Islamic Banking Bulletin September 2006

Transcription

1 Islamic Banking Bulletin September 2006 Prepared By Mr. Imran Ahmad Ms. Sumera Baloch Islamic Banking Department State Bank of Pakistan

2 September 2006 State Bank of Pakistan Islamic Banking Bulletin Islamic Banking Bulletin gives an overview of the Islamic Banking Industry and provides information regarding the developments taking place in this industry locally and internationally. An article pertaining to Islamic Banking & Finance is also presented as an annexure (Annexure-II) with this report. Inside this issue: Bank in Focus 2 Book in Focus 3 Product in Focus 3 Issues in Islamic Banking Upcoming Events 6 Developments at IBD 7 IERS 7 Local News 8 International News 9 5 Islamic Banking Sector Structure of the Islamic Banking Sector Balance Sheet Structure Cash and Liquidity Position Profitability The Islamic Banking Sector continued to grow which is reflected by the increasing branch network of the Islamic Banking Institutions. The network details can be seen in the Annexure-I. The Balance Sheet footing of the Islamic Banking Industry kept on increasing. The total assets portfolio in the Islamic Banking Sector expanded by 0.59% to Rs billion in August 2006 from Rs billion in July Total loans and advances, net of provisions comprised of 57.18% of total assets and stood at Rs billion in August 2006 compared with Rs billion or 57.13% of total assets in July Advances as a percentage of total assets have increased by a nominal percentage. Total assets have increased due to substantial increase in other assets. Deposit liabilities increased by 1.56% % to Rs billion as at the end of August from Rs billion in July Due to the dominant position of advances on asset side, the credit to deposit ratio was 82.15%. a high credit to deposit ratio exposes industry to a fairly high degree of credit risk. Islamic Banking Sector equity and Islamic Banking Fund increased by 0.14% to Rs billion from Rs billion. Cash held by Islamic Banking Institutions at the State Bank of Pakistan increased by 0.71% to Rs billion from Rs billion. It averaged 15.27% of deposit liabilities in August 2006 which was % in the month of July Cash Reserve Requirement (CRR) for the Islamic Banking Institutions is 7% as per BSD Circular No. 10 dated July 22, Islamic Banking Institutions on the liquidity front are consistently meeting their CRR and SLR requirements and significant amount is kept as cash and balances with other banks. Unappropriated / unremitted profit for the month of August increase by 1.42% to stand at Rs billion compared to last month which was at Rs billion. Due to higher volume of business, profitability indicators have also improved..

3 Bank in Focus: Meezan Bank Limited Meezan Bank Ltd is the First Islamic Bank to be given Islamic Banking License in Pakistan. The license was issued on First Branch of the Meezan Bank opened on at Ground Floor, Block B,FTC Building Sharah-e-Faisal, Karachi. Following Product Range is being offered by Meezab Bank Limited Deposit Products Mudarabah based Deposit Products Mission: To be a premier Islamic TRANSACTIONAL ACCOUNTS Bank offering a one-stop shop for Rupee Saving accounts - Karobari Munafa Account innovative value-added products - Dollar Saving accounts - KMA Plus and services to our customers - MIIDA ISLAMIC TERM DEPOSITS within the bounds of Shariah, Riba Free Certificates of Islamic Investments COIIs while optimising the stakeholders Monthly Mudarabah Certificates value through an organizational Dollar Mudarabah Certificates culture based on learning, Meezan Amdan Certificates fairness, respect for individual - Long term deposit product for Pension & Gratuity Funds enterprise and performance. Meezan Providence Certificates (MPCs) RETAIL ASSET PRODUCTS First Islamic Car Financing scheme Car Ijarah (New & Used Cars as well as Motorcycles) First Islamic Housing Finance scheme Easy Home (with 4 variants: Buy, Build, Renovate & Replace ) CORPORATE & SME Corporate Murabaha (PKR & USD) for Short Term Financing Diminishing Musharakah- Long Term Financing for Plant & Machinery, Commercial Premises Corporate Ijarah- Long Term Financing for Fixed Assets Shariah Compliant Schedule of Charges STRUCTURED FINANCE Pakistan s first Musharakah Term Finance Certificates Sitara MTFCs Fayzan Manufacturing Mudarabah with ICI Govt. of Pakistan s Global Sukook TRADE FINANCE Import Financing through Import Murabaha & Musharakah Sight & Usance LCs - Shariah Compliant alternative Shariah Compliant alternative of Bill Discounting Islamic Export Finance Scheme based on Musharakah Meezan Islamic Institution Deposit Account (MIIDA) TREASURY OPERATIONS Exchange Risk Hedging through Forward Promise FX dealings under Bai Salam & Bai Surf rules LIQUIDITY MANAGEMENT Special Mudarabah based account for other Islamic banks for short term liquidity mgmt. Pakistan first Shariah compliant Musharakah & Mudarabah based solutions for Acceptance of funds from Inter-bank Money Market Special Musharakah based Deposits for banks & Corporate sector. MUTUAL FUND: Shariah Compliant Screening Criteria for Investment in Stocks Meezan Islamic Fund Largest Shariah Compliant Mutual Fund of Pakistan Meezan Balanced Fund First Islamic Balanced Fund. TAKAFUL Pakistan s first Shariah compliant Islamic way of Insurance- FIRST TAKAFUL-A joint venture of Meezan Bank and Pak Kuwait Page 2

4 Core Marketing Functions of Meezan Bank Achieve strong and continuous brand awareness in the market. Highlight MBL as a full-fledged commercial bank. Effectively support core product lines to enhance acquisition. Promotion of key distribution channels. Reinforce our key USP of absolute Shariah Compliance through market education. Human Resource Capacity Building Special focus on Islamic Banking training of Meezan Bank staff Special module developed for Islamic banking, Product training, documentation & Shariah Standards Full day advance workshop are organized for Branch Manager, Corporate RMs etc 4-month Islamic Banker Certification Program have been launched Regular training sessions & seminars with NIBAF, EPB, IBP, NIPA, CIE etc Developed graduate level courses for IBA, IQRA, LUMS and other universities Future Plan Establishment of full fledge International Training Institute for Islamic banking - to provide training to MBL Staff, other Islamic banks & general public Book in Focus: An Introduction to Islamic Finance, Muhammad Taqi Usmani Islam does not deny the market forces and market economy. Even the profit motive is acceptable to a reasonable extent. Private ownership is not totally negated. Yet, the basic difference between capitalistic and Islamic economy is that in secular capitalism, the profit motive or private ownership are given unbridled power to make economic decisions. Their liberty is not controlled by any divine injunctions. If there are some restrictions, they are imposed by human beings and are always subject to change through democratic legislation, which accepts no authority of any super-human power. This attitude has allowed a number of practices, which cause imbalances in the society. Muhammad Taqi Usmani writes about these imbalances and tries to provide a cure using Islamic concepts of finance. Islamic Modes of Finance: Murabaha The term Islamic Modes of Finance is defined as follows: The systematic and detailed Shariah rules that govern the contractual relationship of an investment activity that can be applied for attracting money capital (Fahmy & Sarkar). Bai-Murabaha Meaning of Murabaha The terms "Bai-Murabaha" have been derived from Arabic words Bai and Ribhun. The word 'Bai' means purchase and sale and the word Ribhun means an agreed upon profit. Bai- Murabaha" means sale for an agreed upon profit. Bai-Murabaha may be defined as a contract between a buyer and a seller under which the seller sells certain specific goods permissible un- Surat Al-Baqarah, (Verses 278 & 279), what can be translated as, "O you who believe! Fear Allah and give up what remains (due to you) from riba (from now onward), if you are truly believers. And if you do not do it, then take a notice of war from Allah and His Messenger but if you repent, you shall have your capital sums. Deal not unjustly, and you shall not be dealt with unjustly." Page 3

5 Islamic Shariah and the Law of the land to the buyer at a cost plus an agreed upon profit payable today or on some date in the future in lump-sum or by installments. The profit may be either a fixed sum or based on a percentage of the price of the goods. Types of Murabaha In respect of dealing parties Bai-Murabaha may be of two types: Ordinary Bai-Murabaha, and Bai-Murabaha order on and Promise. Ordinary Bai-Murabaha is a direct transaction between a buyer and a seller. Here, the seller is an ordinary trader who purchases goods from the market in the hope of selling these goods to another party for a profit. In this case, the seller undertakes the entire risk of his capital investment in the goods purchased. Whether or not he earns a profit depends on his ability to find a buyer for the merchandise he has acquired. Bai-Murabaha order on and Promise involves three parties - the buyer, the seller and the bank. Under this arrangement, the bank acts as an intermediary trader between the buyer and the seller. In other words, upon receipt of an order and agreement to purchase a certain product from the buyer, the bank will purchase the product from the seller to fulfill the order. There are some important features of Bai-Murabaha as given below. Important Features of Murabaha A client can make an offer to purchase particular goods from the bank for a specified agreed upon price, includig the cost of the goods plus a profit. A client can make the promise to purchase from the bank, that is, he is either to satisfy the promise or to indemnify any losses incurred from the breaking the promise without excuse. It is permissible to take cash/collateral security to guarantee the implementation of the promise or to indemnify any losses that may result. Documentation of the debt resulting from Bai-Murabaha by a Guarantor, or a mortgage, or both like any other debt is permissible. Mortgage/Guarantee/Cash Security may be obtained prior to the signing of the Agreement or at the time of signing the Agreement. Stock and availability of goods is a basic condition for signing a Bai-Murabaha Agreement. Therefore, the bank must purchase the goods in accordance with the specifications of the client, thereby taking ownership of the goods before signing the Bai-Murabaha agreement with the client. Upon acquiring the goods, the bank assumes the risk of ownership. In other words, the bank is responsible for damages, defects, and /or spoilage to the merchandise until such time that it is actually delivered to the buyer. The bank must deliver the goods to the client at the date, time, and place specified in the contract. The bank sells the goods at a price above the cost to obtain a profit. The sale price that is charged by the bank is agreed upon in the Bai-Murabaha. The profit can be stated in terms of a flat dollar amount or on a percentage of the purchase price. If a percentage is used, the percentage shall never be expressed in terms of time, in order to avoid confusion that the price is a form of interest (Riba), which is not allowed. The price agreed to in the agreement is binding on both parties. It is permissible for the bank to contract with a third party to buy and receive the goods on its behalf. This agreement must be a separate contract. These features make Bai-Murabaha distinctive from all other modes of Islamic Investment. Application of Bai-Murabaha Murabaha is the most frequently used form of finance in Islamic banking throughout the world. It is suitable for financing the different investment activities of customers with regard to the manufacturing of finished goods, procurement of raw materials, machinery, and other required plant and equipment purchases. Page 4

6 Issues in Islamic Banking: Liquidity Management In a conventional banking system, the treasury has to manage the bank s cash flow to maximise the profit generating potential of the front lines, and to protect the balance sheet and P&L statement from erosion due to market risk. To achieve this all current and future cash flows are to be identified and priced at market levels. The excess liquidity is to be managed through mainly four ways; (1) Lending the surplus in the inter-bank network, (2) Invest in government securities, (3) Lend to corporate customers, (4) Keep the excess funds at 0 percent return. The first three ways involve interest and Islamic Banks cannot utilise these options. From a liquidity management perspective, Islamic banking have to come a long way. Today, many more multinational companies (MNCs) are exploring the potential to optimise their liquidity across the globe and are making useful improvements in the management of their day-to-day liquidity problems. Liquidity risk encompasses risks arising out of gaps in applications and available resources, mismatching of tenors of sources, and application of funds, not meeting prudential liquidity requirements, lack of access to the market etc. For this, the conventional bank s treasuries used to place the excess funds overnight in money market but the Islamic banks cannot do this because of Shariah constraints. Surplus liquidity with Islamic banks cannot be easily transferred to conventional banks since the Islamic banks do not accept interest, however there is room for exchange of surplus funds among the Islamic banks on a Mudarabah / Musharakah basis. The greater the number of Islamic banks and wider their activities, the greater will be the scope of cooperation in this field. In general, to manage liquidity effectively, you need visibility of your cash positions, good forecasting, a way to concentrate your funds, and the ability to negotiate FX and get it done before cut-off times. The challenges, with liquidity management in Islamic Banks, are not just regulatory ones. It may currently be difficult to manage the excess liquidity but it will soon be possible as steps are being taken to make a liquidity management structure for Islamic banks / divisions. Investments will be made in equity or mutual funds and in any Shariah compliant Islamic product available in the market at that particular time or to invest the excess funds with other Islamic banks. An Islamic Collective Investment Scheme can then be introduced to collectively manage the problem of excess liquidity. State Bank of Pakistan has formed a Task Force to map out a plan for introducing short term and medium term liquidity management products based on innovative Islamic Structures that would enable Islamic Banking Institutions in Pakistan to manage liquidity matters. Terms of Reference of this task force includes structuring of Islamic Instruments for short term liquidity management, comparative study of such Islamic Instruments issued by other countries, practices of IIFS in meeting SLR by Central Banks, structuring of Shariah compliant instruments for money market operations, introduction of Islamic instruments using securitization techniques, examination of these instruments from regulatory, legal and operational requirements, preparation of recommendations on modes and methods for issuance of these instruments, reporting mechanism of these instruments, identifying instruments which can be used by the Government of Pakistan, etc. Page 5

7 Upcoming Events & Training Title Islamic Real Estate Asia 2006 Organisation Finance IQ - A Division of IQPC Worldwide Location of Organisation Singapore Event Dates From: 11/9/2006 to: 12/9/2006 Location of Event Event Details Title Organisation Location of Organisation Grand Copthorne Waterfront Hotel, Singapore Finance IQ is proud to bring you the first and only Islamic Real Estate conference to take place in Asia. Taking place September the conference brings together leading experts in Islamic finance and real estate not just from Asia, but from all over the world. For more information please contact Andrew Thake at (65) , enquiry@iqpc.com.sg or log on to Fundamentals of Islamic Banking & Finance Islamic Finance Training Malaysia Event Dates From: 11/9/2006 to: 14/9/2006 Location of Event Event Details Title Organisation Location of Organisation Jakarta The 4-day programme will explain the background and most important characteristics of Islamic finance. The course will go on to examine the most commonly structured products, including capital markets instruments. World Islamic Infrastructure Finance Conference MEGA United Arab Emirates Event Dates From: 5/11/2006 to: 6/11/2006 Location of Event Event Details Title Organisation Location of Organisation Doha, Qatar The 1st Annual World Islamic Infrastructure Finance Conference will bring together Investors, Project Developers, Conventional & Islamic Financial Institutions with key Government agencies in order to fast-track infrastructure development. The theme of this major world conference will tackle how conventional and Islamic institutions can better collaborate in order to meet the huge demands for project finance. Islamic Financial Engineering & Advanced Products Islamic Finance Training Malaysia Event Dates From: 6/11/2006 to: 9/11/2006 Location of Event Event Details Dubai The course will enable delegates to develop a detailed understanding of core products such as Sukuk and Ijarah, as well as requisites for Islamic financial engineering and the contracts involved. The course will also cover in detail contracts for project financing and Islamic swap structures and uses. Title Organisation Location of Organisation Third International Business Conference World Business Institute Australia Event Dates From: 20/11/2006 to: 22/11/2006 Location of Event Melbourne, Australia Event Page Details 7 Papers, abstract and case studies relating to all areas of Islamic Banking, Islamic Finance, Islamic Insurance (Takaful), Islamic leasing, Islamic Ethics, Islamic Economics, Islamic concepts of Management, Marketing and Accounting are invited from the researchers, students and practitioners. There are outstanding doctoral research awards and best paper awards. Please visit for more information.

8 Developments at State Bank of Pakistan IFSB Task Force Meeting The Islamic Financial Services Board (IFSB) is an international-standard setting body of regulatory and supervisory agency having vested interest in ensuring the soundness and stability of the Islamic financial services industry. To strengthen and streamline the statistical information on the Islamic financial services industry (IFSI) worldwide, IFSB Task Force on Prudential Islamic Finance Database had its first meeting at Hotel Sheraton, Karachi on Wednesday August 23, 2006 under the patronage of State Bank of Pakistan which is a founding member of the IFSB. Business Review Meeting A Business Review Meeting was conducted on 17 th August 2006 at the Board Room of the Learning Resource Center of the State Bank of Pakistan, Karachi for the purpose of reviewing the performance of Islamic Banking Business of Meezan bank. In the meeting following points were in focus: Products being offered Performance Review Marketing Plan Human Resource Capacity Building Service Standards Charity Fund Projects submitted by the Internees Internship of the five Internees assigned to the Islamic Banking Department completed on 16 th August They presented the following projects: Micro Finance in context of Islamic Banking Marketing & Promotion of Islamic Banks in Pakistan Importance of Corporate Governance in Islamic Banking Comparative Analysis of Islamic Banking Industry Islamic Export Refinance Scheme The State Bank has been striving to ensure that the credit requirements of the genuine exporters from the banking system are not effected. In order to ensure smooth flow of credit to the genuine exporters the SBP has already put in place necessary mechanism under its Export Finance Scheme (EFS), which has been in operation since The recent developments relating to the introduction of specialized Islamic banking institutions have made it imperative for us to formulate a Scheme to enable the exporter to avail SBP s refinance through the newly established Islamic Commercial Banks against eligible commodities. Accordingly, we have designed a new Scheme styled as Islamic Export Refinance Scheme (the Scheme). Islamic Export Refinance Scheme was initiated in 2002 through Board approval. The said Scheme shall also be utilized by the dedicated branches of the commercial banks that would work as stand alone branches for providing the Islamic Banking Products and Services, for availing refinance against financing facilities provided by them to exporters for eligible commodities. Page 7

9 International News Islamic banking in foreign currencies soon Bank Negara will issue new conditional licenses under the Islamic Banking Act and Takaful Act to allow qualified local and foreign lenders and even takaful operators to conduct the full range of Islamic banking and takaful business in foreign currencies, said governor Tan Sri Dr Zeti Akhtar Aziz. The move, she said, would augment Malaysia s position as it strengthened itself as an international Islamic financial hub and, at the same time, enhance the capabilities of foreign players that have identified Malaysia as a centre to serve the regional markets. Islamic financial products and services that are transacted in international currencies may now be conducted from anywhere in Malaysia, Zeti said in her opening address at the Malaysian Islamic Finance Forum StanChart, Bank Islam seal world's first Islamic hedging tool Standard Chartered (StanChart) Malaysia Bhd and Bank Islam Malaysia Bhd have introduced the world's first Islamic financial hedging tool to facilitate their in-house risk management. The two banks can now better manage their portfolio of risks by benefiting from lessened exposure from either fixed or floating rates stemming from a Wiqa Forward Rate Agreement (WFRA). WFRA enables a floating rate-based profit payment to be exchanged for a fixed profit payment for a specific time period, or vice versa. Under the deal signed between the two banks on August 15, Bank Islam will hedge RM130 million worth of financial assets over three years, using StanChart's Islamic hedging facility. Bank Negara: Need to resolve Shariah matters Bank Negara plans to launch initiatives for the harmonisation of different Shariah interpretations and called for the stepping up of dialogue among scholars around the globe. Let us debate, confront the issues and hopefully come out with solutions to these long outstanding issues, deputy governor Datuk Mohd Razif Abdul Kadir said in his closing address. We are assembling a group of prominent scholars across the globe to confront issues concerning Islamic banking and finance. So now is the time for us to take these Shariah issues seriously, Razif said. The harmonisation of syariah interpretations would greatly enhance the markets, products and liquidity of the Islamic banking and finance sector, he said. BIBD, BLNG to issue first corporate Islamic bonds In realising the first-ever corporate issue of Islamic bonds or 'Sukuk Al-Ijarah', Bank Islam Brunei Darussalam Berhad (BIBD) as an integral part of the financial community in the country is proud to be working together with Brunei LNG Sdn Bhd (BLNG) and the Ministry of Finance. The first syariah-compliant financial instrument based on the Sukuk Al-Ijarah concept in collaboration between BLNG and BIBD was launched in a signing ceremony held at the BIBD Headquarters in the capital. Page 9

10 Japan set to enter Islamic banking The government-backed JBIC said it was studying the possibilities of issuing Islamic bonds to help Japanese businesses diversify their fund raising Japan is looking to become the first major industrialized nation to issue Islamic bonds in hopes of attracting money from oil-rich Muslim countries, a bank official said yesterday. Islamic financial practices ban the payment or receipt of interest or any transactions that include alcoholic beverages or gambling, which are banned by the Koran. "The bank is studying the possible issuance of the bond with Malaysia," said Hiromi Inukai, a spokeswoman of the government-backed Japan Bank for International Cooperation (JBIC). "The bank has had talks with the central bank of Malaysia with the intention to attract ample petro-dollars not only to Japan but also to the whole of Asia," she said. She declined to give further details such as how much of the bond JBIC officials, with the support of the finance ministry, would place with Bank Negara Malaysia, the Malaysian central bank, and when. Japanese news reports have said that the JBIC has formed an advisory board of Islamic legal scholars to study Islamic financial practices. Moscow bank wins $20m Murabaha facility The UK-based global trade finance group CCH International, through its German subsidiary, CCH Europe GmbH, has arranged a debut Dh73.45 million ($20 million) Murabaha facility for Globexbank in Moscow financed by an unnamed GCC-based Islamic bank. This is the first Murabaha facility extended to a Russian institution by an Islamic bank, said a report in the Arab News quoting managing director of CCH International Eren Nil. "Islamic financial institutions have virtually no exposure to Russian risk and therefore the market is of great interest to CCH. Given the size of the Russian market and its need for liquidity, we are confident of arranging further Shariah-compliant transactions for Russian institutions in the future," Nil is quoted to have said. The facility, which is guaranteed by Globexbank, is being used to supply and sell goods at an agreed price, plus a profit markup, to a client of the bank, the report added. For any query please contact: Imran Ahmad Joint Director imran.ahmad@sbp.org.pk Sumera Baloch Regulating Officer sumera.baloch@sbp.org.pk Mission To Make Islamic Banking the banking of first choice for the providers and users of financial service Islamic Banking Department was established on 15th September, 2003 and has been entrusted with the huge task of promoting & developing the Shariah Compliant Islamic Banking as a parallel and compatible banking system in the country. Page 10

11 Annexure-1 Number of Licensed Islamic Banks and IBBs as at No. of Bank's Name Branches A) Islamic Banks 1 Meezan Bank Limited 42 2 Albaraka Islamic Bank 9 3 BankIslami Pakistan Limited 6 Dubai Islamic Bank Pakistan 4 Limited 8 Emirates Global Islamic Bank 5 Limited* - 6 First Dawood Islamic Bank* - Total of A 65 B) Islamic Banking Branches 1 Muslim Commercial Bank 5 2 Bank of Khyber 5 3 Bank Alfalah Limited 19 4 Habib Bank AG Zurich 2 5 Standard Chartered Bank 3 6 Metropolitan Bank 1 7 Bank Al Habib Ltd.* 1 8 Habib Bank Ltd.* 1 9 Soneri Bank Limited 2 10 Prime Commercial Bank 2 11 Askari Commercial bank 4 Total of B 45 A+B 110 * These two banks are expected to start operations soon. Page 11

12 Local News Islamic banking flourishing in country The Islamic banking has captured 2 percent market share in only three-year period in the country due to rapid growth of this industry. This was stated by Pervez Said, director, Islamic Banking Department, State Bank of Pakistan (SBP), while speaking at a seminar on "Efficiency, Diversity and Competition in Islamic Banking and Insurance Industry", organised by the Institute of Business and Technology at a local hotel on Saturday. He said that four full-fledged Islamic banks are operating in the country, while a couple of license applications of Islamic banks are in pipeline. Pervez said the Islamic banking operation was started in Malaysia in 1983 where the market share of Islamic banking is 11.6 percent while in Indonesia Islamic banking operation was launched in mid-90s and its market share is 1.34 percent. In Pakistan, its operation was started in 2003, he said, adding the Islamic banking has captured 2 percent market share in only three years, which is good achievement. He said that the growth of Islamic banking was resulted due the attractive policies of the present government. Pervez said the central bank wants to run a parallel Islamic banking system with the conventional system and provide opportunity to the people to choose any system, which they like. SBP governor opens Dubai Islamic Bank branch State Bank of Pakistan (SBP) Governor Dr. Shamshad Akhtar inaugurated Dubai Islamic Bank's Karachi branch at Cloth Market. "Given Dubai Islamic Bank's international stature and regional presence, we anticipate that the bank will bring to Pakistan the required technology, instruments and institutional framework, so as to set the standard for other Islamic banks to follow", said the SBP Governor after inaugurating the branch premises. "We have observed phenomenal growth in the Islamic banking industry in a short period of time as Islamic banking has evolved as an institution to help achieve financial sector growth in a Muslim country as Pakistan", she added. Later, the SBP Governor and Advisor to the SBP Governor on Islamic banking, Pervez Said, were given a tour of the branch premises by a delegation of Dubai Islamic Bank, including Chief Executive Officer (CEO) Saad Zaman and Deputy CEO M. A. Mannan; during which network expansion plans of the bank were discussed. Dow Jones Indexes and JS Group to Launch Islamic Index for Pakistan Dow Jones Indexes, a leading global index provider, and JS Group, Pakistan's premier financial group, today announced the launch of the Dow Jones-JS Pakistan Islamic Index. The index measures the performance of companies in the Pakistani stock market that pass screens for compliance with Islamic principles. The Dow Jones-JS Pakistan Islamic Index is designed to serve as an underlying index for investment products such as mutual funds, exchange-traded funds (ETFs) and other investable products. This is the first time that a dedicated Islamic Index for Pakistan has been launched by a major global index provider. Page 8

13 Islamic finance Emerging Islamic CAPITAL MARKETS - a quickening pace and new potential by Zamir Iqbal and Hiroshi Tsubota, The World Bank Describing the Islamic financial system simply as interest-free does not do justice to the system. Promotion of entrepreneurship, preservation of property rights, transparency and the sanctity of contractual obligations, which are crucial to any sound financial system, describe its essence. Today, Islamic financial and banking activities have reached an impressive size of over US$250bn, as compared to a meagre US$6bn in the early 1980s. Market participants and policy makers are increasingly paying attention to its potential and how to take advantage of the opportunities presented. The term Islamic finance or Islamic financial system 1 is not as uncommon today as it was two decades ago when financial institutions in several Muslim countries started exploring ways to operate a banking system prohibiting the payments and receipts of interest. Islamic modes of financing have been in practice in some form or other since the early history of Islam. Throughout the Middle Ages, Islamic merchants became indispensable middlemen for fostering trade through development of sophisticated credit instruments in Spain, the Mediterranean and Baltic states. In modern banking history, an interest in the revival of Islamic modes of financing emerged in several Muslim countries, during their post-colonisation period. In the early 1960s, independent but parallel attempts in Egypt and Malaysia led to the establishment of financial institutions, which were designed to operate on a non-interest basis so as to comply with Islamic principles. But it was not until the first wave of oil revenues in the 1970s and the accumulation of petro-dollars which gave momentum to this idea, that the Middle East saw a mushrooming of small commercial banks competing for surplus funds. At the same time, interest grew in undertaking theoretical work and research to understand the functioning of an economic and banking system without the institution of interest. Continuing demand throughout the 1980s led to sustainable growth and, by the 1990s, the market for Islamic financial products had attracted the attention of several western commercial banks, which started to offer specialised financial services to high net worth individuals and later at the retail level through Islamic windows. Today, there are more than 240 financial institutions operating on the basis of non-interest based instruments in more than 40 different countries. 5

14 Islamic finance 6 BASICS OF ISLAMIC ECONOMIC AND FINANCIAL SYSTEMS An Islamic economic and financial system is a rule-based system comprising a set of rules and laws, collectively referred to as Sharia governing economic, social, political and cultural aspects of Muslim societies. Sharia originates from the rules dictated by the Quran, from the practices of the Prophet Muhammad, and further elaboration of the rules by scholars in Islamic jurisprudence through the process of deduction (Qiyas) and consensus (Ijma ). Over time, four different schools of thought Hanafi, Maliki, Shafei and Hanbali have emerged with some variations on the rules depending on respective interpretations. The central tenet of the financial system is the prohibition of Riba a term literally meaning an excess and interpreted as any unjustifiable increase of capital whether through loans or sales. More precisely, any positive, fixed, predetermined rate tied to the maturity and the amount of principal (i.e., guaranteed regardless of the performance of the investment) is considered Riba and is prohibited. The general consensus among Islamic scholars is that riba covers not only usury but also the charging of interest as widely practiced. This prohibition is not to be confused with a rate of return or profit on capital, as Islam encourages the earning and sharing of profits, because profit, determined ex post, symbolises successful entrepreneurship and the creation of additional wealth; whereas interest, determined ex ante, is a cost that is accrued irrespective of the outcome of business operations and may not create wealth if there are business losses. Undoubtedly, prohibiting the receipt and payment of interest forms the nucleus, but it is supported by other principles of Islamic doctrine; advocating risk sharing; promotion of entrepreneurship; discouragement of speculative behaviour; preservation of property rights; transparency; and the sanctity of contractual obligations. The system can be fully appreciated only in the context of Islam s teachings on the work ethic, wealth distribution, social and economic justice, and the expected responsibilities of the individual, society, the state and all stakeholders. EMERGING ISLAMIC CAPITAL MARKETS During the 1980s and 1990s, Islamic financial institutions were able to mobilise funds successfully through deposits invested in a handful of financial instruments, dominated by trade financing. Activities on the asset side of Islamic financial institutions included cost-plus-sale or purchase finance (Modaraba ); leasing (Ijara ); trust financing (Modaraba ); and equity participation (Musharika ). Due to market conditions, lack of liquid assets and other constraints, the composition of Islamic financial institutions assets stayed fairly static and heavily focused on short-term instruments (mainly commodity finance). By the late 1990s, there were many calls for the introduction of new products and the promotion of financial engineering. 2 Main areas of concern were the lack of liquidity, a lack of portfolio and risk management tools and the absence of derivative instruments. One of the impediments to growth was the lack of understanding the fast changing landscape of modern financial markets as well as the intricacies of rules demanded by the Sharia. The task was further complicated by the different schools of Islamic thought in various parts of the globe. Nevertheless, by the late 1990s, Islamic financial institutions had realised that the development of capital markets was essential for their survival and further growth. Meanwhile, deregulation

15 Islamic finance and liberalisation of capital movements in several countries led to close cooperation between Islamic financial institutions and conventional financial institutions in order to find solutions for liquidity and portfolio management. The result was two distinct developments the introduction of equity funds which were compatible with Sharia and the launch of Islamic asset-backed securities more commonly known as Sukuk. Whereas Islamic equity funds became popular with investors who had a risk appetite for equity investment, Islamic financial institutions, driven by the nature of their intermediation, kept demanding securities which could behave like conventional fixed-income debt securities but also comply with Sharia. In addition, Islamic financial institutions wanted to extend the maturity structure of their assets beyond the typical short-term maturities provided by trade-finance instruments. This led to the creation of Sharia compliant asset-backed securities, Sukuk, which have risk/return characteristics similar to conventional debt securities. The result is that within a short span of less than five years, the market for Sukuk have reached an impressive size of US$30bn which includes several sovereign and corporate issues (see Exhibit 1 - notable transactions in the first half of 2005). WHAT IS A SUKUK? The idea behind a Sukuk is simple. Prohibition of interest virtually closes the door for a pure debt security but an obligation which is linked to the performance of a real asset is acceptable. In order words, Sharia accepts the validity of a financial asset which derives its return from the performance of a real asset. The word Sukuk (plural of the Arabic word Sakk meaning certificate) reflects participation rights in the underlying assets. The design of the security is derived from the conventional securitisation process in which a special purpose vehicle is set-up to Notable transactions in the first half of 2005 Exhibit 1 Issuer Country Issue date Amount Maturity (year) Type Manager(s) Sovereign Government of Bahrain Bahrain February-05 BD30m 5 Ijara (Leasing) Bahrain Monetary Agency Government of Pakistan Pakistan January-05 US$600m 5 Ijara (Leasing) Citgroup, HSBC Amanah Supranational Islamic Development Bank Supranational organisation June-05 US$500m 5 Sukuk HSBC Amanah, Deustche Bank, CIMB, Dubai Islamic Bank The World Bank Supranational organisation April-05 M$760m 5 Bai Bithaman Ajil (BBA) CIMB, ABN Amro Bank Bhd (deferred-payment sale) Corporate PLUS Expressways Bhd Malaysia June-05 M$2,410m Bai Bithaman Ajil (BBA) (deferred-payment sale) CIMB Jimah Energy Ventures Malaysia May-05 M$405m Istisna (purchase order) Ammercchant Bank Berhad, RHB Sakura Merchant Bhd, MIMB, Commercial Real Estate Company Kuwait May-05 US$100m 5 Ijara (leasing) Kuwait Finance House, Liquidity Management Centre Time Engineering (Musyarakah Malaysia April-05 M$566.55m 1-5 Musharika (profit and CIMB One Capital Bhd) loss-sharing Durrat Sukuk Company BSC Bahrain January-05 US$152.5m 5 Istisna and Ijara Sukuk Kuwait Finance House Source: Compiled from various market sources 7

16 Islamic finance Anatomy of a Sukuk Exhibit 2 Fund mobilising entity Credit enhancement Guarantor Pool of assets (Ijara /leases) Special purpose Modaraba SPM/SPV Assets Liabilities Ijara assets (leases) Sukuk certificates Servicing Investors: Islamic, conventional institutional investors, pension funds, etc. Source: Iqbal, acquire assets and to issue financial claims on the asset. Such financial claims represent a proportionate beneficial ownership for a defined period when the risk and the return associated with cash-flows generated by an underlying asset, is passed to Sukuk holders (investors). The core contract utilised in the process of securitisation to create a Sukuk is an Islamic contract of intermediation known as Modaraba (trust financing), which allows one party to act as an agent (manager) on behalf of a principal (capital owner) for an agreed fee or profit-sharing arrangement. The contract of Modaraba is used to create a Special Purpose Modaraba (SPM) entity, similar to the conventional Special Purpose Vehicle (SPV), to play a welldefined role in acquiring certain assets and issuing certificates against the assets. The underlying assets acquired by SPM need to be Sharia compliant and can vary in nature. Depending upon the nature of underlying assets and the school of thought, the tradability and negotiability of issued certificates is determined. The majority of Sukuk issued to date are based on two classes of assets. The first class of assets fall into financial claims created out of a spot sale (Salam) or a deferredpayment sale (bay mu ajjal) and/or a deferred-delivery sale (bay salam) contract, whereby the seller undertakes to supply specific goods or commodities, incorporating a mutually agreed contract for resale to the client and a mutually negotiated margin. Salam-based Sukuk have proved to be a useful investment vehicle for short-term maturity since underlying commodity financing tends to be for a short-term tenor ranging from three months to one year. However, due to the fact that the Sukuk results in a pure financial security and is somewhat de-linked from the risk/return of the underlying asset, Sharia treats it as a pure debt security. Consequently, many investors, including those in the GCC countries cannot trade these Sukuk in the secondary market, either at a discount, or at a premium. Trading will introduce a mechanism to indulge in Riba or interest in the

17 Islamic finance transaction. Due to this restriction, investors tend to hold Salam-based Sukuk up to the maturity of the certificate. In order to provide longer-term maturity and limited tradability and negotiability to investors, a second class of Sukuk is based on leasing (Ijara ). An Ijara instrument is one of the instruments which bears the closest resemblance to a conventional lease contract and offers flexibility of both fixed and floating-rate payoffs. The cash-flows of the lease including rental payments and principal repayments are passed through to investors in the form of coupon and principal payments. Ijara -based Sukuk provide an efficient medium-to long-term maturity mode of financing. CURRENT MARKET ENVIRONMENT Islamic capital markets are now gaining the momentum to grow into a vibrant marketplace, especially for emerging market borrowers in the regions of the Middle-East, South-East Asia, South Asia and North Africa. On the supply side, the volume of Islamic investments with a preference for Sharia compliant instruments has grown to form a critical mass that can support a well-functioning and efficient capital market. It is evolving into a truly international market. Not only highly rated borrowers such as the Multilateral Development Banks (for example, the World Bank), but also developing country borrowers with lower credit ratings, such as Pakistan, have successfully raised a considerable volume of funds in this market. On the demand side, countries in the developing world, especially the middle-income countries, will require a significant volume of investments in infrastructure over the next decade. To illustrate, for Indonesia alone, additional infrastructure investments of US$5bn (2% of GDP) are required annually, to reach a 6% medium-term growth target, as estimated by the World Bank. 3 Because the domestic capital markets of these borrowers are often not deep enough to satisfy their large investment needs, they would have to access external sources of financing. Furthermore, Muslim stakeholders in middle-income countries are increasingly expressing their preference for Sharia compliant financing. Borrowers, especially publicsector institutions, are starting to reflect their stakeholders voices in the implementation of financial operations. In turn, financial intermediaries, including private-sector commercial and investment banks, as well as development finance institutions, are likely to start paying more attention to such non-financial needs of their clients - in addition to satisfying these borrowers funding needs, in order to stay successful in the marketplace. For the Multilateral Development Banks (MDBs), such as the World Bank, the development of Islamic capital markets will be a highly relevant topic. Firstly, MDBs are deeply involved in infrastructure finance in their borrowing member countries and would therefore naturally be interested in the emerging Islamic capital market as a new and alternative source of financing. Secondly, by channeling the funds available in Islamic financial markets, which are mostly based in the countries with high savings such as the GCC countries and Malaysia, to finance investments in developing countries, MDBs can create a new model for international development cooperation while responding to the stake-holders voices on both sides. Thirdly, MDBs can promote financial stability by encouraging the development of Islamic capital markets to enhance liquidity, and enabling Islamic financial institutions to have more diversified portfolios and sound risk management. Furthermore, this could also provide the momentum to integrate the Islamic financial markets within the framework of the international financial system. GOING FORWARD: CHALLENGES AND POLICY ACTIONS NEEDED In the near future, it is most likely that structures which provide investors with a pre-determined return as well as 9

18 Islamic finance 10 full recourse to the obligor (such as Ijara and Murabaha ) would have more market potential than other structures. As discussed earlier, this will be driven primarily by investor preferences, but a large proportion of potential borrowers would also prefer to lock-in their borrowing costs rather than engage in pure profit sharing schemes. While the overall market background appears promising, certain obstacles and constraints may lie ahead and market participants and regulators need to take concrete steps to support market take-off. Firstly and most importantly, market development requires a strong sponsorship and leadership of the host country government, especially on legal and regulatory issues. For example, for an Ijara transaction, the owner of operating assets needs to enter into a leasing transaction. While the owners of operating assets are often the government itself or its related public-sector bodies, the relevant laws and regulations in the host country may not allow these public-sector bodies to pledge or lease assets needed to structure an Ijara transaction. This is a fundamental point; the host country s policy actions to promote such Islamic finance will be a key prerequisite for the market to develop further. Furthermore, borrowers, investors as well as intermediaries need to nurture the market patiently. As of now, Islamic transactions often face a competitive disadvantage to conventional bond issues in terms of cost-efficiency. Each new issue incurs higher levels of legal and documentary expenses as well as distribution costs; and involves examining structural robustness in addition to evaluating the credit quality of the obligor. Also, since the terms available in Islamic capital markets are mostly derived from the pricing levels in the more liquid conventional bond markets, there is no inherent funding cost advantage for borrowers tapping Islamic markets. Borrowers, therefore, would need to formulate a comprehensive, long-term and strategic view on how to reduce the overall funding cost by tapping Islamic markets, rather than focusing on a single transaction. Investors, on the other hand, can significantly support market development by expressing their preference for Sharia compliant instruments more concretely, namely in terms of their bid prices. For intermediaries, they can lead the process to reduce transaction costs, perhaps through further standardisation of transaction schemes and instruments. 4 Sharia scholars can also play an important role. It is essential that multi-disciplinary expertise, covering topics ranging from theological interpretation to financial structuring, be developed through knowledge-sharing, cross-training and acquiring an understanding of the functioning of markets. To stimulate cross-border activities in the primary as well as secondary markets, the acceptance of contracts across regions and across schools of thought and markets will also be helpful. CONCLUSION In the wake of the current wave of oil revenues and increasing demand for Sharia -compliant products, Islamic capital markets are emerging at a quickening pace and stakeholders are starting to realise the potential. Development of institutional infrastructure in the international fora, such as establishment of accounting standards and regulatory bodies, are all steps in the right direction. 5 However, for the market to grow further, it also needs strong leadership and constructive policy actions of host governments, to enable market participants to originate Islamic finance transactions. Well-developed Islamic capital markets will not only be beneficial for borrowers and institutional investors, they can also further enhance the stability of Islamic financial institutions, providing them with improved portfolio, liquidity and risk management tools. Ultimately, all these developments will contribute to integrating Islamic financial markets, as well as the people who form these markets, into the framework of the broader conventional international financial system.

19 Islamic finance Notes: 1. For a further description of Islamic financial systems refer to Iqbal (1997). 2. See Iqbal (1999) and Iqbal and Mirakhor (2002). 3. Indonesia Averting an Infrastructure Crisis: A Framework for Policy and Action, The World Bank, For example, in the Malaysian market, market participants have developed a few well standardised structures, such as Bai Bithaman Ajil. Structuring as well as distribution costs for these standardized Islamic deals in Malaysia are now reduced to a competitive level, making them a viable alternative to conventional debt instruments. 5. These institutions include Islamic Financial Service Board (IFSB), Accounting and Auditing Organization of Islamic Financial Institutions (AAOIFI), Liquidity Management Center (LMC), International Islamic Financial Markets (IIFM) and International Islamic Rating Agencies (IIRA). The World Bank Jakarta Office (2004), Indonesia Averting an Infrastructure Crisis: A Framework for Policy and Action, Jakarta, Indonesia. Hiroshi Tsubota and Zamir Iqbal References: Iqbal, Zamir (1997) Finance and Development, International Monetary Fund, Washington, D.C. June, Iqbal, Zamir (1999), Financial Engineering in Islamic Finance, Thunderbird International Business Review, Vol 41, No. 4/5, July-October 1999, pp Iqbal, Zamir and Abbas Mirakhor (2002), Development of Islamic Financial Institutions and Challenges Ahead, in Simon Archer and Rifaat Abdel Karim (eds.) Islamic Finance: Growth and Innovation, Euromoney Books, London, UK. Zamir Iqbal and Hiroshi Tsubota are Principal Financial Officers in Quantitative Strategies, Risk and Analytics (QRA), and Banking, Capital Markets and Financial Engineering (BCF) departments of the World Bank Treasury in Washington, DC. For further information, please ziqbal@worldbank.org or htsubota@worldbank.org Views expressed in the article are of the authors and do not reflect views of the Board of Directors and of the World Bank Group. Authors wish to thank Hennie Van Greuning, Doris Herrera-Pol, and Kenneth Lay for their comments. 11