Marketing Islamic Finance Products in Pakistan: Trends and Analysis

by Salman Ahmed Shaikh

There are 5 fully-fledged Islamic banks operating in Pakistan and 15 conventional banks with Islamic banking branches. The share of the industry in the banking system has risen to over 7 percent from just 0.5 percent in 2002, according to Reuters.

Citing the challenges for the industry, people usually opine that the industry needs to create awareness about itself, its products and the concepts underpinning their development.

One listed Islamic bank in Pakistan showed Rs 47 million on the expenditures side in 2010 which was more than the Rs 41 million in profits it reported for the same year. Of note is that it is the first time the bank had reported profits and, as odd as this ratio might appear, it nevertheless tells us that a good sum of money was spent on advertising. Another listed Pakistani Islamic bank had also spent Rs 43 million on publicity in 2010.

Creative advertising is also finding its way into these marketing campaigns as evidenced by the few examples of original marketing slogans used by some Islamic banks, which names will not be revealed.

Sample slogans

"Finally, a car that lets you fly. Finance your dream car."

"Live in your dream home."

"Drive your dream car."

"Shariat Mein Barkat. (It means blessing is only in Islamic law)"

Sadly, though these slogans have contributed their share in promoting consumerism in Pakistani society they failed to hail Islamic virtues of Shukr (thankfulness), Sabr (patience), Tawakkul (steadfastness), Infaaq (payment to charity), refraining from Israaf (extravagance), hubb-e-maal (love of wealth) and hubb-e-dunya (love of materialism).

The prevalent practice of marketing efforts includes billboard advertising, TV commercials, print media and additionally running paid content in the form of discussion programs on TV. But, in the name of creating awareness, serious discussions and arguments usually lie missing in the paid discussion programs run on TV.

The proponents of Islamic banking repeatedly try to give some logical answers to support the case of Islamic banking and argue that the end result of many activities could be similar, but their interpretation for Halal and Haram could still be different. These logical arguments are analyzed briefly.

A McDonalds burger in the West may taste the same as in the East, but one may be permissible i.e. Halal and one may be prohibited i.e. Haram if the animal from which the meat was prepared was not slaughtered in the prescribed Shari'ah manner. The forbidden burger is not prohibited on the basis of taste, but rather due to the manner of slaughtering. But regardless of the argument, the way the burger is advertised fails to remind the consumer of the fact that it is God Almighty who has given man permission to take the life of an animal for food consumption.

Similarly, pre-marital and post-marital sex may prompt similar physical and emotional responses, but in Islam, the former is prohibited while the latter is permissible. Here again, the reason for prohibiting pre-marital sex is not biological or utility related, but rather social i.e. Islam treasures the family system and wants to protect its sanctity at all cost, else, from a social point of view, humans would be no different than animals.

If one does not wish to invest money for profit purposes, but has some surplus funds, Islam has encouraged spending on charity over lending for interest and it is supported through many verses. "They ask thee how much they are to spend; Say: "What is beyond your needs." Thus doth Allah make clear to you His Signs: In order that ye may consider." (Al-Baqarah: 219).

"In their wealth, there is a known right for those who ask for it and those who have need for it." (Al-Muarij: 24-25).

Instead of those Islamic institutions who are working in conformity with Islamic rules and principles trying to create awareness about these virtues, emphasis has been on creating wealth. By not using the Islamic virtues mentioned above, Islamic banks have essentially failed to create brand affinity among the masses on the basis of what Islam promulgates as core to its followers beliefs. This is not to deny the efforts and achievements of Islamic banks, but rather meant to point out the shortcomings which need to be looked at and addressed right away.

BOX: Islamic Credit Cards: A Necessity or Luxury By Salman Ahmed Shaikh Islam never encourages one to become indebted unless it is absolutely necessary. Many a -hadith show the viewpoint of Islam on debt creation, especially when it is beyond ones capacity to repay, and points to what extent it should be avoided and used to meet ones necessary requirements. Prophet Muhammad (pbuh) said: -O Allah! I seek refuge with Thee from sin and debt. [Sahih Muslim] The Prophet Muhammad (pbuh) said: -After the grave sins which Allah has prohibited, the greatest sin is that a man dies while he has debt due from him and does not leave anything to pay it off, and meets Him with it. The following supplication is related to the Prophet Muhammad (pbuh) for salvage from debt: -O Allah! I seek refuge in You from all worry and grief. I seek refuge in You from incapacity and slackness. I seek refuge in You from cowardice and niggardliness, and I seek refuge in You from being overcome by debt and being subjected to men. But, the currently practiced and widely used Islamic finance contracts are more based on debt financing than equity financing. Some financial institutions in Islamic countries have developed Islamic Credit Cards for consumer financing. Problems arise due to the fact that credit cards could be used for impulsive buying or even the fulfillment of ones needs while not involving a tangible asset. Even when a transaction may involve a tangible asset, it is hard to fulfill all the necessary requirements of Murabaha in quick time. One way to deal with this is to use the credit card not as a mode of financing but simply offer it as a convenience product that carries a transaction fee. But, charges must be realistic, i.e not excessive. It must also be noted that a credit card might still be provided to the customer (else it will be same as a debit card), but no additional amount is to be charged over the credit amount. The charges so taken from the customer must be transaction-based and not time specific. In the current practice, they are time specific. Monthly charges have to be paid irrespective of whether one uses the card or not. This is not recommendable. As a matter of fact, banks aim at making a profit out of the business of providing finance, even for consumption purposes. This is not recommendable looking at the various principles and philosophy of Islamic faith. Islamic Economics and its basis, principles and objectives will be increasingly compromised if such products are launched.

About the Author

Salman Ahmed Shaikh is a researcher in Islamic Economics. He is author of "Proposal for a New Economic Framework Based on Islamic Principles". He has also written 20 papers and more than four dozen articles on Islamic Economics. He can be contacted at salmanahmed_hyd@hotmail.com. Courtesy provided by Halal Tamweel.

Brand Loyalty and Relationship Marketing in Islamic Banking System

By. MWO Maznah Wan Omar

Abstract

Islamic banks' ability to withstand the global downturn has fuelled an expansion of Islamic finance around the world. Islamic banks have learned that customer loyalty and brand loyalty must be earned. Brand loyalty and relationship marketing among banking consumers particularly in the islamic banking system in Malaysia has captured great interest among the Malaysian public as a whole (i.e. relationship between employees and customers). Relationship marketing is not more than just getting the customers but it is also how to maintain the existing customers as much as possible. There are important dimensions that supported the strength of relationship marketing that can lead to brand loyalty. In relation, brand loyalty refers to the favorable attitude towards a brand in addition to purchasing it repeatedly by the customer. The customer tends to be loyal since there is relationship marketing between them and the organization. This study will show the influence of relationship marketing through Bank Islam employees in Malaysia on Brand Loyalty. The data for this study will be acquired from 3 Bank Islam business premises in Pulau Pinang, Kedah, and Perlis which represent the northern states of Peninsular Malaysia. Various data-analytic tools will be used to analyze the data such as test of differences, reliability analysis, factor analysis, and multiple regression analysis. The study tries to determine how relationship marketing which is measured through three dimensions, that is Customer trust on Bank Islam staff, Bank Islam Staff commitment during the service delivery, and the communication skills among Bank Islam Staff can have an influence on Brand Loyalty among Bank Islam customers.

1. INTRODUCTION

In recent years there has been growing interest in relationship marketing (i.e. relationship between employees and customers) since there has been a change in terms of marketing philosophy which is marketing orientation. One of the most important areas in marketing orientation includes relationship marketing. Relationship marketing is not more than just getting the customers but it is also how to maintain the existing customers as much as possible.

There are important dimensions that supported the strength of relationship marketing that can lead to brand loyalty. In relation, Brand loyalty refers to the favorable attitude towards a brand in addition to purchasing it repeatedly by the customer. The customer tends to be loyal since there is relationship marketing between them and the organization. This study will show the influence of relationship marketing through Bank Islam employees in Malaysia on Brand Loyalty. The data for this study will be acquired from 3 Bank Islam business premises in Pulau Pinang, Kedah, and Perlis which represent the northern states of Peninsula Malaysia.

Various data-analytic tools will be used to analyze the data such as test of differences, reliability analysis, factor analysis, and multiple regression analysis. The study try to determine whether relationship marketing which is measured through three dimensions, that is Customer trust on Bank

Islam staffs, Bank Islam Staff commitment during the service delivery, and the communication skills among Bank Islam Staff do have an influence on Brand Loyalty among Bank Islam customers. Finally the study also attempts to determine if Customer Overall satisfaction would have a mediating effect on the relationship between relationship marketing and Brand Loyalty in the case of Bank Islam.

2. LITERATURE REVIEW

Brand management is an area of increasing importance to marketers today, particularly as organizations attempts to communicate the ever complex and intangible messages as part of brand management strategies (Davis, 2000; Goodchild & Callow, 2001). One of the many interesting questions facing today's brand managers concerns how to develop a better understanding of the appropriate relationship between constructs such as relationship marketing and brand loyalty, particularly in relation to the myriad of known antecedents to brand loyalty in the marketing literature (Taylor et al., 2004). In this study we assess the relative importance of many of the known antecedents to brand loyalty, including overall customer satisfaction.

By having a strong brand, companies not only could facilitate the differentiation of their offer from the competitors. With branding, financial companies are able to create customer confidence and loyalty in their performance, exert greater control over promotion and distribution of the brand, as well as commanding a premium price over the competitors; all while impacting the valuation of the business (Holverson & Revaz, 2006; Pass et al., 1995).

The added value that a brand name gives to a product is now commonly referred to as "brand equity"

(Aaker, 1991). Brand name adds value to each of these interested parties which include the investors, manufacturers, and the retailers. Brand equity and brand loyalty provides a strong platform for introducing new products and insulates the brand against competitive attacks. From the perspective of the trade, brand loyalty contributes to the overall image of the retail outlet. It builds store traffic, ensures consistent volume, and reduces risk in allocating shelf space (Cobb-Walgren et al., 1995). However, if the brand has no meaning to the consumer, automatically there wouldn't be of any value to the investors, the manufacturer, and the retailer unless there is value to consumer (Farquhar, 1989; Crimmins, 1992).

Over the past 15 years, a major shift has occurred in the ways that industrial companies deal with their customers and suppliers (Christopher et al., 1991; Ellram, 1995). This change has come about as companies have recognized that sustainable competitive advantage in the global economy increasingly requires companies to become trusted participants in various networks or sets of strategic alliances (Morgan & Hunt, 1994). Relationship marketing which is powered by the employees of an organization has emerged over the years as an exciting area of marketing that focuses on building long-term relationships among employees who is a proxy to their employer and customers that frequent to their business premises. As Gronroos (1993) observed: establishing a relationship, for example between an employee and a customer, can be divided into two parts: to attract the customer and to build the relationship with that customer so that the economic goals of the organization are achieved through that relationship.

THE RESEARCH MODEL

3.1 The Objectives of This Study

a. To determine whether Relationship marketing between Bank Islam staff and their customers will have any influence on Brand loyalty.
b. To determine whether Relationship marketing within Bank Islam will have any influence on customer's overall satisfaction.

c. To determine whether customer Overall satisfaction with Bank Islam employee will have any influence on Brand loyalty.

d. To determine whether customer Overall satisfaction on Bank Islam employee mediates the relationship between Relationship marketing and Brand loyalty.

3.2 Hypotheses

Hypothesis 1: There is positive relationship between relationship marketing and brand loyalty.

1a: There is positive relationship between trust and brand loyalty.
1b: There is positive relationship between commitment and brand loyalty.

1c: There is positive relationship between communication and brand loyalty.

Hypothesis 2: There is a positive relationship between relationship marketing and overall satisfaction.

H2a: There is a positive relationship between trust and overall satisfaction.
H2b: There is a positive relationship between commitment and overall satisfaction.
H2c: There is a positive relationship between communication and overall satisfaction.

Hypothesis 3: there is a positive relationship between overall satisfaction appeal and brand loyalty.

Hypothesis 4: Overall satisfaction mediates the relationship between relationship marketing and brand loyalty.

3.3 Research Questions

From the previous discussion, we infer specific research questions for this study, they are:

Does customers trust towards the Bank Islam employee during their interaction influences Bank Islam Brand Loyalty?

b) Does Bank Islam employee's commitment towards their customers during employee/customers interaction influence Bank Islam Brand Loyalty?

c) Does Bank Islam employee's communications skills delivered during employee/customers interaction influences Bank Islam Brand Loyalty?

d) Does customer's overall satisfaction towards Bank Islam employee influences Bank Islam Brand loyalty?

e) Does customer's overall satisfaction mediates the relationship between Bank Islam relationship marketing and Bank Islam Brand loyalty?

4. METHODOLOGY

The area of study for this research is limited to three Bank Islam business premises located in Pulau Pinang, Kedah, and Perlis. All the three states are located in the Northern States of Peninsular Malaysia.

A structured questionnaire will be distributed by four research assistance at the entrance/exit of the Bank Islam business premises that was selected for this study. Questionnaire will be collected right after respondents completed the survey. Thus a non-response as well as early and late response analysis is not required for this study. The unit of analysis for this study is individual customers who patronize the Bank Islam business premises.

4.1 Description of Methodology

To have a representative finding, the sampling technique used must be objective. This is an important effort adopted by most researchers in order to furnish a finding pertinent to the general. To choose the sample for this study, probability random sampling was used. A probability sample is necessary if the sample is to be representative of the population (Reeves, 1992). Therefore, a two-stage sampling technique is employed in this study.

The unit of analysis for this study is individual customers who patronize the Bank Islam business premises. Studying primary consumer groups permits a more valid and reliable clarification to the model research in this study. A total number of 500 samples will be collected from 3 different locations (Bank Islam business premises) in the state of Pulau Pinang, Kedah, and Perlis. In determining the sample size for this study, sample size selected was based on 3 considerations. One of the considerations is the criteria set according to Roscoe's rule of thumb (Sekaran, 2003) i.e. a sample that is larger than 30 and less than 500 are appropriate for most research, and the size must be several times larger (10 times or more) for multiple regression analysis to be conducted.

For this study, a survey method is employed. Surveys are a better source of primary data collection in marketing and social sciences in contrast to observation and experiments (Baker, 2001). According to Robson (2002), surveys are use in accord with a cross-sectional design, that is, the collection of information from any given sample of the population only once. The data are collected using a set of questionnaires or structured interviews with the objective of generalizing from a sample to a population to determine attitudes and opinions and to help understand and predict behavior (Baker, 2001; Mokhlis, 2006). Questionnaires will be distributed personally to customers who exit Bank Islam business premises and have had an interaction with any Bank Islam employees.

4.2 Population and Sample Size

Since the mailing list of Bank Islam customers/clients is not made available, a 2-stage systematic sampling technique will be employed.

4.3 Sampling Design

A two-stage sampling technique is employed in this study. During the 1^st stage = A random sampling technique is used to select the Bank Islam business premises. List of Bank Islam business premises will be retrieved from Bank Islam listing. 2^nd stage = systematic sampling. A skip interval of 2 will be utilized in the selection of Bank Islam clients as our respondent (Arithmetic progression will be utilized).

4.4 Sample

A sample of 480 will be collected (16 items (independent variable) X 10 = 160 samples X 3 locations = 480 samples). To accommodate for non-responses, an additional of 20 samples will be collected. Therefore a total of 500 samples will be collected altogether for this study. Sample selected was based on 3 considerations:-

a) The first consideration, Sample size selected was based on the criteria set according to Roscoe's Rule of Thumb (cited in Sekaran, 2003).

30< sample < 500. The size must be several times larger (10 times or more) for multiple regression analysis to be conducted.

Therefore, 16 items (questionnaire) X 10 = 160 samples x 3 independent hoteliers – 480 samples.

b) Second considerations, Cohen & Cohen (1977); Sawyer & Ball (1981), believes that very large sample sizes usually allow even small effects to be statistically significant. It is especially important with highly powered research designs to measure and report effect sizes in addition to statistical significance.

Sawyer and Ball (1981) estimated that a proportion of 13% of the explained variance to effect size values, as a medium effect size for regression analysis. According to Sawyer and Ball (1981), the medium effect of 13% is sufficient for testing an existing model.

f² = R² = 0.13 = 0.1494

1- R² 1 – 0.13

ŋ* = L+K+1

f²

= 13.62 + 3 + 1

0.1494

= 117 samples.

Therefore, 117 samples x 3 locations = 351 samples (to be collected)

Thus, 500 samples will be collected to accommodate for non-responses.

c) The third considerations, Issue's on response rate were covered. Response rate in Malaysia is between 15% - 30% base on the previous research/study/theses.

Therefore, the samples that will be collected are 500 samples, (The sample size was increased to 23%, to accommodate the non-response rate).

4.5 Questionnaire Design

Questionnaire consists of 3 Sections. Section A =Relationship marketing (Caceres & Paparoidamis, 2007). Section B = Overall customer satisfaction ( Bloemer & Ruyter, 1998). Section C = Brand loyalty (Aaker, 1996). An interval scale data (use for independent variable, mediating variable, and dependent variable) and a nominal scale data (demographic data) will be collected from the questionnaire distributed to the hotel guest. A Likert Scale of 1 to 5 will be used to frame answers in the questionnaire.

4.6 Translation Procedure

A back-to-back translation procedure will be utilized. The original instrument in English was literally translated into Bahasa Malaysia and back to English by a bi-lingual lecturer from Universiti Teknologi MARA Kampus Kedah. The instrument will be pre-tested for reliability and language accuracy.

5. CONCLUSION

To ensure success, it is recommended that Bank Islam follows the suggested model above to ensure that they significantly improved their overall brand management particularly building up Brand loyalty among their customers, without losing a large part of their uniqueness, independence and management control. The essence of Bank Islam management is to be able to relate relationship marketing through their employee, customer overall satisfaction, and Brand loyalty as part of their property management. To do so it requires the management of Bank Islam to spend time, effort and commitment, as well as to put in some financial resources, blended with management experience and knowledge of market plus courage to take risks. This venture is achievable and can be used as a strategy to speed up corporate growth and success of Bank Islam. The value of this study lies in the fact that it places the role of brand management firmly in Bank Islam. The employees of Bank Islam play a key role in enhancing good relationship with Bank Islam customers and exert considerable influence on the structure and culture of a company.

DERIVATIVES AND ISLAMIC FINANCE

Muhammad Ayub
(The writer is Senior Joint Director, Islamic Banking Department, State Bank of Pakistan Karachi.)

The conventional options, swaps and futures stem from debts and involve sale and purchase of debts/liabilities. As a group, products such as interest-rate swaps, stock options and futures, currency futures etc are called derivatives i.e. instruments derived from the expected future performance of the respective underlying assets. These are very complex and risky contracts having present market value of trillions of dollars over the world. According to an article published in the Economist, some $ 128 trillion of over the counter derivatives were outstanding in June 2002, a 28% increase over a year earlier. It has been observed, however, that global financial market is becoming increasingly fragile as more and more derivatives and ‘hedging’ instruments emerge.

Just to introduce the terms to common readers, an option to buy a commodity is known as ‘call option’ while the option to sell a commodity is known as a ‘put option’. An option has a nominal size, this being the amount of underlying asset that the option holder may buy or sell at the strike price, the price at which the holder may buy or sell the underlying asset upon exercise of the option. If the price moves favorably, the option is exercised and the commodity is bought/sold at the agreed price. If the price moves unfavorably, the buyer of the option simply abandons it. Thus an option contract confers the right but not the obligation to enter into an underlying contract of exchange at or before a specified future date (the expiry date). The buyer of that option pays a price (the premium) to the seller (the writer) of the option.

We can explain the options trading with help of an example. A call option purchase at a price of say Rs 5 on bond or stock ‘A’ provides a right to Mr. M to purchase the stock at price of Rs 50 three months from now. If as per his expectations the price of ‘A’ increases to Rs 60 on the maturity date, then the buyer of the call has a net gain of Rs 5 (on an investment of Rs 5). This is what the seller or the writer of the call would lose. But if the price of the stock falls below Rs 50 on the maturity date, say to Rs 40, the buyer would allow the option to expire without exercising it since he can buy from the market at a lower price. His loss would amount to Rs 5 or hundred percent with the call. This Rs 5 would be what the seller of the call would gain on zero investment. In the game, the buyer and seller have diametrically opposite expectations. The possibility of risk and returns are magnified, the gains of the buyer being equal to the losses of the seller and vice versa.

The institutions dealing in derivates and hedge funds claim that diversity of hedging products protect their clients against market volatility and provide a larger spectrum of risk management to the benefit of the society. But, actually volatility is caused by their activities when they trade in derivatives as a part of rip-off factor and the clients are sold nothing for something – protection against a danger that never needed to exist in the first place. They may produce huge profits for financial institutions at the cost of others. But these profits are not necessarily indicative of productive efforts. Mr. Warren Buffet, Chairman Berkshire Hathaway says: Derivatives are financial weapons of mass destruction mainly due to opaque pricing and accounting policies in swaps, options and other complex products whose prices are not listed on exchanges; Credit derivatives and total return swaps that are agreements to guarantee counterparty against default or bankruptcy merit special concern.”

The macro-economic arguments for their existence are also not convincing – they are for minimizing risks which do not need to exist as described earlier. The global foreign exchange market as at present is more or less an unproductive pursuit in that it exists because of an unnecessary monetary expansion. It would be better to structure the financial system such that it does not suffer from continuing volatility. What we are seeing in the Western world is the emergence of financial products that are a symptom of a system that has gone wrong. For a more efficient economy, we must promote systems in which people work in productive pursuits rather than unproductive ones. Change the system to relate it with real sector activities
and all those clever dealers who earn huge profits out of thin air could become doctors, industrialists, business people and teachers instead! As such, Islamic financiers who look at the products of this system as a paradigm seem to be at mistake.

Study of the behaviour of the Derivatives market reveals that it has the potential to cause a serious breakdown in the financial system. The degrees of leverage that are afforded by option contracts can be so high that large unpredictable market moves in underlying prices may one day lead to the insolvency of a major financial institution. Liabilities cannot be perfectly hedged even if that is the intention, and some traders deliberately do not hedge their option portfolios because such action would limit the potential for high returns. The case of Long Term Capital Management in the United States, rescued by a Federal Reserve bail out in 1998, demonstrates the degree of risk that can be incurred. The question is whether the central bank or other authorities would be able to move quickly enough, or in large enough measure, to prevent failings.

For example, Collateralized Debt Obligations (CDOs) are sophisticated type of derivatives and clever way of exploiting anomalies in credit ratings. A number of loans or debt securities payable by various companies are put into a pool, and new securities are issued which pay out according to the pool’s collective performance. The new securities are divided into three (or more) levels of risk. The lowest, equity tranche, takes the first loss if any companies in the pool default. If nough losses eat that up, the next, mezzanine level suffers. The most protected level, the senior tranche, should still be safe, unless the collective pool has severe losses. It takes only a couple of defaults in a pool of 100 companies to destroy the equity tranche. Downgrades of investment-grade corporate bonds in America were a record 22% in 2002, according to Moody’s and it recorded bond defaults of $ 160 billion worldwide. The equity and mezzanine tranches of many CDOs have suffered severe losses; some have been wiped out. Even senior tranches, usually rated AAA, have been downgraded because losses may yet reach them. Thus, the whole concept of CDOs as in vogue refers to absolute risk and exploitation.

According to the concept of Option (khiyar) as we find in Shariah literature, the informationally disadvantaged party at the time of entering into the contract has the option to cancel the contract within a specified period. A person has also the right to undo his purchase if the seller specifically allows as part of the terms of the sale. All such forms of option are in the nature of rights embedded in a contract. In the term khiyar as used in Fiqh books we do not see any analogy that would lead us to acceptance of the structure of modern option contracts. These are independent financial contracts traded for a price that do not have any clear-cut parallel in the classical Islamic theory of contracts. Khiyar relates to a halal contract of exchange that has already taken place, whilst a modern option relates to an exchange that is yet to take place. In the case of khiyar, the exchange of one or both counter values is effected immediately while in the case of the modern option contract, future delivery applies to both the payment and the underlying asset. In addition, uncertainty as to the materialization of the exchange exists with the modern option contract but not in khiyar. A resolution of the Islamic Fiqh Academy of the OIC asserts, “Option contracts as currently applied in the world financial markets are a new type of contracts which do not come under any of Shariah denominated contracts. Since the subject of the contract is neither a sum of money nor a utility or a financial right which may be waived, the contract is not permissible in Shariah.

Most of the derivatives incorporate gharar (absolute risk), gambling and interest and support speculative activities. Islamic legal rules, particularly the ban on Gharar and on the sale of debt for debt, do not allow transactions devoid of real/productive activities. Derivatives involving such financial contracts which themselves are prohibited in Shariah (Riba based bonds & forward foreign exchange where mutual exchange is not simultaneous, for example) are clearly un-acceptable according to the Shariah principles. In case the underlying assets are equities and commodities it would be seen whether or not Riba and Gharar are involved. Experts are of the view that even in case of acceptable forms of underlying assets, a key valuation element in arriving at the fair value of an option contract remains the rate of interest. The Black-Scholes formula proposes that since an option can be perfectly hedged through constant trading in the underlying asset, the option position should be riskless and hence earn the buyer the risk free rate of interest on the premium that was paid for it. (In reality, constant trading of the underlying asset to achieve the perfect hedge is unattainable, and so option prices behave in ways that are not entirely predicted by Black-Scholes.) For the unhedged option, the contract becomes one of pure uncertainty. Neither party knows whether the option would be exercised, as it is dependent upon the condition of the market at a future date.

According to some writers ‘Arbun'can become a basis for developing some kinds of Shariah compliant options – contract by which one party buys the right to purchase from the other party specified goods for a specified price on a certain date. ‘Arbun’ is a void contract according to a Hadith and the three schools of Islamic law. Only Hanabalah uphold ‘Arbun’ with the condition imposed by some of them that time should be stipulated for the option. The OIC Fiqh Academy has also endorsed ‘Arbun’ but only if time limit is specified. Even if ‘Arbun’ is accepted as valid transaction, most of the derivatives current in the market would still be unacceptable from Shariah angle due to involvement to Gharar and Riba. A Call Option can be considered near to Bai al Arbun in the sense that the seller does not return the premium or advance payment to the buyer in case the latter does not exercise the purchase option and the buyer loses the option premium even if the option is exercised and the contract is confirmed. In case of Bai al-Arbun, however, the option premium is adjusted in sale price when the contract is confirmed. However, this subject of derivatives needs extensive research.

Samuel L. Hayes, after detailed discussion on derivatives concludes, “There are no effective derivates of Islamic debt contracts which replicate conventional risk-hedging and leveraging contracts such as swaps, futures, and options. Similarly, in the equity security sector, there are no risk-hedging or leveraging contracts in Islamic finance truly comparable to available conventional derivatives….. With respect to commodities and other goods, the Salam contract is an imperfect Islamic substitute for a conventional forward contract. The related Istisna contract for goods being manufactured for a buyer provides another partial Islamic proxy for a forward contract. It is also possible to construct an Islamic contract which partially replicates a conventional futures contract, via back-to-back Salam contracts”.

Derivatives in Islamic Finance

During the late 1980's an opportunity came my way to become an option dealer in the London capital market. At that time I was not a practising Muslim and, given that the pay in this line of work could be enormous, I accepted without a second thought. As the years went by, it occurred to me that the size of my pay packet bore little relation to the benefit enjoyed by society as a result of my work. Others had misgivings of their own. Accountants complained of the hidden risks that banks were taking 'off balance sheet' and, from time to time, government ministers would make a scapegoat of the derivatives market when other excuses were not forthcoming. Regulators scrambled to recruit staff who could understand what the traders were doing but offerred low rates of pay and, therefore, sufferred from a persistent lack of qualified staff.

As the derivatives booty trickled down in ever greater quantities, the financial establishment began to seek a wider economic justification for the existence of this market. The business schools, progenitors of modern option valuation techniques, were only too happy to help. The increasing diversity of hedging products provided a more complete spectrum of risk management tools and was therefore of benefit to society, they told us. But we in the market saw a different story unfolding. XYZ bank would lure the poorly paid treasury manager at the Kingdom of Somewhere-Or-Other into a complex swap deal that only a PhD in Nuclear Physics could properly value. So the bank would book a multi-million dollar profit the very day the deal was closed and the Kingdom's officers would never know any better. Derivatives departments began to swarm around corporate clients like bees around a honey pot.

Of course the scam couldn't last forever. By the early 1990's, Bankers Trust traders were caught discussing the size of the "rip-off factor" on a Procter and Gamble derivatives deal. We know this because the episode was taped and made public on behalf of the company. It was one of many large derivatives losses accrued by clients that had acted on the eager encouragement of their bankers. Soon Orange County and Metallgesellschaft would fall into the same trap at a cost of hundreds of millions of dollars more.

"We can protect you against market volatility" the investment bankers tell their clients. But the market volatility is caused by the activities of those very same investment bankers, and so the clients are sold nothing for something. Protection against a danger that never needed to exist in the first place. Sadly, the world learned little from the derivatives explosion. By the time the internet boom collapsed, a new generation of clients was learning about the motivations that really drive bankers and advisors. The clients tend to be offerred the products that provide financial institutions with the highest profit margin.

What if every country had pure gold coins as its currency? Then what would be the point of the foreign exchange market? What would be the point of exchanging one ounce of American gold for one ounce of Japanese gold? Who would need currency derivatives? Who would need to pay commission on foreign currency transactions? We see very quickly where this idea leads. An end to a trillion-dollar-a-day market that produces huge profits for the financial establishment. But of course profit is not necessarily indicative of productive effort. Theft is a good example of this principle. If we want to achieve a more efficient economy, we must promote systems in which people work in productive pursuits rather than unproductive ones. The foreign exchange market is an unproductive pursuit in that it exists because of an unnecessary monetary convention. Change the convention, in other words adopt a different monetary standard, and all those clever dealers can become doctors and teachers instead!

But back to options. Modern option contracts have a variety of features in common that can be summarised as follows. An option is a right not an obligation to enter into an underlying contract of exchange at or before a specified future date (the expiry date). The buyer of that option pays a price (the premium) to the seller (the writer) of the option. The option may give its holder the right to buy a specified asset (the underlying) from the option writer, gold for example, such being a call option on gold. Or the option may give its holder the right to sell the underlying asset to the option writer. This would be a put option. Every option has a strike price, this being the price at which the holder may buy or sell the underlying upon exercise of the option. And every option has a nominal size, this being the amount of underlying that the option holder may buy or sell at the strike price. A 15 December 2001 European call on gold at $400 per ounce in 100 ounces gives its holder the right to buy 100 ounces of gold from the option writer at $400 per ounce on the 15 December 2001, if the holder so wishes.

If we exclude those financial contracts which are of themselves haram (bonds and forward foreign exchange for example), then we are left with a set of underlyings such as equities and commodities upon which a derivative contract may be based.

Curiously, even where acceptable forms of underlying such as these are concerned, a key valuation element in arriving at the fair value of an option contract remains the rate of interest. The Black Scholes formula proposes that since an option can be perfectly hedged through constant trading in the underlying, the option position should be riskless and hence earn the buyer the riskless rate of interest on the premium that was paid for it. (In reality, constant trading of the underlying asset to achieve the perfect hedge is unattainable, and so option prices behave in ways that are not entirely predicted by Black-Scholes.) For the unhedged option, the contract becomes one of pure uncertainty. Neither party knows whether the option will be exercised, as it is dependent upon the condition of the market at a future date.

The first problem with the standard option contract from a Shari`ah perspective is that a contract of exchange in which both payment and underlying are deferred is widely held to be prohibited. The second problem is the uncertainty that exists with regard to whether or not the option will be exercised. Thirdly, if the option contract is judged to be halal, the question then arises as to whether that option can itself be sold to a third party, as is the case in the market for warrants for example. Fourthly, by buying a put option and selling a call option, a trader can replicate a short position in an underlying asset. Where these options are cash settled, the trader can be seen to achieve the same cash-flows as a short seller of that underlying. Shari`ah scholars have agreed that selling what one does not own is a prohibited commerical activity, and the possibility that such an activitiy can be synthesised through the use of options must therefore call into question their validity under Shari`ah. There is a fifth problem that pertains to more complex option contracts where the strike price itself varies according to an agreed formula. Such is the case with a serial option. For example, a one month 'at-the-money' serial call with daily resets gives the holder a series of one day call options whose strike price is the price of the underlying asset at the previous day's close of trading. As this price is unknown in advance, the strike price itself cannot be known. This represents further gharar.

Under Bay al-Urban, a deposit is paid on an item that a prospective buyer may purchase at a later time. Should the buyer not complete the purchase, the deposit is lost. This contract has been used as a justification for Islamic options by some writers who argue that the deposit can be seen as the premium paid by the buyer of a call option. The problem is that the scholars do not widely allow bay al-Urban. According to Ibn Rushd in Bidayat al-Mujtahid:
Within this topic is the sale of the urban (sale with earnest money). The majority of jurists of different regions hold that it is not permitted, but it is related from a group of the Tabi'un that they permitted it, among them are Mujahid, Ibn Sirin, Nafi ibn al-Harth and Zayd ibn Aslam. The form it takes is that a person puchases a thing and delivers to the seller part of the price on the condition that if the sale is executed between them this earnest money will form part of the price of the goods, if it is not executed the buyer will forgo it. The majority inclined toward its prohibition, as it is from the category of gharar, mukhatara and the devouring of wealth of others without compensation. Zayd used to say, "The messenger of Allah (God's peace and blessings be upon him) permitted it". The Ahl al-Hadith said that this is not known from the messenger of Allah (God's peace and blessings be upon him).

Under Khiyar, which is allowed by the jurists, the buyer of an item has the right to undo his purchase if the seller specifically allows as part of the terms of the sale. This is in other words an option to cancel a previously agreed sale. All buyers have a right to cancel a sale following purchase but before leaving the presence of the seller (khiyar al-majlis). This right is different to that expressly given by the seller to the buyer under sale with an option (bay al-khiyar), where the buyer may leave the presence of the seller for a specified period of time before returning to cancel the sale and take back the money that was paid.

Ibn Rushd in Bidayat al-Mujtahid comments:
Permissibility of option is upheld by the majority, except for al-Thawri and Ibn Shubrama, as well as a group of the Zahirities. The reliance of the majority is on the tradition of Hibban ibn Munqidh, which contains the words "and you have an option for three days", and also what has been related of the tradition of Ibn Umar: "The parties to sale have an option as long as they have not parted, except in sale with an option". The reliance of those who prohibit it is (on the argument) that it constitutes gharar and that the basis of sale is that it is binding, unless definitive evidence is produced for the permissibility of sale with an option from the Qur'an or authentic sunna or ijma. They also said that the tradition of Hibban is either not authentic or it is specific to the case of a person who complained to the Prophet (God's peace and blessings be upon him) that he was deceived in sales. They said that the tradition of Ibn Umar and the words in it, "except sale with an option", have been interpreted through another version of this tradition in which the words "that he says to his counterpart: 'Choose'," have been recorded.

In khiyar it is difficult to see any analogy that would lead us to the acceptance of the modern option contract as described above. Khiyar relates to a halal contract of exchange that has already taken place, whilst a modern option relates to an exchange that is yet to take place. In the case of khiyar, the exchange of one or both countervalues is effected immediately. In the case of the modern option contract, future delivery applies to both the payment and the underlying asset. In addition, uncertainty as to the materialisation of the exchange exists with the modern option contract but not in khiyar.

Disagreements among traditional scholars in the matter of khiyar arise in minor details, such as the length of time for which the buyer has the option to return the goods, or who is liable for any damage to the goods whilst the buyer is in posession of them during the option period. These scholars do not seem to have disagreed upon those fundamental principles which distinguish khiyar from the modern option contract.

It is my view, having been involved in derivatives dealing, that the potential exists in this market to cause a serious breakdown in the financial system. The degrees of leverage that are afforded by option contracts can be so high that large unpredictable market moves in underlying prices may one day lead to the insolvency of a major financial institution. Liabilities cannot be perfectly hedged even where that is the intention, and some traders deliberately do not hedge their option portfolios because such action would limit the potential for high returns. The case of Long Term Capital Management in the United States, rescued by a Federal Reserve bail out in 1998, demonstrates the degree of risk that can be incurred. The question is whether the central bank or other authorities will be able to move quickly enough, or in large enough measure, to prevent future failings.

When looked at from the Islamic perspective, as with so many other Islamic financial products, it seems that theory needs to be stretched in order to justify an Islamic option contract. The macro-economic arguments for their existence are of dubious merit, based as they are on minimising risks which do not need to exist in the first place. Better to structure the economic system such that it does not suffer from continuing volatility. If there was no such thing as interest, there would be no such thing as interest rate options. The same with foreign currency. What we are seeing in the Western world is the emergence of financial products that are a symptom of a system that has gone wrong. Islamic financiers who look at the products of this system as a paradigm are making a big mistake.

The Legal Aspects of Marketing for Islamic Banking Services

INTRODUCTION

In this paper I would deal with basically the two aspects which I consider play a major role, other things being equal, in the decision of a customer opting for or deciding to take up a particular banking product, or availing himself of a particular banking service, over another in relation to Islamic banking services. These are:

1. The forum in which any disputes arising in the transaction will be decided; and
2. The law that will be applied in deciding the dispute.
Accordingly, a clear understanding of these matters is essential in marketing Islamic banking services.

ISLAMIC BANKS AND FINANCIAL INSTITUTIONS

In the strict sense of the word there is o¬nly o¬ne Islamic bank in Malaysia, Bank Islam Malaysia Berhad, it being the o¬nly bank to date licensed under the Islamic Banking Act, 1983 ("The Islamic Banking Act"). However under the amendments made to the Banking and Financial Institutions Act, 1989 ("BAFIA") (Which came into force o¬n 1 August 1996) all conventional banks and financial institutions. Mohamed Ismail Shariff 1 April 1997, The legal aspects of marketing for Islamic banking services.

Can carry o¬n Islamic banking business and Islamic financial business. This is brought about by the amendment to Section 124 of the BAFIA which reads as follows:

"124. (1) Except as provided in section 33, nothing in this Act or the Islamic Banking Act 1983 shall prohibit or restrict any licensed institution from carrying o¬n Islamic banking business or Islamic financial business, in addition to its' existing licensed business, provided that the licensed institution shall consult the Bank before it carries o¬n Islamic banking business or any Islamic financial business.

(2) For the avoidance of doubt, it is declared that a licensed institution shall, in respect of the Islamic banking business or Islamic financial business carried o¬n by it, be subject to the provisions of this Act.

(3) Any licensed institution carrying o¬n Islamic banking business or Islamic financial business, in addition to its existing licensed business may, from time to time seek the advice of the Syariah Advisory Council established under,subsection (7), o¬n the operations of its business in order to ensure that it does not involve any element which is not approved by the Religion of Islam.

(4) Any licensed institution carrying o¬n Islamic banking business or Islamic financial business shall comply with any written directions relating to the Islamic banking business or any other Islamic financial business, carried o¬n by such licenced institution, issued from time to time by the Bank, in consultation with the Syariah Advisory Council.

(5) Any licensed institution carrying o¬n Islamic banking business or Islamic financial business shall be deemed to be not an Islamic bank.

(6) This Act shall not apply to an Islamic bank.

(7) For the purposes of this section -

(a) There shall be established a Syariah Advisory Council which shall consist of such members, and shall have such functions, powers and duties as may be specified by the Bank to advise the Bank o¬n the Syariah relating to Islamic banking business or Islamic financial business;
(b) "Islamic banking business" has the meaning assigned thereto under the Islamic Banking Act 1983 1; and
(c) "Islamic financial business" means any financial business, the aims and operations of which, do not involve any element which is not approved by the Religion of Islam."
So it is clear that both categories of banks, Islamic and conventional, can do Islamic banking business. And in a broad sense they are both subject to the same law (with some variations) in so far as their Islamic banking business is concerned.

WHICH COURT HAS JURISDCTION OVER ISLAMIC BANKING LAW MATTERS - THE CIVIL COURTS OR THE SYARIAH COURTS?

This question arises because of certain amendments made to the Constitution of Malaysia with regard to the jurisdiction of the High Court. The provision of the Constitution referred to is Article 121. Prior to the amendment it read as follows:

"121. (1) Subject to Clause (2) the judicial power of the Federation shall be vested in two High Courts of co-ordinate jurisdiction and status, namely

(a) o¬ne in the States of Malaya, which shall be known as the High Court in Malaya and shall have its principal registry in Kuala Lumpur; and
(b) o¬ne in the States of Sabah and Sarawak, which shall be known as the High Court in Borneo and shall have its principal registry at such place in the States of Sabah and Sarawak as the Yang di-Pertuan Agong may determine;
and in such inferior courts as may be provided by federal law.

(2) The following jurisdiction shall be vested in a court which shall be known as the Supreme Court and shall have its principal registry in Kuala Lumpur, that is to say
(a) Exclusive jurisdiction to determine appeals from decisions of a High Court or a judge thereof (except decisions of a High Court given by a registrar or other officer of the court and appealable under federal law to a judge of the Court);

(b) Such original or consultative jurisdiction as is specified in Articles 128 and 130; and

(c) Such other jurisdiction as may be conferred by or under federal law."
Clauses (3) and (4) are not relevant to the present discussion.
The amended Article reads as follows:
"121. (1) There shall be two High Courts of co-ordinate jurisdiction and status namely -
(a) o¬ne in the states of Malaya, which shall be known as the High Court in Malaya and shall have its principal registry in Kuala Lumpur;

(b) o¬ne in the States of Sabah and Sarawak which shall be known as the High Court in Borneo and shall have its principal registry at such place in the States of Sabah and Sarawak as the Yang diPertuan Agung may determine;

and such inferior courts as may be provided for by federal law; and the High Courts and inferior courts shall have such jurisdiction and powers as may be conferred by or under federal law.
(1A) The courts referred to in clause (1) shall have no jurisdiction in respect of any matter within the jurisdiction of the Syariah Courts.

(2) There shall be a court which shall be known as the Supreme Court and shall have its principal registry in Kuala Lumpur and the Supreme Court shall have the following jurisdiction, that is to say -

(a) Exclusive jurisdiction to determine appeals from decisions of a High Court or a judge thereof (except decisions of a High Court given by a registrar or other officer of the court and appealable to a judge of the court);

(b) Such original or consultative jurisdiction as is specified in articles 128 and 130; and
(c)Such other jurisdiction as may be conferred by or under federal law."

Relying o¬n this amendment (particularly Clause (1A)) it has been argued that the Civil Courts no longer have jurisdiction to hear cases where Islamic law is applicable, such jurisdiction now being vested in the Syariah Courts. Previously the Syariah Courts and the Civil Courts exercised concurrent jurisdiction o¬n certain matters involving Islamic law.2 With the inclusion of Clause (1A) in Article 121 it was thought that the jurisdiction of the Civil Courts o¬n matters involving Islamic law had been taken away.

In at least o¬ne case involving a banking transaction based o¬n Islamic principles in which the writer was Counsel the High Court has ruled that Clause (1A) has not take away its jurisdiction and that it did have jurisdiction to hear the case.3 It is the writer's view, with respect, that this decision is correct for reasons which need not be discussed in detail here.

In brief, Syariah Courts o¬nly have jurisdiction in respect of matters that fall within the State List in the Federal Constitution.4 The Civil Courts have jurisdiction in respect of matters which fall within the Federal List. The Ninth Schedule of the Federal Constitution contains the Federal List and the State List which set out the respective areas where the Federal Parliament or the State Legislature may make laws. Banking as well as the incorporation and regulation of corporations fall within the Federal List. Banks are companies incorporated under the Companies Act, 1965. Accordingly they fall within the jurisdiction of the Civil Courts.
Besides, the State List, which provides for the establishment of Syariah Courts, states that they (the Syariah Courts) "shall have The legal aspects of marketing jurisdiction o¬nly over persons professing the religion of Islam..."5 Banks being a creature of statute can have no religion.
For these reasons it is clear that the Syariah Courts cannot assume jurisdiction over banks and other companies or in respect of any other matter that falls within the Federal List.
There is no written judgment o¬n this issue and it is hoped that should the matter be ever raised again there would be an authoritative pronouncement from the Courts o¬n the subject.

WHAT LAW APPLIES TO ISLAMIC BANKING TRANSACTIONS

The Islamic Banking Act is an unique piece of legislation. It provides for the setting up and licensing of "Islamic banks". It is unique in the sense that probably for the first time an Act of Parliament has been enacted to deal specifically with Islamic banking. The writer is not aware of similar legislation in any other jurisdiction following the common law system.
Up to the present o¬nly o¬ne bank, Bank Islam, has been licensed under the Islamic Banking Act.
The Islamic Banking Act stipulates that a bank licensed under it Act shall carry o¬n "Islamic banking business".

Section 2 defines "Islamic Bank" as "any company which carries o¬n Islamic banking business and holds a valid licence..." and "Islamic banking business" as "banking business whose aims and operations do not involve any element which is not approved by the Religion of Islam". It is to be noted that "banking business" itself is not defined.

The definition of Islamic banking business appears at first flush to be simple; but in reality it is not so. What is the meaning, for example, of the expression "any element which is not approved by the Religion of Islam"? There are four madzhabs in the sunni branch of Islam (as opposed to the Shi'a branch). And opinions even among the four schools do vary o¬n many aspects of the law and no o¬ne can say that o¬ne opinion is correct and the others are not. It is more a question of choice. In the event of differences in opinion o¬n the law applicable in respect of any particular matter, there is no direction in the Act as to the law of which madhab is to be applied. Seen from this point of view the wording may seem to be too general. It might be thought that greater certainty would have been achieved if the definition had been more precise, such as providing that in the event of a difference the law to be applied is the law in accordance with, say, the Shafi'e madzhab.

On the other hand, however, the broad definition does have some positive aspects. The writer considers the definition to be a liberal o¬ne. That would facilitate, for instance, the reception and application of the law from any of the four schools or even from the Shi'a branch to suit the circumstances, thus making the resulting proposition of the law more widely acceptable.
The Islamic Banking Act by not defining banking business has either left it to be: implied by the Courts that the meaning of the term is to be the same as that applied in conventional banking or intended that term to acquire a meaning by custom and usage over the years. The civil courts would have to rule o¬n that issue when the occasion arises; but for now it is an open question.

THE APPLICATION OF ISLAMIC LAW WITHIN A COMMON LAW SYSTEM

It must be remembered that the Islamic Banking Act and Islamic law generally are to be applied and implemented within the existing common law system and the regime of all other existing laws. This includes not o¬nly the laws but also the courts system and court procedure. Needless to say, that system and those laws and procedure were not drafted or designed with Islamic law in mind or to facilitate the application of Islamic law.

A moment's reflection will bring into focus the enormity of the problem. To a legal practitioner this is a legal nightmare. What this means is that any document that is to be used1 in an Islamic banking transaction has to comply with BOTH (1) Islamic law (or in the words of the Act it must "not involve any element which is not approved by the Religion of Islam") AND (2) also with all other applicable laws, eg Contracts Act, 1950, Bills of Exchange Act,1949,just to name two. To take a simple illustration: a contract made in a banking transaction by an Islamic bank or as an Islamic transaction must be valid under Islamic law AND also under the civil law, for it to be enforceable in the civil courts. For example, a contract may be valid under Islamic law yet it could fail in the civil courts for want of consideration and thus be unenforceable. The reverse situation can quite as well happen.

Thus any document or instrument to be used in Islamic banking has to:
(1) Be in accord with Islamic law;
(2) Be in accord with the existing civil laws; and
(3) Be structured in such a way (eg, as to form) as to be enforceable in the civil courts.
This problem was realised at the outset when banking documents were first drafted for use by Bank Islam and a great deal of caution was exercised to ensure their compliance with the above-stated requirements.6 Over the years these documents have been modified and improved upon.
The validity of some of these documents were challenged in the courts but, happily, none of those challenges have been successful.7

One provision of particular significance is Section 3(5)(b) of the Islamic Banking Act which provides that the Central Bank (ie Bank Negara Malaysia) shall not recommend the grant of a licence, and the Minister shall not grant a licence, unless he is satisfied:

(b) that there is, in the articles of association of the bank concerned, provision for the establishment of a Syar'iah advisory body to advise the bank o¬n the operations of its banking business in order to ensure that they do not involve any element which is not approved by the Religion of Islam".

This is an important provision. However, its real purport has not been tested in the courts as yet.8 The setting up of a Syar'iah advisory body is a statutory requirement and its f-unction is "to ensure that [the operations of the bank] do not involve any element which is not approved by the Religion of Islam". What is the ambit of this subsection? To take an example, if a particular document used in banking transactions by a bank licensed under the Islamic Banking Act has been approved by its Syar'iah advisory body, can it then be challenged in court as being contrary to Syar' iah? Can the court find such a document to be not in accordance with the Syar'iah? If it does so, what is the effect of it o¬n the decision of the Syar'iah advisory body?

Put another way, are decisisons of the Syar'iah advisory body open to review by the courts? This is by no means an easy question to answer. And it is not easy either to venture an opinion o¬n the issue since any opinion has to be relative to particular factual situations. In the writer's view the issue should be cleared up by legislation rather than by lengthy and costly litigation in the courts.

The establishment of the Syariah Advisory Council under BAFIA raises another problem. It is this: it will be recalled that o¬ne of the requirements of an Islamic Bank is to have an in-house Syariah advisory body "to advise the bank o¬n the operations of its banking business". What would be the position if the advice of these two bodies (both of which are established under statute) o¬n the same issue differ?

Such conflict of opinion is not unforeseeable. And it should be avoided before it arises. There must be some machinery set up to ensure that both advisory bodies consult each other and agree o¬n the advice to be rendered o¬n any issue of Islamic law. It would be even better if the twc bodies are merged into o¬ne so that there would be no opportunity for such conflicting advice to be rendered at all.

It must be recognised, however, that the documents now in general use by Bank Islam (and adopted and used by other' banks and financial institutions) cannot meet all the banking or commercial requirements. As the application and use of Islamic law in commercial transactions become more pervasive the necessity for new types of documents will be felt (as they have been) and these must be devised (as has beer, done). Great ingenuity and far-sightedness will be needed in the creation of such documents. But the task is enormous and urgent and should not be done piecemeal. It must be adressed and necessary action taken o¬n a collective or central basis rather than by individual banks or financial institutions as seems to be the practice now.

CONCLUSION

In Malaysia Islamic banking is o¬n par with conventional banking:

1. Islamic banking is regulated by the Islamic Banking Act (under which Islamic law is to be applied to banking transactions) but all other laws applicable to banking matters generally also apply to Islamic banking. Thus a customer who does Islamic banking enjoys double protection; and
2. Any legal disputes involving Islamic banking matters are brought before the civil courts.
Thus the writer sees no major legal impediment for the growth of Islamic banking in Malaysia, though certain amendments to existing laws need to be made to make them more suited to Islamic law principles. The real challenge facing Islamic bankers is to bring home the message to Muslims and, more importantly, to non-Muslims:
1.That Islamic banking is open and available to everyone, Muslim and non-Muslim,
2. That it is relevant to present times and can meet the demands of modern-day business; and
3. That it is a true and in many respects a better alternative to conventional banking.

Islamic Banks - Their strategies and ratings
This special comment is based on a speech delivered by Christine Kuo , a Moody's VP/Senior Analyst, at the 6th IFSB Summit on 7 May 2009 in Singapore.

Professionals in the Islamic banking sector are often asked whether the current strategies adopted by Islamic financial institutions will prove effective at competing at the global level in the long run. Since a strategy is a plan of action designed to achieve certain goals, its effectiveness can be assessed only in relation to these well-defined goals.

From the rating perspective, an effective strategy is one that allows a particular Islamic bank to grow its business while delivering a stable and good financial performance, thereby making it stand out against credit ratings of other global banks.

While Islamic banks in different countries operate under different environments and are at different stages of development (and therefore require different strategies), we can still find a set of common characteristics among their various strategies that benefit their long-term ratings.

To address this topic and related issues, this report is organised into the following five sections:

(1) summary of those characteristics in strategies that benefit ratings;

(2) specific strategies adopted by various Islamic banks;

(3) rating implications of these strategies;

(4) selective rating issues concerning Islamic banks; and

(5) how relevant stakeholders could affect strategies and ratings of Islamic banks.

Characteristics in strategies that benefit ratings

Moody's assigns ratings to banks globally, irrespective of their form or nature, and that includes Islamic banks. In assigning ratings to banks, Moody's first evaluates a bank's intrinsic safety and soundness thereby arriving at a Bank Financial Strength Rating (BFSR), and then factors in potential support from the relevant providers to derive the bank's ratings for deposits and debt. This analytical framework is common to all types of banks, so the ratings of Islamic banks are comparable to those of conventional banks globally.

It is worth noting that an Islamic Financial Institution (IFI) is an institution that limits the scope of its business to comply with a set of ethical and moral guidelines derived from the teachings of Islam. It should be noted that there is nothing that stops a 'conventional' bank from operating the same ethically-driven model. It would still be Shari'ah compliant despite not being 'branded' as such. IFIs focus on a subset of global finance consistent with Shari'ah, thus the skills and experience applied to rating broader and more universal institutions is equally applicable and valuable in the Islamic context.

In accessing a bank's financial strength, Moody's considers factors such as franchise value, risk positioning, regulatory environment, operating environment and financial fundamentals. Of these factors, regulatory and operating environments are outside of a bank's control, but bank strategies can definitely affect the other factors in the long term.

Strategies that improve franchise value

Franchise value is about the solidity of a bank's market standing in a given geographical market or business niche. A solid and defensible franchise is a key element underpinning a bank's ability to generate and sustain recurring earnings, to create economic value and, thus, to preserve or improve risk protection in its chosen markets.

The Islamic brand is economically valuable; in many instances Muslim depositors will happily pay a small premium for conducting their finances in what they perceive to be an ethical way. With a large addressable population and relative immaturity there is still scope for solid long-term growth.

Moody's believes strategies leading to sustainable entrenched market position, improved geographical and earnings diversification, and increased earnings stability can enhance a bank's long-term franchise value.

Size is important because diversification is harder to achieve when an institution is small. It should be noted, however, that a bank dominant in smaller but more favourable markets may have a higher franchise value (which could translate into greater earnings stability) than a bigger bank with a highly price-sensitive customer base in a competitive market.

It follows that it is better for Islamic banks to have a strategy that helps achieve a stronger position in a few selective markets than one which results in marginal positions in many competitive markets.

Strategies that improve risk positioning

A bank's risk positioning is a fundamental qualitative factor in Moody's credit analysis; the current credit woes apparent in the global market once again highlight its importance. In this regard, we view positively strategies that improve corporate governance, controls and risk management, financial reporting transparency, credit risk concentration and liquidity management. Strategies that set a conservative market risk appetite are also considered favourably.

Improving risk positioning is particularly relevant. Although Islamic banks are able to pass through a negative shock on the assets side to the investment depositors, displaced commercial risk is at stake.

Islamic banks have a number of buffers to manage displaced commercial risks. These are profit equalisation reserves which contribute to smooth earnings across the cycle; investment risk reserves which absorb negative shocks on asset values; Mudarib fees which can always be decreased in a discretionary manner to avoid penalising the depositing Rab al Maal; and shareholders who can always provide Qardh Hasan to profit-sharing depositors. In a stress situation, those IFIs sufficiently equipped with such mitigating instruments would be considered more resilient to downturns.

Nonetheless, to date few, if any, Islamic banks have passed on losses to their depositors. If the buffers mentioned above are inadequate, the IFIs could experience funding pressure as deposits are moved to other financial institutions.

Additionally, Islamic banks tend to have greater concentration in assets and liabilities compared with conventional banks. They also face challenges in managing liquidity and risk due to the limited range of instruments available.

Moreover, Islamic products are less commoditised and require more tailoring and oversight, and this leads to substantial overheads and operation risk.

Strategies that improve financial fundamentals

We break down our analysis of a bank's financial fundamentals into five sub-factors, namely profitability, liquidity, capital adequacy, efficiency and asset quality. Some financial metrics necessarily reflect a bank's franchise value and risk positioning, but a prudent financial policy also plays an important role in shaping these numbers.

For instance, a bank with a strategy to maintain a conservative financial policy is likely to keep its capital and liquidity ratios higher then most of its peers. The result is a stronger balance sheet and which can better withstand adverse economic cycles. For Islamic banks with significant exposures to equities and properties, conservative financial leverage is particularly important in view of the volatility in the values of these investments.

Most of the strategies of Islamic banks try to achieve profitable asset growth. The differences in their strategies mainly reflect the state of development of Islamic banking and their positions in their respective home markets, their aspirations for the medium and long term, and the resources they have.

Organic growth in home market

This is the main strategy adopted by almost all Islamic banks across different countries since decent growth potential still exists at home. While organic growth does not allow for quantum leaps in assets and earnings, this strategy is of lower risk.

Market with low penetration: strategic focus is on increasing awareness

For markets where Islamic banking has low penetration, such as Indonesia, North Africa, Turkey, Jordan and (probably) the Sultanate of Oman (where Shari'ah-compliant finance is expected to pick up), there is plenty of room for growth and the level of competition is relatively low. Moreover, Islamic banks in these markets are mostly still small in size. Therefore, they are not keen on acquisitions or venturing overseas. Instead, they focus on growing customers and businesses at home. Their major competitors are conventional banks in the same markets and their strategies involve conversion of conventional banking assets into Shari'ah-compliant assets. Increasing awareness of Islamic banking services is essential at this stage.

More mature market: strategic focus is on providing competitive products and services

In the more mature markets, such as Malaysia, Sudan and most countries within the Gulf Cooperation Council (GCC), low-hanging fruit have already been picked. Therefore, Islamic banks need to set their strategies to compete not only with the conventional banks but also with their Islamic banking peers. The target is to increase the wallet share of existing customers, to attract Muslim customers who still bank with conventional banks, and to attract non-Muslim customers if the markets have significant non-Muslim populations. Being able to offer competitive products and services is the critical factor to success.

A few larger Islamic banks have been expanding outside of their home markets to tap other Muslim populations as there is a natural brand affinity. Kuwait Finance House (KFH) is one such example. It has established subsidiaries and associate companies in the Gulf and wider Middle East and North Africa region (MENA), as well as in Asia. Its subsidiaries in Bahrain, Malaysia and Turkey are key to the group's regional expansion strategy.

Its foreign expansion is expected to continue, especially in North Africa (including Morocco), the Gulf region (including Saudi Arabia) and Muslim Asia.Other examples are Al Rajhi Bank and Dubai Islamic Bank. The former ventured into Malaysia in 2006, while the latter launched its operation in Pakistan in the same year. Finally, most Islamic banks established in the UK have majority or strategic bank shareholders headquartered in the Gulf region.

Mergers and acquisitions

This option is adopted by only a very small number of Islamic banks as the potential for organic growth is still great. However, as business and the number of Islamic banks grow, the markets will become more mature and competitive. At that time, Islamic banks operating in fragmented markets would likely pursue M&A strategies for asset and earnings growth.

For example, there are 17 Islamic banks in Malaysia, a mid-size economy with GDP of approximately $200 billion. Islamic banking assets account for less than 20 per cent of total banking system assets. Since the largest Islamic bank (Maybank Islamic Berhad) accounted for only about 2.2 per cent of these assets, this implies that all Islamic banks are small and the market is fragmented. The market is currently growing and profitable, but competition is rising which will drive down margins gradually. This development could lead to market consolidation over the medium term.

In some cases, depending on conditions and regulations, Islamic banks with entrenched positions in their home markets may also consider using M&As to establish their presence overseas. For example, Dubai Islamic Bank has acquired a majority stake in the Bank of Khartoum, the largest bank in Sudan, whereas Abu Dhabi Islamic Bank has acquired Egypt's National Bank for Development with a view to converting it into a fully fledged Shari'ah-compliant bank within two years.

Under current market conditions, M&A activity may be driven by necessity rather than by choice. In the UAE for instance, there are two troubled Islamic mortgage lenders or "home finance companies" facing difficulties due to liquidity issues, and are effectively in the process of being nationalised (although their status is still unclear as the Federal government has yet to announce its final decision on the matter). The two companies together -- Tamweel PJSC (Tamweel) and Amlak Finance PJSC (Amlak) -- have about 60 per cent of the market, but have shown themselves to be just as vulnerable as any other wholesale-funded conventional counterparts.

Per se, a merger would not solve the issue; however, it would give birth to one large systemically important institution that would be easier to regulate, control, fund and strengthen from the perspective of its public-sector shareholder.

Strategic partnerships and joint-ventures

This strategy is popular among Islamic banks which want to build presences overseas. It is also used by banks seeking technical expertise in markets and/or products from other institutions. To facilitate the formation of partnerships and joint ventures, the Islamic banking businesses of conventional banks often need to be incorporated.

For example, Abu Dhabi Commercial Bank of the UAE and RHB Bank of Malaysia have entered into a strategic alliance. While both also operate conventional banking businesses, two reasons given for the partnership involve the ability to leverage each other's strengths in Islamic banking, while they also share the goal of developing a global Islamic banking platform.

Reacting to a crisis scenario

As is often the case in the field of Islamic banking, larger banks and smaller contenders tend to react differently in a situation of stress, which the overall market has been experiencing for several months. While larger Islamic financial institutions, like Saudi Arabia's Al Rajhi Bank or Kuwait's KFH, prefer to protect asset liquidity, capitalisation and their reputation at the expense of growth and profitability, smaller banks –- when they can afford to adopt such an opportunistic view -- are keen to quickly gain market share.

Such a strategy is apparent in the competitive UAE market. At a time when market liquidity has been scarce, most banking players tend to refrain from lending, leaving room for those competitors with ample asset liquidity to use their own balance sheets to capture extra shares of the lending market. For instance, Dubai Bank, one of the UAE's smaller Islamic banks, pursued such tactics: prior to the crisis, the bank managed to accumulate sizeable asset liquidity on its balance sheet, which it extensively used across 2008, resulting in a doubling of its size despite the worsening global credit woes.

Funding was less of a constraint for IFIs, because of market perception that these players will be more resilient than conventional peers amid global credit turmoil. The market acknowledged that Islamic banks could not carry on their balance sheets any toxic assets (in the form of highly-leveraged structured instruments or global investment banks' shares) simply because these are considered "haram" and therefore not eligible for investment as per Shari'ah Boards' fatwas.

In practice, a phenomenon of customers switching savings from conventional banks (perceived as riskier), to Islamic banks (perceived as less directly and indirectly exposed to 'subprime') has been recorded across a number of countries, especially in the UAE, Kuwait and Bahrain.

Rating implications of these strategies

The rating implications of different business strategies need to be considered in relation to individual institutions and the likely impact on their business and financial profiles.

Organic growth in home market

􀂄 Good for long-term ratings, as long as not too aggressive

This strategy is usually good for long-term ratings since the expansion of market positions could improve franchise value. To the extent that growth is a result of tapping new customers, the strategy would also serve to reduce concentration risk and increase earnings diversification. Moreover, organic growth in home markets involves tapping business in a familiar operating environment. And since strategy is implemented by the existing management team, it has lower execution risk.

But overly aggressive growth could still harm bank credit profiles. An institution's risk management system and infrastructure often cannot keep pace with strong business growth. This may be indicated by the experiences of Tamweel and Amlak which became exposed to construction risk by funding under-construction properties. As a result, asset quality problems could surface later. Worse still, if growth is supported by debt-like hybrid capital instruments, any capital buffer utilised to support potential loss from the risk assets will thin

􀂄 Example: Al Rajhi Bank

In September 2006, Moody's upgraded Al Rajhi Bank's financial strength rating to C- from D+. The rating action was to recognise the bank's strengthened franchise, improved financial fundamentals and strong capital base. Organic growth outside of home market

􀂄 Potential higher diversification benefits, but with higher short-term risk

The small size and/or a maturing nature of home markets often drive financial institutions to seek long-term and sustainable growth abroad. Such an expansion strategy is inevitable and, in the long term, beneficial. However, growing the business in less familiar markets, and sometimes in more volatile and often constrained environments, brings near-term challenges.

Until Islamic banks have seasoned their overseas operations and demonstrated that they are able to deliver stable earnings, increased risk profiles may outweigh any benefits. However, once seasoned, the income and risk diversifications benefits would be more evident since assets in overseas markets generally have a lower risk and earnings correlation than have risk assets in the same market. The less correlated and better diversified the new markets, the higher the diversification benefits.

􀂄 Example: KFH

KFH's international operations are growing in importance, and have started to confer visible diversification benefits to the group as well as brand credibility overseas. The performance of foreign subsidiaries has improved over the past few years. This development has somewhat altered its culture in a positive way, forcing it to more efficiently allocate resources across the organisation and experience more intense competition.

Mergers and acquisitions

􀂄 High execution and integration risk, and financial leverage often rise

M&As of material sizes always trigger rating reviews. While the reviews do not always lead to rating actions, when the latter do take place they are often negative for acquirers. The possible results include changing an institution's rating outlook to negative, placing ratings under review for possible downgrade, or simply rating downgrades.

Negative rating actions are more common, and mainly reflect the many risks involved in such a strategy, including execution risk, integration risk, regulation risk and financing risk. With M&As involving targets outside of home markets, the risk is still higher.

Until now, Moody's has not taken any negative rating actions on any Islamic banks as a result of their M&A initiatives, mainly because the acquirers have been able to absorb the added risks without creating too much pressure on their own balance sheets. This has in turn been due to the relatively small sizes of the transactions.

Strategic partnerships and joint ventures

􀂄 Rating neutral in most cases

Moody's recognises that strategic partnerships and joint ventures could be a lower risk strategy for tapping into less familiar business lines or markets. And this strategy sometimes results in an increase in capital, which is good from a rating perspective.

Nonetheless, it is not uncommon to hear of disagreements among partners in terms of the formulation and execution of business strategies. And since each partner emphasises its own primary businesses, and it takes time to form a consensus and resolve any potential conflicts of interest, slow action or inaction could prevent the realisation of full possible benefits.

Moreover, not many strategic partnerships or JVs have brought big enough benefits to transform the business and financial profiles of its investors.

Selective rating issues concerning Islamic banks

While the underlying operations and economics of Islamic banks are substantially similar to those of conventional banks, we see some risk issues that could affect the ratings of Islamic banks.

The limited scope of eligible asset creates asset concentration risk. Non-deposit liabilities could have concentration risk as well due to the relatively small number of Islamic financial institutions available to participate in the inter-bank market. There is also only a small range of Shari'ah-compliant instruments available for managing or transferring risks.

For example, Al Rajhi Bank is highly exposed to the sovereign, primarily through murabaha placements with the government and balances with the Saudi Arabian Monetary Agency. This is in line with other Saudi Arabian banks. If we were to add to this situation the bank's top 19 group exposures and come up with an estimate of its top 20 exposures relative to Tier 1, then the amount could be quite sizeable. This is a common feature for rated Saudi banks and which significantly constrains their BFSRs.

In the case of KFH, the institution has some industry concentration in the property sector, with direct and indirect real estate exposures in Kuwait and internationally (exposure to the US real estate market appears negligible). In its loan portfolio alone, real estate and construction represented 12 per cent of exposures, whereas direct investments in properties accounted for 2.8 per cent of total assets at end-2007. At the same time, like most other GCC banks, single-borrower concentration is rather high.

KFH is also more exposed to market risk since direct investments are a key component of its business model and it has a marked preference for equities (in addition to Sukuk and property).

Focus on tangibles had led to increased property-related financings at IFIs, affected by relatively undiversified nature of the economies. As the real estate markets are highly volatile in the GCC, the concentration risk is magnified.

Challenges in liquidity management

Liquidity management is structurally more challenging at Islamic banks because there is still a significant shortage of liquid instruments, despite the efforts of the various central banks to provide a variety in which Islamic banks can place their surplus cash. In fact, Tamweel and Amlak would have gone insolvent if not for the government with liquidity being the issue.

Moreover, displaced commercial risk is always possible should an Islamic financial institution's assets yield returns for profit-sharing investment account (PSIA) holders that are lower than expected, or worse still, show negative rates of profits. While PSIAs are supposed to absorb losses -- other than those triggered by misconduct or negligence -- it remains to be seen how such account holders would react to losses on their accounts.

Historically, Islamic banks in the GCC have kept very large proportions of core liquidity on their balance sheets in the form of short-term international Murabaha and central bank deposits, at the expense of extra revenue. This approach has proved to be a wise choice in a region prone to numerous cycles and recurring shocks, and given that their investment portfolios tend to be more illiquid as stress situations worsen.

How the relevant stakeholders could affect the strategies and ratings of Islamic banks

Of the various stakeholders in Islamic banks, it is the regulators, shareholders, company management and employees, and customers which have key roles in shaping an Islamic bank's business strategy and performance and so affect its intrinsic financial strength. Additionally, regulators could influence an Islamic bank's deposit and debt ratings according to their capacity and willingness to provide systemic support in time of stress.

Regulators can affect a bank's strategy and ratings through their influence on the regulatory environment and systemic support. A more favourable regulatory environment could contribute to better BFSRs, while systemic support could further lift deposit and issue ratings as the joint-default probability is lower.

A bank regulator's principal objectives are usually focused on protecting depositors and promoting a healthy banking system. As such, the interests of a bank regulator are often aligned with the interests of depositors, bond holders and other creditors.

Through a combination of effective regulations, active supervision, and aggressive and prompt enforcement, a strong regulatory environment can promote sound banking practices and limit excessive risk taking. As a result, a bank's financial strength is often improved.

The level of systemic support is a result of the capacity and willingness of the national government to support troubled banks. Moody's firstly determines whether the countries in which the Islamic banks are domiciled are high, medium or low support countries. We then apply the appropriate level of support based on the importance of the respective bank to the system.

Tamweel and Amlak are examples of systemic support prevalent in jurisdictions where IFIs have been growing (i.e., the GCC).

Shareholders

Balance of growth and returns

The presence of active shareholders often pressures financial institutions to report higher returns on equity (RoE). To the extent that this is achieved by improving franchise and other business fundamentals, which lead to better financial metrics, the bank's long-term ratings will benefit.

However, if a higher RoE is achieved mainly by a more aggressive use of financial leverage, e.g., to make sizeable acquisitions financed by debt and other lower-quality capital instruments, or to conduct a large number of share buybacks, the bank's ratings would be pressured.

Many equity investors have under-estimated the risk of financial leverage in the past. However, we are now seeing that change in light of the prevailing global crisis.

Management and employees

Financial institutions, including Islamic banks, need to solve the most fundamental incentive problems so that strategies that involve excessive risk taking or a focus on short-term gains are discouraged. Staff tend to act based on how they are evaluated and compensated. Ill-devised performance metrics and compensation systems inevitably lead to a weak corporate culture and problems that undermine an institution's long-term prospects.

Client characteristics matters

Client characteristics could affect bank business profiles and financial results. For example, some Islamic mortgage originators in the UK note that the prepayment rate is higher, and the delinquency rate lower, than for conventional customers of similar income. Another example is that the customers in the GCC countries are willing to accept low or no returns on their deposits.

We note that the difference between Muslim and non-Muslim customers, in terms of credit quality and cost of deposits, is not significant across all markets. The point is that customer behaviour does have implications onbank performance; therefore, a selection of target clienteles could affect bank financial strength when distinctions do exist among different classes of customers.

To sum up, it is impossible to lay out one best strategy for all institutions, but Moody's believes those strategies that improve franchise value, risk positioning and financial fundamentals will benefit an Islamic bank's financial strength rating, which is comparable on a global basis.

Various strategies can be adopted by Islamic banks to achieve profitable growth and enhance their competitiveness, but the resulting immediate and long-term risks and benefits differ. It is worthwhile to point out that while asset growth is important, appropriate systems and infrastructure to address risk issues need to be in place to support sustainable growth. Therefore, strategic focus needs to be timed, with risk management being implemented first followed by growth.

Finally, regulators, shareholders, management and employees, and customers all have roles in shaping an organisation's strategy and could influence ratings. When it comes to global comparisons, Moody's believes it is more important for Islamic banks to build strong franchises in selective markets and businesses, and to maintain sound financial profiles as opposed to big balance sheets