Islamic bonds, with the hope ofattracting investment from the Middle East.Lloyds TSB, a huge high street bank,currently has 200 branches offeringShari’ah-compliant services in the UK.

This activity has encouraged a study intoIslamic and other faith-based mortgages, to be conducted by the Canadian Mortgageand Housing Corporation (CMHC), afederal government body which providesmortgage insurance, and this has furtherstoked debate on the subject. The studyaims to determine how much demand there might be for faith-based mortgages in Canada, as well as to consider side issuessuch as whether the lack of faith-basedalternatives is potentially deterring peoplefrom entering the market. (This debatelooks set to rumble on – a spokesman from the CMHC stressed that the researchis not yet under way, and a report may not be produced until the end of this year.)

The Muslim Canadian Congress (MCC), a body which claims to provide a voice forprogressive and liberal Muslims everywhere,has ranged familiar criticisms against theconcept of Islamic banking in a press release

POINT OF VIEW

Baron Junaid Bhatti,Ballencrieff House

form of profits.’ Professor Wilson agrees that ‘no Islamic bank, or indeed conven-tional bank which offers a Shari’ah-compliant service, charges interest. They use different financing techniques, and have different ways of rewarding theirdepositors.’

Professor Wilson goes further, explainingthat, ‘potentially the return is a bit lower, but many people are prepared to pay amodest price to have a clear conscienceabout where their money is actually going’.This point hints at the reason why Islamicbanking may be marginally more expensivethan the conventional alternative in somecases. Shari’ah-compliant banks in the West face extra costs, such as the cost ofcompliance, and the cost of employing aShari’ah board of scholars. Professor Wilson disagrees with the idea that scholarsshould be expected to work for banks forfree, saying that ‘scholars who are sitting on these boards are doing a job, and can expect recompense’. Dr Dar, based on hisexperience of dealing with Shari’ah scholars,suggests that scholars’ fees have in any casedecreased in recent times, particularly inMalaysia. It is also important to note thattoday’s Shari’ah scholars, who sit onShari’ah advisory boards of financialinstitutions, are not only well-versed inShari’ah, but also in operations of theconventional financial system.

To Muslims, Islamic finance can perhaps bestbe compared to the fair-trade food move-ment, or indeed to buying a car. ‘If I buy an expensive car, obviously I’m buying theparticular features of that car. I could getanother car which is much cheaper, but I’mbuying it because it’s the car I want,’ citesWilson, ‘so it’s not just a question of com-peting on price, it’s also a question of thequality, the integrity of what’s provided.’ In

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NEWHORIZON Muharrum–Rabi Al Awwal 1429 POINT OF VIEW

generally understood to encompass all forms of interest, whether ‘reasonable’ or‘exorbitant’. It is prohibited due to beingexploitive and unproductive, as an effortlessgain and unjust enrichment at the expenseof others. Meanwhile, to some, it is largely a question of degree. Professor RodneyWilson, of the School of Government andInternational Affairs at UK-based DurhamUniversity, explains the definition of ‘riba’thus; ‘people in the Islamic financemovement do tend to interpret it as allinterest, and I do myself because I think it’svery difficult to distinguish interest fromusury. Usury is high interest, but how high is high? Do you have it at ten per cent or 15 per cent? Where do you draw the line?’

Professor Wilson also draws attention to the point that high interest is not just anissue in Shari’ah-compliant banking.Conventional credit cards and loans in theWest can often charge high interest, and‘quite often the poor people borrow at veryhigh rates because there’s no collateral tooffer’. Meanwhile, Western consumers whobuild up unaffordable levels of debt can beseen as morally dubious too, for the samereason as highly charging banks, since theycan be seen as ripping off the lender. Withthese kinds of caveats, it is clear thatmorality is hardly the ‘black versus white’issue that critics of Shari’ah-compliantbanking would make it out to be.

In a recent statement, UM Group, aCanadian Islamic finance organisation,supports the CMHC’s move to consider faith-based mortgages, and comparesShari’ah-compliant banking to ethicalfinance. ‘Islamic finance is structured tradeproducts devoid of usury, similar to ethicalproducts which have filters,’ states the UMGroup. ‘Islamic mortgages are equitypartnership with payments coming in the

Potentially the return is a bit lower, but many people are preparedto pay a modest price to have a clear conscience about wheretheir money is actually going.

Professor Rodney Wilson, Durham University

Professor Rodney Wilson,Durham University

12 IIBI www.newhorizon-islamicbanking.com

NEWHORIZON January–March 2008POINT OF VIEW

a similar way, Shari’ah-compliant banking is an exercise in choice by the customer. ‘Itdoes not come at the expense of other pro-ducts and nor does it compel any Canadianto purchase,’ according to the UM Group.

However, a cursory look at the state of theindustry in Britain suggests that it shouldnot be taken as read that Islamic finance is more expensive that its conventionalcounterpart. Baron Junaid Bhatti, an expertin Islamic finance and head of BallencrieffHouse, a consultancy firm for ethical andIslamic finance, suggests that this industrycan indeed compete on price, but that it will not happen instantly. ‘Any new product in any new niche will always be expensiveuntil you reach a certain critical mass, andthen it starts dropping in price rapidly asdifferent providers start to compete.’ So hasthe price dropped in Britain? ‘Absolutely.When you’ve only got one, it can pitch bysaying that it is the only provider. However,when a few more pop up it can no longer do that. It has to start competing on servicequality and price, just like everybody else.’Baron Bhatti points to personal loansoffered by the Islamic Bank of Britain,which have competed with conventionalloans since 2004. ‘It’s a much more matureproduct. Now the rate you can get is, Ibelieve, amongst the top ten cheapestproviders in the UK.’

The idea that Shari’ah finance marginalisesMuslims in the West is also stronglydisagreed with. Omar Kalair, president andCEO of UM Financial, says: ‘We don't seeIslamic financing ghettoising the Muslimcommunity. There would be no reason toassume [that], when today we have banks in Detroit and Chicago which offer Islamicmortgages at par to the Muslim communitythrough their branches’. Meanwhile,Professor Wilson thinks that Islamicbanking can serve as a useful tool forintegration. ‘It’s a way forward for youngMuslims who are keen to see their faithapplied,’ and it sends a positive signal ‘ifthey can aspire to work in a financialinstitution’. As far as the progressive causefor Muslims in the West is concerned,Professor Wilson finds it difficult to beunsympathetic to the MCC. ‘There are

many other bodies in Canada that representMuslim opinion, but not many that have thisparticular agenda, which is about separationof church and state. I’d not necessarily arguewith the agenda, but I’d argue with the wayit tries to forward it.’ Professor Wilson’spoint is that, as one of the most progressiveareas of Shari’ah law, the MCC would bebetter off embracing Islamic banking rather than bundling it with other, moreinflammatory, issues which are unrelated.For instance by claiming that, as the MCCdoes, ‘Saudi-inspired’ Islamic bankinglegitimises a particular brand of extremismassociated with the Wahhabi sect of Islam.

The MCC statement quotes from ProfessorTimur Kuran, a professor of Islamic thoughtand culture at the University of SouthernCalifornia, that Islamic banking ‘haspromoted the spread of anti-modern currentsof thought all across the Islamic world. It hasalso fostered an environment conducive toIslamist militancy.’ The MCC goes as far asto state that it’s ‘clear that most [scholars on Shari’ah boards] are hard line Islamistsand, in at least some cases, open supportersof terrorism.’ But categorisations ofconservatism and liberalism may be ratherdifferent from that which the MCC suggests.It is possible that Shari’ah-compliantbanking has much more of an affinity withliberal rather than strident interpretations of the faith, as Dr Dar implies: ‘As a liberalMuslim myself, I know how much cynicism Iface for being an advocate of Islamicbanking from the conservative echelons ofMuslim communities all over the world’.Likewise, Professor Wilson believes that thischarge is unlikely to stand up to scrutiny,commenting that, ‘I think there’s somemischief making there’. In such a way does the MCC ‘undermine its case’.

Partly for this reason, Baron Bhatti finds ithard to believe that the views of the MCCwill find much traction in the community of up to one million Canadian Muslims, withwords that should encourage the industry inCanada. ‘I am certain that the vast majorityof Muslims in Canada are keen to live theirlife in a halal manner, and this will includethe way they conduct their business andfinancial affairs.’

As a liberal Muslim myself, I know how much cynicism Iface for being an advocate ofIslamic banking from theconservative echelons ofMuslim communities all overthe world.

Dr Humayon Dar,BMB Islamic

Takaful International, the Bahrain-basedIslamic insurer, has shuffled employees insenior positions as part of a restructuringplan. Younis Jamal Al Sayed has becomechief executive of Takaful International,having previously been general manager of the company. He can draw on 20 years’experience from working with ArabInsurance Group.

Essam Al Ansari has replaced Al Sayed as general manager and Abdulaziz AlOthman is promoted to deputy generalmanager. Both have extensive experience in the takaful industry, having worked for a number of high-profile insurancecompanies in Bahrain and outside it.

Abdul Rahman Tolefat has been named as the new chief executive of AllianzTakaful Bahrain. Prior to this assignment,Tolefat worked for the Central Bank ofBahrain where he was responsible for thedevelopment of the country’s Shari’ah-compliant finance sector.

Bank of London and The Middle East(BLME), an Islamic wholesale bank basedin London, has appointed two new non-executive directors. Masood Akbar was anon-executive director at Genesis EmergingMarket Fund for six years before joiningBLME, and is also currently an executivedirector of AREF Investment Group inKuwait.

Sheikh Abdullah Jaber Al-Ahmad Al-Sabah,the other newly appointed non-executivedirector of BLME, has also become vicechairman of the bank. He is currently thedeputy director general of investments atthe Public Institution for Social Security(PIFSS) in Kuwait, as well as the chairmanof Housing Finance Company (ISKAN) and a board member of Global InvestmentHouse and Al-Ahli Bank of Kuwait.

Tuan Hj Sharkawi bin Alis has beenappointed chairman of Malaysia-basedTakaful IKHLAS. He has served in theMalaysian Judicial and Legal Service, as well as working for the Malaysian MiningCorporation and Malaysian SecuritiesCommission. He is also chairman of MNRBHoldings Berhad, Takaful IKHLAS’ parentcompany.

Takaful IKHLAS has also appointed TuanHaji Yusoff Bin Yaacob, to be the board’sindependent director. He is a fellow of theChartered Insurance Institute in the UK, anda director of MNRB and the MalaysianReinsurance Berhad.

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On the move

APPOINTMENTS

Khaleeji Commercial Bank, an Islamic bankin Bahrain, has elected a new board ofdirectors for a three year term, reflecting thenew shareholding structure of the bank. Themembers are: Dr Fuad Al Omar; EsamYousif Janahi; Abdul Latif A Al Meer;Hesham Abdullatif Al Jaber; Talal Alghalib;Rashad Yusuf Janahi; Abdulrahman M AlShared; Abdulla Showaiter AbdullateefMoosa Al Abdul Razzaq and EbrahimHussain Ebrahim.

Suhail Al Shamsi, Naofal Abd Al Karim AlShawarib, Sarah Ahmad Ibrahim andFatima Al Suwaidi have been chosen as thebranch managers of four new branches ofthe Dubai Islamic Bank (DIB) in Abu Dhabi,Sharjah, Ajman, and Ras Al Khaimah. Thefour have extensive experience in thebanking industry and will help DIB in itsaim of widening distribution channels for arange of services.

The Saudi Arabian Alahli Takaful Companyhas appointed Omar Khalifaty as newchairman of the board of the company. Hewas previously director of AlujainCorporation, a Jeddah-based industrialinvestment firm.

Abu Dhabi Islamic Bank has announced the appointment of Tirad Mahmoud to theposition of CEO. Mahmoud has 25 years of experience from Citigroup and SaudiAmerican Bank, with much seniormanagement exposure, including being aCEO and managing director for Citibank.

Saeed Al-Khuraimi has been appointedgeneral manager at Saudi-based SABBAmanah Islamic Services to lead the bank’sShari’ah-compliant financial services. Hehad previously been manager, privatebanking.

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Ms FoziaAmanulla (left) hasbeen named asCEO of MalaysianEONCAP IslamicBank Berhad.Prior to joiningEONCAP Islamicin early 2007,Amanulla headed

the Islamic debt capital markets inAseambankers Malaysia Berhad (aninvestment banking arm of Maybank),responsible for both the domestic andoverseas market operations.

Mohamed QasimAl Ali (right) hasbecome the newCEO of NationalBonds Corporation,the Shari’ah-compliant nationalsaving scheme ofUAE having beenpromoted from deputy CEO of thecompany. He graduated in the US andhas previously served as general managerin the UK and Ireland for EmiratesAirlines.

The term ‘Basel II’ is now commonplacearound the banking world. Most peoplehave at least some idea of what it means,but some of the nuances of its application to Islamic banks may not be quite so wellunderstood.

The intention of Basel II, quite simply, isthat the regulators want to ensure thatbanks are prudent in maintaining sufficientreserves to protect themselves and their de-positors against untoward events in theirloans, their operations or, within reason, themarket itself. The idea is that a bank needsto set aside capital, which is essentially thebank’s own money, for each of a set of de-fined categories of risk. The more risky thebank or its business, then the more capital it needs to put to one side to provide a cush-ion against things going wrong.

As Dr Schoon points out, ‘the initiative wasreally aimed at the large banks of the G10developed countries. What was originallyintended for a Citibank or a JPMorgan nowequally applies to a small savings & loan[institution] in the United States’.

It also, of course, applies to Islamic institu-tions. Depending on the uptake of Basel IIin a particular country, it will apply to someIslamic banks sooner than others. Neverthe-less, it may eventually apply to almost everyIslamic financial institution. In many coun-tries the regulations are already in place –for others it is on its way. In the main,

Islamic banks tend to be relatively small andare often located in countries where Basel IIis not the regulator’s top priority, accordingto Dr Schoon. So the impact on Islamicbanking has not been felt as much as it hasbeen on some small conventional banks thathappen to be situated in nations that havealready adopted the directive. Nevertheless,Dr Schoon believes that Islamic banks willlargely be affected in ‘the same way as anyof the smaller conventional banks’ aroundthe world.

Even though Basel II applies equally acrossall banks, its impact is felt differently in thesmaller banks than in the bigger banks. Thedifferences are not in the legislation itselfbut in the availability of associated modelsand historical data that a bank requires tocomplete its capital adequacy calculations.‘The larger banks are able to progress majordevelopment projects,’ Dr Schoon says,‘even when the actual capital relief was yetunknown’. These development projects re-late to banks creating customised ratingsmodels based on available historical data inthe bank rather than using the ‘standard-ised’ approaches that are generally adoptedby the smaller banks. Those standardisedapproaches offer reduced costs of imple-mentation and maintenance compared tothe custom internally-built models used bythe largest banks.

‘Smaller banks, including the Islamic banks,are likely to suffer from a lack of data and

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Islamic banking and Basel II:challenges ahead ‘No obstacles – no special favours’ describes the UK regulator’s attitude towards Islamic bankswhen applying banking regulations – which includes the regulations surrounding the Basel IIcapital adequacy directive. But is the directive itself quite as accommodating? Don Brownlow,NewHorizon’s contributing editor, talks to Dr Natalie Schoon, head of product development at theBank of London and The Middle East plc.

Dr Natalie Schoon,Bank of London and The Middle East plc

the bank’s internal processes, people and systems.

When comparing Islamic banks to smallerconventional banks there is not likely to betoo much difference in the levels of opera-tional risk encountered by either group. It is in the assessment of credit risk where the Islamic and conventional approaches to financing can result in different capital adequacy treatments.

As an example of such a difference, DrSchoon points out that ‘one of the areas ofconcern to regulators is when banks lend to institutions for which they also own eq-uity’. In the conventional banking world

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a smaller sample size,’ according to DrSchoon, which restricts them when attempt-ing to build their own models, whereas thelargest banks, including those that offer Islamic windows, are able to develop cus-tomised risk models using their own histori-cal experience.

When specifically looking at historical loanlosses, there are loss databases available tothe conventional banks such as the Pan European Credit Data Consortium(PECDC) or the North American Loan LossDatabase (NALLD). These databases arehowever not necessarily suitable for Islamicbanks since they are associated with conven-tional finance. In addition, the risk appetiteof Islamic banks may be different. There is an opportunity in the Islamic banking com-munity to create a specialised database thatis specific to Islamic institutions and theirloan loss history. In fairness, many Islamicbanks are so new that they have not as yetseen the full economic cycle, so even if theindustry’s loan loss history were availablethen it might not yet provide a significantsample size.

The main components of Basel II – creditrisk and operational risk – are shown in Box 1. There are other risks but, for themost part, conversation is often restricted to these two main items. ‘Credit risk’ gener-ally means the quality and risk level of thebank’s loan book; ‘operational risk’ generally refers to the quality of

The amount of regulatory capital is calculated based on the aggregate of all of the bank’s risk weightedassets multiplied by eight per cent. The eight per cent multiplier originated in the Basel I agreementand has not been changed in Basel II. See below:

For example: A loan to a ‘bank incorporated in OECD’ attracts a 20 per cent weighting. The calculation is: for each £100 lent the lending bank must maintain £100 x 20% x 8% or £1.60 in regulatory capital. For the 400 per cent weighting given to lending with an equity position (see body of article), the calculation would be £100 x 400% x 8% or equal to £32 in regulatory capital.

How capital adequacy is calculated

Example Asset Classes Risk Weight

Central governments, central banks, OECD governments 0%

Multilateral development banks, banks incorporated in the OECD 20%

Mortgages 50%

Private sector, commercial companies owned by the public sector, all other assets 100%

Credit risk is defined as the risk that a counter-party will default on one or more payments.Three approaches can be used to determinethe required capital:

Standardised Approach

Roughly the same as the current Basel II approach. In addition to the standard riskweights currently available, clients need to begraded by an External Credit Assessment Insti-tution (ECAI). The rating of the counterpartywill be incorporated into the overall riskweighting.

Foundation Internal Ratings-Based Approach (FIRB)

Banks do not rely on ECAIs for their ratings,but determine the probability of default (PD)of their borrowers using an internally builtmodel. Loss-given default (LGD) and expo-sure-at-default (EAD) are determined basedon supervisory rules defined in Basel II.

Advanced Internal Ratings Based (AIRB)

Not only the PD, but also LGD and EAD are determined based on internally built models.

Operational risk is defined as the risk of loss

resulting from inadequate or failed internalprocesses, people and systems or from external events. This includes legal risk, butexcludes strategic and reputational risk. Simi-lar to the calculation of the minimum capital requirements for credit risk, three methodolo-gies are available for the calculation of opera-tional risk capital charges:

Basic Indicator Approach

The capital charge is calculated as a fixed percentage (15%) of average gross incomeover the previous three years. The percentageis determined by the local regulator.

Standardised Approach

The banks’ activities are divided intro eightbusiness lines, and the capital charge is calculated per business line as a percentage of gross income. The percentages differ ac-cording to the business line and are set by the local regulator.

Advanced Measurement Approach (AMA)

Banks apply their own internally developedmodel, which incorporates quantitative andqualitative criteria such as internal loss data,key risk indicators, scenario analysis and self-assessment.

Basel II: Available approaches for Credit Risk

Basel II: Available approaches for Operational Risk

Box 1

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this could signal a risky situation. But, ofcourse, taking an equity position in a company can often be an integral part of a transaction when an Islamic bank lendsusing Shari’ah-compliant instruments.

Generally, regulators are of the view thatbanks should not hold significant equity positions in companies to which they alsolend. This is based on the belief that abank’s risk increases when the ownershipposition and the provision of lending are inthe same hands. The view is that lendingmoney to a company you own (or have asignificant stake in) results in ‘non-arm’slength dealing’ which generally attracts asignificantly higher risk. Any equity positionheld by a bank is therefore penalised underBasel II by assigning a higher risk weightingfor capital adequacy purposes. This canhave a direct impact on an Islamic bankwhen it lends to an institution under an equity participation financing arrangement,such as a musharakah or a mudarabahstructure for example. In these structuresthe bank’s financing takes the form of an equity position in accordance with Islamicprinciples.

It is in an attempt to rectify possible in-equities that the regulators not only look at the type of instrument being used but also

the purpose for which it is used. Dr Schoonpoints out that, for example, ‘a musharakahthat is used for a mortgage would attractthe same treatment as a conventional mort-gage; if it is used for specialised finance thenthe regulator could apply “supervisory slot-ting criteria”; however, if it is used for otherpurposes then it would attract the sametreatment as would an equity holding’ i.e. athree or four hundred per cent risk weight-ing depending on whether it is public or

private equity. This adds to the capital costs of mudarabah and musharakah agreementsmaking them more expensive. This highercost of capital should be taken into accountwhen advising a client and it may be that alternate structures would meet the client’sneeds at a lower cost.

The Islamic Financial Services Board (IFSB)has published a standard for capital adequacy – The Application of Capital

Adequacy Standards – that follows the BaselII directive. Because this standard is aimedpurely at Islamic institutions its breadth isnot as broad as the main Basel II directive.It contains, for example, only the ‘standard-ised model’. Similarly to Basel II, the recommended IFSB standards are not implemented globally in the same way. For example, the Financial Services Authority(FSA – the UK’s financial services regulator)through its local implementation of Basel II

does not apply the IFSB guidelines in theUK, but treats Islamic transactions underthe same guidelines as conventional transac-tions. There is, however, still no relief fromthe four hundred per cent weighting for equity positions held in counterparty institu-tions. The Islamic banking community issmall but it is pressing for its voice to beheard by regulators regarding this equityissue. There are no known plans at this time for the weightings to be changed.

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Basel II is an update to the original Basel agreement (often referred to as Basel I) that was reached by the Basel Committee for Bank-ing Supervision in the Swiss town of the same name. The Basel I capital adequacy rules came into effect in 1988.

Basel II was intended to improve some of the weaknesses in the original agreement. Most notably, Basel I did not take into accountthe quality or credit-worthiness of a bank’s counterparty (borrower). A large and well managed organisation with no defaults in its history was rated at the same level as a much more risky institution.

This was corrected by the introduction of weighting that varied according to the counterparty’s credit risk history. In addition, weightings for operational risk were also introduced.

Having reached an accord in Basel each regulator was then to arrange for appropriate legislation in its own country to turn the agreement into locally applicable law.

The initiative was really aimed at the large banks of the G10 developed countries. But various international accounting scandals and the atmosphere of corporate regulation that created such reactions as the Sarbanes-Oxley regulations in the US provided a fertile regulatory environment for the emerging Basel II standard to be adopted worldwide and for every type of bank.

The origins of Basel II

The initiative was really aimed at the large banks of the G10developed countries. What was originally intended for a Citibankor a JPMorgan now equally applies to a small savings & loan[institution] in the United States.

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‘Islamic finance through its equity-basednature has a lot to offer for the stability of the markets and the economies of theworld,’ states Dawood. ‘Debt has helpedthe Western economies grow very fast butthey keep having these hiccups,’ hecontinues, referring not only to the recentsub-prime shake-up but to similar crises inthe past as well.

But Dawood does think that the currentsub-prime crisis is helping the Islamicbanking world because of debt tradinguncertainty. ‘You’d get an asset againstwhich you created a debt but then you’dcreate debt against that debt again. If it’s a $100,000 asset (a house, for example)and you’ve created a $90,000 asset out ofthat [mortgage loan] and then out of the$90,000 debt you create another $80,000asset [loan], so out of an original asset of $100K you’ve created a debt of$170,000. That can’t be right. And thathappens again and again and again. It’s likemusical chairs, when the music stops therewill be no chairs to sit on.’ He thinks thatgrowing awareness of the situation will give a boost to Islamic finance, and that it’s important that people know andremember that the conventional side ofbanking is debt-based, whilst the Islamicside is equity-based.

Yet, despite the differences, he sees manysimilarities between the two forms ofbanking. ‘You are comparing a 40 year old industry to a 700 year old one,’ saysDawood. ‘But at the end of the day,

Islamic banking evolution: today’sachievements and tomorrow’s trends In this edition’s interview column, Majid Dawood, chief executive of Yasaar Limited, anindependent firm that provides Shari’ah compliance services and consultancy to financialinstitutions, shares with NewHorizon his views on the contribution Islamic finance can make to the world’s economy and the important contribution the scholars make to Islamic finance.

banking is still banking – the risk analysisand nature of the business are similar.’

There are certain layers in Islamic bankingthat the specialists wish to import into theconventional banking models but, whilethere are some things that can’t be acceptedby Shari’ah-compliant finance, ‘more or less what’s been happening so far is anadaptation of the conventional market –because it’s there – the technology is there,the capability, the innovation is all there’.

Dawood sees this restatement ofconventional banking in Islamic termscontinuing, but he also believes that thenext trend will be for products andstructures which are built ‘from the groundup’, so that they are purely Islamic. Hecompares it to building a house; in order tobuild it exactly the way you want, you haveto start at the foundations. The industry iscontinually evolving – first there wereIslamic windows, then Islamic divisionswere set up and now purely Islamic banksare being established.

‘The other aspect is that we have to get thedevelopment of a critical mass.’ WhatDawood means by this is that as Shari’ah-compliant banking proceeds, more andmore countries are trying to create juris-dictions and tax changes to accommodatethis type of finance, and therefore itbecomes ‘an alternative asset class’. Hecontinues: ‘I have heard that by 2025,about twelve per cent of the world’sbanking will be Islamic banking. If that’s

INTERVIEW

Majid Dawood,Yasaar Limited

A client may expect a Shari’ahscholar to be a scholar, abanker and to know abouttransaction structure; and theywant him to be a lawyer and anaccountant as well. That’sasking a lot.

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INTERVIEW

the case, then you’re getting a critical mass –and once you get it, there will be enoughproducts, enough depth in the market for itto have its own benchmarks.’ There will be no need to use LIBOR (London InterbankOffered Rate, an internationally recognisedinterest rate) or to refer to LIBOR as abenchmark. Islamic finance will have itsown rules, regulations, documentation,standards and so on.

In Dawood’s view, the first generation of products were an adaptation ofconventional products and in some cases the scholars accepted them on the basis ofnecessity. ‘Now the scholars are saying “It’stime to move on”.’ Recently there has beensome controversy over sukuk, and beforethat it was over commodity murabaha andalso hedge funds. Initially, the hedge fundswere based on salam contracts but thesewere deemed not acceptable. So people went back to the drawing board. Salamcontracts have been replaced and funds arenow based on arboun. ‘Development istaking place,’ observes Dawood. Similarly,when referring to the recent debatesurrounding sukuk, he believes that ‘thesethings have been moving away from theoriginal concept to a point where it’sbecoming unacceptable to the scholars.Now they’ve reined them in.’

Dawood notes that it is not just the form of the contract but also its end-purpose that the scholars are interested in. As anexample he points out that ‘the wa’adcontract is a promise from one party toanother to fulfil in the future; a totallyacceptable contract with specification andsuch’. The end-consequences are important,he emphasises. ‘If you do all of this toachieve something and the end-consequences are not acceptable then you’ve circumvented the contract’s essentialnature.’ So, for example, the question ofbenchmarking to a hedge fund becomes an issue if the hedge fund has an incomefrom an unacceptable activity.

‘There will be evolution on all fronts,because it’s a very young industry,’ projectsDawood. ‘But it can be controlled andshould be in the essence of what it is

expected to be.’ The scholars have a centralrole in this control as well as in helping themarket to develop. His belief is that thescholars’ views are important opinionsbecause of their knowledge, and that theindustry needs their interpretation of earlier precedents. He says that ‘things have changed in 1400 years from those of

the Hadith, and today’s world is a verydifferent world’. What the scholars aredoing is interpreting what may have beenthe case and how it would have beeninterpreted then based on certainprecedents.

‘A client may expect a Shari’ah scholar to be a scholar, a banker and to know abouttransaction structure; and they want him to be a lawyer and an accountant as well.That’s asking a lot,’ he notes. In the future,people may refer to the scholars of todayand to their precedents, so their involvementand contribution are essential. Dawoodstresses that it is important to get thescholars engaged early in the productdevelopment process, virtually from DayOne. They can guide as to what direction to follow, or suggest options and warnabout potential pitfalls. ‘It is like a pilotguiding a ship into port,’ says Dawood.‘They take you into it in the right way.’

‘We have got to deal with the scholars andwe have to pay them, but in the end it’s adevelopment cost,’ he continues. Once aproduct is developed and the standard-isation is there, the costs will reduce. If oneShari’ah board has created and devised aproduct and given it a fatwa, the bank thathas developed the product will try to place it with other institutions as investors. Ifsuccessful, this means the Shari’ah boards of those organisations have also seen andaccepted the product. ‘So you have 20 or 30scholars that have cleared it. Surely thatbecomes a standard?’ Then, if a standard-setting body adopts a product, it shouldunderstand the changes for tax and the legalimplications and get the approval of legal

firms, central banks and regulators. ‘Oncethat’s cleared, you have a product that youcan use anywhere in the world, in thosejurisdictions as you need them,’ explainsDawood.

But he disputes the notion that once theindustry is standardised then there will be

no further need for scholars. He feels thateven if the investor knows that the productis acceptable, the Shari’ah board still needsto monitor the use of that product. As anexample of productive monitoring he cites an example of the US-based energycompany, Enron. One year before Enronwent bust, the scholars insisted on removingthis company from the Dow Jones IslamicMarket Index, because of unacceptable debt ratios. The core principles of Islamicfinance and the prudence of the scholarsacting according to those principles meantthat Islamic investors were out of Enron‘before it went belly up’.

And for the future of the industry, Dawoodthinks it is the international business centresthat we should be looking at. He citesSingapore with its efforts to accommodateIslamic finance and also the UK, which is being ‘very, very proactive’. Financialcentres such as Dubai InternationalFinancial Centre (DIFC) in Dubai, as well as those in Bahrain and Malaysia, will play significant roles in the maturity andinternationalisation of Islamic finance. Asfor the US, it is currently ‘behind the curve a little bit’, but once it decides to implementthe changes, these will be done ‘verystrongly and very thoroughly’ (for moreinformation on developments within theIslamic finance industry in the US, seeNewHorizon, October–December 2007).The US economy is ‘one of the biggestcomponents of the engine of the world’seconomy’, emphasises Dawood, and itcannot possibly be ignored. The US, in itsturn, cannot ignore the Islamic market;therefore, ‘both have to work together forthe future’.

I have heard that by 2025, about twelve per cent of the world’sbanking will be Islamic banking.

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between parties in a shared risk–returnmodel. A more comprehensive definition of Islamic banking and finance, however, isone that states that they are the activities,transactions and interactions initiated byfinancial institutions whose intentions,goals, objectives and operations are basedon principles prescribed by the Holy Quranand the Sunnah.

Fundamentally, the Shari’ah principlesforbid ‘interest’ but they do not prohibit allgains on capital. Simply stated, Shari’ahprinciples recognise the time value of money(profit) but not the monetary value of time(interest). Shari’ah law requires that theperformance of capital must be taken intoconsideration when rewarding capital.

Within the past five years, the world hasdiscovered Islamic finance. Today’sinvestors, retail banking consumers andcorporations are embracing Islamic financeas a viable alternative in investments,lending, and corporate financing. Thesurprise and shock of the new century hasbeen that Islamic banking is now being usednot only by Muslims, but by non-Muslimsas well. Why is Islamic finance gaining theattention of worldwide financial markets asa new part of the suite of financial productsthat are a viable alternative to conventionalinterest-based financing? What is the bigattraction? Is Islamic finance better, faster,more competitive, cheaper or safer? In aworld where the promises of liberalcapitalism have brought to light the sadreality whereby economic systems havesimply been unable to solve social problems,Islamic finance presents itself as analternative for both Muslims and non-Muslims to facilitate their finances underthe moral and ethical constructs of Islam.This article aims to address the promise ofIslamic banking to markets worldwide byidentifying what makes it different fromtraditional banking.

So what are the basic tenets of Islamicfinance?

Islamic finance has been defined as Shari’ah-compliant, whereby a local Islamic scholarinterprets the word of the Shari’ah law, atthe same time reflecting the views of thelocal community. Just as Islamic banking isinterest-free, multi-purpose, not purelycommercial, and strongly equity-oriented,Islamic finance strives to achieve equity

A cloud is a promise, fulfilment is rainWhy is the underlying promise in Islamic finance different? Joe DiVanna, managing director ofMaris Strategies Ltd, a strategic think tank for financial institutions worldwide, and the author of‘Understanding Islamic Banking’, ‘The Future of Retail Banking’, ‘Redefining Financial Services’and ‘The Merchants of Fear’, explores the issue.

Therefore, in financial terms, the use ofcapital must add value and not be devoid ofrisk (Holy Quran, 2:275). Islamic financialtransactions are an exchange based on thepremise of an equitable transfer betweentwo parties whereby there is equality insharing risk and a clear title to the owningand handling of physical goods (assets). Inmany cases, in modern societies, banks andfinancial institutions that facilitate thetransfer between two parties typically playthe role of a hands-off intermediary. Islamicbanks act as hands-on intermediaries as they deal and trade in assets purely for thepurpose of income generation or profits.The key difference is that Islamic banksconvert money into assets based on theirutility. An Islamic bank must handle therisks associated with the transfer of assets,trades and other ancillary transactions whileadhering to the best practices of corporategovernance and the principles outlined inShari’ah law. If the profits generated fromthese transactions are considered compliantand free of interest, they are said to bepermissible, or halal, and the proceeds are in turn passed on to the depositors asincome. If they do not meet Shari’ahprinciples, they are considered unsuitable, or haram, and the Shari’ah advisors to theinstitution may in many cases assess apenalty to the intermediary to correct themistake.

It is important to remember that Shari’ahprinciples are not simply a prohibition ofinterest. They are also designed to avoidunethical practices. Islamic institutionsprovide customers with the means tofacilitate the transfer of value between

OVERVIEW

Joe DiVanna,Maris Strategies Ltd

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NEWHORIZON Muharrum–Rabi Al Awwal 1429 OVERVIEW

parties, by measuring their intentionsagainst the fundamental social valuesexpressed in the Holy Quran and theSunnah. Therefore, Islamic institutions areset apart from other financial institutions in two ways. Firstly, they must review theirintentions through a moral and ethical lensbefore they take action, and the products or services they bring to the market mustreflect the direct values and beliefs of theircustomers, ranging from strict funda-mentalism to moderate multiculturalenvironments. Put simply, Islamic financialinstitutions assess the needs of thecommunities they serve in order to createproducts that reflect the values and beliefsof their customers, unlike non-Musliminstitutions that create products with thespecific intention to get customers to adaptto a new banking behaviour.

For Western bankers and non-Muslims, theinevitable question is, how can a financialsystem operate without interest, treatlenders and borrowers equitably and worktowards the overall improvement of society?The answer is not simply that Islamicinstitutions have developed complex profit-and-loss sharing mechanisms. Nor is it that over time the use of interest-likealternatives, such as instituting offsettingservice charges or merely acting as buyingagents from which assets are leased andthen transferred at the end of the term hasevolved. Islamic banking is interpretive,adaptive and, above all, dynamic in that theelucidation of Shari’ah law reflects the localculture and social fabric of the communitiesserved.

A bit of history….

Furthering the question of the differentunderlying promise of Islamic banking asopposed to traditional banking, a fewhistorical considerations are in order. Intoday’s contemporary debate between theacademics who study financial services andthe banking industry professionals, onequestion that often arises is, how can aneconomic system thrive without thecharging of interest? The concept of aninterest-free economic system should not be alien to conventional bankers in Europe

and other large economies though, simplybecause, at one time in history, the samebasic principle guided the Christianeconomies of the Middle Ages.

There are numerous variations on howIslamic banking is brought to marketaccording to various schools of Islamicthought. The variations centre oninterpretations of Shari’ah principles thatare universal in nature throughout Islam. During the Middle Ages, Christianecclesiastics were fiercely against usury,arguing that usury was against the natural order of things, ‘a sin of cosmicproportions’, which was a direct reflectionof the Aristotelian view on lending wherebynatural law was of a just equality: whateverwas lent was returned and nothing more,nothing less. By the thirteenth century,Augustine’s definition of usury as beingpractised by anyone who expected to receive more than the amount lent waswidespread. The Church established canonlaw prohibiting borrowing money where the lender would receive back more that the original amount.

Critics of various implementations oftoday’s Islamic banking compare theformulaic methods of calculating the timevalue of money with a method ofcircumventing canon law used by Europeanbankers during the Middle Ages, known ascontractum trinius.

It is essential to understand the progressionof medieval contracts, which had originatedusing the same set of fundamental beliefs asMuslim finance, in the context of where thevalue proposition for Islamic banking standstoday and what path it may take in thefuture. Shari’ah scholars will continue to review the modern adaptations and use

of more sophisticated techniques infacilitating interest-free commerce with an ever-watchful eye towards the future. As we can see, the evolution to today’s

conventional interest-driven bankingindustry did not happen in one single event.Rather, it was a slow gradual processoriginating from within the Christianeconomies in order to facilitate themonetary needs of a world becoming less agrarian and more commercial.The three central issues that transformedsociety’s views on usury can be directlylinked to the overall value proposition ofthe process of capital provision. First of all, the nature of the Western world’sunderstanding of time was changing from a cyclical mindset to the recognition of alinear progression. This had directimplications for the value of assets,commodities and money over the time each was used, relative to their useelsewhere.

A second factor, that of just price, was alsochanging as society’s attitude moved fromthe idea of fair price or ideal price (iustumpretium), based on a good’s value in itsusefulness to the community, to that ofprices based on the market-driven forces of erratic supply and demand. The ChristianChurch found that over time it wasimpossible to fight the combined forces ofeveryday life. As scholars debated, peoplestill needed to eat, farmers to plant andharvest and businesses to engage incommerce and trade.

Another factor which must be considered is the centralised nature of the Church thatacted to concentrate the matter of legalinfraction due to its hierarchical structure.This is a striking dissimilarity with Islam’s

For Western bankers and non-Muslims, the inevitable question ishow can a financial system operate without interest, treat lendersand borrowers equitably and work towards the overallimprovement of society?

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NEWHORIZON January–March 2008OVERVIEW

decentralisation of Shari’ah principleswhereby local scholars interpret the law that technically reflects the local community.One might argue that this is the first pointof divergence between traditional bankingand Islamic banking, indeed one which willlead the two types of banking to move farapart in modern times.

Several final factors that were shaping themedieval mindset included the realisationthat the value of money was affected bysupply and demand, when over time whatwas lent might be returned at full face valuebut be worth less than before. This line ofthinking shifted the debate from usury toone of risk, fair use and the generation ofprofits. In addition, throughout theRenaissance and into the seventeenthcentury, there was a consistent gradualdecline of the influence of the Church ineconomic affairs.

The Church took little official interest inmatters of usury after the seventeenthcentury. An encyclical of 1745 by PopeBenedict XIV stated that the nature of thesin called usury has its proper place andorigin in a loan contract (mutuum), statingthat one returns to another only as much as he has received. The act that constitutes a sin rests on the fact that sometimes acreditor desires more than was given. Onehundred and fifty years later, in 1917, the Code of Canon Law number 1543described contracting for legal interest asnot in itself illicit, unless interest rates arefound to be manifestly excessive. Over time,the Christian definition has struggled tomake a clear distinction between the cost of capital and interest.

In Islamic finance, the prohibition ofinterest does not imply that capital iscostless: Islam recognises that capital is anaspect of production. However, it is haramto make a prior or predetermined claim on a productive surplus in the form ofinterest. Under Shari’ah principles, theowner of the capital can legitimately sharethe profits made by the entrepreneurbecause it is the ratio of the profit-sharing,not the rate of return, itself that ispredetermined.

Does Islamic finance then open doors to analternative economic system in the longterm?

To answer this question, let us first examinethe fundamentals of Islamic finance with a little history lesson. Economists in the past two centuries who have addressed theinequalities of liberal capitalism specificallyaimed at the role interest plays in striking a balance between social classes. In 1906,Silvio Gesell, a German merchant whomoved to Buenos Aires during the height of the Argentine depression, wrote ‘TheNatural Economic Order’, a reflection ofthe structural problems caused by themonetary system. In the 1930s, JohnMaynard Keynes reviewed Gesell’s work,commenting on his theory and describinginterest as belonging to the quality ofmoney, being purely a monetary occurrencesetting a limit on the growth rate of realcapital. In Keynes’ view, a non-interestbased economic system warranted closerexamination and was conceivably viable.Gesell’s evaluation of zero-interesteconomies advocated that money should be used to stimulate consumption ratherthan to earn interest. If one looks at thefundamental tenets of the Islamic valueproposition, the potential reduction of

money circulating in the economy does notdetermine zero-interest. Rather, the Islamictheory of zero-interest is based on the ideathat the time value of money (profit) isacceptable, but the monetary value of time(interest) is not.

In 1958, Islamic economist Mahmout AbuSaud also wrote about Gesell’s ‘free money’theory; ‘Gesell's theory of interest is inharmony with the teaching of the Koranand should be welcomed in all Islamiccountries. His plan for an interest-free

economy is a solid basis for constructiveattempts to liberate man from the slavery of his own illusions, from the tyranny ofmistaken tradition, and from exploitationby his fellowman.’ Perhaps with furtherdevelopment of Gesell’s ideas, Islamicbanking will be in a key position to helpdevelop an alternative economic systemwhich is fundamentally different from theliberal capitalism that we now know.

So is the underlying promise in Islamicfinance fundamentally different?

Yes, Islamic finance is different in that itoffers both Muslims and non-Muslims anavenue of finance that is based on a higherset of principles. Perhaps John MaynardKeynes, who noted that Gesell’s concept of a fair and equitable economy needed morestudy, gave us a clue as to why the world isnow looking at Islamic finance with neweyes. In Keynes’ words: ‘Capitalism is theastounding belief that the most wickedest of men will do the most wickedest of thingsfor the greatest good of everyone.’ An oldArab proverb is possibly the best descriptionof where Islamic finance is as an industrytoday – ‘a cloud is a promise, fulfilment israin’. Perhaps we should be investing inumbrellas.

It is important to remember that Shari’ah principles are not simplya prohibition of interest; they are also designed to avoid unethicalpractices.

Inside the Islamic Guide:

o Introduction

o Suppliers & Systems List

o Technology Overview

o Islamic Authorities

o Shari’a Boards

o Case Studies of banks which have already implemented Islamic banking systems

o Bank Keshavarzi: Financial Network Systems, Bancs (now TCS Bancs)

o United Bank Limited (UBL) Ameen: Path Solutions - iMal Enterprise Islamic Banking & Investment System

o First Dawood Islamic Bank: System Access – Symbols

o View from the Suppliers

o Supplier Analysis:o Profile of each supplier and its systemso Company detailso History and development of each supplier and its

systemso Functionality details for each system o Customer lists

o Country Analysis

o Summary Analysis

IBS Publishing Limited, 8 Stade Street, Hythe, Kent, CT21 6BE, UKTel +44 (0) 1303 262636 Fax +44 (0) 1303 262646 Email [email protected] Web www.ibspublishing.com

to order call: +44 (0) 1303 262636 or visit: www.ibspublishing.com

The Who, What, Where Guide to

Islamic Banking SystemsEdition 3 – 2008

Printed £595Ebook £495

Printed & Ebook £755

A comprehensive guide to the Islamic core systems market with fully updated vendor profiles and unbiased editorial comment.

For more information including suppliers profiled and a sample chapter, visit our website: www.ibspublishing.com

PUBLISHED MARCH 2008

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Mosque in Astana, capital of Kazakhstan

COUNTRY FOCUS

Kazakhstan holds a unique position amongthe countries that gained sovereignty afterthe collapse of the USSR. Being the ninthlargest state in the world and the largest (byterritory) state with a majority Muslimpopulation, Kazakhstan occupies more than2.7 million square kilometres (over onemillion square miles).

Situated between Europe and Asia and,therefore, called the ‘heart of Eurasia’,Kazakhstan has ample natural resources of oil, uranium, ferrous and non-ferrousmetals. Over the last decade, the economicgrowth of Kazakhstan has been nothing lessthan remarkable: if GDP per capita tenyears ago comprised barely over $700, in2005 it attained $3000, and in 2007 theeconomic growth constituted 8.7 per cent.

The Index of Economic Freedom (a series of ten economic measurements created bythe Wall Street Journal and The HeritageFoundation to measure the degree ofeconomic freedom in the world's nations)ranks Kazakhstan as 75th in the world,which is higher than China (119th) andRussia (120th). The Index takes intoaccount such factors of economic freedomas trade and business freedom, labourfreedom, property rights and financialfreedom.

Kazakhstan has played a significant role inthe history of Europe and Asia over thecenturies, connecting the West and the East.

A considerable stretch of the Silk Road ranacross it, and Kazakhstan was the startingpoint of the great migration of peoples afterthe collapse of the ancient empires.

The wide spread of Islam in Kazakhstanbegan in the 750s, after the Battle of Talas,when the Chinese army was defeated byArab, Kyrgyz and Nepali forces on the bankof the Talas River (which runs through the modern states of Kyrgyzstan andKazakhstan). In the aftermath, the Turkicfolks in the region accepted Islam on a massscale.

The city of Farab (also known as Otrar),birthplace of the prominent philosopher,Mohammed Abu Nasr Al Farabi (870–950)and also home to the world’s second richestlibrary after the Alexandrian Library, islocated within the borders of present-dayKazakhstan. This region was also thehomeland to a host of renowned Islamicpublic figures and scientists of the XI–XIIcenturies, including Usuf Balasaguni (poetand philosopher), Mahmud Kashgari(linguist and philosopher) and KozhaAkhmed Yasaui (a Sufi teacher and mysticalpoet). The Turkic governor of Egypt andSyria, Sultan Baibars, was also born inKazakh lands.

For centuries, Islam has been the mainreligion for the whole region. However, inthe days of the Soviet regime, the countrywhere thousands of Islamic state figures and

Reestablishment of Muslim identity is on the rise in Kazakhstan, a former Soviet republic andnow an independent oil-rich state in Central Asia. The country’s financial sector is gearing up tocater for over eleven million Muslims residing in this ‘heart of Eurasia’. Some Shari’ah-compliantbanking products have already been launched and takaful protection is currently in the pipeline.Kuralay Yeldesbay, actuary at Kazakhstan-based BTA Insurance Group, has been behind theidea of introducing takaful to the country’s insurance market. She reports on the progress thecountry has made so far in accommodating Shari’ah-compliant finance.

NEWHORIZON Muharrum–Rabi Al Awwal 1429

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Kazakhstan: on the path of development

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April–June 2007). Abdulla Showaiter,general manager of corporate andinvestment banking at Emirates IslamicBank, referred to Kazakhstan as ‘a verypromising and prospective region’ anddubbed the country as ‘golden gates’ forIslamic products to other CIS countries. As the first step in introducing Islamicbanking, BTA declared its readiness toswiftly introduce an interest-free deposit to the market.

The two entities are also planning toestablish a fully-fledged Shari’ah-compliantbank in Kazakhstan, with BTA and EmiratesIslamic Bank having an equal 50/50shareholding in this financial institution.According to Roman Solodchenko,chairman of the board at BTA, ‘it willoperate as a joint venture, offeringcorporate and retail products’.

At present, Islamic financing in Kazakhstan,despite the success of the credit transactions,is still only at the start of a great journey.Nevertheless, according to specialists,within a few years, Shari’ah-compliantfinancing will take more than five per centof the country’s banking services market.

In 2007, the Agency for Regulation andSupervision of Financial Market andFinancial Institutions (the industry’sregulator in Kazakhstan), together with the Islamic Development Bank (IDB),announced plans to issue Islamic securitiesin Kazakhstan. These will be nominated inthe local currency, tenge. The plans weremotivated by the state’s proposal to developthe country’s capital markets by introducingIslamic financial instruments, starting withsukuk. This means that Kazakhstan maybecome the second country after Malaysiawhere IDB issues Shari’ah-compliantsecurities in the national currency.

Due to the immense interest in financingaccording to Shari’ah canons, aninternational conference entitled ‘IslamicBanking and Finances in Kazakhstan’ washeld in May 2007 in Almaty, the country’slargest city. This credible event wasorganised under the Agency’s sponsorship

COUNTRY FOCUS: KAZAKHSTAN

scientists lived and worked was subjected toviolent elimination of religious values andIslam was saved for domestic aspects of lifeonly.

Once Kazakhstan had gained sovereignty in the early 1990s after the demise of theSoviet Union, the process of the revival ofIslamic values started with a vengeance.According to recent data, about 16 millionpeople of 120 nationalities are currentlyliving in Kazakhstan, about 70 per cent ofwhom are Muslims. The official number ofmosques operating in the country isapproximately 1700, and construction ofmosques is taking place in all regions of thecountry, mostly on the initiative of stateofficials and businessmen. In recent years,there has been an overwhelming increase innumbers amongst the younger populationattending mosques, which reflects the risingimportance of religion in young people’slives.

TV programmes and documentariesdedicated to various Islamic issues areemerging, with religion becoming a focustopic of many radio programmes, while asignificant number of printed publicationson the subject of Islam have also beenissued. In 2001, the halal standard wasintroduced in Kazakhstan, resulting in agrowing number of cafes and restaurantsoffering halal food, and stores sellingclothes that meet Shari’ah requirements.

Consequently, it is not surprising that thereis vast interest in introducing Shari’ahfinance in Kazakhstan. The financial sector of the country is aware that thedevelopment of Islamic banking will, firstly,meet the demand of the population that

wishes to bank in accordance with itsreligious beliefs; secondly, facilitate theexpansion of international contacts; andthirdly, diversify the country’s financialsystem enhancing its flexibility and stability.

The current instability in the internationalfinancial markets (e.g. the recent subprimemortgage crisis in the US) has had animpact on the local economy, andKazakhstan’s banks and regulatoryauthorities are increasingly turning theirattention to financing based on Shari’ahguidelines.

With respect to the present domesticbusiness environment and local clients’capabilities, murabaha (where the bankbuys and sells items required by thecustomer), which is the simplest type ofIslamic financing, is already practised inKazakhstan today. Other forms, specificallymusharakah (joint venture), ijara (leasing),

sukuk (Islamic bonds) and mudarabah(profit/loss sharing) are currently underexamination, and their introduction is being planned.

Islamic banking guidelines were firstapproved in 2003 by one of the majorbanks in Kazakhstan, Bank TuranAlem JSC (BTA Bank). From 2006, these wereacceded to other leading domestic banks,CenterCredit Bank, Alliance Bank andKazcommertzbank. In the spring of 2007,BTA Bank signed a memorandum ofunderstanding with Dubai-based EmiratesIslamic Bank to promote Shari’ah-compliantbanking in Kazakhstan and other CIS states,where BTA has a number of subsidiaries(reported in detail in NewHorizon,

26 IIBI

We want to see Kazakhstan become a regional centre for Islamicfinance, so that the securities issued within Kazakhstan’s bordersare recognised by the public interested in purchasing suchproducts and banking in accordance with Islamic principles.

Ghani Uzbekov, Agency for Regulation and Supervision of Financial Market and Financial Institutions

NEWHORIZON January–March 2008

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COUNTRY FOCUS

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by the Financial Experts Association ofKazakhstan, IDB, BTA Bank and a numberof state agencies. The conference wasattended by official authorities and expertsof Islamic banks, local financial institutions,auditors and law firms. A wide variety ofissues was discussed at the event, fromgeneral subjects such as the main principlesof Islamic finance, its distinction fromconventional banking and the role ofShari’ah boards at Islamic banks, to thepractical application of this type of financein Kazakhstan and the regulatoryrequirements needed for furtherdevelopment of the industry in the country.

Also, in the course of discussions on thelegal aspects of the broad introduction ofIslamic finance, an inter-agency task groupwas established and a development plandrawn up. The task group, comprising IDBand Agency representatives, is set to resolvethe issues of the absence of a regulatoryframework for the Islamic finance industryin Kazakhstan, the absence of an agency orstate authority with sufficient knowledge ofShari’ah standards, and the disparity ofKazakhstan’s tax laws with a number ofregulations for Islamic banking products.One of the group’s leaders, Ghani Uzbekov,deputy chairman of the Agency, noted: ‘We want to see Kazakhstan become aregional centre for Islamic finance, so thatthe securities issued within Kazakhstan’sborders are recognised by the publicinterested in purchasing such products and banking in accordance with Islamicprinciples.’

At the end of August 2007, a frameworkagreement between BTA and IDB wasexecuted, providing BTA with theopportunity to finance small and mediumbusiness projects in the industrial,agricultural and processing sectors throughthe use of ijara, murabaha and istisna(contractual agreement for manufacturinggoods and commodities) methods.As for Islamic insurance (takaful), it iscurrently in the very initial stages inKazakhstan. The BTA’s subsidiary, BTAInsurance Group, was one of the firstcompanies to express an interest in takaful.

The author of this article nurtured the ideaof introducing takaful to the country’sinsurance market after reviewing a series of publications on Islamic insurance,including Renat Bekkin’s book, ‘Insuranceunder Islamic Law: Theory and Practice’.(An in-depth interview with Bekkin, PhD in Law, on the subject of Islamic finance inRussia and the CIS countries, was

published in NewHorizon, January–March2007.)

After studying the takaful concept and theexperience of Malaysian takaful companies,the management of BTA Insurance Group decided to introduce the alternativeinsurance system. However, at the moment,it seems too early to announce the

Astana,Kazakhstan

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NEWHORIZON Muharrum–Rabi Al Awwal 1429

www.newhorizon-islamicbanking.com

NEWHORIZON January–March 2008

www.newhorizon-islamicbanking.com

COUNTRY FOCUS: KAZAKHSTAN

establishment of a separate takaful company or division. Aiman Mykhtibaeva,chairperson of the board of BTA Life (amember of the BTA Group, which alsoincorporates BTA Bank) – a leading lifeinsurance company in Kazakhstan today –explained: ‘Though there is a demand forhalal insurance products in the country,especially in retail business, the localregulatory framework and securities marketare still unavailable for full implementationof the concept. Nevertheless, we are lookinginto devising a Shari’ah-compliant productthat will operate on the principle of theinvestment of insurance contributions basedon mudarabah concept.’ It is worth noting

that, at present, the insurance market inKazakhstan occupies a small portion of the financial sector – thus, in 2007, theinsurance market ratio to GDP comprisedapproximately 1.8 per cent.

As the country’s economy continues todevelop, the percentage of young practisingMuslims with higher economic andtechnology education keeps growing and so does the number of specialists withprofessional experience in the financialsphere. The Muslim population is eager to work in accordance with their religiousbeliefs, so it can be assumed that theestablishment of an Islamic bank or a

takaful company in Kazakhstan will notface any problems with staff insufficiency.

Of course, further development of Shari’ah-compliant banking and takaful significantlydepends on the modernisation of therelevant legislation and how soon thenecessary amendments are adopted by the parliament of Kazakhstan. But what’smost important and reassuring is that thecountry is already on the development path. The foundation of the critical massrequired for successful growth and theexpansion of the Shari’ah-compliant financeindustry in Kazakhstan is already in fullswing.

28 IIBI

The Islamic Finance News has awarded BTA’s syndicated wakala facility the ‘Best Deal of the Year 2007 in Kazakhstan’. The keyreasons for the award were that the deal was the largest Islamic facility in the country and was the largest Islamic financial institutionsyndicated deal outside the Middle East.

The transaction was launched in May 2007 for an amount of $150 million with syndication limited to a group of investors primarilyin the Middle East and Malaysia. It was so successful that BTA increased the facility amount to $250 million. The syndication closedoversubscribed in July 2007. The facility tenure is two years, and its proceeds are used to finance BTA’s Islamic trade finance activities.

Abu Dhabi Islamic Bank (ADIB), Barclays Capital and CIMB Bank were the principal agents of the transaction. A total of 14 financiersjoined the facility, with four being new players in Kazakhstan’s finance market. ADIB acted as Shari’ah advisor, documentation agentand wakil (facility agent). The structure of the transaction was approved by ADIB’s Shari’ah & Fatwa Supervisory Board. BarclaysCapital acted as bookrunner, and CIMB as Malaysian roadshow arranger in connection with the facility. Allen & Overy, aninternational law firm, provided legal advice.

BTA’s Islamic transaction wins the ‘Best Deal of the Year’ award

Astana,Kazakhstan

©Iilya Postnikov Dreamstime.com

30 IIBI

NEWHORIZON January–March 2008ANALYSIS

Takaful is a form of financial protection,similar to insurance, which is designed to be compliant with Islamic principles and isbased on the principles of solidarity andmutual guarantee.

In order to be acceptable to Islam, insurancemust avoid the payment or receipt ofinterest (riba) amongst other requirements.For instance, gambling (maysir) oruncertainty and unclear terms (gharar) are not permitted. In addition, a takafulbusiness can only invest in industries thatare halal (acceptable) and must avoid thosethat are haram (unacceptable); examples of haram businesses include brewing andgambling, both of which contravene Islamic

law. Although the principles of what ispermitted are fairly clear, the interpretationof these rules can be controversial.Conventional insurers will often fail all ofthe requirements noted above because theymay have significant interest-bearinginvestments or debt issues, non-compliantproduct design and investments inprohibited industries. Takaful firms areincreasingly being set up to address theseissues from an Islamic perspective.

Current takaful landscape

With global takaful contributions estimatedat around $2.6 billion for 2006, the takafulindustry is small compared with the world’sinsurance sector as a whole, which haspremiums of around $3.7 trillion. However,its influence and importance extend beyondits current size. There is substantialpotential for growth in the Middle East andAsia, as well as in certain Western Europeancountries which have sizeable Muslimcommunities. The takaful industry alreadyforms an important part of the totalinsurance market in some Muslim countriesand many of these markets are themselvesseeing rapid growth in insurancepurchasing. This increased purchasing is a trend that is likely to continue, especiallyas a result of steady urbanisation, the ageingof the workforce and rising living standardsin these regions.

The main takaful markets are located in theMiddle East and South East Asia, withAfrica accounting for a smaller percentage

of total premiums. Many of themultinational insurers that are expandinginto this sector have established subsidiariesin either Bahrain or Malaysia, two countriesthat have been particularly proactive indeveloping the necessary legal andregulatory environment and which also havethe required infrastructure. More recently,other countries have also made progress indeveloping a suitable business environmentfor takaful operators. Pakistan is one suchexample; new legislation was publishedthere in September 2005.

During 2006 and 2007, a significantnumber of takaful and retakaful operationswere established by major conventionalre/insurance players (e.g. Munich Re,HSBC, Hannover Re, Prudential, AIG,Tokio Marine and Swiss Re in 2006; Avivaand Allianz in 2007) and more are expectedin 2008. These players see takaful as a way to protect market share in growingIslamic markets as well as to leverage theirexisting expertise to reach a new client base. A key feature of a takaful business is theprinciple of tabarru, or donation. Instead of charging a premium as a conventionalinsurer or reinsurer would, a takaful firmreceives contributions, at least a part ofwhich is treated as a donation.

The fact that contributions are madethrough donation helps to eliminate issuesof gharar and maysir. This is therefore animportant element in making takafulstructures acceptable under Islamicprinciples. Although the classification of

Insurance: the Islamic wayTakaful has been established in its modern form for more than 25 years and firms that offerShari’ah-compliant insurance protection have grown significantly in both number and scale.Takaful contributions (premiums) are expected to increase in volume substantially over the nextdecade, thinks Andrew Murray, senior director of Fitch Ratings’ insurance team in London. In this article, he discusses why takaful is necessary and examines various key features of thisform of financial protection.

www.newhorizon-islamicbanking.com

Andrew Murray,Fitch Ratings

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NEWHORIZON Muharrum–Rabi Al Awwal 1429 ANALYSIS

funds received as a donation rather than aspremiums may appear to make littledifference from a credit perspective, thedifferent classification does have a directimpact on the form of relationship betweenthe participant (policyholder) and the entityproviding protection. In some cases, it cantherefore affect future obligations toparticipants and, hence, have an analyticalimpact.

There are notable differences in structurebetween the various takaful providers. For example, they may operate as non-commercial providers – on a purely mutualand cooperative basis with the participantsof the scheme guaranteeing each other, orthey may operate on a commercial basis.The non-commercial structure is similar to a traditional mutual company; legal andregulatory issues and complexities aregenerally lower than for the commercialform of operation described below.

Under this commercial alternative, thetakaful operation is run with a segregationof assets between the takaful fund and thetakaful operator. In this instance, the takafulfund collects contributions from the fundparticipants and it is from here that claimsand certain expenses are paid. The takafuloperator is a service provider, which isentrusted to organise and run the fund forthe benefit of the fund participants. Thereward for the operator’s services can takeseveral forms and these are discussed furtherbelow. Taken together, the takaful operatorand takaful fund make up a takaful firm or business.

It should be noted that there may be severalpools of assets within the takaful firm, withseparate funds generally applied for familytakaful (life insurance) and general takaful(non-life insurance) where composite firmsare permitted. In addition, differentproducts may be supported by separate sub-funds and, in particular, contributionsfor family takaful are in many cases dividedinto several portions. The extent of legalseparation among the pools, especially in awinding-up scenario, is an important creditfactor and can vary between takaful firms.The shareholders’ and the participants’

funds can be linked in three main ways.There is the pure mudarabah model, underwhich the takaful operator acts as amudarib (entrepreneur) and the participantsas the capital providers (rab-al-maal). Acontract specifies how the profits are splitbut, in the absence of negligence, any losses

are borne entirely by the capital providers.There is also the pure wakala model, underwhich the operator acts as agent for takafulparticipants and takes a fee for performingthis service. In this case, in principle theoperator takes no underwriting orinvestment risk and all profits as well aslosses accrue to the participants only. The fee taken by the takaful operator isknown as the wakala fee and is often set as a percentage of contributions paid. Theoperator is able to make a profit if the feethat is received is greater than themanagement expenses incurred. There mayalso be a performance-based element to thefee, which can help to align more closely theincentives of the fund participants and thetakaful operator (e.g. modified wakala). Inaddition to aligning incentives more closely,such contracts can also make it easier forthe operator to offer its shareholders anadequate economic return.

Finally, a combination of wakala andmudarabah contracts is also possible. It isrelatively common for investment activitiesto be carried out under a mudarabahcontract and for underwriting activities tobe undertaken as part of a wakala contract.This means that a takaful operator doesshare in the potential upside of investmentoperations but is remunerated for itsunderwriting selection based on a wakalafee. This has implications for the incentivesof the operator and for corporategovernance.

Where there is a segregation of assets withinthe takaful firm (for example, between a

takaful operator and takaful funds), it isaccepted practice for a takaful operator toprovide an interest-free loan (known as aqard hasan) to cover any deficiency in thetakaful fund if it arises. This interest-freeloan is generally repaid from futuresurpluses.

If the takaful operator and fund are treatedas a single entity on winding-up (or morebroadly if there is recourse to the takafuloperator by the takaful fund in case of aninsufficiency of fund assets), then all assetsof the takaful firm would be available tofund participants. In such cases, theimportance of the qard hasan would bereduced and the exact terms of the loanwould become much less crucial.

Corporate governance structures

Perhaps the most obvious common featureof takaful firms is the existence of a Shari’ahboard. This body is responsible for thereview and supervision of the company’sactivities in order to ensure compliance with Shari’ah law.

The Shari’ah board operates in conjunctionwith the management board, which isresponsible for strategic decisions and thegeneral running of the organisation inaccordance with the relevant legislation.Where a separate takaful fund exists, thisfund has no management of its own butinstead relies on that of the takaful operatorfor controlling the business and ensuringShari’ah compliance. The interactionbetween these two boards (Shari’ah andmanagement) is critical to an effectivetakaful operation. In many cases, themanagement board will also need actuarialor technical advice in order to facilitate and assist in decision-making.

Many of the Shari’ah scholars who offeradvice will work for more than one

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Further development depends in part on the industry’s ability toconvince Muslims and others of the need to use takafulbusinesses.

company or takaful business. Although thiscan lead to a broader range of experience in Islamic finance issues, it can also lead to conflicts of interest and these potentialconflicts need to be suitably managed.There are also issues concerning corporategovernance, such as oversight over theactions of the board of directors. In atraditional insurance company, there may be non-executive directors and the directorsare often also held accountable to theshareholders at an annual general meeting.For a takaful business, shareholders may ormay not exist, non-executive directors areby no means universally employed and theremay also be heightened ‘principal–agent’challenges if the takaful operator does notsuffer the negative consequences of poorunderwriting or investment losses. Thiswould be the case, for example, if therewere no existing (or compulsory future)qard hasan between the takaful operatorand fund and no legal recourse of thetakaful participants to the assets of thetakaful operator.

Products

Products offered by takaful businesses aregrouped into two main categories, generaltakaful (non-life or property and casualty

32 IIBI

insurance) and family takaful (lifeinsurance). Within these categories, theproduct range that is offered by takafulbusinesses can be quite different from thatoffered by conventional insurers. Thisreflects a number of factors including thegeographical concentration of takaful firmsin certain regions with particular marketstructures but also the requirements ofShari’ah compliance.

For example, takaful products tend to havea high degree of transparency associatedwith them due to the Islamic requirementfor the contracts to be fair and to avoidunclear terms. Disclosure and the avoidanceof ambiguity is therefore a critical aspect of product design and guarantees are veryrarely offered as this can create anunbalanced contract which contravenesIslamic principles.

Some product types are only offered in avery limited way due to difficulties incontrolling risk. For example, it can bedifficult for takaful firms to offer annuityproducts on a large scale due to the limitedavailability of appropriate sukuk (Islamicfinancial instruments) to back them. Therelative scarcity of high-quality instrumentswith a fixed return to match the annuity

payments can make annuities difficultproducts to provide without takingexcessive risk.

In practice, general insurance tends to beconcentrated in motor and propertyinsurance, with medical insurance, accidentand marine constituting the majority of therest. A business line that has performed well may pay a distribution to participantswhere a surplus has arisen. The degree towhich results are considered by product orin total can vary significantly between firmsaccording to the applicable documentation.The participants in takaful pools tend to be concentrated in the personal and smallbusiness sectors, with larger corporatesmuch more rarely using takaful solutions.To the extent that personal and smallbusiness insurance lines are morepredictable than those of larger corporates,a takaful portfolio may contain less riskthan some conventional portfolios writingsimilar business lines.

Challenges for the takaful sector

Although there is undoubtedly very strongpotential for the takaful industry and rapiddevelopment is taking place, there are also anumber of challenges for the future. For

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ANALYSIS NEWHORIZON January–March 2008

Simplified diagram of generic commercial takaful structure

Source: Fitch Ratings

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NEWHORIZON Muharrum–Rabi Al Awwal 1429 ANALYSIS

example, it has already been noted that thetakaful sector is very small relative to thesize of the conventional insurance industry.Further development depends in part on theindustry’s ability to convince Muslims andothers of the need to use takaful businesses.In some cases, this may involve individualsaccepting cover which has a lower financialsecurity due to lack of diversification, ashort operating history or increasedconcentration of investment risks because of the narrower range of investment assetsavailable. It will be a key challenge fortakaful firms to educate customers andconvince individuals and businesses thatsuch perceptions are either unwarranted or a worthwhile trade-off. In this regard, credit ratings are increasingly being viewedas an important method for demonstratingfinancial strength, gaining access to businessand increasing transparency, and this trendis expected to continue.

Other challenges for the industry includestrong competition, both from conventionalinsurers, which may be able to earn agreater investment return and have greatereconomies of scale, as well as from othertakaful businesses. Economies of scale area particular challenge due to the small sizeof many takaful operations, as are the lackof a clear regulatory and accountingframework for many takaful providers, and a shortage of skilled staff. There is aneed for training and compliance to ensurethat Shari’ah practices are understood andadhered to by the workforce. Many takafulbusinesses currently have only modest levelsof capitalisation, especially within thetakaful fund. Increasing this capital basewithin the takaful fund can take time as the surplus is often provided by the fund’sparticipants and would thereforeaccumulate gradually over time.

A scarcity of suitable (Islamic-compliant)investments and reinsurers can lead toconcentration risks or lower quality assetsthan desired by the takaful businesses. Inaddition, there is a need for careful productdesign to ensure both a suitable risk profileand compliance with Shari’ah principles.A few challenges have a particular impacton the rating process including the legal

framework, risk management andregulation. These are considered in moredetail below.

Legal Framework – The legal system usedvaries significantly between jurisdictions,particularly as some countries operate aShari’ah-based legal system (e.g. Iran, SaudiArabia and Sudan) while others (e.g.Malaysia and Bahrain) operate a dual legalsystem with Shari’ah-based laws operatingalongside either common or civil law. Inother countries, such as the UK and France,Shari’ah plays no role in the legal process.Where more than one set of laws apply(legal pluralism) this can in some casesaffect the certainty and predictability oflegal transactions and procedures, especiallyas it affects Islamic finance and takaful.There is also a wide divergence in the extent to which the legal and regulatoryregimes of different countries addresstakaful. Where no specific provisions aremade for takaful then legal certainty can be reduced and risk correspondinglyincreased. However, this is an area wheremany countries are making progress withconsideration being given to new (orrevised) legal and regulatory provisions in respect of takaful.

There are several legal aspects which areimportant in assessing the financial strengthof takaful firms. These issues include theextent to which the takaful operator and the takaful fund are legally consideredseparate in the event of a winding-up of thebusiness, the circumstances (if any) underwhich an interest-free loan is required fromthe operator to the fund, and the priority of the interest-free loan (qard hasan) from the operator in the event of a winding-up of the takaful firm.

Risk Management – Risk managementwithin a takaful undertaking has someimportant differences compared withconventional insurers. The lack ofguarantees offered and the high degree oftransparency usually associated with theproducts generally helps to reduce risk. However, takaful firms are also morelimited in the forms of risk managementthat they are able to use. For example, a

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takaful firm would not usually be permittedto use investment derivatives (such asoptions, futures and forwards) to controlrisks, as these instruments are generallydeemed to contain unacceptable levels ofuncertainty and have no underlying assets.Although Shari’ah-compliant versions ofthese instruments do exist in some cases, the liquidity associated with these markets is considerably reduced compared with theconventional alternative. The regulatory and accounting framework used by takafulfirms is generally at an earlier stage ofdevelopment than that used by equivalentconventional insurers. In some cases, theregulatory requirements (for example, those relating to required investmentholdings) require companies to breachShari’ah principles by investment in non-compliant instruments. That said, therehas been significant development in someregulatory regimes over recent years, with an increasing number of countriesdeveloping regulations specifically targeted at the takaful sector.

Regulation – A key challenge for regulatorswill be ensuring adequate protection fortakaful participants, especially in those cases where takaful firms have modestcapital within the takaful fund (or funds). A failure to apply equivalent capital require-ments to takaful and conventional insurerscould potentially lead to inadequate pro-tection for policyholders, as well asencouraging regulatory arbitrage. In ad-dition, regulators also face many of the sameissues as the takaful firms, such as trying to recruit and retain skilled experts in thearea of takaful.

Conclusion

Takaful is an increasingly important sector of the market for financial protection whichhas strong future growth prospects. Thatsaid, as would be expected for a rapidlygrowing industry that is in many cases com-peting against more established conventionalinsurance players, challenges do lie ahead.However, the takaful industry continues todevelop and mature, with an increasingnumber of takaful firms considering creditratings as a method of differentiation.

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NEWHORIZON January–March 2008

beyond those that are currently available.While still adhering to the prohibition of riba(interest), gharar (uncertainty) and maysir(gambling), but promoting the provision ofzakat and avoiding activities which areharam, Islamic finance is seeking ways tomanage the specific risk incurred in itsdiversified and ever-evolving product range.

Financial intermediation creates a chain ofrelationships which result in a series offinancial obligations. The web ofrelationships involved among the financialentities creates uncertainty which leads tofinancial risk. The unpredictability of factorsin the financial transactions creates risk: thegreater the unpredictability, the higher therisk. Information asymmetry is also acontributing factor. There is a directrelationship between the ways in which FIsmanage the risk and the return generated.Risk-based pricing is a fundamental theoremin risk management, where the products andservices are directly related to the risks theycarry. If the FI fails to recognise the riskaccurately it is at a disadvantage on twofronts: if it overestimates the risk, it loses agood customer, hence also the revenue; if itunderestimates the risk, it finances a badcustomer, thus exposing itself to possible

Background

An important way for financial institutions(FIs) to avoid default is to have adequatecapital in place. The ultimate goal of Basel II,which focuses primarily on capital adequacy,is to foster better risk management practices.The safety of the bank and the soundness ofthe banking system are at the core of riskmanagement in the conventional financialmarkets. In Islamic finance, the need for aminimum capital requirement is just asrelevant. Despite being only three decadesold, the modern Islamic finance movement ismaking remarkable progress, especially in theMiddle East and Malaysia. Some of theindicators of growing influence of Islamicfinance are an increasing number ofinstitutions offering Islamic financialproducts, an improved range of productsbeing available, the rapid progress of thesukuk market, and the consolidation ofstandards in relation to accounting and riskmanagement.

The failures of several conventional FIs in therecent past, together with growing concernsabout the occurrence of such incidents againin the future, have prompted Islamic financeto look for risk management practices

Risk management in murabaha

Islamic finance is typified by products which are based around a small number of contracts. Risk in Islamic finance revolves around the nature of these financial contracts. Because of themethods stipulated for participation, however, Shari’ah-compliant financial products are quitedifferent from their conventional counterparts. Islamic financial institutions (IFIs) are exposed tocredit risk, market risk, operational risk, equity investment risk and ‘rate of return’ risk.Musharakah, mudarabah, murabaha, ijara, salam, and istisna are some of the more populartypes of Shari’ah-compliant contracts. Dr Sunil Kumar, head of risk management, Middle East,IRIS integrated risk management ag Switzerland, discusses the risks associated with amurabaha contract and related risk mitigation measures.

losses. So, effective risk management ispertinent to the FI’s financial stability, thesoundness of its business and its profitability.Risk can be broadly categorised as financial,business, and operational. Credit risk,market risk, and liquidity risk are threecommon subsets of financial risk.Operational risk includes risks related tointernal or external systems, people andprocesses.

Murabaha and risk

In murabaha which is commonly referred to as ‘cost-plus financing’ or ‘mark-upfinancing’, the seller discloses the true cost of the product and then adds a mark-up tosell it at an agreed price to the customer.Payment can be at spot or in the future.Murabaha is a sales contract and henceshould honour all the requirements of a valid contract of sale under Shari’ah, namely:

o The commodity should be certain and an existing commodity and not a futurecommodity which is going to be producedor cultivated;

o The seller must be the owner, eitherphysical or constructive, at the time of

ACADEMIC ARTICLE

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and interwoven and are highly time-specificin the Shari’ah-compliant contract. Inmurabaha, before the client takes delivery,the IFI faces market risk as well as creditrisk. Then, as the customer takes deliveryand starts making murabaha payments, theIFI is exposed to credit risk and liquidity riskas a result of the credit risk. The dynamismof risk exposure through the life of thecontract is unique to Islamic finance. Riskmanagement in Islamic finance needs a cleartime-line, showing the relational changestaking place between the parties to thecontract. It warrants special treatment in the form of breaking down the contract life-span into identifiable phases and managingthe risk differently in each phase.

Risk in murabaha should be consideredwithin the wider context and should be dealtwith on an integrated basis rather than inisolation. It would be inappropriate tomanage each risk separately. For example, in order to cover market risk, the IFI mayhave a higher mark-up, which may in turnmean that the customer is unable to pay theinstallment, so exposing the IFI to credit and liquidity risk. Similarly, when the marketprice falls significantly, it creates adisincentive for the customer to continue

price of the underlying commodity.

Between stages 3 and 4, the IFI is furtherexposed to market risk via the downwardmovement in the price of the underlyingcommodity. The IFI is also exposed to theoperational risk incurred in holding thecommodity (as a result of damage, spoilage,theft etc.) for the period in which it is in itspossession. If the IFI delays delivery itexposes itself further to market andoperational risk.

Between stages 4 and 5, the IFI is exposed to credit risk linked to potential default ordelayed payments from the customer, as wellas to liquidity risk resulting from changes inthe anticipated cash flow.

The relationship between the IFI and thecustomer also keeps changing at variousstages, namely from promisee–promisor instages 1/2, to seller–buyer in stages 3/4 and,finally, to debtor–creditor in stages 4/5. Several steps are required to address theserisks, including risk identification,measurement, mitigation, and management.

Credit risk, market risk, operational risk andliquidity risk are all interlinked, interrelated,

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sale;

o The sale cannot be conditional and musthave a fixed consideration;

o The commodity must have value at thetime of sale.

Other covenants of murabaha may include:

o A penalty may be applied in the case ofdelayed payments. This amount thuscollected from penalty should be used forcharitable purposes;

o In the event of default in payment animmediate claim can be made on theremaining instalments;

o Security in the form of mortgage or lien isalso permitted.

IFIs use murabaha as a sale agreementwhereby the IFI first purchases and then sellsthe contracted goods to the customer at an agreed profit with payment either ininstalments or as a lump sum. Murabaha isextremely popular and is widely used by IFIs.It is their preferred mode of financingconsumer goods, real estate, raw materials,machinery and equipment. Sometimes it isalso used to finance letters of credit.

The activities which make up a murabahacontract pass through several importantphases, each of which has different riskimplications. The process generally startswith customer identifying the commodityhe/she wishes to acquire through bankfinancing. The IFI is then approached by thecustomer for financing. The commodity isacquired by the IFI, which subsequently sells it to the customer after adding its profitmargin. The IFI is exposed to different risksin each stage of this process. The four maintypes of risk associated with a murabahacontract are: credit risk, market risk,operational risk and liquidity risk. Figure 1summarises these phases.

Between stages 2 and 3, the IFI faces the riskof the customer refusing to honour hiscommitment to buy, thus it is exposed tomarket risk through any fluctuation in the

ACADEMIC ARTICLE

Figure 1: The sequence of activities in a typical murabaha contract

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NEWHORIZON January–March 2008ACADEMIC ARTICLE/IIBI NEWS

to make payments, thus exposing the IFIto credit and liquidity risk vis-à-vis themarket.

There are several ways of handling risk inmurabaha contracts:

o To cover the operational risk related tocustomer binding, the IFI can takecollateral from the customer;

o To cover other operational risks related to possession in the intervening period,Shari’ah-permitted insurance can beused;

o To cover any potential paymentdefault, a guarantee or a mortgage canbe used;

o To cover the commodity price risk, the IFI can use dynamic simulation tocreate scenarios for future commodityprices and can use optimised prices formark-up;

o Liquidity risk exposure can be coveredby properly managing the other risks.The IFI is also able to estimate the cashflows associated with the murabahacontract more accurately, thus reducingthe liquidity risk.

Murabaha is a transitory mode and not a full profit and loss sharing mode likemusharakah. Shari’ah scholars generally do not encourage the long-term use ofmurabaha. According to many Shari’ahexperts, murabaha should be used only as a stop-gap. Because of its fixed cash-flow pattern, however, murabaha ispreferred by IFIs over other contractssuch as musharakah and mudarabahwhich do not offer a fixed cash-flowpattern. One disturbing trend is the useof murabaha for financing non-commodity needs, such as holidays,house renovations and other similarfinancial needs which fall under the greydefinition of commodities. Although verypopular, murabaha should be usedjudiciously and IFIs should reduce theirdependence on it.

This major Islamic finance event providedover 300 attendees with the opportunity tointeract with both Shari’ah scholars andpractitioners. The objective of the forumwas to create increased awareness amongprofessionals and members of the public in relation to the evolution of Islamicfinance from the global perspective, and theresulting opportunities as well as challengesfaced by the industry. A key part of theprogramme was the panel discussion byleading Shari’ah scholars and practitionersfrom the industry.

This was moderated by Iqbal Khan, CEO of Fajr Capital plc, a board member ofBrunei Islamic Development Bank, chair of the executive committee of Jedwa Bankin Saudi Arabia, a member of IIBI’s Board of Governors and former founding CEO ofHSBC Amanah. The panel members were:Mohammad Faiz Azmi, leader of theFinancial Services Group,PricewaterhouseCoopers (PWC) Malaysiaas well as the PWC Global Islamic financialleader; Mohammad Khan, director oftakaful and retakaful services at PWC,London; Mohaimin Chowdhury, head oflegal, Shari’ah and compliance at theEuropean Islamic Investment Bank (EIIB);Sarwar Lodhi, head of marketing at theIslamic Bank of Britain (IBB); Dr MohdDaud Bakar, president and CEO of theInternational Institute of Islamic Finance;Mufti Barakatullah, Shari’ah scholar forAlburaq (a subsidiary of Arab BankingCorporation) and a member of the AlQalam Shari’ah Scholars Panel; MuftiMuhammed Zubair Butt, senior advisor on Islamic law at the Institute of Islamic

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Islamic Banking Forum: discussing growth, innovation & Shari’ah challenges

Mohammad Shafique, IIBI programme development co-ordinator,presents a summary of the Islamic Banking Forum, organised bythe London UMNO Club in partnership with the IIBI and held on2nd February 2008 at Imperial College, London.

Jurisprudence, Bradford, and chair of the Al Qalam Shari’ah Scholars Panel; andMuhammad Nurullah Shikder, Shari’ahboard member at the Arab BankingCorporation (London) and Lloyds TSBBank (UK).

The keynote speaker, Encik Badlisyah AbdulGhani, CEO of CIMB Islamic, Malaysia,discussed the growth of Islamic finance andthe leading role played by Malaysia. TheIslamic finance industry is continuallyexpanding and becoming increasinglymainstream, meeting the needs of clients byoffering many products, including homefinancing, asset management, debt capitalmarkets, equity capital markets and manymore financial activities. He said thatShari’ah is approached in a pragmatic wayin Malaysia, stating that ‘it is incorrect thatthere should be one Shari’ah principle forone financial activity’. For example, theShari’ah principles relating to ijara (leasing)may be applied to many financial activitiesincluding operating lease, financial lease,fixed/floating rate and auto financing. Healso mentioned other financial activities,such as home financing based ondiminishing musharakah, which combinesijara, musharakah and sale contracts.

There must be a ‘substance over form’approach when applying Shari’ah principlesfor various products and services, asShari’ah principles by themselves cannotdetermine the substance of a transaction.Industry practitioners should find ways andmeans to serve the needs of their customersin a Shari’ah-compliant way, while theregulators should provide enabling

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IIBI NEWS

frameworks for meeting the needs ofcustomers. He said that difference inShari’ah scholars’ opinions is allowed and,in fact, is a blessing from God. However, inMalaysia, the Central Bank (Bank NegaraMalaysia) Shari’ah Advisory Council’spronouncements are applicable to all Islamicfinancial institutions (IFIs) in the country.This creates certainty about the Shari’ahcompliance of products and simplifies theoperations of IFIs.

Ghani concluded the session by stating thatthe global Islamic finance industry hasevolved from a mere faith-based to abusiness-driven industry aimed at allcommunities, but it still has a long way togo. Its current size of over 300 institutions is very small compared to the more than2300 conventional financial institutions.

Malaysia is playing a key role in the growthof both the local and the internationalmarkets. He pointed out that we should not place too much emphasis ondevelopment of the Islamic global marketbut should focus instead on the growth ofthe local market. When there is sufficientcritical mass in the local market, it will grow naturally into the internationalmarket. Meanwhile, there must be respectfor each jurisdiction active in promotingShari’ah-compliant finance business, as each jurisdiction has its own customs, which may not be applicable in otherjurisdictions.

After the keynote speaker, Iqbal Khanmoderated a panel discussion by theShari’ah scholars and practitioners. In hisintroductory comments, he mentioned thatIslamic finance is a customer to business(C–B) model. This means that, just as it hasattracted Muslims, it should proveappealing to non-Muslims who areinterested in ethical finance and investment,which is founded on similar premises.

Panel member and practitioner Azmi thendiscussed the accounting frameworkrequired for IFIs and the role played byAAOIFI. He also stressed the need forlevelling the playing field of taxation forShari’ah-compliant products.

Then Mohammed Khan discussed theimportance of the development of takaful(Islamic insurance). He pointed out thatthere is a lack of asset classes where fundsmay be invested, and that it is also a bigchallenge for IFIs to deploy their surplusfunds in a Shari’ah-compliant way.

Later, Chowdhury discussed the need for alegal and regulatory framework for IFIs,which he said should be on a par with theframework for conventional financialinstitutions.

The final practitioner on the panel, Lodhi,discussed the challenges of pitchingShari’ah-compliant products to the retailmarket.

From the Shari’ah scholars’ panel, Dr Bakarhighlighted the way the industry has movedfrom imitating conventional products toinnovating Shari’ah-compliant products,and how Shari’ah scholars are facilitatingthe growth of the industry.

Then Mufti Barakatullah discussed thechallenges for Shari’ah scholars whenissuing fatwas (Shari’ah rulings). He saidthat the education of customers and thewider public is the main challenge for theindustry.

Mufti Butt followed by outlining thechallenges involved in the innovation and

growth of Islamic finance, and by discussingthe issue of harmonisation of Shari’ahscholars’ rulings.

Finally, Shikder expressed the need for theinvolvement of Shari’ah scholars from dayone in the product development process, aswell as the need for more dialogue betweenShari’ah scholars and practitioners toresolve any issues which arise. He alsoemphasised the importance of setting upsystems of Islamic finance disputeresolution, and arbitration centres, in orderto meet the growing demand of the Islamicfinance industry. The questions surroundingthe enforcement of judgments given by sucharbitration centres in western jurisdictionsremains a great challenge ahead for theindustry.

After the panel members’ comments, therewas a lively question and answer session.Participants raised questions about: thecontinuing use of LIBOR (the LondonInterbank Offered Rate) for the pricing of products; the issue of conflict of interestwhen one Shari’ah scholar sits on the boardsof various IFIs; the process of the issuanceof fatwas and whether scholars consider theviews of all schools of thought when doingso; the problems in application of Islamicand conventional law in a dual jurisdiction;the problems in the trading of sukuk; andthe provision of debt in Shari’ah-compliantequity transactions.

Islamic Banking Forum,London

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NEWHORIZON January–March 2008IIBI NEWS/LECTURES

Over the past fifteen years, there has beentremendous growth in private equity,producing significant returns. The size ofthe industry has grown substantially –

January: Exploringopportunities within theIslamic private equitymarket

Promoting Islamic finance

Omar Shaikh discussed the growth ofprivate equity as an asset class in theconventional financial system, andhow the private equity model, on theface of it, seems to provide a naturalmusharakah-based solution to theIslamic finance industry which mayalso improve its image and credibility.

Shaikh currently works in Ernst &Young’s Private Equity TransactionAdvisory Services practice. He hasrecently established the Middle Eastdesk for providing services to largeMiddle Eastern funds that targetEuropean acquisition. In addition,Shaikh is leading the roll-out of Ernst& Young’s London Islamic financeservice. He is a member of the IIBIand the Islamic Finance Council(based in Scotland), and also sits onthe UK Treasury Islamic Finance Sub-Committee which supports theformation of government policies toprovide a level playing field for Islamicfinancial products in the UK.

The lecture was chaired by Richard Tde Belder, partner at the internationallaw firm, Denton Wilde Sapte LLP.

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according to some estimates, a quarter ofthe workforce in the UK is employed bycompanies owned by private equity funds.The term ‘private equity’ represents adiverse set of investors who typically take amajority equity stake in a private limitedcompany. In Europe, the term issynonymous with ‘venture capital’ and isused to cover funding at all stages of abusiness life cycle. In the United States,‘venture capital’ refers specifically toinvestments in early-stage and expandingcompanies, while ‘private equity’ relates toinvolvement in more mature businesses –typically through leveraged buy-outs(LBOs). Private equity provides medium- tolong-term finance (usually three to sevenyears) in return for an equity stake inpotentially high-growth, unquotedcompanies. In the course of the holdingperiod, the focus of the private equity firm

is to improve the profitability of the com-pany, thereby increasing its value on exit.

After outlining the concept and principlesof private equity, Shaikh discussed thegrowth of the Islamic finance industry, andhow it has emerged from a niche to themainstream in the short time span of fourdecades. He pointed out that the essence ofIslamic finance is equity-based rather thandebt-based. The Islamic finance sector isstill in its infancy, and so far, products havebeen structured to provide customers with

IIBI and AAOIFIsign MOU

IIBI and the Accounting and AuditingOrganisation for Islamic FinancialInstitutions (AAOIFI) have signed amemorandum of understanding(MOU), under which the IIBI will offer the Certified Islamic ProfessionalAccountant Programme (the CIPAprogramme) of AAOIFI in the UnitedKingdom. This agreement was the result of discussions between KamalAbdelkarim Hassan (below) fromAAOIFI and Mohammad Shafique from IIBI, and marks the beginning of cooperation between the IIBI andAAOIFI in supporting each other’sprogrammes in the future.

‘The agreementbetween IIBIand AAOIFI –leadingorganisationsin the Islamicfinanceindustry –will certainlycontribute increating greater

awareness about the CIPA programmeamong professionals in UK andEurope,’ said Shafique, programmedevelopment co-ordinator at the IIBI. ‘It will also facilitate the students of this programme to get assistancewithout the need for traveling toBahrain, headquarters of AAOIFI.’

Hassan, director at AAOIFI, noted that ‘the CIPA Programme is a perfectaddition to the array of professionaltraining programmes and certificationin the area of Islamic banking andfinance offered by the IIBI’. He alsoexpressed hope that with the successfullaunch of the CIPA programme, theCertified Shari’ah Adviser & Auditors(CSAA) programme will follow suit.

Omar Shaikh,Ernst & Young

an alternative choice which complies withtheir faith while having the same features asthose offered by conventional financialinstitutions. This was necessary in order togain a foothold in the financial sector, asthe supporting legal, regulatory andtaxation framework for Islamic finance wasnot widespread. However, this ‘copy andpaste’ structure has raised questions aboutthe differentiation and credibility of thisnewly emerging financial industry. Shaikhemphasized that the spirit of Islamic financeis reflected more in partnership-basedmodes like musharakah, which give rise totrue asset or commercial risk. According tothe principles of musharakah, the loss mustbe shared in proportion to the capitalinvested, whereas the profit share can be setat agreed levels. In general, the Islamicmodel for business financing encouragesprofit and loss sharing through equitablefinancial and contractual arrangements.

He then went on to discuss the growth ofprivate equity in the Middle East, the keyarea in the growth of Islamic finance. Dueto high oil prices, the region is flush withliquidity. Analysts have estimated that theregion currently has approximately $1.5trillion of excess liquidity. Part of this cashhas been directed towards Shari’ah-compliant investments and, because of thelimited universe of such assets, many of thesukuk issues have been oversubscribed.Islamic banks continue to face the challengeof excess liquidity. A report by the GulfVenture Capital Association (GVCA)indicates that $7.1 billion was raised inprivate equity funds in 2006, up from $4.3billion in 2005. The value of private equityhas reached $14 billion, which is a

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significant increase on the $78 millionexperienced in 2001.

Shaikh concluded the session by stating thatthe private equity model, on the face of it,seems to provide a natural musharakah-based solution with a proven track record ofsuccess in the conventional financial system.This is resulting in a greater number ofIslamic banks becoming involved in privateequity deals. To engage effectively in privateequity deals, Islamic banks need to ensurethat they have experienced individuals oralternatively, they should considerpartnering up with existing boutiques ordeploying a ‘fund of funds’ approach.

After the presentation, the participantsraised questions about: how to leverageShari’ah-compliant equity transactions; why there are inconsistencies in Shari’ahscholars’ opinions about leveraging privateequity transactions; how the targetcompanies’ financing structures areconverted from conventional debt-based to Shari’ah-compliant debt or equity; andwhat the hurdles are for the growth ofShari’ah-compliant private equity firms in the UK.

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IIBI LECTURES

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February: Prospects forShari’ah-compliant fundmanagement

Professor Rodney Wilson presentedan overview of Shari’ah-compliantfund management, its importance forthe Islamic finance industry and thepotential growth prospects.

Professor Wilson is the director ofpostgraduate studies at DurhamUniversity’s School of Government andInternational Affairs. He manages theDurham Islamic Finance Programmeand is also on the academiccommittee of the IIBI. He has workedwith the Islamic Development Bankand is currently serving as a consultant

Professor Wilson explained that funds have a greater role in Islamic than inconventional investment, as not only dothey provide portfolio diversification andrisk reduction, but the fund managers can accept responsibility for Shari’ahcompliance – which may be managed eitherby putting in place in-house monitoringmechanisms or by outsourcing to anexternal institution like the Dow JonesIslamic Index. Fund managers may alsoadvise investors about the deduction of‘haram’ income that must be donated tocharity for purification purposes. Open-ended funds remain open for investmentirrespective of the size of the fund,certificates of which can be bought and sold either at the issue counter of the fundor in the capital markets. Closed-endedfunds are issued for specified amounts, andsometimes also for specified projects, andcan only be sold in the capital market.

After discussing the importance of Shari’ah-compliant investment funds for the Islamicfinance sector, Professor Wilson explainedthe traditional Shari’ah concerns aboutfunds, which relate to ensuring theavoidance of riba, gharar and maysir (or qimar). He explained the generalresponsibilities of fund managers: they have to play the role of an agent or stewardfor investors; they should treat investmentsas amanah and avoid the betrayal of trust and confidence of the investors; they should provide them with correctinformation for decision making; and their agreement should clearly lay down the fees or commission to be charged forservices rendered to investors. Hementioned that Shari’ah scholars are

January lecture to the Islamic Financial ServicesBoard. He has contributed to anumber of professional publications onIslamic finance topics including sukuk,asset management, retail banking and,most recently, takaful.

The lecture was chaired byMohammad Amin, tax partner atPricewaterhouseCoopers LLP.

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IIBI LECTURES NEWHORIZON January–March 2008

40 IIBI

divided about the gearing of investmentfunds, as gearing involves riba and reducesthe element of risk sharing for debtproviders (gearing magnifies both gains andlosses). While some Shari’ah scholars allowgearing up to maximum of one-third offund capital in special circumstances,scholars generally encourage no gearing of Islamic investment funds.

He then looked at the marketing aspects ofIslamic funds. The retail market for thesefunds comprises open-ended funds, whichare of great interest to the investing public.These may include lump sum and monthlysavings plans, the use of ISAs and other tax-efficient wrappers, indirect selling throughfinancial advisors and law firms, as well ascross-selling to holders of Shari’ah-compliant accounts in conventional andIslamic banks. Meanwhile, high net-worthindividuals may be more interested inclosed-ended funds.

Shari’ah-compliant institutional investorsmay be targeted by Islamic banks whichprovide Shari’ah compliance for offeringsfrom major fund management groups andprivate banks, while wealth managers canattract their clients to invest in Shari’ah-compliant funds. He then looked atcategories of Shari’ah-compliant funds,which include equity funds, ijara funds,commodity funds, funds of funds, hybridcapital protected funds, income funds,index tracker funds, infrastructure funds,

and leasing and real estate funds. Just as in the conventional funds world, differentShari’ah-compliant funds may havedifferent aims. They may be growth fundsaimed at achieving capital gains, incomefunds aimed at maximising dividendincome, balanced funds to produce bothincome and modest growth, or recoveryfunds which invest in undervaluedcompanies.

Professor Wilson outlined the risk andreturn profile of Shari’ah-funds. Murabahafunds have lower risk and lower returns,while Islamic hedge funds have higher riskand higher returns. Between these two fitother Shari’ah-compliant funds, like sukukfunds, ijara funds, Islamic equity funds and musharakah funds. Professor Wilsonmentioned that regulatory requirementsdiffer from one jurisdiction to another.Generally, these include the disclosure ofShari’ah compliance and publicising Shari’ah board members, as well asinformation about screening methods andsignificant exclusions. He also said that,typically, management fees would includeinitial fees, annual fees and exit charges ifany, and they would range from 0.5 percent to 1.5 per cent of the investmentamount.

Professor Wilson pointed out that there are over 300 Shari’ah-compliant funds,around two-thirds of which are equity-based. However, real estate funds are alsopopular, as well as commodity and leasingfunds. Islamic funds are mostly offered inSaudi Arabia and Malaysia, but there arealso a few offerings by major internationalfund management groups. Scottish Widows,a leading UK-based pensions andinvestment provider, offers two Islamicfunds which have attracted much attention.The UK's position as a major fundmanagement centre, where there is muchexperience with ethical funds, means it iswell placed to tap into the growing marketfor Islamic funds.

After the presentation, there was anextensive question and answer session. Theparticipants raised questions about: thepurification of capital gains and dividends;

March: Stock screening forShari’ah-compliant funds

Iqbal Asaria from Afkar Consultantsdiscussed the rationale andmethodologies of stock screening forShari’ah-compliant funds and the roleof Shari’ah scholars from theperspective of managing Shari’ah-compliant stocks.

Asaria has worked as an investmentanalyst in the City of London forseveral years. He is also a member ofthe Bank of England’s Governor’sworking party set up to facilitate theintroduction of Shari’ah-compliantfinancial products in the UK market.He is an associate of the IIBI and theIslamic Banking and Finance Instituteof Malaysia (IBFIM), a member of theCity's FMLC (Financial Markets LawCommittee), and has spoken atseveral conferences and symposia onShari’ah-compliant banking andfinance.

The lecture was chaired by Dr KadomShubber, principal lecturer in finance atWestminster Business School,University of Westminster.

Asaria started by pointing out that, with thegrowth in Shari’ah-compliant investments,the need for having a screened universe ofstocks is increasing. These screens typicallyopine on the permissibility or otherwise ofinvestment in stocks and securities.Investors and/or their fund managers arethus able to offer Shari’ah-compliantinvestment channels.

Professor Rodney Wilson,Durham University

use of Shari’ah-compliant debt forleveraging Islamic funds; and the prospectsfor more Islamic fund offerings from global financial centres such as London.

www.newhorizon-islamicbanking.com IIBI 41

NEWHORIZON Muharrum–Rabi Al Awwal 1429 IIBI LECTURES

Traditionally, these screened universes havebeen used by long equity fund managers.Now, increasingly, such universes are usedby index providers such as FTSE and DowJones to provide benchmarks for funds.They are also used by providers ofexchange-traded funds and other index-based instruments. Recently, alternativeinvestment funds have also started to usethem.

He argued that, given this increasing andvaried usage, it is important to have arobust methodology which is transparentand verifiable. In addition, there is the need to bear in mind that the universe ofinvestible stocks needs to be as large aspossible so as not to detract from the risk-mitigating advantages of portfoliodiversification. Therefore, the screening of stocks for Shari’ah compliance isbecoming a critical task which demandsthoroughness and professionalism.

Asaria also looked at the rationale behindthe Shari’ah screens and the methodologiesof various providers of these services. Thisessentially involves looking at businesscompliance and financial compliance. Forbusiness compliance, it needs to bedetermined whether a corporation isengaged in haram industries such as alcohol, gambling, armaments, tobacco,pornography or pork. Most Shari’ahscholars have put a tolerance level of fiveper cent on such activities.

For financial ratios, gearing levels,receivables and interest income all need tobe considered. One can either base the levelson a proportion of total assets or of themarket capitalisation of the corporation.Presently, Dow Jones is the only screeningprovider that uses market capitalisation. Allother providers, such as MSCI, S&P, FTSEand Amiri S3, use total assets for thecalculation of financial ratios. Asariadiscussed the rationale of the ratios, and the benefits and disadvantages of the twoapproaches. Asaria said that the basicmethodology of ensuring business andfinancial compliance may, at first glance,seem simple. However, on closer exam-ination, several critical issues crop up. The

first is of business classification. The broadcategory of prohibited categories is clear.However, corporations are complex entitiesand engage in a diverse variety of activities.For this purpose there are two classificationsystems that can be used. One is theStandard Industry Classification (SIC) code, the other is theInternationalBusinessClassification (IBC)code. SIC codes aremuch more detailed,and delve into several layers ofcorporations’activities – anindividual companymay have up to eight SIC codesassociated with itsactivities. The IBCcodes are much moregeneral and tend to look at the corebusiness of the corporation in question.

With the help of some examples he outlinedthe complex processes that need to be inplace to keep the screens up to date. For thepurpose of determining whether theproportion of unacceptable activities is under five per cent, SIC codes seem toprovide greater robustness. However,aggregation of activities by their associatedSIC codes is not free from caveats. As anexample, an SIC code could be assigned tolivestock production. It would be difficult to determine whether this includes pigfarming or not. This would have to bedetermined by actual contact with thecorporation concerned. Similarly,production of beverages presents a host of issues, including the possible production or otherwise of alcoholic drinks.

At another level, business compliance alsoinvolves some decisions of principle to be made. A company specialising inconventional financial industry publicationsis a case in point. Does this activityconstitute a part of the conventional financecategory or the more neutral publishing? Ifthe latter point of view is accepted, thenwhat classification would be given, for

example, to a company manufacturinggaming machines? As one ploughs throughthe possible investible stock universe amultitude of such issues need to beaddressed. In many cases, detaileddiscussions with Shari’ah scholars areneeded in order to come to a decision.

For financial compliance, the issuesare somewhat more straightforwardonce the definition of terms andtheir composition have been agreed.However, even this area can presentdifficult issues. For example, if a corporation is generally compliantbut the gearing ratio shoots justover the prescribed limit in aparticular year, should its status be changed to ‘fail’? This could justbe an aberration due to the arbitraryyear-end date. One thus needs todetermine whether the gearing ratiorepresents a long-term change in thecorporation’s operating profile or

a mere blip in its activities. If the latter, then Shari’ah scholars would need to beconsulted if the current ‘pass’ status is to be retained for the next period. This couldbe quite an issue for large ‘index’constituents as frequent changes in theirstatus create instability and unsuitability oftheir use as benchmarks.

Finally, Asaria threw some light on the roleof Shari’ah scholars in managing a Shari’ahscreened universe of stocks. He also outlineda possible affinity with ethical screening andthe possibility of having a unified Shari’ahand ethical screened universe.

After the presentation, the participantsraised questions about: why there isdivergence in Shari’ah scholars’ opinions for allowing tolerance levels for stockscreening; what grace period is used forholding the stock if a company begins to fail in its Shari’ah compliance; and how theShari’ah-compliant index providers coverthe time lag between the actual businessactivity and the preparation of financialstatements by corporations.

For information on the upcoming lectures,please visit the IIBI’s website at

www.islamic-banking.com

Iqbal Asaria,Afkar Consultants

at the bank’s disposal was never timely andin one place’.

The inefficiencies led to the decision fiveyears ago to seek a new core system. It setabout what Yazdi describes as a ‘structuredselection process’ which took in all the maininternational players. The bank also consid-ered an in-house development or the possi-bility of working with a local company tobuild a system but these routes were quicklydiscounted, partly due to a belief that therewas insufficient expertise.

A large Request for Proposal (RFP) docu-ment was produced by the bank and localconsultants. It was felt that internationalconsultants would not be of use because thebank’s practices were so different to those of non-Iranian banks.

The RFP was sent to 26 companies, withthis number then reduced to five main-stream international suppliers of core bank-ing solutions. Each was asked to do a oneweek presentation. Representatives from 60 or so departments attended and saw the applications, then rated them. Those rat-ings, plus price, formed the basis for thefinal decision, which came down in favourof Australia-based Financial Network Services (FNS) and its Bancs system.

One attraction of Bancs was that it wasproven to run on the IBM mainframe. Therewas a lot more expertise within the bankand locally for this platform than for Unix,and the mainframe was also felt to be morestable. The scalability of Bancs was felt to

There is no doubt that nowadays moderntechnology is regarded as a strategic compo-nent of success by any financial institution,whether conventional or Islamic. Banks require sophisticated ‘engines’ to run theirbusiness – core banking systems that areflexible, scalable and have a variety of modules to support a wide range of bankingactivities. Front office, middle office andback office of a financial institution heavilydepend on technology these days. Somecountries, including the US and those inWestern Europe, have their banking systemsmarkets firmly established, while othercountries are still playing catch-up andsome, like Iran, are just embarking on thejourney.

Government-owned Keshavarzi, Iran’s agricultural bank, is the first of the coun-try’s banks to take the IT modernisationpath. Its project to replace the core bankingsystem is already well under way, whileother banks are seemingly keeping a watch-ing brief on it before making any decisionsof their own. Formerly, Keshavarzi had abranch-based system which was used bymost of the outlets. The software stemmedfrom a local company and there was no online banking support. From a customerpoint of view, says the bank’s chief informa-tion officer, Dr Farzad Yazdi, this meant alot of inconvenience. For the bank itself, itplaced an administrative burden on thebranches, with the need to spend time col-lecting data for head office, doing account-ing and handling inter-branch tasks such as remittances between the individualbranches. In head office, ‘the information

42 IIBI www.newhorizon-islamicbanking.com

NEWHORIZON January–March 2008CASE STUDY

IT modernisation: reaping the benefitsat Bank KeshavarziOne of the top five banks in Iran, Keshavarzi, has surged ahead of its rivals in terms of putting in place a new systems infrastructure. The benefits are now starting to be realised. Martin Whybrow, NewHorizon’s contributing editor, reports.

It is a huge project by anystandards, considering the sizeof the bank. A NatWest orBarclays, for instance, wouldbe the same sort of scale.

Negara Indonesia, but not too much weight was placed on this. ‘Their Islamicbanking was totally different from ours but because we knew FNS had done it forthem, we knew they could do it for us.’ The Central Bank of Iran’s rules for lending inparticular are markedly different from else-where and, to a large extent, the bank hadto implement much of the Islamic bankingsupport from scratch. This was achievedthrough ‘very deep involvement from thebank from day one’ and all of the requiredIslamic banking products were duly imple-mented. This was despite changing require-ments due to changes by the Central Bank –‘banking laws are very fluid in this country’,says Dr Yazdi.

As well as Islamic banking in its Iranianform, there were plenty of other anomalies.For one thing, the sheer size of the bank wasa challenge. Those 1850 branches and 27

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NEWHORIZON Muharrum–Rabi Al Awwal 1429

be a benefit, with some large sites in Indiaand Indonesia. The company’s web-basedtechnology also seemed to be appropriate,says Dr Yazdi, and FNS was felt to be astrong company.

At the time of the selection, in 2003, and the subsequent signing of the contractin 2004, an Indian company, Tata Consul-tancy Services (TCS), was a partner of FNSbut had not yet acquired the Australianbanking systems vendor (this was to occurthe following year). TCS’s involvement as a partner at the time of the selection was ‘a big confidence booster for us’, says DrYazdi, and the full acquisition was ‘a wel-come development’ although there were no dramatic changes as a result. In terms ofIslamic banking support, this would clearlybe needed by Keshavarzi. There was felt tobe some benefit from FNS having success-fully delivered a Shari’ah version for Bank

CASE STUDY

million customers span 27 million depositaccounts and nearly three million loans.That is a big bank by any standard. Therehave been five or six projects in parallel.One of these has been for the network infrastructure, connecting each branch tothe centre via both VSAT (a two-way satel-lite ground station, most commonly used to transmit narrowband or broadband data)and terrestrial networks so that there is al-ways a back-up connection.

The bank has also built a new data centreand disaster recovery centre, there was aneed for new hardware in head office andthe branches, and there were various organ-isational and reengineering projects. Themainframes were acquired two and a halfyears ago and so far the UN Security Council and US sanctions have not been a problem.

In terms of products, a common part of the bank’s day-to-day business is centred on paper, particularly the equivalent of travellers cheques. These are used as a substitute for cash in Iran and are exchange-able on a one-time only basis. Businessescan exchange them for cash or as value totransfer to their accounts. There are alsobonds and certificates of deposit, again with national characteristics. Banks can repurchase them so can act as a secondarymarket.

With more than 200 branches using the newcore system by the end of 2007, the aim inthe new year has been now to connect 20branches each weekend until April so bythat point there are around 450 brancheslive, supporting more than ten million cus-tomers. There will then be a three weekbreak, followed by a return to the weeklyroll-out, perhaps increasing the rate to 30per weekend. Dr Yazdi believes that by themiddle of next year or slightly later, thebank should have completed the roll-out to all 1850 branches.

The benefits are starting to be realised. Onthe efficiency side, those branches that areconnected have been relieved of the admin-istrative tasks, which means staff can focusmore attention on customers and can also

plenty more to do, the solid base that DrYazdi was seeking appears to be in place.This is important from the perspective ofcompeting not only against the incumbentsbut also against newcomers. A small num-ber of new private banks have been allowedonto the market in the last few years, threeof which were previously credit institutions(Saman Bank, Karafarin Bank and ENBank). While foreign banks are little in evidence, there are recent signs of a slightopening up, with an initiative to encourageTurkish banks to establish operations inIran.

With all due respect, most of the Iranianbanks are slow moving and unsophisticated.In fact, the make-up of the market has similarities with the Indian banking marketof a decade or so ago. It was new competi-tion that provoked all of the Indian behe-moths into action and it might need rathermore pressure than is currently being ex-erted to persuade most Iranian banks to dolikewise. However, under its own steam,Bank Keshavarzi has cracked on with theoverhaul of its systems infrastructure and it should gain a clear advantage with the imminent launch of online internet bankingand card services, combined with its cen-tralised branch configuration. That in itselfwill put more pressure on the other banks,so perhaps where Keshavarzi has led, otherswill follow.

44 IIBI

NEWHORIZON January–March 2007CASE STUDY

www.newhorizon-islamicbanking.com

leave on time, at the end of the working day.In head office, the bank is gaining consoli-dated customer information. Customers arealso seeing the up-side to the investment,with the ability to repay loans or make cashdeposits in any online branch.

However, the real advantages will come a bit later, says Dr Yazdi. ‘We are building a sound, solid base to offer services on top.’This will include the introduction of elec-tronic channels and cards. Using the FNSsoftware, the bank is doing the ‘finishingtouches’ for internet banking and, usingsoftware from another vendor, will belaunching new card products shortly. Otherbanks in Iran have only very limited internetbanking and off-line card services, he says,so there should be a competitive advantagefrom the new systems.

It has been a major project with major chal-lenges and, of course, there have been upsand downs along the way, says Dr Yazdi.Most of the effort has been by the bank andsupplier; a local company has helped withsome aspects, mainly Farsi language sup-port. ‘It is a huge project by any standards,considering the size of the bank. A NatWestor Barclays, for instance, would be the samesort of scale.’

So of all the Iranian banks, why was it Keshavarzi that became the core systems pioneer? Despite its considerable size, thebank is actually smaller in terms of revenuesand branch network than three or four others. ‘We knew we would never have theirrevenues and customers so we felt we had to be first in another area and chose elec-tronic banking.’ That decision was basicallymade at the board level and the directiongiven from the top is cited by Dr Yazdi as a key reason for the innovation. ‘The otherIranian banks have not really started be-cause they are waiting for us, to see how we get on.’ Despite what looks to be a clearsuccess story, there still seems to be a wait-and-see approach from the others, althoughhe feels that all are under pressure to tackletheir core system challenges.

The bank has achieved a great deal in the last couple of years and, while there is

Dr Farzad Yazdi,Bank Keshavarzi

The other Iranian banks havenot really started because theyare waiting for us, to see howwe get on.

NEWHORIZON January–March 2008

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RATINGS & INDICES

46 IIBI

Islamic banks, financial institutions & financial instruments

Below is a monthly list of the latest long- and short-term credit ratings for each Islamic financial institution and financialinstruments monitored by Capital Intelligence (CI), an international credit rating agency. Detailed information on ratingprocesses and definitions can be found on the CI’s website www.ciratings.com

29th February 2008

CURRENT RATING

FOREIGN CURRENCYFINANCIALSTRENGTH

SUPPORT OUTLOOK SINCELONG TERM SHORT TERM

ISLAMIC BANKS

Abu Dhabi Islamic Bank A- A2 A 2 Stable Jun 2007

Al-Baraka Islamic Bank (Bahrain) BB+ A3 BB 2 Stable Sep 2007

Al Rajhi Banking & Investment Corp. A+ A1 A+ 2 Stable Jan 2008

Arab Islamic Bank NA NA B+ 3 Stable Oct 2005

Bahrain Islamic Bank BBB A3 BBB 3 Stable Sep 2007

Bank Islam Malaysia BBB- A3 BB+ 2 Stable Jan 2008

Faysal Bank (Pakistan) B+ B BB 2 Stable Aug 2006

Gulf Finance House BBB+ A2 BBB+ 3 Stable Sep 2007

Jordan Islamic Bank for Finance & Investment BB B BBB- 3 Stable Nov 2007

Kuwait Finance House A A1 A 2 Positive Dec 2007

Qatar International Islamic Bank BBB A2 BBB 3 Stable Aug 2007

Qatar Islamic Bank A- A2 A- 3 Stable Jul 2007

Sharjah Islamic Bank BBB+ A2 BBB+ 3 Stable Jun 2007

Shamil Bank of Bahrain BBB A3 BBB 3 Stable Sep 2007

The National Commercial Bank A+ A1 AA- 1 Stable Oct 2007

Tadhamon International Islamic Bank B- B BB- 3 Stable Oct 2007

CORPORATE RATING

OUTLOOK SINCELONG TERM SHORT TERM

FINANCIAL INSTITUTIONS

Al Tawfeek Company for Investment Funds Limited BBB A2 Stable Oct 2006

A'Ayan Leasing & Investment Co BBB A3 Stable Oct 2007

Grand Real Estate Projects Co BB B Stable Nov 2006

Investment Dar Company BBB+ A3 Stable Oct 2007

International Investment Group BB B Positive Dec 2006

CAPIVEST BB+ A3 Stable Jan 2007

BOND RATING

OUTLOOK SINCELONG TERM SHORT TERM

FINANCIAL INSTRUMENTS

Commercial Real Estate Sukuk Company A- Stable Sep 2007

KCMCC Sukuk Company BBB Stable Jul 2006

KSA MBS International Sukuk Co. Ltd A- Stable Oct 2007

Kuwait Resorts Sukuk Co. BSC BBB Stable May 2006

Diary of events

NEWHORIZON Muharrum–Rabi Al Awwal 1429

www.newhorizon-islamicbanking.com

1–3: 7th International Conference onIslamic Economics, JeddahConference to commemorate the passage ofthirty years since the commencement ofmodern academic research in the field ofIslamic economics.Tel: +966 2 695 1768Email: [email protected]

2: Islamic Finance News Forum, SingaporeForum to discuss the key issues andchallenges surrounding the growth andfuture innovation of the Islamic financeindustry. This forum is repeated in variouslocations through the year (see website forfurther details).Contact: Andrew MorganTel: +60 321 416 025Email: [email protected]

13–17: The International Islamic FinanceForum, DubaiCombined forum and workshop to focus onkey topics, including infrastructure issuesand Islamic asset classes.Contact: Swati TanejaTel: +971 4 335 2437Email: [email protected]

14–15: The 3rd World TakafulConference, DubaiConference to discuss practical

issues, strategies and plans of the takafulindustry on the global scale.Tel: +971 4 343 1200Email: [email protected]

19–20: Eighth Harvard University Forum on Islamic Finance, Cambridge, USAForum to focus on the latest innovationsand developments in the Islamic financeindustry and the long-term impact, scope

and authenticity of these ideas in thecontext of an Islamic community and wayof life. Tel: +1 617 496 2296Email: [email protected]://ifp.law.harvard.edu

22: London Islamic Capital MarketsSummit, LondonConference to examine the role of Londonas a hub of the industry, and topical issuesfacing the sukuk industry in Europe.Tel: +44 (0) 20 7156 5190Email: [email protected]

22–23: Shari’ah and Legal Aspects onIslamic Banking and Finance, KualaLumpurSeminar to address the legal aspects of theIslamic finance industry.Tel: +60 321 636 990Email: [email protected]

29: IIBI Training: Sukuk, TheirPractical Applications andChallenges, London

An overview of sukuk, including thediscussion of application, structuring issues,challenges and the development of capital

CALENDAR

April

London

IIBI 47

markets. Contact: Mohammad ShafiqueTel: +44 (0) 20 7245 0404Email: [email protected]

May

6–7: The Euromoney Saudi ArabiaConference 2008, RiyadhConference organised in partnership withthe Ministry of Finance of Saudi Arabia tofocus on the internationalisation of theSaudi financial sector.Contact: Ms Evelyne AtimTel: +44 (0) 20 7779 8701Email: [email protected]

13–14: Islamic Financing of EnergyProjects Conference, Abu DhabiConference to explore the challenges andopportunities for Shari’ah-compliant financein the energy industry.Contact: Rudinov VincentTel: +971 4 336 9992 Email: [email protected]

13–14: 5th IFSB Summit: FinancialGlobalisation and Islamic FinancialServices, AmmanSummit to address some of the majoropportunities and challenges which financialglobalisation poses to the Islamic financeindustry.Contact: Ms Farrah ArisTel: +60 326 984 248Email: [email protected]

14–15: Kuwait Insurance Forum, KuwaitForum to discuss the developments of theinsurance and reinsurance industry, bothconventional and Islamic.Tel: +965 4 342 929Email: [email protected]

©iStockphoto Douglas Freer

www.newhorizon-islamicbanking.com

CALENDAR NEWHORIZON January–March 2008

18–21: Cards Middle East 2008, DubaiConference to focus on practical issues ofpayments in the Middle East and globally.Contact: Michael ParsonsTel: +971 4 709 4530Email: [email protected]

19–20: Islamic Finance Forum,DubaiForum to explore the key to

success in the Islamic finance industry andto establish where the opportunities lie.Tel: +971 4 221 3452Email: [email protected]

19–22: Islamic Finance World NorthAmerica 2008, New YorkConference to focus on the key industryissues, including the opportunities in theregion, development of Shari’ah-compliantproducts and the future of Islamic finance inNorth America.Contact: Michael WeinbergTel: +1 212 379 6320Email: [email protected]

20–21: Conference on IslamicManagement and Leadership Ethics, Kuala LumpurConference to focus on various managerialissues in Islamic finance industry.Tel: +60 321 636 990

June

1–3: MEFX, DubaiThe Middle East International Banking,Financial Technology and ServicesExhibition and Conference to focus onfinancial technology, banking products andprofessional services for the financeindustry. Contact: Aleks DuricTel: +971 4 308 6597Email: [email protected]

15–19: Sukuk World Middle East, DubaiConference to explore the techniques andmethodologies involved in all facets of thesukuk issuance and investing process.Tel: +971 4 335 2437Email: [email protected]

16–17: The 2nd Global Islamic FinanceConference (GIFC2008), Kuala LumpurConference to address key issues anddevelopments of the industry worldwide.

Email: [email protected]

20–21: The London IslamicCapital Markets Summit, LondonSummit to address the issues

facing sukuk, with an emphasis on Islamicbanking in the West, including the UKgovernment’s consideration of sukuk. Contact: Nick NoakesTel: +44 (0) 1483 720 707Email: [email protected]

26–28: 4th Annual Middle East ProjectFinance Forum, Abu DhabiForum to discuss conventional and Islamicproject finance opportunities in the MiddleEast.Contact: Ms Maria LuminitaTel: + 971 4 361 6112Email: [email protected]

26–27: The World Islamic Funds& Capital Markets Conference,Bahrain

Conference to discuss the prospects of theIslamic capital markets, with a focus onprivate equity, real estate, alternativeinvestments and sukuk.Tel: +971 4 343 1200Email: [email protected]

26–27: Bringing Into Market, IslamicSukuks III, SingaporeTraining course to teach how to capture thehearts and minds of financial investors inthe industry.Tel: +65 6324 9733Email: [email protected]

26–29: Leaders in Islamic Finance,IstanbulSummit to herald the launch of the Centrefor Innovation in Islamic Finance, a newglobal platform for the Islamic financeindustry to invest in innovation.Tel: +971 4 364 2975Email: [email protected]

48 IIBI

Dubai 29–30: Bringing Into Market, IslamicSukuks IV, Hong KongTraining course to teach how to marketsukuk products.Tel: +65 6324 9733Email: [email protected]

Istanbul

©Jarnogz Dreamstime.com

©iStockphoto atbaei

NEWHORIZON Muharrum–Rabi Al Awwal 1429

www.newhorizon-islamicbanking.com

CALENDAR

Events endorsed by the IIBI

July

August

8–10: IIBI Training: StructuringInnovative Islamic Financial Products, Cambridge, UK

Workshop to focus on continuingdevelopments in innovation in Islamicfinance structures and the underlyingtechniques evolving in the moderneconomy.Contact: Mohammad ShafiqueTel: +44 (0) 20 7245 0404Email: [email protected]

11–13: MIF 2008 Issuers & InvestorsForum, Kuala LumpurForum to focus on the challenges facingIslamic finance issuers and investors, and todiscuss the developments within Islamic

Tel: +60 321 636 990Email: [email protected]

16–18: Middle East Investments Summit2008, DubaiSummit to explore the key aspects andissues of conventional and Islamic financeindustries in the region, including propellingIslamic finance in capitalising globalinvestment trends.Tel: +357 22 849 321 Email: [email protected]

30–1 July: Seminar on Islamic Trade Finance and Sukuk, Kuala LumpurSeminar to focus on the key issues,developments and challenges of Islamictrade finance and Islamic bonds.Tel: +60 321 636 990Email: [email protected]

IIBI 49

8: The World Islamic BankingConference, European Summit,London

Conference to focus on issues anddevelopments of the dynamically evolvingmarket for Islamic in the European context.Contact: Anu ThomasTel: +971 4 343 1200

equity capital markets. Contact: Andrew MorganTel: +60 321 416 025Email: [email protected]

12–13: Risk Management for FinancialServices, Kuala LumpurConference to discuss risk management inconventional and Shari’ah-compliantfinance.Tel: +60 321 636 990Email: [email protected]

25–28: Islamic Finance and InvestmentWorld Africa 2008, JohannesburgConference to address key issues anddevelopments of Islamic finance industryand investment opportunities in Africa andworldwide.Contact: Brian ShabanguTel: +271 14 636 001Email: [email protected]

Cambridge

Email: [email protected]

14–16: The 2nd International Takaful Summit and Masterclass, LondonForum for practitioners and researchers todiscuss the current state of the takafulindustry.Contact: Mohaned AbdullahTel: +44 (0) 7765 811 312Email: [email protected]

15–16: Conference on Islamic FinancialPlanning & Asset Management, KualaLumpurConference to discuss prospects, principles,issues and avenues of Islamic financialplanning and asset management.Tel: +60 321 636 990Email: [email protected]

22: Innovative Product Development Seminar, LondonSeminar to focus on the future trends inproduct innovation in the Islamic financesector.Tel: +44 (0) 20 8200 9002Email: [email protected]

Kuala Lumpur

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50 IIBI www.newhorizon-islamicbanking.com

NEWHORIZON January–March 2008GLOSSARY

amanah

Lit: reliability, trustworthiness, loyalty, honesty.Technically, it describes a business deal where one partykeeps another’s funds or property in trust.

arboun

An Islamic version of option, a deposit for the delivery ofa specified quantity of a commodity on a predetermineddate.

fatwa

A ruling made by a competent Shari'ah scholar on aparticular issue, where fiqh (Islamic jurisprudence) isunclear. It is an opinion, and is not legally binding.

gharar

Lit: uncertainty, hazard, chance or risk. Technically, saleof a thing which is not present at hand; or the sale of athing whose consequence or outcome is not known; or asale involving risk or hazard in which one does not knowwhether it will come to be or not.

Hadith

A record of the sayings and actions attributed to ProphetMuhammad (PBUH).

halal

Activities which are permissible according to Shari'ah.

haram

Activities which are prohibited according to Shari'ah.

ijara

A leasing contract under which a bank purchases andleases out a building or equipment or any other facilityrequired by its client for a rental fee. The duration of thelease and rental fees are agreed in advance. Ownership ofthe equipment remains in the hands of the bank.

istisna

A contract of acquisition of goods by specification ororder, where the price is fixed in advance, but the goodsare manufactured and delivered at a later date.Normally, the price is paid progressively in accordancewith the progress of the job.

maysir

Gambling – a prohibited activity, as it is a zero-sumgame just transferring the wealth not creating newwealth.

mudarabah

A form of business contract in which one party bringscapital and the other personal effort. The proportionateshare in profit is determined by mutual agreement at thestart. But the loss, if any, is borne only by the owner ofthe capital, in which case the entrepreneur gets nothingfor his labour.

mudarib

In a mudarabah contract, the person or party who acts as the entrepreneur.

mufti

An Islamic scholar, who interprets or expounds Islamic lawand gives fatwa.

murabaha

A contract of sale between the bank and its client for the sale of goods at a price plus an agreed profit margin for thebank. The contract involves the purchase of goods by thebank which then sells them to the client at an agreed mark-up. Repayment is usually in instalments.

musharakah

An agreement under which the Islamic bank provides fundswhich are mingled with the funds of the business enterpriseand others. All providers of capital are entitled to participatein the management but not necessarily required to do so.The profit is distributed among the partners inpredetermined ratios, while the loss is borne by each partnerin proportion to his contribution.

musharakah, diminishing

An agreement which allows equity participation and sharingof profit on a pro rata basis, but also provides a methodthrough which the bank keeps on reducing its equity in theproject and ultimately transfers the ownership of the asset to the participants.

qard hasan

An interest-free loan given for either welfare purposes or forfulfilling short-term funding requirements. The borrower isonly obligated to pay back the principal amount of the loan.

qimar

Lit: gambling. Technically, an agreement in which possessionof a property is contingent upon the occurrence of anuncertain event. By implication it applies to thoseagreements in which there is a definite loss for one party and definite gain for the other without specifying whichparty will gain and which party will lose.

rab-al-maal

In a mudarabah contract the person who invests the capital.

riba

Lit: increase or addition. Technically it denotes any increaseor addition to capital obtained by the lender as a conditionof the loan. Any risk-free or 'guaranteed' rate of return on a loan or investment is riba. Riba, in all forms, is prohibitedin Islam. Usually, riba and interest are used interchangeably.

salam

A contract in which advance payment is made for goods tobe delivered later on.

Shari’ah

Refers to the laws contained in or derived from theQuran and the Sunnah (practice and traditions of theProphet Muhammad (PBUH).

Shari’ah board

An authority appointed by an Islamic financialinstitution, which supervises and ensures the Shari’ahcompliance of new product development as well asexisting operations.

sukuk

Similar characteristics to that of a conventional bondwith the key difference being that they are asset backed; asukuk represents proportionate beneficial ownership inthe underlying asset. The asset will be leased to the clientto yield the return on the sukuk.

Sunnah

It refers to the sayings and actions attributed to ProphetMuhammad (PBUH).

tabarru

A donation covenant in which the participants agree tomutually help each other by contributing financially.

takaful

A form of Islamic insurance based on the Quranicprinciple of mutual assistance (ta'awuni). It providesmutual protection of assets and property and offers jointrisk sharing in the event of a loss by one of its members.

usufruct

A legal right to use and derive profit from propertybelonging to someone else provided that the propertyitself is not damaged.

wa’ad

A promise to buy or sell certain goods in a certainquantity at a certain time in future at a certain price. It isnot a legally binding agreement.

wakala

A contract of agency in which one person appoints someone else to perform a certain task on his behalf,usually against a certain fee.

wakil

In a wakala contract, a representative (agent), who actson behalf of the principal/investor.

zakat

An obligation on Muslims to pay a prescribed percentageof their wealth to specified categories in their society,when their wealth exceeds a certain limit. Zakat purifieswealth. The objective is to take away a part of the wealthof the well-to-do and to distribute it among the poor andthe needy.

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