Islamic Finance

ISLAMIC BANKING AND FINANCE #13
Education demands intensifyThe rapid growth in Islamic finance activities in recent years has led to an increasing demand for qualified personnel. Tan Su Lin reports on the availability and quality of courses worldwideAfter more than 10 years of service at Hong Leong Bank, a household name in conventional banking in Malaysia, Bernard Khoo chose to leave for a posting as branch manager of the newly opened Asian Finance Bank in the capital city, Kuala Lumpur. With its generic moniker, nobody would have had an inkling that it is actually an Islamic bank until they notice the absence of interest-free banking. In a way, this also illustrates how quickly Islamic finance is spreading. Naturally, this has led to the industry’s recruitment net being cast onto the talent pool for conventional banking and finance. “It’s not very different from normal banking, operations-wise, but I am thinking of a course in Islamic finance, maybe a post-graduate diploma,” says the 42-year-old. “It would be difficult to sell our products without it.”As Islamic banking activities flourish across Europe, the Middle-East and Asia, opportunities exist for executives with a combination of market savvy and the ability to differentiate between mudharabah and murabaha contracts. For job-seekers, the Islamic finance qualification may help to set them apart from the competition. “It’s impossible for me to know, but I had four interviews, and in most of those it came up as a topic for discussion,” recalls Morris Blumenthal, a 32-year-old legal counsel with Standard Chartered Bank UK. Mr Blumenthal cut his teeth in private practice at Clifford Chance and later DLA Piper. It was at his Canary Wharf office that he first worked on a sukuk deal. While networking and attending free lectures offered at the Institute of Islamic Banking and Insurance (IIBI) in Northwest London, he then enrolled in its postgraduate diploma programme, which he completed two years ago.“I thought the course looked interesting and it was an opportunity to cement the knowledge I had and learn more,” he says.
Commodity-linked investmentsThe Shariah-compliant commodity-linked and structured product market is increasingly presenting more comprehensive offerings. David Kemp focuses on the latest developmentsIt should come as no surprise that Shariah-compliant commodity-linked investments have become available in the market, given that Shariah finance and commodities as an asset class are leading themes in finance. A combination of the two are highly sought after by Islamic investors Commodity investment predates Islam and is a natural Islamic investment, being both tangible and representing the raw material necessary to the means of production. Shariah-compliant commodity-linked investment began with the physical holding of a commodity, accompanied by the associated issues of sourcing, storing and funding. A further development enabled investors to hold a commodity through an intermediate vehicle such as a metals fund, which frequently imposed high running costs and limited scale. The market can offer fully fledged commodity-linked structured products. These include investment certificates, providing exposure to risk-return profiles ranging from a single commodity or basket of commodities through to modified benchmark indices and beyond into bespoke commodity indices. Each of these products is discussed. Many believe that now is the time to invest in commodities.Islamic investors, as with their conventional counterparts, are aware that an investment in commodities can provide otherwise unobtainable diversification benefits to a balanced portfolio. In particular, research has shown the low correlation of commodities with the traditional asset classes of equities and bonds. In addition, the high Sharpe ratio and low volatility of commodities enable a portfolio that includes commodities to move along the efficient frontier in a way that both reduces volatility and increases returns (see diagram 1).
Unlocking French banking codeFrance must remove restrictions on foreign banks if it wants to share in the expansion of Islamic banking and protect its markets, says Fehmy Saddy. Sooner or later, there will be a tide of change Establishing an Islamic bank, or any bank for that matter, is usually a simple process. A banking institution or an investment advisory firm assembles a group of investors and retains a law firm, an accounting firm, a bank technology firm and a public relations firm. It selects a couple of experienced bankers to oversee the preparation of a feasibility study, develops a business plan and submits an application to the regulatory authorities. The capital is then deposited, a banking license is issued and a bank is born. It is a fairly straightforward process. However, the process is more difficult in some countries. The extreme case is Brazil, where a moratorium on issuing new bank licenses has been in effect since 1988. In the United States there are strict requirements, such as holding hearings for the community to express its views and meeting the requirements of the Community Reinvestment Act. Probably the most flexible is the UK, where Her Majesty’s government is determined to make London the world centre of Islamic banking. There are certain basic requirements, particularly with respect to transparency, but once they are met and the funds are there, a license will be issued, regardless of the nationality, ideology, religion or skin colour of the shareholders. In France, the issue is a little more complicated. The nationality of the majority shareholders is a critical factor and there are explicit as well as some unwritten requirements. First, foreign banks or investors (defined as non-EEC or EEC space nationals) must have a French or European financial institution participate in the capital structure of the new bank and hold at least one-third of the equity. This national or European bank shall act as parrain (guarantor) for the foreign shareholders. Second, the French or EEC parrain must have been engaged in the banking business in France for at least 15 years and must be financially strong enough to sustain the loss in case the new bank failed.
On the crossroads of Shariah complianceShariah scholars have arrived at the minimum criteria to provide investors with a wide choice of compliant equities. MH Khatkhatay and Shariq Nisar assess the norms set by three organisationsIslamic banks, investment companies and equity funds have their own norms for assessing Shariah compliance of companies in which they consider investing. Most do not publicise the norms they use for selection or screening. Organisations such as Islamic Development Bank, the Association of Islamic Banks, IFSB and the Islamic Fiqh Academy of the OIC also have not laid down any definite criteria.Information is available on the screening criteria of Dow Jones for inclusion and tracking of equities in its Islamic equity indices. Similarly, the screening criteria of the Securities and Exchange Commission (SEC), Malaysia are available as are the criteria of Meezan (Pakistan). The rationale they apply for a particular norm is not available.The Dow Jones Islamic Index screens for acceptable business activities by stating that activities of the companies should not be inconsistent with Shariah precepts. Therefore, based on revenue allocation, if any company has business activities in the Shariah inconsistent group or sub-group of industries, it is excluded from the Islamic index. The supervisory board established the following broad categories of industries as inconsistent with Shariah precepts: alcohol, pork-related products, conventional financial services, hotels, entertainment, tobacco, and weapons and defense industries.Dow Jones also screens for acceptable financial ratios by removing companies with unacceptable levels of debt, liquid assets and receivables. It excludes companies for which total debt divided by its trailing 12-month average market capitalisation (TTMAMC) is greater than or equal to 33%. It also excludes companies for which the sum of cash and interest-bearing securities divided by TTMAMC is greater than or equal to 33% and those companies whose accounts receivable divided by TTMAMC are greater than or equal to 33%.
Expansion is only the beginningDemands for portfolio diversification have led to greater private equity opportunities for Islamic financial institutions and investors. Robert Varley looks at the benefits and possibilitiesThe last two years have seen a massive expansion of Shariah compliant private equity (PE) funds. By 2006 there were 126 Islamic PE funds with a collective value of US$16 billion. Apart from volume, though, the market has developed in terms of sophistication and range of assets. By looking at where the market has come from, we can start to see what it is likely to do over the next two years.It is worth taking a moment or two to look at the origins of Shariah-compliant PE funds and, in particular, the economic drivers. Shariah-compliant funds are nothing new. Cayman Islands-domiciled funds with Islamically acceptable structures and products were being established before the turn of the century for US real estate investments, and not long afterwards for UK, European and GCC property portfolios. The assets were relatively easy to screen for Shariah compliance, while the massive—and growing —liquidity among Islamic investors in recent years justified the additional marginal cost of ensuring Shariah compliance. Indeed, the compliance costs were (and are) far from prohibitive, even for the more complex funds structured to take advantage of conventional leverage.Shariah-compliant PE lagged behind the real estate funds sector by several years. The reasons are straightforward. Investors in Shariah-compliant funds had a preference for real estate as an asset class. This was reinforced by the spectacular returns available on GCC real estate funds in particular in recent years.However, a number of factors have changed in recent years. First, the success of Islamic financial institutions has led to growth and an appetite among those institutions for expansion into new areas. At the same time, greater sophistication on the part of the investors has driven demand for portfolio diversification.
An interest-free commodity currencyMost modern money exists as the balance sheet counterpart to the interest-bearing loans of commercial banking. Tarek El Diwany discusses why the underpinning of paper currency is so precarious and proposes a less volatile interest-free alternativeThe origin of money is a rarely discussed topic in media outpourings on economics and finance. This is rather strange, given that money is the measuring rod by which the worth of so many other efforts are judged. Supply and demand determine price, but this is only part of the story, because the value of money itself helps to determine price. If the measuring rod of economic activity is unreliable, then the conclusions of myriad arguments among economists may themselves be unreliable, as may the commercial decisions of individuals and corporations the world over. While the man in the street typically believes the government alone has the right to create money and regulate its value, the professional economist usually acknow­ledges that both the state and deposit-taking financial institutions create the monetary medium of the modern nation. Given that commercial banks are the most common form of deposit-taking institution, the following discussion refers to two types of modern money, “state money” and “bank money” (see box, Paper tiger cannot stand up to gold).In 1935 Professor Irving Fisher proposed the elimination of the power of the commercial banks to create money on the basis that they had consistently used this right to profit at society’s expense. The side-effect of their profit-seeking action was, argued Fisher, a boom and bust economy, unnecessary levels of debt, and the needless paying of interest on money that the commercial banking system had, in effect, created out of nothing.The method that Fisher proposed for achieving his objective was the gradual raising of required reserve ratios for commercial banks (that is, the ratio of monetary base to a bank’s sight deposit liabilities) to 100%. The entire money supply of a nation would then comprise money issued by the state, from which point onwards the state alone would have the right to create money. Over the years, economists such as Frank Knight and Henry Simons have argued in a similar vein to Fisher, and so the idea is not an entirely novel one.
Why London is so influentialLondon has been involved with Islamic finance for more than 30 years. Professor Rodney Wilson examines its role and suggests how its standing could be enhanced to curry even more favour in the years aheadInitially the major Islamic finance activity in London involved wholesale operations, with banks in London providing overnight deposit facilities for the newly established Islamic banks in the Gulf. These Islamic banks could not hold liquid assets such as treasury bills, which paid interest, but the joint venture Arab banks in London, accepted deposits on a murabahah mark-up basis, with the associated short-term trading transactions being conducted on the London Metal Exchange.The next milestone was in 1982, when the Jeddah-based Al Baraka Investment Company bought Hargrave Securities, a licensed deposit taker, and converted it into an Islamic bank. This served the British Muslim community to a limited extent, but its main client base was Arab visitors of high net worth who spent the summer months in London. Its business expanded from 1987 when it opened a branch on the Whitechapel Road in London, followed by a further branch on the Edgeware Road in 1989, and a branch in Birmingham in 1991, as by then the bank had between 11,000 and 12,000 clients. Al Baraka’s ambitions were in wealth management rather than banking, however, and in 1992 it converted into being an investment company, and it was no longer constrained by the regulatory requirements that applied to banking.As the Muslim population increased and many became more affluent, there was clearly scope for developing and marketing Shariah-compliant financial products. Housing finance was the key to this, as for most UK residents, their mortgages represent their largest financial commitment. Al Baraka provided some Shariah-compliant housing finance during its years as a bank, but the first serious attempt to reach this market was made by the London-based Islamic Banking Unit of the United Bank of Kuwait in 1997. The trading transactions necessary to make these mortgages Shariah-compliant attracted double stamp duty, however, making the financing relatively expensive. It was only when this was abolished in 2004 that the market for Shariah-compliant mortgages took off. Further tax concessions with respect to diminishing musharakah mortgages, arguably the product best suited for housing finance, resulted in it becoming the most popular vehicle, with funding of more than £150 million. The Alburaq division of ABC Islamic Bank accounts for much of the market, with its products being distributed by Lloyds TSB and the Islamic Bank of Britain.