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Master Thesis

MSc. in Finance & International Business

Academic Advisor:

Baran Siyahhan

Author:

Waheed Faiz

CHALLENGES AND OPPORTUNITIES ISLAMIC FINANCIAL INSTITUTIONS ARE FACING IN THE WESTERN COUNTRIES

Department of Business Studies

Aarhus School of Business

University of Aarhus

November 2011

AbstractNowadays, we hear about the resistance of Islamic finance to latest global financial crisis and

about the continuous growth of Islamic financial institutions. We can daily hear and see public

authorities in the western countries having some heated discussions about introducing Islamic

finance in their countries and on making amendments in their financial regulatory frameworks.

While these discussions continue, the establishment and growth of Islamic financial institutions

in these western countries, with prevailing conventional financial regulatory system, are under

question. This thesis tries to look closer at the measures to be taken and changes to be made from

both, the western regulatory authorities and Islamic financial institutions, in order to come up

with suggestions on how this problem could be solved, paving the way for the establishment and

growth of Islamic finance in these countries. First, the challenges Islamic financial institutions

are facing globally and particularly in the western countries are addressed and theoretically

analyzed. Then, in the same way opportunities are addressed and analyzed. The analysis shows

that Islamic finance has indeed some internal challenges, in the form of weak corporate

governance practices, lack of products for liquidity risk management, lack of standardization in

the products, and the relative small size of the majority of Islamic financial institutions compared

to conventional institutions. On the western regulatory authorities’ side, the analysis shows that

the existing regulatory framework is not compatible with Islamic financial institutions’

operations. This thesis suggests that first of all these regulatory authorities resolve the issues

related to double taxation and VAT of some IFIs’ products. It also suggests Islamic financial

institutions to address the above mentioned challenges in order to attract the positive attention of

the critics.

Key Words: Shariah, Islamic, Western, Regulatory, Riba

AbbreviationsIFI – Islamic Financial Institutions

CFI – Conventional Financial Institutions

AAOIFI – Accounting and Auditing Organization for Islamic Financial Institutions

IFSB – Islamic Financial Services Board

IMF – International Monetary Fond

WP – Working Paper

GCC - Gulf Cooperation Council

SPV – Special Purpose Vehicle

IIRA – Islamic International Rating Agency

IIFM – International Islamic Financial Market

IILM – International Islamic Liquidity Management

ISDA – International Swaps and Derivatives Association

OECD – Organization for Economic Co-operation and Development

LIBOR – London Inter Bank Offer Rate

DCR – Displaced Commercial Risk

IAH – Investment Account Holder

UIA – Unrestricted Investment Accounts

RIA – Restricted Account Holder

PER – Profit Equalization Reserve

IRR – Investment Risk Reserve

BCBS – Basel Committee on Banking Supervision

OIC – Organization of Islamic Cooperation

M&As – Mergers and Acquisitions

Table of ContentsAbstract....................................................................................................................................................... ii

Abbreviations.............................................................................................................................................. iii

1. Introduction.........................................................................................................................................3

1.1 Research Question.............................................................................................................................4

1.2 Delimitation.......................................................................................................................................5

1.3 Structure of the thesis.......................................................................................................................5

1.4 Methodology.....................................................................................................................................6

1.5 Data review........................................................................................................................................6

2 Literature review......................................................................................................................................7

2.1 The concept of Halal and Haram in Islam..........................................................................................7

2.2 Principles of Islamic finance...............................................................................................................8

2.2.1 Interest (Riba).............................................................................................................................8

2.2.2 Gharar.........................................................................................................................................8

2.2.3 Maysir.........................................................................................................................................9

2.3 Islamic finance products....................................................................................................................9

2.3.1 Partnership based mode of financing.......................................................................................10

2.3.2 Trade based modes of financing...............................................................................................11

2.3.3 Rental based modes of financing..............................................................................................13

2.4 Derivatives.......................................................................................................................................14

2.5 Insurance.........................................................................................................................................15

2.5.1 Takaful......................................................................................................................................16

2.6 Zakat................................................................................................................................................16

2.7 Sukuk...............................................................................................................................................17

2.8 Istisna...............................................................................................................................................18

2.9 Theory behind the Islamic finance...................................................................................................19

2.10 Leading organizations....................................................................................................................21

2.10.1 Shariah Boards........................................................................................................................22

2.10.2 AAOIFI.....................................................................................................................................23

2.10.3 IFSB.........................................................................................................................................23

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2.10.4 IIRA.........................................................................................................................................24

2.10.5 IIFM.........................................................................................................................................24

2.10.6 IILM.........................................................................................................................................25

3 Challenges and their possible solutions..................................................................................................26

3.1 Corporate governance.....................................................................................................................26

3.1.1 Agency theory...........................................................................................................................29

3.2 Risk Management............................................................................................................................30

3.2.1 Shariah compliance risk............................................................................................................31

3.2.2 Operational risk........................................................................................................................33

3.2.3 Market risk................................................................................................................................35

3.2.4 Credit risk..................................................................................................................................36

3.2.5 Liquidity risk..............................................................................................................................38

3.2.6 Displaced commercial risk........................................................................................................42

3.3 Central Banks...................................................................................................................................43

3.4 Regulative challenges......................................................................................................................45

3.5 Public policy and taxes.....................................................................................................................47

3.6 Concluding remarks.........................................................................................................................49

4 Opportunities.........................................................................................................................................50

4.1 Market development.......................................................................................................................51

4.2 Product development......................................................................................................................54

4.3 Consolidation and M&As.................................................................................................................55

4.4 Concluding remarks.........................................................................................................................58

5 Summary and final conclusion................................................................................................................58

5.1 Overview of the thesis.....................................................................................................................59

5.2 summary..........................................................................................................................................60

5.3 Conclusion.......................................................................................................................................61

5.4 Limitation of the study.....................................................................................................................63

References.................................................................................................................................................63

Books, Papers and Articles:....................................................................................................................63

Website Links.........................................................................................................................................70

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1. Introduction

Islamic banking has drawn an increasing attention around the financial world in recent years,

especially in light of Global financial crisis starting in late 2000s. Global financial crisis have

caused the downfall and casualties of well-known and trusted conventional financial institutions

(CFIs) all over the world such as Lehman’s Brothers and UBS, which in return have raised the

interest of the general public on Islamic Banking also in the Western part of the world. Islamic

banking system has since its establishment in 1970s been expanding its principles through the

entire world, but in light of global financial crisis it has experienced a double digit growth rate

with worldwide assets close to 1 trillion (IMF, WP/11/156).

Although Islamic banking is one of the fastest growing segments in the financial world it is still

in its infancy stage, at about 1 percent of the global banking system. When compared to the

conventional financial system it certainly faces many challenges. The most important challenge

it is facing now is the fact that it operates in economies driven by interest, which is not compliant

with Islamic banking principles. The regulation and policies of the Western world are created

and fit the conventional banking system. In order for Islamic banking to become an alternative in

the world’s financial system there has to be introduced regulatory measures removing the

obstacles to the development of Islamic banking, such as central bank support, taxes and public

policy. These kinds of regulatory measures taken by UK have shown that it is possible for

Islamic banking to operate and grow its activities in such economies. In this relation, my

preliminary research suggests that Islamic finance has enormous potential for further expansion

when including non-Muslims as target group.

On the other hand I have, in my research, faced many ambiguities about Islamic banking from

reputable researchers in the financial world. El-Gamal et al. (2005) for example, have concluded

that Islamic finance simply seeks to replicate the functions of conventional financial instruments

and is primarily a form of rent-seeking legal arbitrage (IMF, WP/11/156). Being a Muslim

myself and a finance student, the ambiguities and the above mentioned problems which are

facing the growth of Islamic banking in the western world motivated me to research more in this

field.

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The aim of this thesis is to get insight into Islamic banking, its opportunities, its challenges, and

to find out whether Islamic banking is an alternative to the conventional banking or just a

replication of the conventional system.

1.1 Research Question

The majority of the literature related to Islamic finance in the Western world is country related.

They only examine the role of Islamic finance in a respective country according to its Muslim

population. I would like to gather all these studies and give a comprehensive overview of

opportunities and challenges that Islamic financial institutions (IFIs) face in the world. In the

course of my research on Islamic finance, I found that UK is the only western country in the

world that has benefitted from the growth of this market. One of the reasons, which have been

explained by many researchers, is the large Muslim population in this country. While countries

like USA, Germany, France and Spain all have relatively large Muslim population, the Islamic

banking is just at the introduction stage. One problem here is non-compatibility of Islamic

banking with the established financial order of these countries. The other is the limited effort of

these countries to encourage the introduction of Islamic finance.

The above mentioned led me to following problem statement:

What regulatory measures do the Western world countries must take, and what institutional

changes IFIs must make, in order for Islamic finance to thrive and prosper in the Western world

not only for Muslim but also non-Muslim consumers?

To provide a basis for concluding on this problem statement, the following research questions

will be answered:

- Which regulatory changes have to be taken into consideration by legislators in the

Western world for encouraging and integrating IFIs into the prevailing system?

- Which institutional changes have to be taken into consideration by major Islamic banking

and finance organizations, in order to make Islamic finance attractive to non-Muslim

consumers and compatible with the conventional financial system in the Western world?

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1.2 Delimitation

Islamic finance is a nascent industry compared to the conventional financial industry, therefore

there are numerous challenges and opportunities connected to its future development. This thesis

is focused only on the challenges and opportunities that are of vital importance for the

establishment and future growth of Islamic finance in the western world, therefore, other specific

challenges and opportunities of secondary importance will not be discussed in this paper. As

Islamic financial industry tries to gain a stronger foothold in the western world both with the

capital and money markets, the focus of this thesis is on Islamic finance industry as a whole and

not on a particular market. Though, it should be noted, that there are vast numbers and types of

products provided by Islamic financial institutions in the Muslim countries, as in the

conventional system. But due to the size and limit of this thesis, only those products will be

focused on which are of direct interest and have potential for growth in the western world in near

future. Furthermore, it will be too much for this thesis to mention all potential markets for the

Islamic finance in the western world. Therefore, this paper will only focus on few of those

countries that offer the best prospect for Islamic finance growth.

1.3 Structure of the thesis

The thesis structure is summarized in the brief descriptions of chapters below. Chapter two starts

with an outline of the Islamic finance, its theory, products and institutions, in order to provide the

reader with fundamental theoretical background of the Islamic banking, and to gain an

understanding of the terms and services that Islamic finance provide. Then, the challenges and

opportunities facing the Islamic finance globally, and particularly in the western world, will be

discussed and analyzed in chapters three and four.

Chapter three will focus on the following challenges and their possible solutions:

- Corporate governance

- Risk management

- The role of central banks

- Regulations

- public policies and taxes

Chapter four will focus on the following opportunities and how to exploit them:

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- Market development

- Product development

- M&As

The final chapter will conclude the findings and make some final remarks regarding what is need

to be done, from both the Western legislators’ side and Islamic financial organizations’ side, in

order for Islamic financial services to thrive and prosper in the prevailing conventional financial

systems.

1.4 Methodology

The problem statement in this thesis is going to be answered through a theoretical analysis on

basis of both primary and secondary data. The level of this analysis will be on industry level and

not firm level because the challenges and opportunities mentioned in this paper are not firm

specific. It is necessary to get an in-depth knowledge about all the possible existing

theories of Islamic finance, meaning that the research approach will be qualitative and

exploratory in order to obtain greater understanding of Islamic finance, and to define the

challenges and opportunities that it faces in the Western world. As Blumberg (2005) states, a

new investigations often start with qualitative studies exploring new phenomena. Although

Islamic finance is not a new phenomena in itself, the aim of this thesis which looks for a new

perspective on this matter have not been studied thoroughly yet, which makes the chosen

research approach the most appropriate.

1.5 Data review

This thesis is mainly a desk research project. Therefore, almost all the information for this

project is gathered from the databases of international financial institutions, books, academic

articles in newspapers and magazines. The short list of academic databases which are used

frequently are as follows: IMF, World Bank, Cambridge Journals Online, EBSCOhost, ELIN,

JSTOR, Oxford Journals Social Sciences, ProQuest and SSRN. Most of these databases were

available through the ASB’s library portal. The others were available directly.

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2 Literature review

We are going to start this part by reviewing the principles of Islamic finance and the

definitions of its products. Then the theories behind the Islamic finance will be reviewed. The

main part of this chapter is based on books which are mentioned in the List of References.

2.1 The concept of Halal and Haram in Islam

The concept of Halal (lawful/permissible) and Haram (unlawful/impermissible) introduced by

the religion of Islam is in fact the foundation of Islamic finance. Both Halal and Haram are used

by Muslims throughout the world and refer to anything that is considered permissible and lawful

under religion, and what is forbidden and punishable according to Islamic law respectively.

For many Non-Muslims the two words are related to food and beverages that a Muslim is

allowed or prohibited according to Islam. However, for Muslims these words can be found in

every aspect of their life, it applies to everything from speech, dress code, the way they behave,

to their manner and dietary.

The above mentioned social and ethical concept reigns supreme also in the Islamic finance and

economy. Halal includes a long list of legal and permitted business activities, and Haram

includes a long list of forbidden and inadmissible business activities. This Halal and Haram list is

not complete because Muslim scholars in many countries have some differences in interpretation

of what is allowed and what is forbidden, especially when a new product comes into the market.

Many IFIs have created their own Shariah boards1 that issues opinion on new products available

in the market, which add significantly to the differences in interpretations of what is Halal and

what is Haram. Some of these general activities which Muslims are not allowed to invest in are

mentioned below:

Alcohol, cinema (immoral), gambling, pork products, pornography, tobacco and of

course Riba (interest).

Actually, these prohibited activities are not always prohibited. For example investing in alcohol

activities is not allowed, but when the same alcohol is used for the protection of life, like

alcohol-based antiseptics, it is allowed. Another example states that in one case the financing of

1 Shariah boards are comprised of independent experts (mostly Islamic academics and economists). Will be elaborated on in the following chapters

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a major luxury hotel was allowed where the casino was forbidden, but the sale of alcohol within

the hotel was allowed because it was deemed necessary for its economic viability, and as long as

it was not sold to Muslims (Novethic, WP, 2009).

2.2 Principles of Islamic finance

As it is obvious from its name, the Islamic finance system compared to western conventional

system is related to the religion of Islam. The principles of Islamic finance are based on three

main factors which are mentioned in the Quran and are an important part of Shariah2 and Islamic

jurisprudence. They are Riba, Gharar and Maysir, which are explained in detail below.

2.2.1 Interest (Riba)

In Islam it is not allowed to either receive or pay any interest on transactions involving money.

This prohibition essentially implies that the fixing in advance of a positive return on a loan, as a

reward for waiting, is not permitted by Shariah. This prohibition has not been confined to Islam.

According to Visser (2009, p. 39), based on passages from the Bible, the Christian Church at

various times took a strong stand against demanding and paying interest. Also in the Old

Testament, Jews were forbidden to demand interest on loans from their own but they could

charge interest on loans given to foreigners. Perhaps, best definition of Riba is given by Iqbal

and Molyneux:

”In its basic meaning, Riba can be defined as anything (big or small), pecuniary or non-

pecuniary, in excess of the principal in a loan that must be paid by the borrower to the lender

along with the principal as a condition, (stipulated or by custom), of the loan or for an extension

in its maturity. According to a consensus of Islamic jurists it has the same meaning and import

as the contemporary concept of interest. (Iqbal and Molyneux, 2005, p. 9)

2.2.2 Gharar

Translated directly from Arabic it simply means uncertainty or risk. Gharar is as important in

Islamic finance as Riba. Compared to Riba, Gharar is more difficult to define clearly in financial

transactions. It is one of the most difficult tasks for the experts in Shariah boards in many IFIs to

agree upon when there are new products available on the markets. in this relation, Iqbal and

Molyneux (2005, p. 14) state that, “jurists make a distinction between two kinds of Gharar:

2 Islamic law – the fundamental religious concept of Islam, namely its law, systemized during the 2nd and 3rd centuries of the Muslim era equal to 8th-9th centuries AD. (Encyclopedia Britannica)

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Gharar ahish (substantial) and Gharar yasir (trivial). The first kind is prohibited while the

second is tolerated since this may be unavoidable without causing considerable damage to one

of the parties. In many cases, it is simply not possible to reveal all information (not because the

seller wants to hide anything, but because it is in the nature of the product). The buyer has to

trust the seller”. It is Gharar yasir (trivial) that sometimes causes problems for Shariah boards to

agree upon. To prevent Gharar in a transaction, the full implications of this transaction must be

clearly known to contracting parties. In other words there must not be “asymmetric information”

between parties because it breaches the principle of Islamic law. Elgamal (2006, p. 58) states

that, Gharar translated conceptually by professor Mustafa Al-Zarqaa means “trading in risk,

which cannot be defined”. He further gives us examples of naked options, financial futures, and

derivatives that are not backed by tangible and verifiable assets.

2.2.3 Maysir

Maysir is closely related to Gharar. In some papers about Islamic banking these two principles

are used interchangeably even though there is a difference between these two principles. Where

in Gharar the main focus is on uncertainty, Maysir, translated from Arabic “gambling”, focuses

on and prohibits transactions that are based on one side’s gain at the cost of the other.

Conventional banking products such as life insurance are prohibited in Islamic finance as it

comes under Maysir. When gambling, the player pays a certain amount of money in the hope

that he will gain much larger amount, similarly the conventional life insurance policy where the

assured hopes for a chance to make a gain.

The three principles mentioned above are the main principles of Islamic finance. However, there

are some general rules under which financial transactions become void in Islamic finance. This

could be a contract which involves immorality, which involves illegality against public policy,

which foundation or substance is unlawful or illegal, or any other contract or agreement which

directly or indirectly is contrary to the divine principles of Shariah.

2.3 Islamic finance products

A large number of products are available in Islamic finance, and the number is growing as

demand for more Islamic compliant products grow throughout the world. Broadly speaking,

Islamic commercial law is based on three modes which serve as the basic building blocks for

other more complex financial products. These three modes are partnership based, trade based,

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and rental based modes of financing. Nearly all Islamic finance products come under these three

modes. The use of each mode is dependent on the purpose and size of transactions, but all of

them are based on principle of Riba prohibition. One thing to remember is that, as mentioned

earlier, as a result of the difference in interpretation not all of new products are universally

acceptable. The three mentioned modes are covered in details below.

2.3.1 Partnership based mode of financing

Partnership based or Profit-and-Loss-Sharing (PLS) mode suggests an equitable sharing of risks

and profits between the parties involved in a financial transaction, and include Mudarabah,

Musharakah and other hybrid products. Theoretically, Mudarabah and Musharakah are the most

desirable forms of Islamic financing.

2.3.1.1Mudarabah

Mudarabah is an agreement between a lender (bank), who acts as an investor, and a borrower,

whereby the borrower can mobilize the borrowed amount for his business activity. If profits are

made they will be shared between the lender and borrower according to the mutually agreed

ratios. In the case of loss the lender shares the losses in proportion to his contribution. Elazrag

Hussein (2010) gives a good example; “an Islamic bank lends money to a client to finance a

factory, in return for which the bank will get a specified percentage of the factory’s net profits

every year for a designated period. This share of the profits provides for repayment of the

principal and a profit for the bank to pass on to its depositors. Should the factory lose money, the

bank, its depositors and the borrowers all jointly absorb the losses”.3

2.3.1.2 Musharakah

Musharakah is in its basic a business partnership or joint venture between two parties where one

party could be a bank and the other party its customer. It is effected for a particular period like a

few months, year or more than a year. Both parties agree on a certain percentage of the profit to

be given to each party. The profit of the bank must not exceed the percentage of its investment in

the Musharakah. The losses, if incurred, will be divided based on strict proportion to the equity

participation ratio, i.e. to the capital contributed by each party. For example, if the bank invests

65 % and the customer 35 %, they must share the loss in the same ratio. “All parties, including

the bank, have the right to participate in the management of the project, but equally, all parties

3 Elasrag, Hussein, Global Financial Crisis and Islamic Finance (April 17, 2010). http://ssrn.com/abstract=1591563

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have the option to waive such right. All parties agree through negotiation on the ratio of

distribution of the profits generated from the project, if any. This ratio need not coincide with the

ratio of participation in the financing of the project”. (Venardos 2005, p. 76). Musharakah is

used by financial institutions for asset and/or real estate financing, working capital financing, and

etc.

Both Mudarabah and Musharakah are closely related products. Mudarabah differs from

Musharakah in the way that only bank is the investor here, whereas in Musharakah all parties

invest in the project. In Mudarabah management is the prerogative of the investor, whereas in

Musharakah all partners can manage the project based on a pre-specified agreement. And finally,

in Mudarabah the customer does not bear losses if incurred, whereas in Musharakah profits and

losses are shared based on the percentage of the investment.

2.3.2 Trade based modes of financing

Trade based modes of financing became available in the market much later than partnership

based mode, but its products gained dominance among other products very quickly. Because it

targeted a much larger group of investors, both private and business customers, and it also is

safer for both parties to invest in this mode of financing, compared to partnership based mode.

2.3.2.1 Murabaha Finance

Murabaha is an agreement between a bank and its customer. The customer requests the bank to

purchase or import commodities on his/her behalf, with a promise to buy them from the bank at

purchase price plus profit margin of the bank, and to be paid on deferred installments. One of the

most used forms of Murabaha by Islamic banking customers is home financing. Murabaha could

be named as the locomotive of Islamic finance because it was after the introduction of Murabaha

that Islamic banking assets grew at double digits. But there are numbers of critics among

prominent scholars criticizing Murabaha’s compliance with Shariah. As Usmani states, “It

should never be overlooked that originally, Murabaha is not a mode of financing. It is only a

device to escape from ‘interest’ and not an ideal instrument for carrying out the real economic

objectives of Islam. Therefore, this instrument should be used as a transitory step taken in the

process of Islamization of the economy. And its use should be restricted only to those cases

where Mudarabah and Musharakah are not practicable.” (Usmani 1998, p. 104).

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This statement can be confirmed by looking at a problem that Murabaha contains. The problem

is that the customer’s promise to buy commodities from bank once the bank has bought it, cannot

be binding since this would be a contract in which neither side is obligated immediately to

perform. The solution to this problem, that Shariah boards has come with, is allowing banks to

take collateral against losses incurred from a customer’s breach of promise.

2.3.2.2 Salam Finance

As mentioned before, Shariah does not permit selling what you do not own but Salam is exempt

from this condition. In Salam, as long as the commodity is specified by both quality and quantity

and at full payment at spot, it is allowed to sell it in a given future date. The seller is obliged to

have the commodity by the end of contract. If the seller does not have the commodity in hand at

the time of execution of the contract, he/she must buy it in the market. Salam is similar to

forward contracts in conventional financial system with the difference that in Salam the entire

amount must be paid when signing contract. Salam is used by IFIs in agricultural financing, pre-

shipment export finance, and project financing. Iqbal and Molyneux (2005, p. 25), have stated

four basic rules that govern Salam:

1. The price should be paid in full at the time of the contract.

2. Goods whose quality or quantity cannot be determined by specification cannot be

sold through the contract of Salam. An example is precious stones.

3. Goods can be sold only by specifying the attributes. They cannot be particularized

to a given farm, factory or area.

4. The exact date and place of delivery must also be specified.

There are also three major risks connected with the use of Salam, as mentioned by Venardos

(2006, p. 77), which according to him reduces the Salam’s value as a financing vehicle.

1. The risk of default by seller which could just partially resolved by obtaining some

form of security from the seller.

2. The bank’s need to liquidate the goods after delivery, an inconvenience made

more serious by the Islamic legal rule that a Salam buyer cannot sell the expected

goods before actually taking possession of them. But this is also resolved by

Shariah boards, who allows banks to sell the goods with conditions that the new

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contract is unconnected to the first one (buying goods from seller), and that the

goods are of exactly the same description, quantitatively and qualitatively, and

with the same due date.

3. Requirement of Shariah that if at the time of delivery the seller can neither

produce the goods nor obtain them elsewhere, the buyer has only two choices:

either withdraw his offer, or wait for the goods to become available later, with no

compensation permitted for the delay. In either case, the buyer loses all or much

of the profit from the use of his money.

2.3.3 Rental based modes of financing

Rental based modes of financing have existed since the beginning of Islam. It was used mostly in

relation with agricultural products. Ijarah have been the only type used in this mode, but with

time and the development of new products financial institutions have added other more

complicated products under this mode. The main idea of this mode is that the financial institution

purchases an asset for its customer and then hands it over to him/her on rental basis. This can be

an operational asset, where IFI act as warrantor of the asset or financial asset, and where the

customer deals directly with the supplier so the ownership titles remains with the IFI until it is

transferred to the customer. The two most used products in rental based mode of financing are

Ijarah and Diminishing Musharakah.

2.3.3.1 Ijarah finance

Ijarah is much equivalent to leasing agreement in conventional financial system, but with a

difference that Ijarah does not involve interest bearing contracts and they should be Shariah-

compliant. When translated from Arabic, Ijarah means to provide something on rent. Venardos

(2006, p. 170) define Ijarah as; “a contract under which the bank leases equipment to a customer

for a rental fee. It is pre-agreed that at the end of the lease period the customer will buy the

equipment at an agreed price from the bank, with the rental fees already paid being part of the

price”.

Ijarah is the most used type of product, not only among rental based mode products but also

among all products provided by IFIs, when it is concerned the acquisition of assets for

businesses. Ijarah have generally been used by private customers for financing consumer goods

like homes and automobiles. But recently it has gained popularity among business customers in

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relation with project and transportation financing. Ijarah is used for almost everything that could

be leased, but some certain items that is prohibited in Shariah and a few others like fuel, food and

etc. are not included in Ijarah.

2.3.3.2 Diminishing Musharakah finance

As with Musharakah, diminishing Musharakah is a business partnership with the difference that

in diminishing Musharakah, at the end of partnership, one part becomes the full owner of the

asset in a predetermined mechanism agreed upon, when the contract is signed. The transfer of the

ownership is determined by a leasing agreement where the lessee purchases the ownership on a

pro-rata basis through periodical lease payments. Iqbal and Molyneux (2005, p. 22) describe

diminishing Musharakah as a contract between a financier (the bank) and a beneficiary in which

the two agree to enter into a partnership to own an asset, but on condition that the financier will

gradually sell his share to the beneficiary at an agreed price, and in accordance with an agreed

schedule. Diminishing Musharakah is increasingly used in sectors like housing and real estate,

project finance, and construction. Diminishing Musharakah takes different shapes according to

the shape of the transaction. A general rule is that when a customer wants to buy a commodity

he/she approaches the IFI which agrees to join into partnership. The customer has to pay at least

10-20 percent of the price, according to IFIs requirements, and the rest is paid by the IFI. The

share of IFI is then divided into units which the customer has promised to purchase one after

another in a predefined schedule. During this process the IFI gains on rent claimed according to

its proportion of share.

2.4 Derivatives

CFI derivatives include call and put options, futures, forwards, and swaps and are used for

hedging, arbitrage, and speculation. From the Shariah point of view most of the derivatives

provided by CFIs are deemed to be Haram i.e. prohibited for IFIs because these kinds of

transactions refer to the commodities that might not be in seller’s possession. IFIs seemingly

allow derivatives for the purposes of hedging and arbitrage, but prohibit their use for speculation

or gambling. As mentioned before, Islam prohibits Gharar and Maysir (gambling and

speculation). However, the need for a mechanism that could help IFIs customers to manage

unnecessary risk has prompted Islamic jurists and scholars to come up with some standardized

liquidity and risk management products, directly based on the generally accepted Islamic

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financing modes. A number of products are similar to conventional financial products, Forward

or futures contracts (a combination of Salam and Murabaha), call (Arbun) and put options, total

return or currency swaps and etc., but completely within an Islamic framework. As the numbers

of different derivatives grow in Islamic finance, the criticism is also growing from different parts

of the world by Islamic jurists and scholars arguing, that these kinds of products are not in full

compliance with Shariah. Jobst (2007) States that; “Shariah scholars take issue with the fact that

futures and options are valued mostly by reference to the sale of a non-existent asset or an asset

not in the possession of the seller, which negates the Shariah. Shariah principles, however,

requires creditors (or protection sellers) to actually own the reference asset at the inception of a

transaction.” Anybody who is familiar with the rules of Shariah can see that the idea behind

these derivatives goes against the very pillars of Islam. Therefore the creation and development

of such products are one of the most challenging tasks for Islamic finance practitioners. The size

of the Islamic derivative market is not known but is quite small and derivatives are much less

widely available to IFIs than to CFIs (Visser 2009).

2.5 Insurance

Insurance is one of the much discussed products in Islamic finance. Some hardliners in Islam

condemn any kind of insurance arguing that insurer-insured relationship involves Gharar and

Maysir and is not allowed in Islam. “Conventional life insurance was already declared

unacceptable in 1903 by some prominent Islamic scholars in the Arab countries. This was

followed in 1978 by a resolution of the Fiqh4 Council of the World Muslim League and in 1985

by one from the Fiqh Council of the Organization of the Islamic Conference declaring that

conventional insurance as presently practiced is Haram (O.C. Fisher 2001)”. (Visser 2009, p.

102). Moderate Muslim scholars, on the other hand, argue that as long as Gharar and Maysir are

separated from insurance product it is in compliance with Shariah. They state that in particular

business activities such as construction, transport and investment services, the professional

liability insurance is not involving Gharar and Maysir. Takaful is such an insurance product that

does not involve Gharar and Maysir.

4 Islamic Jurisprudence

15

2.5.1 Takaful

Translated directly from Arabic, Takaful means cooperative or mutual insurance. Takaful is

developed by Muslim scholars and economists because the conventional insurance contains

Gharar which is forbidden in Islam. The main idea behind Takaful is that both insurer and

insured are viewed as contributors to the pool of money which they voluntarily have agreed to

share in case of loss incurred to one of them. “Islamic insurance, or Takaful, differs from

commercial insurance in that it is a cooperative form of insurance, though the actual business

operations may be left to commercial firms, who act as managers, or agents, with the policy

holders as their principal” Hans Visser (2009, p. 104). First a Takaful company is organized by

IFIs, then both insurers make a periodic payment to the Takaful company which it maintains in

individual accounts for each member, and these amounts can be invested in other Shariah

compliant products during the contract period. There are three major Takaful models and they

are as follows:

1. Mudarabah – derived from the Mudarabah contract, the Takaful company acts as the

operator and share in the returns from the investments of the Takaful fund according to a

predetermined profit-sharing arrangement. If there is no profit, the operator will receive

no compensation for management services.

2. Wakalah – insurers appoint the Takaful company as their agent or manger to handle all

the activities of the Takaful fund in accordance with established guidelines. A

predetermined fee compensates the agent or manager.

3. Mixed model – under this model the Takaful company will be assured compensation

under the Wakalah contract and will receive a share of profit under a Mudarabah contract

as well.

2.6 Zakat

Zakat is one of the five pillars of Islam which are obligatory on every Muslim. It is the fourth

important pillar among them. Translated directly from Arabic it means “purity”. IFSB define

Zakat as follows: “The amount payable by a Muslim on his or her net worth as part of his or her

religious obligations, mainly for the benefit of the poor and the needy. Paying Zakat is an

obligatory duty for every Islamic adult Muslim, whose wealth Finance exceeds a certain

threshold” (IFSB 2007). Zakat becomes obligatory when the individual’s wealth, after deducting

16

all the costs or any amount he/she owe somebody, exceeds the price of approximately 85 grams

of pure gold in today’s money. The individual is obliged to pay 1/40 th of it as Zakat which is

equivalent to 2,5 %. Zakat has been the centre of much discussion among Islamic scholars. Some

IFIs make donation of their yearly income to the Zakat centers in Muslim countries voluntarily,

in accordance with their organizational charter, and others are required by law. However, as

Maali et al. state; “Because the Quranic injunction to pay zakah predates large corporations, the

varying tax levels specified in the Shari'a apply largely to individuals. Consequently it is debated

whether zakah should even be applied to business organizations.” (Maali et al 2006, p. 275).

According to Hassan5 paying Zakat, as one of the pillars of Islam, is a compulsory contribution

by individuals. Furthermore, it contradicts the intention of Zakat because IFIs are simply not

aware of the individual depositor’s or investor’s financial condition. To impose compulsory

Zakat payment by IFIs, he argues, will lead to the discrimination against IFIs and will shift

equity investors’ preference to the conventional banks.

2.7 Sukuk

Due to its similarity to conventional interest-based bonds’ characteristics Sukuk are often

referred to as Islamic bonds. Like bonds, the holders of Sukuk are entitled to a regular stream of

coupons and a final payment at maturity. However, in principle it is wrong to refer to Sukuk as

Islamic bonds because the conventional bonds are debt transactions while Sukuk are asset-based

and/or asset-backed. The difference in asset-based and asset-backed is risk associated with them.

The asset-backed is much less riskier than asset based. The asset-backed Sukuk resemble the

equity position in conventional system because they own a part of the underlying asset, while

asset-based Sukuk are closer to debt position because the holders of asset-based Sukuk do not

own the underlying asset and have recourse to the originator in case of default. AAOIFI define

Sukuk as certificates of equal value representing undivided shares in the ownership of tangible

assets, usufructs and services or (in the ownership of) the assets of particular projects or special

investment activity (AAOIFI). Sukuk are used mostly to finance large investment projects. After

the introduction of Sukuk they are increasingly used by IFIs in order to manage their liquidity

because these securities are typically short term in nature, ranging from three months to one year

and which can be liquidated easily in the secondary market. As mentioned before, IFIs are not

5 http://gulfnews.com/business/banking/scholar-against-compulsory-Zakat-on-islamic-banks-1.98342 accessed on 10/6-2011

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http://gulfnews.com/business/banking/scholar-against-compulsory-zakat-on-islamic-banks-1.98342

allowed to use the available conventional instruments for liquidity management as they are

interest based and therefore not in compliance with Shariah. The Gulf Cooperation Council

(GCC) countries have prohibited trading of Sukuk in the secondary market arguing it involves

Riba. Therefore, Salam-based Sukuk and the likes are typically held to maturity in this region

while in other regions leading by Malaysia the secondary market for Sukuk is growing. Although

Sukuk is in its infancy stage, first issued in the late 1990s, the increasing use of it as a liquidity

management instrument has contributed to the fast growth of Sukuk market. Most of Sukuk

offering have been asset-based or Ijarah. Ijarah-based Sukuk have medium- to long-term

maturities, carry a put option, and can be traded in the secondary market. In a typical Ijara Sukuk

structure, the originator sells assets to the Sukuk issuer, a bankruptcy-remote special purpose

vehicle (SPV) created to act as a trustee for investors acquiring the assets (Iqbal and Mirakhor,

2007). Sukuk returns are tied to the cash streams generated by underlying assets held in SPVs.

This cash stream can be in the form of profit from a sale, profit from a rental (Ijara), or a

combination of the two. The conventional asset securitization process is used in structuring

Sukuk. The Sukuk is a nascent product as well as the whole Islamic capital market is very young,

therefore new Sukuk products are evolving around the world. In this relation AAOIFI issued a

statement in 2008 stating that IFIs must avoid involvement of Sukuk in debt-related operations.

2.8 Istisna

Istisna is used in financing goods that are not yet ready for sale and will have to be manufactured

according to certain agreed criteria and requirements, with payment on agreed terms. IFSB

(2008) defines it as an agreement to sell to a customer a non-existent asset, which is to be

manufactured or built according to the buyer’s specifications and is to be delivered on a specified

future date at a predetermined selling price. The IFI agrees to construct and to sell the project to

be constructed at the bank’s selling price to the customer and thereafter it requests a third party

to construct the project; Upon completion, the contractor will hand over the project to the IFI or

the IFI will authorize the contractor to deliver the project directly to customer. Istisna is used in

services such as tailoring, architect and construction projects, industrial equipment, plants and

machinery, ships and aircraft, contract or asset financing, in pre-shipment exports financing and

usable in all other situations where goods have to be manufactured before sale. Under these

transactions the payment can be flexible depending on the agreement between the bank and the

client; the price can be paid up front, according to manufacturing process, at completion or

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installments after completion (Hassan and Lewis 2007, p. 178). Istisna is perhaps one of the most

flexible products available by IFIs. Istisna offers greater future structuring possibilities for

trading and financing. The contract can be cancelled at any time by any party given a prior

notification time before starting the manufacturing process, but not later than that.

2.9 Theory behind the Islamic finance

The concept of Islamic finance has existed since the emergence of Islam. However, it was not as

developed and systematic as today before late 1970s. The main idea of Islamic finance is perhaps

best described by Iqbal and Molyneux (2005, p. 6). They state that under Islamic jurisprudence

there are two kinds of rulings, the worship ruling which governs the relationship between man

and Allah, and the second being mutual dealing rulings which governs the relationship among

mankind. The general principle of mutual dealing rulings is that, everything is permitted unless

clearly prohibited, which includes the principle of Halal and Haram discussed earlier. They call it

the “Doctrine of Universal permissibility”. Iqbal and Molyneux (2005, p.7) further state that; “In

addition to the Doctrine of Universal Permissibility, Islam permits the contracting parties to

agree on any conditions as long as they do not violate any Sharijah ruling. …We call this the

‘Golden Principle of Free Choice’. As may be seen, this principle gives a very wide scope for

designing contracts”.

They argue that; “the purposes of such prohibitions are to provide a level playing field to protect

the interests of weaker parties, to ensure justice and fairness and in general to ensure mutual

benefit for the parties as well as society at large, and to promote social harmony”.

As mentioned before, theoretically, Islamic finance is based primarily on the avoidance of Riba

(interest), Gharar (speculation), and Maysir (uncertainty) and exercising profit and loss sharing,

which is touted as the foundation upon which all IFIs are based. Furthermore, there should not be

pure economical interest in transactions. They must contribute to the social harmony. They must

be balanced between equity and debt, and the trade of debt must be avoided which is explicitly

expressed in the pillars of Islamic banking. Although this way of doing business has existed from

the dawn of Islam, the theoretical and systematic development of Islamic finance began only

after the World War II, when majority of Muslim countries achieved their political and

economical freedom from the colonial powers. Majority of these newly independent countries,

with a nationalistic mood, wanted to transform their financial institutions to Shariah compliant

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institutions. But it was not an easy task because by that time the conventional western financial

system had been rooted in these countries. After the World War II, Muslim scholars, economists

and jurists had been working hard together, in order to uncover the forgotten by centuries

practice of conducting Islamic financial affairs, and to create and advance a modern Islamic

based mode of financing business transactions. According to most of literature found about

Islamic finance the first modern IFI in the world is mentioned to be created by a German-

educated Egyptian banker Ahmad an-Najjar, named Mit Ghamr bank, by 1963. The bank earned

profits through its profit and loss sharing partnership products without involving Riba. Abdul-

Rahman states; “He was distressed to see the poor farmers in his small village of Zefta/Mit

Ghamr in the Egyptian Nile Delta lacking the funds needed to finance the purchase of seeds,

farm animals needed to plough the land, cattle, animal feedstock, and simple pumps—even to

finance their subsistence and basic needs until the crop was cultivated and sold on the market.

The bank expanded its operations throughout the Egyptian farmland and became very popular

until it was nationalized by the government of the late president Nasser”. Abdul-Rahman (2010,

p. 192)

However, it is a well-known fact that the first IFI was established in Kuala Lampur, Malaysia in

1956 by the name of Tabung Hajj. It was a savings organization primarily established to finance

the Hajj (pilgrimage to Mecca). This fund rapidly gathered huge amount of savings which it

invested in a way that was in compliance with Shariah in sectors agriculture and real estate. It

has become the oldest Islamic financial institution in modern times6. According to Abdul-

Rahman (2010, p. 193) it is important to know that most of the Malaysian Muslim religious

leaders received their religious education in the 1950-1960s in Egypt. The success of these IFIs

among ordinary Muslims had already attracted prominent figures in the Islamic world by 1970s.

This success, combined with the wealth gathered from jump in oil prices and the creation of OIC

(Organization of Islamic Countries), created the incentives in establishing the first international

Islamic bank, Islamic Development Bank, followed by the first commercial Islamic bank, Dubai

Islamic Bank. Following the establishment of these two banks there was a boom in establishment

of IFIs in Middle East: countries like Egypt, Sudan, Kuwait and Bahrain having large sums of oil

money established Islamic banks one after another in late seventies.

6 Islamic Development Bank (2007)

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Khan and Ahmad (2001) state that theoretically, it has been an aspiration of Islamic economists

that on the liability side, Islamic banks shall have only investment deposits. On the asset side,

these funds would be channeled through PLS contracts. Under such a system, any shock on the

asset side shall be absorbed by the risk sharing nature of investment deposits. PLS dominates the

theoretical literature of Islamic finance. However, the practice of IFIs has become different from

the theoretical aspirations with the predominance of trade based operations. In past decade these

institutions began to spread their markets beyond the region by establishing international

investment banks not only in Muslim countries but also in the western world, especially in

Europe with the UK as centre.

2.10 Leading organizations

In the beginning the industry focused all its attention on retail, which was followed by

commercial banking activities. The next step, capital market activities, took a bit longer time to

be developed, but it began to boom in a very short time and this boom attracted more and more

actors into this business, especially western countries in the mid 1990s. As the Islamic finance

industry attracted more and more countries and the public interest grew all over the world,

central banks and regulatory authorities in these countries began to call for regulations and

supervision of the Islamic finance industry. Another additional problem that followed the boom

in IFIs was the difference in products available by these institutions. IFIs in the beginning of

1970s began increasingly to consult experts in Islamic law in order to be sure if their product

were adherent to Shariah. However, there was need for a standard setting so the products at least

could be of same content, if not the same name. All these problems led to the establishment of

Shariah boards within the IFIs. But this was not enough because the inconsistencies in

interpretations of different Shariah boards in IFIs led to the fact that some transactions were

Shariah compliant in the rules of one board and not compliant with Shariah in the rules of other

board. Therefore, international standard setting organs such as Accounting and Auditing

Organization for Islamic Financial Institutions (AAOIFI), Islamic Financial Services Board

(IFSB), Islamic International Rating Agency (IIRA), and International Islamic Financial Market

(IIFM) were found to facilitate, by issuing international standards and guidelines, the

homogeneous interpretation of Islamic jurisprudence and dealing with corporate governance

issues. Recently the International Islamic Liquidity Management Corp (IILM) has been

established to assist institutions offering Islamic financial services in addressing their liquidity

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management issues in an efficient and effective manner. These main bodies of Islamic finance

are explained in detail in the following subchapters.

2.10.1 Shariah Boards

It should be stressed that Shariah board is not a standard setting body in itself, but assist other

regulatory and standard setting organizations in establishing and maintaining a good governance

practice among IFIs. Shariah board is a committee of Islamic scholars whose job is to verify if

the new products presented by IFIs comply with Shariah. These scholars’ functions are similar to

members of boards in conventional corporations, i.e. they are not employed be IFIs but receive

honoraria, and they have the right to be members of Shariah boards in different IFIs

simultaneously. The latter is because there are few dozen countable Shariah scholars who are

familiar with both Islamic law and modern financial needs in the world. Although the numbers of

such scholars are growing, they still lag behind the growth of the industry need. The first ever

Shariah board was established by Egypt’s Faisal Islamic Bank in 1976 and soon other IFIs

followed this example. Today Shariah boards of IFIs are required by law in majority of Islamic

countries, and even if it is not required by law, Shariah boards have become an important part of

IFIs. However, lately Shariah boards have been criticized by many economists for being a part of

corporate governance or agency theory problems in IFIs because of conflict of interests. To

tackle these kinds of problems Malaysia as the first country in the world has regulated scholars to

be member of the Shariah board of maximum three IFIs simultaneously. AAOIFI standards have

defined Shariah boards’ duty as directing, reviewing and supervising the activities of the IFIs in

order to ensure that they are in compliance with Shariah principles. AAOIFI standards have also

made it mandatory for all IFIs to elect their Shariah board members through the shareholders

annual general meeting upon the recommendation of the board of directors, taking into

consideration local legislation and regulations. Furthermore it states that these members should

not be chosen among directors and majority shareholders of the IFIs (AAOIFI 2003, governance

standards). According to Algoud and Lewis (2001, p. 81), maintaining and formalizing the

internal regulatory role of Shariah boards is considered vital as these internal bodies are best

placed to assist their individual organizations in achieving Shariah compliance, and thus play an

important role in the overall regulatory environment.

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2.10.2 AAOIFI

The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) is an

Islamic international autonomous non-profit making corporate body that prepares accounting,

auditing, governance, ethics and Shariah standards for Islamic financial institutions. It was

established in accordance with the Agreement of Association which was signed by Islamic

financial institutions on 26 February 1990 in Algiers (Iqbal and Molyneux 2006, p. 60). The

AAOIFI has a two-tiered organizational structure in order to separate the standard-setting

function from financing the organization, so that the standard setters are not subject to a conflict

of interest. IFIs are not obliged to adapt AAOIFIs standards and guidelines. However, regulatory

and supervisory authorities around the world are increasingly relying upon them and align their

standards according to it. For example many Shariah boards consist of at least three scholars who

have a comprehensive financial expertise and education in legal questions according to AAOIFI

standards. The AAOIFI provides guidelines for IFIs when/if they face difficulties in

interpretations, or understanding of issues related to new financial products. So far the AAOIFI

has issued 25 standards in accounting, 5 in auditing, 7 in corporate governance and 2 codes of

ethics (AAOIFI 2010). The AAOIFI is focusing on the auditing and accounting side, where

processes and transactions need to be handled differently from conventional banking practice.

2.10.3 IFSB

To ensure the sound and stable development of the Islamic financial industry, it needs to be

supported by a strong regulatory and supervisory framework. To fulfill this requirement, the

Islamic Financial Services Board (IFSB) was established in 2002. The IFSB is an international

body hosted by Malaysia. It has the important mandate of developing the prudential standards in

accordance with the unique features of the Islamic financial institution (Iqbal and Molyneux

2006). IFSB was established under the sponsorship of the International Monetary Fund, and in

close cooperation with IMF and Basel Committee on Banking Supervision, has become one of

the most influential international organizations that promote Islamic finance and its standards.

IFSB tries to adapt the existing standards and guidelines of the mentioned organizations and

adjusts them in accordance with the Shariah principles to IFIs. The IFSB's focus is very much on

the standardization of procedures and the way Shariah rulings are interpreted across the industry.

Since its establishment the IFSB has issued 17 standards, guiding principles and technical notes

in the areas of risk management, corporate governance, transparency and market discipline, and

23

etc. IFSB is closely cooperating with the Basel Committee on Banking Supervision, International

Organization for Securities Commissions and the International Association of Insurance

Supervisors (IFSB 2011).

2.10.4 IIRAThe Islamic International Rating Agency (IIRA) started operations in July 2005 to facilitate

development of the regional and national financial markets by delineating relative investment or

credit risk, providing an assessment of the risk profile of entities and instruments. This should be

an integral part of the decision process employed by institutional investors.7 IIRA assists the

Islamic financial services industry to gain recognition locally and internationally as strong and

capable financial institutions, adhering to greater standards of disclosure and transparency. Its

mission is to support the development of the regional capital market and to improve its

functioning. IIRA has become an alternative to the international rating agencies and it aims to

become a reference on which investors and financiers can rely to achieve “Quality” in terms of

compliance with the related Shariah rules and principles for Islamic financial services. IIRA is a

profit making body and it works like its conventional counterparts, charging a set fee per piece of

work.

2.10.5 IIFMInternational Islamic Financial Market (IIFM) is the global standardization body for the Islamic

Capital & Money Market segment of the IFIs. Its primary focus lies in the standardization of

Islamic financial products, documentation and related processes.8

The Agreement to establish the IIFM was signed in November 2001 by the Governors of the

Central banks /Monetary Agencies Malaysia, Bahrain, Indonesia, Sudan, and the President of the

Islamic Development Bank. It began its operation in 2002. Its main objectives are:

1. To spur the establishment and development of an international financial market

based on Shariah rules and principles

2. Addressing the issue of liquidity management in IFIs

3. Developing an active secondary market, and

7 http://www.iirating.com/about_profile.asp accessed on 12/6-20118 http://www.iifm.net/default.asp?action=article&id=126 accessed on 15/6-2011

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http://www.iifm.net/default.asp?action=article&id=126

http://www.iirating.com/about_profile.asp

4. Creating the environment that will encourage both Islamic and non-Islamic

financial institutions to actively participate in a secondary market and the

information of new traceable instructions.

IIFM will also act as the focal point for the harmonization of Shariah interpretations in the global

financial market and enhance the cooperative framework among IFIs globally. In September

2006 the IIFM signed a Memorandum of Understanding with the International Swaps and

Derivatives Association (ISDA), with an eye to developing a master agreement for documenting

privately negotiated Shariah-compliant derivatives transactions. In march 2010 the ISDA/IIFM

Tahawwut master agreement was launched. It is a completely new framework document though

the structure of the document is similar to the conventional ISDA Master Agreement. However,

the key mechanisms and provisioning such as early termination events, closeout and netting are

developed based on the Islamic Shari’ah principles.9

2.10.6 IILMThe International Islamic Liquidity Management Corp (IILM) is a collaborative effort by 11

central banks or monetary agencies from countries such as Malaysia, Indonesia, Iran,

Luxembourg and the United Arab Emirates, as well as two multilateral organizations to assist

institutions offering Islamic financial services in addressing their liquidity management. The

IILM has been established to assist institutions offering Islamic financial services in addressing

their liquidity management issues in an efficient and effective manner. This institution addresses

one of the fundamental problems of Islamic financial institutions: the provision of adequate

liquidity in times of stress. The IILM is expected to issue high quality, triple A-rated liquid,

tradable and low risk Shariah-compliant financial instruments at both the national level and

across borders, to enhance the soundness and stability of the Islamic financial markets. The

instruments of the IILM will be utilized in liquidity management as eligible collateral for

interbank transactions and central bank financing, or through trading of IILM instruments (either

within the same country or cross border) in the secondary market. As the IILM is intended to

facilitate cross-border liquidity management, its instruments shall be denominated in major

reserve currencies such as the US dollar and the euro. This is to ensure access to a large pool of

global investors and broaden the range of its holders, thereby enhancing the prospects for active

9 http://www.isda.org/media/press/2010/press030110.html accessed on 15/6-2011

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http://www.isda.org/media/press/2010/press030110.html

secondary market. If the assets can be traded through the IILM, then much fewer of these assets will be

held by the institutions.

3 Challenges and their possible solutions

While the Islamic finance has experienced a double digit growth for the last decade around the

world, there are some challenges, especially in the western world, that raises questions about the

long-term growth of Islamic finance. Furthermore, IFIs, in the aftermath of financial crisis

became overly exposed to real estate and related sectors. The Sukuk market has also been

affected, and while some recovery is in sight, sovereign issuers are outnumbering corporate ones

at present. The challenges to be discussed in this chapter include corporate governance, risk

management, the role of central banks, regulations, and public policies and taxes. It should be

stated that these challenges, are relevant to this thesis, and their possible solutions are going to be

discussed in detail in this chapter.

3.1 Corporate governance

Considering the size of Islamic finance, very little has been researched and discussed about

corporate governance in IFIs, since their establishment in late 1970s. According to recent

estimates, there are over 600 IFIs operating in more than 75 countries worldwide, and the

number is growing10. Corporate governance plays a vital role in design and promotion of the

principles of accountability, fairness and transparency of the corporations to ensure and protect

investors’ interests. IFIs have been lately criticized from different parts of the world for the lack

of accountability and transparency, especially in last decade, after some huge scandals took place

in relation to several respected IFIs. The biggest scandal involved Dubai Islamic Bank in 2009

where lack of corporate governance practices resulted in a fraud case involving $501 millions11.

These scandals attracted the attention of different economists, scholars and institutions to

research and work on the improvement of corporate governance practices in IFIs. IFIs’ structure

are more complicated than those of conventional corporations, and therefore critics argue that

IFIs must try even harder to design and implement more robust corporate governance practices

and mechanisms, tailored to ensure good behavior and protection of shareholder’ interests. Khan

10 http://arabnews.com/economy/islamicfinance/article405998.ece On 20/07-201111 http://gulfnews.com/news/gulf/uae/crime/dubai-islamic-bank-dh1-8b-fraud-case-referred-to-court-1.56801 accessed on 27/07-2011

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http://gulfnews.com/news/gulf/uae/crime/dubai-islamic-bank-dh1-8b-fraud-case-referred-to-court-1.56801

http://arabnews.com/economy/islamicfinance/article405998.ece

and Sharif (2008) argue that: “The level of good governance required by sharia principles

arguably transcends that of conventional financial systems, as Islamic financial principles

categorize an IFI as a trustee of its investors. As such, the IFI must be transparent, act fairly and

be held accountable to the investors. Considering the significant amount of wealth currently

entrusted to IFIs and their role as the trustees of their investors, is it time for the introduction of

more robust corporate governance practices tailored specifically for IFIs?” While conventional

systems’ corporate governance practices are globally converging, governance practices of IFIs

are diverging. According to Khan and Sharif (2008), this is due to regulators responsible for

supervising IFIs have taken a non-prescriptive approach. Rather than setting criteria and

standards which IFIs must comply with to be authorized and licensed to carry out Shariah-

compliant activities, the onus is placed on the individual IFIs to put adequate measures in place

to ensure that the services and products they offer accord with Islamic principles. The numbers

of corporate governance models in conventional finance system are exhaustive. However,

generally they can be divided into two different approaches, the Anglo-Saxon and the European.

The Anglo-Saxon approach is shareholder-oriented and the European approach is stakeholder-

oriented. Islamic finance system is closer to European approach. According to Iqbal and

Mirakhor (2004), the governance model in the Islamic economic system is a stakeholder-oriented

model whereby governance structure and process at both the system and the firm levels protect

the rights of all stakeholders who are exposed to any risk as a result of the firm’s activities (Iqbal

and Molyneux 2005, p. 119). But Islamic economists and scholars are divided into three groups

concerned with which corporate governance approach is best for the future growth of IFIs. The

first group is proponents of the European model arguing that the essence of the Islamic corporate

governance necessarily has a wide commission, with obligations extending beyond shareholders

and embracing financiers, employees and customers as European approach does (Malekian and

Daryaei 2010). The second group is proponents of the Anglo-Saxon approach arguing that the

economic organization and business and commercial practices in majority of Muslim countries

are inherited western colonial powers practicing the Anglo-Saxon approach of corporate

governance. This implies that in actual practice, many Islamic corporations adopt the Anglo-

Saxon approach (Hasan 2008). They argue that it is for the best of IFIs to work on the adaptation

of the Anglo-Saxon approach which also make it easier for them to enter the western financial

world and compete with the existing conventional system. The third group is opponents of the

27

both above mentioned approaches. They argue that the IFIs’ structures are completely different

of those in conventional corporations. The depositors in IFIs are also stakeholders whose interest

is also at stake, and they do not generally get much attention in the Anglo-Saxon as well as

European approaches. In IFIs it is the depositors rather than shareholders who provide a

preponderantly large proportion of funds (Chapra and Ahmed 2002). Therefore, the third group

promotes the idea of a completely different approach which could be consistent the IFIs’

structure. The problem with the third group is that they have not yet managed to create a solid

model of corporate governance. In the context of Islamic corporate governance, there are a few

studies have been carried out particularly Islamic financial institutions to come up with

alternative models of corporate governance. The studies seem to suggest that Islamic corporation

may adopt a totally different model of corporate governance or a modified version of the

Stakeholder-oriented model as an alternative for its corporate governance framework (Hasan

2008).

Therefore, both AAOIFI and IFSB, together with other national regulatory institutions, pursue

and work on common regulatory policies to upgrade IFIs’ corporate governance regime to

international standards. They have issued several regulatory guidelines and codes of corporate

governance. They both stress the need for more specific governance practices for IFIs and are

working on guiding principles intended to help IFIs establish and improve their corporate

governance frameworks and assist regulators in assessing such frameworks. Almost all of these

regulatory guidelines however have a non-prescriptive approach. Therefore, it is of high

importance that Shariah boards assist these regulatory and standard setting organizations in

establishing and maintaining a good governance practice among IFIs. A study conducted by

Vinnicombe (2010) in Bahrain showed high levels of compliance with AAOIFI standards in

some areas, and relatively low levels in other areas by IFIs. The relatively low levels of

compliance are related to the Mudarabah and Zakat which are part of the agency problem of IFIs.

Corporate governance covers many issues such as stakeholder theory, management

compensation, board of director’s role and disclosure and etc. The issue that has been most

discussed and criticized, especially by western regulators, has been the conflict of interest

between the parties involved in the contractual relationship, the so called “Agency problem” or

“principal/agent problem”. Hart, O (1995:678) notes that; “Corporate governance issues arise

28

in the corporation in two situations namely whenever there is an agency problem of conflict of

interest involving members of the organization such as board of directors, managers and

shareholders and cost of business are such that agency problem cannot be dealt with through a

normal contract”. This thesis is concerned with the agency problem, as it is directly related to

the actual problem of IFIs.

3.1.1 Agency theory

Agency theory is one of the most researched and discussed issues in conventional corporate

governance. A series of corporate scandals which shook the world in 1990s, especially in the

United States with a huge scandal related to Enron, gave a further boost to the number of

researches followed by guidelines and regulations concerned agency theory. In Islamic finance

corporate governance the agency problem is of primarily concern. The theoretical structure of

IFIs, which share profits and losses on both their asset and liability sides, pose a greater need for

transparency to its investment account holders (Iqbal et al. 2007, p. 7). They further explain it as

follows; “This is due to the agency problem faced by the investment account holders when they

share in profit and loss of the bank, which themselves are the consequence of trade and

investment decisions of the managers and shareholders of the banking firm. Bank shareholders

(or their appointed management), as agent for investment account holders, exercise control over

investment decisions. Unless their interests and risk profile is aligned with that of the depositors,

agency problem will remain.” Another twist to this agency problem, they add, is provided by the

current practices of Islamic banks pertaining to rate of return smoothing which creates another

kind of agency problem for the equity holder of the banks, and also leads to weakening of market

discipline for the managers12. Furthermore, a number of agency problems are encountered in the

contractual structure of Islamic banks which may also affect the CSR disclosure presented by

Islamic banks in their annual reports (Iqbal et al. 2007, p. 226). In addition Safieddine (2009), by

conducting one of few important empirical researches in this field, highlighted the specific

agency problems that current corporate governance practices by IFIs face in the Gulf

Cooperation Council member countries. He revealed the following deficiencies in corporate

governance practices of IFIs which could potentially result in agency problems:

12 The problem is explained in detail on Appendix 1 at the end of the thesis.

29

The establishment of a governance committee or an audit committee is not common

among IFIs, and a clear internal audit functions are not properly established.

Investment accounts holders and other investors lack access to relevant information and

influence on management decisions.

The latter deficiency suggest that, while investment accounts holders entrust managers with their

money and exclusively bear the risk of the projects’ failure, they are not able to monitor the

performance of their investments or to oversee the activities undertaken by the management, thus

leaving some agency problems unresolved (Safieddine 2009).

In light of the above mentioned problems, Chapra and Ahmed (2002) conclude that the

governance mechanisms that aim at safeguarding the interests of shareholders in conventional

corporate structures might not be sufficient in the setting of IFIs. Also Safieddine (2009)

concludes that; “The implications reveal that a model of conventional and idiosyncratic

governance practices that preserves both the foundations of Islamic finance and the rights of all

investors, including investment account holders is much needed to be developed by regulators

and adopted by Islamic banks given the implications on performance and the development of the

industry.” Another problem which recently is being underlined by critics is the conflict of

interest arising from relations of top management and Shariah boards. As in many IFIs Shariah

scholars are being appointed by shareholders also influenced by top management, some Shariah

scholars may feel pressure and threat of losing their position in the board, and hence approve

products Shariah compliant while they are non-compliant. In future this approval could lead to

enormous costs including litigations, loss of revenue and, not least, decline in the IFI’s

reputational image. This particular problem is more highlighted by the fact that in majority of

IFIs Shariah boards are not subjected to disclosure rules. In order to cope with this problem there

is a need for more transparency and disclosure in Shariah boards.

3.2 Risk Management

Risk management is the identification and quantification of risks connected with the specific

business, then taking care of those risks and if possible reducing or preventing them. Islamic

finance industry has grown rapidly and today includes, as its conventional counterpart, a diverse

range of financial products. Compliance with Shariah precludes IFIs from risks that are common

in conventional system with their debt trading. However, for the same reason, Shariah

30

compliance, IFIs are exposed to their own unique and systematic risks. In addition to some

general operational, credit and market risks, similar to their conventional counterpart, IFIs, as a

result of their specific structure and rapid growth, are exposed to risks by equity holders more

than debt holders. According to Iqbal and Greuning (2007, p. 172), it is crucial for IFIs to

develop a comprehensive risk management framework, as there is growing realization among

IFIs that sustainable growth depends critically on it. General factors that currently make the

operation of IFIs riskier, not only in western countries but also in majority of Muslim countries,

and consequently less competitive and less profitable than their conventional counterparts, are

Shariah compliance risks, operational risks, market risks and credit risks. As Khnifer (2010)

notes: “Recognizing and mitigating Shariah risk, which is sometimes not understood very well

even by some industry experts, is not especially different from managing market risk, credit risk,

liquidity risk and operational risk.”. It should be noted that all risks mentioned above could be

correlated and influence each other. For example, during the contract life, the risk inherent in a

Murabaha contract is transformed from market risk to credit risk13. In IFIs’ portfolios, it is often

challenging to distinguish between risk categories. It is generally difficult to distinguish between

the market and credit risks attached to a financial transaction abiding by the rules of sharia. In a

large number of contracts, risk categories of a different nature are entangled. In order to highlight

special issues in each type of risk, the nature of these risks will be discussed separately in detail

below.

3.2.1 Shariah compliance risk

The compliance of IFIs’ products with Shariah means that many risk hedging instruments which

are available for CFIs, such as futures, forwards and options are not available for them and this is

a risk in itself. In addition, sometimes IFIs also need to meet regulatory requirements for risk

measurement and capital of western countries which contradicts Shariah compliance. Shariah

compliance risks are risks that arise from the IFIs’ failure to comply with the Shariah principles.

Sometimes complex products, having gone through a long process of development, are rejected

by the Shariah boards for non-compliance with Shariah, which can cause additional costs to IFIs.

Some practitioners have suggested involving Shariah scholars in the earlier stage of product

development process. However this suggestion have been criticized by others arguing that it 13 State Bank of Pakistan, “Risk Management Guidelines for Islamic Banking Institutions” available on www.sbp.org.pk accessed on 20/07-2011

31

http://www.sbp.org.pk/

could only lead to a more executive role of Shariah scholars hence adding more problems to

already existing corporate governance issues. As IFIs are focusing more on establishing

themselves in western countries, they are increasingly exposed to the risk of creating products

that are not Shariah compliant. There is a growing concern among scholars that it will increase

Shariah compliance risks, and that the direct consequence of these risks will be losing

conservative customers and thus decline in profits. Islamic banks are heavily reliant on the

loyalty of their depositors. Furthermore, it can lead the IFIs into a serious problem. Once the

more conservative depositors withdraw their funds, it could raise doubt of other depositors on the

credibility of the IFI and consequently, affected by rumors, even non-Muslim depositors will

rush to withdraw their deposits. In 2007 and 2008 criticism from some prominent Islamic

scholars on several Sukuk issuances led to a massive reduction in global issuance volumes

(Wyman 2009). During the global financial crisis, many solid banks witnessed how fragile and

helpless they are against bad rumors. In order to lessen this kind of risk, AAOIFI have

introduced several special programs directed to Shariah scholars, to increase the number of

qualified Shariah advisers who also understand how the international financial system operates.

Firoozye (2009) notes that in recent years IFIs have become increasingly sensitive to Shariah

compliance risk, as more and more respected Islamic scholars began to openly criticize certain

types of Islamic banking practices. Firoozye (2009) considers the recent ruling on Tawarruq14 by

OIC Fiqh Council as the most significant Shariah risk event; “Tawarruq is firmly embedded in

the Islamic Banking system in a great many countries and an undiversified revenue stream for

many IFIs. Meanwhile, while all other cases involved questions that could be clarified by

broader consensus, or lower court rulings which could be overturned, there are no means of

overturning OIC rulings, although they are not binding. Consequently, this ruling could then be

seen as one of the largest examples of Shariah Risk in recent history, attempting to nullify

billions of dollars of yearly transactions in one fell swoop”. Even though Malaysia continued the

issuance of Tawarruq after the rulings, with a minor difference made, it had an effect on the

international trade.

In order to manage Shariah risks there is an urgent need of developing and implementing

appropriate mechanisms and adequate systems of control to ensure that new products are in full 14 Tawarruq is an arrangement in which one party sells a commodity to the other party on deferred payment at cost plus profit. The other party, namely, the buyer, then sells the commodity to a third party on cash with a purpose of having access to liquidity (State Bank of Pakistan)

32

compliance with Shariah internationally. Khnifer (2010) states that Shariah risk management is

identical in process and procedures to general risk management, of which there is an abundance

of professional reference works to refer to for guidance. He suggests Basel II as the ultimate risk-

management system, which is now nearly universal in identifying, measuring, and protecting

against any and all risks that affect a bank’s operations. Another group of Islamic academics

suggest that risk management system in IFIs must be developed according to the unique structure

of IFIs, and not to be a copy of conventional system. They argue that Shariah risk management

begins ex-ante from the actual products that ultimately receive fatwa. Laldin (2009) suggest that

risk management systems that start prior to the Shariah board certification must be developed,

i.e., at the stage when a bank is engineering a new product and designing its relevant contracts.

Ibrahim states further that IFIs must strengthen a controlling system where identification and

assessment of Shariah risk would be systematically monitored and controlled in order to avoid

non-compliance of Shariah. Similar to the first suggestion, IFIs are increasingly recruiting

employees that are also familiar with Shariah law. This practice helps them to identify Shariah

compliance risk, if any, at a much earlier stage.

3.2.2 Operational riskBasel Committee on Banking Supervision (BCBS) define operational risk is the ‘risk of direct or

indirect loss resulting from inadequate or failed internal processes, related to people, technology

or from external events. Iqbal and Greuning (2008) define operational risk as; “Operational risk

also includes the risk of failure of technology, systems, and analytical models. It is argued that

operational risks are likely to be significant for Islamic banks due to their specific contractual

features and the general legal environment.” Due to the latest global financial crisis, operational

risk of financial institutions has lately been one of the most discussed issues among economists.

The late global financial crisis proved that some major financial institutions in the world are

exposed to operational risk. IFIs are exposed to similar and some additional risks which stem

from their specific contractual features. According to IMF (WP/02/192) The administration of

PLS modes imply several activities that are not normally performed by conventional banks,

including the determination of profit-and-loss-sharing ratios on investment projects in various

sectors of the economy, as well as the ongoing auditing of financed projects to ensure proper

governance and appropriate valuation. These operations of IFIs together with the growing

complexities of banking regulation and supervision, and the additional layer of Shariah

33

compliance, require complex suites of Islamic banking software, structured to conform to legal

and regulatory as well as strict Shariah requirements. Khan and Ahmed (2001) state that

operational risk in IFIs is relatively higher and more serious than credit risk and market risk.

They believe it is because of new nature of Islamic banking, and that a lot of the issues related to

the operations are not instituted. These issues include the legal risk involved in contracts, the

understanding of the modes of financing by employees, producing computer programs and legal

documents for different instruments, etc. Furthermore, they argue that; “Operational risk in this

respect particularly arises as the banks may not have enough qualified professionals (capacity

and capability) to conduct the Islamic financial operations. Given the different nature of

business the computer software available in the market for conventional banks may not be

appropriate for Islamic banks. This gives rise to system risks of developing and using

informational technologies in Islamic banks.”

As mentioned before, the IFIs are facing the shortage of professional employees and this has

forced them to hire experts with conventional banking background, especially in the western

countries. However, structure of IFIs’ products is more complicated than conventional.

Therefore, the above mentioned problem must be of high priority. IFIs must set up a sound

internal training system that professionally trains employees in identifying and dealing with

operational risks. Effective management of operational risk in IFIs in the western countries needs

extremely skilled employees, with both conventional and Islamic banking background. These

employees must be trained in administrating and conducting Islamic financial operations

professionally, especially the profit and loss modes identified by IMF as one of the most

important issues in dealing with operational risk. The assessment of this risk is a difficult task

and unique to IFIs. After the global financial crisis international regulatory authorities have

focused much on the enhancement of the operational risk management practices. The Basel

Committee on Banking Supervision has lately specified, in its regulatory standard, requirements

that safeguard financial institutions against operational risk. To fulfill the requirements of the

Shariah as well as the Basel III, it is necessary to create a large pool of highly qualified

professionals and experts with in-depth knowledge of not only the Shariah and its objectives, but

also dual financial systems. In addition they should be properly trained in using IT systems as

part of the implementing processes and self-regulating the products and services offered by IFIs.

IFSB has announced that it will revise its rules to enhance Shariah banks’ capital in line with

34

Basel III reforms.15 IFIs are interested in implementing Basel III because they are already well-

capitalized compared to CFIs. In addition, the regulatory and supervisory framework of IFIs will

converge to the global standards, and thus increase their competitiveness in the western world.

Despite this enthusiasm from IFIs, they are at the same concerned with the lack of distinction

between CFIs and IFIs in the Basel III Capital Accord. The distinct operational risks in IFIs such

as PLS activities, profit smoothing and other particular needs are not addressed.

3.2.3 Market riskIn the risk management guidelines of the State Bank of Pakistan16 Market risk is defined as the

risk of losses in on- and off-balance sheet positions arising from movements in market prices i.e.

fluctuations in values in tradable, marketable or leasable assets (including Sukuk) and in off-

balance sheet individual portfolios (for example restricted investment accounts). It states also

that, the risks relate to the current and future volatility of market values of specific assets (for

example, the commodity price of a Salam asset, the market value of a Sukuk, the market value of

Murabaha assets purchased to be delivered over a specific period) and of foreign exchange rates.

IMF (WP/02/192) has identified four major issues related to the market risk exposure of IFIs.

They are:

1. Commodity Price Risk

2. Equity Price Risk

3. Interest Rate Risk, and

4. Exchange Rate Risk

According to Khan and Ahmed (2001) IFIs consider market risk to be the least risky. They argue

that it could be because of the structure of IFIs’ products and Shariah compliance that forbid

engaging in sale of debt and Riba. The prohibition of Riba in Islamic finance has resulted in less

risk from interest rate changes. Still, IFIs are indirectly affected, to a lesser degree, by interest

rate risk through the mark-up price of deferred sale and leased based transactions. IFIs use the

London Interbank Offered Rate (LIBOR) as a benchmark in their Murabaha and Ijarah

transactions. IFIs are exposed to commodity price risk because of the same products. The

15 http://www.tradearabia.com/news/bank_189707.html accessed on 4/8-2011 16 State Bank of Pakistan, “Risk Management Guidelines for Islamic Banking Institutions” available on www.sbp.org.pk accessed on 20/07-2011

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http://www.tradearabia.com/news/bank_189707.html

inventory items must be carried by IFIs until the Murabaha and Ijarah transactions are

completed, thus an increase in the underlying items expose IFIs to commodity price risk. IFIs are

exposed to equity price risk through their profit and loss sharing contracts, precisely Mudarabah

and Musharakah. The capital invested in these contracts does not constitute a fixed return and in

the event of lower profit or even loss this capital is exposed to impairment. And finally, IFIs are

exposed to exchange rate risk in almost the same way as CFIs.

To manage market risk in IFIs, Hasan and Antoniou (2004) propose to employ Value at Risk

model which is used by major conventional trading institutions for market risk management.

This model is used to measure market risk in general, but other risks like foreign currency,

commodities, and equity risks are also measured. They argue that IFIs’ market risks are almost

similar to market risk of CFIs, thus it could be used with advantage by IFIs. On the other side,

IFSB have stated in its guideline that IFIs shall have in place an appropriate framework for

market risk management (including reporting) in respect to all assets held, including those that

do not have a ready market or are exposed to high price volatility.

3.2.4 Credit riskCredit risk is a risk that arises from the change in net asset value due to changes in the perceived

ability of counter parties to meet their contractual obligations. From this definition, it is obvious

that this kind of risk could be found in every single product offered by financial institutions, but

with a different degree of exposure. CFIs are exposed to this kind of risk mostly in their lending

activities, while IFIs, due to their profit sharing structure, are exposed to it in majority of their

products. IFSB has defined credit risk in IFIs as potential that counterparty fails to meet its

obligations in accordance with agreed terms (IFSB 2005). Iqbal and Greuning (2008, p. 120)

define credit risk as the chance that a debtor or issuer of a financial instrument—whether an

individual, a company, or a country—will not repay principal and other investment-related cash

flows according to the terms specified in a credit agreement. Inherent to banking, it means that

payments may be delayed or not made at all, which can cause cash flow problems and affect a

bank’s liquidity. Despite innovation in the financial services sector, more than 70 percent of a

bank’s balance sheet generally relates to this aspect of risk management. For this reason, credit

risk is the principal cause of bank failures. If we take in to consideration just the profit and loss

products of IFIs (Musharakah and Mudarabah), they are much more risky than loans given by

36

CFIs. In profit and loss transactions Shariah states that a party which has no capital invested in

the contract does not have to share the losses. In transactions which end with losses it is IFIs that

must cover the most of it. In addition, they may not charge penalties due to default of payments

by the customer or nor they can require collateral to reduce risks as in CFIs. Theoretically, as

mentioned before, Shariah states that profit and loss sharing products must be based on the

concept of brotherhood, equal treatment and mutual trust. IFIs followed this concept in 1970s

while operating mostly locally in small towns or cities. But as the customer numbers grew and

IFIs began to expand their activities in the western world, this concept was not applicable

anymore because this concept begun to be misused increasingly by customers. High level of

moral hazard, adverse selection and IFIs’ limited competencies in project evaluation and related

techniques forced IFIs to rely more on other products than profit and loss sharing. At the same

time different types of risk management systems were invented to safeguard IFIs from credit

risk. According to Iqbal and Greuning (2008, p. 120): “the techniques used by Islamic banks to

mitigate credit risk are similar to those used by conventional banks. However, in the absence of

credit-rating agencies, banks rely on the client’s track record with the bank and gather

information about the creditworthiness of the client through informal sources and local

community networks.” IFSB (2005) lists exposed products as follows: accounts receivable in

Mudarabah contract, Musharakah, Salam contract, Ijarah and Sukuk held to maturity in the

banking book. In order to manage credit risk properly, the State Bank of Pakistan has come up

with the following principles in their latest guideline17:

1. IFIs shall have in place a strategy for financing, using various instruments in compliance

with Shariah, whereby they recognize the potential credit exposures that may arise at

different stages of the various financing agreements.

2. IFIs shall carry out a due diligence review in respect of counterparties prior to deciding

on the choice of an appropriate Islamic financing instrument

3. IFIs shall have in place appropriate methodologies for measuring and reporting the credit

risk exposures arising under each Islamic financing instrument.

4. IFIs shall have in place Shariah-compliant credit risk mitigating techniques appropriate

for each Islamic financing instrument.

17 State Bank of Pakistan, “Risk Management Guidelines for Islamic Banking Institutions” available on www.sbp.org.pk accessed on 20/07-2011

37


3.2.5 Liquidity riskIqbal and Greuning (2008, p. 150) define liquidity risk as follows; “It represents a bank’s ability

to accommodate the redemption of deposits and other liabilities and to cover the demand for

funding in the loan and investment portfolio. A bank is said to have adequate liquidity potential

when it can obtain needed funds (by increasing liabilities, securitizing, or selling assets)

promptly and at a reasonable cost.”

From the above it means that liquidity risk arises when there is a possibility that an asset or a

position in a portfolio cannot be converted quickly to liquid assets, or when institutions have

difficulties with obtaining cash at reasonable cost for their short-term liabilities. This was one of

the main causes of recent global financial crisis. During the crisis we have witnessed some

intense discussions and arguments on improving financial institutions’ liquidity management

practices by central banks and fiscal authorities throughout the world. Even though IFIs have not

been affected as much as CFIs by the global financial crisis, they have become the centre of

fiscal authorities and central banks’ attention in the western world because of their restricted

access to the short-term and medium-term funding options. Prohibition by Shariah law from

borrowing on the basis of interest in case of need, and the absence of an active interbank money

market have restricted Islamic banks’ options to manage their liquidity positions efficiently.

Malaysia, the leading Islamic finance innovator, has been actively promoting the establishment

of interbank and secondary market for IFIs. In fact Malaysia established the first Islamic

interbank money market in the world as well as secondary market. But according to Khan and

Porzio (2010, p. 101) even though interbank and secondary markets exist to some extent,

designing and developing Shariah compliant instruments for them has proven to be conceptually

difficult. The liquid nature of banks’ liabilities, related to the predominance of deposits of short-

term maturities, predisposes the system to hold substantial liquid assets and excess reserves.

Difficulties in defining the rates of return on these instruments have also constrained the

development of money and interbank markets. The absence of well organized, liquid interbank

markets, that can accept banks’ overnight deposits and offer them lending to cover short- term

financial needs, has exacerbated banks’ tendencies to concentrate on short- term assets. The lack

of a cross-border liquid market infrastructure and instruments for the management of liquidity

risk has been a long-standing challenge for the IFIs. According to Parker (2011), the need and

urgency for establishing a global Islamic liquidity management scheme is underlined by the fact

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that the global commodity Murabaha market, which constitutes the main underlying transactions

of an Islamic liquidity management system, is estimated at a staggering $1.2 trillion. Iqbal and

Greuning (2008, p. 154) state that limited availability of a Shariah-compatible money market,

secondary market for debt instruments and intra-bank market are the leading causes of liquidity

risk in IFIs.

3.2.5.1 Interbank marketAs its name suggests, the interbank market is a market through which banks lend to each other.

Like the discount market this provides individual banks with an outlet for surplus funds and a

source of borrowing to manage their liquidity. The loans are normally for very short periods,

from overnight to fourteen days, though some lending for three, six months and one year occurs.

The rate of interest paid on interbank loans is known as London Interbank Offered Rate or

LIBOR. Unlike other instruments ‘traded’ in the money markets, interbank deposits cannot be

bought and sold between third parties (Howells and Bain 2007, p. 129). While the interbank

market is well-developed for CFIs, this market is not acceptable for IFIs because it involves

interest which is prohibited by Shariah. Access to interbank money markets for short-term

borrowings gives considerable flexibility to banks to manage their short-term liquidity problems.

As a nascent industry, IFIs have some shortages in comparison with their conventional

counterparts. As mentioned above, Malaysia, the leading Islamic finance innovator, has been

actively promoting the establishment of interbank and secondary market for IFIs. Creating

Shariah compliant interbank market is not an easy task, but Malaysia has managed to introduce

several products since the establishment of first interbank market in 1994. According to Visser

(2009, p. 127) the following are successful products introduced by Malaysia:

Mudarabah interbank investment - periods of investment run from overnight to 12

months. These investments earn a share of the profits for investment of one year of the

investee bank, at a negotiable profit-sharing ratio. Mudarabah interbank investments

replace Certificates of Deposit and are issued and traded by the banks.

Government Investment Issues - The Malaysian central bank opened a window to

purchase and sell GII on the secondary market, at prices set by them. For financing a

government budget deficit that is not attributable to specific projects, one solution is to

39

borrow in the form of loans at zero per cent and offer gifts (dividends), at the discretion

of the issuer, in recompense.

Islamic Accepted Bills - these resemble bankers’ acceptances and are based on Murabaha

(mark-up). A bank selling a good under a Murabaha contract draws a bill of exchange on

its client and may sell the bill to a third party at an agreed price. Outside Malaysia is not

universally accepted as Shariah-compliant.

Venardos (2010, p. 244) suggests that short-term Sukuk, mostly commodity Murabaha, can serve

as money market instruments for liquidity management and collateral in money market

transactions, promoting interbank lending activities between IFIs. In Malaysia, GIIs and

Malaysia Islamic treasury bills, eligible for statutory liquidity reserve requirements, allow IFIs to

hold liquid paper.

3.2.5.2 Secondary marketExistence of secondary markets for financial instruments is also an important source of liquidity.

In the existence of the secondary markets the primary markets function more efficiently. In order

for secondary markets to function properly, there are some basic conditions that must be met in

the form of standardized regulations and clearly established rules so that both parties in a

transaction know their responsibilities. There must be a well established and globally

harmonized trading system. These are characteristics that Islamic secondary market still lacks.

Iqbal and Mirakhor (1995) state that all things being equal, a certificate holder would rather

participate in a well structured and well regulated secondary market instead of trading in a poorly

run market. While countries like Malaysia, GCCs and UK are trying hard to develop well

functioning Islamic secondary markets, these markets do not even exist in most of other Islamic

countries, and where they exist they are unorganized or are regulated by laws and regulations.

Some countries do not even allow the establishment of secondary markets arguing it is not in

compliance with Shariah. Another problem in developing a strong secondary market is the lack

of Shariah-compliant products. One of the reasons being the strong appetite for Islamic products

by investors, to the extent that each issue is always over-subscribed and those bought are kept

until maturity so little room is left for a secondary market. According to Iqbal and Molineux

(2005, p. 127), also predominance of debt-based modes of financing has made it difficult for IFIs

to transform these financial modes into negotiable financial instruments. Once a debt has been

40

created, it cannot be transferred to anyone else except at par value. This renders the whole

structure of the Islamic financial market highly illiquid. This is one of the major obstacles in the

development of secondary markets in Islamic financial instruments. They suggest that to develop

Islamic secondary markets, equity-based financial instruments and securitization modes must

become wider applicable and negotiable instruments based on Ijarah, Salam and Istisna are being

developed. Visser (2009, p. 56) agrees and explains how Musharakah partnerships can be

securitized so they can be traded in secondary markets. If the underlying assets are not mainly

liquid assets and the price of these certificates would reflect the nominal value of the assets, the

trade would be Shariah-compliant. Shariah scholars seem to agree that a minimum of 50 per cent

of the assets should be non-liquid. He further elaborates that Ijarah-based Sukuk can also be

traded on the secondary market. Islamic secondary market faces challenges from both sides; first

from Muslim scholars who mean that secondary markets are not Shariah compliant and second

because it also have to compete with established and a well functioning conventional secondary

market. Developing Shariah-compliant products for the secondary market is a complicated in the

form of voluminous documentation, double or triple contracts on a single asset, and elevated

legal risks which make them expensive and time-consuming compared to conventional products.

CFIs with Islamic windows that do not care about Shariah compliance as much as IFIs do, would

prefer to conduct their operations in conventional markets instead of Islamic secondary markets.

However, efforts are being made, to develop the Islamic secondary market with better structured

products and tweak the rules and regulations, capable of meeting the above mentioned

challenges, by many leading Muslim and non-Muslim countries. Latest, in October 2010, in a

landmark global initiative, the International Islamic Liquidity Management (IILM) was

established with 14 founding shareholders, comprising the 12 central banks of Indonesia, Iran,

Kuwait, Luxembourg, Malaysia, Mauritius, Nigeria, Qatar, Saudi Arabia, Sudan, Turkey, and the

United Arab Emirates (UAE), as well as two multi-lateral institutions, the Islamic Development

Bank and the Islamic Corporation for the Development of the Private Sector18. IILM is expected

to issue high quality Shariah-compliant financial instruments at both the national level and across

borders, to enhance the soundness and stability of the Islamic financial markets. These

instruments will be utilized in liquidity management as eligible collateral for interbank

transactions and central bank financing, or through trading of IILM instruments in the secondary

18 http://www.islamicfinance.de/?q=taxonomy/term/3034 accessed on 30/8-2011

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http://www.islamicfinance.de/?q=taxonomy/term/3034

market. As the IILM is intended to facilitate cross-border liquidity management, its instruments

shall be denominated in major reserve currencies. This is to ensure access to a large pool of

global investors and broaden the range of its holders, thereby enhancing the prospects for active

secondary market.

3.2.6 Displaced commercial riskDisplaced commercial risk (DCR) is a distinct and specific feature of IFIs. IFSB (2005) 19 define

DCR as the risk arising from assets managed by IFI on behalf of investment account holders

(IAH), which is effectively transferred to the IFI’s own capital because the IFI follows the

practice of forgoing part or its entire Mudarib20 share of profit on such fund, when it considers

this necessary as a result of commercial pressure in order to increase the return that would

otherwise be payable to IAH’s. It should be noted that IAHs are generally divided into two

types; Unrestricted Investment Accounts (UIA) – the funds are invested at the discretion of the

IFIs, and Restricted Investment Accounts (RIA) – the funds are invested in a pre-agreed manner

with customers. Measures taken by IFIs in order to deal with DCR are called “Smoothing” the

returns. Smoothing returns is more generally found in connection with UIAs since they are

considered a Shariah-compliant substitute for conventional deposits.21 IFIs are less exposed to

DCR in countries with predominant Muslim population and Islamic financial services. However,

in the western world, in order to compete with the CFIs and to mitigate potential withdrawal of

funds by depositors, the IFI may confront commercial pressure to pay returns that exceed the rate

that has been earned on its assets financed by investment account holders. In the western

countries the existence of rational depositors, that indifferently position Islamic banking and

conventional banking is one of the most important issues because these depositors can take

their funds anytime and place the funds in the conventional banks when interest rate is

high. The IFIs are ready to forego part or its entire share of profit in order to retain IAHs and

dissuade them from withdrawing their funds. According to Venardos (2010, p. 79), the funds

from the depositor and IAHs form more than 60% of the total source of funds for the IFIs. To

ensure that the account holders remain with the IFI, depositors and investors must be assured of a

competitive rate of return for their fund placements. Kaouther et al. (2010) state that; “in theory,

19 IFSB “Guiding Principles of Risk Management for Institutions (other than Insurance Institutions) offering only Islamic Financial Services”20 A Mudarib is the person or party who acts as entrepreneur. In this case the IFI.21 IFSB 2010 GN-3 “Guidance Note on the Practice of Smoothing the Profits Payout to Investment Account Holders”

42

the profits are shared in pre-agreed ratio and all losses on assets financed by the investment

funds are to be borne by IAHs, except in the case of misconduct, negligence or breach of

contracted terms by the IFIs. In practice, the concept of sharing the actual profits with

IAHs is far from being the common practice of IFIs. Under commercial pressure or

regulatory pressure, the majority of IFIs absorb a proportion of losses normally borne by IAHs

in order to mitigate potential massive withdrawal of funds.”

Four most used smoothing methods used by IFIs are following (IFSB 2010):

1. IFI’s Mudarib fee – IFI gives up part of its management fee in order to absorb

expected losses

2. Profit Equalization Reserve (PER) - reserve is built up by setting aside amounts

from the investment profits before allocation between the shareholders and

the unrestricted IAH and the calculation of the Management fee.

3. Investment Risk Reserve (IRR) – Reserve is built up by setting aside amounts

from the investment profits attributable to the UIAH, after deducting the

IFI’s management fee.

4. Retained earnings – make a transfer from shareholders’ current or retained

profits to a UIAH.

All four methods used above are subject to governance issues and lack of transparency,

especially the PER and IRR methods. IFSB (2010) has addressed these issues and tried to come

up with recommendations on how to improve transparency and deal with governance issues. The

list of recommendations is extensive compared to the limitations of this paper and will not be

mentioned here.

3.3 Central BanksIn conventional financial economy, beside the regulative support, the role of central bank is

crucial for liquidity management for CFIs, and perhaps even more important is the role of lender

of last resort. Unfortunately, this is not the case for IFIs. The challenge for IFIs is that their

operational procedures must comply with Shariah, and as mentioned before, Shariah prohibits

Riba (interest). This non-compatibility prevents central banks from controlling of giving support

to IFIs. While in most Muslim countries with developed financial markets, Shariah compliant

43

practices, such as government investment issues (GII) in Malaysia and central bank securities in

GCC, that reduces this non-compatibility evolves slowly, the connection between IFIs and

central banks in the western world is non-existent except a couple of countries. Shariah

compliance impedes IFIs’ access to financial transactions in central bank money in the western

countries. In addition, the limited capital of IFIs and their limited economical influence in the

western countries leads to the marginal recognition by the central banks. The reliance on central

banks in western world, even for liquidity management, is still low as most short-term borrowing

facilities that are available in Muslim countries have not been adapted by them. The Islamic

financial instruments that are currently being traded in the majority of Muslim countries’ markets

on the basis of bay’ al-dayn (sale of debt) are the green bankers acceptances22, Islamic accepted

bills, Islamic mortgage bonds, and Islamic private debt securities. In addition, financial

institutions can sell government investment issues to the central bank, as and when required, to

meet their liquidity needs. In turn, financial institutions can buy Shariah-compliant investment

issues from the central bank (Iqbal and Greuning 2008 p. 155). Another problem facing IFIs is

the requirements of central banks to keep some of commercial banks’ deposits with them. While

central banks in majority of Muslim countries have aligned these requirement according to

Shariah, central banks is western countries pay interest on those deposits which is cannot be

accepted by IFIs. As IFIs have to hold comparatively larger proportion of these deposits with

central banks, the unavailability of profit earnings on these accounts significantly affects their

profitability. With the growing importance of Islamic finance in the world, central banks in

western countries inevitably have to implement practices and some operating instruments that are

available by central banks in Muslim countries. Malaysian central bank’s is perhaps one of the

best practices they could look up to. Malaysian central bank has developed an integrated and

well-functioning dual banking system. It maintains separate current accounts and clearing

accounts for IFIs and CFIs. In addition, the financial safety net framework in Malaysia

encompasses the lender of last resort facility and a comprehensive deposit insurance system that

provides coverage for both conventional and Islamic deposits. Iqbal and molyneux (2005, p. 117)

state that countries that host Islamic banking and financial institutions have a real interest in

dealing with this problem, and this can only be done through a coordinating body which

produces and enforces sound regulatory and supervisory standards, and which would be tailored 22 Banks may purchase BA issued by other banks (inclusive of conventional banks) provided that it is: An export or sales BA and/or drawn to finance “Halal” goods or commodity (Malaysian Central Bank).

44

to the needs of Islamic banking and finance. They suggest that, it is important that the IFSB

works in close coordination and understanding with international standard-setters, such as the

Basel Committee, to develop standards that are suitable for supervision of Islamic banks, yet

acceptable to international bodies.

Theoretically, there is nothing that makes central banks in Islamic financial system differ in a

major way from their conventional counterpart. In practice however, majority of Muslim

countries’ central banks do not take their essential role of initiating and fostering the

development of money and capital markets that are Shariah compliant as their conventional

counterparts do. Thomas et al. (2005, p. 207) point out that, the central banks in Muslim

countries do not have an effective role in regulating the standards and practices for IFIs. As a

result, their accounting practices were inconsistent and the financial statements were not

transparent due to inadequate disclosure. Greuning and Iqbal suggest (2008, p. 56) that western

central banks could collaborate and use the experience of IMF in implementing Shariah

compliant practices for IFIs; “IMF worked closely with the Central Bank of Sudan to transform

the central banking operations to conform with the Shariah….Beginning in the late 1990s the

IMF began to assist Muslim countries in establishing multilateral institutions and to facilitate

cooperation among them, notably on issues such as establishing an Islamic money market, an

Islamic capital market, and an international Islamic banking and financial supervisory and

standard-setting institution.” In relation to central bank challenges, there are also some

regulatory challenges to be considered, and they are discussed in the following subchapter.

3.4 Regulative challengesAs a nascent and constantly developing industry Islamic finance faces different kinds of

regulative challenges. Besides, Muslim countries are constantly implementing new rules and

regulations that sometimes contradict each others. The legal and regulatory practice governing

IFIs varies across countries. According to Chapra and Ahmed (2002), Islamic Research and

Training Institute (IRTI) revealed that the regulatory and institutional environment for Islamic

banks does not appear to be adequate and the variation is also relatively greater between

countries. This indicates that there are a number of issues confronted by the authorities with

respect to the regulation and supervision of Islamic financial institutions. They identify three

issues; the first relates to the removal of all the legal obstacles that hinder the rapid expansion of

45

Islamic financial institutions. The second is about the clarification, harmonization and

codification of standards of Islamic finance as much as is possible, and about ensuring the

compliance of these institutions with these standards. And the third issue relates to

implementation of the guidelines provided by the Basel Committee. In addition, Hassan and

Chowdhury (2004) argue that financial services regulators and central banks cannot take on the

responsibilities for Shariah compliance, but they should ensure proper procedures for ensuring

compliance are in place. They should also be aware of what Shariah law implies, and follow the

moves to arrive at international Shariah classification standards. Regulators should concern

themselves with corporate governance issues that involve examining the remit of the Shariah

advisors. They underline that with the increasing internationalization of IFIs, regulators must

focus on improved transparency.

After the global financial crisis, different regulatory architectures for conventional financial

sector are being implemented around the globe. Islamic finance has not been forgotten either.

Especially in the western world, with the rapid growth, increasing public interest and

establishment of Islamic windows by major CFIs, the focus has also shifted to Islamic finance.

The regulatory challenges faced by IFIs in western world are of the same type as mentioned

above but much complicated. There are several other regulative issues that hold Islamic finance

back in western countries. Even in UK which has created an attractive environmental and

regulatory framework for the Shariah compliant products in secondary market, and several other

initiatives to introduce and to attract Shariah compliant products, PLS products of IFIs, where

the return of account holders is not guaranteed, have not been permitted because it does not fit

UK’s financial regulations. In the case of U.S., it is the set of restrictions placed on the range of

permissible investments that commercial banks may hold and different regulatory authorities that

IFIs must convince before they can start their operations (Rutledge 2005). Furthermore, the

secular law of western countries does not understand the rulings of Shariah boards either.

Regulators need to know exactly the role of Shariah board, whether it is advisory or executive. It

makes them reluctant to support the establishment of IFIs. The lack of regulatory support with

specific legal and policy framework continues to hold the rapid expansion and acceptance of

Islamic finance back in western world.

46

All of the above mentioned challenges are reflected upon the IFIs as a competitive disadvantage

compared to CFIs. IFIs suffer from application of such rules and regulations well fitted to CFIs,

and require tailor made regulation for their unique products. Organizations like AAOIFI and

IFSB are developing a range of prudential and regulatory standards to solve this problem, in

cooperation with leading western countries like Luxembourg and UK. Islamic finance enjoys the

support of the Luxembourg Government, which set up a special Task Force in 2008 to identify

obstacles to the development of Islamic finance and how to remove them23. The Central Bank of

Luxembourg is the only member of the IFSB from EU and the central bank of Luxembourg is a

founder member of the newly established IILM. There are currently 22 banks in the UK, of

which 5 are stand alone Shariah-compliant banks, offering Islamic finance products, exceeding

that of any other Western country.24 As Parker (2011) states; “The irony is that the UK has more

enabling legislation to facilitate Islamic financial products and institutions than most Islamic

countries”.

The new challenges set out under Basel III are currently being actively addressed by the IFSB to

ensure continued operation under globally accepted norms. In addition, IASB requires each

organization to comply fully with IFRS in order to be considered as following IAS (Abd El

Razik 2009). In 2011, there has been growth in the trading of Islamic financial products from

Middle Eastern and far eastern jurisdictions to Europe. Most notably, Dubai has increased

trading of Sukuk and other products to France and Germany due to tax advantages25. The above

mentioned developments hint to the growing acceptance of Islamic finance and increasing

willingness of western countries to develop tailor made regulations to IFIs’ operations.

3.5 Public policy and taxesThe importance of public policies is critical for promotion and success of nascent industries. The

growth opportunity as well as the challenges facing the development of the Islamic financial

industry needs supportive and targeted public policies both at the national and especially in the

international levels. Growing importance and increasing assets of IFIs globally will eventually

attract the attention of public policy makers and institutions interested in introducing alternative

financial products, but without proper public policies this process will happen too slowly. In 23 http://www.lff.lu/products-services/islamic-finance/ accessed on 3/9-201124 http://arabnews.com/economy/islamicfinance/article448955.ece?service=print accessed on 5/9-201125 http://events.centralbanking.com/events/static/how-to-regulate-islamic-financial-markets-and-products accessed on 7/9-2011

47

http://events.centralbanking.com/events/static/how-to-regulate-islamic-financial-markets-and-products

http://arabnews.com/economy/islamicfinance/article448955.ece?service=print

http://www.lff.lu/products-services/islamic-finance/

contrast to the conventional system, the Islamic financial system is based on the active

participation of public policy institutions, regulatory and supervisory authorities, and Shariah

authorities (Iqbal and Greuning 2008, p. 187). In majority of Muslim countries IFIs, have taken

an intensified program to familiarize the public and policy makers with the functions of Islamic

finance. It is expected that awareness and understanding of Islamic finance by both the public

and regulators will strengthen the demand for and supply of Islamic financial services. Even in

Muslim countries general public and policy makers are not completely familiar with the Islamic

financial products. The reason can be traced to the political and economical dependencies of

these countries to western colonial powers and their conventional financial system in the past.

According to Ahmed (2002, p. 120) the case is worse in western countries where IFIs have faced

multiple problems with mainstream regulations. For instance, treatment of Ijarah in Islamic

banking system is recognized as normal leasing instead of mortgage which changes the concept

of Ijarah from purchasing the asset by the bank and leasing it to customers to a normal lease of

real estate26. Also, imposing taxes by non‐Muslim governments on Zakat, leads to double

taxation. Zakat is treated as a non-operating expense in IFIs financial statements and

consequently has no influence on their net income. The same applies to Murabaha transactions.

IFIs pay VAT twice on Murabaha mark-up.27 Thus, IFIs are required to pay regulatory fees

which results in double payments to meet the dual regulations of Islamic and conventional

system. Public policy involvement in tax framework has proven to have positive consequences

for the development of Islamic finance in the countries with prevailing conventional system.

Since the early 2000s the EU countries, for reasons of wider public policy, have introduced a

series of tax and legislative changes specifically designed to remove obstacles to the

development of Islamic finance. So far only UK and Luxembourg have been successful in

creating a friendly environment for Islamic finance over the past decade, and this has largely

been achieved by effective public policy. Schoon (2009) concludes in her country report that

although large, international banks generally offer Islamic financial services, no other

governments have so far announced any plans to review and, where required, amend their

regulatory, legal or tax framework.

26 As property would be bought and sold (legal title transferred) more than once. Thus stamp duty would otherwise be payable initially when the bank purchased the property and again when the legal title is transferred to the customer upon repayment of the loan to the bank.27 An example is shown in the Appendix 2

48

3.6 Concluding remarksAs a nascent industry, IFIs face numerous challenges both locally and internationally that raises

questions about the long-term viability of Islamic finance, including building its presence in the

international capital market to compete with the conventional banks. This will require much

more co-operation between IFIs, not only locally but also internationally. By looking at

challenges discussed in this chapter, it is apparent that a lot of variation exists among IFIs’

products and the way they are legally constituted. Strength of an Islamic financial system

requires institutionalized regulations and universally accepted standards to promote stability and

consistency. First of all it is essential to ensure a strong legislative base for the establishment of

IFIs in majority of leading non-Muslim countries. Furthermore, the success of IFIs in the global

scene requires the establishment of a universal framework to regulate and stabilize IFIs. There is

no institution for Islamic finance, like Basel Committee of the Bank of International Settlements

is there for conventional system, to promote a strong framework ensuring harmonization and

universally accepted standards. Institutions like IFSB and AAOIFI are trying to construct

uniform standards for IFIs and encourage IFIs to comply with Basel III requirements. However,

in order to overcome global challenges specifically related to IFIs, these institutions must

enhance their multilateral cooperation with BCBS and ensure appropriate environment,

conditions and level playing field for IFIs.

The tax treatment of certain IFIs’ products remains unclear and unfavorable as compared with

their conventional counterparts in majority of western countries. Even in the UK which is the

leading western country in establishing the Islamic financial market, tax treatment of some

products remains unclear. Islamic International standard setting organizations should cooperate

and provide assistance to policy makers and national standard setting organizations on how to

augment the national financial architecture with a new regulatory framework that consider

institutional differences.

With regard to IFIs, there is the need for more specific governance practices to improve controls

and transparency. Although national and international standard setting organizations are working

on guiding principles intended to help IFIs establish and improve their corporate governance

frameworks and assist regulators in assessing such frameworks, there is the need for more

prescriptive approach. IFIs must also work together to improve their risk management systems to

49

ensure the stability and soundness of Islamic financial system. There is an urgent need of

developing and implementing appropriate mechanisms, adequate systems of control to address

specific and unique characteristics of risks involved in Islamic finance.

4 OpportunitiesThe strong performance of the IFIs during the global financial crisis has grown the interest of

investment community, consumers and intermediaries investors around the world and is

increasingly gaining ground in western countries. Majority of large western conventional banks

have opened Islamic financing windows. Despite the regulatory hurdles presented by operating

in a non-Muslim financial environment IFIs have experienced double digit growth also in the

western countries. The growth of Islamic finance partly reflects demand from Muslim minority

communities residing in these countries, but also non-Muslim population of these countries is

increasingly using IFIs as a viable alternative to the CFIs. Latest legislative acts creating

favorable tax and legal conditions for the development of IFIs, in countries such as Australia,

Germany and France shows the growing importance of Islamic finance in the global financial

world. As a nascent industry, Islamic finance is constantly changing and evolving. The Islamic

debt market so far has been the most rapid growing segment of Islamic finance, even though it

suffered significant jitters in the wake of the Dubai debt crisis in2009/10. IFIs leaded by

Malaysia have been gearing up for further expansion by continuing to develop, refine and market

innovative Islamic financial instruments, on both the asset and liability sides. Many new Islamic

financial products have been developed and are increasingly used in financial market activities,

including equity and bond trading and investment, Islamic insurance, Islamic syndicated lending.

Innovation plays a big part in the growth of Islamic finance globally. In order to prosper and

become more competitive within the mainstream financial system worldwide IFIs must grab the

opportunities and exploit this momentum. The four opportunities that will be looked at and

discussed in this chapter are Market development, Product development and M&As. The first

two are based on the Ansoff’s matrix. The Ansoff’s matrix provides the knowledge of products

and market choice available to the organizations, or in this case industry, when they wish to grow

intensively (Kotler et al., 2003).

50

4.1 Market developmentThe consequences of global financial crisis, European sovereign debt crisis and the latest

Middle-East unrest urge IFIs turning to fresh sources and new markets for growth. Several

Islamic and also non-Islamic countries, around the globe, have taken initiatives in creating more

liquidity, enhancing market transparency and re-evaluating their domestic legislation with a view

to develop Islamic capital markets. While the CFIs suffer ratings downgrade, mistrust from

consumers and fiscal shortfalls due to the global financial turmoil, Islamic Finance has proved to

be a more stable and promising finance sector. However, the above mentioned events have also

highlighted the Islamic finance’s long-standing challenge in liquidity management. As

mentioned in the previous chapter, the challenges of liquidity management are caused by the

limited availability of Shariah-compatible capital markets. IFIs have difficulties managing their

liquidity properly due to lack of well functioning Islamic capital markets. Ali (2008, p. 30) points

out that; “capital markets at individual country level are underdeveloped in many OIC28

countries and segmented. Of the 57 OIC-member countries only 21 have stock markets of any

significance that are covered in the World Development Indicators of World Bank in 2006…

Different Muslim countries have adopted different practices in relation to various Islamic capital

market product and services which is a result of the varying interpretation on various Shariah

issues across jurisdictions.” However, in the past five years as a result of global financial crisis

the development of Islamic capital markets have been accelerated by both Muslim and non-

Muslim countries. International Islamic standard setting organizations such as IFSB, AAOIFI,

IIFM and recently established IILM have joined forces with western regulatory and standard

setting organizations in order to further develop the nascent Islamic capital markets. The collapse

of some prominent Western financial institutions and a general crisis of confidence in the

conventional system have created an upsurge of interest in Islamic finance from western

countries. Global financial markets are more than ever linked together and this applies naturally

to Islamic capital markets. In order for western investors to have any alternative choice of

investment opportunities or risk management tools a global Islamic capital market is required. As

Islamic finance plays an increasingly important role in mobilizing deposits and providing

financing in the western world, the development of an Islamic capital market allows the

corporate sector to source some of their financing needs. The development of Islamic capital

28 The Organization of Islamic Cooperation (OIC)

51

markets is an integral part of global capital markets development because it adds to the

efficiency of mobilization and allocation of resources internationally. A dynamic and vibrant

Islamic capital market can immensely contribute in overcoming the current recession the world

is facing. The leading IFIs in the world together with Islamic regulatory and standard setting

organizations need to embrace this potential opportunity and not let it slip away. They must work

hard together to enable the expansion and development of international Islamic capital markets

by means of standardizing contracts and documentation of Islamic financial products that are

Shariah compliant but at the same time compatible with the conventional system predominant in

the western world. Furthermore, they need to collaborate with the public and regulatory

authorities in the west because Islamic capital markets may have prospects only if these

authorities will take interest in it, and because without the development of specialized legislation,

it will be difficult for an Islamic capital market to function. It is important to promote the

economic benefits of Islamic financial instruments, and to position them as an alternative form of

financial transactions that may be interesting to a large count of businessmen and investors in the

western world. Insufficient understanding of its essence by regulatory authorities or investors,

including ambiguous attitude towards the Islamic financial products will impede the

development of Islamic capital markets. While the Islamic primary market is functioning better

and is expected to grow,29 its secondary market needs attention, not least because a sustainable

and vibrant secondary market promotes and sustains a well functioning primary market. The

existence of different opinions and Shariah interpretations on the permissibility of specific

financial products is a reality that confronts any attempt to establish commonly accepted

standards for products and practices for the secondary markets. On the other hand, shortages of

Shariah compatible instruments, the lack of qualified market makers and the limited

dissemination of information and data have impeded the development of well-functioning

secondary markets where long-term instruments can be traded. UK and Luxembourg have

recently canceled their planned sovereign issuance of Sukuk, which are considered as one of the

major catalysts for the development of secondary markets, reasoning “not value for money”30.

Issuance of the Sukuk depends much on the political and regulatory flexibility to reduce issuance

29 http://www.qfinance.com/capital-markets-best-practice/the-international-role-of-islamic-finance?page=3#s4 accessed on 10/9-201130 http://islamicfinanceturkey.blogspot.com/2011/05/capital-markets-fragile-sukuk-market.html accessed on 13/9-2011

52

http://islamicfinanceturkey.blogspot.com/2011/05/capital-markets-fragile-sukuk-market.html

http://www.qfinance.com/capital-markets-best-practice/the-international-role-of-islamic-finance?page=3#s4

costs. Therefore, government initiatives in this regard especially by easing laws related to

ownership and taxation is very important. The growing interest of non-Muslim investors for

Sukuk investments adds to the need for both sovereign and commercial issuance of Sukuk. These

factors reinforce the imperative for a higher level of standardization of Islamic financial products

which would reduce issuance and transaction costs, hence overall level of confidence in Islamic

financial products. IILM which has heralded to be savior to the Islamic secondary market is

expected to issue its first short-term commercial paper, with the minimum size of USD300

Million, at the end of 2011 in order to meet growing investor demand for Shariah-compliant

products in the secondary markets. But the issuance of these papers will hardly cope with the

demand. As it is presently common in the market, these issuances will be held to maturity by

investors due to the lack of alternative opportunities to invest in. Therefore, it is necessary for the

development of secondary markets and the capital markets in general that leading IFIs and

countries such Malaysia and GCC countries take the initiative to issue high quality Shariah-

compliant financial instruments at both the national level and across borders, to meet the demand

of the market and to provide it with the much needed tools for development. London, as the first

secondary market-maker for Sukuk31, could join this initiative which could further strengthen its

position as one of the major contributor to the development of Islamic finance. As one of the

world’s leading financial centre with its enormous experience London is well placed to act as a

catalyst in the further development of Islamic capital markets. As Anwar and Miller (2008) state;

“The UK financial services industry has a proven record of developing and delivering new

products and a large pool of legal, accounting and financial engineering skills on which to draw.

Several of these firms have now established or expanded offices in other Islamic centers. English

law is already the preferred legal jurisdiction for many Islamic finance transactions”. At present

products are increasingly being developed in London and then marketed in other countries,

especially in the Middle East because of their strong ties.

4.2 Product developmentThe increasing demand for more Shariah compatible instruments by consumers not only in

Muslim countries but around the globe have urged IFIs to focus more on product innovation to

meet the growing demand. The development of new products is one of the most important

elements for IFIs to prosper and become more competitive within the mainstream financial

31 London set up the first ever secondary market for trading Sukuk in 2006.

53

system worldwide. From the establishment of the first IFI in 70s through the new millennium in

2000, majority of Islamic financial products were developed in response to the demands within

Muslim communities. However, from 2000 to present there have been significant innovations in

the Islamic financial system from developments within the broader financial markets. Different

Islamic financial instruments have been introduced that have made it possible to provide equal

attractive Shariah-compliant alternatives to conventional financing requirements, competitive in

terms of both cost and service quality. While in the beginning the major obstacle to the

innovation of Islamic financial products have been Shariah compliance, today IFIs face

numerous other obstacles that they have to tackle in the product development process. As the

global financial markets are increasingly becoming interconnected, Islamic finance customers

face new challenges in their business transactions. A key challenge for IFIs today is to develop a

Shariah compliant instrument that is also acceptable within conventional financial system and

regulatory frameworks of western countries. This particular challenge has been more highlighted

by the limited number of both financial professionals with Shariah knowledge and/or Shariah

scholars with expertise in international finance. Although the increasing establishments of new

financial courses combined with Shariah law in educational institutions, in both Muslim and

non-Muslim countries, provide a new generation of practitioners who understand how the

modern Islamic legal system, Western regulations, and international finance integrally function

in a global economic system, they cannot keep up with the pace of the rapid growing Islamic

finance industry and provide enough banking professionals. It should be stated that innovation

does not only mean the creation of new products. Innovation also means enhancing existing

product features in order to accommodate changes in market dynamics and customer needs. At

present, innovation in product structuring is far more important to Islamic financial institutions

than introduction of new products, to keep the momentum of growth and development of

monetary and secondary markets. IFIs must seek to establish greater standardization and

harmonization of their products globally. Shariah rulings differences in different countries or in

different regions impede IFIs in introducing products that are accepted globally. For example,

products such as Murabaha and Istisna introduced by Malaysia are very popular and tradable in

the bond market of South Asian countries while it is not so popular in GCC countries. This is due

to an apparent conflict of Shariah rulings on the tradability restriction of these products. It is time

for Islamic financial products to be launched internationally and not locally or regionally. This

54

can be achieved by standardization and harmonization of Shariah rulings across the globe, as

mentioned previously. This standardization and harmonization will also help IFIs’ structured

products in the capital markets. Structured products are a combination of debt securities and

derivatives, like conventional products, but again due to differences in Shariah rulings these

products are accepted in some markets and rejected in others. Furthermore, when engineering

these products the approval from different Shariah boards take a lot of time and efforts, which

affect the cost considerably making them less competitive than their conventional counterparts

(Bennett 2011). In many CFIs with Islamic windows the staff that was used engineering

conventional structured products is being shifted to Islamic windows departments to develop

Islamic structured products. This practice however criticized by majority of Islamic banking

professionals and scholars as being a blind replication of products from the conventional

financial system dressed with an Islamic veneer. They argue that, this practice firstly is not time-

and cost-efficient because of additional approval of different Shariah boards, secondly in the

long run, it will only lead Islamic financial system to the same risks and problems that

conventional system if faced with. Considering the above mentioned problems, there is an urgent

need for the development of international regulatory measures on standardization and

harmonization of products. Product development in Islamic finance must accelerate in order to

grow and compete with the conventional financial system, but it must be based on creativity and

constructive thinking, while remaining true to Shariah principles, and avoiding imitation of

conventional products. Products developed must be based on the core Islamic finance theory, and

that is profit and loss sharing, otherwise Islamic finance will only add to the existing problems

world is faced with after global financial crisis.

4.3 Consolidation and M&AsMergers and Acquisitions (M&As) in conventional financial system have a long history and now

a days is very common in countries around the globe. These M&As activities find place both

domestically and internationally. With the help of M&As in the financial sector, the CFIs have

achieved significant benefits of economies of scale. The first wave of M&As in conventional

financial system in the U.S. occurred during 1895-1900 and it was characterized as horizontal

mergers, when merging entities are involved in the same kind of activities. These mergers

happened because there was fast growth in the industry, institutions wanted to build market

55

power, and new technology was available.32 While these characteristics are similar to those

Islamic finance are described with at present, M&As in this industry are far lesser and in some

regions even non-existent. Even in the GCC countries which have too many IFIs operating in

the region, and where multinational institutions with Islamic windows are crowding out local

smaller IFIs, the M&As trends are not seen. For the better part of the last five years, there have

been repeated calls for consolidation33. Financial analysts around the globe have been calling for

more consolidation and/or M&AS to take place in Islamic finance industry. They believe that

IFIs are small and are struggling for growth compared to CFIs, therefore there is an urgent need

for IFIs to consolidate/merge and create much larger institutions in order to compete with CFIs

internationally. In recent study conducted by IMF (WP/10/201), the analysis shows that large

Islamic banks fared better than small ones as a result of better diversification, economies of

scale, and stronger reputation. Based on this study the paper suggests that development of the

industry might be achieved through establishing large, well-managed Islamic banks that can

compete with existing banks. Indeed, by merging into larger institutions IFIs could enhance their

efficiency, profitability and competitiveness both locally and internationally. It should be stated

that in the financial industry size do matter. As Kahf (2004) states; “The financial sector is like a

jungle where the fatter the prey the larger the predator animal that is needed to devour it. The

bank that enters the market with huge capital is able to find higher return investments, in

addition to it being able to instill greater confidence in investors, thus making them to come

forward to it with their investments”.

In the latest publication by A.T.Kearney (2010), the reason for low interest in M&AS in the

region is explained as IFIs experiencing easy double-digit organic growth were too expensive for

a profitable acquisition or mergers for that matter. It states also that after 2008, as the economic

crisis continues to hamper growth and the market becomes more crowded, the need for

consolidation in the industry is increasing. But despite the low asset prices, merger and

acquisition (M&A) activity has been limited and one of the major hurdles is mentioned to be

regulative issues.

32 Bartholdy, J. 2010, Mergers and acquisitions, lecture slides distributed in Advanced Corporate Finance at The Handelshoejskolen i Aarhus, Denmark.33 http://gulfnews.com/business/banking/the-need-for-consolidation-of-gcc-insurers-should-be-heeded-1.858335 accessed on 25/9-2011

56

http://gulfnews.com/business/banking/the-need-for-consolidation-of-gcc-insurers-should-be-heeded-1.858335

However, during the global financial crisis more and more liberalization of the financial sector is

seen in the GCC countries and other predominantly Islamic financial regions. The central banks,

Central Bank of Kuwait (CBK) for example, and other regulatory institutions are increasingly

encouraging consolidation by local and cross-border M&As.34 Furthermore, the planned merger

of two Bahraini banks, intended to create the largest Islamic lender in the kingdom, is seen as

encouraging consolidation and breaking down the psychological blocks to M&As in this region 35. Indeed, this kind of deal can be a start to chain-reactions in the region driving the Islamic finance to

the next level of industry maturity and eventually encourages IFIs to cross border M&As. At present,

majority of IFIs in the GCC region are state owned and there are strict ownership restrictions in majority

of these countries which limits foreign ownership which impede consolidation and M&As. However,

GCC countries are increasingly adapting the experience of South Asian countries such as Malaysia and

Indonesia that have taken the leadership in Islamic finance with deregulations and easing of restrictions

on foreign ownership. These countries have experienced greater competition and innovative products and

have attracted major international players from around the globe as a result. In order to be more

competitive with other regions GCC countries will have to ease restrictions on foreign ownership and

encourage private banking and wealth management services. Another way for consolidation and M&As

to find place, in order to make IFIs larger, is mandatory consolidations. IFSB (2007) have predicted that

Market-driven as well as mandatory industry consolidation, in particular through mergers and

acquisitions, is expected to take place in view of the small capitalization of most Islamic banks. In the

past some countries such as Sudan and Pakistan had announced mandatory programs for strengthening

the capital of banks and of mergers to the extent to which this is necessary for the purpose (Chapra and

Khan 2000). This has worked in the past and could be necessary for other countries, especially in the

GCC countries, to announce such programs if market driven consolidation or M&As does not happen. It

is necessary for the viability, competitiveness and further growth of IFIs in the international environment.

4.4 Concluding remarks

During the global financial crisis Islamic finance proved to be more resilient and came out of it relatively

unscathed. This has attracted not only the attention of latent Muslim countries generally but also many

conventional investors around the globe. In order to grab this opportunity and exploit this

momentum for the growth becoming more competitive within the global mainstream financial

system, IFIs must become more pro-active in market development, product development and 34 UK Trade & Investment Sector briefing (2011): “Financial & Professional Services opportunities inKuwait” available on http://www.globaltrade.net/f/market-research/pdf/Kuwait/Banking-Finance-and-Insurance-Financial---Professional-Opportunities.html 5/10-201135 http://www.reuters.com/article/2011/08/17/banks-middleeast-idUSL5E7JE04I20110817 accessed on 8/10-2011

57

http://www.reuters.com/article/2011/08/17/banks-middleeast-idUSL5E7JE04I20110817

http://www.globaltrade.net/f/market-research/pdf/Kuwait/Banking-Finance-and-Insurance-Financial---Professional-Opportunities.html


consolidation in the international markets. Discussing these opportunities in this chapter, it could

be concluded that in order to grab this opportunity there is an urgent need for IFIs, especially

those located in the GCC region, to come up with a new strategy that is not building solely on

organic growth. In some parts of the world, primarily South Asia, there are evidences that a new

strategy for IFIs where the growth which previously was based on local or regional organic

growth, is now being transformed into a global positioning strategy. Malaysia for example has

chosen to actively exploit the mentioned above opportunities. They have a high rate of product

innovation, eased the foreign ownership requirements in the financial sector in order to attract

international investors, and in collaboration with them, to develop new markets. And finally,

they encourage consolidations and M&As through their recent deregulations. These actions have

also encouraged other countries to be more proactive exploiting these opportunities. However,

although these transformations are taking place in the Islamic finance industry, IFIs have, with

some exceptions, a number of years to go before they reach the stage when they can compete

with major CFIs globally. Perhaps the most damning concern so far is that majority of western

countries are taking too much time to make changes in their financial regulations so that IFIs

could operate properly. The long process of engineering Shariah compliant structured products

for the monetary and secondary markets, and which is also acceptable within conventional

financial system, and regulatory frameworks of western countries add to this concern. It seems

though that global demand for IFIs’ products is growing, and this market driven demand will

eventually speed up both exploitation of the mentioned opportunities by IFIs and deregulatory

measures taken in the western world.

5 Summary and final conclusion

This chapter includes an overview of the structure and concepts of this thesis and serves to

summarize the result of the theoretical analysis that we went through in the preceding chapters.

5.1 Overview of the thesisAs was stated at the beginning the purpose of this thesis was to give a comprehensive overview

of opportunities and challenges that Islamic financial institutions (IFIs) face in the world, and to

explore the reasons behind the slow growth of Islamic banking in the Western world. More

specifically, the objective of this thesis was to come up with suggestions for both IFIs and

58

western regulatory authorities, after looking at the challenges and opportunities the Islamic

finance is facing in the world, on how to pave the way for further growth of Islamic finance

globally, particularly in western countries including non-Muslim customers. This objective led

me to the following research question:

What regulatory measures do the Western world countries must take and what institutional

changes IFIs must make, in order for Islamic finance to thrive and prosper in the Western world

not only for Muslim but also non-Muslim consumers?

The challenges discussed in chapter three and opportunities in chapter four have partly answered

the above mentioned statement which will be summarized in the conclusion. Furthermore, to

help answering the research question, it was also partly necessary to get an in-depth

knowledge about all the possible existing theories and concepts of Islamic finance. It was

evident though, from the review of the available theoretical literature in the chapter two, that

there are as many different theories and concepts of Islamic finance as there are schools of

thoughts in Islam because Islamic finance is based upon religion. These schools of thought have

different interpretations of basic Islamic concepts. The concept differs also from region to

region, from fundamentalists dreaming of Islamic financial industry just for Muslims and saving

Islamic world from western capitalism, to banking professionals who see it as an ethic and viable

alternative to conventional financial industry. But in order to sum up, overall Islamic finance

builds up upon the main principle of Islam which is Halal (permissible) and Haram

(impermissible). Three main concepts which modern Islamic finance is based on are part of the

Haram principle, mentioned in the chapter two, and are followings:

Prohibition of interest (Riba) - fixing in advance a positive return on a loan, as a reward

for waiting, is not permitted.

Gharar - there must not be “asymmetric information” or uncertainty between parties.

Maysir – prohibition on transactions that are based on one side’s gain at the cost of the

other.

5.2 summaryIslamic finance has experienced a rapid growth during the last few decades, but this growth has

mostly been organic. With most IFIs being state owned or being aided by state, this organic

59

growth did not meet any competition locally or in their regions. Only, with the beginning of the

new millennium, with deregulations taking place in majority of Muslim countries, and IFIs

expanding their operations internationally, they started increasingly to meet competition from

larger CFIs with Islamic windows. As the introduction part of this thesis indicated, IFIs have

taken this competition seriously, and without doubt, the recent global financial crisis has played

into the hands of IFIs. While the global financial crisis has discredited the conventional financial

system, hurting some of the largest CFIs, and still does, the Islamic financial system has been

experiencing growth, except some small IFIs that were hit when crisis touched real economy.

The contribution of knowledge and experience of some leading western countries to Islamic

financial industry in financial matters has also had its impact on the growth of Islamic finance,

especially of the UK. Due to their resistance to the crisis IFIs are facing rising demand for their

services not only from Muslim investors but also from conventional investors, with the

increasing popularity around the globe. Islamic finance is being actively discussed by experts

both in the public and private sectors in majority of western countries. While there is demand for

Islamic finance in majority of western countries, public authorities are divided on introducing the

elements of Shariah-compliant finance to their country by making regulative changes. In fact,

this division of public authorities in the western world, in large part, is due to some challenges in

compatibility with the existing financial systems, rigorous practices of IFIs’ operations and the

way they are run, which are used against them by oppositions. With only minor changes in their

practices, in some cases large changes, but still Shariah compliant, IFIs can successfully remove

these barriers and provide a much better ground for the supporters of Islamic finance in these

countries. Chapter two highlighted some general problems existing in the theory of Islamic

finance in the form of differences in the interpretations of some basic Islamic concepts which

then is transferred to products available by IFIs. In the following chapters, chapters three and

four, some specific challenges and opportunities related to the further growth of Islamic finance

and its establishment in the world, specifically western world, were addressed and analyzed.

These analyses helped me and made it possible for me, to come up with the following

suggestions on what must be done from both IFIs and western countries’ side to pave the way for

further growth of Islamic finance globally, and especially in western countries which includes

non-Muslim customers. This has also been the objective of this thesis.

60

5.3 ConclusionThe challenges and opportunities reviewed in the last two chapters were all somehow related to

one particular problem, which make it priority number one, and that is regulatory issues. The

prevailing legal systems in the western countries, including some Muslim countries, are

predominantly based on the conventional financial system which makes it difficult for IFIs to

establish themselves and compete on the same playing field as CFIs in these countries.

Especially, issues related to double taxation of some IFIs’ products must be resolved. IFIs have

been recognized as an alternative investment opportunity and resistant to the global financial

crisis, and considering the economic situation in majority of western countries, with CFIs’

damaged reputation, it is in the interest of public authorities to provide an alternative investment

opportunity for the general public. Therefore, it is up to the western countries regulatory

authorities to take the initiative and introduce a series of tax and legislative amendments,

specifically designed to remove obstacles to the development of Islamic finance, focusing in the

first place on tax and VAT issues related to products provided by IFIs. Further, central banks or

other regulatory institutions in these countries, in cooperation with institutions such as AAOIFI,

IFSB or the central bank of Malaysia in this case, could establish joint special task forces in

order to remove the regulatory obstacles for the PLS operations of IFIs, which are considered not

compatible with the banking requirements of these countries, because these products are an

important part of Islamic financial industry. Finally, the lender of last resort or central banks in

these countries must develop Shariah compliant alternatives, used for example by the central

bank of Malaysia, in dealing with deposits of IFIs required to be kept with them. By acting

proactively these authorities could prevent and lessen risks related to the operations of IFIs hence

future instabilities in their financial markets, because Islamic finance growth eventually will be

market driven and in the near future IFIs will be in the too big to be ignored class.

From IFIs’ side, the issues that must be addressed are as important as mentioned above. It is

though difficult to prioritize here because all issues are much or less equally important.

Regardless of priorities, IFIs must address these issues as soon as possible in order to benefit

from the current situation. IFIs must improve their corporate governance practices and define the

precise role of Shariah boards. Operating in countries which have focused so much on this issue,

and have some of the strongest corporate governance practices, requires IFIs to improve their

practices otherwise experienced investors in these countries will stay away from them, especially

61

when they meet an industry that they know less about. IFIs should adapt their standards to

international set of standards and guidelines like OECD’s, which is also followed by CFIs, as

much as possible. In the same time, IFIs must address the issue of risk management, and

especially the vital issues of liquidity and credit risk management, which will eventually lessen

their dependence on the central banks of western countries. IFIs should support and cooperate

with IILM, which has solely been established for this purpose, to enhance capital market

functions and thus provide themselves with a solid liquidity management structure. They can

also increasingly use products such as Sukuk, famous also among conventional investors, as

mechanisms of liquidity management, but to do so the issuance of these kinds of products must

be improved and approved by IFIs globally. This leads us to the next issue that must be

addressed by IFIs, specifically product standardization. IFIs must seek to establish greater

standardization and harmonization of their products globally, by harmonizing the Shariah rulings

across the globe. The existence of different rulings on a certain product will only discourage

western investors from investing in such products, especially when they are new in this field.

Finally IFIs must seek to consolidate. It must start within Islamic countries in regions where

market is overcrowded such as GCC countries. When Islamic finance has problems establishing

themselves in western countries in advance, the small size of these IFIs will make it much harder

or even impossible. Once IFIs get larger in size they will also be welcomed with open arms

everywhere, this will also make it easier for public authorities to make amendments their

regulatory requirements considering the amount of investments. In the second phase, these larger

IFIs will have the capability of merging or acquiring financially distressed conventional

institutions in the western countries and convert them to IFIs.

There are plenty of other suggestions, but in my opinion the above mentioned are most important

issues that must be addressed from both sides and as soon as possible in order to pave the way

for continuing growth of Islamic finance in the world, with focus on the western countries. Other

challenges and opportunities mentioned in this thesis could, to some extent, be met by market

driven demand itself.

It should be acknowledged that Islamic finance is still a nascent industry thus in constant

development, therefore the growth of IFIs in the world and particularly in the western countries

must be monitored. As the time passes, future studies could be made in this relation, with more

62

empirical data on the performance of IFIs in these countries available, to get a better insight on

the suggestions discussed in this thesis, whether affirming or disaffirming them.

5.4 Limitation of the studyDuring the writing of my thesis I encountered on more challenge relevant to the topic, but due to

space and time considerations this challenge was not discussed. The challenge is unfamiliarity

and the negative picture of Islam among majority of non-Muslims in western countries. Due to

some reasons, general public in the western countries have developed a common misconception

about Islam as religion. This misconception could seriously impede the growth of everything that

is connected with Islam hence Islamic finance.

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