Islamic Finance

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

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

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

iii

Certificate of University iv

Certificate of University

CERTIFICATE

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

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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
Percentage of Market Share and Growth in Assets of Islamic Banks
9 20
and Conventional Banks
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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EXECUTIVE SUMMARY 1

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 2000s

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


Islamic investment companies Mutual funds/unit trust
Broker/bankers Islamic Bonds
Shariah – compliant stocks
Islamic stock broking


Islamic investment companies

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

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EXECUTIVE SUMMARY 2

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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EXECUTIVE SUMMARY 3

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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VISIT & SURVEY OF FINANCIAL INSTITUTIONS 4

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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SCOPE 5

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 Levant South East Asia
 Bahrain  Jordan  Pakistan
 UAE  Turkey  Malaysia
 Kuwait
 Saudi Arabia
 Oman
 Qatar

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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DATA ANALYSIS 6

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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DATA ANALYSIS 7

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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DATA ANALYSIS 8

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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DATA ANALYSIS 9

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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DATA ANALYSIS 10

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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DATA ANALYSIS 11

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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DATA ANALYSIS 12

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

Expenses Claim Retakaful

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-

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DATA ANALYSIS 13

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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DATA ANALYSIS 14

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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DATA ANALYSIS 15

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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DATA ANALYSIS 16

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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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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DATA ANALYSIS 18

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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DATA ANALYSIS 19

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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DATA ANALYSIS 20

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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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

21

DATA ANALYSIS 22

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.

22

DATA ANALYSIS 23

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.

23

DATA ANALYSIS 24

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

24

FACTORS DRIVING FUTURE GROWTH OF ISLAMIC FINANCE 25

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.

25


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

26


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.

27


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

28

CONCLUSIONS 29

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.

29

Annexure/Appendix 30

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

These are comprise of Levant, Turkey, the Balkans, Central Asia, Indian
subcontinent, Iran, Afghanistan, China and Egypt. The Hanafi School in Islam
Hanafi 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."

Followers of Shafi’i school are found in Yemen, Somalia, Djibouti, Eritrea, Ethiopia,
Southern Iran, Muslim Southeast Asia, Egypt, Swahili Coast, Maldives and southern
Shafi'i 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.

According to Hambali school, gharar as "that whose consequences are unknown" or
Hambali
"that which is undeliverable, whether it exists or not." Saudi Arabia and Qatar.

30


Islamic Financial Terminologies

Term Explanation

Gharar is the sale of probable items whose existence or characteristics
Gharar
are not certain, due to the risky nature that makes the trade similar to
gambling.

It is a financing facility with the underlying buy and sells transactions
between the financier and the customer. The financier buys an asset from
Bai' Al 'Inah
the customer on spot basis. The price paid by the financier constitutes the
(sale and buy-back
disbursement under the facility. Subsequently the asset is sold to the
agreement)
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 Sale of goods on a deferred payment basis at a price, which includes a
(deferred payment profit margin agreed to by both parties. Interest payment can be avoided
sale) as the customer is paying the sale price which is not the same as interest
charged on a loan.

Bay mu’ajal The seller can sell a product on the basis of a deferred payment, in
(Pre-delivery, installments or in a lump sum. The price of the product is agreed upon
deferred payment) between the buyer and the seller at the time of the sale, and cannot
include any charges for deferring payment.

Bay salam
The buyer pays the seller the full negotiated price of a product that the
(Pre-payment,
seller promises to deliver at a future date.
deferred delivery)

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

A manufacturer (contractor) agrees to produce (build) and to deliver a
Istisna
certain good (or premise) at a given price on a given date in the future.
(Deferred payment,
The price does not have to be paid in advance (in contrast to bay salam).
deferred delivery)
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.

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

31


Islamic Financial Terminologies

Mudaraba Rabb -ul- mal (capital’s owner) provides the entire capital needed to finance a
(Trustee finance project while the entrepreneur offers his labor and expertise. Profits are shared
contract) 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 The seller informs the buyer of his cost of acquiring or producing a specified
(Mark–up financing) product. The profit margin is then negotiated between them. The total cost is
usually paid in installments.

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

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

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
Musawamah
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.

This is a token given voluntarily by a debtor to a creditor in return for a loan.
Hibah (gift) 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 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
Takaful (Islamic
with respect to an individual may cease to be uncertain with respect to a very
insurance)
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.

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
Wadiah (safekeeping) 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, is the Arabic term for financial certificates that are the Islamic equivalent of
bonds. However, fixed-income, interest-bearing bonds are not permissible in
Sukuk
Islam. Hence, Sukuk are securities that comply with the Islamic law (Shariah) and
(Islamic bonds)
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.

32


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.

33


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.

34


Top 10 Islamic funds by key Performance statistics

35


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

36

Bibliography 37

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

37

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