Over the past three decades or so the Islamic banking and finance industry has emerged from nothing to an industry with assets of hundreds of billions of dollars under its management. Today some more than 250 Islamic banks and financial institutions are operating in and outside the Muslim World. With the expansion and growth of the Islamic finance, conventional interest-based international banks have followed suit by offering products to investors and even deposit-windows for Muslim customers who want to invest their savings in a religiously approved manner.
Economists say that the growing demand from the world's 1.2 billion Muslims for "halal" or lawful banking has left financiers scrambling to legitimise Western-style services. Consequently, a number of Western commercial banks and financial institutions including the Citibank, Kleinwort Benson, HSBC, Grindlays and Chase Manhattan Bank have developed substantial Islamic operations. Both Dow Jones and London FTSE have Islamic Market Indexes. Institutions such as al-Rajihi Banking and Investment Corporation (ARABIC), Kuwait Finance House (KFH).
The International Investor (TII), and the First Islamic Investment Bank have registered annual growth rates of about 20% during the past few years. Dresdner Kleinwort Benson has an annual turnover of over US $6 billions in the Islamic trade finance. The International Investor, established in 1992, manages around US $3 billions in funds.
THE CONCEPT: Islamic finance is an ethical and equitable mode of finance that derives its principles from the sacred law of Islam ( the shari'ah). The principles of shari'ah are based on the injunctions of the Holy Book Quran and the teaching of Prophet Muhammad (PBUH) and the interpretations of Muslim scholars when and where necessary.
The most distinctive feature of Islamic finance, as is well-known by now, is the prohibition of interest, whether nominal or excessive, simple or compound, fixed or floating. The other elements of the Islamic financial ethics include the prohibition of gambling, and the elimination of uncertainty and ambiguity in business contracts.
Islamic finance, therefore, encourages profit sharing over fixed guaranteed returns, discourages speculation and precludes practices like short selling, conventional debt instruments and derivatives.
ISLAMIC FINANCE TECHNIQUES: Islamic finance advocates equity financing as against debt financing. Conventional debt financing (interest-based financing or interest-based bonds) is not, therefore, acceptable in Islamic finance because it relies on interest.
In the Islamic system of finance interest-bearing contracts are replaced by non-interest, return-bearing forms of partnerships. Islamic banks attract capital of the investors in classical Islamic equity instruments called mudarabah and musharkah. In such partnerships profits are shared between the investors and the bank on a predetermined basis with residual profits or losses being allocated to investors in proportion to their financial contributions. Another financing technique adopted by the Islamic banks to earn returns to the financial capital without resorting to interest is ijarah ie lease financing.
The Islamic law permits rental charges to be realised for property services. The permissibility of rental contracts provides a further return-bearing outlet for financing capital whilst offering firms an alternative source of finance via leasing or hire-purchase of equipment.
Other common Islamic financing techniques are istisna' (commissioned manufacture), salam, (advance purchase) and bay' mu'ajjal (credit sale).
These instruments, although widely accepted in the Islamic finance industry, represents a small part of an Islamic bank portfolio. The most popular technique used by the modern Islamic financial institution is the one known as murabahah or sale with markup which accounts for more than 90% of the portfolio of most of the Islamic financial institutions.
This contract permits a customer to authorise an agent (bank) to purchase a particular good, with repayment by the customer made in instalments or as a lump-sum at an agreed mark-up. The mark-up charged by the Islamic banks although apparently resembles 'interest', it is not so, argue the Islamic financial experts.
They argue, and rightly so, that technically, this is not interest since the profit is made in the exchange of money for goods and not of money for money as is the case with interest.
TO BE CONSISTENT WITH THE ISLAMIC SHARI'AH LAW THE BANK MUST ADHERE TO THE FOLLOWING PROCEDURE:
(i) make separate contracts with the supplier and the customer, (ii) take physical possession of the merchandise and, (iii) not link the mark-up to the period of repayment.
As a matter of principle, conventional debt financing (interest-based lending) is completely ruled out in the Islamic finance. Islamic finance advocates partnership and profit sharing much like the contemporary venture capital, investment management and project financing.
The Islamic Fiqh Academy- one of the major legal bodies in the Muslim world- has ruled that trading in stocks and equity funds is permitted subject to certain criteria.
The Islamic financial experts and religious scholars have, therefore, developed a filtering mechanism to screen out the undesirable companies in view of their nature of business; or the level of their involvement in interest (interest income they receive must be less than 9% of total income); and ratio of debt in total asset. (less than 33% of the total asset). Accordingly, investment in certain businesses that are incompatible with the Islamic shari`ah is not allowed.
Incompatible lines of business include trade in alcohol; pork-related products; conventional financial services (banking, insurance, etc); entertainment (hotels, casinos/gambling, cinema, pornography, music, etc).
THE ISLAMIC FINANCE INDUSTRY: The first modern Islamic financial institutions emerged in the 1960s and 1970s in the countries of Middle East and Egypt. Since then Islamic banking and finance industry has spread not only to a large number of Muslim countries but the Muslim communities in the West as well.
The Middle East, of course, is the hub of the Islamic banking and finance industry, with Malaysia taking the second place after it. Today more than 250 Islamic financial institutions are spread all over the globe in the form of commercial banks, investment banks, investment and finance companies, insurance companies and financial service companies.
They take different forms; wholly Islamic institutions, Islamic subsidiaries of conventional banking groups, and Islamic banking windows within conventional banks. According to the latest figures issued by the General Council for Islamic Banks and Financial Institutions the global Islamic banking industry has grown by almost 23.5% during the past five years.
Its total world-wide assets now stand at over US $260 billion with financial investments above US $400 billion. The number of Islamic financial institutions has increased from 176 in 1997 to 267 at present.
In the Middle East, Islamic banks delivered an impressive financial performance during the last few years. According to the a current report of Bahrain-based General Council for Islamic Banks and Financial Institutions (GCIBFI) GCC Islamic financial institutions have achieved phenomenal growth during the last few years.
Their assets surged to Dh190 billion with growth rising 18.6 percent and net profits estimated at Dh4.5 billion during the third quarter of 2004. The report indicates that during the past five years, current and savings accounts in the GCC countries rose nearly twenty fold, totalling more than Dh 60 billion by the end of the year 2003. This reflects the confidence of investors and customers in Islamic financial institutions.
Two large Islamic banks, Al Rajhi Banking and Investment Corporation (ARABIC) and Kuwait Finance House (KFH) were included among the Top 25 GCC Banks. KFH delivered an impressive 21.8% ROE. This was the best financial performance among Kuwaiti banks and the third best performance among the top 25 GCC banks.
In 2004, KFH, announced net profit of 148 million dinars (501.7 million dollars), up 23.3 percent on 400 million dollars posted in 2003. The assets of the bank, in which the government has a major stake, rose 13.8 per cent to 11.7 billion dollars on December 31, up from 10.3 billion dollars at the end of 2003. Deposits also increased by 11.3 percent to 8.7 billion dollars at the end of 2004 compared to 7.8 billion dollars the previous year.
Bahrain Monetary Agency (BMA) records show that Bahrain-incorporated Islamic financial institutions posted total net profits of US $113.8 million for 2003 as compared with US $84 million in 2002. Profits of the Islamic Investment banks (Ibs) rose 23% to US $80.3 million in 2003, from US $65.3 million in 2002. Total assets, including restricted investment accounts, of Islamic Ibs stood at US $2.7 billion at 2003-end as compared with US $2.1 billion at 2002-end.
Profits of Islamic commercial banks doubled to US $18.4 million in 2003, from US $9.2 million in 2002. Assets of the Islamic Commercial banks totalled US $1.3 billion at 2003-end, as compared with US $996 million at 2002-end. Profits of the Islamic offshore banking units (OBUs) grew 59% to US $15.1 million in 2003, from US $9.5 million in 2002, while their assets stood at US $2.2 billion at 2003-end as compared with US $2 billion at 2002 end.
In the UAE, the Dubai Islamic Bank (DIB)- the oldest commercial Islamic bank in the world- has made steady growth during the last few years. According to a current report issued by the Bank for the year 2004, IDB's total assets rose by 35% from AED 22.8 billion in 2003 to AED 30.8 billion. DIB's net profits (excluding depositors' profits) rose from AED 234 million in 2003 to AED 461 million in 2004 (97% increase).
The net profit for the bank, including depositors' profit, reported a 36% increase at AED 1.02 billion compared to 751 million for 2003. The bank's total revenue increased by more than 43% last year to AED 1.47 billion from AED 1.02 billion in the previous year.
The Abu Dhabi Islamic Bank (ADIB) has reported a net profit of Dh122.9 million for 2004, an increase of 22 percent over the previous year. The bank's total assets reached Dh12.69 billion in 2004 from Dh9.22 billion in 2003, a growth of 38 percent.
AIDB's customer deposits grew to Dh9.6 billion end-2004 compared to Dh6.1 billion in 2003, up 56 percent.
In Malaysia, Islamic banking currently accounts for 10% of the financial system and is forecast to achieve at least 20% market share by 2010. At June 2004 the assets mobilised by the Islamic banking sector have increased to RM 89.1 billion, accounting for a market share of about 10% of the Malaysian banking system.
The size of the Islamic equity funds is estimated to be approximately US $3.3 billion and it has been growing at over 25 % over the past seven years. There are estimated to be over 100 Islamic equity funds world-wide. The rapid growth of the number of Islamic equity funds and its assets is expected to continue as new players enter the market due to enhanced awareness and familiarity with the Islamic finance products.
Many major US and European fund managers are active in the field including AXA, the Citibank, the Deutsche Bank, the HSBC, the UBS, and the Wellington Management.
Islamic debt instruments (sukuk) are also receiving investors' response in the international capital market. In October 2003, the Bahrain Monetary Agency announced that the Citi Islamic Bank and its American parent, Citigroup, would arrange a $250m Islamic bond Issue. Companies such as the Swiss food giant Nestle placed a $184 million seven-year Islamic bond in 2003.
In the Malaysian Capital Market in the year 2003, the total funds raised via the issuance of Islamic bonds amounted to RM8.1 billion constituting 19% of the total funds raised in the bond market.
In the UAE capital market, Islamic bonds are receiving overwhelming investor interest. The Department of Civil Aviation (DCA) has awarded the world's largest Islamic finance package - a US $750 million sukuk al Ijara (leasing bonds) issue to Dubai Islamic Bank , to raise funds for the Dh 15 billion (US $4.1 billion) phase II of the expansion of the Dubai International Airport. The size of the sukuk has been increased to US $1 billion due to the overwhelming response which led to two times oversubscription.
The issue has been fully written by a six member group of the banks acting as joint lead managers including DIB, Citigroup, Gulf International Bank, HSBC, Kuwait Finance House, and Standard Chartered Bank.
The National Central Cooling Co (Tabreed) issued US $100 million Islamic sukuk in the year 2004. The significance of the Tabreed sukuk is that, for the first time, the Islamic bonds issued by a UAE corporate borrower will be listed on the Luxemburg Stock Exchange. Currently Pakistan has marketed a dollar 500 million-plus Islamic bond in the international market.
The bond offering by Pakistan has attracted orders worth $750 million in the international capital market. Citigroup and HSBC are lead managers of the offering. It is for the first time that Pakistan has launched an Islamic bond in the international market.
DOW JONES ISLAMIC MARKET INDEXES: The Dow Jones Islamic Market Index (DJIMI) was launched in Bahrain on February 9,1999. It (DJIMI) consists of nearly 600 companies drawn globally from 34 countries, covering over 100 industry groups and ten economic sectors and having a market cap of nearly 8 trillion dollars.
The Dow Jones Islamic Market Indexes were especially created for people who wish to invest according to the Islamic investment guidelines. The indexes track shari'ah compliant stocks from around the world and provide Islamic investors with comprehensive tools based on a truly global investing perspective.
The Dow Jones Islamic Fund (Fund) adheres to the stringent criteria and the two-step process developed by the Shari'ah Supervisory Board of Dow Jones that consists of internationally renowned Muslim scholars.
THE TWO STEPS ARE:
I. Based on pre-established parameters, at the outset, businesses, industries and interest-related financial instruments that are inconsistent with shari'ah precepts and hence not suitable for Islamic investment purposes, are not considered for the Dow Jones Islamic Market Indexes. Excluded businesses include: alcohol, conventional financial services (banking, insurance, etc), entertainment (casinos/gambling, cinema, pornography, hotels, etc), tobacco manufacturers, pork related products and defence and weapons companies.
II. Once companies with unacceptable primary business activities have been eliminated from the universe, the remaining stocks are tested against three "filters" designed to remove those with unacceptable financial ratios. These financial ratio filters are applied to exclude, among other things, companies with unacceptable levels of debts or interest income.
COMPANIES ARE, THEREFORE, EXCLUDED IF:
-- total debt as a proportion of total assets is 33% or more;
-- accounts receivable as a proportion of total assets is 47% or more;
-- non-operating interest income as a proportion of operating is 9% or more.
Companies that pass these screens are included in the stock universe from which index components are selected for the various Dow Jones Islamic Market Indexes.
The experiments of Islamic banking and finance all over the world during the last three decades shows a steady growth in the performance of Islamic finance industry. The Islamic banking industry, initiated to provide an Islamic alternative to the interest-based banking, is now receiving an overwhelming response from Muslim as well as non-Muslim investors alike. It has become increasingly more innovative and is developing more complex instruments and structures to meet the demands of modern day business.
Surprisingly, much of this innovation has been driven by non-Muslim, western financiers. At the annual get-together of the Organisation of Islamic Countries (OIC), held in Malaysia from October 11th to 18th 2003, participants credited the Western banks with spurring the development of the Islamic finance.
They also chastised the Islamic institutions for remaining "inward-looking". Given the growing demand from Muslim investors for financial products, it is the efficient and aggressive banks -whatever their origins- that are likely to win.
Thanks to the efficiency and profitability of interest-free financing techniques non-Muslim investors are showing more and more interest in the Islamic products. In a press statement, recently, vice-president of Sales at the Dubai Islamic Bank (DIB) disclosed that the number of non-Muslims seeking Islamic financing products is fast increasing as they stand to obtain better rates than from the conventional banking products. Islamic finance is, thus, no more a Muslims' domain. It has much to offer to the humanity at large.