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Facoltà di Economia Corso di Laurea Magistrale in Economia E Finanza Internazionale

Islamic Banking and Finance in Europe:

A Challenge and Insight Possibilities in Italy

Islamic finance, growing phenomenon to impulse the economy growth. European experience and an insight on the possibilities in Italy, the ethical challenges, future prospect and suggestions.

Relatore: Prof. Federico RAJOLA

Tesi di Laurea di:


Matricola n. 3807255

Anno Accademico 2011/2012



To my beloved Mother

ةبيبحلا يمأ ىلإ

، ماركلإاو للاجلا اذ اي ، مويق اي يح اي مهللا كيلإ بحلأا ، كرابملا بيطلا مظعلأا كمساب كلأسأ ، تمحر هب تمحرتسا اذإو ، تبجأ هب تيعد اذا يذلا تجرف هب تجرفتسا اذإو ، نيقباسلا نم كتاجرد ىلعأ ىلاو نيلوبقملا نم ىمأ لعجت نأ نيملسملا عيمجو اهاياطخو اهبونذ اهل رفغاو اهمحراو اهنع فعاو اهفاعو اهل رفغا مهللا نيقثاولا نم كناوضر دوجب اهعلجأو نينئمطملا نم كتمحر سنأبو نيمحارلا محرأ اي نيعتسأ كتمحرب

















Understanding Islamic Finance


1.1. Islamic Law


1.2. Fundamental Principles of Islamic Finance


1.3. Basic Principles


1.3.1. Prohibition of Riba (Usury)


1.3.2. Prohibition of Activities With Elements of Gharar (Uncertainty)


1.3.3. Prohibition of Maisir (Speculative, High-Risk, Gambling)


1.3.4. Zakat ”Alms For Poor”



Understanding Time Value of Money in Islamic Finance





The Stability of IFS and differences between Islamic - Conventional Banking



Financial Stability of Islamic Finance


2.1.1. Theoretical Considerations


2.1.2. Some Empirical Evidence


2.2. Differences between Islamic and Conventional Banking


2.3. Advantages and Disadvantage of Islamic Finance


2.3.1. Advantages of Islamic Finance


2.3.2. Perceived Disadvantages of Islamic Finance





Islamic Financing Techniques and Products



Equity-Based Financing Techniques









3.1.3. Wakalah


3.1.4. Difference Between Mudarabah and Musharakah Contracts



Debt-Based Financing Techniques


3.2.1. Murabaha


3.2.2. Bay Salam


3.2.3. Istisnaa






Pure Ijarah



Capital Market Instruments



Islamic Stocks and Equity Funds


3.4.2. Islamic Investment Certificates (Sukuk)



Funding operations and Accounts


3.5.1. Current Accounts


3.5.2. Savings and Investment Accounts


3.5.3. Islamic Credit Cards


3.6. Takaful (A Shariah Compliant Insurance Concept)


3.7. Use of Islamic Financing Products and Profitability




4. Governance and Compliance Structure of Islamic Banks



Corporate Governance and Shariah Board



Shariah Board and Performance of Islamic Banks



The Shariah Supervisory Board


4.2.1. Shariah Supervisory Board Standards


4.2.2. Characteristics of a Shariah Supervisory Board


4.2.3. Functions of a Shariah Supervisory Board


4.2.4. Product Innovation Process


4.2.5. Shariah Board and Profit


4.2.6. Inconsistency of Fatawa



Regulatory Framework



Standardization and Harmonization



4.3.2. AAOIFI


4.3.3. IFSB


4.3.4. Regulation


4.3.5. Accounting, Reporting and Zakat





Management from Islamic Perspective



Managerial Leadership: An Islamic Perspective


5.1.1. Team Building Under Islamic Leadership


5.1.2. Islamic Model of Managerial Leadership



IF Asset Management


5.2.1. Shariah Compliant Fund Management


5.2.2. Islamic Fund Management Structure


5.2.3. Asset Management Company Structure


5.2.4. The Islamic Fund Market





IF Risk Management


6.1. Specific Risk Surrounding Islamic Banks


6.2. General Risk Surrounding Islamic Banks


6.3. Reducing Risks of Islamic Banks


6.3.1. Credit Risk


6.3.2. Market Risk


6.3.3. Liquidity Risk


6.3.4. Operational Risk


6.3.5. Legal Risk


6.3.6. Displaced Commercial Risk


6.3.7. Shariah Risk


6.3.8. Risk Management Techniques And Regulations


6.3.9. Suitable Clear Information Strategy




7. History and Current Development of Islamic Finance


7.1. Historical Milestones


7.2. Islamic Banking and Finance in the Middle East


7.2.1. Bahrain


7.2.2. Iran


7.2.3. Jordan


7.2.4. Kuwait


7.2.5. Lebanon


7.2.6. Qatar


7.2.7. Saudi Arabia


7.2.8. Syria


7.2.9. United Arab Emirates


7.2.10. Islamic Banking and Finance in Sudan (Africa)


7.2.11. Best Islamic Institutions for 2011


7.2.12. Prospects For Islamic Financial Industry



Issues and Challenges for IF Globalization


7.3.1. Regulating and Supervising Islamic Finance


7.3.2. Reluctance to Promote Risk Sharing


7.3.3. Performance of IB: “Difficulties to return to pre 2007 profitability levels”


7.3.4. Concentrated Banking


7.3.5. Liquidity


7.3.6. Weak Risk Management and Governance Framework


7.3.7. Integration with Global Financial Landscape


7.3.8. Risk Management Framework


7.3.9. Wealth Management


7.3.10. Shortage of Competent Shariah Experts and University Talents


7.3.11. Going Beyond Banking



Suggestions for enhancing the Islamic industry


7.4.1. Promotion of SME Financing


7.4.2. Proposals for Organizational Structure of Islamic Banks



Proposals for Growth of PLS on Assets







State of Islamic Banking in Europe


8.1. Euro-Arab Banking Relation


8.2. Islamic Finance in Europe


8.2.1. Shariah Compliant Liquidity Management in Europe


8.2.2. Sukuk Issuance and Trading in Europe


8.2.3. Shariah Compliant Fund Management


8.2.4. Islamic Retail Banking Europe


8.2.5. Islamic Investment Banking



European Countries - Current Situation and Future Outlook



8.3.1. The UK


8.3.2. France



8.3.3. Germany


8.3.4. Other European Countries


8.3.5. Future Prospects for Islamic Finance in Europe





Islamic Finance Growing, But Not In Italy


9.1. The European Experience: A Message to Italy



Europe’s Countries Market Players


9.2. Italy A Potential Market For Islamic Banking?




Islamic Finance In Italy: “how much Potential in terms of Euros?”



A Solution to the Italian Economic Crisis?



Obstacles And Hindrances Facing Italy


9.3.1. Main Challenges For Islamic Institutions Wishing To Set Up In Italy


9.3.2. Islamic Banking and Prudential Supervision in Italy


9.3.3. Islamic Banking: Impression of an Italian Jurist: Pietro Abbadessa


9.4. Prospect for Islamic Finance and Banking in Italy


9.5. Results: The Determinants of IRB in the Italian Context



Demand Conditions


9.5.2. Supply Conditions


9.5.3. Societal Conditions


9.5.4. Regulatory Conditions


9.6. Conclusion







ANNEX 1 Islamic Banking Structures Within The Conventional Banking System


ANNEX 2: Example: The use of Tawarruq to make the transition from conventional to Islamic

balance sheets


ANNEX 3 The UK Example


ANNEX 4 Islamic banking for Italian SMEs


ANNEX 5 Determinants of Islamic Bank Profitability: Evidence from Jordan


ANNEX 7 The Constitution Of An Islamic Financial Institution In Italy




Figure 1 -- Example of a Mudarabah


Figure 2 Permanent or diminishing Musharakah transaction


Figure 3 -- comparing equity and agency structures


Figure 4 -- Murabaha transaction


Figure 5 -- Salam transaction


Figure 5a Istisna


Figure 6 -- Pure Ijarah transaction


Figure 7 -- The pay-off profile of asset-backed securities under the three basic forms of

Islamic finance.


Figure 8 -- Islamic equity fund based on Mudarabah partnership from Gassner and Wackerbeck (2007)


Figure 9 -- Simple Sukuk Structure


Figure 10 -- The concept of an Ijarah Sukuk transaction


Figure 11 -- Takaful model based on Mudaraba transaction (Gassner and Wackerbeck,


Figure 12 -- A Diagram of Team Building under Islamic Leadership, (Ather and Sobhani




Figure 13 -- Model of Managerial Leadership from Islamic Perspective (Ather and Sobhani



Figure 14 -- SALAM model


Figure 15 -- Islamic Asset Management Structure (Schoon 2011)


Figure 16 -- Asset management organization (Schoon 2011)


Figure 17 -- Average assets under management (Schoon 2011)


Figure 18 Islamic Banks geographical investment strategy (Schoon 2011)


Figure 19 -- Muslims as a Share of world population, 1990-2030 (Pew Research Center)


Figure 20 -- Muslims population by Region, 1990-2030 (Pew Research Center)


Figure 21 -- Best Islamic Bank by Country, 2010 (


Figure 22 -- Painful decline in profitability of Islamic Banks (Ernest and Young



Figure 23 -- Growth Rates of Assets and Deposits across Countries (Salman Syed Ali,



Figure 24 -- Analysis of leading Islamic commercial banks in the MENA region shows a large variation in the average ROE between 2006-10. (Ernest and Young 2011-12) 150

Figure 25 -- shows Return on Assets (ROA), ROE and NFI averaged for all Islamic banks by each country for each year since 2006. Data for Bahrain, Kuwait, Qatar, Saudi Arabia,

and UAE up to 2010. (Ernest and Young 2011-12)


Figure 26 Comparison of sector allocation of S&P 500 and S&P Shariah 500, Source:

S&P (2009)


Figure 27 - EUROPE -- Number of Muslims in Western Europe, 2010-2030 (Pew Research



Figure 28 EUROPE -- Projected Distribution of Muslim Population, 2030 (Pew Research



Figure 29 -- Regulatory initiative in the United Kingdom (Financial Services Authority



Figure 31 - EUROPE -- Number of Muslims in Western Europe, 2010-2030 (Pew Research



Figure 32 Degree of use of banking services by Nationality (percentage of total bankerized by country)


Figure 33 Muslims and non-Muslims considerations towards Islamic Banking (own



Figure 33 Muslims considerations towards Islamic Banking (own illustration)


Figure 34 Italian Companies considerations towards Islamic Banking (own illustration)


Figure 35 -- The determinants of Islamic retail banking (IRB) in Italy (own illustration)




Table-1: Comparison between Riba and Profit


Table-2: Differences between Islamic & Conventional Banking


Table-3 Shariah approval process for a new product orstructure, Natalie Schoon



Table-4: Differences between Islamic & Conventional Banking, (Iqbal 2011)




Box-1: Landmark Islamic finance deal inked, (Khaleej Times: 03 July 2003)


Box-2: Do Islamic Banks Perform Better than Conventional Banks? (Hadeel Abu Loghod,



Box-3 Research study Islamic perspectives on conflict management within project managed

environments (Kasim Randeree and Awsam Taha El Faramawy, 2009)


Box-4 How to Invest Today According to Shariah according to Eurekahedge




Al wadiah Principle to keep or deposit something in-custody

Amanah Describes both a relationship of trust and items in safekeeping

Bay Salam A contract determining a pre-paid purchase

Daruah Doctrine of necessity

Fatwa (plural: fatawa) An authoritative legal opinion issued by a Shariah Supervisory Board/ single Shariah scholars, based on the Shariah

Fiqh Practical Islamic jurisprudence (jurists’ law)

Fiqh Mu’amalat Islamic commercial jurisprudence (rules of transaction)

Hadithe Technical term for sources related to the sayings and doings of the Prophet, authentic traditions

Ijarah / Ijarah wa Iqtina A contract determining a leasing agreement/A lease-purchase agreement

Istisnaa A contract of sale of specified goods to be manufactured

Maisir Gambling

Manfa’a The right to use an asset

Mudarabah A partnership contract in which one partner contributes capital and the other partner invests time and effort 1 The explanations are aligned with the Glossaries of Hassan and Lewis 2007 and Jaffer 2005.

Mudarib The entrepreneur or manager in a Mudarabah contract

Murabaha The resale of goods with an agreed upon profit mark-up on the cost

Musharakah A partnership contract in which both parties contribute capital and may form a joint management

Qard Hassan A benevolent (interest-free) loan

1 The explanations are aligned with the Glossaries of Hassan and Lewis 2007 and Jaffer 2005.

Qirad A dormant partnership (for example in a Mudarabah contract)

Rabb al mal The partner in a Mudarabah agreement providing the funds

Shariah Islamic religious law derived from the Holy Quran and the Hadith

Sukuk (plural of sakk) Participation securities, coupons, investment certificate

Tabarru Donation

Takaful A Shariah compliant insurance concept (similar to conventional mutual insurances)

Tawarruq The purchase of goods on deferred payment and their subsequent sale (to raise cash)

Wakalah An agency contract


Islamic banking is a relative young industry, with a high rate of growth, which in the last years became a highly discussed subject, due to the challenges and opportunities that it brings. Due to the fact, that in the last decade, the Islamic banking made its presence in the European Union market, however, unlike in all of Europe, is far from appearing in Italy, despite the fact that investors are saying they are ready for it and that Italy shares ethical and religious principles with the Islamic world.

Italians have wrong perception on Islamic finance considering that it is only for Muslims and on the other hand Muslim community is not a strong community in Italy and their integration with the Italian community is limited and they are not debating how they can develop this work and repair the Muslim image in Italy.

Moreover, other than Regulatory and tax obstacles, the main challenges for Islamic institutions wishing to set up in Italy is that Italian traditional banking lobby is particularly strong and closed in the territory, and has no interest in losing market share, neither its monopolistic position in the Italian/European financial markets in favor of Islamic financial institutions.

However, the success of a financial model in a market must not be allowed to depend on market rules. Market participants must observe market rules but it will be the market itself that decides whether or not a kind of institution may enter into the market, providing that its products are complying with standards of contractual and market transparency as well as investor protect legislation.

Italy’s strategic positioning, its dense network of small financial institutions throughout the territory and the most powerful movement of business ethics in Europe make Italy a natural candidate for the development of the Islamic sector. Once solved the problems of societal, fiscal and regulatory, Italy will play a central role in the Mediterranean and Islamic Banking will be a new engine for finance in Italy.


Islamic finance is growing fast. It has a global value of 1.7 trillion USD and counts 400 institutes with their offices. The Muslim population in Europe is over 18 million and in Italy there are over 1.5 million Muslims (2011), who represent about one third of foreign residents and 2.8% of Italy’s population, and a remarkable number of Italian non-Muslims are willing to shift towards Islamic finance instruments but the system is not breaking through into Italy.

Islamic finance can no longer be dismissed as a passing fad or as an epiphenomenon of Islamic revivalism. Islamic financial institutions now operate in over 70 countries. They have grown at respective annual rates of 10% and 15%. By certain (probably overly optimistic) estimates, up to half of the savings of the Islamic world may in the near future end up being managed by Islamic financial institutions. The first Islamic banks were created in the 1970s, at the time when the aggiornamento of Islamic doctrine on banking matters was taking shape. At the time, Islamic banks were typically commercial banks operating on an interest-free basis. Today, as a consequence of broad changes in the politicaleconomic environment, a new generation of Islamic financial institutions, more diverse and innovative, is emerging as the doctrine is undergoing a new aggiornamento. Perhaps the most important development has been the growing integration of Islamic finance into the global economy. There is now a Dow Jones Islamic Market Index 2 , which tracks 600 companies (from inside and outside the Muslim world) whose products and services do not violate Islamic law. Foreign institutions such as Citibank have established Islamic banking subsidiaries, and many conventional banks in the Muslim world but also in the United States and Europe – are now offering ‘Islamic products’ that are sometimes aimed at non-Muslims.

2 The Dow Jones Islamic Market Indexes, introduced in 1999, was the first representative set of Sharia compliant benchmark portfolios. Today the indices listed are over 70 and remains the most complete family of Islamic market indicators, includes global indexes, regional, individual countries, individual industries. Among the most important are the Dow Jones Islamic Market Titans 100 index (indicator of the 100 largest companies compatible with the dictates of Sharia), the Dow Jones Islamic Index (Dow Jones selection made with Islamic criteria), and the Dow Jones Islamic Market Asia / Pacific Titans 25 Index (the 25 largest companies in Asia and the Pacific).Other very important group of indices are the FTSE Global Islamic Index Series, these are also an indicator for those wishing to invest in global equity and in line with Islamic laws, we FTSE SGX Shariah then the Index Series, a set of indexes made in collaboration with the Stock Exchange of Singapore, representing the performance of companies in the markets of Asia and the Pacific (Japan, Singapore, Taiwan, Korea and Hong Kong), the FTSE Bursa Malaysia Insex Series, with two indices for Muslim investors, and finally the FTSE DIFX Index Series, in collaboration with the Dubai Stock Exchange, which represents the leading companies in the Arabian Peninsula.

Islamic finance is thus in many ways well suited to the global economy. This is all the more striking and paradoxical in that it is often said that Islam is incompatible with the “new world order” that emerged with the end of the cold war. In addition, how could a medieval economic system be relevant in a world of revolutionary, technology-driven global finance? And how could an interest-free system fit within the broader interest-based financial system?

The first part of the thesis provides background information on Islam and Finance, introduces and describes the world of Islamic finance (Chapters 1 to 6). Explaining the Islamic law , its principles, Islamic financial instruments, regulatory framework, Islamic Management, strategy and culture (how the practices of Islamic financial institutions differ from those of conventional ones.

The second part of the thesis traces the historical evolution of Islamic economics and finance in the Arabic world and in Europe(Chapters 7 to 8). It traces the birth, challenges, managerial problems, evolution of modern Islamic finance and places it in its proper political and economic context. It accounts for the diversity of the industry by analyzing the ways different countries have introduced and dealt with Islamic finance, and by providing a typology of Islamic financial products.

The third part (Chapter 9) deals with the issues and challenges facing Italy to host Islamic Finance and Islamic Retail Banking from four points: demand conditions, supply conditions, societal conditions and regulatory conditions. Discussing the main challenges embedding Islamic finance to locate in Italy and the cultural barriers to the implementation of true Islamic financial systems; economics (the role of Islamic finance in mobilizing savings, allocating funds, and promoting development; Islamic capital markets; the macro- economic implications of Islamic finance); regulation (the regulatory issues raised, domestically and internationally); politics (the connection between Islamic finance and domestic politics); and religion (the battles over religious interpretation).


1. Understanding Islamic Finance

In order to understand how Islamic law informs Islamic finance, it is necessary to know something about how law and authority are positioned in Islamic thought.

1.1. Islamic Law

In order to give more comprehensive idea about Islamic banking, some background must be examined. Islamic financial principals are derived from Holy Qur'an. It plays essential role in every Muslim's life. Basically it can be described as the guidance for life, where duties and practices of crime, inheritance, worship, prayer, moral values, marriage and commercial transactions are described. Islamic law or Shariah is directly derived from it. Shariah embraces all aspects of human activity moreover it consists of regulatory and constitutive rules according to which every Muslim, must conduct their affairs.

As the primary source in conducting affairs Muslims rely on Qur'an, furthermore secondary sources are Hadith, oral traditions relating to the words and deeds of the prophet Muhammad (pbuh), and Sunna those religious achievements and manners that were instituted by the prophet Muhammad (pbuh 3 ) during the 23 years of his ministry, which Muslims initially obtained through consensus of companions of Muhammad (pbuh), and further through generation-to-generation transmission.

1.2. Fundamental Principles of Islamic Finance

The Islamic financial system broadly refers to financial market transactions, operations and services that comply with Islamic rules, principles and codes of practices. The laws and rules of the religion require certain types of activities, risks

3 Peace Be Upon Him

or rewards to be either prohibited or promoted. While Muslims undertaking financial transactions are encouraged to use financial instruments that comply with these rules, other investors may find the appeal of these instruments from an ethical standpoint. Islamic laws and rules are known as Sharia and are also referred to as Islamic jurisprudence. Sharia governs all aspects of Islamic Finance. The rules and laws are derived from three important sources, namely the Holy Quran (the holy book of the religion of Islam), Sunnah (the practice and tradition of the Prophet Muhammad pbuh) and Ijtihad (the reasoning of qualified scholars). Further elaboration and interpretation of the rules dictated by the Holy Quran and Sunnah are provided by qualified scholars in Islamic jurisprudence via Ijtihad or an interpretative process which is carried out within the framework of Quran and Sunna.

Modern Islamic financial products and services are developed using two different approaches. The first approach is by identifying existing conventional products and services that are generally acceptable to Islam, and modifying as well as removing any prohibited elements so that they are able to comply with Sharia principles. The second approach involves the application of various Sharia principles to facilitate the origination and innovation of new products and services.

In order to provide a better understanding on the unique attributes of Islamic finance, this Chapter discusses the fundamentals, principles and structure, which form the foundation of Islamic financial services.

1.3. Basic Principles

Islamic law on commerce is known as fiqh 4 . Much of the laws, rules and interpretations of Shariah takes into consideration issues of social justice,

4 Fiqh is the collection of all sources of law including Qur’an, Sunna, Qiyas (The practice of analogical reasoning) and Ijma (The principle of independent human reasoning) and constitutes the Islamic jurisprudence. It regulates the relationship between men and Allah (Fiqh´Ibadah) as well as all aspects and relationships of men among each other (Fiqh Mu´amalat). The latter comprises the regulation of commercial and financial transactions and financial institutions. The Shariah gives important incentives according to religious beliefs whereas Fiqh adjusts to the pressure of society as it is subject to political influences and public opinions.

equitability, and fairness as well as practicality of financial transactions. In general, the Shariah legal maxim in relation to commercial transactions and contracts state, “they are permissible unless there is a clear prohibition.” In a nutshell, prohibited elements of a commercial transaction must first be removed for it to be Shariah- compliant. The major prohibited elements under Shariah are riba (interest), gharar (uncertainty), maisir (gambling), non-halal (prohibited) food and drinks and immoral activities.

1.3.1. Prohibition of Riba (Usury) Majority of conventional banks run its activity on the basis of interests, which in turn not applicable and prohibited by Shariah law.

Riba has the literal meaning of “an excess” and is defined as an increase or excess which accruesvto the owner in an exchange or sale of a commodity, or, by virtue of a loan arrangement, withoutvproviding equivalent value to the other party.

More precisely there are two categories of riba riba qurudh and riba buyu`. Riba qurudh, in its application to modern financial transactions, occurs through loans. The prohibition of riba qurudh relates to any fixed or predetermined rate of return tied to the maturity and the amount of principal (i.e., guaranteed regardless of the performance of the investment). The general consensus among Shariah scholars is that riba covers not only usury but also the charging of “interest” as widely practiced.

However, the lending activities or loans are still allowed in Islam through the concept of Qardh Hasan. This type of lending is a contract of loan between two parties on the basis of social welfare or to fulfill a short-term financial need of the borrower. The amount of repayment must be equivalent to the amount borrowed. It is however legitimate for a borrower to pay more

than the amount borrowed as long as it is not stated or agreed at the point of contract.

On the other hand, riba buyu` occurs through the sale and purchase of six riba’s commodities (i.e., gold, silver, dates, wheat, barley and salt). The transaction of riba’s commodities is required to adhere to the following


i) In trading commodities of the same group and kind, such as gold for gold or dates for dates; two conditions must be fulfilled, i.e., both commodities must be exactly equivalent and there must be prompt delivery

ii) In trading commodities of the same group but of different kinds, such as gold for silver, or wheat for barley, there is only one condition, i.e., the promptness in delivery is not a condition.

iii) In trading commodities of different groups and kinds, such as gold for wheat, or silver for barley; no condition is imposed and free trading can exist, whether there is equality, inequality, promptness or delay.

Thus, Islam encourages the earning of profits but forbids the charging of interest. Profit symbolizes successful entrepreneurship and the creation of additional wealth through the utilization of productive assets, whereas interest is deemed as a cost that is accrued irrespective of the outcome of business operations and may not create wealth if there are business losses.

Social justice under Shariah requires borrowers and lenders to share rewards as well as losses equitably and that the process of wealth accumulation and distribution in the economy be fair and representative of true productivity.

Truly those who believe, and do deeds of righteousness, and perform As- salat, and give Zakat, they will have their reward with their Lord. On them shall be no fear, nor shall they grieve. O you who believe! Be afraid of Allah

and give up what remains (due to you) from Riba (usury) (from now onward), if you are (really) 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 (by asking more than your capital sums), and you shall not be deal with unjustly (by receiving less than your capital sums)”. 5 Linguistic definition of Riba is stated as follows:

“To increase, to augment, swellings, forbidden “addition”, to make more than what is given, the practicing or taking of usury or the like, an excess or an addition, or an addition over above the principal sum that is lent or expended” 6

1. Riba reinforces the tendency for wealth to accumulate in the hands of a

few, and thereby diminishes human beings concern their fellow men.

2. Islam does not allow gain from financial activity unless the beneficiary is

also subject to the risk of potential loss; the legal guarantee of at least nominal interest would be viewed as guaranteed gain.

3. Islam regards the accumulation of wealth through interest or usury as

selfish compared with accumulation through hard work and personal


According to Mirakhor(1989) regarding interest as being a reward for savings, it is justified if it resulted in reinvestment and growth in capital was not due to only postponed consumption.

As for interest as productive capital, interest paid on money and is required no matter whether capital used productively and thus is not justified. Interest as an adjustment between value of capital goods in present and future is not

5 Surah al-Baqarah:275-279

6 E.W. Lane's Arabic-English Lexicon, zamir iqbal

rightness, it is more reasonable next year's economic condition to determine

the extent of reward as opposed to predetermining it in the form of interest. 7

Table-1: Comparison between Riba and Profit





1. When money is “charged”, its imposed positive and definite result is Riba











trading), its








By definition, Riba is the premium

2. By definition, profit

is the

paid by the borrower to the lender along with principal amount as a condition for the loan.

difference between the revenue from production and the cost of production.


Riba is prefixed, and hence there is


Even if a sharing ratio is agreed

no uncertainty on the part of either the givers or the takers of loans.

in advance, profit is still uncertain, as its amount is not known until the activity is completed.


Riba con not be negative, it can at


Profit can be positive, zero or

best be very low or zero.

even negative.



From Islamic Shariah point of view,


From Islamic Shariah point of

it is Haram (prohibited).

view, it is Halal (allowed).


1.3.2. Prohibition of Activities With Elements of Gharar (Uncertainty)

Gharar is defined as activities that have elements of uncertainty, ambiguity

or deception. In a commercial transaction, it refers to either the uncertainty

of the goods, price of goods, deceiving the buyer on the price of goods,

payment terms are not specified in detail over a period of time, or ignorance

all this gharar occurs.

An element of gharar is considered a normal phenomenon in the market if it

is not excessive in the contracts and where the effect on the economy and

society is considered minimal. This is accepted by Shariah as it would be

practically impossible to eradicate this element completely from the market.

A large element of gharar in a commercial transaction, on the other hand, is

prohibited according to Shariah as it may affect the legality of a transaction.

7 Hennie van Greuning, Zamir Iqbal , risk analysis for islamic banks, p 9.

One of the examples of gharar in the financial market is in conventional insurance. Shariah scholars are of the opinion that conventional insurance is not Shariah compliant due to the large element of gharar. This is because the policyholder enters into an agreement to pay a certain sum of premium and in turn the insurance company guarantees to pay a certain sum of compensation in the event of disaster. However, the amount of compensation that the company will pay to them is uncertain and it is also dependant on the occurrence of specific events in the future. Prohibition of Gharar clearly indicated in Hadith: Ahmad and 'Ibn Majah narrated on the authority of 'Abu Said Al Khudriy (mAbpwh) 8 :

“The Prophet (pbuh) has forbidden the purchase of the unborn animal in its mother's womb, the sale of the milk in the udder without measurement, the purchase of spoils of war prior to their distribution, the purchase of charities prior to their receipt, and the purchase of the catch of a diver.”

Thus in Islamic finance prohibits contract with high degree of asymmetric information. Most financial derivatives like options, forward, futures, in speculation and short-selling, are banned because it involves uncertainty regarding future delivery of the underlying assets. More detailed explanation is given by Sheikh Dhareer.

“In this variety of sale the offer is shifted from the present to a future date, for example, one person say to another; 'I'll sell you this house at such price as of the beginning of next year' and the other replies: 'I accept'. Majority of Jurist are of the view that the sale contract cannot accept clauses of this manner. If the sale is shifted to a future date the contract becomes invalid. Gharar in a future contract lies in the possible lapse of the interest of either party and to his consent with the contract when the time set therein after. If somebody buys mudhaf (futures) contract and his circumstances changes or

8 May Allah be peace with him

market changes bringing its price down at the time set for fulfillment of the contract, he undoubtedly be averse to its fulfillment and will regret entering into it. Indeed, the object in question may itself change and the two parties may dispute over it. Thus, gharar infiltrates the mudhaf contract from the viewpoint of uncertainty over the time, when parties conclude the contract they do not know whether they will be in agreement and have continued interest in that contract when it falls due.” 9

1.3.3. Prohibition of Maisir (Speculative, High-Risk, Gambling) Gambling is referred to as qimar or maisir in Arabic, which means any activity that involves an arrangement between two or more parties, each of whom undertakes the risk of a loss where a loss for one means a gain for the other, as it is common for gambling activities. The gain accruing from these games is unlawful in Islam, as it diverts the player’s attention from productive occupation, and amassing wealth without effort. It is considered an immoral inducement by the person involved in expecting to make a profit at the expense of another party.

In relation to the above, Muslims are also prohibited from having any affiliation to gambling activities including participating, investing or financing any businesses related to, or associated with, the gambling industry.

Holy Qur'an explicitly prohibits games of chances:

“O ye who believe! Intoxicants and gambling, (dedication of) stones, and (divination by) arrows, are an abomination,- of Satan's handwork: avoid such (abomination), that ye may prosper. Satan's plan is (but) to excite enmity and hatred between you, with intoxicants and gambling, and hinder

9 Mervyn K. Lewis, Latifa M. Algaoud (pp.18-19)

you from the remembrance of Allah, and from prayer: will ye not then abstain?”


Gambling in all forms are banned by Islam, besides its explicit forms, business transactions involving gambling like features are prohibited. Regarding the question whether is it permissible to invest in stock market, many scholars agree that if the earnings are halal(permitted) 11 it is lawful to invest in the stock market if certain conditions are met which should exclude prohibited elements (Haram) 7 . Prohibition of involvement into the financing of Conventional Banking and Insurance, alcohol, pork-related products, tobacco, adult entertainment, gambling, weapons, arms and defense manufacturing. (Please refer to chapter 3.4.1. Industry Screen) Islam prohibits any financing or business transaction which are not line with ethical norms.

To summarize the essence and goal of Sharia I can quote Al-Ghazali's statement regarding Islamic law:

"The very objective of the Shariah is to promote the welfare of the people which lies in safeguarding their faith, their life, their intellect, their posterity and their property. Whatever ensures the safeguard of these five serves public interest and is desirable."

1.3.4. Zakat ”Alms For Poor” Religious levy, is one of the five fundamental pillars of Islam. Fulfilling this obligation causes Muslims for share one fortieth of their surplus wealth to poor. By carrying this process Muslims are purifying themselves from selfishness and greed.

10 Qur'an 5:90-91

11 Halal and Haram – Code of “ethical investment”

“Believe in Allah and His apostle, and spend (in charity) out of the (substance) whereof He has made you heirs. For, those of you who believe and spend (in charity),- for them is a great Reward.” 12

This wealth redistribution mechanism of income is inherited in Islam, so that every Muslim individual is guaranteed fair living standard. Zakat plays essential economic and social functions. Some scholar suggest that in can be used in fiscal policy quite effectively. By redistributing wealth fr om rich to poor, this instrument helps to maintain equality and justice within society. Since all resources are gifts of God to all human beings, there is no reason why they should remain concentrated in few hands (Chapra). Noble Qur'an states:

“(so that) wealth does not circulate only among your rich” 13

Moreover funds raised through zakat can be used only specific things. Noble Qur'an clarifies where these funds can be utilized.

“the poor and needy, those who work to collect them, those whose hearts are brought together[in the Truth], the ransoming of slaves, debtors, in the God's way, and the traveler, so Allah ordains ”


Zafar Sareshwala emphasizes main objectives and positive effects of Zakat. (1) the promotion of stable economic growth through investments, employment and balance consumption, and (2) the achievement of greater income equality through an equitable distribution of wealth, thereby eliminating poverty and extreme disparities of wealth between the rich and the poor. Positive economic effect of Zakat is an increase in the money supply and a consequent increase in the demand for goods and services. Zakat also provides debt relief and enhances price stability.

12 Qur'an 57:7

13 Qur'an 59:7

14 At- Taubah, 60

1.4. Understanding Time Value of Money in Islamic Finance

Interest rate is regarded as the main tool of making profit in finance. As interest is clearly prohibited in Islamic finance, still there are some confusions regarding time value of money. As already mentioned above, Islamic finance based on strict principles. According to Najmul Hassan, in order to better understand time value of money, basic principles of both Islamic and conventional banking should be examined (Please refer to chapter 2.2.), having in mind that in Hadith Quoted by Ali Ibn Talib: “All loans that draw interest is riba” and Qur'an's verse (2:275) where any excess of loan besides principal amount is considered as riba, furthermore money and commodity has different characteristics, as money has no intrinsic value but can be regarded as medium of exchange and measure of value, in order to satisfy human needs it should be converted into commodity.

Shariah, approves time value of money in the case of sale transaction, but in lending interest is prohibited as material compensation for time. Zamir Iqbal and Abbas Mirakhor (2011) As commodity has its quality and intrinsic value, and owner can sell at whatever price both parties agree on even though the prevailing market price is higher. Thus, excess money charged against deferred payment is riba where money exchanged for money, as excess charged against nothing but time. 15

15 Time value of money in Islamic Banking, Najmul Hassan


2. The Stability of IFS and differences between Islamic - Conventional Banking

2.1. Financial Stability of Islamic Finance

The Islamic financial system (IFS) consist of a banking sector, a stock market, an a market for securitized assets. It was also shown that the banking sector may have a sub-sector which specializes in high-credit and short-maturity securities to finance trade or commodities on the basis of murabaha ( cost-plus sale) to support the payment system. This would be analogous to the concept of narrow banking which has been suggested in the conventional system to promote stability in the payment system and in the financial system.

Proponents of the Islamic system claim that a financial system based on the Islamic framework of risk sharing would be more efficient in allocating resources than a conventional interest-based system. This claim can be defended on the basis of the general proposition that any financial development that causes investment alternatives to be compared to one another based strictly on their productivity and rates of return is bound to produce improved allocations. Such a proposition is the cornerstone of the Islamic financial system. But would such a system also improve stability?

The general argument underlying the proposition that the Islamic financial system is more stable that the conventional system is based on three notions: 1) the avoidance of leverage and debt refinancing due to the prohibition of debt; 2) the matching of assets and stabilities; and 3) the elimination of the multiplier effect.

Due to the essence of Islamic banking it was not or at least less affected by the financial crisis. As Islamic banks do not deal with debt trading and engage in highly speculative transactions that most conventional banks are undertaking. There are several opinions of experts regarding this issue.

“Islamic banks do not rely on bonds or stocks, and are not involved in the buying and selling of debt unlike most conventional European and US banks. He noted that Islamic banking is distinguished by the fact that it is prohibited from buying debts under Islamic Sharia law; therefore, Islamic banks are safe from the effects of the global financial crisis.”-CEO of the Bahraini-based Albaraka Banking Group Adnan Ahmed Yousif, adding also that Islamic banks became safe place for secured liquidity.

“Islamic banks have not been affected by the mortgage crisis that afflicted the international financial markets and that they are largely immune against such crisis thanks to inherent factors within Islamic banking. The most important of these factors is the prohibition of debt trading, taking precautions against money laundering, as well as the official and professional restraints upon which banks are based such as caution against embarking upon projects that entail financial difficulties and risks, crisis has caused significant global inflation in world banks because they buy debts and enlarge accounts without tangible transactions taking place or without brokers being aware of them, in which Islamic banks do not engage ”-General Manager and board member of the Arab Finance House Dr. Fouad Nadim Matraji.

Islamic banking is a part of the global economy and can be affected either negatively or positively by it but Islamic banks are not major investors in conventional western banks so as to be affected by such crises, I expect expects Islamic banks to end the year successfully with the forthcoming announcements of their budgets because of the clarity of contracts and Islamic banking projects that

are spread throughout the countries of the Islamic world.”-Dr. Tawfiq Bin Abdul Aziz al Swailem, Chairman of the Gulf Bureau for Research and Economic Consultation.

According to Zamir Iqbal and Abbas Mirakhor (2011) Conventional banks fail to meet inherent stability conditions even in the presence of prudential regulations. First, credit losses from debt default or the depreciation of assets may create a large divergence in relation to liabilities that remain fixed in nominal value. Second, bank credit has no fixed relation to real capital in the economy and bears no direct relation to the real rate of return. Un- backed credit expansion through the credit multiplier and further leveraging is a fundamental feature of conventional banks. Cash flow could fall short of expectations and force large income losses on banks, especially when the cost of funds is fixed through a predetermined interest rate. Third, banks caught in a credit freeze, with a drying up of liquidity, may default on their payments. Fourth, banks are fully interconnected with each other through a complex debt structure; in particular, the assets of one bank instantaneously become liabilities of another, leading to fast credit multiplication. Credit cash causes a dramatic contagion and a domino effect that many impair even the soundest of banks.

Credit can be issued to finance consumption, and hence many rapidly deplete savings and investment. The depletion of savings could be significant if credit finances large fiscal deficits. Hence, credit is no longer directly related to the productive base, as it is in the equity-based system, and the income stream from credit is no longer secured by real output as shown for the equity system. Credit can expand through leverage to an unsustainable multiple of real national income, increasing the risk of default. Credit expansion through the credit multiplier is determined by the reserve- requirement system, whereas equity in the equity-based system cannot expand more than real savings. In the case of securitization, credit can, in the theory, expand to an infinite degree.

In an economy governed by the principles of Islamic finance, the rate of return on equities is determined by the marginal efficiency of capital and time preference, and is positive in a growing economy. This implies that Islamic banks are always profitable provided that real economic growth, and conventional banking, where profitability is not driven primarily by the real growth. As we have seen, the Islamic banking system has two types of banking activity: deposit banking for safe keeping; and banking for payment, and fees may be collected for this type of service. In the system, investment banking operates on a risk/profit-sharing basis, with an overall rate of return which is positive and determined by the real economic growth rate. Islamic banks do not create and destroy money; consequently, the money multiplier, defined by the savings rate in the economy, is much lower in the Islamic system than in the conventional system, providing a basis for strong financial stability, greater price stability, and sustained economic growth.

Conventional banks issue debt and earn interest. Debt accommodation by banks has often been unlimited and has been checked only by crashes. We have shown that credit expansion may have no relation to the real capital base an no direct relation to the real cash flow in the economy that may be required for servicing debt. If financing were to be extended to consumption, then credit could erode the capital base and economic growth. The equilibrium interest rate that clears the money market may have no direct relation with the real rate of return in the economy. Such a deviation was acknowledged by the classical economists and was seen to be a cause of booms and busts, and excessive speculation in commodities and assets. Banks are obliged to pay the face value of their liabilities. In the case of credit loss, banks have to fully absorb these losses from their capital reserves or through recapitalization. Governments may be compelled to extend large and costly bailouts to rescue impaired banks and prevent a total collapse of the financial system.

The conventional system is vulnerable to many sources of instability. Besides the inability to reach full-employment output, the system can suffer from interest-rate distortions in relation to a natural interest rate and can suffer from the absence of a direct link to a real capital base that generates cash flow for servicing debt. Minsky (1986) described the conventional system as endogenously unstable, evolving from temporary stability to periods of crisis. Credit losses play havoc with the real economy and cause unemployment. The drying-up of credit during credit crashes makes the Modigliani-Miller theorem untenable. In such circumstances, leveraged firms will face higher financing costs for their investments of fluctuations in their operations. The issue of instability in conventional finance is not limited to the role of commercial and investment banks. In conventional finance, the central bank plays the critical role of lender of last resort. If it didn´t do so, conventional banks- which are interrelated through loans- would risk simultaneous failure. Banks are exposed to credit and interest rate risk and many run out of liquidity. In order to maintain their payments, the rediscount and borrowing from the central bank become pillars for the smooth functioning of conventional finance. In Islamic finance, banks do not have or cause any liquidity mismatch and are thus nor dependent on central bank finance to maintain their liquidity.

Finally, I should note that the social and human costs of financial instability and financial crises, through impossible to quantify, might dwarf even the economic costs. The human cost of prolonged unemployment-its impact on the individual psyche and on families- cannot be overestimated. The impact on individual regions is much more extreme than average effects. The unfair redistribution of wealth, at the expense of individuals on fixed incomes and creditors, is simply immoral. Islamic finance avoids these and other pitfalls of a financial system based on credit and leveraging. Islamic Finance shed its reliance on debt, interest and leveraging, to totally revamp the financial system to rely on risk sharing.

2.1.1. Theoretical Considerations From a prudential perspective, given that Islamic banks are expanding their presence in conventional systems, it is relevant to know whether Islamic banks are more or less stable than conventional banks. As mentioned above, some authors have argued that the risks posed to the financial system by Islamic banks differ in many ways from those posed by conventional banks. Risks unique to Islamic banks may arise directly from the specific features of Islamic contracts, as well as indirectly from the overall legal, governance and liquidity-management infrastructure available to Islamic institutions. For example, PLS financing shifts the direct credit risk from banks to their investment depositors. But it also increases the overall degree of risk on the asset side of banks’ balance sheets, because it makes Islamic banks vulnerable to risks normally borne by equity investors rather than holders of debt. In addition, the absence of viable Islamic money markets could exacerbate liquidity risks. Similarly, prohibitions against the use of conventional derivatives limit Islamic banks’ ability to hedge certain risks. Moreover, most Islamic banks have operated in environments with less developed or nonexistent interbank and money markets and government securities, and with limited availability of and access to lender-of-last-resort facilities operated by central banks. These differences have been reduced somewhat because of recent developments in Islamic money market instruments and Islamic lender-of-last resort modes, and the implicit commitment of most authorities to provide liquidity support to all banks during exceptional circumstances. On the other hand, there are features of Islamic banks that could render them less vulnerable than conventional banks. For example, Islamic banks are able to pass through a negative shock from the asset side (such as a worsened economic situation that causes lower cash flow from PLS transactions) to the investment depositors. The risk-sharing arrangements on

the deposit side thus arguably provide another layer of protection to the bank, in addition to its book capital. Also, it could be argued that the need to provide a stable and competitive return to investors, the shareholders’ responsibility for negligence or misconduct (operational risk) and the more difficult access to liquidity put pressure on Islamic banks to be more conservative. Furthermore, because investors (depositors) share in the risks (and typically do not have deposit insurance), they have more incentive to exercise tight oversight over bank management. Finally, and partly due to the lack of short-term investment opportunities, Islamic banks have traditionally held a larger proportion of their assets than commercial banks in reserve accounts with central banks or in correspondent accounts with other banks. Thus, even if Islamic investments were more risky than conventional investments, from a financial stability perspective the question is whether or not these higher risks are offset by bigger buffers. In sum, whether Islamic banks are more or less stable than conventional banks depends on the relative sizes of the effects discussed above, and it may in principle differ from country to country and even bank from bank.

2.1.2. Some Empirical Evidence Čihák and Hesse (2008) find, based on a sample comprising 18 countries, that larger Islamic banks tend to be riskier than smaller Islamic banks and similar large commercial banks, while smaller Islamic banks tend to be more stable than small commercial banks. Furthermore, as the presence of Islamic banks grows in a country’s financial system, there is no significant impact on the soundness of other banks. This suggests that Islamic and commercial banks can co-exist in the same system without substantial “crowding out” effects through competition and deteriorating soundness.

A plausible explanation of the contrast between the high stability in small Islamic banks and the relatively lower stability in larger ones is that it is significantly more complex for Islamic banks to adjust their credit risk monitoring system as they become bigger. For example, the PLS modes, used by Islamic banks, are more diverse and more difficult to standardize than loans used by commercial banks. As a result, as the scale of the banking operation grows, monitoring of credit risk becomes rapidly much more complex. That results in greater prominence of problems relating to adverse selection and moral hazard. Another explanation is that small banks concentrate on low-risk investments and fee income, while large banks do more PLS business.

2.2. Differences between Islamic and Conventional Banking

An Islamic bank is similar to a modern Western bank in almost all functions which empower it to mediate any shortcomings or surpluses that may exist in a monetary exchange economy. The Islamic bank requires a careful management team to balance the different levels of credit (personal credit, secured credit, letters of credit), and also functions as a specialist in estimating projects risks and estimated returns. The main difference between Islamic and conventional banks (see Table-2) lies in the fact that conventional banks charge and pay interest, whereas Islamic banks do not as they consider interest as riba (Please refer to chapter 1.3.1.). Traditionally, rather than charging interest, Islamic financial institutions will typically share some of their borrowers’ risks and profits. A bank’s profit from these ‘loans’ depends on the overall success of the loans in generating additional revenue or profits for the borrowers.

Islamic finance also avoids investing in ventures that may have components that are not in line with the values of Islam (alcohol, gambling, drugs and tobacco) and speculation (e.g., reliance on the occurrence of events that may or may not take

place). Despite such, Islamic law does not require that the seller of a product be

Muslim, or that its services also be Islamic.

Table-2: Differences between Islamic & Conventional Banking


Islamic Banking System

Conventional Banking System


Guided by Quranic edicts, Hadeeth, Islamic ethics and Islamic laws.

Guided by profit motive alone, with no religious or ethical considerations.


Ethics of

Financing being asset-backed, and meant for productive use helps reduce the overall debt burden.

Debt burden arising out of excessive use of credit leads to bankruptcies, and waste of financial resources.



An Investment Account Holder will have similar rights as shareholders.

Depositors are paid before the shareholders.


Involvement of risk & Equity financing

Equity financing is available to a project or venture that involves profit-and-loss sharing. Risk- sharing and profit sharing go together.

Commercial banks do not usually indulge in equity financing, only venture capital companies and investment banks do. Conventional banks carry much less risk, major part of the risks being transferred to the borrowers.

Return on

Depends on productivity, idle money cannot earn any return. Money is not capital per se, only potential capital 16 .

Even idle money in bank deposits earns returns.


Prohibition of

The existence of uncertainty in a contract is prohibited because it requires the occurrence of an event which may not ultimately occur. “Full disclosure” by both parties is the norm in contracts. Derivatives trading e.g. options are considered as having elements of Gharar.

Trading and dealing in derivatives are widely considered as the main source of liquidity in the conventional financial, commodity and capital markets.



Profit and Loss Sharing

Most transactions are based on this variable returns, dependent on lenders’ performance. Greater share of risks forces them to manage risks more

There is no relationship between bank performance and returns to the depositors or investors, who mostly enjoy a risk-free return. Conventional institutions mostly act as

16 It becomes actual capital only when it joins hands with other resources to undertake a productive activity. Islam recognizes the time value of money, but only when it acts as capital, not when it is "potential" capital.



professionally, to ensure better returns than conventional accounts. Depositors & investors have opportunity to earn higher returns than in conventional systems.

intermediaries between lenders & borrowers enjoying almost a risk-free spread.


It has become one of the functions of the Islamic banks to collect and distribute Zakat.

Government Taxes perhaps serve the same purpose - mode and rate of charging are different, though.

Compounding or Interest on interest

The Islamic banks have no provision to charge any extra money from the defaulters.

It can charge additional money (compound rate of interest) in case of defaulters.


For the Islamic banks, it is comparatively difficult to borrow money from the money market.

For commercial banks, borrowing from the money market is the main source of liquidity.



Since it shares profit and loss, the Islamic banks pay greater attention to developing project appraisal and evaluation systems.

Since income from the advances is fixed, it gives little importance to developing expertise in project appraisal and evaluations.


Viability v/s

The Islamic banks, on the other hand, give greater emphasis on the viability of the projects.

The conventional banks give greater emphasis on credit-worthiness of the clients.




The status of Islamic bank in relation to its clients is that of partners, investors and trader.

The status of a conventional bank, in relation to its clients, is that of creditor and debtors.

with Clients


No guarantee.

Built into the system.




An integral component



2.3. Advantages and Disadvantage of Islamic Finance

2.3.1. Advantages of Islamic Finance

Efficient allocation of funds: Since allocation of funds by banks will be dependent upon the soundness of projects under the PLS 17 arrangements, the allocation is more efficient.

Productive use of capital: Banks are likely to know their fund users better in order to ensure that the funds are used for productive purposes. In this way, both the fund providers and the financial intermediary contribute to promoting productive economic activities and greater financial responsibility. Thus, IBFs would promote economic growth (Chapra 1998 and Siddiqui 1983)

Similarly, since banks have no pressure of fixed regular payments on deposits, the efficiency of allocating resources to profitable and more productive use is further boosted.

Equitable distribution of wealth: The efficiency in allocation leads to this, and creates additional wealth as well. Interest distribution is considered unjust and inequitable because it is not based on any productive use of capital, and it exploits the misfortune of the borrower (who has run out of money).

Generation of employment: Productive use of capital implies investments and creation of jobs. The investment is not dependent upon the cost of capital (and positive NPVs) or time value of money, hence number of investible projects is likely to be much higher resulting in larger capital formation.

Saving-in information costs: Being a partner of the entrepreneur (or a firm), the financial institution has easier and cheaper access to

17 Profit Loss Sharing

information on matters relating to the firm. This may make credit rating agencies redundant, and lending more efficient.

Saving in deposit insurance costs: Risk-sharing concept built into the IBF system, there will be no need for deposits to be insured.

Reduction of debt burden: The IBF system of equity financing encourages debt to be swapped with equity which can help many developing countries get rid of the immense debt-burden. Instead of rescheduling of existing loans or selling Brady bonds at heavy discounts, which does not help relieve the pressure much, converting debt to equity promises a much more fruitful alternative.

Promoting Ethical behavior: Because of its strong emphasis on the ethical and moral dimensions of doing the business and selecting the activities/ commodities to be financed, the Islamic financing institutions could play an important role in promoting socially desirable investment and corporate behavior. In this context, it is worth mentioning that Islamic financing institutions are subject to Shariah (Islamic Law) regulations in addition to conforming to the conventional regulatory standards. This is further expected to ensure greater prudence and responsibility.

Higher profits: Account holders under Islamic finance could expect higher profit from their investment as Islamic banks are required to share the entire net profit according to the agreed formula rather than just a portion of the profit, as is the conventional practice.

Reduction in run-on-deposits: Banks using profit and loss sharing (PLS) to mobilize resources are less likely to face a sudden run on their deposits.

More stable economic environment: The perspective of investments is long-term in comparison to short-term expectations of returns in

conventional financial system this may result in a more stable economic environment less dependent on business cycles.

Less likelihood of flight of capital: Under Islamic finance, debt instruments that may be created through selling goods and services on credit are not readily tradable. This greatly eliminates the possibility of sudden mass movement of funds from one country to another.

Reduction in speculative transactions: Examination of daily records of trading in financial markets vividly shows that institutional participants carry out huge speculative transactions. More often than not, such transactions are sources of instabilities. In contrast, Islamic banks and financial institutions are inherently prevented from carrying out such activities. As a result destabilizing speculations would be significantly curtailed in financial markets, although liquidity will remain with secondary market trading allowed in stocks or investment certificates.

Reduction of inflationary pressures: Under Islamic economics the inflationary pressures would be reduced to a great extent, as over or under-supply of money with respect of supply of goods is not allowed (money directly linked to supply of goods in the economy).

Reduction in unproductive use of borrowings: By eliminating unnecessary and excessive borrowing (borrowing beyond productive use), risk to lenders is reduced under PLS, as lending is directly related to project appraisals and feasibility.

Automatic Shock-absorption: For banks involved in the equity-based system, Khan (1986) argues that the shocks to asset positions are immediately absorbed by changes in the values of shares held by depositors in the bank. This makes the real values of assets and liabilities of banks equal at all times, preventing banking crises. Nienhaus (1986) agrees with the argument.

Box-1: Landmark Islamic finance deal inked

Khaleej Times: 03 July 2003

DUBAI - In a landmark deal for Islamic finance, Dubai Islamic Bank (DIB), in partnership with ABC Islamic Asset Management of London, has signed a leasing transaction agreement with the AAA-rated General Electric of the USA. The transaction involves the purchase of machines and engineering equipment by DIB and ABC and leased under Sharia principles to General Electric.

"We intend to source more deals with investment grade companies from around the world," Mr Aref Kooheji, DIB's Executive Vice-President for Investment Banking said. "We pay special attention to the elimination of risk by means of watertight structures that provide protection against residual risk during the term of the lease."

Mr Kooheji concluded the signing with Mr Duncan Smith, ABC Islamic Asset Management's CEO, in Dubai recently.

"This is a landmark deal. If General Electric is prepared to go the Islamic financing route, then it's hard to see how similar multinationals will not avail themselves of this excellent financing facility in the future. This will give the Islamic industry a tremendous boost," Mr Smith said.

Mr Smith added that the partnership transaction was made possible through cooperation between investment professionals at DIB and ABC Islamic Asset Management, whose understanding of complex structures, legal and other matters, particularly Sharia compliance, facilitated smooth cross-border dealings of significance in the development of investments in the Islamic financial industry.

Abu Dhabi power project signs $1.8b loan deal

Khaleej Times: 3 July 2003

ABU DHABI - A $1.8-billion loan facility was signed here yesterday for the expansion of Abu Dhabi's fourth independent power and water project in what was described as "the largest project financing ever" in the capital of the United Arab Emirates.

Project developers International Power of Britain and Japan's Mitsui and Co. and Tokyo Electric Power Company (Tepco), signed the facility with a consortium of local and international banks to finance the Umm Al Nar project.

Lead arrangers of the conventional loan include Gulf International Bank, HSBC, Sumitomo, Mitsui Banking Corporation and National Bank of Abu Dhabi, while Abu Dhabi Islamic Bank lead arranged a $250-million Islamic tranche.

2.3.2. Perceived Disadvantages of Islamic Finance

With Profit-Loss Sharing (PLS), the role of the bank undergoes a change from being an intermediary trader of money, earning profits from the margin between lending and borrowing, to being an investing partner. The role of an investment bank brings in added costs:

- Search cost resulting from the need to decide on the most profitable ventures. With an Islamic bank required to finance so many different kinds of businesses, acquiring skills in all of them may be immensely costly.

- Monitoring costs resulting from the need to prevent mishandling of the venture and fraudulent means (including creative accounting) adopted by borrowers/ partners are in addition to those involved in conventional financial system.

- Managing costs incurred because of its obligation as a partner in the PLS deals.

Determination of mechanism for profit sharing in the short-term is difficult in a PLS system based on returns only from productive deployment of funds. In the absence of a standard mechanism for profit/ loss sharing (both for short-term as well as long-term), the possibility of exploitative contracts cannot be eliminated.

Eliminating interest may reduce the propensity to save (with banks) or invest (considering the risk associated with returns), thus curtailing economic growth affecting employment (Pryor-1985), generation of wealth and its distribution. Of course, IBF proponents do not agree, as an opportunity for equitable sharing of wealth earned from productive activities could be enough stimulant for investors.

Dispute settlement mechanism adds to the cost further, as the account put forward by the borrower (entrepreneur) may not be convincing enough

for the banks or other investor partners. Fixed return of the conventional

system has no such costs.

A risk sharing proposition of IFBs and resulting absence of deposit

insurance system leaves small investors in the risky avenues, particularly

when the Islamic financial institution carries fraudulent intentions.

Curtailing speculative activities in the secondary market would be

extremely difficult resulting in the same risks and costs that the

conventional financial systems carry.

The mark-up system of most of the non-PLS schemes resembles the

interest-based system to the extent of becoming indistinguishable,

sometimes, and provides unscrupulous financiers opportunity to replicate

the conventional system.

Additional cost of supervision by the Sharia Board: Product

development, its offering, agreements between counterparties,

Need to be Sharia

compliant which needs certification by the Sharia Boards resulting in

functioning of the IBF system, accounting, etc

additional cost burden over the IBF Operators.

Account holders under Islamic finance could expect higher profit from

their investment as Islamic banks are required to share the entire net

profit according to the agreed formula rather than just a portion of the

profit, as is the conventional practice.

Box-2: Do Islamic Banks Perform Better than Conventional Banks? Evidence from Gulf Cooperation Council countries

Hadeel Abu Loghod: 2011

Islamic Banking has been growing worldwide significantly in the past three decades and is developing remarkably in the Southeast Asia, Middle East and even in Europe and in North America. The Gulf Cooperation Council Countries (GCC 18 ), have dual banking system

18 Gulf Cooperation Council. Economic cooperation between Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates.

where Islamic and conventional banks are operating side by side. The purpose of this paper is to compare the financial performance (profitability, liquidity and structure) of the two banking styles over the 2000-2005 time period.

The Empirical Results

To summarize, there are some ratios indicate that there are differences between the performance of both types of banks and some showed that there are no differences. Empirical results showed that there were no significant differences in terms of profitability between both types of banking. However, Islamic banks proved to be profitable in all GCC banks except for UAE. That was due to high competition, and more diverse market. In markets where there are customers who are willing to deal with Islamic banks, such as, Kuwait, Bahrain, Saudi Arabia and Qatar, Islamic banks proved to be more profitable.

As expected that Islamic banks tend to have high liquidity ratios relative to conventional banks and that was due to the fact that Islamic banks cannot rely on borrowing money from central bank or any other sources. On the other hand, conventional banks are more leveraged compared to Islamic banks. This is my partially explained by the nature of Islamic banking, they cannot borrow money from central bank or other sources because of the interest.

Summary and conclusions

The aim of this paper was to compare between the financial performance of Islamic banks and conventional banks in the GCC countries using statistical analysis of summary financial information and selected financial ratios. Most of the published literature explains the differences in culture and principles between both banking types, but very few studied the differences in financial performance in practice utilizing statistical model.

In this paper, quantitative method is used to examine the differences in financial performance between both types of banks. For the most part, financial ratios were also used to predict future performance such as type of a bank. The analysis utilized an econometric LOGIT technique to find out the differences between the financial performance of Islamic banks and conventional banks using key financial ratios over the period (20002005), in a panel sample of both types of banking in the GCC countries. Six models were developed to avoid multi collinearity.

The results were very significant and robust and were confirmed by the calculation of marginal effect, since the magnitude of calculated marginal effects of financial ratios to the probability of bank type is less than one and standard errors were very small. Models were successful in describing the differences in financial performance based on selected financial ratios.

The obtained statistical results suggest that:

1- Market share, defined as total assets, of the financial data published over the period (2000-2005), shows that conventional banks are dominant in GCC countries. However, they are losing their market share against Islamic banks. Since in 2000 the

total assets of conventional banks in GCC countries was 87.91%. It decreased to 85.84% in 2005 with 40.64% growth rate. Islamic banks increased from 12.09% in 2000 to 14.16% in 2005 with 50.53% growth rate. This indicates that Islamic banks are growing faster than conventional banks over time.


Analysis of differences in Profitability ratios, presented in this paper, by return on assets, return on equity and dividend payout ratios, the statistical results show that there are no significant differences between both types of banks. However, comparing averages of both banking types and industry in each country of the GCC countries show that Islamic banks had higher ratios in GCC countries except in the case of UAE. The result is reasonable, market and management play important role in determining profitability, in addition to the bank performance.


As for differences in Liquidity ratios, it is vital for the survival of a bank. Liquidity ratios are presented by Cash to Assets and Cash to Deposits ratios in this paper. Analysis of the ratios shows that conventional banks are exposed to liquidity risk more than Islamic banks. Liquidity ratios are in favor of Islamic banks.


Analysis of differences in structure ratios shows the following statistical results:

Debt to Asset ratio is in favor of Conventional banks indicating that conventional banks depend more on external liabilities.

Loans/Receivables to Assets ratio is in favor of Islamic banks too. This implies that customers are more attracted to use Islamic banking financing instruments because they comply with Islamic sharia.

Deposits to Equity, Deposits to Assets and Investments and deposits to Assets were in favor of conventional banks but this result is debatable. Average of these ratios for both banking types showed that Islamic banks in some GCC countries like Kuwait and Qatar had higher ratios than conventional banks, while in Bahrain, Saudi Arabia and UAE showed the opposite. This can be explained by conventional banks outnumbered Islamic banks in these countries, which made competition high in attracting deposits.

Fixed Assets to Assets ratio is in favor of Islamic banks. This result is very rational because Islamic banks use financial instruments such as Murabaha, Ijara, and these instruments increase the rate of Fixed Assets to Assets.

The statistical results show that there are no significant differences between both banking types in terms of Internal Growth rates.

Loans/Receivables to Deposits and Loans to Equity ratios are in favor of Islamic banks, indicate that Islamic banks are more into financing operations rather than receiving deposits and this implies that credit risk of conventional banks is less than it is in Islamic banks.

Deposit to Equity ratios and Investment and deposits to Assets ratios are in favor of conventional banks. Obviously, this result indicates that the ability of conventional banks to leverage their operations by attracting more deposits and investments.

Equity to Assets ratio is in favor of conventional banks. This ratio is an important measure of capital adequacy; higher values of this ratios reflect a strong financial structure of the bank and less possibilities of financial difficulty.


3. Islamic Financing Techniques and Products

One may view the Islamic financial system as grounded in four basic principles:

Risk-sharing -- the terms of financial transactions need to reflect a symmetrical risk/return distribution each participant to the transaction may face;

Materiality -- a financial transaction needs to have a “material finality”, that is it is directly or indirectly linked to a real economic transaction;

No exploitation -- a financial transaction should not lead to the exploitation of any party to the transaction;

No financing of sinful activities such as the production of alcoholic beverages.

Financial intermediation based on the principles of Islam has an established historical record and has made significant contributions to economic development over time. Financiers in early periods of Islam were known as sarrafs who undertook many of the traditional and basic functions of a conventional financial institution, such as intermediation between borrowers and lenders, operation of a secure and reliable domestic as well as cross-border payment system, and offering services such as issuance of promissory notes and letters of credit. 19

Sarrafs operated through an organized network and well-functioning markets, which established them as a sophisticated intermediary given the tools and technology of their time. 20

19 For further details see Udovitch (1981), who equated the function of sarrafs with a bank and considered them as "bankers without banks".

20 Chapra and Ahmed (2002). It is claimed that financial intermediaries in the early Islamic period also helped each other overcome liquidity shortages on the basis of a mutual help arrangement.

There is evidence that some of the concepts, contracts, practices and institutions developed in the Islamic legal sources of the late eighth century provided the foundations for similar instruments in Europe several centuries later. 21

In Islam, the whole fabric of Divine Law is contractual in its conceptualization, content, and application. Islam forcefully places all economic relations on the firm footing of “contractus”. 22 Islamic economics is based on a set of contracts and instruments which form the backbone and building blocks for more complex and elaborate frameworks.

Islamic banking and financial institutions have developed a wide range of techniques which allow them to uphold the religious and legal principles while enabling them, at the same time, to offer viable financial products. The search is actually still going on to find newer techniques, and for variations based upon the existing ones to offer more attractive and useful instruments for the investors.

The four root transactions according to Shariah are sales (Bay), hire (Ijâra), gift (Hiba) and loan (Ariyah) describing respectively the transfer of ownership, the transfer of the right to use, the gratuitous transfer of ownership and the gratuitous transfer of the right to use. These basic forms are applied to specific transactions such as pledge, deposit and guarantee and build the basis for all transaction structures in Islamic finance. (Lewis and Algaoud


The traditionally most accepted and most correct forms of Islamic financing are the profit- and loss sharing contracts: Mudaraba and Musharaka. According to Algaoud and Lewis (2007) this form of equity based financing is considered as the “backbone of Islamic banking practice” as it represents the idea of the Holy Qur’an, namely that every investment should foster economic development by providing capital to companies and infrastructure projects (Gassner and Wackerbeck 2007). As can be derived from the name, profits and losses are shared between the creditor and the borrower on a predetermined

21 Udovitch (1981).

22 Mirakhor (1989). Contractual foundation of the Shariah judges the virtue of justice in man not only for his material performance but also by the essential attribute of his forthright intention (niyya) with which he enters into every contract. This intention consists of sincerity, truthfulness and insistence on rigorous and loyal fulfillment of what he/she has consented to do (or not to do). This faithfulness to one’s contractual obligations is so central to Islamic belief that when the Prophet was asked “who is the believer?” He replied that “a believer is a person in whom the people can trust their person and possessions.”

basis. Consequently it is considered as a “return-bearing” contract in contrast to an “interest-bearing” contract in conventional banking (Mirakhor and Zaidi 2007). The two basic concepts Mudarabah and Musharakah and other financial products will be explained in the following chapter. The following list covers many of them:

3.1. Equity-Based Financing Techniques

Mudarabah (fund management) and musharakah (equity partnership) are mainstream contracts for capital investment.

3.1.1. Mudarabah The Mudarabah contract is a two tiered transaction for an Islamic bank. On the asset side it provides money, for example for an entrepreneur called “Mudarib”, and finances its project as so called “Rabb al-mal”. As such it possesses all assets but does not have any active part in the enterprise. At the end of the contract the investment is redeemed by the entrepreneur and the bank participates in the generated profit on a predetermined basis. However if the project fails it participates simultaneously in the losses and can, in the worst case, lose all its investment (but not more). The entrepreneur manages the project and provides his economic and technical knowhow.

Figure 1 -- Example of a Mudarabah He is liable to the bank in case

Figure 1 -- Example of a Mudarabah

He is liable to the bank in case of gross negligence and might lose his income. As he has not invested capital, his financial damage will be very limited (Mirakhor and Zaidi 2007 and Zamir Iqbal and Abbas Mirakhor 2011). The funds used by the bank are usually held in trusteeship from savings or investment account holders, i.e. depositors (liability side). The depositors share in turn the profits and losses experienced by the bank and thus participate in the earnings of the projects or companies the bank has invested in. To come to full circle their rate of return depends from the real sector and cannot be considered as interest (please refer to chapter 1.3.1.)

(Mirakhor and Zaidi 2007). As the bank only provides capital but no management expertise this form of financing is also called “Qirad”, to be translated as “dormant partnership” (Lewis and Algaoud 2001). The

mechanism of a Mudaraba contract between a bank and a company (i.e. the asset side) is shown in Figure 1.

3.1.2. Musharakah The Musharakah partnerships are very similar to the Mudarabah form however in contrast to the former both, entrepreneur and bank, provide capital for the project and form de facto a kind of Joint Venture. Both partners have the rights (but not the obligation) to participate in the management and share profits according to a predetermined ratio and losses in proportion to their respective capital invested. Consequently both have the incentive to invest wisely and should have an active interest in the investment (Mirakhor and Zaidi 2007). In order to illustrate the structure of a Musharakah partnership, please refer to Figure 2.

of a Musharakah partnership, please refer to Figure 2. Figure 2 – Permanent or diminishing Musharakah

Figure 2 Permanent or diminishing Musharakah transaction

Subcategories of the Musharakah contract can be differentiated according to the duration the bank’s engagement in the venture:

Permanent Musharakah

The duration of the contract is unlimited until one party resigns the

contract or the project is liquidated. This form of financing is

designed for long-term financial investment of the bank. (Altundag and Nadia 2005,)

Diminishing Musharakah

In contrast to the permanent Musharakah, the bank’s engagement is reduced over time and another party (usually the entrepreneur) buys the bank’s shares to a higher price than the original value. Hence the bank commits to a short or medium term investments and receives a profit out of the difference between original share value and received price. The diminishing Musharakah structure is used for example in house financing. (Zamir Iqbal and Abbas Mirakhor 2011).

3.1.3. Wakalah A recent trend among Islamic banks is to apply the concept of Wakalah, or agency, to both financing and deposit taking. While Wakala bears strong resemblances to Mudarabah, there is a key difference: a Wakil, or agent, merely represents the party that has the money. For instance, if the bank appointed Mario as Wakil instead of Mudarib, then Mario would be eligible for a salary, not just a share of the profits. As an agent of the bank, Mario uses the bank’s money, but owes it back (unless there is a loss). Here the financial dynamics are more like those of a loan. Conversely, if after many successful years, Mario wishes to deposit his funds with the bank, he may place them in a Wakalah deposit. This too is a PSIA, except that it is one in which the funds belong to Mario and are applied by the bank. The bank is able to pay itself a fee akin to margin. If the bank loses money, so may Mario. If not, the bank must return his money at the term of the Wakala. The main difference beyond the fee concept is that the Mudarabah is either a formal partnership or a business operation contract. As a formality, the Mudarabah must be terminated and the partnership dissolved or bought out. The Wakalah, however, ends without a business operation terminating or a

partnership being formally dissolved. The Wakalah simply ends with the repayment of funds.

3.1.4. Difference Between Mudarabah and Musharakah Contracts In a Mudarabah contract, the managing agent (beneficiary or the borrower, called the Mudarib) does not have any financial participation. In a Musharakah contract, the agent is a financial partner along with the provider of fund (Rabb-al-Mal of Mudarabah contract) sharing the gain or loss at the pre-designated ratio which is likely to be higher than what he is likely to get in a Mudarabah contract. Thus, in Mudarabah, the agent acts as a working partner who does not bear any losses and simply manages the fund (the project in which the fund is invested), whereas in Musharakah, all the parties are shareholders in the venture.

For both Mudarabah and Musharakah contracts, the profitability of Islamic banks is directly linked to their physical investments. This is the main difference to conventional banks who earn interest on the loans they provide irrespective of the profitability. Therefore Islamic banks are more likely to demand a continuous, complete flow of information from their counterparty which might lead to higher transparency and stability. They tend to be more interested in stable long-term relationships with their clients. (Mirakhor and Zaidi 2007) According to Iqbal these forms of equity financing fosters the better understanding and monitoring of the business and involved risks from the bank’s side. However Gassner and Wackerbeck argue that the current use of equity-based forms in Islamic finance is very low (approximately 5 percent on the asset side in Islamic banks). This is mainly due to the high risk involvement of the banks, an obvious principal-agent problem and the increasing innovation in the Islamic finance industry evolving debt-based instruments, leasing forms and efficient capital market instruments.

Figure 3 -- comparing equity and agency structures 3.2. Debt-Based Financing Techniques These contracts can

Figure 3 -- comparing equity and agency structures

3.2. Debt-Based Financing Techniques

These contracts can be categorized into two components. First component is more concerned with sale, which includes deferred purchase, manufacturing, deferred payment sale and etc. Second type of contracts deals mainly with operational and financial leasing.

3.2.1. Murabaha In Islamic banking business, loans to private and business clients have to be granted for a specific purpose (for example to buy a specific commodity). In this way the Islamic bank purchases the commodity from a third party on behalf of its client. Before reselling it to him it adds a predetermined mark- up on the spot price constituting the return for its services. The client redeems the amount either immediately or on a deferred payment basis- called “Murabaha-bimuajjal”. (Mirakhor and Zaidi 2007 & Lewis and Algaoud 2001) The mark-up is fixed in a contract before hand and cannot be changed during the duration of the contract. Therefore it is to be clearly differentiated from interest at it is not linked to the duration but “computed on transaction basis for services rendered” (Lewis and Algaoud 2001). The

bank bears an associated risk as it owns the assets between purchase and resale. (Mirakhor and Zaidi 2007)

between purchase and resale. (Mirakhor and Zaidi 2007) Figure 4 -- Murabaha transaction In order to

Figure 4 -- Murabaha transaction

In order to adapt the Murabaha concept to different customer needs, several variations exist. Two of them are Bay Salam and Istisnaa.

3.2.2. Bay Salam According to the Shariah, goods cannot be sold if they are not yet in existence, at the time when the contract is closed. The Salam contract constitutes an exception, provided strict rules are adhered. It is mostly used in agricultural context and recently as Islamic alternative to conventional derivatives. Following this transaction, the bank purchases the goods (for example the yield of a farmer) in advance before they are produced. It pays the full purchase price immediately to the farmer as soon as the contract is closed (please refer to Figure 5). Therefore both parties have an advantage.

Figure 5 -- Salam transaction The quality and quantities of the goods to be sold,

Figure 5 -- Salam transaction

The quality and quantities of the goods to be sold, the date and place of delivery and the purchase price have to be exactly determined in the contract. The deal cannot be closed if the provision of the goods is uncertain. (Zamir Iqbal and Abbas Mirakhor 2011) Furthermore it has to be about “homogenous goods” (Zamir Iqbal and Abbas Mirakhor 2011) which are not characterized by special features that could make it difficult to find a substitute. The contract is binding. In this way that the seller (farmer) has to buy the goods on the market if he is not able to provide them at the agreed date. (Zamir Iqbal and Abbas Mirakhor 2011) Usually the Islamic financial institutions tries to resell the goods immediately as it does not want to be in the physical possession of it. Consequently they might enter a parallel contract. Either the goods are resold to the original seller or to a third party for a higher price than the purchase price, so that the Islamic financial institutions makes a profit. (Bacha 1999)

3.2.3. Istisnaa The Istisnaa contract can be seen as subcategory of Salam, designed for a special purpose, such as the financing of manufacturing on contract or for project financing. The structure becomes obvious using an example: A

customer approaches the Islamic bank because he needs a specific good (for example a machine), which is not yet produced and which he cannot pay immediately. After the Istisnaa contract is closed, the bank assigns a respective supplier with the production of the machine according to the specifications of its customer. The manufacturer receives a first installment from the bank at the start and further payments as the production advances until the machine is finished. Subsequently the machine is handed over to the bank and later on to the customer who pays the purchase price plus a predetermined margin to the bank in regular installments after he has received the good. Additionally to Salam and Istisnaa there exist further forms of contracts that are based on the Murabaha concept (for example Arbun) which will not be explained in the context of this paper. 23

will not be explained in the context of this paper. 2 3 Figure 5a -- Istisna

Figure 5a -- Istisna

3.3. Leasing

“The transfer of the right to use” (Ijarah) was mentioned before as one out of four root transactions in Islamic banking. Ijarah contracts are quite similar to the conventional concept of leasing, however some aspects are different in order to

23 Further information can be retrieved from for example from Gassner and Wackerbeck (2007, 53 to 63) or Lewis and Algaoud (2001, 55 to 59).

avoid Riba and Gharar (please refer to chapters 1.3.1. and 1.3.2.). They are very popular with Islamic financial institutions and can be found in the structures of the most innovative structures (please refer, for example, to Ijarah Sukuk in chapter 3.4.2.) owing their great flexibility. In one of the largest Islamic financial centers, Malaysia, 31.6 percent of the total Islamic financing activities in 2005 was based on the Ijarah concept. 24 (Bank Negara Malaysia 2005) As described below the bank owns the assets until the end of the lease term at least. Even if the lessee fails to pay the rental payments, the bank still can sell the asset on the market easily. Additional to the pure Ijarah contract, the further development Ijarah wa Iqtina exist.

3.3.1. Pure Ijarah Core of the Ijarah contract is the sale of the “Manfa’a”, the right to use an asset, for a specific period. The goods are bought by the Islamic bank from a third party. Afterwards they are leased out to the clients who pay rental fees for their use (please refer to Figure 6). The bank, as lessor, bears the risk as it is the owner of the assets. Consequently it is responsible for maintenance and insurance.

it is responsible for maintenance and insurance. Figure 6 -- Pure Ijarah transaction 2 4 The

Figure 6 -- Pure Ijarah transaction

24 The Annual Report states further that only 0.3 percent was based on Mudaraba and Musharaka contracts and the Mudaraba principle was applied in 6.9 percent of the cases. (Bank Negara Malaysia 2005)

The leased asset must have a productive usage (for example building, aircraft, car) and the rent is pre-agreed for the whole period, in order to avoid speculation. (Mirakhor and Zaidi 2007) However the terms of the lease payment can be renegotiated at agreed time intervals so that the bank can react to major market developments. (Bergmann 2008) The pure Ijarah transaction can be compared with the conventional operating lease contract. (Lewis and Algaoud 2001) Ijarah wa Iqtina. In the pure Ijarah contract (refer to the chapter above) the lessee has not option to buy the asset at the end of the lease term. In the Ijarah wa Iqtina, to be translated as “hire and purchase”, he has. (Mirakhor and Zaidi 2007), Consequently the ownership is transferred to the lessee after the term of the contract when all rental payments have been made. Up to this point of time, the lessor bears all risks for possible losses or damages regarding the lease asset, except they are caused by gross negligence of the lessee. The Ijarah wa iqtina contract is similar to a financing lease arrangement in the conventional system. (Lewis and Algaoud 2001)

3.4. Capital Market Instruments

Due to the infancy of the Islamic financial industry the number of Shariah- compliant capital market instruments is very small compared to the conventional market. However numerous product innovations have been developed in the last decades in order to create competitive products for private and business customers as well as for the Islamic financial institutions themselves. Islamic capital markets are generally underdeveloped. Religious constraints on permissible investment rule out conventional forms of interest-bearing debt finance. In the absence of tradable debt and valuation problems of financing contracts, Islamic finance has proven conceptually difficult especially for money management. Banks operating under Islamic law are predisposed to adopt buy-and-hold investment strategies and carry

excess short-term reserves for lack of sufficient long-term reinvestment opportunities, which has inhibited efficient financial intermediation and capital- market deepening. Nonetheless, financial institutions have been able to develop various forms of Islamic finance instruments that are virtually identical to their conventional counterparts in substance. However, as I will explain in this chapter, these securities are not surrogates for conventional interest-based securities that mimic the interest rate structure. To give some examples, this chapter will focus on Islamic stocks, mutual equity funds, Sukuk and Islamic derivatives.

Before examining the implications of shariah compliance on conventional structured finance, it is necessary to clarify how Islamic securitization fits with the notion of Islamic finance. Since most Islamic financial products are based on the concept of asset backing, the economic concept of asset securitization is particularly amenable to the basic tenets of Islamic finance. Asset securitization describes the process and the result of issuing certificates of ownership as pledge against existing or future cash flows from a diversified pool of assets (“reference portfolio”) to investors. It registers as an alternative, capital market-based refinancing mechanism to diversify external sources of asset funding in lieu of intermediated debt finance based primarily on the risk assessment of securitized assets (Jobst, 2006).

Islamic securitization transforms bilateral risk sharing between borrowers and lenders in Islamic finance into the market-based refinancing of one or more underlying Islamic finance transactions. In its basic concept, originators would sell existing or future revenues from lease receivables (asset-based), “sale-back profit” (debt-based) or private equity from a portfolio of Islamically acceptable assets to a

special purpose vehicle (SPV), 25 which refinances itself by issuing unsecured

securities to market investors, who are the “capital market corollary” to a singular

lender in Islamic finance (see Figure 7). They assume the role of a “collective

financier” whose entrepreneurial investment does not involve guaranteed, interest-

based earnings.

does not involve guaranteed, i nterest- based earnings. Figure 7 -- The pay-off profile of asset-backed

Figure 7 -- The pay-off profile of asset-backed securities under the three basic forms of Islamic finance.

In keeping with our previous presentation of the three basic forms of Islamic

finance above, I can illustrate the concept of Islamic securitization by simply

reversing the ex-ante lender payoff from Islamic finance transactions (Exhibits 1

and 2). Using a pass-through securitization structure on the proceeds from a

dedicated reference portfolio of one or more Mudharabah futures with deferred

delivery or payment (which implies limited recourse due to market risk or other

25 In conventional securitization, a SPV is set up solely for the purpose of the securitization and might be a trust, limited liability company, partnership, or a corporation. In Islamic securitization, the objectives set out in the constitutional documents of the SPV also must not infringe on the prohibition of riba and haram under Islamic law.

contingencies from certain payment and repurchase provisions), originators would be able to issue unsecured financial obligations with investor payoff S+C(E)-P(F) backed by expected repayment L2. Investors receive full repayment of principal and a pre-specified share of profits (as investment return) if the asset performance of the underlying Islamic transaction generates proceeds in the amount of PV(F) or higher (indicated by area “A” in Figure 1). Whenever the issuer is unable to repay some or all of the promised return (and original investment amount), default occurs (indicated by areas “B” and “C” in Figure 1). If the originator had no endowment to finance the underlying asset(s) in the first place, expected repayment L2 would be reduced by asset value –S owed to a third party as “asset supplier” over the term of the lending transaction, who holds a short position P(E). Therefore, the maximum issuance amount would be limited to PV(E)-PV(F).

3.4.1. Islamic Stocks and Equity Funds Investment in shares is very interesting for Muslim investor as no element of Riba (please refer to 1.3.1.) is involved in contrast to other capital market instruments, like bonds for example. From the point of view of Shariah scholars, equity shares are preferred instruments because the capital is provided for productive purposes and the shareholder participates directly in the entrepreneurial success. However investment targets have to be filtered following two processes: the “industry screen” and the “financial-ratio screen”. (Dow Jones Indexes 2012)

Industry screen

Firstly there exist restrictions regarding the industry in which the

target company operates. According to the code of ethical investment that distinguishes between Haram and Halal investments, Muslims are only allowed to invest in shares of Halal businesses.

The business activity screening aim to exclude Investment in companies dealing with haram activities/products such as:

- Companies that produce/sell/trade/slaughter/distribute pork- related products;

- Companies that promote pornography or obscenity in any form;

- Companies whose activity involves gambling, such as casinos, lotteries, bingo, Internet gambling…;

- Companies active in the conventional banking and insurance;

- Companies primarily active in the pure entertainment business (e.g. movies, theater, cinema…)

- Companies active in the defense or weapons industry;

- Companies active in the tobacco or alcohol business (this includes producers, sellers and distributers); and Any other type of company that might be prohibited by the Shariah board.

Although some business activities are very easy to monitor, others are more difficult to determine precisely. Indeed, halal businesses such as grocery stores, supermarkets, airlines, hotels and restaurants may derive part of their profits from prohibited activities such as selling cigarettes or alcohol.

In these cases, Islamic scholars generally allow Islamic funds to invest in such halal businesses on condition that the income derived from that prohibited activity is no more than 5% of the companies' total income and that any dividends received as a result of investing in these companies are purified. The purification principle is relatively straight-forward and involves donating to a charitable organisation (not necessarily Islamic) 5% of the dividends received from that particular investee company as it is deemed to be attributed to the non Shariah compliant activities.

Financial - ratio screen

As soon as a stock passed the industry screen its financial parameters are scrutinized. Firstly the debt to equity ratio 26 has to be lower than 33 percent. Secondly the percentage of cash and interest bearing securities has to be lower than 33 percent in reference to market capitalization. The same is true for the relation between accounts receivables and market capitalization. (Dow Jones Indexes 2008). Due to complexity of modern companies, in cannot be avoided that firms are to a very limited extend active in Haram businesses. Therefore more liberal

Shariah scholars argue that the ratio of Haram business in relation to total revenues must not exceed 5%. However this ratio is controversial and not applied by all Shariah Supervisory Boards. (Zamir Iqbal and Abbas Mirakhor 2011). As can been seen from both the industry and financial-ratio screen it is rather complicated for a private investor to find a Shariah-compliant investment. Therefore Islamic equity indices are very popular as the screening processes are executed by professional firms and supervised by a Shariah supervisory board. The major Islamic equity indices are the Dow Jones Islamic Market Index series, the Standard and Poor’s Shariah Indices and the FTSE Global Islamic Index Series. Many Islamic funds as well as private and business investors align their portfolio with these indices.

Islamic equity funds

Islamic equity funds can be structured in two ways- either as a Mudarabah partnership (please refer to 3.1.1.) or according to the Wakalah model 27 . In both cases a Shariah Supervisory Board has to

26 The debt to equity ratio is calculated by dividing the total debt by the 12-months average of equity capital or the firm’s market capitalization. (Dow Jones Indexes 2008)

27 Literally Wakalah means “looking after, taking custody” (Ayub 2007, 347) and describes an agency contract in Islamic finance.

supervise the Shariah-conformity of the investment decisions and the

investment companies operations.

In the first case the investment company is the Mudarib and the

shareholders assume the role of the Raab-al-mal. The remuneration

for the investment company is taken from the generated profits and

variable depending on the result. If the fund generates a loss, it is

passed on to the shareholders and the investment company receives

nothing. (Zamir Iqbal and Abbas Mirakhor 2011 and Ayub 2007)

nothing. (Zamir Iqbal and Abbas Mirakhor 2011 and Ayub 2007) Figure 8 -- Islamic equity fund

Figure 8 -- Islamic equity fund based on Mudarabah partnership from Gassner and Wackerbeck (2007)

In the second case the investment company operates as an agent for

the shareholders and agrees on fix remuneration in advance (absolute

or percentage of the fund volume). This has to be approved by the

Shariah Supervisory Board and disclosed in the fund prospectus.

Furthermore this concept is consistent with the conventional equity

fund. (Zamir Iqbal and Abbas Mirakhor 2011). There are several

other categories of Shariah compliant funds in existence for example

Ijarah funds, commodity funds, Murabaha funds or mixed funds.

(Ayub 2007) At present approximately 350 islamic funds are issued, the majority of them being equity funds.

3.4.2. Islamic Investment Certificates (Sukuk) Sukuk is probably the most well-known instrument in Islamic finance and is most correctly identified as an investment certificate. It is often called a bond type instrument because it has some similar characteristics.

Although the religious prohibition of the exchange of debt and the required conferral of ownership interest to participate in business risk still poses challenges to further development of Islamic securitization, the gradual acceptance of Islamic investment certificates, so-called sukuk bonds, represents a successful attempt to overcome these impediments based on the adequate interpretation and analogical reasoning of shariah principles applied in Islamic finance. Sukuks are shariah-compliant and tradable asset- backed, medium-term notes, 28 which have been issued internationally by governments, quasi-sovereign agencies, and corporations after their legitimization by the ruling of the Fiqh Academy of the Organization of the Islamic Conference in February of 1988. 29 Over the last five years, the sukuk has evolved as a viable form of capital market-based Islamic structured finance30 , which reconciles the concept of securitization and

28 “Investment sukuk are certificates of equal value representing undivided shares in ownership of tangible assets, usufructs and services or (in the ownership of) the assets of particular projects or special investment activities.” (AAOIFI Standard No. 17).

29 Although there is no formal obligation of compliance associated with the ruling, it carries considerable weight with most Islamic financial institutions. 30 Source Financial Management | March 2011: The global Islamic finance industry grown from about $10bn worth of invested assets in 1975 to $2.2trn today, according to the 1st Ethical Charitable Trust, an adviser on sharia compliance in the UK. The tenets of Islamic finance generally forbid the payment of interest and investing in activities deemed speculative, uncertain or unjust (such as gambling, alcohol and the sale of certain foods). This has appeal beyond the Muslim world. Indeed, about 80 per cent of sharia-compliant investment products in Malaysia are held by non-Muslim investors. So will the rise of Islamic finance continue, particularly given the lack of trust in Western banking? And what changes can be expected in the global sharia investment mix? By the end of 2010 5.5 per cent of the $2.2trn invested in Islamic instruments was held in dedicated Islamic funds, with 31.1 per cent in broader-based assets (mainly in sharia-compliant bank accounts and money-market vehicles). The rest was held in other Islamic instruments, particularly sharia-compliant bonds (sukuk), insurance packages (takaful) and equities products. Where are the world's Islamic finance hot spots? "The main centres have stayed largely the same for the past three years: Malaysia continues to lead the way in sukuk and equities products, while Saudi Arabia does the same for bank deposits," says Sohaib Umar, a partner in Ernst & Young's Islamic financial services group in Bahrain. Dedicated multi-product Islamic funds are split largely among Malaysia, Saudi Arabia, Kuwait, Luxembourg, Bahrain, the Cayman Islands and Ireland. Yet the focus of the Islamic finance industry - especially for bond and equity products.

principles of the shariah law on the provision and use of financial products and services in a risk-mitigation structure subject to competitive pricing (El- Qorchi, 2005). The Accounting and Auditing Organization of Islamic Finance Institutions (AAOIFI) (please refer to chapter 4.5.2.) currently recognizes different types of sukuks, which are traded on the Scripless Securities Trading System (SSTS) 31 in Malaysia. Only appropriate Islamic bodies, so-called shariah boards, may adjudicate the shariah compliance of the terms of any sukuk issuance. Sukuk notes convey equity interest to (capital market) investors in the form of a call option on partial or complete ownership of underlying reference assets, including the right to some calculable rate of return as a share of profit (secondary notes) and the repayment of the principal amount (primary notes). All three broad types of Islamic finance transactions (asset, debt, and equity-based) can be reference assets of such Islamic securities. I distinguish between two broad structures of sukuk contracts that convey shariah-compliant asset ownership to investors: either (i) asset originators themselves issue notes backed by existing Islamic assets, or (ii) the originator sells Islamic assets (and/or the proceeds thereof) to an unaffiliated SPV, which issues notes with a put/tender feature to fund the acquisition of assets. The notes are funded by the proceeds from the underlying assets paid to the SPV as part of the repurchase obligation by the asset originator. Depending on the claim- generating asset type of Islamic finance, the SPV acquires ownership rights on either (i) existing assets within a lease-purchase or sale-repurchase agreement, or (ii) future assets as equity investor, and structures the anticipated cash flows from these assets into sukuk payment obligations of different risk and maturity. These obligations entitle investors to a pro rata ownership in the SPV and the proceeds generated from the net revenue of a

31 The SSTS is a system operated by the Bank Negara Malaysia (BNM)’s real time gross settlement/deliveryversus- payment system through which sovereign and unlisted corporate bonds are registered, cleared, and settled via the Real-time Electronic Transfer of Funds and Securities (RENTAS), Malaysia’s scripless book-entry securities trading and funds transfer system. SSTS also maintains securities accounts for financial institutions.

loan, a lease or an investment project. The amount of debt issued is limited to the value of assets held by the SPV.

Most sukuk issues have been sponsored by sovereign and quasi-sovereign issuers in Islamic countries. A government-linked SPV would issue discounted and tradable zero coupon bonds with varying maturities on the back of Islamically approved assets with pre-fixed terms to maturity. However, the indemnification of investors in such transactions may not conform to the shariah prohibition of guaranteed investment income. The shariah compliance of these bonds has been contested by Islamic scholars on two grounds: (i) the discount on the issued bonds could be construed as equating to interest return, and (ii) the guaranteed ex ante profit from a discounted offer does not exposure investors to investment risk.

offer does not exposure investors to investment risk. Figure 9 -- Simple Sukuk Structure Sukuk always

Figure 9 -- Simple Sukuk Structure

Sukuk always has one of the following underlying transaction types as a basis:






Although asset-based (ijarah) sukuks are the most common form of Islamic securitization, sukuks on other Islamic finance transactions have been structured as well over the recent past.

Ijarah Sukuks

Are financial obligations, issued by a lessor, and backed primarily by cash flows from lease receivables from a credit lessee, such as sovereign governments, regional governments, corporations, and multilateral lending institutions (Richard, 2006). In the popular sale- leaseback ijarah sukuk transaction structure (“sale model”), the SPV holds legal title to the assets, which are leased back to the originator

in return for rental payments (and possibly other cash flows from the assets depending on the transaction structure) to service payments on the issued sukuks. The SPV holds a repurchase obligation for a price equal to the amount of outstanding debt in order to insulate the transaction from an adverse performance of the underlying assets (see Figure 10). In the head lease-sublease ijarah sukuk model, the owner of the assets head leases them to the issuer and rents them back. Since this arrangement does not include a repurchase obligation of transferred assets like a sale-leaseback ijarah sukuk, the credit risk of non-performance by the sub-lessee is usually covered by a quasi-guarantee on payments due to sukuk note holders. One

recent example of such a transaction was the US$250 million sukuk issued by the Bahrain Monetary Agency International Sukuk Co. in June 2004 as an unconditional, unsubordinated, unsecured and general-payment obligation, backed by the full faith and credit of the Kingdom of Bahrain. 32 In this case, the notes are more akin to guaranteed obligations than to non-recourse, secured obligations of RMBS or CMBS transactions. 33

secured obligations of RMBS or CMBS transactions. 3 3 Figure 10 -- The concept of an

Figure 10 -- The concept of an Ijarah Sukuk transaction

3.5. Funding operations and Accounts

Islamic retail banking is a very recent phenomenon and fostered by certain newly established Islamic financial institutions, for example the Islamic Bank of Britain. 34

32 The payments to sukuk note holders were serviced by the Kingdom of Bahrain acting through the Ministry of Finance and National Economy (“sub-lessee”).

33 An alternative guarantee is the purchase of sukuks by the asset originator if the underlying assets fail to perform. In April 2005, the Dubai Metals and Commodities Centre Authority (DMCC) issued a US$200 million musharaka sukuk (joint venture) backed by the sale of three residential tower complexes via the Gold Sukuk DMCC transaction. In order to insulate the transaction’s rating from the performance of the underlying assets, DMCC as originator would be required to purchase musharaka units from the issuer and not the commercial property per se in the case of credit event.

34 In 2004 when the Islamic Bank of Britain (IBB) received authorization by the FSA, it attracted major media attention being th e first fully-fledged Islamic bank in the United Kingdom, after the Al Baraka company gave up its banking license in 1993 (please refer to 2.1.1), and the pioneer in Islamic retail banking business. (Wilson 2007, 421) The company formerly known as “Islamic House of Britain” was found in 2002 with £14 million start-up capital raised by a private placement in the Gulf, major contributors being the Qatar International Islamic Bank with 49 percent share in initial capital and the Abu Dhabi Islamic Bank which provided resources and personnel. (Middle East Economic Digest 2004 and Islamic Bank of Britain 2008) In October 2004 the bank became listed on the Alternative Investment Market of the London Stock Exchange in order to broaden the shareholder base and especially to include more

In the following chapters, typical retail banking products like Islamic current, savings and investment accounts are briefly described.

3.5.1. Current Accounts

Deposits in current accounts are guaranteed loans to the Islamic bank. These funds are held in trust by the bank and can be used for its operations, as long

as they are in conformity with the Shariah. However these deposits cannot be invested in profit and loss sharing ventures by the bank (in contrast to deposits of other accounts, please read below) as this might endanger the customers’ deposits. As taking of interest is prohibited (please refer to chapter 1.3.1.), the depositor receives no remuneration. The money is hold according to either of the following principles: “Al wadiah” to be translated as trust and safekeeping (Lewis and Algaoud 2001), “Qard hassan”, to be translated as good, interest free loan (Gassner and Wackerbeck 2007) or as a benevolent loan (Lewis and Algaoud 2001). Basically Islamic banks provide the same services in conjunction with current accounts like conventional banks. These are, for example, the execution of bank transfers, the use of automated teller machines (ATMs) with the help of debit cards or the provision of online banking facilities and credit cards. Obviously Islamic banks are not entitled to charge interest on overdraft. In order to compensate this problem, banks might charge a “penalty charge” which is a lump sum, independent from the amount and duration of the overdraft. (Gassner and Wackerbeck 2007)

3.5.2. Savings and Investment Accounts

Islamic savings and investment accounts are similar in their nature to their

conventional counterparts. In a savings account the customer makes a

deposit at the bank and is guaranteed the full repayment plus a small return. In investment accounts, however, the full repayment is not secured but the return is usually higher. The major difference between conventional and Islamic accounts is that the return (if paid) is not fixed in advance, as this would constitute interest. For the savings accounts the already mentioned principle of “Al wadiah” can be extended by a permission, granted by the depositor, that the funds can be employed at own risk. This guarantees him full return and voluntary profit sharing in the return generated with the help of his funds. A second possibility to realize a savings account is to treat the deposits as “Qard hassan” deposits (please refer to chapter above) while the bank grants “pecuniary or non-pecuniary benefits”(Lewis and Algaoud 2001). Investment accounts are realized on the basis of Mudaraba contracts. In this way the depositors participates in the entrepreneurial risk resulting from the use of his funds in equity participations. Thereby the bank acts as Mudarib and the depositor takes the role of the capital provider Raab al mal. The returns generated are shared, according to an agreement made in advance, between the bank and the depositor. However in case of a loss, the depositor risks parts or all of his deposits. (Lewis and Algaoud 2001)

3.5.3. Islamic Credit Cards An Islamic credit card holder does not pay interest on outstanding debt. The cardholder pays an upfront fee which represents a part of the total payment and through this mechanism it is possible to rollover the outstanding debt balance to the next payment cycle. Some Islamic banks return a part of the upfront fee to an Islamic card holder if the credit is repaid in time. The Islamic credit card is based on the principle of Al Bai Bithaman Ajil (BBA) (deferred payment sale). In other words, the bank issues an interest free and penalty free credit card. As goods are purchased using this credit

card, the bank makes the transaction on behalf of the customer and simultaneously sells it back to the customer. This credit is payable over a deferred period through installments within a certain time frame. However, the BBA principle is sometimes criticized as a two-party transaction that tries to circumvent Riba. This is because the financing of the credit amount is normally done based on the bank selling a part of its assets (based on “cost + margin”). Instead of paying cash to the credit card holder, s/he is given ‘an overdraft’ facility which can be utilized when paying using the card. 35 Several banks are doing away with this concept and are using Tawarruq (Commodity Murabaha) and Ijarah instead. In Tawarruq, the relationship between the issuer (a bank) and borrower (credit card holder) is developed based on actual sale and purchase of a tangible asset through a third party. Ijarah is a new principle used where a bank grants financing (the credit

limit) to the holder with an agreed predetermined profit. The holder will then pay the bank a fee for utilizing the facility. This fee is calculated based on the total profit amount due (based on the credit limit) minus the percentages of the unutilized amount. The most common features of an Islamic credit card in the UK are:

A small fee may be charged annually for the credit card.

Customers may enjoy the value-added benefits of conventional credit cards e.g. bonus points, gifts, shopping discounts, travel cheques etc.

Customers may need to have some kind of collateral that has been agreed upon in advance with the financial institution.

A credit limit will be based on the customer’s collateral value.

It may be possible to obtain general Takaful (insurance) coverage.

Some banks may provide other services such as Zakah (welfare contribution) payment via this credit card.

It may be possible to apply for a supplementary card.

35 Bhattacharya 2007.

3.6. Takaful (A Shariah Compliant Insurance Concept)

“Analogue to the development of Islamic banks, Muslim economists have tried to find a Shariah-compliant alternative to conventional insurance. In this way the so- called Takaful insurance evolved.” (Zamir Iqbal and Abbas Mirakhor 2011) Given the increasing popularity and the high market growth rates in this segment (10 to 25 percent per annum according to Ayub (2007), the Islamic alternative to conventional (non-mutual) insurance products will be briefly explained in the following focusing on the basic concept. In principle Takaful products are distributed by Islamic banks which either promote their own takaful products or establish a separate takaful company. Conventional insurance products are not Shariah-compliant due to the involvement of Riba, Maisir, Gharar and an “invalid transfer of risk from the insured to the insurer” (Ayub 2007). Firstly Riba (please refer to 1.3.1.) is involved as the insurance companies usually invest the capital in interest-bearing capital market instruments and secondly as soon as the amount insured is exchanged against the amount of premiums, there emerges an excess of money on one side, constituting Riba, too. (Ayub 2007) Furthermore the insurer-insured relationship contradicts with Shariah principles as “commercial benefit is involved on both sides for an uncertain event” (Ayub 2007), hence Gharar (please refer to 1.3.2.). Assuming a life insurance one could also detect elements of Maisir (please refer to 1.3.3.) as the insured person “bets” on the fact that he is still alive when the insurance contract term ends, so that he can enjoy the redemption. In other words “the profit of one party is dependent on the loss of the other” (Ayub 2007). The Islamic alternative to conventional insurance, called Takaful is based on the concept of mutuality and a contributory agreement among the insured parties, similar to conventional mutual insurance models. The International Monetary Fund (Solé 2007) explains:

“Several individuals agree to pool resources with the understanding that in case of need, each of them is entitled to draw resources from the pool.”

In this way the Takaful concept is based on “shared responsibility, common benefit and mutual solidarity” (Ayub 2007). The pool mentioned above is a Takaful fund which might be complemented by savings funds. The Takaful operator (either an Islamic bank or a Takaful company) manages these funds and receives remuneration from the premium payers. The mode of operation of the Takaful insurance depends on the underlying basic transaction (for example Mudaraba or Wakalah) and the type of insurance (for example property insurance or life insurance). (Ayub 2007).

To take an example out of Gassner and Wackerbeck (2007), a Takaful insurance based on a Mudarabah transaction is assumed (please refer to Figure 11). In the first step the insured persons pay their premiums in the Takaful funds in form of a donation (called Tabarru concept). The Takaful operator administers these funds and withdraws resources needed for potential damages of the insured, for Retakaful premiums for Islamic reinsurer and for distribution costs. The fund and the operator close a Mudarabah agreement (please refer to 3.1.1.), in which the operator takes the role of a Mudarib, who is agent of the Takaful funds (Rabb-al-mal), responsible for the Shariah-compliant investment of the premiums. Consequently the annual surplus is shared on a predetermined basis between the two parties whereas the operator distributes parts of the results to the shareholders. In this way the operator has an incentive to generate positive results and minimize risks. However the operator has the responsibility to provide for the risk of a loss. Firstly reserves are accumulated in profitable years and secondly the operator commits to provide interest-free loans (Qard hassan principle) to the funds to be used for payment in cases of damage.

According to Iqbal a main difference to conventional insurance products is that the

insured person in a Mudarabah Takaful insurance participates in the profits or losses

generated by his/ her funds.

in the profits or losses generated by his/ her funds. Figure 11 -- Takaful model based

Figure 11 -- Takaful model based on Mudaraba transaction from Gassner and Wackerbeck (2007)

3.7. Use of Islamic Financing Products and Profitability

On a global base Iqbal and Mirakhor (2007) note that “Murabaha (41 percent) has

been the first choice of Islamic banks, followed by Musharakah (11 percent),

Mudaraba (12 percent), Ijarah (10 percent) and others (26 percent)”.

Being subject to several religious restrictions Islamic finance and banking products

bear generally higher risks. At the same time they should render the same return as

conventional products in order to stay competitive. Given the requirement that every

contract must be based on assets, transaction costs are significantly higher as well as

monitoring costs, especially in equity contracts (Iqbal and Mirakhor 2007).

Consequently it could be assumed that Islamic products and services are more

expensive, which might be partially accepted by Muslims who appreciate the Shariah conformity. According to Gassner and Wackerbeck (2007) empirical researches have shown that lower competitiveness of this product cannot be proven and Muslims and non-Muslims alike are increasingly attracted by those offers. For example a high percentage of Chinese (non-Muslims) in Malaysia buy Islamic financial products. However other sources indicate that it is very difficult in practice to measure the performance of Shariah compliant products and the efficiency of Islamic banks as adequate and transparent benchmarks are missing so far. At present the LIBOR (London Inter-Bank Offer Rate) is used generally, however it belongs to the interestbased system. (Iqbal and Mirakhor 2007)

Furthermore it has to be kept in mind that the industry is driven by high growth rates and rising demand whilst institutions face few market pressure and competition. This situation might lead to unrealistic assessments. In this way “some levels of inefficiency is compensated by the abnormal initial profit margin” that might erode fast as more banks become active in this Islamic financing. (Iqbal and Mirakhor 2007) Additionally to the special requirements for products and services offered by Islamic financial institutions, the latter are challenged by further specifications resulting from Islam. In this way they have, for example, to establish a second layer of governance and compensate the lacking Islamic inter-bank market to manage their liquidity and risks. These aspects will be discussed in the next chapters.

Islamic inter-bank market to manage their liquidity and risks. These aspects will be discussed in the


4. Governance and Compliance Structure of Islamic Banks

The governance issues in Islamic banking differ substantially from those of the conventional system. The main difference lies in additional key stakeholders that have to be considered in everyday operation.

One out of two new stakeholder groups is, according to Algaoud and Lewis (2001), the Islamic Community. The Islamic bank has an “overriding obligation” (Lewis and Algaoud 2001) to obey Islamic law, being the Shariah. That implies that all products and services offered have to be strictly Shariah compliant. The ideas of “Amanah” (trust) and stewardship play important roles in this respect and should guide the operational practice of every Islamic financial institution. In order to safeguard the compliance with the strict religious standards, each Islamic financial institution is supposed to have a Shariah Supervisory Board as defined in chapter 4.2.

The second stakeholder group which is not present in conventional financial institutions consists of Musharakah and Mudarabah partners (please refer to chapter 3.1.1. and 3.1.2.). The Islamic bank captures the role of a management or dormant partner in a selected business venture and has therefore different obligations and risks to bear. These two stakeholder groups provide “strong justification for an additional layer in the corporate governance of an Islamic bank” according to Voker Nienhaus (2007), being the Shariah Supervisory Board.

4.1. Corporate Governance and Shariah Board

From its nature, a bank conducting Islamic finance is subject both to those forms of regulation which apply to conventional banks (banking supervision, financial reporting standards and external audit), with due regard to the characteristics of

Islamic banks, and also to the review of its compliance with Islamic principles and rules by the Shariah board, which constitutes a key organ of governance in an Islamic bank. The Shariah board of a bank is part of the corporate governance framework. (Racha Ghayad) 36 Islamic banks offer Islamic banking products and services (IBS banks) are required to establish Shariah board /consultants to advise them and to ensure that the operations and activities of the bank comply with Shariah principles. Each Islamic bank will have a Shariah board which reviews both proposed new products of the bank, and the types of transactions into which that bank has entered, to ensure that they are Shariah-compliant. New products will not be introduced until they are in a form acceptable of Shariah board. Shariah board in the past has been composed of Shariah scholars, some of whom had little knowledge of modern banking and who often could not understand the language in which transactions were documented. This could be a significant handicap to the progress of Islamic finance and the development of new products. There is currently a move to recruit Shariah board members with more experience of banking and this can only be welcomed.

4.1.1. Shariah Board and Performance of Islamic Banks The Islamic system imposes important constraints on operation of Islamic banks and their directors. In fact, added to the governorship exerted by the board of directors, undertaken very conventionally, the directors of the Islamic banks are subjected to a second governorship, that of the Shariah board. In theory, the Islamic bank should not seek the profit at any price because this last is not an end in itself. Unlike the directors of the conventional banks, the directors of the Islamic banks are subjected to important constraints as they do not have a margin of rather broad work.

36 Paper “Corporate governance and the global performance of Islamic banks” Lebanese University-CNAM, Beirut, Lebanon.

In an Islamic bank, the director does not have the autonomy to deploy their resources in any activity or any sector. Unlike conventional banks, Islamic banks do not have many instruments on the secondary market. Also Islamic banks do not have an inter-bank deposits market to make the excess of short-term liquidity profitable or to meet immediate requirements in liquidity. In general, they cannot use derived products and even less the financial lever. Additionally, the leaders can make only ethical decisions and which ensure the legitimacy and the acceptability of the organization. The role of an Islamic bank director is to ensure profit in compliance with Islamic law. In addition the governorship of an extremely demanding of board directors with regards to the financial performance, which remainder it is not easy to reach under such conditions, are subjected to the strict control of the Shariah Board which is laid out to approve only the compliance of the banking transactions with the rules of Shariah, without consideration of the dimension profit required by the leaders. Which role does the Shariah board play in the operation of Islamic banks? And what influence does it have on the performance of these banks? I will discuss in the following chapter.

4.2. The Shariah Supervisory Board

The Shariah Supervisory Board takes a “unique position in the governance structure of an Islamic Bank”. It acts as a religious supervisory board ensuring that the bank’s practices and activities do not contradict Islamic ethics. One distinct feature of the modern Islamic banking movement is the role of the Shariah board, which forms an integral part of an Islamic bank. A Shariah board monitors the workings of the Islamic bank and every new transaction that is doubtful from a Shari’ah standpoint has to be cleared by it. These boards include some of the most respected

contemporary scholars of Shariah and the opinions of these boards are expressed in the form of fatwas. In addition, the International Association of Islamic Bankers, an independent body, supervises the workings of individual Shariah boards while its Supreme Religious Board studies the fatwas of the Shariah boards of member banks to determine whether they conform with Shariah.

Shariah law is open to interpretation and Shariah boards often have divergent views on key Shariah issues. In this regard, there is no practical guide as to what constitutes an acceptable Islamic financial instrument. A document or structure may be accepted by one Shariah board but rejected by a different Shariah board.

4.2.1. Shariah Supervisory Board Standards

Until recently there was a lack of unique requirements and standards regarding the composition, characteristics and functions of Shariah Supervisory Boards. However as the industry grows, they are increasingly important in order to create a level playing field for all Islamic financial institutions. By today, approaches to harmonize essential standards are taken by the “Accounting and Auditing Organization for Islamic Financial Institutions” (abbreviated AAOIFI, please refer to chapter 4.3.2.). An

increasing number of financial insitutions committs to the “Accounting and Auditing General Standards for Islamic Financial Institutions ” (AAGSIF) issued by the AAOIFI.

4.2.2. Characteristics of a Shariah Supervisory Board

For every fully-fledged Islamic bank it is obligatory to have a permanent Shariah Supervisory Board. (Iqbal and Mirakhor 2007) This religious committee is characterized in three features, being the qualification of its members, their independence from the financial institution and the binding nature of its decisions for the respective financial institutions (Zamir Iqbal

and Abbas Mirakhor 2011).


According to the AAOIFI (please refer to 4.3.2.) a Shariah Supervisory Board should consist of at least three Shariah scholars, who must have a comprehensive education in legal questions (Fiqh Mu’amalat, please refer to 1.3.1.) (Zamir Iqbal and Abbas Mirakhor 2011). Traditionally the scholars’ reputation in public, achieved by excellent education and a high position in society, was most decisive for their appointment (Altundag und Nadia 2005). Today the financial expertise of the Sharia Supervisory Boards members becomes increasingly important as they have to assess financial

instruments, products and processes that are becoming more and more complex (Zamir Iqbal and Abbas Mirakhor 2011) there are currently not more than fifty scholars worldwide who fulfill both of the prementioned requirements. Often, one Sharia scholar holds several mandates in various Sharia Supervisory Boards of different financial institutions and additionally in standard setting organizations like the AAOIFI. The shortage of adequate Scharia Scholars hinders the development of this industry as religious supervision is one of the most important features in Islamic banking. Consequently Islamic financial insitutions, non-governemental organizations and governements of certain countries invest heavily in the education of new Sharia scholars. It is common practice that the Sharia scholars are appointed by shareholders upon recommendation of the board of directors. There are no specifications regarding the duration of a scholar appointment.


It is essential for the credibility and reputation of the financial institution within the Muslim community that the Sharia Supervisory

Board is absolutely independent. Therefore its members should

neither have management positions nor important financial interest in the company (for instance as a shareholder) in order to avoid conflicts of interest. (Algaoud und Lewis 2007). The Sharia Supervisory Board must not be “subject to instruction by management, board of directors and shareholders” . However the scholars are mostly employed by the bank and “their remuneration is proposed by the management and approved by the board” (Iqbal and Mirakhor 2007). This employment status may affect the required unbiased opinion.

Binding nature of fatawa

As described later in this chapter the main function of a Shariah Supervisory Board is to certify that the bank’s products and processes are compliant with Shariah precepts in order to give believers the certainty to invest or deposit in accordance with their faith (Jaffer 2005).The scholars, being experts in Islamic jurisprudence (Fiqh Mu’amalat) are capable to issue their own interpretation of Islamic law (Shariah) as described in chapter 1.1. This “authoritative legal opinion” (Jaffer 2005) of a Shariah Supervisory Board or single scholars is called “fatwa” (plural form is “fatawa”) and absolutely binding for the financial institution.

(Algaoud und Lewis 2007) Looking at Islamic banking practice in Europe, it is appearent that the fatawa are only binding inside the financial instituion, (i.e. between the Sharia Supervisory Board and the management) as the legal system in non-Muslim countries does not rule on Islamic law. (Zamir Iqbal and Abbas Mirakhor 2011)

4.2.3. Functions of a Shariah Supervisory Board According to Iqbal the Sharia Supervisory Board is “entrusted with directing, reviewing and supervising the activities of the Islamic financial institution, in order to ensure compliance with Islamic Shari’a rules and principles”. These activities are referred to as “Shariah Audit and Certification” and comprise the issuance of fatawa. The Sharia Supervisory Board functions can be differentiated between a constitutive and an alternating or operative function.

The constitutive function

Before a new Islamic bank can start operations, its Sharia Supervisory Board has to certify the Sharia conformity of all products and internal processes. Afterwards the scholars should prepare a report of compliance. (Zamir Iqbal and Abbas Mirakhor 2011) This process has to be run only once and is described by Iqbal and Mirakhor (2007) as “ex-ante Shariah audit”.

The alternating or operative function

Subsequently the running operations of the institution are monitored and the Sharia Supervisory Board has to “vet all new contracts, audit new contracts, approve new product developments and overseas the collection and distribution of Zakat” (please refer to chapter 1.3.4.) (Algaoud und Lewis 2007). Furthermore it is concerned with the “disposal of non-Shariah compliant earnings and [the] advise on the distribution of income or expenses among the bank’s shareholders and investment account holders” (Iqbal and Mirakhor 2007). The management has to inform the Sharia Supervisory Board regularly on activities and should consult it whenever a new product or process is under development. For daily business, internal employees with respective knowledge are asked to control the processes and provide their results to the Sharia scholars. In the annual report of the Islamic

financial institution, the report of the Shariah Supervisory Board

should be integral part. (Iqbal and Mirakhor 2007) The product

innovation process will be described seperately due to its high

complexity and importance for competitveness and development of

Islamic financial service institutions.

4.2.4. Product Innovation Process

The certification of new products and processes belongs to the most

important processes in an Islamic bank. Natalie Schoon (2011) how the

Shariah Supervisory Board can be integrated in the product innovation

process. (Please refer to table-3). Internal Structuring Product/concept Legal SSB Finalise Product Approval from
process. (Please refer to table-3).
Approval from
Table-3 Shariah approval process for a new product orstructure,
Natalie Schoon (2011)

In the first step the management or the respective operative entity develops a

rough outline of the new financial product or internal process. The drafted

structure is then presented to the Shariah Supervisory Board which examines

and fundamentally approves the basic structure. After this first hurdle is

taken, business experts can refine the concept and a jurist is contracted to

prepare necessary papers. Subsequently the final product or process

description is handed over to the Shariah Supervisory Board which proceeds

with the detailed analysis. If applicable it gives recommendations for

improvement which should be incorporated before the fatwa constituting

the final certification- is issued. If the Shariah Supervisory Board is not

content with the business experts’ proposals the process is repeated several


Consequently the period for product development is considerably longer for Islamic banks compared to their conventional competitors. This fact is amplified by the small number and high work load of available Shariah scholars. Both constitute a bottleneck factor for the growth of Islamic financial institutions and leads to a disadvantage in competition with conventional banks.

However the vetting and auditing of new products and processes is essential for credibility and marketing. (Natalie Schoon 2011)

In search of measures for improvement, Islamic banks hire special Sharia consultants or advisers who are involved in product and process development. They identify critical issues beforehand and shorten the process considerably. (Natalie Schoon 2011) Notably many London law firms advise on Islamic financing techniques and new market entrants rely on their expertise, experience and well-established contacts to financial institutions in Muslim countries. (Baba 2007)

4.2.5. Shariah Board and Profit As I previously mentioned, the main objective of an Islamic bank is to offer banking services according to Islamic law. Therefore, the presence of Shariah board is so essential to control bank transactions.

The Islamic doctrines encourage man to adopt a positive attitude in regard to the profit; Islam encourages the true profit as an output of the entrepreneurial effort and the financial capital. According to the Islamic definition, a true profit, i.e., conforms to Shariah. For the Shariah board, the organizational performance is measured by the respect of the principles of Islamic law by the bank directors. Therefore, profit must be generated with full respect of Shariah rules. The bank directors do not have, therefore, any

interest to present transactions which generate incomes coming from Riba. As it has been observed, Shariah and profit are quite compatible. These directors of Islamic bank had called upon the specialists in Islamic jurisprudence to help them to develop financial products and single investments not only adapted to ensure the needs of the extremely demanding and increasingly sophisticated clients, but also compatible with the prohibition of the interest.

In this division of competence, economic calculation and the profit concerns are allocated to the directors and the appreciation of the licit character of this profit is allocated to the Shariah board. The members of Shariah board are increasingly conscious of the challenges and pressures to which the leaders are subjected.

It has been observed, that in the early stages of Islamic banking, the membership of Shariah board was a serious handicap for the directors of the Islamic banks. Directors and members of Shariah board did not speak the same language. The members of the Shari’a board were not very specialized in the fields other than Shariah, which was contrary the directorship in the Shariah. Therefore, having regular periodical meetings between the Shariah supervisory board and the management of the bank is preferred not only by the Shariah advisers but also by the management of the bank. It could be that in this way, the bank will only present the cases that they think require deliberation. In other words, the bank can shortlist the issues of discussion. This could be very problematic if the bank management fails to disclose cases of practices that they think to be non-Shariah compliant in their banking operations. The other possible reason that is perhaps the most likely is that many, if not most, of the Shariah advisers are not full-time Shariah advisers to the bank.

Accordind to Racha Ghayad it is advised that Islamic bank must have Shariah advisors board with a good knowledge in finance to help the management of the bank to develop a new products in accordance with Shariah rules. In order to achieve better corporate governance in Islamic banks, it has been proposed to broaden the scope of investment account holder (IAH) represented in the board of the bank. Because, IAH share risks so they should have a seat in the board.

4.2.6. Inconsistency of Fatawa In absence of global standardization and of a superior national or supranational Shariah Supervisory Board it is possible that fatawa of different Shariah Supervisory Boards on the same financial product are inconsistent. This leads to the scenario that for example the same transaction is prohibited by the Shariah Supervisory Board of the Islamic bank A but certified and therefore declared admissible by the Shariah Supervisory Board of Islamic bank B. (see example in Gassner and Wackerbeck 2007). In consequence decision-making within the industry is inefficient as efforts are duplicated and standards are missing. (Iqbal and Mirakhor 2007) Thanks to improved transparency of issued fatawa (for example in the internet) and active exchange between Sharia scholars, it becomes more common to consider old fatawa in decision processes. (Natalie Schoon 2011) However an extensive harmonization of fatawa cannot be expected. This would contradict the Islamic idea that every men has to interpret the Holy Qur’an and the Shariah in his own (imperfect) way as no common interpretation exists. (Iqbal 2001)

4.3. Regulatory Framework

Even though the Islamic banking and finance sector expanded rapidly over recent decades it is still in its infancy. In Western and Islamic countries Islamic banks are still a minority compared to conventional banks, expect Iran, Sudan and Pakistan where the whole financial sector is Islamized. (Brown, Hassan and Skully 2007) Consequently Islamic banks’ efficiency is constrained, among others, by lacking industry-wide standards and regulations as well as by disadvantages in the tax treatment of their products in Western legislations (for example the double stamp duty). It is one of the most important tasks ahead to create adequate legal, regulatory and tax frameworks to contribute to the further development of this industry. In addition to national legislators, non-governmental agencies like the AAOIFI and the IFSB (please refer to the chapter below) invest considerable efforts in order to foster standardization and harmonization. These approaches are important in order to enhance the comparability between Islamic banks and their competitive position regarding conventional banks. (Iqbal and Mirakhor 2011)

4.3.1. Standardization and Harmonization The two most important standard setting organizations in Islamic finance and banking sector are the “Accounting and Auditing Organization for Islamic Financial Institutions” (AAOIFI) and the “Islamic Financial Services Board” (IFSB). Islamic financial institutions are not forced to adapt the standards, guidelines and concepts issued by both organizations. However regulatory and supervisory agencies in many Muslim countries have aligned their laws and standards according to their publications (Gassner and Wackerbeck 2007). Furthermore they are used on a voluntary basis by Western fully-fledged Islamic Banks like the European Islamic Investment Bank and Islamic Windows in conventional Western banks like the HSBC Amanah.

4.3.2. AAOIFI

The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) is an international Islamic non-profit body that was found in 1991 in Bahrain based on an agreement signed in 1989 by large financial institutions from Middle East 37 . AAOIFI’s objectives are to “develop, disseminate (through training, seminars, publication of periodical newsletters), interpret, review and amend accounting and auditing standards for Islamic financial institutions”. In this way the confidence from consumer side should be improved.

So far the organization has issued about fifty-six standards in accounting, auditing, governance, ethics and Shariah compliance for Islamic financial institutions. Furthermore the AAOIFI carries out professional qualification programs (for example the Sharia Adviser and Auditor “CSAA”) to “enhance the industry’s human resource base” (AAOIFI[1] 2006-2007) AAOIFI’s members comprise currently about 150 financial institutions in thirty countries

(Natalie Schoon 2011and AAOIFI[4] 2006-2007) as well as regulatory and supervisory authorities (for example central banks or monetary agencies), organizations and associations responsible for regulating the accouting and auditing profession and “supporting members” who “already have or intend to have relations with Islamic financial institutions’ products” (AAOIFI[3]


4.3.3. IFSB

Another international organization dedicated to standardization in the Islamic financial industry is the “Islamic Financial Services Board” (IFSB)

found in 2002 in Kuala Lumpur. (IFSB[1] 2008) The IFSB works in close

37 The institutions involved were the Islamic Development Bank (Saudi Arabia) , the Al Baraka Banking Group (Bahrain), Dar Al Mal Al Islami (Switzerland) , the Al Rajhi Banking and Investment Corporation (Saudi Arabia), the Kuwait Finance House (Kuwait) and Bukhari Capital (Malaysia). (AAOIFI[3] 2006-2007)

cooperation with international associations of bank and capital market supervisors, for example the Basel Committee on Banking Supervision. In principle it adapts the existing standards and guidelines of these international associations and adjusts them according to the particularities of Islamic financial institutions. So far the institution has issued seven standards, guidelines and technical notes for instance on the areas of risk management, capital adequacy, corporate governance, transparency and market discipline and recognition of ratings. (IFSB[2] 2008) In particular the IFSB strives towards the determination of uniform criteria to identify23 The institutions involved were the Islamic Development Bank (Saudi Arabia) , the Al Baraka Banking Group (Bahrain), Dar Al Mal Al Islami (Switzerland) , the Al Rajhi Banking and Investment Corporation (Saudi Arabia), the Kuwait Finance House (Kuwait) and Bukhari Capital (Malaysia). (AAOIFI[3] 2006-2007) measure, manage and publish risks of financial institutions. (Gassner and Wackerbeck 2007) By the end of Januar 2008, the IFSB counted 150 members including the International Monetary Fund, the World Bank, the Bank for International Settlement as well as several market players in twenty-nine countries. (IFSB[2] 2008)

4.3.4. Regulation Islamic financial institutions compete in all countries with conventional banks (except Iran, Sudan and Pakistan 38 ). The conventional competitors outnumber the Islamic financial institutions and regulations are “generally aligned to the conventional system” (Brown, Hassan and Skully 2007). This leads to disadvantages for Islamic financial institutions and Shariah compliant products, for instance to unfavorable in tax treatment of their products or to difficulties in refinancing. “Several studies indicated that these regulations influence the operational performance of Islamic banks significantly” (Gassner and Wackerbeck 2007). Consequently it is

38 Iran, Sudan and Pakistan have fully Islamized their financial sectors.

questionable whether both conventional and Islamic institutions should be subject to the same regulatory frameworks as their business models differ substantially.

Some countries like Malaysia, Bahrain and notably the United Kingdom actively support the improvement of regulatory conditions for Islamic financial institutions from a national quarter. (Natalie Schoon 2011)

4.3.5. Accounting, Reporting and Zakat Referring to chapter 4.3.2. it can be stated that generally accepted accounting and reporting standards are missing. Despite the fact that many Islamic financial institutions align their systems by now with the standards issued by AAOIFI, the majority of them reports additionally according to conventional standards, for example IFRS. This leads to confusion and problems, due to operational differences in Islamic banking business. In this way the calculation of key figures such as the results generated with certain Islamic financing activities is very difficult. The treatment depends very much on the basic Islamic concept applied in the respective financing technique and “the same products can affect the balance sheet and profit and loss statement of an institution in completely different ways.” (Gassner and Wackerbeck 2007) Another problem constitutes the reporting of additional risks comprised in active Islamic financing techniques.

Furthermore the Islamic finance and banking concept requires additional duties of disclosure, such as the reporting on the Shariah conformity of its products (please refer to chapter 4.2.) and the information necessary to calculate and pay Zakat (please refer to 1.3.4.). Uniform Zakat regulations are not in place, yet leading to a distortion of competition.


5. Management from Islamic Perspective

Management is evaluated according to technical ability, leadership, administrative capability, ability to plan and respond to changing circumstances and also willingness to serve the legitimate needs of the community. All these factors should be considered in Islamic financial institutions. Given the complexity of many Islamic banks’ operations, monitoring of investment projects, managing the assets at times, legal uncertainties relating to the Shariah litigation system, control of risks and validation of contracts play a vital role in the effective management of operational risks.

The Islamic approach to management is an emerging discipline. Often referred to as Islamic management, it views the management of organizations from the perspective of Islamic sources of knowledge, and results in applications that are compatible with Islamic beliefs and practices. Muslim workers derive their motivation from their religious and cultural heritage; thus, any approach to motivation that ignores this will not be successful. The Prophet (pbuh) 39 taught that every human endeavor is an act of worship and charity. For a Muslim, working is a form of worship of his Lord, and this in itself is a powerful motivator, irrespective of any material gain. (Ahmad, 2006) Overall, the study of leadership from the Islamic perspective is still in its infancy, compared with more the advanced research conducted in Western countries. However, how is managerial leadership defined from Islamic perspective?

39 Peace be upon him

5.1. Managerial Leadership: An Islamic Perspective

Allah (Swt) 40 has created mankind with noble objective that people would lead their lives in peace and harmony following the tenets of His revelations sent down through Prophets from time to time since the very beginning of the society. Leadership is one of the core corners in our social activities (Patwary, 2003). It refers to a process of influencing and supporting others to work enthusiastically toward achieving objective (Koontz, 1994). It is a major factor for the success of any organization whether it is small or large, formal or informal. An effective leader is a must for attaining success in family life, business concern, government and political parties. Classically, managerial leadership is an approach of getting things done through others most effectively and efficiently in an organization. In view of Islam, leader is a member of a team who is given a certain rank and is expected to perform in a manner consistent with it. A leader leads a group who is expected to exercise influence in forming and accomplishing the ethical goals and objectives. The success of a leader is dependent on team building that leads to team spirit.

Islam does not permit any Muslim to live without having a leader in any situation even if they are on a trip or in a desert. The primary duties of a leader are to lead the people in offering prayers, to look after their interest with justice and run their activities in a disciplined and systematic way (Ahmad, 2006). However, an Islamic managerial leader will serve his followers or subordinates under some distinctive principles, out of which some distinct operational principles are mentioned below (Ather and Sobhani 2008):

Shura Managerial leaders in Islam must consult with their people before making any decision. It is also the fundamental aspect of democratic system. Managers in an organization must consult with their subordinates in formulating any strategy or policy. Allah (Swt)

40 SWT is from Arabic meaning "subhanu wa ta'ala" which translates as "Glorified and Exalted".

directed his Prophet (Sm) to consult with his companions. Allah says “And those who have answered the call of their lord and establish prayer and who conduct their affairs by consultation and spend out what we bestow on them for sustenance.” 41 Allah also says “And by the mercy of Allah, you dealt with them gently. And had you been severe or harsh-hearted, they would have broken away from about you; so pass over (their faults), and ask for (Allah’s) forgiveness for them; and consult with them in affairs. Then when you have made a decision, put your trust in Allah.” 42

Freedom of Thought

Islam encourages freedom of thought. Practicing managers or executives should create such an environment in the organization so that the staff members can easily opine on any issue. The Four

Khalifs of Islam considered this as an essential element of their leadership (Patwary, 2003). Hazrat Umar (R) praised Allah (Swt) that there were people in the Ummah who would correct him if he went astray.

Sources of Islamic Jurisprudence

There are four sources of Islamic Jurisprudence. These are: Quran, Hadith, Izmah, and Kias. In managing any activity, the managers first look to its hints for solution from the Holy Quran. If hints are not available, he should give a second search of Hadith. Again if the solutions are not found in Hadiths, he should look to Izmah and Kias of recognized religiously learned persons and his good conscience.

41 Surah Al Shura, Verse-38

42 Surah Al-Imran, Verse-159


The management leaders must behave with team members justly and fairly without any discrimination regardless of their race, color or religion. Islam always urges for doing justice to all. The Qur’an commands Muslims to be fair and just in any circumstances even if the verdict goes against their parents or themselves. Allah says “O you, who believe! Stand out firmly for justice, as witness to Allah, even as against yourselves or your parents or your kin and whether it be against rich or poor, for Allah protects both” 43 .

Dependence on Allah

The managerial leaders in Islam must depend on Almighty Allah (Swt) for the outcome of any action. It is known in Islam as Tawakkul. Allah asked his believers to depend on Him. Allah says, “ ….when you have made a decision, put your trust in Allah, certainly, Allah loves those who put their trust (in Him)” 44 . However, dependence on Him without any endeavors is not supported by Islam. The mangers must prepare managerial plans and policies in order to achieve the rational (halal) objectives. But he must depend on Allah (Swt) for the success of his plan.


Islam teaches accountability as vital component of management. The managers must be accountable for their duties and responsibilities to the Board of Directors. The Board must be accountable to the beneficiaries or stakeholders. According to Islam, each and every human being will be made responsible for his good or bad deeds and accordingly he will be rewarded or punished. Allah says

43 Surah An-Nisa, Verse-135

44 Surah Al-Imran, Verse-159

“…whosoever does good equal to the weight of an atom (or a small ant) shall see it. And whosoever does evil equal to the weight of an atom (or a small ant) shall see it.” 45


An Islamic managerial leader must be sincere enough to achieve the objectives of an organization. The Qur’anic terminology of sincerity is Khulusiat. The Holy Quran urges people to be utmost sincere in

his praying, meditations, and good deeds.

Dignity of Labor

Islamic leaders must recognize the dignity of labor. Mohammad (Sm) says, “Pay the wages to the labor before his sweat dries up” (Al Hadith). Islam pointed out that earning as the best, which is earned by the toil of the labor. Hence, practicing managers should duly recognize the dignity of all categories of efforts especially physical labor of the workers and employees.

Esprit de corps

The managerial leaders must try to achieve organizational goals and

objectives with team rather than individual endeavors. The highest level of unity should be maintained among the executives, staff and workers for motivating and energizing team works. Islam encourages esprit de corps i.e. team efforts. Prophet Mohammad (Sm) says “The Hand of Allah is with the Jama’ah (team)” (Sunon Al Tirmidhi). (Ather, 2006)

45 Surah Az-Zilzal,Verse- 7-8

5.1.1. Team Building Under Islamic Leadership

A team is not a random collection of individuals with different agenda. A

dozen of individuals in a restaurant by random chance are not a group

although they may be interacting, have a common goal of eating and

drinking and be aware of each other. Teamwork does not just happen. It has

to be organized and nourished through effective leadership and management

(Altalib, H., 1991). Working together with team spirit is an Islamic

directive. It is said in Hadith “The Hand of Allah is with the team (Jama’ah).

Then, whoever singles himself out (from the Jama’ah) will be singled out for

the Hell Fire” (Sunon Al Tirmidhi). A team from Islamic point of view may

be defined as a group of people under a team leader who work together on a

continuing mission with common (halal) goals and objectives.

continuing mission with common (halal) goals and objectives. Figure 12 -- A Diagram of Team Building

Figure 12 -- A Diagram of Team Building under Islamic Leadership (Ather and Sobhani 2008)

The figure 12 is a diagram where people designate A, B, C, P, Q, X, Y, and

Z are working together under a team leader ‘M’ to achieve organizational

goal considering Islamic values. Here the team members are mutually

interactive and connected with their leader. The goal is accomplished

through specific and defined tasks that may be simultaneous or sequential

and may change from time to time. A large team may be divided into sub-

teams. Everyone in the team is expected to take responsibility for the

success of the team as a whole. The work and performance of each member

and of the whole team must relate to clearly defined objective. While each

team member contributes particular skills and knowledge, the team as a

whole, as well as each member, is responsible for the task on which it is

focused. (Ather and Sobhani 2008)

5.1.2. Islamic Model of Managerial Leadership

A model has got lot of significance. It pictorially represents something for

better understanding and communication of thoughts and ideas, which has

got ever lasting impressions in the readers mind. Therefore, the authors

believe that without developing a model the research on ‘Managerial

Leadership: An Islamic Perspective’ cannot be well conveyed and

convincing to the interested groups. Hence it is rationally justified to

develop the following model.

it is rationally justified to develop the following model. Figure 13 -- Model of Managerial Leadership

Figure 13 -- Model of Managerial Leadership from Islamic Perspective (Ather and Sobhani 2008)

Explanation of the Model

On the bases of previous discussions, concepts and facets of Islamic Leadership, a Model of Managerial Leadership from Islamic Perspective has been developed (see Figure 13). Basic three elements of leadership as shown in the model are: Organization, Leaders and Followers. Leaders will take decisions consulting with the followers. Leaders will act, as both the servant and guardian leadership while the followers will show dynamism in their participation and action. Leaders will be gentle to the followers and they should never be harsh with them. Leaders must pass over followers’ faults, if any, and ask for Allah’s forgiveness. They must consult followers when necessary. After consulting leaders must decide and put trust in Allah (Swt). The role of followers in Islamic leadership process will be positive. They will act as observers of men, women and things. They must be cooperative with their leaders. They provide necessary suggestions to their leaders thus contributing to decision-making. They also warn their leaders for their actions if necessary. The followers must withdraw their support if and when the leaders are seen deviating from the right path of Islam (Anisuzzman, 1996). Thus they will play the role of dynamic rather than blind followership. The functions and operations of the organization must be guided and controlled by the rules of Islamic Shariah i.e. Qur‘an, Hadith, Izma and Qias. Nothing will be considered which is not supported by Islamic Shariah. The leaders and followers both will be accountable for their responsibilities to the organization and Allah (Swt) as well.

The objectives of Islamic leadership include both mundane welfare and eternal bliss. The ultimate objective of the Islamic Leadership

will be attaining satisfaction of Allah (Swt) through fulfillment of

organizational rational (halal) objectives.

Box-3 Reaserch study Islamic perspectives on conflict management within project managed environments 46

Kasim Randeree a , Awsam Taha El Faramawy b

a BT Centre for Major Programme Management, Saı¨d Business School, University of Oxford, Park End Street, Oxford, OX1 1HP, United Kingdom, b M.A. Al Kharafi & Sons, United Arab Emirates (2010)

The research study set out with the objectives to address questions proposed: (a) Is there is an Islamic conflict intervention model available for project managers to implement in their workplace? (b) Is such a model beneficial and can it be implemented by project managers and individuals with non-Islamic backgrounds?

The Islamic approach to conflict management is derived from the major principles and values of Islam as a religion, such as justice (Randeree, 2008), equality, freedom, and affirmative critical and goal oriented thinking (Abdalla, 2001; Al-Buraey, 2001; Khadra, 1990; Yousef, 2000). Leadership has a vital impact on effective conflict management from an Islamic viewpoint. In the case of the project manager, the leadership role includes resolving conflict (Khadra, 1990; Randeree and Chaudhry, 2007).

The nature of Islam as an adaptive method of thinking allows individuals to implement several techniques to cope with conflict even if such techniques are imported from western cultures unless such styles contradict with Islamic values and principles (Abdalla, 2001; Al-Buraey, 2001; Khadra, 1990; Yousef, 2000).

Ali (1996) reflects that from an Islamic perspective, conflict is characteristic of an unhealthy situation as it is a threat to cohesiveness and conformity of the group, adding that, it may be reduced by openness in dealing with subjects; it is avoidable by expressing concerns through strong-willed debate, consequently reinforcing consensus. He further states that debating issues over which there is conflict is necessary for group benefit and that differences in ideas should be respected. Conflict can thus become a foundation for positive change, and can lead to the voicing of concerns to

46 Available online at -- International Journal of Project Management 29 (2011) 2632

increase awareness which is important to avoid stagnation. Thus, the concept of change is a positive one in an Islamic connotation, where change is goal oriented and is a continuous and normal process (Ali, 1996;

Al-Buraey, 2001).

There are different drivers that provoke change and once the environment is ready for change it is time for people to act. People, however, are not passive actors; rather people are proactive in directing change in a way that serves their own or the project’s interests. Therefore, change should be planned, managed, and monitored by all stakeholders (Ali, 1996; Al-Buraey, 2001). Existing research provides conceptual Islamic models of conflict management, three of which are tested empirically here, following the viewpoint conceded by established research that change is a key factor in conflicts, and pertinently the cause or effect or both.

The SALAM model

Fig. 1 illustrates the SALAM model which prescribes the starting point by stating the conflict view (S), which means that the disagreement is defined obviously to all parties part of the conflict. Here the conflict nature, source, and size are to be stated clearly. Subsequently the participating parties agree (A) that a disagreement exists without making any judgment and by disregarding any personal

Fig. 14 -- SALAM model

and by disregarding any personal Fig. 14 -- SALAM model bias. Thereon the listen and learn

bias. Thereon the listen and learn (L) process between parties is aimed for, which is denoted as the most demanding part of the model. In this model the parties listen to others points of view to learn about the disagreement. This step can be effectively practiced through swapping the positions, whereby, implicitly each party adopts the other’s position and defends the idea

in a consulting environment. Such conflict environment will foster advising (A) one another by finding a common area that both share as a ground for conflict management. In addition, after agreement about the intervention, one party may propose to assist the other(s) in a proactive behavior that facilitates implementing the intervention

and fosters a collaborative environment. Idealistically, consequently by minimizing (M) aspects of possible conflict through proactive debate, destructive conflict sources could be thus eliminated (Ahmed, 2007).

The S.N.T model

The S.N.T model is a proactive process that fosters constructive conflicts. Avoiding conflict in the

S.N.T model does not refer to conflict ignorance; rather it presents ways to enrich favorable conflicts. The “S” stands for a key principle in the Islamic religion which is ‘Shura’, or consultation, implying consulting others before implementing any change. Such an approach minimizes disagreement between stakeholder parties and enables fostering a conducive environment for change. The second principle is ‘Naseeha’ “N” which means advice. In a project context, advice can be offered to all stakeholders, with feedback to project managers and clients providing clarity about changes. Sincere advice and viewpoint exchange between parties fosters common understanding of consequences of the change. The last element ‘Ta’awun’ denoted by “T”, indicating cooperation which is essential for the change process, to promote healthy communication, reduce change opponents, and eliminate hostile workplace environment (Ahmed,


Conclusions of the research

The literature review has indicated existence of pervasive Islamic style conflict management models with potential for application by project managers. The Islamic models as the proactive, S.N.T and SALAM are pure Islamic approaches to handle conflict.

Overall, the study of leadership from the Islamic perspective is still in its infancy, compared with more the advanced research conducted in Western countries. Conventional management studies have made rapid strides during more than a century of its existence. Attention to working on Islamic perspectives is a later development and as yet remains a relatively unexplored field of research work. Studies done till now are more of a tentative, descriptive type and do not yield much scope for future directions for research. A start has yet to be made in the real sense.

5.2. IF Asset Management

The last decade has seen increasing demand for shariah compliant asset management from institutional and private clients in the GCC 47 , partly driven by the rapid rise in the region’s wealth, but also by the increasing number and breadth of asset classes now available for Islamic investors. International banks, notably HSBC, Citigroup, Deutsche Bank, UBS and Standard Chartered have seized the

47 Gulf Cooperation Council. Economic cooperation between Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates.

opportunity to adapt their existing asset management services to the needs of Islamic investors, and have appointed their own boards of shariah scholars to assure their clients that they are indeed Shariah compliant. This has been a learning experience for the banks themselves as well as the Islamic investors, the former learning about shariah principles, while the latter have learnt about asset management options and the implications for portfolios of the trade-off between risk and returns.

Asset management encompasses both fund management and discretionary portfolio services for institutions and individuals of high net worth. For private banking clients, this may involve the management of trusts, established for tax or inheritance reasons. Shariah compliance in all of these areas poses interesting, but usually solvable, challenges. Fund management is a good starting point, as over 100 shariah compliant funds are available for retail investors in the Gulf, but treasury, wealth management and investment portfolio services, including the holding of Islamic sukuk securities, will also be reviewed in this chapter, as these are crucial for both private and corporate clients in the GCC.

5.2.1. Shariah Compliant Fund Management Funds offer major advantage for investors who wish to have shariah compliant asset holdings as a shariah board is usually accountable for the criteria governing the portfolio selection and in the case of equities, the actual stock included. Muslim investors who purchase stock directly through a broker or invest in other types of assets such as commercial property can have no guarantee that their money is being utilised for halal purposes, unless they had the resources to engage personal shariah advisors to monitor all their investments. Few, other than high net worth investors, could contemplate such an approach, and in practice it is ruled out, not only on grounds of cost, but because it would delay investment decisions, and

undermine potential gains in financial markets where timing is crucial for success. In contrast, fund managers can operate within known parameters that are established by the shariah boards of the institutions in which they are employed.

Unfortunately, none of the major specialized fund management providers such as Fidelity or Jupiter offer shariah compliant funds, most at present being offered by Islamic banks or conventional banks providing shariah compliant products. In these cases, it is the shariah boards of the banks that have the responsibility to audit the funds offered, their remit being to approve new product offerings and monitor the operation of existing funds, especially their purchase of equities and other financial assets. This requires different skills and experience however to those needed to audit Islamic banking activities. The task of shariah auditing consists in the authentication of the Islamic products to ensure they are compatible with the traditional contracts used in fiqh jurisprudence. In contrast, most funds comprise financial instruments such as equities that were unknown under shariah, although now regarded as conditionally permissible on the grounds that all instruments are allowed unless explicitly forbidden. Equities are not forbidden, as there are simply no references to such instruments in historical fiqh texts, the emphasis instead being on partnership contracts such as mudarabah and musharakah that have quite different financial and legal characteristics.

Rather than relying on bank shariah board to authenticate assets as halal, the task can be outsourced. The Dow Jones Islamic Indices provide such a service, as when compiling their indices they have to exclude stock that is not shariah compliant. This information can therefore be shared with clients for a fee, as it is of commercial value to fund managers who are seeking to market their products to pious Muslim investors. It is therefore the shariah

board of the Dow Jones Islamic Indices who are responsible to ensure the investments are halal, but as specialists in this area of finance, with almost a decade of experience, they are arguably better qualified to act than a bank’s shariah board that has little knowledge of stock selection criteria. Of course Dow Jones Islamic Market Indices does not have a monopoly in this area, as there are also the Financial Times Islamic Indices, and the specialist provider of shariah financial solutions, Yasaar Limited of Dubai and London, has expertise in this area through its access to leading scholars who undertake work on a free-lance basis.

5.2.2. Islamic Fund Management Structure The general fund management structure is shown in Figure 15. The fund investors are generally known as the rabb al mal, or the providers of capital. The relationship between the investors and the fund is based on a Mudarabah (see chapter 3.1.1.) or Wakalah (see chapter 3.1.4.) contract in which the fund manager is either the Mudarib or business manager, who provides investment knowledge, expertise and experience or, in cases where the fund management contract is based on a wakalah contract, the wakil or agent. When it comes to the investment processhowever, the fund manager takes on the role of the capital provider on behalf of the fund unit holders.

Figure 15 -- Islamic Asset Management Structure (own illustration) 5.2.3. Asset Management Company Structure Funds

Figure 15 -- Islamic Asset Management Structure (own illustration)

5.2.3. Asset Management Company Structure Funds have a variety of associated parties, which vary marginally depending on the type and the jurisdiction in which they are based. A generic structure is defined in Figure 16, which demonstrates that the structure of Shariah compliant asset management is almost identical to that of its conventional equivalent but with one major difference. In order to ensure Shariah compliance of the funds, a Shariah supervisory board is part of the structure. (Please refer to chapter 4.2.)

Where a Shariah compliant fund is part of a conventional bank or asset manager 48 or an Islamic bank, the fund platform tends to have its own Shariah supervisory board. For a Shariah compliant vehicle that is part of a conventional institution, the Shariah supervisory board is typically specifically appointed for the fund or fund platform. Where the fund is part of an Islamic financial institution, there are three options:

48 Each fund is managed by a dedicated asset manager whose responsibility it is to ensure the monies are invested in the most efficient and effective way given the fund’s investment mandate.

1. The fund’s compliance is included in the overall Shariah compliance of the institution which is catered for by the institution’s Shariah supervisory board.

2. The fund’s compliance is segregated from the institution’s but the fund’s Shariah supervisory board consists of (a subset of ) the same members as the parent company.

3. The fund’s compliance is fully segregated from the institution and the fund appoints its own Shariah supervisory board.

and the fund appoints its own Shariah supervisory board. Figure 16 -- Asset management organization (own

Figure 16 -- Asset management organization (own illustration)

The organization structure outlined in figure 15 above identifies a variety of roles and responsibilities which are designed and structured in such a way as to ensure segregation of duties and appropriate corporate governance and to avoid conflict interest.

5.2.4. The Islamic Fund Market As of the end of 2009, the number of funds listed in the Eurekahedge 49 database was nearing 700 with reported assets of just under $50 billion. Taking into consideration the fact that around 20 per cent of the funds do not disclose their assets under management, the total assets is estimated to be around $70 billion. This implies an average size in assets under management of $100 million which, in comparison with the conventional fund market, is


particularly small. In comparison, the Lipper 50 database contains in excess of 200,000 funds operating globally.

Out of the funds that report their assets under management, the majority hold assets below $50 million. Only very few funds hold assets under management in excess of $ 500 million, the amount which for conventional funds is deemed to be benchmark size.

80% 70% 60% 50% 40% 30% 20% 10% 0% Below $50 million $50 million -
Below $50 million
$50 million - $ 100
$100 million - $ 500
In excess of $500

Figure 17 -- Average assets under management (own illustration)

The geographic investment mandate of the majority of shariah-compliant funds focuses on Asia, the Middle East 51 and Africa or has a global mandate.


51 Eurekahedge: There is a wide variety of asset managers operating and investing in the Middle East. They run the gamut of large international banks and independent money managers to local entrepreneurial firms that are gaining assets and attention. There is believed to be more than US$15 billion in assets in about 125 Islamic funds worldwide. The asset managers with the highest number of funds include Wellington Management Co, Pictet & Cie, Worms & CIE/SEDCO, Al Rajhi Banking & Investment and Azzad Asset Management. Some estimates place the number of funds overall in equities, structured products and real estate at more than 500, including both open and closed funds. Prominent local financial institutions in the Middle East and Southeast Asia include Dubai Islamic Bank, Global Finance House (Bahrain), National Commercial Bank (Saudi Arabia), Bank Islam Malaysia and Bahrain Islamic Bank, among many others. Asset management firms active in Shariah fields include international money managers such as Société Générale Asset Management Alternative Investment and numerous entrepreneurial asset managers in the local markets. Although the Islamic asset management market has existed for some time, progress has only really occurred in this decade, specifically with advancements in the capital markets, coupled with Middle Eastern and Asian governments updating regulation and formalising greater acceptance of a foreign presence in their countries. These changes have created a market considered ripe with opportunity, attracting multinational foreign firms. A few foreign, conventional, multinational firms that focus on the capital market side of the business have extended their participation into Shariah asset management through their firms’ money management divisions active in the capital markets or asset management. Two notable firms with Shariah-compliant asset management products are HSBC, which works through its Amanah Capital division, and UBS, which operates under Noriba Bank. Barclays wealth division launched a presence in Dubai in 2007.

Most funds have a fairly wide remit within which they invest. Few funds

have specific focus on sub-segments such as the gulf cooperation Council

(GCC), or individual countries.

40% 35% 30% 25% 20% 15% 10% 5% 0% North Global Europe Emerging Asia Pacific
Asia Pacific
Middle East
& Africa

Figure 18 Islamic Banks geographical investment strategy (own illustration)

In excess of 65 per cent of the funds listed does not specify a particular

industry, but reports all industries are in scope of the investment mandate.

Generally, the types of fund offered are similar to the ones offered in the

conventional world. The funds are divided into following broad categories:

1. Fixed income funds

2. Lease funds

3. Commodity funds

4. Equity funds

a) Private equity

b) Public equity

c) Equity index funds

5. Real state funds

6. Exchange traded funds

7. Hedge funds

Box-4 How to Invest Today According to Shariah according to Eurekahedge (2009)

How to Invest Today According to Shariah

Islamic asset management is no different than conventional asset management when it comes to constructing a portfolio that will have a high probability of achieving an investor’s goals. To do that, an investor seeking professional investments with competent