CAN ISLAMIC law incorporate modern investment theory? This possibility, being explored by a new generation across the Islamic world, is taking a shape now. It’s already a way of life in parts of the Middle East. The OER team revisits the concept, with special focus on the GCC

(This article first appeared in Oman Economic Review in the year 2006, and was later carried by several other websites, including


(With Clarence Michael in Dubai, Dr Jasim Husain Ali in Manama and Vani Saraswathi in Doha)

IT WAS an interesting disclosure by any yardstick. Talking to OER on December 11, 2005 (the day Sohar Aluminium’s equity and technical partners had gathered in Muscat to put their seal of approval to go ahead with the development of the project in Sohar), Tony Kinsman, the CEO, declared his company had the distinction of bringing in Islamic finance to the shores of Oman.

The comment, coming from a top CEO, perhaps, was a pointer to a probable paradigm shift. Is this to be a trend? Is Islamic finance (IF) on its way to Oman?

If we talk of the Muslim world, IF has been wildly successful in Malaysia, accounting for 10 per cent of all banking operations there. In the GCC region, Bahrain was the first to catch on to the trend and promote the concept. And the UAE has seen a renewed push in this sector in the recent times.

Formally, Oman is not into IF. The Central Bank of Oman (CBO) does not allow the local banks to deal in Islamic finance, banking or insurance products. On that count, the Sultanate has a different policy compared to its GCC peers like Bahrain, Saudi Arabia, Qatar or the UAE. But companies operating in the Sultanate are increasingly climbing on to the IF bandwagon. There is heightened interest in IF in Oman. As of now, the regional banks have moved in to fulfil this need.

Sohar Aluminium’s case is, probably, a pointer to the shape of things to come. The first Greenfield aluminium smelter project in over a quarter century in the entire Middle East, Sohar Aluminium is raising US$260 million of the total US$ 1.58 billion project, from the IF route. This makes up for around 15 per cent of the total project finance. For the first time in Oman, a capital project is probably availing of IF of this size.

What made Sohar Aluminium approach the IF route? OER raised this question to Musab Abdullah Al Mahruqi, the Deputy Chief Financial Officer of Oman Oil Company (the local sponsors of Sohar Aluminium). Musab says: “We wanted to tap the other markets too. We wanted to expand our options. We were confident that such a scheme would work in the Omani environment. As for the future, we do not have any problem in approaching the IF route.”

Clearing the cloud further is Usman Ahmed, Deputy CEO of Citi Islamic Investment Bank E. C. (CIIB) in Dubai, a 100 per cent-owned subsidiary of Citigroup. He reveals to OER that his bank has recently closed the first Islamic tranche for the Omani issuer — the US$ 260 million Islamic facility for the Sohar Aluminium project.

There are other examples as well. One of the reasonably large diversified groups in the oil and gas sector in the Sultanate is reported to have borrowed money for a transaction on an Islamic basis. AES Barka, the 427 MW gas fired power plant and 20 MIGD desalination plant, is also reported to have borrowed some of its project finance through IF. A real estate sector company, and some leasing companies are also reported to be interested in considering the IF route.

Rajeev Singh, Partner, Ernst & Young, Oman, informs that his firm was approached by a consortium of developers bidding to the government on the Sohar Independent Water and Power Project. (They did not go on to win the bid). Ernst & Young, Oman, were their financial advisors and had approached an IF institution to put in almost US$200 million worth of project finance.

This brings us to the issue of the market appetite for IF. Khalid Ahmed Alhosni, Managing Director & CEO, InfoMart (Commercial Information Market LLC), Muscat, feels the market appetite has always been there. “Call it Islamic finance or traditional funding, corporates need funds. Many companies in Oman would like to avail themselves of IF,” says Khalid.

Has IF arrived in Oman? “I think it has definitely arrived,” argues Rajeev. “It has been a force in the region for sometime. Oman government has been very pragmatic in consciously trying to avoid linking religion with business. We understand that the regulator doesn’t have a problem if you have these (IF) products without specifically marketing it under that tag. IF transaction and lending has been taking place in Oman for the past few years, but quietly, and without a lot of publicity. But businessmen continue to use that. It’s now a way of life in the Middle East.”

Is the trend likely to pick up in the future? Rajeev believes it has to; it’s a fact of life across the region. A big development for Islamic banks, points out Rajeev, is that while in the past it was confined to retail business, and later corporate, the recent times have seen the arrival of the Islamic component for project finance. “You now see sizeable IF component forming part of project finance tranches. Anything between 20 per cent and 35 per cent of project finance transactions now comprise of Islamic tranches,” he informs.

However, Khalid sees the non-standardization of IF banking procedures as the biggest hurdle for its growth in Oman. This, he views, as a problem with the structural element of the IF concept. The Abu Dhabi Commercial Bank or the Dubai Islamic Bank have their in-house Shariah boards, he points out. Malaysia, where IF is breaking new ground, has set the benchmark for standardization. “We don’t have this,” he says.

Khalid then points to the problem relating to the marketability of IF products. Here, he sees a big problem with liquidity, which he says, is an issue with both IF and conventional products. The primary market is low. However, change of hands is not taking place in the secondary market. Khalid cites the example of Sukuk (Islamic leasing bonds), which has done extremely well in the primary market. In the secondary market, Sukuk has the attractiveness but not the liquidity. Khalid says the prospect of IF looks bright in the short-term. Petrodollars have made the market more attractive. “But only when the secondary market sees transactions taking place, that liquidity and attractiveness will come to the IF market.”

Rajeev, on the other hand, sees a silver lining with regard to the IF terms and conditions, which have been improving in recent times, for example the tenure of the loan, the sort of paperwork and documentation required, and the level of compliance etc. “In recent times, IF has become easier to understand and easier to facilitate. IF now has standard packages so there is no need to bother about checking compliance from scholars. Bankers arrange all that. The transaction process has become very smooth now,” says Rajeev.

The eased procedures and the heightened interest bring us to back the basic question: what is happening on the regional and global maps? How far has IF’s reach grown?

IF: Third Generation

In fact, Muslim societies have always looked to means of conducting their banking and investment affairs according to the Shariah, the sacred law of Islam. However, the discovery of oil in the Arab world in the 1930s brought about radical changes, stepping up the challenge of compliance in the global economy.

Today, there seems to be a growing interest in IF even in such parts of the globe as Europe and North America, where Muslims are a minority. And in the Middle East, IF may become a way of life! A recent study illustrates that the Asia-Pacific region looks promising as well, following estimates that Islamic banks will account for 40 per cent to 50 per cent of total savings of the Muslim population worldwide within the next eight to 10 years.

Modern Islamic finance, clearly, has come a long way since it appeared on the scene some 30 years ago. The industry is now seeing a third generation of evolution. The concept as such started with the creation of Islamic banks in the Middle East in the mid-1970s. However, majority of their assets were either real estate or very short-term, trading-type activities.

The second generation lasted from the mid-1980s to mid-1990s. Now, Islamic banks were developing a bit more sophisticated corporate and retail banking structures, trying to come up with better products and a better level of service. From the mid-to late 1990s to the present day, is the time for the third generation of IF institutions. Sophisticated product offerings mark this phase.

The first Islamic investment bank was founded in Bahrain in 1997. Since then, several Western banks have set up Islamic windows, including UBS Group’s Noriba Bank, Citigroup’s Citi Islamic Investment Bank, and HSBC Amanah Finance. It is not unusual, now, to find conventional banking models operating side by side with Islamic banking systems.

What They Offer

Islamic financial institutions typically offer such traditional Islamic banking services as investments in Murabaha (instalment sales), equity investments that conform to Shariah precepts, real estate investment programs, treasury products, foreign exchange, and private wealth, and portfolio management. An Islamic fund of hedge funds is only the latest milestone in the development of Islamic finance, an opportunity lying somewhere between US$200 billion and US$300 billion.

Islamic financing in the GCC in general, and Dubai in particular, has seen a surge recently following the launch of Islamic banking services by regional and international banks.

“In fact, Islamic financing has grown in double digits from a low statistical base. At some point in the future, growth rates will be slower because the industry is maturing,” points out Dr. Eckart Woertz, Program Manager, Economics, of the Dubai-based Gulf Research Center.

Adds Dr. Woertz: “Islamic financing has quite some potential in the Islamic countries and among migrant communities in the West. But much of its future growth depends on how it will be able to copy conventional banking products, including project financing, options, short selling.”

“This in turn might raise discussions about its specific Islamic identity, as boundaries to conventional banking become increasingly blurred.”

For example one can argue whether murahaba constructions are some kind of disguised interest and in fact treasury departments of Islamic banks, which invest in such vehicles use the LIBOR (London Inter-bank Offered Rate) of conventional banking as a benchmark.

That may be so for now. But in future Islamic financial institutions will come under increasing competition. Will they be able to withstand such competition from the likes of Citigroup, HSBC and Deutsche Bank?

They could, says Dr. Woertz.

It is not too difficult for a conventional bank to ease into Islamic financing. The similarities are greater than the differences, says Dr. Woertz, who says it is about risk management and the time value of money… “Once a Shariah board is in place and there is administrative separation of Islamic/non-Islamic accounts, there is no problem. All the bigger banks, including Citi, HSBC, Deutsche etc. are venturing into the field since there is increasing business.”

But Islamic banks will have to keep initiating new measures with products that will be able to maintain profitability.

“The huge profit margins of Islamic Banks will decline once investors become more sophisticated and demand some kind of profits or ‘disguised interest’ on their current accounts. So far, the Islamic Banks mostly get deposits at essentially no cost while operating profitably with them on the consumer financing and murahaba markets.”

But what needs to be done in order for the industry to expand and still corner more share of the international finance is to integrate value with sustainable growth.

The Islamic finance sector needs to do more to encourage socially responsible investing (SRI), a recent forum in Dubai was told.

Of particular interest and key to the moral dimension of investing will be the parallels drawn between Islamic Finance and Socially Responsible Investing (SRI), a strong and growing force in Europe and the US, which aims to balance sustainable value to both society at large and the shareholders by investing in companies who meet their exacting standards of Corporate Social Responsibility (CSR).

“Islamic finance is rapidly maturing into a mainstream and powerful financial industry, and Shariah-compliant disciplines are accelerating into many new sectors,” according to Christianna Tsiterou, Conference Director at IIR Middle East, organizers of the 9th International Islamic Finance Forum (IIFF) in Dubai.

Probably the Dubai International Financial Centre (DIFC), which plans to list Islamic instrumnets at some stage can play a key role in the development of Islamic financing.

Islamic banking and financial institutions intending to operate out of Dubai International Financial Centre (DIFC) must ensure a clear division between senior management and company-appointed Shari’a Supervisory Boards (SSBs), according to Hari Bhambra, Senior Manager – Supervision at DIFC Financial Services Authority (DFSA).

While a company’s board would hold ultimate responsibility for the organisation’s operations, including its general compliance with DIFC’s regulatory framework, as well as its Shari’a aspects, the SSB would be responsible for approving the Shari’a aspects and reporting to DFSA, adds Bhambra.

But future growth in the GCC Islamic financial services industry hinges on developing and introducing standardisation and innovation of products and services.

Says Dr. Habib Al Mulla, Chairman, Dubai Financial Services Authority (DFSA), ‘The Islamic financial services industry should seek to be as innovative as possible in terms of products and services that they offer. The industry would greatly benefit from standardisation of Islamic services and products, and this would promote greater consistency across the industry.”

Industry experts point out Islamic firms would greatly benefit by being able to respond more quickly to the needs of clients, and not be delayed by the legal and Shariah approval process.

The DFSA considered many jurisdictions when devising its regime for the DIFC as a whole and specifically Islamic finance. With respect to Shari’a, the DFSA chose to act as a Shari’a Systems Regulator rather than a Shari’a Regulator.

”For the future, the DIFC has established the Islamic Finance Advisory Council its responsibility is to begin work with the industry to identify the gaps and issues in the market, and then set realistic timetables with a view to improving the operating environment for Islamic finance. This is just a start. As a regulator, we recognise that we along with the market have to continue to evolve,” adds Dr. Al Mulla. Of equal importance is the Citigroup Dow Jones Islamic bond index recently launched, to help create a benchmark for Sukuks“But Sukuks as such are far from constituting a benchmark, most of the time they are 5-year floating rate notes and fixed coupon and government sukuks are rare. Thus a benchmark all across the yield curve is not possible yet,” said Dr. Woertz of GRC.

The Dow Jones Citigroup Sukuk Index includes investment-grade, US dollar-denominated Islamic bonds-also known as Sukuk-issued in the global market. The Index tracks seven issues: Islamic Development Bank, Solidarity Trust Services Ltd, BMA International Sukuk, Qatar Global Sukuk, Malaysia Global Sukuk, Sarawak Sukuk and Dubai Global Sukuk.

To be included in the Index, an Islamic bond must comply with both Shariah law and the Bahrain-based Auditing & Accounting Organization of Islamic Financial Institutions (AAOIFI) standards for tradable Sukuk. Once a bond meets these criteria, Dow Jones Indexes and Citigroup will apply market-based criteria such as minimum maturity of one year, minimum issue size of US$250 million, and an explicit or implicit rating of at least BBB-/Baa3 by leading rating agencies.

Bahrain is increasingly emerging as the undisputed capital of Islamic finance. This notion is supported by continued advances made in the sector.

To begin with, some 30 Islamic financial institutions (IFIs) operate in Bahrain. These include investment IFIs like Gulf Finance House (GFH) or commercial banking entities such as Shamil Bank. Still, other leading banks such as Citibank and Arab Banking Corporation have dedicated units catering to Islamic finance in Bahrain.

Supportive Institutions

To be sure, Bahrain is well placed to lay claim on being the primary hub for Islamic finance by virtue of supportive institutions in place. Already, Bahrain plays host to numerous institutions promoting and organising Islamic banking activities, like the International Islamic Financial Market (IIFM). Set up in November 2001 by several Muslim countries and Saudi-based Islamic Development Bank, IIFM serves as a money market for Islamic institutions worldwide. In turn, this is sustained through Liquidity Management Centre (LMC), which helps realising IIMF’s objective.

Set up in July 2002, LMC provides a platform for IFIs to manage their day-to-day liquidity requirements. In particular, LMC manages the sale of Islamic leasing bonds, better known as Sukuks. In short, LMC intends to develop an active secondary market for short-term Shariah-compliant treasury products.

To add to it all, the International Islamic Rating Agency (IIRA) is based in Bahrain. Set up in 2002 as a pioneering project, IIRA extends ratings to IFIs and other Shariah-compliant products. As such, the global banking industry’s necessary infrastructure is based in Bahrain.

Serious Regulations

Financial authorities in Bahrain regard Islamic banking sector as one with extraordinary growth potential. Not surprisingly, the government is keen to promote Islamic banking by providing a supportive regulatory environment, with emphasis placed on high standards, transparency and accountability.

The Prudent Information and Regulatory Framework for Islamic Banks (Piri) came into effect in 2002. Piri requires Islamic banks to maintain a capital-adequacy ratio of 12 per cent. In fact, the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) is based in Bahrain too. According to International Monetary Fund (IMF), Islamic finance houses anywhere are mandated to follow standards set by AAOIFI.

Other regulations are in place in dealing with asset quality, management of investment accounts and liquidity. In 2003, BMA signed a memorandum of understanding with the London Metal Exchange (LME) to develop contracts and documents that abide by Islamic law. The final aim of the deal is to assist IFIs conduct transactions on the LME.

Innovative Businesses

In many respects, Bahrain-based IFIs are noted for their innovative business ideas. They are credited for standing behind a number of property-related projects across the region.

For example, GFH is leading force behind Bahrain Financial Harbour, the US$1.3 billion project, set to become the country’s main financial district by 2007. Also, GFH is the financial advisor to the newly launched Qatar Energy City. In fact, Essam Janahi, Chief Executive Officer of GFH, serves as chairman on the board of Qatar Energy City, whose first phase will be built at the cost of US$1.6 billion. Besides, promoters expect to launch a stock market dedicated to trading in oil and gas derivatives, as part of Qatar Energy City project.

Also, GFH shows that IFIs can be profitable — it posted net profit of US$57 million in the first quarter of 2006, up 75 per cent from the same period in 2005.

Bright Future

The IMF believes that Islamic banking extends opportunities to Bahrain’s financial services sector. The point was made during the financial sector assessment programme (FSAP) review of Bahrain, released in March. Says IMF: “The variety and popularity of Islamic instruments has surged in recent years, driven mainly by the supply of funds from savers who wish to invest in Islamic vehicles, and to a lesser extent, by entrepreneurs seeking financing using Islamic instruments. The growth is likely to remain rapid over the near term.”

In fact, according to FSAP’s report, Islamic banking is assisting Bahrain remain an attractive location for financial institutions. Likewise, the IMF’s report noted growing demand for Islamic insurance in Bahrain. Islamic insurance activity is known as Takaful.

Suffice to say that the financial services sector, which includes Islamic banking, is the main contributor to Bahrain’s gross domestic product (GDP). In 2004, the sector accounted for 24. 2 per cent of the GDP in constant prices, up from around 19 per cent in 2003. Activities related to the financial services sector, namely investment banking, advisory and management services, grew by a hefty 35 per cent in 2004.

The challenge to financial authorities in Bahrain lies in continuing the drive to encourage development and introduction of innovative Islamic banking products. And there are numerous indications that Islamic financial institutions operating in Bahrain plan to remain innovative while taking calculative risk. For instance, Kuwait Finance House (Bahrain) has recently revealed plans to set up KFH Industrial Oasis within Bahrain International Investment Park (BIIP). KFH’s project intends to stimualte diversification within Bahrain’s industrial sector by building on growing demand for indudstrial-based real estate projects in the country.

In short, Islamic finance is bound to remain an agent of change in Bahrain’s vital financial servcies sector.

It has never been this good for Islamic finance in Qatar. In recent times, three local conventional banks have branched out and launched Islamic financial entities. Qatar market is witnessing an escalation in competition in this area — in providing Shariah-compliant products and services to the local clientele.

Qatar Islamic Bank (QIB), that started its operations in 1983, is the pioneer in the field. Its local investments exceed 70 per cent of its gross investments. With assets standing at QR8.294 billion, QIB’s success is proof of the readiness of the market for competition.

And that’s why conventional banks have joined the bandwagon. QNB Al Islami, Al Safa (Commercialbank) and Doha Islami (Doha Bank) join Qatar Islamic and Qatar International Islamic Banks. “In countries such as the UAE and Saudia Arabia, both such models of banking have simultaneously existed for a long time. It should be construed as ‘healthy competition’ as it keeps everybody on their toes in terms of coming up with offerings that are value packed. Qatar is now experiencing the same and I am optimistic that it will contribute positively in all aspects,” says Mohammad I Mandani, Deputy CEO and Head of Islamic Banking, Al Safa Islamic Banking. “Conventional banks opening up Islamic branches only prove how popular the concept has become. And this increased competition will only being about improved quality in products and services,” says a QIB spokesperson.

Islamic finance is indeed coming of age in Qatar. It is no longer a unique or niche service, as its appeal crosses religious and national boundaries. It is probably a little intriguing why this concept of banking had not found wider favour earlier here.

QIB, the leading Islamic bank in Qatar, has ventured overseas in its expansion. It has stepped forward to lead the establishment of three finance houses in Europe, Asia and the USA. Musadag El Melik, Head of QNB Al Islami, says the basic concept of Islamic banking is something that is built on the ethical beliefs or principles of not just Muslims, but also of the two other major religions — Judaism and Christianity. “Usury is banned in all three religions. So we are providing a service that is interest-free. So we can simply look at this form of banking as ‘interest-free banking’ — as one economic concept. Yes, there is more than just being interest-free, we will not invest in what is prohibited — alcohol, tobacco, gambling etc. But those may well be the principles of those who are not Muslims too.”

Businesses Seek It Too “The Qatari market has become so appealing that there is excellent opportunity for investing locally in Shariah-compliant projects. That is why so many new players are entering the market,” says the QIB official.

Recently, Dolphin Energy Limited signed what is considered the biggest Shariah-compliant financing agreement ever. Dolphin Energy signed an Islamic financing agreement with 14 financial institutions that will provide $1 billion to finance a portion of the Dolphin Gas Project. Dolphin had earlier appointed five banks with Shariah Supervisory Committees to lead the financing.

Dolphin also invited other banks, including a number that had never invested in Islamically structured financing facilities before, to join the financing.

Key Challenges

The Islamic finance industry is comparatively young. Therefore, the there will be challenges.

One of the key challenges is the relatively small talent pool of qualified personnel to run Shariah-compliant programs.

Another obstacle is the lack of uniform standards. Differences in approach can make it difficult for professionals who try to adapt their financial business practices in one Islamic country to another.

Islamic banks looking to compete in the global economy must eventually align themselves with Basel II, the international banking standard. This means developing the necessary technological capability and operating procedures. However, conventional banks that already comply with Basel II and decide to enter the Islamic banking business, must reengineer their processes to make their activities Shariah-compliant.

Then, assessing the performance of Islamic banks is often confounding for experienced regulators, let alone newcomers to the sector. The problem is a lack of adequate transparency and disclosure. This is the other big challenge.

Finally, there is the persistent skepticism that interest in IF is being driven by marketing needs rather than the sector’s own merits.

Source: OER (Oman Economic Review)

(This article first appeared in Oman Economic Review in the year 2006, and was later carried by several other websites, including

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