Issue Sixteen

Rocked to the foundations

When an industry expands at a rapid pace, glitches can be expected. This was recently experienced in the sukuk market that is fast emerging as the most significant form of financing around the world. Debt papers that adhere to Shariah law have been growing at a frantic pace of 40% per annum and the value of global sukuk issuances this year is anticipated to double the amount of 2007 and exceed US$80 billion. At this rate, the global sukuk market is on track to surpass the US$100bn mark in a few years. But this industry is not without its problems. One of the biggest obstructions in its development to date is over its legitimacy with Shariah principles. This concern gained notoriety at the end of last year when Sheikh Muhammad Taqi Usmani, chairman of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), issued a statement to the media in which he said that 85% of all Gulf Islamic bonds do not fully comply with Islamic laws. AAOIFI accounting standards are binding across six Arab countries as well as the Dubai International Financial Centre. Regulators in other countries including Malaysia, Australia and South Africa also use these standards as a base for sukuk issued in their respective countries. Banks such as Goldman Sachs Group Inc and UBS AG also use guidelines issued by AAOIFI to develop their products. With such an extensive global influence, comments made by the group's chairman quickly led to scepticism and suspicions over the authenticity of the global sukuk market, which was already battling unfavourable credit conditions. According to Bloomberg, sales of global sukuk had dropped to US$856m this year as compared to US$4.7bn in the first quarter of 2007. This concern further fuelled speculation on the compliance of other Islamic financial products.

Call for more intellectual capital

As Western financial institutions, be it investment banks or insurers, rush to roll out Shariah-compliant products and services targeting Muslim consumers, there is a struggle to secure financially erudite Islamic scholars. With an estimated 50 to 60 scholars qualified to advise banks on Islamic law worldwide, the demand for Shariah scholars in the Middle East, Asia and the Western front far outweigh the current supply. Kuala Lumpur-based Islamic Financial Services Board was reported to have estimated that assets managed under Islamic rules will almost treble by 2015 to US$2.8 trillion. One can only imagine how this small pool of scholars will be able to distribute the weight of approving these assets in time to come. A Shariah supervisory board is needed because the blessing of a Shariah scholar is pivotal for any bank or insurer before it can even consider releasing the product into the market. 'Unless a financial product or service can be certified as Shariah-compliant by a competent Shariah supervisory board, that productís authenticity is dubious," says Sheikh Yusuf Talal DeLorenzo, chief Shariah officer at Shariah Capital Inc, a Shariah consultancy. He says this is why the Accounting and Auditing Organisation of Islamic Financial Institutions, which governs ethics and Shariah standards for Islamic financial institutions, insists that such decisions be made by a Shariah supervisory board (of not less than three members). The board is expected to have specialist knowledge of Islamic laws for transacting fiqh al mu'amalat as well as knowledge in modern business, finance and economics. Collective decision-making by the Shariah supervisory board ensures that decisions are not unilateral and that difficult finance issues receive adequate consideration by a number of qualified people. Many financial institutions look to have their own Shariah supervisory board who can issue fatwas for new financial products such as sukuks, loans or mutual funds. Banks such as HSBC Amanah and Standard Chartered Saadiq have their own independent Shariah committee, while others hire on an ad hoc basis.

Surge in hiring is widely forecast

The boom in Islamic banking products and services has led to a huge demand for Islamic banking experts worldwide within all areas of banking/retail, commercial and corporate, and at all levels. Organisations across multiple regions are actively seeking CEOs, risk analysts, accountants, product specialists and a whole host of other positions. While Islamic banking continues to grow, there will need to be a corresponding increase in hiring by organisations. The initial boom in the early 90s of Islamic banking in Malaysia created a new breed of bankers with both conventional and Islamic expertise. Malaysia was the traditional breeding ground for Islamic bankers. Soon after the Middle East started to expand Islamic banking, many individuals in Malaysia were made extremely attractive offers to move to the Middle East and help set up Islamic windows and subsidiaries. Saudi Arabia was aggressive in trying to import talent into the region by offering inflated compensation. After some initial success of attracting people, the country also started to lose good individuals as other countries in the Middle East, such as the UAE, started increasing their Islamic banking presence. The increased freedom in lifestyle and culture was a key motivator in people moving from Saudi to other areas. Saudi is now in such a position that it has to pay significantly higher salaries to attract the top talent. This has forced other countries, such as Malaysia, to try to employ initiatives to retain their top talent after losing significant numbers of employees between 2001-2006. Many established Islamic banks have extremely high turn-over as a result of employees leaving once they have been trained in Islamic finance and banking. Some organisations are concerned that the quality and vision of their Islamic offering may be tarnished if they focus purely on hiring conventional bankers. There are several prominent figures in Islamic banking, based in both the Middle East and Malaysia, who are non-Muslims and are British/American nationalsófurther proof that conventional banking concepts can be transferred into an Islamic offering. Some traditional organisations are concerned about the impact of hiring a non-Muslim to lead their Islamic offering.

Response to new demographics

Most Islamic and non-Muslim countries are paying serious attention to Islamic banking. Those that are not taking urgent steps to catch the wave of growth in Islamic banking fear being left behind in attracting good inward investments and financial institutions. Much progress has been made in the UK towards launching Islamic products from high street financial institutions. This is expected to be followed by similar initiatives among 20 million Muslims in Europe, Canada and the United States. Tax implications, consumer protection act and some similar obstacles remain an issue but are solvable. The UK has done wonders in recent years in supporting the development of Islamic banking and making allowances such as abolishing the double stamp duty on Islamic mortgages and authorising the operations of two Islamic banks. Such initiatives have encouraged the global players to set up dedicated Islamic windows within their mainstream activity. In Europe, the challenge will be to operationalise the equity considerations of the Shariah and make this mode of financing widely accepted among a constituency that transcends Muslim communities. Islamic banking has to be embraced by the wider communities to make a real commercial and practical impact and to create secondary markets in the non-Muslim countries. The main concern is that European countries such as France and Germany have been slow to encourage the establishment of Islamic financial institutions. They are losing a lot of ground. The other main challenge is financing and creating funds to offer alternatives to the customers. Bank lending is still practised but is limited to either no-cost loans (mainly consumer loans) including overdrafts, tawarruq-basis or loans with service charges only. These types of loans bring little income to the banks; they are not that keen to engage in this activity. That leaves investment financing and trade financing. Islamic banks are expected to engage in these activities only on a profit- or loss-sharing (PLS) basis. This is the banks' main income source and from where the investment account holders derive their profits. It is precisely the PLS scheme, however, in which the main problems arise.

How technology keeps banks in line with Shariah compliance

With an estimated value of US$500 billion and an annual growth rate of between 15% and 20%, the global Islamic financial sector market is advancing at a rapid pace. Financial services firms and new start-ups such as retail banks, wealth management firms, investment banks and insurance comp anies have started to move into the Islamic finance market. Intense competition among these players has not only pushed up the expected service level but has also accelerated the development process of Shariah-compliant products. This has resulted in a demand for technological solutions that not only cater to the demands of day-to-day operations but also provides the financial organisation with a competitive advantage, such as reducing the time taken to create and deliver new products or by augmenting its service. Although the conventional financial industry is already supported by wellconfigured, stable financial systems, the Islamic banking and financial transactions necessitate technological solutions that fulfil the underlying principles of Shariah laws. Banks are the pillars of a financial sector and some, known as universal banks, can provide all the products for the corporate and retail market. Consequently, these institutions are usually the first to seek technological solutions. Islamic banks operate in the context of Islamic law, whereby money acts as a store of value for tangible trade and financial risk is to be shared among investors and institutions. Rosie Kmeid, head of corporate communications and marketing for Path Solutions, says: "Some of the important goals [for Islamic finance] are socio-economic justice and equal distribution of income and wealth as well as stability in the value of money. Islamic banks that engage in business processes and products consistent with these Shariah precepts will safeguard Islamic communities from activities that are forbidden by Islam." This means that all business processes executed by the Islamic bank, including delivery of the product, must be Shariah compliant. Jamil bin Hassan, an Islamic banking technology expert and principal consultant for the Islamic banking practice at i-flex solutions, says: ìIf the sequence to execute a contract [between the Islamic bank and customer] stipulates that step B comes after step A, a reversal of these two steps invalidates the contract. Shariahcompliance extends to the delivery of the Islamic product and this is a massive task for the respective institution.

Western tax and Islamic finance

A company wishes to purchase a machine, to be delivered immediately, with a manufacturer's price of $1,000. The machine will be useable for five years. If purchased with conventional finance, the customer will pay for this machine immediately, financed by a bank loan of $1,000, carrying simple interest at 5% per year, with all of the interest to be paid in full when the loan is repaid after two years. If acquired with Islamic finance, the bank will purchase the machine from the manufacturer for $1,000 and resell it to the customer for $1,100 with immediate delivery, permitting the customer to only pay the bank the price after two years. In both scenarios, the customer has the same cash-flows, obtaining the machine for immediate use and paying out $1,100 after two years. Tax law varies from country to country, and is usually complex. Assume a hypothetical tax system under which capital equipment, such as this machine, can be amortised for tax purposes, on a straight line basis, commencing only after the machine has been paid for. Tax relief for finance costs is given on an accruals basis over the life of the debt. The hypothetical tax system, developed in an environment of conventional finance, has no problems computing the tax deductions the customer is entitled to. The key principles underlying the tax treatment are that the customer has paid for the machine on delivery (even though financed by a bank loan) so the tax amortisation starts immediately, and the customer will be paying $100 interest to the bank, spread evenly over the two-year life of the loan. When the customer acquires the machine under Islamic finance, it is not paid for until after two years, and the legal contracts record no cost of finance. Instead there is the purchase of a machine costing $1,100, which is only paid for two years after delivery. There are two fundamentally different ways for the hypothetical tax system under consideration to look at this Islamic finance transaction.