PROJECT TITLE

ISLAMIC FINANCE

ORGNISATION/COMPANY NAME

INVESTMENT & DEVELOPMENT OFFICE GOVERNMENT OF RAS AL KHAIMAH

UAE

PROJECT SUMITTED BY

KHURRUM IQBAL EXECUTIVE MBA (FINANCE)

PROJECT GUIDE

DR. RAJESH PUARKAR DIRECTOR UOP UAE – RAK CAMPUS

PROJECT SUBMITTED TO

UNIVERSITY OF PUNE UAE CAMPUS

RAS AL KHAIMAH

ACADEMIC YEAR

2009-2011

i

ACKNOWLEGEMENTS

In the name of Allah the most gracious & merciful.

I dedicate this project to my parents, my wife who give me the real insight and thought

about Islam & and to my office colleagues, friends and honorable teachers who make

this possible for me.

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Contents .................................................................................................................... iii Certificate from the Company

Certificate of University .............................................................................................................................. iv

List of Figures ............................................................................................................................................... v

EXECUTIVE SUMMARY ............................................................................................................................ 1

VISIT & SURVEY OF FINANCIAL INSTITUTIONS ................................................................................ 4

SCOPE .......................................................................................................................................................... 5

DATA ANALYSIS ......................................................................................................................................... 6

Non-Banking Islamic Products ............................................................................................................... 6

Islamic Investment Funds ..................................................................................................................... 14

Banking Institutions ................................................................................................................................ 19

Conventional Banks versus Islamic Banks ........................................................................................ 20

FACTORS DRIVING FUTURE GROWTH OF ISLAMIC FINANCE ................................................... 25

Human resource for Shariah compliance ........................................................................................... 27

Unresolved Fiqh Issues ......................................................................................................................... 27

Legal framework ..................................................................................................................................... 27

Excess Liquidity ...................................................................................................................................... 27

Technology .............................................................................................................................................. 27

Islamic Banking — Possible solutions ................................................................................................ 28

CONCLUSIONS ......................................................................................................................................... 29

Annexure/Appendix .................................................................................................................................... 30

Islamic Economic Fundamentals ......................................................................................................... 30

Islamic Financial Terminologies ........................................................................................................... 31

Islamic Shariah Board ........................................................................................................................... 33

Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) ...................... 34

Top 10 Islamic funds by key Performance statistics ......................................................................... 35

Bibliography ................................................................................................................................................ 37

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iii Certificate from the Company

Certificate from the Company

C E R T I F I C A T E

This is to certify that Mr. Khurrum Iqbal holder of Pakistani passport number AR1336642,

Executive MBA (Final Year) student of University of Pune – UAE campus RAK, is our

employee working in a capacity of Office Accountant.

He has submitted this report to his own research, Investment & Development Office,

Government of Ras Al Khaimah has no obligation and responsibility for the outcome of

this report.

Certified by:

_________________________

Jim Stewart

Chief Executive Officer

iv

iv Certificate of University

Certificate of University

C E R T I F I C A T E

This is to certify that Mr. Khurrum Iqbal (Permanent Registration No. 2120801009) holder

of Pakistani passport number AR1336642, Executive MBA (Final Year) student of

University of Pune, UAE Campus RAK, has worked on the Project Title ISLAMIC

FINANCE during the period from 1st October 2010 to 10th December 2010. He has

carried out the above project work as per the University guidelines and worked sincerely.

………………………………………….

Signature & name of the Student

Name of the Project Guide: Dr. Rajesh Puharkar

Signature of the External Examiner……………………………………….

Date: 17th December 2010

Place: Ras Al Khaimah - UAE

v

v

List of Figures

Figure Description Page Ref.

1 Stages of Evolution of Islamic Finance 1

2 Global Sukuk Issuance 6

3 Sukuk Issuance by Type 7

4 Islamic Funds Launched by Assets Class 9

5 Global Takaful Contribution 10

6 Takaful Mechanism 12

7 Mechanism of Murabahah Fund 18

8 Key Players in Islamic Banking Market 19

9 Percentage of Market Share and Growth in Assets of Islamic Banks and Conventional Banks

20

10 Impact of Global Crises on Islamic Finance 21

11 Market Share of Islamic and Conventional Bank Assets in 2008 23

12 Market Penetration of Islamic Banks in GCC 24

13 GCC’s Breakdown of Total Banking Assets 24

14 Top 10 Countries by Value of Shariah-Compliant Assets, 2009 26

15 Geographical Distribution of Reported Shariah Assets, GCC, 2009 26

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1 EXECUTIVE SUMMARY

EXECUTIVE SUMMARY

The Islamic Finance (IF) is not at all a new concept. It is a concept which is addressed

by many in the changing world order. The economy is diversified from culture to culture

from Europe to Asia, and from one religious believes to another.

In early 1970s (Figure 1) when the concept of banking without interest was introduced,

the majority of people considered it a novelty. It took almost thirty years to implement

Islamic banking in practice, with the Dubai Islamic Bank becoming the first full-fledged

Islamic finance bank (UAE perspective).

Figure 1: Islamic Financial Services: Stages of Evolution in Islamic Finance

Institutions Products Area

Commercial Islamic Banks Commercial Islamic banking products Gulf/Middle East

Takaful Takaful Asia Pacific

Islamic investment companies Mutual funds/unit trust Europe/Americas

Islamic investment banks Islamic Bonds Global/Offshore Market

Asset management companies Shariah – compliant stocks

e-commerce Islamic stock broking

Broker/bankers

Commercial Islamic Banks Commercial Islamic banking products Gulf/Middle East

Takaful Takaful Asia Pacific

Islamic investment companies Mutual funds/unit trust

Broker/bankers Islamic Bonds

Shariah – compliant stocks

Islamic stock broking

Commercial Islamic Banks Commercial Islamic banking products Gulf/Middle East

Takaful Takaful Asia Pacific

Islamic investment companies

Commercial Islamic Banks Commercial Islamic banking products Gulf/Middle East

Source: World Islamic Funds and Capital Markets Conference, May 2006, Bahrain

2000s

1990s

1980s

1970s

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2 EXECUTIVE SUMMARY

There are shariah scholars who provide the religious foundation based on Islamic

Jurisprudence and the practices instituted by earlier scholars. They endeavor to translate

and rationalize the long-standing practices into contemporary usage. Islamic finance is

unique because of its interdisciplinary nature.

Islamic finance is one of the fastest growing segments of global financial industry. In

some countries, it has become systemically important and, in many others, it is too big to

be ignored. Several factors have contributed to the strong growth of Islamic finance,

including:

i. strong demand in many Islamic countries for Shariah-compliant products;

ii. progress in strengthening the legal and regulatory framework for Islamic finance;

iii. growing demand from conventional investors, including for diversification

purposes; and

iv. The capacity of the industry to develop a number of financial instruments that

meet most of the needs of corporate and individual investors.

It is estimated that the size of the Islamic banking industry at the global level was close

to US$820 billion at end-2008 according to International Finance Supervisory Board

2010.

The area of research is Islamic Finance, which mainly focuses on the establishment and

implementation of Islamic Financial System in the economy, as per the principals led by

Shariah (Islamic Jurisprudence) in the light of Quran & Sunna, proposed by Islamic

Jurists and Scholars. Under the Islamic system ‘Riba’ (interest) is haram (prohibited),

unlike in conventional financial system.

Project Scope

The scope of the project to oversee the current trends of Islamic and Non Islamic

(conventional) products, key players in both Banking & Non-Banking Financial

Institutions and countries promoting Islamic Finance.

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3 EXECUTIVE SUMMARY

Research Methodology

The methodology for primary research is based on currently available past data of

Islamic and Non Islamic Financial Institutions. The sample size taken in this research is

limited to 10 leading Islamic countries, promoting Islamic Finance in particular and non-

Islamic products and services in general.

For secondary research and in-depth analysis, 5 leading banking and non-banking

financial institutions have been taken, while discussing their product base, and market

capitalization and competition, in comparison to Islamic & Non Islamic products.

Risks & Limitation

The sub-prime limitation of the project is non-availability of current consolidated data and

statistics, of both Islamic & Non Islamic Financial Institutions from authentic and non-

speculative market source.

Since Islamic Finance is in its emerging phase, it is hard to avoid associated risks; one of

the major risks is market acceptability and challenges to compete with conventional

economic system.

To mitigate these risks some leading Islamic Finance Professionals have posted their

Speeches and Scholarly articles on various websites.

Objectives

The main objective of the project is to highlights the global impact on the Islamic System

and the economic challenges to be faced in transforming conventional financial system

into Islamic Financial System.

Conclusion & Outcome

The outcome of the research to evaluate future market demand for Islamic products and

services in the economy.

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4 VISIT & SURVEY OF FINANCIAL INSTITUTIONS

VISIT & SURVEY OF FINANCIAL INSTITUTIONS

Primary Research & Survey

The purpose of the visit of the following financial institutions to know about current

market trends and products offering from conventional (Non-Islamic) to Islamic Products

and services.

Abu Dhabi Islamic Bank (UAE)

National Bank of Abu Dhabi (UAE)

Emirates Islamic Bank (UAE)

Oman Insurance (Takaful)

Noor Islamic Bank (Wakala Deposits)

Secondary Research & Survey

The secondary research is based on internet blogs and research articles posted the

various websites.

Dubai Islamic Bank

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5 SCOPE

SCOPE

The scope of the project is comprised of banking and non-banking financial institutions of

both Islamic Finance and non-Islamic and conventional financial institutions. The period

coverage for the analysis purposes is starting from 2004 to 2010.

The project is limited to UAE in particular and other Islamic countries in general.

The Islamic Countries which are discussed in this report are:

Gulf Region

Bahrain

UAE

Kuwait

Saudi Arabia

Oman

Qatar

Levant

Jordan

Turkey

South East Asia

Pakistan

Malaysia

Islamic Finance Institution have taken the form of commercial banks, investment banks,

insurance companies, funds management companies and other financial services

companies. Current estimates of the total number of IFIs world-wide range from 400 to

600.

In Asia, the most prominent IFIs are currently found in Malaysia, such as Bank Rakyat,

Maybank Islamic Berhad, BIMB Holdings, CIMB Islamic Bank Berhad and Public Bank

Islamic Berhad. Of the global conventional banks operating in Asia, HSBC Amanah, the

Islamic finance division of HSBC established in 1998, has a high profile operation as

does Standard Chartered Bank through Standard Chartered Saadiq.

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6 DATA ANALYSIS

DATA ANALYSIS

Non-Banking Islamic Products

ISLAMIC BOND (SUKUK)

In 2009, according to S&P, the ratio rose even more and is likely to do so again this year.

Those in the capital markets may have drawn solace from the fact that the value of

sukuk, or Islamic bonds, issued worldwide during 2009 rebounded to $23.3 billion, up

from a paltry $14.9bn the year before. The total was still short of the record value of

$34.3bn seen in 2007. (Figure 2)

Figure 2: Global Sukuk Issuance

Asian issuers accounted for more than 60 per cent of the total value of sukuk issued

around the world in 2009, with Malaysia alone making up just over half of the total. Last

year’s partial revival in the market brought the total value of Islamic bonds issued so far

to $100 billion, a landmark of significance to be sure.

About $20 billion-worth of sukuk are reckoned to be in the pipeline, with a further $10

billion or so being talked about if the market keeps its calm. If so, that could bring the

total value of bonds issued this year close to the record achieved in 2007. The default of

two sukuks issued by Saad Group of Saudi Arabia and Kuwait’s Investment Dar –

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7 DATA ANALYSIS

unsettled issuers and investors alike. A third issue – by Nakheel of Dubai – was rescued

at the last minute by the federal government in Abu Dhabi.

Figure 3: Sukuk Issuance by Type

It is worth noting, too, that governments and entities related to governments, accounted

for most of the issuance of Islamic bonds during 2009. This is good in one way because

it gives the market more breadth and depth. The more sukuk that governments issue, the

easier it is for riskier borrowers to price their own issues thanks to the benchmark

established by the sovereign or quasi-sovereign sukuk.

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8 DATA ANALYSIS

ISLAMIC INVESTMENT EQUITY FUNDS

Islamic investment equity funds market is one of the fastest-growing sectors within the

Islamic financial system. Currently, there are approximately 100 Islamic equity funds

worldwide. The total assets managed through these funds currently exceed US$5 billion

and is growing by 12–15% per annum. With the continuous interest in the Islamic

financial system, there are positive signs that more funds will be launched.

Despite these successes, this market has seen a record of poor marketing as emphasis

is on products and not on addressing the needs of investors. Over the last few years,

quite a number of funds have closed down. Most of the funds tend to target high net

worth individuals and corporate institutions, with minimum investments ranging from

US$50,000 to as high as US$1 million. Target markets for Islamic funds vary; some cater

for their local markets, e.g., Malaysia and Gulf-based investment funds. Others clearly

target the Middle East and Gulf regions, neglecting local markets and have been

accused of failing to serve Muslim communities.

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9 DATA ANALYSIS

Figure 4: Islamic Funds launched by Assets Class

Islamic asset managers have to learn to adapt to survive, amid stagnating asset pools,

investor risk aversion and crimped liquidity. The past year has been tough for the Middle

East’s asset management industry generally, and the Sharia-compliant sector has not

been spared the pain. If anything, asset management is the sector that has been hit

harder than others in the Sharia-compliant sphere. According to the Ernst & Young

Islamic Funds & Investment Report 2010, released in May, global Islamic fund assets

stagnated at $52.3 billion in 2009, barely registering an increase on the $51.4bn posted

in 2008. In contrast, the global conventional mutual fund assets under management

exhibited signs of recovery from their lows of $19 trillion in 2008, reaching $22 trillion in

2009. The research reveals that only 29 new Islamic funds were launched in 2009,

almost offsetting the 27 Islamic funds that were liquidated during the same period. This

compares to 173 that were launched in the market’s 2007 peak.

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10 DATA ANALYSIS

ISLAMIC TAKAFUL

As a nascent, specialized sector in its first years of significant growth, the takaful

industry, one might think, had particular reason to fear the global economic downturn.

However, almost two years since the collapse of US investment bank Lehman Brothers

sparked the credit crunch, the global value of takaful contributions continue to show

double digit growth, and according to consultants Ernst & Young will reach almost $9

billion this year.

Figure 5: Global Takaful Contribution

Bullish growth in the number of firms offer takaful and re-takaful – insurance and re-

insurance which complies with Sharia seems to support the idea that the sector has a

bright future in an Islamic world which remains severely underinsured. Perhaps the

closest conventional corollary to the takaful industry is that of the co-operative insurance

industry. In common with that branch of the insurance sector, takaful sees participants

pool their funds together to insure one another. Liability is spread among the funds policy

holders and any losses divided between them meaning, in the words of Ernst & Young

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11 DATA ANALYSIS

that ‘policyholders are both the insurer and the insured’. The structure of a takaful fund

adheres to the Islamic principle of Ta’awun (mutual assistance) and all investments must

use instruments free of Riba, or interest. However, the tumultuous events of the last two

years have left the industry far from unscathed, and it now must meet the challenges of

any embryonic enterprise building scale, establishing an identity, and achieving

sustainable profits – against an economic backdrop which is likely to remain difficult in

the near term.

Takaful companies may have been prohibited from investing in the toxic financial

derivatives which humbled conventional giants like AIG, but the resultant fall in asset

prices caused by the downturn has negatively affected the investment portfolios of many

firms. With this, the onus is now on firms to find operating efficiencies, and even more

pressingly, build scale – something which will likely only be achieved by mergers and

acquisitions. This will likely be complicated by the fact that different regulatory

environments in different countries both within and outside the Gulf Co-operation Council

(GCC) add an added layer of difficulty to cross-border transactions.

The way that different regulations have given rise to different operating models in the

takaful industry is most apparent when one contrasts the way the industry has developed

in the GCC, with the path taken by Malaysian takaful operators. There are several

significant differences between the two jurisdictions in the way that takaful operators

conduct their business.

Ernst & Young’s World Takaful Report 2010 finds GCC takaful operators have been hit

harder by the financial crisis than their Malaysian counterparts. Its data shows that

whereas a sample of Gulf takaful operators could point to an average return on equity

(ROE) of 10 per cent in 2005, by 2009 that figure was minus 6.5 per cent. Over the same

period, a sample of Malaysian operators saw their ROE rise from 1.6 per cent to 7.6 per

cent. While Malaysian firms can take heart from their resilience during the global

financial crisis, the results of several GCC firms leave more to be desired, in no small

part due to operating models which has prioritized the investment side of insurance over

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12 DATA ANALYSIS

developing expertise in the underwriting skills which are the cornerstone of the business.

In recent years GCC takaful companies have been heavily reliant on income from their

investments, but an exposure to asset classes badly affected by the downturn until 2009

two thirds of investments were in real estate has seen the average yield on investments

fall from 35.1 per cent in 2005 to just 3.5 per cent in 2009.

Figure 6: Takaful Mechanism

Their rush to acquire market share in the face of growing regional contribution has also

seen Gulf companies look to undercut rivals, with the result that questions have been

raised about the quality of their customer base.

Meanwhile, takaful operators in Malaysia have focused on developing a strong

underwriting capacity and with it the ability to better gauge the risks presented by each

particular customer. As a result, Malaysian takaful firms are increasingly confident about

retaining a larger proportion of their actual business on their own books. In contrast,

Ernst & Young found that GCC operators cede between 30 and 50 per cent of their gross

premiums to re-takaful companies – the Sharia compliant equivalent of conventional re-

Expenses Claim Retakaful

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13 DATA ANALYSIS

insurance companies. Insurers look to reduce their exposure to losses by transferring

risk to such firms.

However, the fact that takaful operators in the Gulf cede such a high proportion of their

premiums to retakaful companies reduces their ability to generate strong income from

underwriting and has left them overly reliant on investment returns to generate

profitability. With investment returns under real pressure in these straitened times, the

development of underwriting skill sets would avoid GCC-based takaful companies

effectively handing such a large proportion of their potential returns to a re-takaful firm.

By way of comparison, in Malaysia operators generally cede less than 15 per cent of

their gross premiums to the re-takaful sector. By keeping most of the risk on their own

books, Malaysian operators have had to develop stringent underwriting techniques to

avoid damaging losses. They have been rewarded for this with an average claims ratio

of between 25 to 35 per cent – compared to a GCC average which ranges between 40

and 60 per cent.

Gulf takaful firms have focused on the investment returns side of the business at the

expense of the underwriting side in part to satisfy shareholder expectations. As the

industry moves forward, managing such expectations will be a crucial part of the job

description of the executive management of those firms who aspire to lead the pack. The

days of 20 per cent returns are not likely to come back any time soon.

But if firms must be frank with shareholders, they must also maintain their

communication with potential customers, and the suspicion lingers that the industry is

still grasping for an identity, and a simple way of presenting the tangible benefits of its

Sharia-compliant practices to those either oblivious to the benefits of insurance, or used

to dealing with conventional operators. The future for the industry will require, perhaps

counter-intuitively, both further diversification and specialization. Takaful firms have

concentrated heavily on the industry’s low hanging fruit, with analysts warning that at

some firms a single sector, such as motor takaful, accounts for 80 per cent of their

premiums. As companies look to achieve a better business mix, sectors such as life

coverage, and products serving the construction industry, including covering contractors

and customers against financial losses incurred when projects are delayed or cancelled

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14 DATA ANALYSIS

offer new opportunities. Equally, while in the conventional markets specialist operators

focus on particular segments, such as, for example, only catering to female customers,

such firms are conspicuous by their absence in the takaful sector. By focusing on a

particular type of customer believed to carry lower risk than others, firms may be

confident they can achieve better underwriting results.

Islamic Investment Funds

The term "Islamic Investment Fund" means a joint pool wherein the investors contribute

their surplus money for the purpose of its investment to earn halal profits in strict

conformity with the precepts of Islamic Shariah. The subscribers of the Fund may receive

a document certifying their subscription and entitling them to the pro-rated profits actually

accrued to the Fund. These documents may be called "certificates" "units" "shares" or

may be given any other name, but their validity in terms of Shariah, will always be

subject to two basic conditions:

1. Instead of a fixed return tied up with their face value, they must carry a pro-rated

profit actually earned by the Fund. Therefore, neither the principal nor a rate of profit

(tied up with the principal) can be guaranteed. If the Fund earns huge profits, the

subscribers will earn profits to according to the proportion of Investment however, in

case the Fund suffers loss, they will have to share it also, unless the loss is caused

by the negligence or mismanagement, in which case the management, and not the

Fund, will be liable to compensate it.

2. Second, the amounts so pooled together must be invested in a business acceptable

to Shariah. It means that not only the channels of investment, but also the terms

agreed with them must conform to the Islamic principles.

Keeping these basic requisites in view, the Islamic Investment Funds may accommodate

a variety of modes of investment which are discussed briefly in the following paragraphs.

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15 DATA ANALYSIS

Equity Fund In an equity fund the amounts are invested in the shares of joint stock companies. The

profits are mainly achieved through the capital gains by purchasing the shares and

selling them when their prices are increased. Profits are also achieved by the dividends

distributed by the relevant companies.

It is obvious that if the main business of a company is not lawful in terms of Shariah, it is

not allowed for an Islamic Fund to purchase, hold or sell its shares, because it will entail

the direct involvement of the shareholder in that prohibited business.

Similarly the contemporary Shariah experts are almost unanimous on the point that if all

the transactions of a company are not in full conformity with Shariah, which includes that

the company borrows money on interest nor keeps its surplus in an interest bearing

account, its shares can be purchased, held and sold without any hindrance from the

Shariah side.

Ijarah Fund

Another type of Islamic Fund may be an Ijarah fund. Ijarah means leasing. In this fund

the subscription amounts are used to purchase assets like real estate, motor vehicles, or

other equipment for the purpose of leasing them out to their ultimate users. The

ownership of these assets remains with the Fund and the rentals are charged from the

users. These rentals are the source of income for the fund which is distributed prorated

to the subscribers. Each subscriber is given a certificate to evidence his subscription and

to ensure his entitlement to the pro-rated share in the income. These certificates may be

preferably called "Sukuk" -- a term recognized in the traditional Islamic jurisprudence.

Since these sukuk represent the pro-rated ownership of their holders in the tangible

assets of the fund, and not the liquid amounts or debts, they are fully negotiable and can

be sold and purchased in the secondary market. Anyone who purchases these sukuk

replaces the sellers in the pro-rated ownership of the relevant assets and all the rights

and obligations of the original subscriber are passed on to him. The price of these sukuk

will be determined on the basis of market forces, and are normally based on their

profitability.

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16 DATA ANALYSIS

However, it should be kept in mind that the contracts of leasing must conform to the

principles of Shariah which substantially differ from the terms and conditions used in the

agreements of the conventional financial leases. The leased assets must have some

usufruct, and the rental must be charged only from that point of time when the usufruct is

handed over to the lessee.

1. The leased assets must be of a nature that their halal (permissible) use is possible.

2. The lessor must undertake all the responsibilities consequent to the ownership of the

assets.

3. The rental must be fixed and known to the party’s right at the beginning of the

contract. In this type of the fund the management should act as an agent of the

subscribers and should be paid a fee for his services. The management fee may be a

fixed amount or a proportion of the rentals received.

Commodity Fund Another possible type of Islamic Funds may be a commodity fund. In the fund of this type

the subscription amounts are used in purchasing different commodities for the purpose

of the resale. The profits generated by the sale are the income of the fund which is

distributed pro-rated among the subscribers. In order to make this fund acceptable to

Shariah, it is necessary that all the rules governing the transactions and fully complied

with. For example:

1. The commodity must be owned by the seller at the time of sale, therefore, short sales

where a person sells a commodity before he owns it are not allowed in Shariah.

2. Forward sales are not allowed except in the case of salam and istisna'

3. The commodities must be halal, therefore, it is not allowed to deal in wines, pork, or

other prohibited materials.

4. The seller must have physical or constructive possession or the commodity he wants

to sell. (Constructive possession includes any act by which the risk of the commodity

is passed on to the purchaser).

5. The price of the commodity must be fixed and known to the parties. Any price which

is uncertain or is tied up with an uncertain event renders the sale invalid.

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17 DATA ANALYSIS

In view of the above and similar other conditions, it may easily be understood that the

transactions prevalent in the contemporary commodity markets, especially in the futures

commodity markets do not comply with these conditions. Therefore, an Islamic

Commodity Fund cannot enter into such transactions. However, if there are genuine

commodity transactions observing all the requirements of Shariah, including the above

conditions, a commodity fund may well be established. The units of such fund can also

be traded in with the condition that the portfolio owns some commodities at all times.

Murabahah Fund

"Murabahah" is a specific kind of sale where the commodities are sold on a cost-plus

basis. This kind of sale has been adopted by the contemporary Islamic banks and

financial institutions as a mode of financing. They purchase the commodity for the benefit

of their clients, and then sell it to them on the basis of deferred payment at an agreed

margin of profit added to the cost. If a fund is created to undertake this kind of sale, it

should be a closed-end fund and its units cannot be negotiable in a secondary market.

The reason is that in the in the case Murabahah, as undertaken by the present financial

institutions, the commodities are sold to the clients immediately after their purchase from

the original supplier, while the price being on deferred payment basis becomes a debt

payable by the client. Therefore, the portfolio of Murabahah does not own any tangible

assets, rather it comprises of either cash or the receivable debts, and both these things

are not negotiable, as explained earlier. If they are exchanged for money, it must be at

par value.

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18 DATA ANALYSIS

Figure 7: Mechanism of Murabahah Fund

Mixed Fund

Another type of Islamic Fund maybe of a nature where the subscription amounts are

employed in different types of investments, like equities, leasing, commodities, etc. This

may be called a Mixed Islamic Fund. In this case if the tangible assets of the Fund are

more than 51% while the liquidity and debts are less than 50% the units of the fund may

be negotiable. However, if the proportion of liquidity and debts exceeds 50%, its units

cannot be traded in according to the majority of the contemporary scholars. In this case

the Fund must be a closed-end Fund.

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19 DATA ANALYSIS

Banking Institutions

The countries of the Gulf Cooperation Council (GCC) have the largest Islamic banks (IBs).

The market share of Islamic finance in the banking systems of the GCC countries at end-

2008 was in the range of 11−35 percent, compared with 5−24 percent in 2004. While Islamic

banking remains the main form of Islamic finance Islamic insurance companies (Takaful),

mutual funds and the sukuk have also witnessed strong global growth.

• Islamic banking is one of the fastest growing industry segments in the Financial

Services sector

• Growth momentum, both in the Arab world and globally, estimated at plus 20% p.a.

• Approximately 400 Islamic institutions globally with assets in excess of US$ 500

billion

• More than US$ 20 billion in international Islamic bond issuance to date

• Targeted regions include GCC, South Asia, South East Asia and select niche

markets

• Entry by Global Commercial/ Investment banks in this sector

Figure 8: Key Players in Islamic Banking Market

Standard & Poor’s (S&P), notes that the weighted average of non-performing facilities

(mostly murabaha and ijara transactions) to total financing of the five largest Islamic

banks in the Gulf was just over 5% at the end of 2008, up from 3% the year before.

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20 DATA ANALYSIS

Conventional Banks versus Islamic Banks

The countries of the Gulf Cooperation Council (GCC) have the largest Islamic banks

(IBs). The market share of Islamic finance in the banking systems of the GCC countries

at end-2008 was in the range of 11−35 percent, compared with 5−24 percent in 2004.

While Islamic banking remains the main form of Islamic finance Islamic insurance

companies (Takaful), mutual funds and the sukuk have also witnessed strong global

growth.

Figure 9: Percentage of Market Share and Growth in Assets of Islamic Banks and Conventional Banks

The recent global crisis has renewed the focus on the relationship between Islamic

banking and financial stability and, more specifically, on the resilience of the Islamic

banking industry during crises. Industry specialists and academics have taken note of

the strong growth in Islamic banking in recent years. Some have argued that the lack of

exposure to the type of assets associated with most of the losses that many conventional

banks (CBs) experienced during the crisis and the asset-based and risk-sharing nature

of Islamic finance have shielded Islamic banking from the impact of the crisis. Others

have argued that IBs, like CBs, have relied on leverage and have undertaken significant

risks that make them vulnerable to the second round effect of the global crisis.

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21 DATA ANALYSIS

Figure 10: Impact of Global Crises on Islamic Finance

Comparing the performance of IBs to CBs globally would suggest that IBs performed

better, given the large losses incurred by CBs in Europe and the US as a result of the

crisis. However, such a comparison would not lead to reliable conclusions about financial

stability and the resilience of the Islamic banking sector because it would not allow for

appropriate control for varying conditions across financial systems in countries where IBs

operate. For example, this comparison might not reflect the moderate impact of the crisis

on the GCC, Jordan, and Malaysia.

To assess the impact of the crisis, the paper uses bank-level data covering 2007−10 for

about 120 IBs and CBs in eight countries Bahrain (including offshore), Jordan, Kuwait,

Malaysia, Qatar, Saudi Arabia, Turkey, and the UAE. These countries host most IBs

(more than 80 percent of the industry, excluding Iran) and have a large CB sector. The

key variables used to assess the impact are the changes in profitability, bank lending,

bank assets, and external bank ratings.

The evidence shows that, in terms of profitability, IBs fared better than CBs in 2008.

However, this was reversed in 2009 as the crisis hit the real economy. IBs‘ growth in

credit and assets continued to be higher than that of CBs in all countries, except the

UAE. Finally, with the exception of the UAE, the change in IBs‘ risk assessment, as

reflected in the rating of banks by various rating agencies, has been better than or similar

22

22 DATA ANALYSIS

to that of CBs. Hence, IBs showed stronger resilience, on average, during the global

financial crisis.

Factors related to IBs‘ business model helped contain the adverse impact on profitability

in 2008, while weaknesses in risk-management practices in some IBs led to larger

declines in profitability compared to CBs in 2009. Thanks to their lower leverage and

higher solvency, IBs were able to meet a relatively stronger demand for credit and

maintain stable external ratings.

To address the lack of adequate information, bank-level data were collected for CBs and

IBs in Bahrain (including offshore), Jordan, Kuwait, Malaysia, Qatar, Saudi Arabia,

Turkey, and the UAE. These countries were chosen because of the importance of IBs in

their banking systems and data availability. The database includes about 120 CBs and

IBs, of which about one-fourth are Islamic. The sample covers over 80 percent of IBs

globally if Iran is excluded.

Countries differ in terms of Islamic banking model and market structure. For example, in

Jordan, Kuwait, and Turkey, CBs do not have Islamic windows. The Bahraini wholesale

(offshore) banks are largely involved in investment activities and are not regulated as

rigorously as domestic (retail) banks. Indeed, by covering Bahrain offshore activities, the

sample includes an important part of investment banking. The Malaysian IBs included in

the sample are all subsidiaries of CBs. Five countries (Turkey, Saudi, the UAE, Malaysia,

and Kuwait) represent about 85 percent of the sample total assets and about 77 percent

of the IB market shares (Figure 12). Islamic banking activities conducted by CBs are not

captured in sample due to lack of reliable data.

The assets (loans) boasted by the world’s top 500 Islamic banks rise to a total of $822

billion during 2009, compared with $639 billion the year before. The value of those of

banks in the six countries of the Gulf Co-operation Council (GCC) reached a total of

$285 billion at the last count. That gives them 22 per cent of the worldwide market for

Islamic finance, more than double the total five years earlier.

23

23 DATA ANALYSIS

Figure 11: Market Share of Islamic and Conventional Bank Assets in 2008

More important still is the fact that banks complying with Sharia now account for just over

a quarter of all banking assets within the GCC. Yet this is still less than the share of

Islamic assets accounted for by the Islamic windows of conventional banks.

This is the certainly true for asset management. According to consulting firm Ernst &

Young most new products and services unveiled recently by asset managers complying

with Sharia were aimed at institutional, not retail, customers. Either Islamic fund

managers have yet to find the right formula or retail customers are reluctant to part with

their cash. The result is that Islamic funds under management still account for a mere 5.5

per cent of the total market for finance complying with Sharia.

24

24 DATA ANALYSIS

Small wonder then that the value of assets worldwide held by funds complying with

Sharia, at $52 billion, remained more or less flat during 2009. Or that the industry itself

faces difficult choices. Some 70 per cent of firms managing Islamic funds have less than

$100 million under their charge.

Figure 12: Market penetration of Islamic Banks GCC Figure 13: GGC’s Breakdown of Total Banking Assets

25

25 FACTORS DRIVING FUTURE GROWTH OF ISLAMIC FINANCE

FACTORS DRIVING FUTURE GROWTH OF ISLAMIC FINANCE

Dynamic growth in Islamic finance will be driven by the following.

Rising oil revenue and strong economic growth of the Gulf: In the past few years,

economic growth in the GCC has been robust on the back of higher oil prices. The GCC

holds around half of the world’s known oil reserves, and oil earnings account for 70 per

cent of the GCC’s exports and revenues.

The substantial petrodollar liquidity in the Gulf economies has meant that petrodollar

investors are increasingly seeking to invest in offshore assets, a proportion of which is

sought in the form of Shariah-compliant financial assets. In addition, the GCC is planning

massive infrastructure and construction spending of US$1.4 trillion from 2009-2015

which will require financing.

Demand from Muslim and non-Muslim investors: Investors from the Middle East and

Asia are increasingly seeking to invest in products that are compliant with their religious

beliefs. Surveys suggest that half of the Muslims world-wide would opt for Islamic finance

if given a competitive alternative to conventional services.

Low penetration levels: In spite of the growth in the Islamic banking and finance

industry, there remains a lack of depth across asset classes and products, signifying

untapped potential. In particular, countries such as Indonesia, India and Pakistan which

have the largest Muslim populations in the world are not considered to have well-

developed Islamic banking and finance industries.

Ethical character and financial stability of products: Islamic finance is attracting

attention in a world of increasing corporate social responsibility. IFIs have not invested in

impaired asset classes that have hampered many conventional banks’ financial profiles

and performance recently. According to Standard & Poor’s, Islamic commercial banks

recorded a ratio of liquid assets to total assets of 19.9 per cent at 30 September 2008,

and although this ratio declined in the first quarter of 2008, it remained adequate.

26

26 FACTORS DRIVING FUTURE GROWTH OF ISLAMIC FINANCE

Key countries for Islamic capital On a regional basis, the Middle East and Asia are the primary locations for Islamic

capital. In particular, the UAE, Bahrain and Malaysia are seen as the main canters of

Islamic finance, with significant activity also taking place in London.

FIGURE 14: TOP 10 COUNTRIES BY VALUE OF SHARIAH-COMPLIANT ASSETS 2009

FIGURE 15: GEOGRAPHICAL DISTRIBUTION OF REPORTED SHARIAH ASSETS, GCC, 2009

27

27 FACTORS DRIVING FUTURE GROWTH OF ISLAMIC FINANCE

ISLAMIC BANKING ISSUES

Human resource for Shariah compliance

Users of Islamic financial services assign primary importance to Shariah compliance of

the services they use. It is understandable that Shariah noncompliance entails a serious

operational risk and can result in withdrawal of funds from and instability of an Islamic

bank, irrespective of its initial financial soundness. Shariah compliance is hence a

serious matter for an Islamic bank, in addition to its compliance with other regulatory

requirements.

Unresolved Fiqh Issues

Lack of standard financial contracts and products can be a cause of ambiguity and a

source of dispute and cost. In addition, without a common understanding of certain basic

foundations, further development of banking products is hindered.

Legal framework

An appropriate legal, institutional and tax framework is a basic requirement for

establishing sound financial institutions and markets. Islamic jurisprudence offers its own

framework for the implementation of commercial and financial contracts and

transactions. Nevertheless, commercial, banking and company laws appropriate for the

enforcement of Islamic banking and financial contracts do not exist in many countries.

Excess Liquidity

Islamic banks have over 60 % excess liquid funds which cannot be properly utilized due

to non-availability of Shariah Compliant products and instruments.

The competitiveness and soundness of financial institutions depend on the availability of

efficient financial products. Islamic banks urgently need Shariah compliant products to

meet a number of pressing needs.

Technology

Designing technological solutions around a concept requires extensive knowledge of the

domain. Conventional banking today is technologically advanced; however, for crafting

Islamic financial solutions, considerable time and expertise are required.

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28 FACTORS DRIVING FUTURE GROWTH OF ISLAMIC FINANCE

Islamic Banking — Possible solutions

Establishment of Shari'ah Governance Systems

Settling unresolved Fiqh Issues

A sufficient number of well-trained, competent, high-caliber Islamic finance

professionals and management teams with the required expertise

Well-informed individual and corporate consumers, knowledgeable about Islamic

banking and takaful

The availability of Sharia'h compliant products (Sharia'h Compliant Stocks, Sukuks,

etc.)

Development of a Legal, Regulatory, and Institutional Framework complying with

Sharia'h

Advanced technology solutions designed to support Islamic Finance

29

29 CONCLUSIONS

CONCLUSIONS

As one of the fastest growing segments in global financial services, Islamic finance has

become systemically important in many markets and too big to ignore in others. While

conventional intermediation is largely debt-based and allows for risk transfer, Islamic

intermediation, in contrast, is asset-based, and centers on risk sharing. In addition to

providing IBs with additional buffers, these features make their activities more closely related

to the real economy and tend to reduce their contribution to excesses and bubbles.

Our analysis suggests that IFs fared differently than did CF (conventional Finance) during

the global financial crisis. Factors related to IBs‘ business model helped contain the adverse

impact on profitability in 2008, while weaknesses in risk management practices in some IBs

led to larger decline in profitability compared to CBs in 2009. In particular, adherence to

Shariah principles precluded IBs from financing or investing in the kind of instruments that

have adversely affected their conventional competitors and triggered the global financial

crisis. The weak performance in some countries was associated with sectorial/name

concentration and, in some cases, was facilitated by exemptions from concentration limits,

highlighting the importance of a neutral regulatory framework for IBs and CBs and

strengthening risk management in some banks.

Despite higher profitability during the pre-global crisis period (2005–07), IBs‘ average

profitability for 2008–09 was similar to that of CBs, indicating better cumulative (pre- and

post-crisis) profitability and suggesting that higher pre-crisis profitability was not driven by a

strategy of greater risk taking. Large IBs have fared better than small ones. Better

diversification, economies of scale, and stronger reputation might have contributed to this

better performance. This suggests that developing the industry and increasing competition

should be achieved through establishing large and well managed IBs that can compete with

existing banks.

IBs‘ credit and asset growth were at least twice higher than that of CBs during the crisis,

suggesting a growing market share going forward and larger supervisory responsibility.

External rating agencies’-assessment of IBs’ risk was generally more favorable or similar to

that of CBs. Higher solvency has facilitated meeting the relatively more robust demand for

Islamic banking finance and maintaining stable external ratings. Lending to the less affected

consumer sector has helped support strong credit and asset growth.

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30 Annexure/Appendix

Annexure/Appendix

Islamic Economic Fundamentals

The definition of riba in a classical Islamic jurisprudence was "surplus value without

counterpart, or to ensure equivalency in real value, and that "numerical value

was immaterial." During this period, gold and silver currencies were the benchmark

metals that defined the value of all other materials being traded.

The Quran prohibits gambling (games of chance involving money) and insuring ones'

health or property (also considered a game of chance). The hadith, in addition to

prohibiting gambling (games of chance), also prohibits bay al-gharar (trading in risk,

where the Arabic word gharar is taken to mean "risk" or excessive uncertainty).

There are four schools (or Madh'hab/factions) of Sunni Muslims are each named by

students of the classical jurist who taught them. The Sunni schools are:

Schools Scope & thought

Hanafi

These are comprise of Levant, Turkey, the Balkans, Central Asia, Indian

subcontinent, Iran, Afghanistan, China and Egypt. The Hanafi School in Islam

defines gharar as "that whose consequences are hidden." Ibn Hazm (Founder of

Hanafi school) wrote "Gharar is where the buyer does not know what he bought, or

the seller does not know what he sold."

Shafi'i

Followers of Shafi’i school are found in Yemen, Somalia, Djibouti, Eritrea, Ethiopia,

Southern Iran, Muslim Southeast Asia, Egypt, Swahili Coast, Maldives and southern

parts of India. The Shafi’i school defined gharar as "that whose nature and

consequences are hidden" or "that which admits two possibilities, with the less

desirable one being more likely."

Maliki

North Africa, the Muslim areas of West Africa, Kuwait, the United Arab Emirates and

Bahrain.

Hambali

According to Hambali school, gharar as "that whose consequences are unknown" or

"that which is undeliverable, whether it exists or not." Saudi Arabia and Qatar.

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31 Annexure/Appendix

Islamic Financial Terminologies

Term Explanation

Gharar

Gharar is the sale of probable items whose existence or characteristics

are not certain, due to the risky nature that makes the trade similar to

gambling.

Bai' Al 'Inah

(sale and buy-back

agreement)

It is a financing facility with the underlying buy and sells transactions

between the financier and the customer. The financier buys an asset from

the customer on spot basis. The price paid by the financier constitutes the

disbursement under the facility. Subsequently the asset is sold to the

customer on a deferred-payment basis and the price is payable in

installments. The second sale serves to create the obligation on the part of

the customer under the facility.

Bai' Bithaman Ajil (deferred payment sale)

Sale of goods on a deferred payment basis at a price, which includes a profit margin agreed to by both parties. Interest payment can be avoided as the customer is paying the sale price which is not the same as interest charged on a loan.

Bay mu’ajal (Pre-delivery, deferred payment)

The seller can sell a product on the basis of a deferred payment, in installments or in a lump sum. The price of the product is agreed upon between the buyer and the seller at the time of the sale, and cannot include any charges for deferring payment.

Bay salam (Pre-payment, deferred delivery)

The buyer pays the seller the full negotiated price of a product that the seller promises to deliver at a future date.

Ijara (Lease, lease purchase)

A party leases a particular product for a specific sum and a specific time period. In the case of a lease purchase, each payment includes a portion that goes toward the final purchase and transfer of ownership of the product.

Istisna (Deferred payment, deferred delivery)

A manufacturer (contractor) agrees to produce (build) and to deliver a certain good (or premise) at a given price on a given date in the future. The price does not have to be paid in advance (in contrast to bay salam). It may be paid in installments or part may be paid in advance with the balance to be paid later on, based on the preferences of the parties.

Kifala

It is a pledge given to a creditor that the debtor will pay the debt, fine or liability. A third party becomes surety for the payment of the debt if unpaid by the person originally liable.

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32 Annexure/Appendix

Islamic Financial Terminologies

Mudaraba (Trustee finance contract)

Rabb -ul- mal (capital’s owner) provides the entire capital needed to finance a project while the entrepreneur offers his labor and expertise. Profits are shared between them at a certain fixed ratio, whereas financial losses are exclusively borne by rabb -ul- mal. The liability of the entrepreneur is limited only to his time and effort.

Murabaha (Mark–up financing)

The seller informs the buyer of his cost of acquiring or producing a specified product. The profit margin is then negotiated between them. The total cost is usually paid in installments.

Musharaka (Equity participation)

The bank enters into an equity partnership agreement with one or more partners to jointly finance an investment project. Profits (and losses) are shared strictly in relation to the respective capital contributions.

Qard Hassana (Beneficence loans)

These are zero-return loans that the Qur’an encourages Muslims to make to the needy. Banks are allowed to charge borrowers a service fee to over the administrative expenses of handling the loan. The fee should not be related to the loan amount or maturity.

Musawamah

Musawamah is the negotiation of a selling price between two parties without reference by the seller to either costs or asking price. While the seller may or may not have full knowledge of the cost of the item being negotiated, they are under no obligation to reveal these costs as part of the negotiation process.

Hibah (gift)

This is a token given voluntarily by a debtor to a creditor in return for a loan. Hibah usually arises in practice when Islamic banks voluntarily pay their customers a 'gift' on savings account balances, representing a portion of the profit made by using those savings account balances in other activities.

Takaful (Islamic insurance)

Takaful is an alternative form of cover that a Muslim can avail himself against the risk of loss due to misfortunes. Takaful is based on the idea that what is uncertain with respect to an individual may cease to be uncertain with respect to a very large number of similar individuals. Insurance by combining the risks of many people enables each individual to enjoy the advantage provided by the law of large numbers.

Wadiah (safekeeping)

In Wadiah, a bank is deemed as a keeper and trustee of funds. A person deposits funds in the bank and the bank guarantees refund of the entire amount of the deposit, or any part of the outstanding amount, when the depositor demands it. The depositor, at the bank's discretion, may be rewarded with Hibah (see above) as a form of appreciation for the use of funds by the bank.

Sukuk (Islamic bonds)

Sukuk, is the Arabic term for financial certificates that are the Islamic equivalent of bonds. However, fixed-income, interest-bearing bonds are not permissible in Islam. Hence, Sukuk are securities that comply with the Islamic law (Shariah) and its investment principles, which prohibit the charging or paying of interest. Financial assets that comply with the Islamic law can be classified in accordance with their tradability and non-tradability in the secondary markets.

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33 Annexure/Appendix

Islamic Shariah Board

Islamic banks and banking institutions that offer Islamic banking products and services (IBS

banks) are required to establish a Shariah Supervisory Board (SSB) to advise them and to

ensure that the operations and activities of the banking institutions comply with Shariah

principles. On the other hand, there are also those who believe that no form of banking that

involves interest payments can ever comply with the Shariah.

The Shariah board is a key element of the structure of an Islamic financial institution, carrying the

responsibility of ensuring that all products and services offered by that institution are fully

compliant with the principles of Shariah law.

The role of the board also involves the reviewing and overseeing of all potential new product

offerings. Additionally, the board may be called on to make a judgment on individual cases

referred to it, relating to whether specific customer business requests are acceptable to the

institution.

Shariah law is derived from studies of both the Quran and the Sunna; with slight modifications

occur in the interpretations of precisely where the boundaries of compatibility lie, with the result

that some Shariah boards may deem unacceptable proposals that may be approved by other

boards.

With demand for shariah-compliant financial services growing at a faster rate than mainstream

banking, the board can also play a vital role in helping to develop new procedures and products

to position the institution to adapt to industry trends, and customers’ expectations. The board

should also be closely involved in overseeing Shariah-compliant training programs for

employees. Board members also participate in the preparation of an annual investors’ report on

the bank’s balance sheet, with particular reference to its compliance with Shariah principles.

Given the importance of the role of the Shariah boards in ensuring the conformity of the

institution’s offerings, boards typically include acknowledged experts, such as contemporary

Islamic scholars. It is common for such scholars to sit on the shariah boards of multiple

institutions; some senior scholars may sit on the boards of 15 or more institutions.

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34 Annexure/Appendix

Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI)

The AAOIFI was established in 1990 and is headquartered in Bahrain. Its main purpose

is to issue accounting and auditing standards and governance norms within the Islamic

finance sector.

As an independent international organisation, the AAOIFI is supported by institutional

members (200 members from 45 countries) including central banks, IFIs and other

participants in the international Islamic banking and finance industry.

AAOIFI standards have now been adopted by IFIs in many countries such as Bahrain,

UAE-Dubai, Jordan, Lebanon, Qatar, Sudan and Syria. The standards cover accounting,

auditing, corporate governance, capital adequacy and ethics. Future standards will

include corporate social responsibility and presentation and disclosure.

While the AAOIFI has introduced a range of accounting standards, many IFIs are

required to report to the market in accordance with local Generally Accepted Accounting

Principles (GAAP) or International Financial Reporting Standards (IFRS).

The treatment of Islamic products under local GAAP or IFRS may well differ from their

treatment under Islamic principles.

An external auditor of IFIs requires skill sets and experience that some accounting

organizations may not possess.

35

35 Annexure/Appendix

Top 10 Islamic funds by key Performance statistics

36

36 Annexure/Appendix

TOP 10 ISLAMIC FUNDS BY KEY PERFORMANCE STATISTICS – (Continue)

37

37 Bibliography

Bibliography

a. Annual Review of Islamic Banking & Finance – The Gulf Analysis of Banking & Finance November

2010.

b. The Effects of the Global Crisis on Islamic and Conventional Banks, A Comparative Study, by Maher Hasan and Jemma Dridi – International Monetary Fund Paper, September 2010

c. Islamic Finance – Austrade, Australian Government January 2010

d. Islamic Finance at a Crossroad (by Andrei Juravliov) International Conference Islamic Banking: specifics and prospects March 17 -18, 2009, Moscow.

e. Standard & Poors Islamic Finance Report 2008, Earnst & Young Islamic Finance & Banking Report 2009.

f. PriceWaterhouseCoopers Ireland (Sukuk - A Catalyst for growth of Islamic Finance) 2009, by Omer Khan (Manager) & Ken Ovens (Partner).

g. Islamic Terminologies explanation http://en.wikipedia.org/wiki/Islamic_banking

h. Top 10 Islamic Funds by performance Statistics, Islamic Finance news Guide 2008 http://www.eurekahedge.com