Islamic Financial Services - Current Developments

This is the last in this series. I hope you have found it useful and informative.
Since the late 1990s the Islamic banking world has stepped up efforts to standardize regulation and supervision. The Islamic Development Bank is playing a role in developing internationally acceptable standards and procedures and strengthening the sector’s architecture in different countries. Several other international institutions are working to set Shari’a-compliant standards and harmonize them across countries. These include the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), the Islamic Finance Service Board (IFSB), the International Islamic Financial Market, the Liquidity Management Center and the International Islamic Rating Agency.

Accounting Standards

A number of countries and institutions have adopted accounting standards developed by the AAOIFI, which are designed to complement the International Financial Reporting Standards. The IFSB aims to promote the development of a prudent and transparent Islamic financial services industry and provides guidance on the effective supervision and regulation of institutions offering Islamic financial products. The IFSB has recently finalized standards on capital adequacy and risk management, and has made progress in developing standards on corporate governance. Once developed and accepted, these international standards will assist supervisors in pursuing soundness, stability, and integrity in the world of Islamic finance.

Liquidity Management

Another issue concerns the design of Islamic instruments for monetary operations. In countries with a dual banking system, the lack of non-interest bearing securities has limited the scope of monetary management. The liquid nature of banks’ liabilities, related to the predominance of deposits of short-term maturities, predisposes the system to hold substantial liquid assets and excess reserves. This, in turn, inhibits financial intermediation and market deepening. Difficulties in defining rates of return on these instruments have also constrained the development of money and interbank markets.
Developing these markets is indispensable for the conduct of monetary policy and financial market deepening. The inadequate development or absence of these markets in many countries constrains central bank intervention through indirect instruments and has occasionally encouraged the use of direct controls on credit. The absence of well-organized, liquid interbank markets, that can accept banks’ overnight deposits and offer them lending to cover short-term financial needs, has exacerbated banks’ tendencies to concentrate on short-term assets. Effective liquidity management requires the adoption of a comprehensive, integrated approach to developing money and securities markets.

Areas for future development

Other issues include the lack of aggregate data making it virtually impossible to compare Islamic banks across countries, which, together with the absence of common reporting and accounting standards, complicates the work of supervisors.
The markets for Islamic instruments and government securities remain shallow and an organized international Islamic financial market is still nascent. The sector must improve the range and sophistication of asset and liability classes and develop new instruments and financial techniques that would enable Islamic banks to diversify their balance sheets.
Finally the adoption of a common position on certain financial instruments would help develop Islamic finance and improve its competitiveness globally. For example, a number of issues relating to speculation and the use of derivatives must be resolved before a fully functioning Islamic stock market can evolve. While arbitrage and short selling are not acceptable under Shari’a, other financial transactions appear to be, in practice, subject to varying interpretations. For instance, transactions involving the purchase and sale of debt contracts in secondary markets are permissible only in Malaysia.

The Future

The Islamic financial services sector should continue its recent compound annual growth for some time to come. It is a valuable addition to the more conventional, Western, style of financial services. Because of the nature of the products issued, it should also have some appeal beyond the Muslim community and some of its products could well be adopted by the financial community at large.
There are, however, many issues to be faced. Most of these issues are related to the relative immaturity of the market and the steep learning curve being faced by all participants in the market: the institutions, the regulators (including the interpreters of Shari’a) and the consumers, many of whom are uncertain of which products may comply with their interpretation of Shari’a.
For the foreseeable future, supervisory authorities will continue to face the dual challenges of understanding the industry and striking a balance between providing effective supervision and facilitating the industry’s legitimate aspirations for further growth and development. These conditions would create a level playing field and provide the infrastructure needed for the industry’s market-driven development. A sound, well-functioning Islamic financial system can pave the way for the regional financial integration of the countries involved. It can also contribute to their economic and social development, by financing the economic infrastructure and creating job opportunities.

Can Islamic Banking Survive? A Micro-Evolutionary Perspective Mahmoud El Gamal

Download Pdf : An Economic Explication of the Prohibition of
Riba in Classical Islamic Jurisprudence - Mahmoud A. El-Gamal

An Economic Explication of the Prohibition of Riba in Classical Islamic Jurisprudence - Mahmoud A. El-Gamal

Download Pdf : An Economic Explication of the Prohibition of
Riba in Classical Islamic Jurisprudence - Mahmoud A. El-Gamal

Media in Islamic finance

Hitting the right formula for a successful Islamic finance publication has been the elusive goal of a number of publishers for a number of years. Paul McNamara share some thoughts on why and suggests a possible answer.

It sometimes comes as a surprise to people who do not work in the media to discover that the industry works much like any other. It is all about making money.
Your favourite newspaper or magazine or website does what it does to make a profit There are essentially three models of publishing for profit.

• The first is where the subscriber pays. Typically this covers the newsletter market. Such products are often niche and expensive.
• The second is where the advertiser pays. Typically this would cover a wide range of B2B magazines. The advertiser wants to reach a specific niche (like doctors or lawyers) and will pay to do so.
• The third model is a hybrid of the two - where the subscriber pays and the advertiser pays too. This kind of model is at work in many daily newspapers.

It doesn't matter which media you pick, the economic drivers are always the same.


How does this affect the world of media in Islamic finance?

It goes some way to explaining why there is a relative paucity of good products out there covering the world of Islamic finance. There is a range of titles, from magazines to newsletters to e-newsletters to web based services, but while some are good, the rest are far from good and there isn't one really good strong title that can be taken as the benchmark across the globe. I mean no disrespect to the many Islamic finance journalists and editors who pour their hearts into every issue they produce, of whatever sort, since they are all we have got. But the lack of funding behind almost all of these efforts is plain to see.
None of the major financial publishers have taken a committed leap into the area.

Why would that be?

The reason is fairly plain to see. There isn't any money in it.
From a purely business point of view, you can hardly blame the media for failing to bring out a product that will lose them money. It is not why they are in business. As outlined before, they need to look at revenues from one source or another and unless they can be assured of making some money, even in the medium term, then they will hang back. And hang back.

Which leads us to the question:

Why is there no money in it?

Let's look at advertising spend to begin with.

There are lots of Islamic finance institutions out there. Practitioners. Banks. Investment banks. Lawyers. Consultants. Advisers. Educators. Regulators. The list goes on. There are at least 700 of these institutions and they are spread across the globe. We have a high concentration in Asia, particularly in Malaysia, Indonesia, Pakistan, Brunei, Singapore and even some in Thailand. There is an equally high concentration in the Middle East and North Africa. Then we have quite a number in the UK and the USA.

Some of these institutions are big and some are small. But almost all of them have one thing in common. They won't spend money on advertising in publications. Of course some will spend a bit here and there, but cumulatively it wouldn't amount to very much at all. My guess is that if you put together all of the expenditure in Islamic finance titles it would amount to something between $500,000 and $1 million. This does not include the amounts of money that they spend at retail level in newspapers of a general nature and elsewhere.

To put that in context, a single B2B title in the conventional finance field could book that kind of revenue and more in a single issue.

Here are some verbatim comments from multimillion dollar companies which Islamic finance publishers have forwarded to me in the past two months which typify the approach of these institutions:

• "Further to your invitation for us to participate in your new publication, we would like wish you luck on the launch of your new publication. Although we were very keen to participate, unfortunately we will not be able to take part in this year's edition."
• "We get offers like this all the time. We are only interested in UK. We have a limited budget and have spent it all."
• "We would be interested but unfortunately due to staff shortage during the coming weeks it may not be possible."
• "We regret to inform you that we will not be able to support your publication at this time. However, we would like to take this opportunity to wish you success in your new venture and look forward to receiving your first publication. Thank you for your interest in (company name)"

So if they don't spend money in publications devoted to the industry, where do they spend it? You only have to look at the conference calendar to see where the money goes. It goes on promoting the company at conferences and exhibitions which take place all over the globe.

Walk down the street in Dubai and you see Emirates Islamic Bank painted on the sides of buses and of course Dubai Islamic Bank is a leader in the field. So some of the banks are becoming more savvy about consumer marketing.

But many companies will still not spend in specialist media. Why is that? The answer is pretty plain. Why would they want to talk to a geographically disparate bunch of people whose only common link is working, in however peripheral a way, in the same industry. In other words, a Gulf bank does not want to talk to a consultancy in Kuala Lumpur.

So what does that leave us with?

It leaves us with the circulation income model. Pretty much the only model that works under this structure is the newsletter one. It is low cost, high price and low volume. In other words, you need to sell a small number of copies for a high price while using a small staff and without spending a fortune in advertising and marketing.

This has been tried on more than one occasion and it doesn't work in this industry either. The reason it doesn't work is that the same companies who don't want to advertise also don't want to pay for a subscription that is $500 or more. There seems to be an acceptance that, since they have never relied on information of this sort in the past, they will not need to do so in the future.

This is a terrible error. The reason that the world of conventional finance is so healthy and robust is because practitioners share information and read about each other's developments. The same is true in the legal profession, the medical profession and every other profession.

It is, to use a well worn cliché, a chicken and egg situation. Publishers publish this material because the reader needs the data and so will pay for it and so the publisher makes money. The driver is the need for data - not the need for profit.

The Islamic finance industry needs the same level of data interchange and they simply don't have it because they won't pay for it. This is one of the reasons why the industry is still small and growing slower than it should.

So what is the solution to the problem?

Someone has to carry the torch and show the way. Someone has to be the hero and spend the money.

Like who? Well like the Islamic Development Bank which spends so much money on infrastructure projects but much less on assisting the industry itself to develop.

Another option would be one (or more) of the big players in the industry from the banking or investment banking side of things. Many of these companies are announcing record profits this year. If the top 20 companies pooled $50,000 each we could see the birth of a true vehicle for the industry. It wouldn't be partisan. It wouldn't have an axe to grind. It would be an organ that speaks for the industry to the industry. It would cover trade finance, project finance, sukuk, murabaha, takaful, retail products. Everything.

What kind of statement would it make about one of the big players if they were to fund a publication themselves? Not for profit, but to show what good (Islamic) corporate citizens they are? And of course once you have one such publication, others would follow, driven by profit and the industry as a whole would benefit.

Then maybe we would see the beginnings of a healthy Islamic finance media where we could see the healthy interchange of ideas between academics, practitioners, regulators. The entire gamut.

Reasons to issue Sukuk and the structures behind them


Sukuk is the hot topic in Islamic finance, and we will soon see the industry reach a value of some tens of billions, as Michael Saleh Gassner from IslamicFinance.de writes.

Islamic finance has for some time missed investment opportunities for Muslims that offer a predictable return with low risk. The majority of investment opportunities are based either on stock markets with high volatility or on real estate transactions. The investment galaxy for the Islamic investor is lacking the variety of instruments to create an efficient portfolio in line with portfolio theory and financial planning. Sukuk certificates meet the pressing need for a medium term investment and reached, in 2004, a market volume of nearly US $7 billion. This volume will multiply in coming years to tens of billions of dollars annual volume. Already a number of world-class borrowers have used the new Islamic Sukuk market: Germany; the IMF Group; and Sovereign states like Qatar and Malaysia.

Sukuk are securitised assets and therefore belong to the category of Asset Backed Securities. Unlike conventional ABS structures, Sukuk need to have an underlying tangible asset transaction either in ownership or in a master lease. The securitisation of pure cash flow streams from credit portfolios as undertaken in the mortgage market, for instance, cannot be structured in the same way. A properly made Sukuk limits the debt to the value of the underlying assets. A solid investment policy of the borrower results and the vicious circle of raising debts and running after them in hard times is handled in an ethical and socially more convenient way. This allows the borrowers time sort the situation out. This is important for modern states as many of them borrow money to be repaid by future generations without regard to whether any assets cover the debt or not.

Different types of Sukuk

The Accounting and Auditing Organisation of Islamic Financial Institutions (AAOIFI) issued standards for 14 different Sukuk types. The most common in 2004 were Sukuk Al Ijarah based on leasing transactions. In Malaysia the Sukuk bithaman Al Ajil (Murabaha based) is very popular but not so for Middle Eastern investors. Furthermore Sukuk Al Istisna’a had been used to raise financing facilities for real estate development.
A good example of Sukuk Al Ijarah is the German US$ 100 million Sukuk issued by the federal state of Saxony-Anhalt. The federal state is among the new states of Germany after reunification and their debts are guaranteed by the whole federation of Germany. Consequently the Sukuk received an excellent rating of AAA by Fitch and AA- by Standard & Poor’s. The bond was priced plus 1 basis point 6-month EURIBOR (European Interbank Offered Rate), which was chosen as the benchmark. Citigroup was appointed as Lead Manager and Kuwait Finance House as Co-Lead Manager. The Shari’ah Board of Citi Islamic Investment Bank certified the Sukuk from the Shari’ah point of view.

The underlying transactions are a certain number of specified buildings owned by the Ministry of Finance. The master lease was sold for 100 years to a Special Purpose Vehicle (SPV) which in turn rented it back for 5 years to the Ministry. The SPV was registered in the Netherlands since German law is not yet fully developed regarding securitisation, especially from a tax perspective. Choosing the Dutch foundation the Sukuk remains competitive in regard to municipality tax which would not apply for a conventional bond. The certificate holders receive a variable rent benchmarked to the EURIBOR over the period of five years. After repayment the Ministry could decide to use the SPV a second time for a new issue. The paper is listed at the Luxembourg Stock Exchange.

Benchmarking

How do you benchmark to an interest rate reference such as LIBOR or EURIBOR? Scholars, such as Sheikh Nizam Yaquby from Bahrain or Sheikh Taqi Usmani from Pakistan, explain it by using the example of two brothers working in drinks, one in alcoholic drinks and the other in soft drinks. The brother dealing in soft drinks take over the pricing of his brother dealing in alcohol. Although it is not ideal, it is regarded as acceptable. Nonetheless Yaquby has suggested that economists, students and bankers should find an alternative.

The reasoning of the federal state of Saxony-Anhalt in issuing an Islamic certificate was to broaden the investor basis to gain access to different sources of funding with a long-term view. Furthermore the state is also looking for investors and entrepreneurs interested in going into Germany and choosing Saxony-Anhalt as their new location. The German Sukuk demonstrates their open-mindedness and interest in Muslim investors worldwide. The message which was widely heard.

Another structure was applied by the private sector arm of the International Monetary Fund, the International Finance Corporation (IFC). The IFC issued the Wawasan RM 500 million (US$132 million) Bond in December last year on the Islamic principle of Bay bithaman Al Ajil, which means a deferred payment. The basic feature of the underlying transaction is a sales contract resulting in debt and not a lease. The Joint Lead Managers first purchased the assets from the issuer at RM 500 million and then sold the assets back at the deferred sales price plus profit. The exceptional rating of a supranational entity will clearly strengthen the local Malaysian bond market and complement the yield curve.

The Malaysian Sukuk bithaman Al Ajil structure is controversial in the Islamic finance industry. It results in a debt and could not therefore be traded other than at face value as debt and money cannot change value with passage of time. The majority of Middle Eastern Islamic scholars declare such an action as belonging to the definition of the forbidden Riba. Consequently the IFC did not list their Sukuk on any stock exchange in the world and there is no intended secondary market. It is likely that future issues in Malaysia will consider applying the tradable Ijarah type of Sukuk to enable secondary market trading worldwide and foster the acceptance in the Middle East markets for Malaysian Sukuk. Otherwise the Malaysian issuers will face higher pricing expectations as non-tradable Sukuk will carry an increasing premium.

The Wawasan Ringgit Sukuk by IFC was rated at AAA by S&P and Aaa by Fitch. The profit rate of the issue was fixed at 2.88 % for a three-year maturity. The Joint Lead Managers were HSBC Bank (Malaysia) and Commerce International Merchant Bankers Berhad (CIMB), Malaysia. Shari’ah certification was undertaken by the CIMB Fiqh Council and Dr. Mohd Daud Bakar.

Sukuk can be used for project finance as the US$ 120 million Durrat Sukuk of Bahrain demonstrated. The Durrat Al Bahrain is a major real estate development project. The current Sukuk partly finances the US$ 1.2 billion project of world class leisure and tourist destination. The project company Durrat Khaleej Al Bharain BSC is jointly owned by the Government of Bahrain and Kuwait Finance House (Bahrain).

The issue was oversubscribed by US$ 32.5 million. The Sukuk matures in five years and pays a return quarterly. The issue was priced at 125 basis points above three-months LIBOR. Arranger and Placement Agent for the fundraising was the Bahrain based Liquidity Management Centre (LMC), an institution holding an Islamic investment banking license which was established in 2002 to manage the secondary market and short term investment needs of Islamic financial institutions. Among the underwriters are Dubai Islamic Bank, LMC, Bahrain Islamic Bank, Islamic Development Bank, Emirates Islamic Bank, Bank of Bahrain and Kuwait, General Organisation for Social Insurance Bahrain, National Bank of Sharjah and Arab Islamic Bank (Palestine). The Shari’ah endorsement was managed by the International Islamic Financial Market also based in Bahrain.

The Sukuk will be listed on the Bahrain Stock Exchange to enable trade and secondary market for its investors. Since a Sukuk Istisna’a is not a tradable security by Shari’ah as the underlying asset does not yet exists, the goal to be tradable set by the issuer needs to be met in a pool securitisation. Contemporary Islamic scholars accept a security as tradable as long as the underlying tangible assets are of 51% of market value.

The proceeds of the issue (cash) will be used by the Issuer to finance the reclamation of the land and the development of Base Infrastructure through multiple project finance (Istisna’a) agreements. As the works carried out under each Istisna’a are completed by the Contractor and delivered to the Issuer, the Issuer will give notice to the Project Company under the Master Ijara Agreement and will lease such Base Infrastructure on the basis of a lease to own transaction. If the Sukuk is listed during the Istisna'a period, the Istisna'a receivable (amounts held as cash) shall be traded only at par value. Any appreciation or depreciation in the value of the Sukuk will represent a relative change in the value of the Base Infrastructure.

Summary

Summarising these three case studies, it is obvious that Sukuk can serve a variety of different needs to finance and at the same time meet the need of investors. As proper conventional portfolios of wealthy clients always comprise a percentage of bonds, so will be the portfolios of Islamic investors. Considering the figures of US$ 260 billion with Islamic financial institutions according to the General Council of Islamic Banks and financial institutions and a similar number managed with Islamic windows according to the estimations of Noriba a total volume of about US$ 150 million is likely to be reached over the coming years without any growth of the industry, simply by restructuring the portfolios. On top of this the appetite of conventional institutional investors needs to be added. Most likely 2005 will show us an annual volume of the Sukuk market exceeding for the first time the US$ 10 billion benchmark and then quickly expand to multiple of that amount in the following years.

Islamic hedge funds Islamic hedge funds: Recipes, merits and critics In a unique report, Islamic finance consultant Michael Saleh Gassner delves into the history of Islamic hedge funds. In the last five years hedge funds have become the fashion of the finance industry since the stock markets have been underperforming. Hedge funds were originally invented in 1949 by Alfred Winslow Jones, a journalist and sociologist, while researching an article on the latest techniques used for analysing and forecasting the stock market for Fortune magazine. He thought he could do a better job than the professionals at this time and so raised an initial amount of $100,000 to start what is now called a hedge fund. His strategy was to buy stocks long where he was positive on them and sell stocks short which he thought would underperform. On top of the funds raised he used credits to 'leverage' the results. In addition his compensation was benchmarked to his success. All the same features are still in place with modern hedge funds. Beside Islamic finance, hedge funds are the growth sector of the financial industry. More than 8,000 funds exist nowadays and providers of such funds show impressive charts that offer returns and risk profiles that should be better than other asset classes like real estate, long-only mutual funds and many other investments. Capital market theory suggest that long/short strategies could eliminate or reduce the so-called market risk and offer absolute returns depending on the selection success, independent of the market trend. Market risk is known by practioners as the way that stocks tends to follow the general market trend despite specific company achievements. But the hedge funds went beyond long/short strategy into other strategies to identify market anomalies, which could be done mainly as they are defined as non-regulated funds for savvy investors (rather than a regulated retail product). Each strategy is practically a different financial product and it is misleading to put them all under the umbrella of the term hedge fund. Many invest in equities, some in fixed income and others in emerging markets. The total number of strategies is over a dozen. Among them low risk and extreme risk strategies could be applied - hedging and stretching. It is best not considered as a single asset class. This leads to the question of whether is there a place for hedge funds in Islamic finance. The question needs to be looked at from different angles; from the Shari'ah, from the prospective investor's needs as well as the quality of supply. The Shari'ah opinions of many strategies are short and simple: Haram (forbidden). Muslim investors following the rules will not go for hedge funds active in conventional fixed income sectors, with conventional leverage and without a screen on the business activities. But is there a way to start, as the hedge fund industry started, with a simple long/short strategy? First of all an investor has to decide whether or not conventional stocks could be compatible with his or her investment strategy. Since 1999 there have been commonly accepted rules about debt levels, interest income and industry activities in which a Muslim may invest. The Dow Jones Islamic Index uses these screening criteria as do most of the Islamic mutual stock market funds. However, not all Shari'ah scholars do agree to compromise, considering time and circumstances in regard to debt levels and interest income. Each single investor needs to decide on his own which position to follow and many still feel uncomfortable discussing whether stock investing is similar to gambling and whether or not Shari'ah scholars accept it. If the answer is positive regarding stocks, the question of the short sale arises. "ERIC MEYER'S ATTEMPT TO LAUNCH AN ISLAMIC HEDGE FUND HAS BEEN DISCUSSED FOR QUITE SOME TIME PUBLICLY AND MIGHT BE THE MOST KNOWN PRODUCT IN THE MARKET." Do not sell what you do not own A conventional short sale is selling a stock which you have borrowed; a transaction which would violate the general Islamic rule of 'do not sell what you do not own'. However, in Islamic contractual law there is another transaction called Salam, which replicates a similar economic outcome. It was used for example to sell wheat on a future date against payment today. As an exception to the general rule, it is subject to certain conditions, which the Shari'ah scholars on the board have accepted will be applied if the contracts and documentation is properly adjusted. Salam fixes the price I get for wheat at 100, which I receive today. I could buy the commodity in three months for 90 if prices are falling, making a profit of 10. If the price goes up, I have a loss. To reach the high water mark, the high return goals set, hedge funds typically use leverage techniques; borrowing money from their broker. Money, however, cannot be accepted to be lent against money. The way Islamic hedge fund operators look at this point is to apply a Murabaha contract for the long position, which replicates economically the standard margin facility. Similar to normal margin finance, the Murabaha deal gets liquiditated with losses if the price goes down below the level at which the bank would no longer be protected. There is no waiting period. The stocks are used as collateral immediately. The leverage for the short position is much more delicate. A Salam contract requires that the full amount be paid immediately and therefore leveraging does not take place and the short position is not replicated as it would be in a conventional hedge fund. The fund of fund concept of Eric Meyer from Shariah Capital therefore uses the Arbun contract. Arbun could be translated as downpayment. The buyer pays 10% of the price for the stocks as a down payment. If the price in the future is below 90% of the price on the transaction date, the buyer will buy the stock cheaper in the market place. His downpayment remains with the seller. If the price goes up instead, the seller has to buy the more expensive stock and take a loss. With Arbun there are two concurrent sayings of the prophet (pbuh), one permitting and one forbidding Arbun and consequently the different schools of thought interpret Arbun differently. The Hanbali School generally accepts it while the Hanafi school seems to declare it Haram. Any Muslim investor seeking to look into such a model should therefore ask for clarification of how the majority of the school he aims to follow interpreted this issue. First market neutral fund in 1997 Islamic hedge funds have been a hot topic for some years now on the Islamic conference circuit. The International Investor (TII) launched in 1997 the Al-Khawarizmi Market Neutral Fund managed by Axa Rosenberg. A market neutral fund uses 50% long and 50% short, so that the market risk is eliminated, while a long/short fund manager may decide to hedge the market risk to a lesser degree if he is positive about the trend. The next hedge fund for Muslims was offered by SEDCO in Saudi Arabia called Al Fanar Hedge Fund, using the long/short strategy with the Salam contract managed by a single manager. Many other asset managers apply long/short strategies to individual managed accounts without going public; among the less known is the GAFM Global Asset - and Fundsmanagenent AG in Switzerland. Such accounts may or may not have a dedicated Shari'ah approval. GAFM might come up at the end of the year with a repeatedly used Islamic hedge fund approved by a Shari'ah board. Deutsche Bank announced their Islamic hedge fund tracker certificate, which is by definition not a hedge fund, but the returns achieved through a not yet disclosed structure are benchmarked to the HFRX Global Hedge Fund Index. We hear that other big names in the market may follow with other offerings. Eric Meyer's attempt to launch an Islamic hedge fund has been discussed for quite some time publicly and might be the most known product in the market. The final launch of two funds is due for September. Having previously employed UBS as placement agent and Noriba as Special Advisor this partnership has now been ended. Eric has invested over $3 million in these products already since 2000 and gained Shari'ah approval from Sheikh Nizam Yaquby, Yusuf Talal DeLorenzo and Dr. Mohammed Daud Bakar. Eric offers a principal protected, liquid market neutral fund as an alternative short-term instrument. Indicated returns should be 200-300 basis points above Murabaha based products. It will be interesting to see whether such anomalies in the markets really do exist. His second product is the Shari'ah Long/Short Master Fund, gathering a number of selected fund managers using the Murabaha/Arbun long/short techniques for a screened stock market universe which goes beyond the limits of the current Dow Jones Islamic Index including a wider number of candidates, screening them with the most current online annual reports and widening the investment universe which is an important approach as capital market theory suggests that a smaller investment universe would result in lower returns. "THE QUESTION NEEDS TO BE LOOKED AT FROM DIFFERENT ANGLES; FROM THE SHARI'AH, FROM THE PROSPECTIVE INVESTOR'S NEEDS AS WELL AS THE QUALITY OF SUPPLY AS WELL." Risky investment or proper hedge Hedge funds commonly claim to have low risk and prove this with charts showing an animal called 'historic volatility' measured in days, months or years. Historic volatility could be explained with the illustration of waves on the sea. For a certain beach, the size of waves are limited, let's say, to one metre in 66% of the cases and in 95% of the cases they will not exceed two metres. However, once in a century there may be a tsunami that the historic wave volatility did not indicate might arrive. Leveraged portfolios like the typical hedge fund suffer most, and the market neutrality feature can be abolished if the wave comes first from the stocks which are long and does not push down those which are short. The entire portfolio will quickly be executed. Leveraging is not a good idea for this reason and the amount of leverage needs to be adjusted to the portfolio of the investor to match their personal risk appetite (which leveraging increases and not hedges). Any investor needs to know the exact exposure of leveraging for his own optimal portfolio, whether margin facilities are applied, other borrowed money, and debt inside the stocks (on- and off-balance sheet). The US Central Banker, Greenspan warned at the beginning of June that hedge fund managers take too much risk to generate the high returns they promised at a time of unsually low market returns. He is convinced that it will not affect the financial system; however, he thinks that the industry will shrink and many wealthy fund managers and investors could become less wealthy. The job of the active fund manager is to achieve outperformance above market risk. If he is achieving returns based on market risk or leverage, this risk/return profile could be obtained much cheaper from an investor's point of view. Is there a long/short hype? The current media perception and the trend to sell hedge fund products to retail clients show a boom which is quite advanced. A hedge fund is an actively managed portfolio which looks for anomalies. An investor should be convinced of the superiority of their trading approach, and be aware that too many managers using long/short techniques are typically coming to an end of the historic out performance of such a strategy. Nowadays the rational way is to decide on the quality of the fund manager since he is dedicated to achieving the indicated results in future. Hedge funds are considered to be an alternative investment class which lowers the entire portfolio risk as it is not correlated with other investments. Following the old strategy of not putting too many eggs in one basket, diversification could be reached by other alternative asset classes as well, which have a different nature from the 'standard' long/short hedge fund. Other alternative investments The Appleton Crescent Currency Fund from Chicago-based Crescent Capital Management domiciled in Cayman Islands was launched in 2003. The fund manager is Appleton Capital Partners in Dublin. The investment strategy follows an approach to buy sets of currencies that look undervalued by mathematical modelling; a long only, no-leverage strategy so far. In 2000 the UBS SEDCO Shari'ah Compliant Timber Fund launched a long term, uncorrelated and absolute returns product, which is a serious investment for pension funds and insurance funds because of predicable returns, lack of leverage and is not related to any current hype in the markets which sets it apart from any bubble. Conclusion Islamic hedge funds might be structured alongside a long/short strategy; it raises some Shari'ah concerns which need to be made transparent to the investor especially if he is following a specific school. The market cycle may not currently favour investing in hedge funds as too many people are following the same strategy and consequently the returns might not be too exciting in the foreseeable future. The hedging of risk is linked to historic volatility. Leverage always leads to higher risk even if limited by a long/short strategy and this is definetely to be taken into account when assessing the personal risk appetite of the individual investor. Alternative investments could be undertaken in other areas and these should be analysed to see if these do not offer potentially better returns and to serve the overall objectives of Shari'ah with regard to society, environment and wellbeing.

Dealing with record profits

Record profits are all well and good, but they raise the question; what to do with it?
Go regional, argues Robin Wigglesworth

July and August are traditionally when banks report their first half profits, and they have generally made entertaining reading for shareholders and managers alike.

Islamic banks are no exception, having capitalised on the tremendous boom in the Middle East in general, and Islamic banking in particular. Take some of the larger players as examples: Qatar Islamic Bank (QIB) made $129 million, Dubai Islamic Bank (DIB) made $192 million, Kuwait Finance House (KFH) made $259 million, Bank AlJazira made $359 million, and Al Rajhi Bank made a staggering $941 million.

However, the banks are not resting on their laurels. All are aware that, as the recent stock market tumble showed, nothing can last forever, and to use a old clich‚, if you stand still you are moving backwards.

According to Adnan Yousif, CEO of AlBaraka Banking Group (ABG), Sheikh Saleh Kamel was the first person to raise the issue of the need for an Islamic 'megabank', a view he shares with his chairman. "The Islamic financial system needs a big banking institution, because truly to matter on the global stage you have to be big."

Most of the major Islamic banks in the region are investing tremendous resources into becoming regional, even international, banking players. Bahrain-based ABG is probably the most geographically diversified Islamic bank, with subsidiaries in Egypt, Lebanon, Sudan, Tunisia, Turkey, Jordan, Algeria, and South Africa, and has invested in the Islamic Bank of Britain and the European Islamic Investment Bank. It is all part of Sheikh Saleh's vision of a global Islamic bank, present in all predominantly Muslim countries.

ABG recently issued a $430 million IPO with the express intention of using the capital to bolster its subsidiaries, and expand internationally into new markets, particularly Malaysia, Indonesia, India and Syria, and "hopefully Europe soon", according to Adnan.

QIB has entered into a joint venture with Islamic investment banking big-hitters Gulf Finance House (GFH), based in Bahrain, and established Qatar Finance House (QFH), a Shari'ah compliant Qatari investment bank with $1 billion in authorised capital and $500 million in paid-up capital, with each bank owning 15%. QFH has already applied for a license to operate from the Qatar Financial Centre, and the board of directors is a veritable who's who of Qatari and Bahraini investors.

DIB, the world's first Islamic bank, has also spread its geographical wings, primarily in Sudan and Pakistan. Together with Abu Dhabi Islamic Bank, Sharjah Islamic Bank, and the Islamic Development Bank (IDB), DIB has taken over Al Khartoum Bank, Sudan's first bank, renamed it Emirates and Sudan Bank, and given it a paid-up capital of $113.5 million and an authorised capital of $200 million.

Interestingly, DIB also holds a significant stake in Bosna Bank in Bosnia, as does IDB. Though it is still a miniscule market, Bosna Bank could, with the right backing and economic conditions, potentially become a leading Islamic bank in Eastern Europe.

There are also reports that DIB is in the final stages of acquiring MNG Bank in Turkey for $160 million, and converting it into a fully Shari'ah compliant institution. Due to the secular constitution in Turkey, Shari'ah compliant banks must call themselves 'participation banks', but with a buoyant, thriving economy and an EU membership on the cards, a presence in Turkey is potentially extremely lucrative.

"DUE TO THE SECULAR CONSTITUTION IN TURKEY, SHARI'AH COMPLIANT BANKS MUST CALL THEMSELVES 'PARTICIPATION BANKS."

DIB's move into the Pakistani Islamic banking market is perhaps even more significant. In a Memorandum of Intent, DIB has committed to opening 70 branches across Pakistan over the next 18 months, making it one of the largest foreign banks in the Islamic republic. Explaining the move, Saad Abdul Razak, CEO of DIB, revealingly said that it would enhance DIB position "leading Islamic financial institution on the global scene".

It is a title that is likely to be contested, not least by KFH and Al Rajhi Bank. KFH in particular has a well-established pedigree outside the Kuwaiti borders. For many years, KFH was regulated directly by the Ministry of Economy, and was able aggressively to expand abroad, most notably in Turkey through its Kuveyt Turk subsidiary, Bahrain through KFH Bahrain, and the UAE through its 20% stake and management contract with Sharjah Islamic Bank.

It is also present in more far-flung areas, and not only through its real estate investments in the west. It operates in Malaysia through its wholly-owned subsidiary KFH Malaysia, which has a $100 million in paid-up capital. KFH Malaysia caught the attention of the Islamic financial world when it announced plans to bring a $200 million Islamic bond to the market, backed by Chinese energy infrastructure assets. It would be the first Chinese Sukuk, and KFH is also reportedly looking at issuing Sukuk on the behalf of Indonesia and the Philippines as well.

However, the largest Islamic bank in the world is predictably a Saudi one. Al Rajhi Bank is the second largest bank in the Middle East, and the largest Islamic one by some distance. Its sheer size allows it to take risks some smaller banks might shy away from, and uniquely for the largest Islamic banks, its focus is squarely on retail banking.

"This was our model from the very inception of the bank. We wanted to be the people's bank, and the strategy of the bank was built around this vision," says Saeed Mohammed Al Ghamdi, head of retail banking at Al Rajhi. It has announced plans to open 50 branches in Malaysia, arguably the world's most advanced country within Islamic finance, and as in Saudi Arabia, Al Rajhi's focus in Malaysia will be on retail.

The retail sector in Malaysia is very competitive, and Shari'ah boards in Malaysia are sometimes accused of taking a 'mercantile' approach to Shari'ah compliance. As Al Rajhi will still be relying on its own, Saudi board, this might disadvantage it vis-…-vis Malaysian competitors like RHB Islamic, Bank Islam, Bank Muamalat and CIMB. However, its venture into the Malaysian market should be applauded, and considering the tremendous financial backing and extensive retail experience accrued from years as a top player in Saudi Arabia makes it a well-calculated venture.

Saeed is certainly convinced that it will prove successful, and says once Al Rajhi are successfully established in Malaysia, it will use it as a springboard to other Muslim markets nearby. "We don't want to limit ourselves to one area or another, and all Muslim countries represent an opportunity for us. After we are successful in Malaysia we will closely study all the other regional markets, and determine the best way to expand in those in due course. We want to be a leading, global Islamic bank."

The larger players obviously have the advantage when it comes to expanding outside core markets, but wary of the dangers of standing still, smaller GCC Islamic banks are also looking around for opportunities. Often, their domestic markets are dominated by the larger banks, and though nimble, they cannot compete with their economies of scale, making regional expansion increasingly attractive.

Bank Boubyan in Kuwait has to face domestic giants KFH, and has decided to look abroad as well, having acquired a significant stake in Bank Muamalat Indonesia. "The bank has a very interesting history, has an excellent track record, good profitability over the past three years, and excellent future potential," says Fuad Al-Shehab, deputy general manager and head of investments, who wants to use the bank as a window into the Far East markets, particularly Malaysia and Japan.

"Malaysia is very advanced in terms of Islamic banking, but Japan has no knowledge of Islamic banking. Our investments in Japan are restricted to buying real estate, but we have found that Japan is very willing to entertain the concept of Islamic transactions," says Fuad. With Islamic banking and finance thriving in Malaysia, Singapore attempting to become an Islamic finance hub, and Indonesia the world's most populous Muslim country, Fuad thinks that South East Asia will attract a lot of attention from capital-rich Islamic banks in the GCC.

There are also many opportunities closer to home for more cautious banks. Take International Islamic in Qatar. It was a founding partner of Islamic Bank of Britain, is establishing a Takaful company in Pakistan, setting up an Islamic bank in Syria, and is in the early stages of setting up another bank in Morocco.

"BANK BOUBYAN IN KUWAIT HAS TO FACE DOMESTIC GIANTS KFH, AND HAVE DECIDED TO LOOK ABROAD AS WELL, HAVING ACQUIRED A SIGNIFICANT STAKE IN BANK MUAMALAT INDONESIA."

However, regional consolidation, whilst the good times are rolling, is all well and good, but some true Islamic 'megabanks', capable of competing with the multinationals, would be a boon to the industry, and help it move forwards. Ernst & Young did a survey with ABG, and found that 85% of all Islamic banks do not have capital exceeding $25 million, only 12% of Islamic banks have more than $100 million in capital, and despite abundant liquidity, there is not a single Middle East bank among the top 100 banks in the world, ranked by Tier 1 capital.

Perhaps the larger regional players, awash with budget surpluses, should rather look for merger and acquisition possibilities closer to home. There are several Islamic banks that, due to their size, look like ideal possibilities for an ambitious and capital-flushed bank, and due to the complicated ownership structure of Middle East companies, many banks are owned by the same government or family office.

Take for example Emirates Islamic Bank, wholly owned by the Emirates Bank International Group, in turn owned 76.8% by the government of Dubai, which also controls DIB. Furthermore, the government also owns Dubai Bank through Dubai Holding and Emaar Properties, and Dubai Bank is currently in the process of converting into a fully Shari'ah compliant institution.

There is also a case for cross-border consolidation in the Islamic financial sector. KFH could certainly afford fully to acquire Sharjah Islamic Bank, thereby getting a foothold in the lucrative UAE market, and a bank like Bahrain Islamic Bank has little chance of competing against the giants of Bahrain, and would have much to gain from, for example, a Saudi patron bank. Arab Islamic Bank's general manager Atiyeh Shananier certainly makes no secret of his desire to see an Islamic bank from the GCC investing in the Palestinian bank.

With most banks doing well, the price of consolidation might very well be extortionate, but the stock market downturn has made acquisitions a bit more palatable, with shareholders no longer asking for unrealistic valuations. As regional Islamic banks expand further, and become locked in increasingly tough competition, the smaller players will see their margins tighten, and an even stronger case might be made for M&As.

Islamic Banking and Finance: A Snapshot of the
Industry and Its Challenge Today (KPMG)

In publishing this paper on challenges and opportunities in Islamic banking and finance our aim at KPMG's network of firms is to provide perspective on these issues and, hopefully, have it serve as a catalyst for a discussion on change, opportunity, and growth.

Download Pdf (3.41MB) : Islamic Banking and Finance: A Snapshot of the Industry and Its Challenges Today

Western investors go shariah

There is growing interest among western investors in shariah compliant finance, particularly in areas such as ethical investing. Kamal Mian, Associate Director, HSBC Amanah, explains how ancient guidelines can be interpreted and applied to business today.

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Malaysia: Leading Islamic Finance The wide range of tax exemptions across the Islamic finance spectrum would further establish Malaysia as a key Islamic finance centre. Dato Johan Raslan Executive Chairman, PricewaterhouseCoopers Malaysia Islamic banking and finance has become a force to be reckoned with in the global economic scenario. It often forms part of the equation in international finance, whether at a government-to-government or the private sector levels. Its significance has grown over the years and is now present in over 60 countries. The Malaysian Islamic financial sector is seen as one of the most progressive and attractive in the world given the numerous incentives planned and further liberation in the coming years. Malaysia is the Largest Islamic Banking and Financial Market Islamic banking assets: RM113.5 billion (US$30.9 billion). Takaful assets: RM6.2 billion (US$1.7 billion). Largest Islamic private debt securities (IPDS) market: 45.5% (RM125 billion or US$34 billion) of domestic corporate bonds. Active Islamic money market channelling about RM30 billion - RM40 billion monthly. Critical mass of diversified players - Islamic banks, investment banks, takaful companies, development financial institutions, savings institution, fund management companies, stock brokers and unit trusts. Progressive industry developments The international financial community has taken note of Malaysia's strategic direction in developing and nurturing Islamic banking and finance. With this, they have acknowledged Malaysia as the leading Islamic financial centre. The strategies are being implemented through clear and deliberate policies spelt out in both the Financial Sector Master Plan as well as the Capital Market Master Plan. Its progressive industry developments include: Pioneering many Global Islamic Banking and Finance initiatives Robust regulatory framework Malaysia has a comprehensive regulatory and supervisory framework that caters to the unique characteristics of Islamic finance. Stronger standards have been set for corporate governance, transparency, disclosure, accountability, market discipline, risk management and customer protection. Shariah Framework Operate in an environment that offers conducive and effective legal and Shariah framework. The Islamic Banking Act 1983 and Takaful Act 1984 were enacted to govern the conduct of Islamic banking institutions and takaful operators respectively. Liberal Foreign Exchange Regime Resources This includes the establishment of the: Institute of Islamic Banking and Finance Malaysia (IBFIM) International Centre for Leadership in Finance (ICLlF) International Centre for Education in Islamic Finance (INCEIF) A wide range of tax exemptions across the Islamic finance spectrum

Corporate governance in Islamic banks The Muslim banking world faces the challenge of expanding internationally while remaining true to Islamic principles By Nasser M. Suleiman Introduction Corporate governance in banking has been analysed almost exclusively in the context of conventional banking markets. For example, there has recently been some discussion of the role 'market discipline' exerted by bank shareholders and depositors in constraining the risk taking behaviour of bank management. At the same time, there is growing interest in, and analysis of, banks as stockholders in companies themselves playing a central role in corporate governance, especially in Germany and other countries with universal banking structures of the traditional type. By contrast, little is written on governance structures in Islamic banking, despite the rapid growth of Islamic banks since the mid 1970s and their increasing presence on world financial markets. There are now over 180 financial institutions world-wide which adhere to Islamic banking and financing principles. These banks operate in 45 countries encompassing most of the Muslim world, along with Europe, North America and various offshore locations. Islamic financing increasingly is a market segment of interest of Western banks, and the latest addition to the list of Islamic banks in October 1996 in the Citi Islamic Investment Bank, Bahrain a wholly owned subsidiary of Citicorp. Islamic banking represents a radical departure from conventional banking, and from the viewpoint of corporate governance, it embodies a number of interesting features since equity participation, risk and profit-and-loss sharing arrangements from the basis of Islamic financing. Because of the bank on interest (riba), an Islamic bank cannot charge any fixed return in advance, but rather participates in the yield resulting from the use of funds. The depositors also share in the profits according to predetermined ratio, and are rewarded with profit returns for assuming risk. Unlike a conventional bank which is basically a borrower and lender of funds, an Islamic bank is essentially a partner with its depositors, on the one side, and also a partner with entrepreneurs, on the other side, when employing depositors' funds in productive direct investment. These financial arrangements imply quite different stockholder relationships, and by corollary governance structures, from the conventional model since depositors have a direct financial stake in the bank's investment and equity participations. In addition, the Islamic bank is subject to an additional layer of governance since the suitability of its investment and financing must be in strict conformity with Islamic law and the expectations of the Muslim community. For this purpose, Islamic banks employ an individual sharia Advisor and/or Board. My examination of corporate governance in Islamic banking begins with the comparing governance structures in the Islamic bank and will continues with the principles of Islamic banking. This study compares the Islamic banking, financial model and its implications for governance structures. The study intends to give a small picture on the principles of Islamic banking. The Islamic bank Governance structures are quite different from these under Islamic banking because the institution must obey a different set of rules - those of the Holy Qur'an - and meet the expectations of Muslim community by providing Islamically-acceptable financing modes. These profit-and-loss sharing methods, in turn, imply different relationships than under interest-based borrowing and lending. Figure 1 sets out the key stockholders in an Islamic bank. There are two major difference from the conventional framework. First, and foremost, an Islamic organisation must serve God. It must develop a distinctive corporate culture, the main purpose of which is to create a collective morality and spirituality which, when combined with the production of goods and services, sustains the growth and advancement of the Islamic way of life. To quote janachi (1995): 'Islamic banks have a major responsibility to shoulder ....all the staff of such banks and customers dealing with them must be reformed Islamically and act within the framework of an Islamic formula, so that any person approaching an Islamic bank should be given the impression that he is entering a sacred place to perform a religious ritual, that is the use and employment of capital for what is acceptable and satisfactory to God.' (p.42). There are equivalent obligations upon employees: 'The staff in an Islamic bank should, throughout their lives, be conducting in the Islamic way, whether at work or at leisure.' (p.28). Further, obligations also extend to the Islamic community: 'Muslims who truly believe in their religion have a duty to prove, through their efforts in backing and supporting Islamic banks and financial institutions, that the Islamic economic system is an integral part of Islam and is indeed for all times ... through making legitimate and Halal profits.' (p.29). Second, interest-free banking is based on the Islamic legal concepts of shirkah (partnership) and mudaraba (profit-sharing). An Islamic bank is conceived as financial intermediary mobilising savings from the public on a mudaraba basis and advancing capital to entrepreneurs on the same basis. A two-tiered profit-and-loss sharing arrangement operates under the following rules: The bank receives funds from the public on the basis of unrestricted mudaraba. There are no restrictions imposed on the bank concerning the kind of activity, duration, and location of the enterprise, but the funds cannot be applied to activities which are forbidden by Islam The bank has the right to aggregate and pool the profit from different investments, and share the net profit (after deducting administrative costs, capital depreciation and Islamic tax) with depositors according to a specified formula. In the event of losses, the depositors lose a proportional share or the entire amount of their funds. The return to the financier has to be strictly maintained as a share of profits. The bank applies the restricted from of mudaraba when funds are provided to entrepreneurs. The bank has the right to determine the kind of activities, the duration, and location of the projects and monitor the investments. However, these restrictions may not be formulated in a way which harms the performance of the entrepreneur, and the bank cannot interfere with the management of the investment. Loan covenants and other such constraints usual in conventional commercial bank lending are allowed. The bank cannot require any guarantee such as security and collateral from the entrepreneur in order to insure its capital against the possibility of an eventual loss. The liability of the financier is limited to the capital provided. On the other hand, the liability of the entrepreneur is also restricted, but in this case solely to labour and effort employed. Nevertheless, if negligence or mismanagement can be proven, the entrepreneur may be liable for the financial loss and be obliged to remunerate financier accordingly. The entrepreneur shares the profit with bank according to previously agreed division. Until the investment yields a profit, the bank is able to pay a salary to the entrepreneur based on the ruling market salary. Many of the same restrictions apply to musharaka financing, except that in this instance the losses are borne proportionately to the capital amounts contributed. Thus under these two Islamic modes of financing, the project is managed by the client and not by the bank, even though the bank shares the risk. Certain major decisions such as changes in the existing lines of business and the disposition of profits may be subject to the bank's consent. The bank, as a partner, has the right to full access to the books and records, and can exercise monitoring and follow-up supervision. Nevertheless, the directors and management of the company retain independence in conducing the affairs of the company. These conditions give the finance many of the characteristics of non-voting equity capital. From the viewpoint of the entrepreneur, there are no fixed annual payments needed to service the debt as under interest financing, while the financing does not increase the firm's risk in the way that other borrowings do through increased leverage. Conversely, from the bank's viewpoint, the returns come from profits - much like dividends - and the bank cannot take action to foreclose on the debt should profits no eventuate. Governance structures These structures are depicted in Figure 2 which sketches the conceptual framework of corporate governance for Islamic bank. Central to such a framework is the Sharia Supervisory Board (SSB) and the internal controls which support it. The SSB is vital for two reasons. First, those who deal with an Islamic bank require assurance that it is transacting with Islamic law. Should the SSB report that the management of the bank has violated the sharia, it would quickly lose the confidence of the majority of its investors and clients. Second, some Islamic scholars argue that strict adherence to Islamic religious principles will act as a counter to the incentive problems outlined above. The argument is that the Islamic moral code will prevent Muslims from behaving in ways which are ethically unsound, so minimising the transaction costs arising from incentive issues. In effect, Islamic religious ideology acts as its own incentive mechanism to reduce the inefficiency that arises from asymmetric information and moral hazard. Such matters are obviously basic to the successful operation of Islamic modes of finance, and they are assessed in the next section when I examine Principles of Islamic Banking. Principles of Islamic Banking An Islamic bank is based on the Islamic faith and must stay within the limits of Islamic Law or the sharia in all of its actions and deeds. The original meaning of the Arabic word sharia was 'the way to the source of life' and it is now used to refer to legal system in keeping with the code of behaviour called for by the Holly Qur'an (Koran). Four rules govern investment behaviour: the absence of interest-based (riba) transactions; the avoidance of economic activities involving speculation (ghirar); the introduction of an Islamic tax, zakat; the discouragement of the production of goods and services which contradict the value pattern of Islamic (haram) In the following part I explain these four elements give Islamic banking its distinctive religious identity. Riba Perhaps the most far reaching of these is the prohibition of interest (riba). The payment of riba and the taking as occurs in a conventional banking system is explicitly prohibited by the Holy Qur'an, and thus investors must be compensated by other means. Technically, riba refers to the addition in the amount of the principal of a loan according to the time for which it is loaned and the amount of the loan. While earlier there was a debate as to whether riba relates to interest or usury, there now appears to be consensus of opinion among Islamic scholars that the term extends to all forms of interest. In banning riba, Islamic seeks to establish a society based upon fairness and justice (Qur'an 2.239). A loan provides the lender with a fixed return irrespective of the outcome of the borrower's venture. It is much fairer to have a sharing of the profits and losses. Fairness in this context has two dimensions: the supplier of capital possesses a right to reward, but this reward should be commensurate with the risk and effort involved and thus be governed by the return on the individual project for which funds are supplied. Hence, what is forbidden in Islamic is a predetermined return. The sharing of profit is legitimate and that practice has provided the foundation for Islamic banking. Ghirar Another feature condemned by Islamic is economic transactions involving elements of speculation, ghirar. Buying goods or shares at low and selling them for higher price in the future is considered to be illicit. Similarly an immediate sale in order to a void a loss in the future is condemned. The reason is that speculators generate their private gains at the expense of society at large. Zakat A mechanism for the redistribution of income and wealth is inherent is Islam, so that every Muslim is guaranteed a fair standard of living, nisab. An Islamic tax, Zakat (a term derived from the Arabic zaka, meaning "pure") is the most important instrument for the redistribution of wealth. This tax is a compulsory levy, one of the five basic tenets of Islam and the generally accepted amount of the zakat is one fortieth (2.5 per cent) of Muslim's annual income in cash or kind from all forms of assessed wealth exceeding nisab. Every Islamic bank has to establish a zakat fund for collecting the tax and distributing it exclusively to the poor directly or through other religious institutions. This tax is imposed on the initial capital of the bank, on the reserves, and on the profits as described in the Handbook of Islamic Banking. Haram A strict code of 'ethical investment' operates. Hence it is forbidden for Islamic banks to finance activities or items forbidden in Islam, haram, such as trade of alcoholic beverage and pork meat. Furthermore, as the fulfilment or materials needs assures a religious freedom for Muslims, Islamic banks are required to give priority to the production of essential goods which satisfy the needs of the majority of the Muslim community, while the production and marketing of luxury activities, israf wa traf is considered as unacceptable from a religious viewpoint. In order to ensure that the practices and activities of Islamic banks do not contradict the Islamic ethical standards, Islamic banks are expected to establish a Sharia Supervisory Board, consisting of Muslim jurisprudence, who act as advisers to the banks. Profit-sharing agreements Although the restriction against the use of interest might seem to be a binding constraint upon expansion, Islamic banks and financial institutions have in fact grown rapidly. Table 1 sets out the number of banks, paid up capital, total deposits and total assets of these Islamic banks, classified by region. It shows that the total assets of these reporting banks amounted to US $155 billion in 1994, with employment in excess of 220,000 (data supplied by the International Association of Islamic Banks). If the paying and receiving of interest is prohibited, how do Islamic banks operater It is necessary to distinguish between the expressions 'rate of interest' and 'rate of return'. Whereas Islam clearly forbids the former, it not only permits, but rather encourages, trade. In the interest-free system sought by adherents to Muslim principles, people are able to earn a return on their money only by subjecting themselves to the risk involved in profit sharing. As the use of interest rates in financial transactions is prevented, Islamic banks are expected to undertake operations only on the basis of Profit and Loss Sharing (PLS) arrangements or other acceptable modes of financing. Mudaraba and musharaka are the two profit-sharing arrangements preferred under Islamic law. Mudaraba A mudaraba can be defined as contract between at least two parties whereby one party, the financier (sahib al-mal), entrusts funds to another party, the entrepreneur (mudarib), to undertake an activity or venture. This type of contract is in contrast with musharaka. In arrangements based on musharaks there is also profit-sharing, but all parties have the right to participate in managerial decisions. In mudaraba, the financier is not allowed a role in management of the enterprise. Consequently, mudaraba represents a PLS contract where the return to lenders is a specified share in the profit/loss outcome of the project in which they have a stake, but no voice. In interest lending, the loan is not contingent on the profit or loss outcome, and is usually secured, so that the debtor has to repay the borrowed capital plus the fixed interest amount regardless of the resulting yield of the capital. Under mudaraba, the yield is not guaranteed in profit-sharing and financial losses are borne completely by the lender. The entrepreneur as such losses only the time and effort invested in the enterprise. This distribution effectively treats human capital with equally financial capital. Musharaka Under musharaka, the entrepreneur adds some of his own to that supplied by the investors, so exposing himself to the risk of capital loss. Profits and losses are shared according to pre-fixed proportions, but these proportions need not coincide with the ratio of financing input. The bank sometimes participates in the execution of the projects in which it has subscribed, perhaps by providing managerial expertise. Figure 3 illustrates the elements. Mudaraba and musharaka constitute, at least in principle if not always in practice, the twin pillars of Islamic banking. The two methods conform fully with Islamic principles, in that under both arrangements lenders share in the profits and losses of the enterprises for which funds are provided and shirkah (partnership) is involved. The musharaka principle in invoked in the equity structure of Islamic banks and is similar to the modern concepts of partnership and joint stock ownership. Two-tiered mudabara For banking operations, the mudaraba concept has been extended to include three parties: the depositors as financiers, the bank as an intermediary, and the entrepreneur who requires funds. The bank acts as an entrepreneur when it receives funds from depositors, and as financier when it provides the funds to entrepreneurs. In other words, the bank operates a two-tier mudaraba system in which it acts both as the mudarib on the saving side of the equation and as the rubbul-mal (owner of capital) on the investment portfolio side. Insofar as the depositors are concerned, an Islamic bank acts as a mudarib which manages the funds of the depositors to generate profits subject to the rules of mudaraba. The bank may in turn use the depositors' funds on a mudaraba basis in addition to other lawful (but less preferable) modes of financing, including mark up or deferred sales, lease purchase and beneficence loans. The funding and investment avenues are now listed. Sources of funds Besides their own capital and equity, Islamic banks rely on two main sources of funds, a) transaction deposits, which are risk free but yield no return and, b) investment deposits, which carry the risks of capital loss for the promise of variable. In all, there are four main types of accounts: Current accounts Current accounts are based on the principle of al-wadiah, whereby the depositors are guaranteed repayment of their funds. At the same time, the depositor does not receive remuneration for depositing funds in a current account, because the guaranteed funds will not be used for PLS ventures. Rather, the funds accumulating in these accounts can only be used to balance the liquidity needs of the bank and for short-term transactions on the bank's responsibility. Savings accounts Savings accounts also operate under the al-wadiah principle. Savings accounts differ from current deposits in that they earn the depositors income: depending upon financial results, the Islamic bank may decide to pay a premium, hiba, at its discretion, to the holders of savings accounts. Investment accounts An investment account operates under the mudaraba al-mutlaqa principle, in which the mudarib (active partner) must have absolute freedom in the management of the investment of the subscribed capital. The conditions of this account differ from those of the savings accounts by virtue of: a) a higher fixed minimum amount, b) a longer duration of deposits, and c) most importantly, the depositor may lose some of or all his funds in the event of the bank making losses. Special investment accounts Special investment accounts also operate under the mudaraba principle, and usually are directed towards larger investors and institutions. The difference between these accounts and the investment account is that the special investment account is related to a specified project, and the investor has the choice to invest directly in a preferred project carried out by the bank. Uses of funds The mudaraba and musharaka modes, referred to earlier, are supposedly the main conduits for the outflow of funds from banks. In practice, however, other important methods applied by Islamic banks include: Murabaha (mark up). The most commonly used mode of financing seems to be the 'mark-up' device. in a murabaha transactions, the bank finances the purchase of a good or assets by buying it on behalf of its client and adding a mark-up before reselling it to the client on a 'cost-plus' basis profit contract. Figure 4 illustrates the sequence. Bai' muajjal (deferred payment). Islamic banks have also been resorting to purchase and resale of properties on a deferred payment basis. It is considered lawful in fiqh (jurisprudence) to charge a higher price for a good if payments are to be made at a later date. According to fiqh this does not amount to charging interest, since it is not a lending transaction but a trading one. Bai'salam ( prepaid purchase). This method is really the opposite of the murabaha. There the bank gives the commodity first, and receives the money later. Here the bank pays the money first and receives the commodity later, and is normally used to finance agricultural products. Istissanaa (manufacturing). This is a contract to acquire goods on behalf of a third party where the price is paid to the manufacturer in advance and the goods produced and delivered at a later date. Ijara and ijara wa iqtina (leasing). Under this mode, the banks buy the equipment or machinery and lease it out to their clients who may opt to buy the items eventually, in which case the monthly payments will consist of two components, i.e. rental for the use of the equipment and instalment towards the purchases price. Qard hasan (beneficence loans). This is the zero return type of loan that the Holly Qura'n urges Muslims to make available to those who need them. The borrower is obliged to repay only the principal amount of the loan, but is permitted to add a margin at his own discretion. Islamic securities. Islamic financial institutions often maintain an international Islamic equity portfolio where the underlying assets comprise ordinary shares in well run businesses, the productive activities of which exclude those on the prohibited list (alcohol, pork, armaments) and financial service based on interest income.