Banking on Sharia

What do you call 2.1 billion Muslims with specific banking needs? A dream market, according to industry commentators.

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By  Mark Johnson Published  January 27, 2005

|~|HASBC.jpg|~|Adel Khashabi, head of HSBC Amanah, Middle East, creating in-house expertise.|~|Until recently, little was known of the principles of Islamic finance outside of the Muslim banking scene, but with more and more practising Muslims and Islamic companies demanding Sharia-based financial products - from retail end current accounts to corporate financing structures - the global banking world is beginning to sit up and take notice. The main difference between Islamic finance and conventional banking lies in the Sharia principles, which govern how Islamic banks operate. Sharia law requires profits to be shared and bans investment in industries related to alcohol, gambling, tobacco, pornography or weapons, as well as prohibiting the charging of interest. Instead of mortgage loans, for example, an Islamic bank would buy a house and sell it to a would-be homeowner at a premium using fixed monthly instalments. In many ways it's an ethical investor's dream. Major international banks such as HSBC and Standard Chartered Bank already offer fully Sharia-compliant banking products to their customers. HSBC, for example, was the first to offer Islamic mortgages to its customers in the UK. Moreover, it was the first international banking house to offer Sharia-compliant current accounts in the United Arab Emirates. Dubai-based Adel Khashabi, head of HSBC Amanah, Middle East, says the company has witnessed a growing need in the market to give people the option between conventional banking and Islamic banking. 'Our operations started in the personal banking area, with a current account and personal finance, but we’re now developing other products, which will launch in the future. The reaction so far has been very positive.' In the UK, the first fully Islamic British bank, Islamic Bank of Britain, opened its doors in central London last September, offering a range of banking products that are all compliant with Islamic law. The Islamic Bank of Britain was the first to get Financial Services Authority (FSA) approval to operate entirely in accordance with Islamic Sharia law. The bank, which will target the UK's two million Muslims, plans to offer its first mortgage product by the end of the year and an internet banking service in 2005. It launched with $25 million backing from investors in the Gulf region, including the Qatar royal family and the Qatar International Islamic Bank, as well as investors from Bahrain and Saudi Arabia. Moreover, it recently raised $72 million via a stock market listing in the UK, in what was described as a watershed event in the history of Islamic finance. With so much Arab region backing there is every reason to expect that, at some time in the future, further shares could be offered to Gulf Co-operative Council (GCC) states via a listing at the Dubai International Financial Centre (DIFC), on its fledgling DIFC International Financial Exchange (DIFX). Khalid Yousaf, Islamic finance expert at the recently launched DIFC, quantifies the market opportunity: 'When you look at the total population of the 57 Muslim countries around the world, they number about 1.2 billion. This is a huge market by any standard.' He agrees that the GDP per capita in the Muslim world is abysmally low, at around US$250, but he argues that this includes the lowest earners from war-ravished countries such as Sudan. However, in the region served by the Gulf Co-operative Council (GCC), it is much higher, therefore the market opportunity greater. 'In Qatar,' he adds, 'GDP per capita, at US$25,000, is one of the highest in the world. And in the UAE alone there are around 46,000 to 47,000 millionaires, most of whom are locals.' The growth in Islamic finance has been driven by a number of factors. The events in New York on 11 September 2001 triggered the need for certain changes. One of these is a massive repatriation of capital from the US, where most of the money from the Gulf is invested. That money is now beginning to come back 'home' and is looking for asset classes in which it can be listed. Many believe this is by far the biggest opportunity to grow Islamic financial business in the region. UK-based legal firm, Norton Rose, is widely regarded as one of the world's leading advisors on Islamic finance. Nadim Khan is head of banking and Islamic finance at the firm's Dubai office, and he says the market has really woken up: 'Over the last three years we have been on a steep upwards curve in terms of activity, and I'm sure that will be maintained in the short-to-medium term future. A lot of financial institutions are throwing resources at this market and the level of activity in both transactions and product development is right up there.' Of course Islamic finance is nothing new - Norton Rose has been advising on the subject for the past 25 years. The fundamental reasons for the rise of this very particular form of banking can be traced back to the 1970s and the associated oil boom that brought much wealth to the Gulf region. Almost overnight the Arab population was awash with liquidity and this created a kind of vacuum. People found themselves with considerable amounts of money, but nowhere appropriate to invest it. In line with their Muslim beliefs, they sought guidance from Sharia principles as to where to invest their money, thus creating the need for an Islamic finance model. Islamic banks sprung up and held onto customer deposits on an interest free basis. This was due to the Sharia law that forbids the making of money from money. Of course many customers, unhappy with this arrangement, wanted to get a return on their deposits and this drove the need for new asset classes that were acceptable under Sharia rules. However, in the early days, Islamic finance came at a premium. This was due to the amount of research and development that went into creating those new asset classes. There were also additional, often complicated steps required to complete a transaction, and there were further costs due to the documentation and legal work involved. All this made it an unpopular choice with many Muslims and left Islamic banks far less competitive than their conventional counterparts. For years Islamic finance was a relatively innovation-free zone, but more recently these institutions realised that, in order to stand a chance of selling their products in the market, they would have to be either on a par with, or better than, their conventional rivals. So they have now cut out much of the burdensome paperwork and extra costs which were previously associated with it. Additionally, many regional and local finance houses have been making good progress towards broadening the range of simple, more attractive Sharia-based financial products. However the DIFC's Yousaf says the big international banks have also played a major role: 'The biggest contributions have been made by multinationals, such as HSBC, Citigroup, ABN Amro and Standard Chartered. All of these have actually done the research, they have gone through the due diligence process in terms of learning what is Sharia-compliant and what is not. Then they have come up with the structuring of Islamically acceptable products.' Khan says the large conventional banks, many of which are relatively new to the concept of Islamic finance, are often far more particular about how they create their Sharia-based portfolio of products than their regional Islamic counterparts. “They are used to working in world-class regulatory frameworks, and they want to get it right.” He adds: “This is having a positive impact on the entire market, as it raises the bar in terms of ensuring there are more products coming out that fall within the acceptable parameters of Sharia.” Naturally, it's been a slow process, but this is because the multinationals have had to deal with steep learning curves, cultural sensitivities, addressing the issues at a corporate level and then moving down to creating products and services at the retail level, where the growth in Islamic finance is most visible. “We are seeing a surge in Islamic mortgages, car loans, retail finance, holiday loans, medical expense loans and educational loans, all based on Sharia law,” says Yousaf. Norton Rose's Khan predicts the corporate sector will also see considerable growth over the next few years: 'If we take the (Middle East) region for starters, I think there's going to be a lot of activity in the structured finance side of the market. In the Sukuk (bond) market we're even looking at developing Sharia-compliant derivative-based products.' Innovation is definitely the watchword, he adds: 'Some of the finance structures are using well-established Sharia products to get an end result that falls within the parameters that the scholars are comfortable with. Although that aspect of the market is very much in its infancy, there's a lot of resource being thrown at it.' Project finance is another area pegged for growth: “I don't think it will be very long before we have a wholly Sharia-compliant project financing market for big-ticket deals.” But he says the real focus will be on the Sukuk (bond) markets: “People are looking to create secondary market instruments to increase liquidity and tradability in the region.” While there is much positive talk on the growth prospects of the Islamic finance sector, the industry also faces some serious challenges ahead, on a number of different fronts. One of the key issues is a lack of skilled professionals in the banking world to service the growing needs of the Islamic side of the business. Standardisation of broad Sharia financial rules is also lacking, and the tiny, elite group of experienced and respected Sharia scholars, who are charged with making the key decisions on new products and instruments, cannot continue to exist in its current form in a growing market. The problem faced by the banks on the skills front is that it's currently difficult to recruit suitably qualified staff to successfully run an Islamic banking division. They are often forced to position existing staff in the role that have had little or no previous experience of Islamic banking, and are required to simply get on with the job, learning the intricacies of the Sharia principles as they go, not a perfect situation. HSBC Amanah's approach to dealing with this issue is pragmatic: “It is still a new phenomenon for many banks so currently there is not a lot of expertise around the world,” says Khashabi. “Everyday we learn something new, and we are focusing on our people and trying to create a lot of in house expertise. However, we do try to share experience from different parts of the world, such as Malaysia, Saudi Arabia, the UAE and the UK.” The situation looks set to change in the next year or two, as efforts are already under way to train more experts. In the UK, the Universities of Durham, Leicestershire, Southampton and even Oxford all now offer either courses or parts of courses devoted to Islamic finance. Similarly, the Institute of Islamic Banking and Insurance claims to have enrolled 450 students in its post graduate diploma course, of which more than 120 have already graduated. Regionally, the Bahrain Institute of Banking and Finance (BIBF) has been training financial professionals since 1981. As well as diploma courses in Islamic finance, the BIBF offers short training courses — aimed at experienced banking professionals — covering an introduction to Islamic banking, Islamic investment funds, Sharia standards and structuring Islamic transactions. The key players in the Islamic banking world realise, too, that the revered Sharia scholars responsible for guiding institutions on Sharia compliance are buckling under the strain of a growing market and new product development. Critically, there is a lack of standardisation of rules within Sharia to the extent that each new product must be examined on its merits in isolation. This cannot continue because the handful of knowledgeable Sharia scholars to whom the task falls to pass judgment on new products will simply grind to a halt under the sheer weight of growing demand for these products from both the institutions and the markets in to which the products are sold. DIFC's Yousaf says the burden being placed on the current band of Sharia scholars is unfair: “The shortage of trained people is such that dependence on the Sharia scholars is greater than it should be.” He adds that the same names frequently come up on the various committees that exist, suggesting the need for urgent expansion of the scholar base. Standards also vary, as DIFC's Yousaf explains: “From Saudi Arabia to Malaysia there is a sliding scale of conservatism, where Saudi very conservative and Malaysia more liberal.” At the less conservative end of the pool there is what is known as the 'doctrine of necessity', which allows disciplines to be adopted from outside the religion if it is required. Khan says it is one of the issues that has dogged Islamic financing for a number of years, but that now an increasing level of consistency is emerging across the board. 'By no means are we there yet, but the gap's closing,' he says. 'A global standard is a little way off I think, but from a regional perspective there are certainly discussions underway to try and achieve a level of consistency.' How this is likely to emerge remains to be seen. "With the big Islamic financial institutions it may be by way of publication of a number of broad based principles or something more specific than that," Khan says. However, the powers that be have at least acknowledged that it must be resolved in order to develop the market. The most likely outcome will be that it will occur regionally, then globally. Of course these types of issues are common with any new emerging market and will likely be resolved, naturally, as the market continues to grow. And grow it will. The reality is that the principles of Islamic finance are based on morally acceptable concepts — the fair apportionment of risk across society. In a world increasingly dominated by consumer and corporate concerns over the ethical use of savings, deposits, investments and funds, Islamic finance could emerge as a clear leader.||**||

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