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Patching holes in the net

Companies are subjected to analysis by Shariah-compliant fund screening to identify their involvement in Shariah non-compliant businessand financial activities. This enables the exclusion of businesses that are not truly Shariah-compliant. Business activity screening eliminates companies whose primary business activity does not comply with the Shariah, such as conventional banks, bars and casinos. Financial screens, on the other hand, measure businesses’ involvement in Shariah non-compliant financing activities, such as interest earnings and debt financing.
     Dow Jones Islamic Indexes, for example, employs a financial screen in which the debt of the company divided by its trailing 12-month average market capitalisation value must be less than 33%. In general, business activity screening is accomplished by standardised industry classification codes, such as GICS (general industry classification system) or ICB (industry classification benchmark).
     Companies are assigned a single, specific industry code based on the business segment that generates its revenue. As companies can operate in multiple business segments, a business may be assigned to a Shariah-compliant industry but still generate revenue fromnon-compliant activities.
     Using Dow Jones Islamic Indexes as an example, its rulebook states “…if the company has business activities in any one of the following sectors defined by the ICB, it is considered inappropriate for Islamic investment purposes.” These sectors include distillers and vintners, food products, and food retailers and wholesalers.

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Tale of two cities

Recent years have seen a significant surge in new Islamic financial institutions. While Shariah-compliant business is gaining ground—especially in investment banking—Islamic financial institutions are exploring territories starting from their Asian and Middle Eastern platforms.
     Africa, the Americas and Europe have been identified as attractive potential markets. In the US, initiatives have been undertaken by Islamic financiers but the segment remains uncoordinated, with little active involvement from the authorities.
     The UK has been the most successful market in Islamic finance outside the Muslim world. But countries in continental Europe offer potential opportunities—in particular, France, home to the largest Muslim community in the West. Paris, the capital of French business, aims to compete with London, the UK’s financial capital, as a European hub for Islamic finance.
     The UK’s experience of developing Islamic finance, which has seen Islamic financial services incorporated into its overall financial system successfully, is worth examining. Islamic finance has been introduced into the UK with farsightedness, opportunism, commonsense and liberalism. It has been adopted on four fronts: retail banking, wholesale banking, takaful and sukuk. Objectives have been clearly identified with clear and open motives, and without triggering a religious debate.

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Marketing to hearts and minds

Retail Islamic banking was driven originally by demand from high-net-worth individuals in the Middle East looking for Shariah-compliant products. These individuals were willing to pay a premium to bring their finances in line with their beliefs. But the customer segment experiencing the biggest growth is the emerging Islamic middle class. Worldwide, more of these customers are forecast to convert fromconventional to Islamic banks as awareness of Shariah-compliant products increases.
     Can banks with Islamic windows continue to compete with pure Islamic banks? HSBC Amanah and Lloyds TSB have been showing good growth as distribution arms of conventional banks’ Shariah-compliant products. They are competing with Al Rajhi Bank, Kuwait Finance House and the Islamic Bank of Britain among others, which ensure all supporting operations are Shariah-compliant, not just theirproducts.
     In the Middle East, banks appear to be favouring pure Islamicism. Among the banks with Islamic windows that have excised their Western products are Sharjah Islamic Bank (formerly National Bank of Sharjah), and the Bank of Kuwait and Middle East. Rather than try to be conventional and Islamic, trends indicate new entrants are opting for the latter, such as Noor, Al Hilal, Masraf Al Rayan, and Alinma.So to what extent does the level of compliance impact on customers’ choice of bank?
     A comparison can be made between the Islamic banking market and the mature, customer-driven retail food market. Over the past decade, supermarkets have addressed customers’ environmental concerns in a manner few commentators could have predicted. Increased awareness of global and local environmental issues led to an initial surge in customer concerns, resulting in a need for productsand services to be environmentally friendly and appealing to customers financially and morally.

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Solid to the core

An often cited statistic is that 75% of large IT projects end in failure. Fortunately, this wasn’t the case of the core banking system installed at Dubai Islamic Bank (DIB). Implementing i-flex’s Flexcube suite of applications earned DIB’s tech partner Cedar Management ConsultingInternational LLC an award for program management support.
     But such success does not come easy. Chetan Parekh, principal consultant at Cedar, says the firm had to address challenges such as demanding system requirements, the complexity of the core banking system, and team morale. The biggest challenge was managing the size and complexity of the project. The implementation took 18 months, involving more than 50 people at a cost of about US$20m.
     Core systems are the backbone of banking IT infrastructure, without which no modern financial institution can function. To reduce the risk of being overwhelmed by the project size, the methodology had to track and monitor progress continuously. Rather than aim for full implementation in one step, incremental improvements were preferred. To address “scope creep”—in which system requirements grow steadily beyond the original project boundaries—department heads were asked to do cost-benefit analysis to prioritise new requests so as not to adversely affect the project timeline.
     The system adopted to prioritise new requests was to place them into “buckets” of requirements. These would be classified as either essential or desirable—essential buckets had a higher priority. Another challenge was distributing profits by mudarbaha. This was met by developing a profit pool for each customer on various inclusion and exclusion criteria and distributed monthly, quarterly or half-yearly by DIB.
     Mr Parekh recalls the deployment. “DIB has complex inclusion and exclusion criteria for building the mudarbaha profit pool and i-flex was developing this for the first time. It was committed to making it successful by deploying its lead designers on-site for six months to workclosely with the bank’s finance department.”

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Tolerating challenges

Banking, in all its forms, contains risks that pose a challenge to banks and supervisory authorities. Islamic banks—like their conventional counterparts—are financial institutions providing services to depositors and investors and financing to companies, public sectors and individuals. They are, therefore, subject to the risks similar to those confronted by conventional banks. But Shariah-compliant banking has its own risks. Islamic banks can provide funds by meeting the principles governing Islamic banking—the most important being risk sharing.
     There is an urgent need to identify, measure, manage, monitor and control such potential risks and mitigate them within the capacity and capital adequacy of the relevant bank.
     The most important challenges confronting Islamic banks are unique risks arising from financing formulae and Shariah-compliant banking. Investment risks, Basel II proposals applications, capital market and financial derivatives risks need to be controlled efficiently.
     Supervisory authorities must pursue a comprehensive control method based on risk assessment. They should not discriminate in a way that may suggest that Shariah-compliant banks are rated differently or are confronting larger risks. Corporate governance, risk management, transparency, disclosure and internal control requirements should always be developed and adjusted to meet the specific needs of Islamic banks. These banks rely on the impression and reputation of their services, so they should be aware of their role.
     The nature of these risks may raise issues relating to assets and inventory assessment, investment costs, regular income, recognition of losses and adequacy of guarantees. The development of mechanisms to cover such risks is crucial. Islamic banks need to be integrated into global financial markets, encourage competition, and provide a proper climate for ongoing innovation. Banks can then consolidate their position in a range of markets and provide products for more customers.

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Lack of understanding

While Islamic banking has been around for several decades—originating from pioneering efforts from the Sudan, Egypt, Malaysia, Bahrain and Iran—its rapid development has been a recent phenomenon. Consequently, research material tends to lack the empirical analysis of conventional banking. Despite the industry’s valuation of some $750bn—according to McKinsey & Co—with over 300 dedicated institutions and thousands of Shariah-compliant banking service windows operating in more than 75 countries, research with time series data and cross-country analysis has not been available.
     In an attempt to fill this gap, the IMF has released a working paper using data on 18 banking systems with substantial presence of Shariah-compliant finances to provide a cross-country analysis on its impact on financial stability. It poses the question: “Are Islamic banks more stable than conventional banks?”
     At the foundation of Shariah compliance are the two concepts of profit- and loss-sharing and mark-up. In the former, the rate of return on the financial asset or venture is either not known or fixed before the undertaking; in the latter, the purchase-resale transaction is determined with reference to the benchmark rate of return. Benchmark rates similar to that offered by, for example, Libor, serve as reference points.
     Profit-share implies the bank’s ability to secure a sound return arises from its own investment decision and input post-investment. By comparison, in conventional banking the borrower shoulders the entire risk. Poor investment decisions by the bank have a direct bearing on the returns gained by depositors, as the rate of return is determined by the profit-and-loss sharing ratio.