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    Islamic Finance in a Nutshell: A Guide for Non-Specialists
    Islamic Finance in a Nutshell: A Guide for Non-Specialists
    Islamic Finance in a Nutshell: A Guide for Non-Specialists
    Ebook457 pages4 hours

    Islamic Finance in a Nutshell: A Guide for Non-Specialists

    By Brian Kettell

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    About this ebook

    The recent turbulence in the global financial markets has drawn attention to an alternative system of financial intermediation: Islamic banking and finance, which has so far remained on the sidelines of the unrest.

    Islamic Finance in a Nutshell is a quick and easy guide to understanding the fundamentals of Islamic Finance and how the Islamic Financial markets work. Designed as a quick read for practitioners needing to pick up the basics of the industry, it will enable readers to understand the differences Islamic and Western finance.

    Starting with the rise of Islamic finance, the book highlights the key areas which practitioners need to grasp to understand the marketplace including financial   statement analysis, Sharia’a law, making money in the absence of interest and regulation.  The book also provides readers with a basic guide to Arab terminology and a guide to the top financial institutions within the Islamic markets.

    This is an ideal guide for anyone with an interest in how these financial markets work, but who do not want to be bogged down in complex and unnecessary terminology.

    LanguageEnglish
    PublisherWiley
    Release dateOct 20, 2011
    ISBN9780470710036
    Islamic Finance in a Nutshell: A Guide for Non-Specialists

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      Book preview

      Islamic Finance in a Nutshell - Brian Kettell

      Introduction

      The ongoing turbulence in the global financial markets has drawn attention to an alternative system of financial intermediation, Islamic banking and finance. This sector has so far remained on the sidelines of the unrest. The sector has grown rapidly in recent years and this new found prominence has raised many questions as to what exactly is Islamic banking and how does it work. This short text, a nutshell, is designed to provide readers with an understanding of the central tenets of the industry.

      Islam is not only concerned with the relationship between man and God but it is also a system of beliefs, justice, equity, fairness and morality, these being the values that underpin the entire Islamic way of life. These beliefs are governed by the body of Islamic principles generally referred to as Sharia’a, which is, not surprisingly, the basis for the creation of Islamic financial products.

      Since the inception of Islamic banking, about three decades ago, the number and reach of Islamic financial institutions worldwide has risen significantly. Institutions offering Islamic financial services constitute a significant and growing share of the financial system in several countries. For example, the entire banking system of Iran is based on Islamic principles. Although Islamic banks are concentrated in the Middle East and Southeast Asia, there are also niche players in Europe and the United States. Islamic banking assets and assets under management are currently standing at over $800 billion. According to a recent study by a global management consulting firm, McKinsey, ‘The World Islamic Banking Competitiveness Report 2007/08: Capturing the Trillion Dollar Opportunity’, the value of Islamic banking assets and assets under management is expected to reach US$1 trillion by 2010, with Islamic banks growing more rapidly than the average banking sector in many countries.

      The Islamic banking industry is in the midst of a phenomenal expansionary phase, exhibiting average annual growth rates of about 15 per cent in recent years. This rapid growth has been fuelled not only by surging demand for Sharia’a-compliant products from financiers from the Middle East and other Muslim countries, but also by investors around the world, thus rendering the expansion of Islamic finance a global phenomenon. Besides its wide geographical scope, the rapid expansion of Islamic finance is also taking place across the whole spectrum of financial activities, ranging from retail banking to insurance and capital market investments. But perhaps the most striking was the fast growth of sukuk (Islamic bonds), the most popular form of securitised credit finance within the industry. Sukuk issuance soared over the period 2001–2007 although it has fallen back more recently.

      What Is Islamic Banking?

      Sharia’a-compliant banking provides and uses financial services and products that conform to Islamic religious practices and laws which, in particular, prohibit the payment and receipt of interest. In practice, this means that instead of loans, Islamic banks use profit-and-loss sharing (PLS) arrangements, purchase and resale of goods and services, and the provision of services for fees. These principles all form the basis of Sharia’a-compliant contracts. In PLS modes, the rate of return on financial assets is not known or fixed prior to undertaking the transaction. In purchase-sale transactions, a mark-up is based on a benchmark rate of return, typically a return determined in international markets such as LIBOR (London Interbank Offered Rate, an internationally recognised reference interest rate).

      Islamic banks also determine the return on deposits differently. In a commercial bank, the rate of return is set contractually (fixed in advance or tied to a reference rate) and does not directly depend on the bank’s lending performance. In an Islamic bank, the rate of return on a deposit is directly linked to the quality of the bank’s investment decisions. If the bank records profits then the depositor benefits. If, however, the bank records losses as a result of bad investments, depositors may lose some (or all) of their deposits. The contractual agreement between depositors and Islamic banks does not pre-determine any rates of return, it only sets the ratio according to which profits and losses are distributed between the parties to the deposit contract.

      The fact that the Islamic banking model is different from the conventional model does not mean it is without risks. A majority of the relevant literature suggests that the risks posed by Islamic banks to the financial system differ in many ways from those posed by conventional banks. Risks unique to Islamic banks arise from the specific features of Islamic contracts, and the overall legal, governance, and liquidity infrastructure of Islamic finance. For example, PLS financing shifts the direct credit risk from banks to their investment depositors. But it also increases the overall degree of risk on the asset side of banks’ balance sheets, because it makes Islamic banks vulnerable to risks normally borne by equity investors rather than holders of debt.

      In addition, because of their compliance with Sharia’a, Islamic banks can use fewer risk-hedging techniques and instruments (such as derivatives and swaps) than conventional banks. Moreover, most Islamic banks have operated in environments with less developed or non-existent interbank and money markets and government securities, and with limited availability of and access to lender-of-last-resort facilities operated by central banks. These differences have been reduced somewhat because of recent developments in Islamic money market instruments and Islamic lender-of-last-resort modes, and the more recent implicit commitment to provide liquidity support to all banks during exceptional circumstances in most countries.

      In some ways, Islamic banks should be less risky than conventional banks. For example, Islamic banks are able to pass through a negative shock from the asset side (such as a worsened economic situation that causes lower cash flow from PLS transactions) to the investment depositors. The risk-sharing arrangements on the deposit side thus arguably provide another layer of protection to the bank, in addition to its book capital. Also, it could be argued that the need to provide a stable and competitive return to investors, the shareholders’ responsibility for negligence or misconduct (operational risk) and the more difficult access to liquidity put pressures on Islamic banks to be more conservative. Furthermore, because investors (depositors) share in the risks (and typically do not have deposit insurance), they have more incentive to exercise tight oversight over bank management. Finally, Islamic banks have traditionally held a larger proportion of their assets than commercial banks in reserve accounts with central banks or in correspondent accounts with other banks. So, even if Islamic investments are more risky than conventional investments, from a financial stability perspective, the question is whether or not these higher risks are offset by bigger buffers.

      Trends in Islamic Banking in Europe

      The UK has taken a major lead in Europe in promoting and encouraging Islamic banking activities but this has mainly focused on retail banking and only more recently on investment banking.

      The Financial Services Authority (FSA), the UK banking regulator, has only authorised one Islamic retail bank, the Islamic Bank of Britain (IBB). Although other investors have looked into the retail banking arena, no other dedicated competitors have so far entered the retail market, mainly due to the level of investment required to acquire the critical mass of customers that are needed to ensure a retail bank is profitable.

      The major hurdle for IBB and any new Islamic retail bank in the UK and Europe is creating banking products that are competitive with conventional products offered by other retail banks. Also, competitive product development provides opportunities for potential new entrants into the market to differentiate themselves and add competitive advantage against existing banks in the market.

      More recently in the UK, there have been new Islamic investment banks authorised by the FSA including the European Islamic Investment Bank and the most recent entry, Gatehouse Bank. In total, there are five Islamic investment banks in the UK focusing on institutional investors in Europe and also looking to gain institutional funding from organisations in the Middle East. The Islamic investment banking sector in the UK has flourished enormously with other potential new entrants in the pipeline.

      While Islamic Finance Grows Rapidly in the GCC and Asia, What Is Its Prognosis in Europe?

      A considerable demand exists for Islamic banking products in Europe but to date, for a number of reasons including risk-aversion and conservatism, this need has gone largely unfulfilled.

      The Islamic banking market continues to flourish around the world with current estimates suggesting that assets managed by Islamic banks are in excess of $800 billion – predominantly concentrated in the Middle East.

      It is certainly a fact that there are sufficient Muslim investors and borrowers in both Islamic and non-Islamic countries to warrant the attention of traditional banks that seek to serve such clients and capture a potentially profitable slice of a still relatively untapped market. This is corroborated by the growth of Islamic finance in the US, which has a population of over 7 million Muslims.

      The challenge for European financial institutions is how to leverage their banking knowledge and expertise in developing sufficient products and services that fulfil the requirements of their Islamic customer base whilst being compliant with Islamic finance principles.

      The European Market Size and Scope

      There are more than 15 million Muslims in Europe, of which 1.8 million are resident in the UK plus an additional 72 million in Turkey. There are 360,000 Muslim households in the UK alone.

      The following table illustrates the potential market size in mainland Europe for an Islamic bank, as well as highlights the potential for extra-European expansion in countries such as Turkey.

      Islamic banking in Europe will inevitably focus on both the retail and institutional customers as these are the two major dominant players in the market. As the table clearly illustrates there is a significant retail market opportunity in Europe for new retail banks, but in terms of sheer volume of transactions the institutional market provides the more lucrative opportunity for the Islamic banks.

      Customer Segmentation in Retail Islamic Banking

      Developing Sharia’a-compliant retail financial products can be complex, with a multitude of options available. Before embarking on such a route, it is paramount that the target customer base for the product is clearly defined and their needs and priorities are understood. As in European banking, where there is no ‘one size fits all’ approach to product development, the same can be said of Islamic banking, with an array of customer segments each with different product and service requirements as well as brand criteria.

      In terms of products, a key differentiator between Islamic banking customer segments is the interpretation of what constitutes acceptable levels of Sharia’a compliance. The scale is divided between the more traditional and conservative customers on the one side, and those who seek higher levels of Islamic assurance on the other. Certain customer segments are willing to pay a premium for the most compliant Sharia’a products, whereas others will be more attracted to products that are only part Sharia’a compliant but offer a more competitive rate. Prior to designing a Sharia’a-compliant product concept, the requirements of the target customer segment should be clearly understood, and the resulting costs and benefits weighed.

      In addition to the products, service requirement is another area that will differ between customer segments. Characteristics such as a customer’s age, education, lifestyle and desired relationship with the bank will determine these criteria. Delivering against these is a key element in the Islamic banking proposition and will differentiate banks, which otherwise might offer similar Sharia’a-compliant products.

      Brand recognition is also a key factor that will differ between customer segments. Certain customer segments will only bank with brands that have a strong history and presence in Islamic countries, whereas other customer segments will be more willing to accept European brands with the right product and service propositions.

      As with any new product development, prior to taking a Sharia’a-compliant product to market, the customer segments which form that market must be understood, their product, service and brand criteria defined, and the economic, technical and regulatory feasibility of delivering against them assessed. Only by doing this will banks be able to develop compelling propositions that provide the desired level of return.

      Islamic Banks: The Way Forward

      In the wider context, Islamic finance faces the perpetual challenge that it operates as a subset of conventional finance which is based on fundamentally different premisses. While this may be a limiting facet (in that Islamic financial institutions, for reasons of competitivity, must model their products after conventional models) Islamic financial institutions (IFIs) also have the capacity to innovate within this space. In a sense, the constraints can become boundaries that Islamic finance pushes against. Certainly, in the current context of well branded financial institutions failing the world over, IFIs should be able to showcase their own equitable forms of financing and risk sharing. This in turn may allow IFIs to influence the development of financial systems the world over.

      In Europe, the UK is leading the charge to enact laws that embrace Islamic banking. It abolished double stamp duties that until recently hindered the purchase of a property under Islamic principles. The UK Government is reviewing other laws in order to soften the establishment and offering of Islamic banking products and naturally this has opened the doors for European banks to further their focus in this market.

      In 2005, Lloyds TSB launched services that provided Sharia’a-compliant banking products to its existing retail customer base but, many argued, these products were merely white labelling an existing limited product range, and thus not competitive compared to conventional retail banking offerings in the UK. This was the first major activity from a European bank in this market and has encouraged other banks to evaluate their strategy and to take a closer look at the potential for this market.

      European banks need to incorporate various aspects of traditional banking with Islamic banking concepts in order to fully capture the Islamic market in Europe. While being compliant with Islamic principles may initially be seen as a hurdle, the potential return and increase in customer base will inevitably outweigh any financial investments and commitments made by the bank.

      Islamic Banks Going Forward: Challenges

      The continuing rapid growth of demand for Islamic financial services is clearly good news for Islamic banks. At the same time, it also presents a variety of challenges. The banks need to invest in upgrading their credit risk management capabilities in line with the more complex and larger projects into which they are entering.

      Despite the rapid growth, business models and products of Islamic banks are still rather homogeneous, while Sharia’a compliance amplifies risks stemming from product configuration and process implementation. The success of Islamic banking in recent years has produced too many Islamic banks with the same business model.

      In addition, there is a large and diverse set of accounting standard differences across different jurisdictions. The development and setting of simple standard legal contracts is necessary in order to overcome the complexity and heterogeneity of current contracts. Furthermore, the deployment of IT systems that help monitor the fulfilment and visibility of processes on an end-to-end basis is crucial to facilitate the continuous monitoring of activities by Sharia’a scholars while eliminating the possibilities of non-compliance, which in some cases might render transactions invalid.

      Liquidity risk management of Islamic banks is an important challenge and is constrained due to limited availability of tradable Islamic money market instruments and weak systemic liquidity infrastructure. At the moment, there is no Sharia’a-compliant short-term Islamic money market (less than one week maturity) in local currency or in US dollars, and Islamic repo markets have not yet developed. Islamic money markets with longer maturities, which are based on commodity Murabaha transactions (mark-up financing), sometimes suffer from unreliable brokers with low creditworthiness. Islamic banks also have a competitive disadvantage with conventional banks, as they deposit their overnight money with their domestic central bank interest free. The lack of liquidity and viable alternatives, combined with the competitive disadvantage, hamper the local Islamic banks and can even create a liquidity crisis.

      Islamic Banks Going Forward: Solutions and Opportunities

      Both risk managers and regulators are working to address the above challenges. To overcome the shortcomings of the Islamic money market, many investment banks are currently designing new complex products, compliant with Sharia’a law. It remains to be seen whether these new solutions will obtain widespread Sharia’a-compliant status in the Islamic finance community, and generate enough demand for a functional Islamic money market to develop.

      Rapid developments are likely to continue. Financial institutions in countries such as Bahrain, the UAE and Malaysia have been gearing up for more Sharia’a-compliant financial instruments and structured finance – on both the asset and liability sides. At the same time, the leading financial centres, such as London, New York and Singapore, are making significant progress in establishing the legal and prudential foundations to accommodate Islamic finance side-by-side with the conventional financial system. Many of the largest Western banks, through their Islamic windows, have become active and sometimes leading players in financial innovation, through new Sharia’a-compliant financial instruments that attempt to alleviate many of the current constraints such as a weak systemic liquidity infrastructure. More conventional banks are expected to offer Islamic products, enticed by enormous profit opportunities, especially across the Middle East.

      New product innovation is also driven by domestic banks’ interest in risk diversification. With a large number of new Islamic banks across the Middle East and Asia especially, diversification of products enables banks to offer a differentiated product mix to more sophisticated clients. A few banks are already active across different jurisdictions, and this trend is certainly going to continue in the near future, possibly with some consolidation.

      On the regulatory front, the Islamic Financial Services Board (IFSB), an international standard-setting organisation based in Malaysia, has moved ahead with its efforts aimed at fostering the soundness and stability of the Islamic financial services industry through more standardised regulation. Globally accepted prudential standards have been adopted by the IFSB. These are designed to smoothly integrate Islamic finance with the conventional financial system. For instance, the adoption of the IFSB standards (somewhat akin to Basel II), which take into account the specificities of Islamic finance, ensures a level playing field between Islamic and conventional banks.

      Chapter 1

      What Is Islamic Banking?

      Conventional Bankers and Islamic Banking

      Ask a conventional banker exactly what is Islamic banking. He will mumble something about religion. He will then say well they cannot charge interest but they use something else which is the same thing. This ‘something else’, incidentally, is never defined. He will then move on to describe Islamic banking as being about smoke and mirrors. To conclude he will then profoundly announce that, with a few tweaks, it is what he does every day anyway. And that is the end of it.

      If you push him to actually describe an Islamic financial instrument, and even worse if you actually use some Islamic terminology, Murabaha, Mudaraba etc, then his eyes will start to glaze over.

      Frankly this stereotyped image is all too prevalent within the conventional banking world. In an endeavour to both enlighten conventional bankers and to broaden the understanding of Islamic banking principles this chapter will go back to basics and will highlight the key characteristics of Islamic banking which differentiate it from conventional banking.

      As you will learn, Islamic banking is not about smoke and mirrors. It is in fact about banking based on Islamically-ethical principles which are, in many ways, very different indeed from conventional banking principles.

      Islamic banking is not about smoke and mirrors

      So What Exactly Is Islamic Banking All about?

      Islamic financial institutions are those that are based, in their objectives and operations,

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