NATIONAL BANK OF PAKISTAN

ISLAMIC FINANCINGEMERGING CHALLENGES

Introduction More than three decades have passed since the first Islamic bank Mit-Ghamr began its operations in Egypt and more than ten years have passed since the Islamic Republics of Iran and Pakistan opted for an Islamic banking system. This period, particularly the last ten years has seen a surge of interest in the analytical and operational aspects of Islamic banking. Aside from the fact that a third country, Sudan, has adopted an Islamic financial system, a number of Islamic banks, financial institutions and transactions have emerged all over the world. Additionally, recognizing the market potential of Islamic finance, an increasing number of Western banks and financial institutions have begun providing portfolios, transactions and instruments that are essentially noninterest based. The feasibility and viability of non-interest based financial transactions, instruments, institutions and systems are no longer in question: neither is the legitimacy of academic research in these areas. Given that until the late l970s and early 1980s the concept and the modes of transactions that could avoid the use of interest rate as the central balancing mechanism between the supply of and demand for financial resources were virtually unacknowledged, the speed of growth of interest-free financial institutions, transactions and instruments has been impressive. Equally important has been the growth of scholarly interest in the subject. Background Diversification and structural transformation in financial sector has been accompanied by increasing integration among different segments of the financial sector. The traditional boundaries between banks and non-bank financial institutions are eroding and we are witnessing the growth of universal banking and/or mergers among different segments of sectors. This trend has its benefits but has associated risks as well. Supervisors face a dual challenge. On one hand, supervisors are promoting financial diversification and consolidation to achieve market development and innovation. On the other hand, supervisors have to position themselves to recognize the new dimensions and types of risks and encourage appropriate risk mitigation. These considerations have triggered worldwide debate on how to effectively supervise different segments of financial sector in conglomerate and universal structure. So far these debates had been concentrated around conventional banking but now it is widely gripping the world of Islamic Finance (IF). Stronger interdependencies among different segments of IF are emerging largely because Islamic Financial Institutions (IFIs), in principle, have features and inherent characteristics and more compulsion, than conventional banking, to conform to universal banking or to evolve inter-linkages among different market segments. A Brief Historical Review of Theory and Practice The last three decades of developments in the theory and practice of Islamic banking can be divided roughly into two equal periods. In the first period, the efforts of Muslim scholars were concentrated basically on raising the consciousness of Muslims regarding the issue of Riba. Thus, considerable emphasis was placed on moral, philosophical and religious arguments against the institution of Riba; economic arguments were given less prominence. On the question of substitutes for the rate of interest mechanism, most Muslim

scholars believed, that in financing individual projects, the best instrument would be profit-sharing. Much to their credit, however, they fully recognized that once there is a move from individual project financing to institutional banking, profitsharing could not be efficiently employed to perform all the functions of modem interest-based banking. Although profit-sharing has now become the pre-eminent method of Islamic banking, it is important to emphasize that, strictly speaking, the position of Shariah on the freedom of contract is flexible. It holds that any transaction subject of a contract is permissible so long as, specifically in case of financial transactions, it does not contain any element of Riba and/or Gharar. Although some debate continues on the definition of Riba, there is a strong enough consensus among Muslim scholars to have at hand a firm operational definition of this concept. Gharar can be defined as a situation when either party to a contract has information regarding some element of the subject of contract that is withheld from the other party and/or the subject of contract is something over which neither party has control. Classic examples include transactions involving birds in flight or fish not yet caught. More modern examples include transactions whose subject is not in the possession of one of the parties and there is uncertainty even about its future possession. Clearly then, types of future contracts in which one of the parties is not demonstrably in possession of the commodity is not permissible. However, a known producer of a commodity is permitted to engage in future transactions via Salaf or Salam transactions for which a spot contract is made for delivery at some future date. It follows, therefore, that it may be possible to develop a variety of non profitsharing methods of financial transactions that meet the basic requirement of Shariah; a prime and very important example is the method of al-Qard al-Hasan. Hence, if a financial system operates primarily, or even mostly, with modes that are not profit sharing but satisfy the requirements of the Shariah, the system is not rendered un-Islamic. This is a very important point, because many critics of the present practices of Islamic banks contend that much of these banks transactions, e.g. Murabahah, Installment Sales, Leasing or Salaf, are not profitsharing methods and that these transactions resemble interest-based transactions. While the latter may be true in that, for example, Installment Sales may resemble interest-based transactions, the fact is that the former is permitted by the Shariah but interest-based transactions are not, even though they may produce identical results. From an economic point of view, however, a system that operates primarily with profit-sharing mechanisms has advantages that are not obtained in a system that, although Shariah compatible, operates mostly with non-profit-sharing methods. The most important drawback of the latter type system is that it does not have, or it has not yet developed, ways and means of promoting long-term investments and has to limit itself to short-term and trade transactions. While single banks operating on this basis may not have a discernible impact on the economy, a total system operating on this basis can hamper the process of capital accumulation and, thereby, economic development and growth of the economy. While in practice not much happened in the first half of this period in so far as banking institutions were concerned, an important development was the growth of al-Qard-al-Hasan funds in Islamic countries, including Iran. These funds were basically of two kinds. The first, attached to, and/or, located in the Masajids, would collect funds from those able and, for a small administrative charge, provide interest-free loans for those who needed them. The second was much

like financial co-ops or credit unions where a fund would be set up by selling shares to members who could borrow a multiple of these shares in the form of interest-free loans. Much of the loans provided by both types of funds were used for consumption purposes. Review of Analytical Developments While the concept of profit-sharing based Islamic banking emerged clearly as the dominant substitute for interest-based banking by the end of the l970s, much of its analytical underpinnings and theoretical justification were developed in the late l980s. As Islamic resurgence gained momentum and as Muslims began to pin their hopes and aspirations on Islam to provide a third alternative to Communism and Capitalism, attention was focused on the Islamic economic system in general and banking in particular, Many saw Islamic solutions of mans economic problems as unworkable. In particular, the immediate intuitive response to elimination of fixed interest rates was that without this mechanism there would be a financial mark failure; demand for loan able funds would be infinite while its supply zero, so that a banking system without an interest rate would be neither viable nor feasible The challenge for Muslim scholars was to demonstrate that such would not be the case by building on the works of earlier Muslim scholars on profit-sharing based banking. The ongoing research in the area of finance and contract theory was of considerable importance to the understanding of how financial markets work. A very simple but crucial insight of Muslim scholars made it possible to tie in the developments modern theory of finance and Islamic banking i.e., the notion that prohibition of Riba meant elimination of all fixed-fee debt contracts and that an Islamic financial system would have to be primarily equity based. Developments in Financial Theory and Islamic Banking The period under consideration saw an explosive development regarding knowledge of financial risk, of understanding how to measure it, and how to manage it. Over this period capital asset pricing theory portfolio theory, options pricing theory, and efficient market theory developed rapidly. Almost concurrent with these theories, new instruments of market-based risk management developed, including options, futures, sophisticated mutual funds, collateralization, and derivatives. At present these are rather large markets, yet none of them existed before the l970s. Private sector entities, such as corporations and financial institutions, are now devoting considerable resources to management of financial risks. Many of these developments have increased our understanding of why people tend to prefer fixed nominal contracts. They are, therefore, relevant to the theory of Islamic banking. In this section, we review briefly some of the most important developments in modern financial theory that have direct implications for our understanding of how Islamic banking, based on profit-sharing, works. Briefly, between the late 1950s and mid-l980s four areas of research in financial theory yielded important results: a. Standard Modigliani-Miller theorem showed that under certain assumptions, the method of finance would be irrelevant to the capital structure of a firm under conditions of perfect capital market, implying that for debt financing to be preferred over equity finance other factors such as taxes or other capital market imperfections would have to play a role; b. Modern portfolio theory was developed showing the importance of risk diversification and how efficient portfolios can be constructed;

c. The concept of capital market imperfection was more precisely defined in terms of information imperfection of failures. Concepts of asymmetric information, moral hazard, and adverse selection went a long way in explaining a large number of capital market phenomena as well as behavior of capital market participants; and finally d. Modern contract theory was developed which, interalia, showed how contracts between principals and agents could be designed that would be compatible with desired results. Most importantly, this literature stressed the importance of providing incentives for agents and that any incentive structure must have managerial rewards depending significantly on firm performance, rather than on fixed payoffs. It is important to mention one more development in modern financial theory. Beginning in the late 1950s, Western economists tried to answer two fundamental questions that had not been satisfactorily addressed. These were: (1) why did banks develop and (2) why were all their operations based on fixedfee contracts? These questions were importantly, albeit indirectly, relevant to the theory of Islamic banking. The traditional explanation for the existence of banks had relied, first, on the ability of banks to intermediate between the preference of lenders for short-term liquid assets and the preference of borrowers for long-term illiquid liabilities, by transforming maturities thereby issuing claims of the kind depositors prefer and purchasing the kind of liabilities which borrowers prefer to issue. Secondly, the traditional answer argued that banks, by operating at high volumes, benefit from economies of scale that would lower their average costs incurred in gathering information on borrowers and in managing portfolios. The modern theory of finance has refined these explanations and added new ones. Briefly, it argues that in modern economies, investment depends crucially on the availability of credit. Extension of credit to any investor, in turn, is based on information. Ascertaining that an individual is creditworthy requires resources, and standing by that judgment, providing or guaranteeing credit entails risk taking. When there are information imperfections and financial markets are incomplete, particularly when secondary markets for claims issued by individuals and small companies are lacking and transaction costs are nonzero, banks emerge as financial intermediaries that specialize in gathering private information as well as the monitoring and enforcement of loan contracts. Thus, in addition to their important function of serving as social accounts, banks play a crucial role as screening devices for allocation of credit. Asymmetric information literature suggested that not only banks, as intermediaries, save on duplicated monitoring costs, but also on indirect costs of transmitting information through signals. By diversifying risks across assets, banks are able to provide signals at lower cost. These results have an important implication. The more incomplete the financial markets and the greater the information imperfection, the larger the need for banking institutions. This makes banking institutions indispensable, particularly for developing countries, including all Muslim countries, where capital markets do not exist or are very thin. The second question, of why do banks operate on a fixed-rate basis, has been much harder to explain. Not only the fixed payoff but also related questions regarding the necessity of interest rate ceilings on bank liabilities and other controls and regulations such as non-interest bearing required reserves, control on asset portfolios, entry controls and, finally, deposit insurance without

adequate response of insurance premia to asset risks, needed answers. Implicit understanding had been that without a fixed payoff and all other related controls and regulations, a highly competitive banking environment would result in risky bank asset portfolios as well as risky deposits and this state of affairs was deemed undesirable. It has not been shown; however, why in the presence of deposit insurance and required reserves, banks investing in risky assets is inherently bad. Incidentally, even the modem-day explanation, that since longterm investments are illiquid, their presence in banks asset portfolios makes bank runs more costly for everyone, does not explain why the presence of risky assets should precipitate bank runs. Additionally, it has been shown that if preferences are risk-neutral and the choice of risk level is unobservable, it would be an inefficient choice to sacrifice higher-mean asset payoffs. Consequently, if banks exist solely to save on transaction and monitoring costs in asset choice, there is no explanation of why their liability cannot or should not be all-equity. Asymmetric information literature, however explains that since debt-type contracts are reinforced by threat of bankruptcy and since fixed payout commitments diversify the risk of losses through early liquidation of illiquid assets, debt-type contracts dominate. The upshot of all these results derived by modern theory of finance is that, in a world of perfect information, ceteris paribus, there is no reason why debt-type contracts should dominate equity-type contracts. In the presence of imperfect information when the need for monitoring arises, to demonstrate the superiority of debt-type contracts one needs additional assumptions, at least, regarding the risk preference of lenders and borrowers, institutional setups and the incentive structure embedded in the relationship of principals and agents. Generally though it has been shown that efficient contracts require incentive-compatibility in order to induce agents to deliver in accordance with the terms of the contract. It has been demonstrated that efficient contracts are possible with Islamic methods. The most recent published example is a paper by Presley and Session in the May 1994 issue of the Economic Journal. By the mid 1980s economic and financial theory had demonstrated that there were disadvantages in fixed-payoff contracts that dominated interest-based banking. First, these contracts create inefficient default or non-performance incentives. To overcome this risk, fixed-payoff contracts need the additional stipulation of threat of bankruptcy, early liquidation of illiquid assets and/or collateral. Second, in the presence of asymmetric information, debt contracts suffer from adverse selection effects (i.e., beyond a certain level of interest rates, lower quality borrowers are supplied credit) and moral hazard effect (i.e., applicants undertake greater risks in reaction to the contract). These last two effects are sufficiently strong that the net return may be lowered as the banks increase the interest rates charged, therefore, market equilibrium may be characterized by credit rationing. Consequently some groups may be excluded from the credit market although the expected returns of these groups investment may be higher than those who receive credit. Equity finance, however, is free of adverse selection and moral hazard effects. Third, fixed-fee contracts create a fundamental conflict between the interests of the borrowers and those of the lenders. The borrowers consider the upper tail of the distribution of investment payoffs while the lenders are concerned about the lower tail of the distribution. In the case of equity finance the expected return to an equity investor would be exactly the same as the expected return to the project itself, thus avoiding the conflict of interest between lenders and borrowers that exists in debt-type contracts. Fourth, with fixed-fee contracts, the banks are primarily interested in safe and well-established borrowers; therefore,

new borrowers will find it difficult and/or expensive to obtain credit in order to finance their investments. Fifth, in the down-phase of an economic cycle or as a result of unforeseen shocks, interest-based banks may be forced into a liabilitymanagement mode where, in order to maintain their present deposits and attract additional depositors, they increase their deposit rates while their earnings reduce, thus leading to a banking crisis. Drawing on these findings, Muslim scholars, conceptualizing Islamic banking as one in which assets and liabilities of banks are acquired on a profit-sharing basis, derived important propositions in a relatively short span of time. Briefly, it has been shown that in such a system: (a) the real values of assets and liabilities would be equal at all points in time; (b) the prospect of instantaneous equilibrium between the asset and liability side of the banking system, means that, by necessity, there must be a close relationship between investment and deposit yields; (c) since the return to liabilities of the banking system is a direct function of the return to asset portfolio of the system and since assets are created in response to investment opportunities in the real sector of the economy, it will be the real sector that determines the rate of return to the financial sector rather than the reverse; (d) adjustment to shocks that results in banking crises and disruptions of the payments mechanism of the country is more rapid than in the conventional system; (e) there will be no disruption in the intermediation process of the banking system nor is there any reason to believe that savings and investment processes will be impaired; (f) savings and investment need not decrease and if the Shariah rules regarding contracts, including full disclosure requirements, are observed, both will increase; (g) monetary policy can be effective in stabilizing the economy (this has been shown both in closed and open economy models); (h) in an open economy context, to the extent that mobilized external resources (through profit-sharing modes) are channeled into productive investments, such investments can be expected to generate a stream of returns at least sufficient to repay the associated external liabilities; and finally, (i) again in an open economy context, there will be twoway capital flows, i.e., there is no reason to expect only capital outflows, the net results depend on the domestic relative to external rates of return. In summary, from a theoretical standpoint, there is no reason to suggest that an Islamic bank or an Islamic financial system cannot fulfill the basic tasks required of any financial intermediary or a system. Indeed, it is possible to argue that, under certain circumstances, they can do better. Operational Challenges and Prospects Both the theory of Islamic banking and the rapid expansion of Islamic banks recent years have demonstrated the viability and feasibility of non-interestbased operations. This must be surprising to those who believed that banks and financial systems could not operate in a modern economy without reliance on an interest rate mechanism. Indeed, experience has shown that Islamic banks are powerful means of mobilizing resources. Operationally, however, both the Islamic financial systems in the three countries that have adopted it as well as individual Islamic banks face challenges that need to be addressed. The most important among these challenges is the fact that, while it has been relatively easy to create a system in which deposits do not pay interest, the asset portfolios of Islamic banks do not contain sufficiently strong components that are based on profit-sharing. The main reasons for this are: (a) lack of a legal and institutional framework to facilitate appropriate contracts as well as mechanisms to enforce them; and/or (b) lack of appropriate menus containing a broad range and a variety of maturity structures of financial instruments.

Consequently, a relatively strong risk perception has become associated with profit-sharing methods in particular and Islamic banking in general. This, in turn, has led to concentration d asset portfolios of the Islamic banks in short-term and trade-related assets with inimical effects on investment and economic development. The problem is exacerbated by the fact that Muslim countries, as is the case in much of the developing world, suffer from a lack of deep and efficient capital and money markets that can provide the needed liquidity and safety for existing assets. The absence of suitable long-term instruments to support capital formation is mirrored in the lack of very short-term financial instruments to provide liquidity. a. The challenges facing individual Islamic banks Impressive as the growth record of individual Islamic banks may be, the fact is that at present, those banks have mostly served as intermediaries between the financial resources of Muslims and major commercial banks in the West. In this context, this has been a one-way relationship, so far. There is still no major Islamic bank that has been able to develop ways and means of intermediating between Western financial resources and the demand for them in Muslim countries. It also appears that individual Islamic banks face difficulties in fund placement because they have had a major bias towards short-term, secured, low-return but liquid investments. The challenge for these institutions stems from motivational and technical factors. Motivationally, their basic aim appears to have been that of demonstrating the viability of Islamic banking without taking too many risks. Admittedly, this is a noble and a very important objective, however, although they have succeeded in this effort and have managed to create a market niche for Islamic banking, they do not seem to have achieved the market depth that could ensure long-term profitability and survival. This stems from the fact that they appear to be far behind in technical innovations and financial market developments that in recent years have revolutionized finance and capital markets. There is no evidence that these banks have made any large investment in research and product development, nor is there any evidence that new financial products developed in recent years, particularly in equity derivatives, have been utilized to any significant degree by the major Islamic banks. This is unfortunate because the market opportunities that these banks have been able to develop, to allow funds from Islamic communities to be placed in Islamically permissible portfolios, can and will be exploited by more efficient and innovative Western financial institutions that already have or will discover this market niche. While there is considerable room for competition and expansion in this field, the long-term survivability of individual Islamic banks will depend on how rapidly, aggressively, and effectively they can develop techniques and instruments that would allow them to carry on a two-way intermediation function. They need to find ways and means of developing marketable Shariah-based instruments by which asset portfolios generated in Muslim countries can be marketed in the West as well as marketing Shariah-based Western portfolios in Muslim communities. b. The challenge of adopting an Islamic financial system The most important challenge for Islamic banking is in its system-wide implementation. At present, many Islamic countries suffer from financial disequilibria that frustrate attempts at wholesale adoption of Islamic banking. Financial imbalances in the fiscal, monetary and external sector of these

economies cannot provide fertile ground for efficient operation of Islamic banking. Major structural adjustments particularly in fiscal and monetary areas are needed to provide Islamic banking with a level playing field. Additionally, adoption of a legal framework of property ownership and Contracts that would clearly specify the domain of private and public property rights as well as stipulation of legally enforceable rights of parties to contract that fully reflect the requirements of the Shariah, are necessary to allow an operational framework conducive to efficient operation of Islamic banking. An Islamic financial system can be said to operate efficiently if, as a result of its adoption, rates of return in the financial sector correspond to those in the real sector. In many Islamic countries fiscal deficits are financed through the banking system. To lower the costs of this financing, the financial system is repressed by artificially maintaining limits on bank rates. Thus, financial repression is a form of taxation that provides governments with substantial revenues. To remove this burden, government expenditures have to be lowered and/or revenues raised. Massive involvement of governments in the economy makes it difficult for them to reduce their expenditures. Raising taxes is politically difficult. Thus, imposing controls on domestic financial markets becomes a relatively easy form of raising revenues. Under the above circumstances, it is understandable why governments would have to impose severe constraints on private financial operations that can provide higher returns to their shareholders and/or depositors. This makes it very difficult for Islamic banks and other financial institutions to realize fully their potential. For example, Mudarabah companies that can provide higher returns than the banking system would end up in direct competition with the banking system for deposits that are used for bank financing of fiscal deficits. While Muslim countries may, for legitimate reasons, opt for an Islamic financial system, for the economy as a whole to benefit fully from the operations of such a system, it is necessary that (a) government expenditures are fully rationalized, (b) revenues from taxation, and those derived from property legitimately placed within the government domain by the Shariah, are raised to meet the expenditure needs the government, (c) the financial sector is liberalized so that returns to this sector reflect returns to the real economy, (d) equity markets are developed to allow financing of investment projects outside banking institutions, and, finally, (e) the structure of the banking system should be such as to allow strong banking supervision and prudential regulation commensurate with the risks involved in various transactions.* To accomplish the last objective, the banking structure can be tiered in accordance with principal Islamic financial transactions. It is reasonable to assume that risks involved in Musharakah or Mudarabah financing, are different from those involved in trade-type financing. It follows, therefore, that prudential regulations of these transactions should be different. Supervisory Challenges posed by Cross-sector Developments It is some of these above considerations that have augmented strategic alliances and linkages of various types among IFIs, both within country and cross borders. As such, IFIs are evolving either as part of a global financial concern or as a domestic bank acquiring or establishing subsidiaries and/or the two arms, i.e. Islamic and conventional banks coexist. Moreover, as the conventional parts of financial institutions move towards crosssector integration, their Islamic counterparts (either as specialized window or as independent entities) will also follow eventually.

While it has by now been well established that there are significant benefits of enhanced integration and inter-linkages or conglomeration in IF, such as the economies of scale, operational synergies and effective use of scarce human resource, there are definitely certain risks.1 In this area, I would like to offer few basic observations. Firstly, it is inevitable that enhanced exposure of Islamic banks into capital markets exposes them to the volatility in associated businesses. Likewise, conglomeration, whether through universal banking or through parent subsidiary model,2 exposes them to a variety of issues such as contagion risk, regulatory arbitrage, high group exposures, conflict of interest etc. These risks apply equally to both Islamic and conventional modes of finance. However, Islamic banks have thus far not erected firewalls, like conventional banks, to separate legally, financially and managerially their investment and commercial banking activities. Obviously these risks pose a challenge to the supervisors and necessitate that appropriate changes be made in the supervisory regime. Secondly, Shariah compliance issues necessitate taking a more aligned view across IF businesses as user of Islamic products may be oblivious of ideological differences as well as varying perceptions and interpretation of the Shariah advisors or boards and/or by regulators. Since institutions being supervised by one regulatory authority may be offering products of institutions being supervised by a different regulatory body, this could introduce complications and the challenge of ensuring uniform Shariah compliance across financial institutions and products. Thirdly, traditionally different segments have been regulated by their specialized supervisory authorities. These authorities have adopted risk management principles and supervisory stances which are strictly in line with the risk profile of supervised sectors in isolation. With sector integration, supervisors have to coordinate closely in policy formulation and regulation as well as on-site supervision. They have to coordinate creation of necessary firewalls, remove moral hazards and govern the degree of cross segment exposure. This may even call for institutional restructuring through merging various supervisory bodies into a single entity or for closer coordination between supervisors through creation of a third coordinating body. Factors Driving Cross-sector Linkages and Interdependencies First and foremost, IFIs depositors/borrowers desire to conduct financial transactions that are Shariah compliant. It can be assumed that a person preferring to bank with an Islamic bank will also seek to use other faith-based financial services such as Takaful and Islamic mutual funds. This faith-driven feature in itself forces and incentivizes IFIs to offer, alongside bank-based services (i.e. deposit and loans), a wide range of financial services. As a result, Islamic banks end up undertaking non-core banking activities such as fund management, capital market operations, securitization, leasing, and housing finance. This has enhanced the degree of integration between various segments of IF. For example: Islamic banks are likely to be strongly integrated with the Shariah capital markets since on credit portfolio side, Islamic banks do not have the same investment avenues as those available to their conventional counterparts. The outcome is that Islamic banks either end up taking large

exposure in the capital markets directly or acquire subsidiaries which primarily engage in such businesses. Second differentiating aspect is the nature of contractual arrangements that drive deposits mobilized by conventional banks as compared to Islamic banks. Conventional bank deposits are interest based contracts with guaranteed interest return whereas Islamic banks raise deposit on a profit and loss sharing basis in either a Mudaraba or Musharaka structure. Mudaraba/Musharaka contracts transform the Islamic banks deposits into essentially a fund management product (although currently most regulators recognize these as equivalent to conventional deposit contracts) and this impacts the corresponding asset portfolio. There is a need therefore that Islamic banks acquire assets on a PLS basis as well and eventually move beyond fixed return products, like Murabaha and Ijara. This pushes an Islamic bank towards universal banking since in order to manage the portfolio profitability; it needs to invest across sectors in businesses based on Shariah principles, like equity and Sukuks in the capital market and trade contracts like commodity Murabaha, Musharaka, Ijara and Takaful. Thirdly, further development of Islamic banking itself depends on concurrent development of Islamic capital market. For instance, development of Islamic debt market is key to the provision of adequate liquidity support while providing additional investment avenues. Likewise, Takaful development is critical to provide insurance coverage to Islamic banking products, like auto and consumer financing, while strengthening secondary capital and Islamic bond markets by being a major buyer of Islamic instruments. It is the confluence of these factors that have induced regulators to encourage and IFs to promote rapid and deeper financial inter-linkages and integration. Rising oil prices also results in massive accumulation of wealth and an increasing awareness for investment diversification. A survey conducted by the Economist Intelligence Unit found that 59% of the surveyed Middle East financial service professionals expected a significant rise in Islamic finance products in the next three years Over 20% expected the Asia Pacific region to attract the largest portion of equity investment among their clients S&P estimates the current size of global Shariah compliant assets to be worth US$400 billion, roughly 10% of the OIC nations GDP Total market potential is also estimated to be around US$4 trillion. With global Islamic finance industry estimated to be worth US$1 trillion, these figures suggest that the growth of the Islamic finance industry has not been fast enough to match the increase in Islamic wealth Challenges and opportunities for Islamic capital markets in Asia

Strengthening financial market integration in Asia This can be achieved by:

Development of Islamic finance is not a zero-sum game. Asian players together can benefit from greater efficiency, diversity and stability of a more integrated capital market in our region Promoting financial integration in Asia, in the context of Islamic capital markets in particular, is challenging Also provides a strong catalyst for change and growth to leapfrog developments in conventional capital markets in Asia

 Promoting links between jurisdictions across the whole spectrum of

financial infrastructure trading, payment, clearing, settlement and custodian systems Reducing uncertainties and risks in cross-border financial transactions is conducive to market development Hong Kong and Malaysia has strengthened financial infrastructure links PvP and DvP to facilitate cross border financial transactions Relaxation of non-supervisory restrictions to remove unnecessary hurdles to the development of Islamic finance in the region Mutual recognition agreements signed between Malaysia Securities Commission and Dubai Financial Services Authority (DFSA) for fund marketing and distribution Framework of co-operation already established between Hong Kong and the Dubai International Financial Centre (DIFC) to look at market facilitation measures Harmonization of standards needed on practical and operational perspectives Regulatory harmonization also needs to be addressed as different countries adopt difference approaches in defining the standards for Shariah-compliant products in determining, for example, the granting of tax neutrality treatment Hong Kong is reviewing its tax law to provide tax neutrality to Islamic financial transactions having regard to overseas market experience strengthening of dialogues and stepping up regional cooperation can expose regulators to developments elsewhere Create an environment conducive to a higher degree of regulatory harmonization Strong commitment by HKMA to these efforts it has become an associate member of the IFSB Greater capital mobility is a necessary condition for financial integration Relaxation of controls on cross-border transactions can drive more efficient allocation of resources Ultimately conducive to the development of larger capital market with greater breadth and depth Growth in Islamic finance in the recent decade is enormous, but the talent pool is still relatively small to meet the global needs Need to nurture a larger pool of talent with expertise in Islamic finance In Hong Kong, local industry bodies such as the Accounting Association and the Treasury Markets Association can play a significant role

Performance:
Islamic banks have withstood the recent turmoil in the global banking industry triggered by the subprime mortgage crisis because their rules do not allow dealings in products like derivatives, options or papers that caused the

meltdown. At least thats what I keep reading in the media. And its a fair point. If the credit crunch was essentially caused by gambling and inadequate regulation, then surely a system in which gambling is banned, where everything must be backed by tangible assets, should be cleaning up in its aftermath. In this era of scarred savers and investors, why is everyone not moving their money over to this lowrisk system? Well, a lot of us are. And not just Muslims either. Even the Pope agrees. One of the most important points about Islamic banking is that, even if global banking assets continued to tank for the next five, ten, fifteen years, Islamic banks could keep on growing because they still account for such a small proportion of the market.

By way of example, in Bahrain, a Muslim state and global pioneer of Islamic finance for several years, sharia-compliant banks account for 10% of total assets. In Indonesia, Islamic banks assets have grown by around 35% on average between 2004 and 2008. Now accounting for a still fairly meagre 2.2% of total commercial banks assets, the central bank estimates that this figure will growth to 15% by 2015. This rate of growth makes sense, not only for the reasons outlined above, but also due to the sheer number of Muslims who would prefer not to be committing a sin every time they pay into their bank accounts. Anecdotal evidence suggests that most Muslims would choose sharia-compliant banking if they believed these services to be of equal financial benefit at no additional cost, which makes for a huge potential market. But have Islamic banks managed risk better than their conventional counterparts? Its true, we havent seen any solvency problems with any Islamic financial institution, we havent seen any go under and we havent seen worried customers queuing round the corner demanding to get their money out. Come to think of it, though, we havent seen those scenes anywhere in the Middle East or

Asia, where Islamic banks are concentrated. Looking at balance sheets as well, Islamic banks do look well capitalised. But then again, so do their non-Islamic competitors in the same markets.

Saudi Arabia - Q209 Provisions For Loan Losses (SARmn) Theres also an argument that the rigidity of the regulation in fact restricts banks ability to diversify risk. One of the problems that has affected both Islamic and conventional banks in the Middle East is exposure to the declining real estate market. Because sukuk and other sharia-compliant instruments have to be backed by tangible assets (as opposed to representing money as a commodity in itself), and many of the projects in the Middle East have been real estate-focused, this affected conventional banks as well. However, by their very nature, Islamic banks are unable to diversify risks as well as conventional banks because there are less investment avenues open to them. By and large, Islamic banking has worked reasonably well, given its short history, but it does face challenges. Nearly all of these challenges are, however, technical in nature and can be met given that sufficient resources can be committed to this task. For instance, developing a suitable menu of Shariah-compatible financial instruments is a technical problem that can and will be solved. There is no reason to believe that financial engineering cannot span the existing menu of assets to create a much larger variety of instruments of different maturity structures to serve the needs of the market. The rapid growth of emerging equity markets in developing countries is a very hopeful sign that, with strong commitment in the next decade much of hit existing institutional and technical bottlenecks that may have hampered mote efficient operation of Islamic banking will be removed. The most serious challenge to Islamic banking, however, is in its system implementation Without a sizeable effort at structural reform and adjustment that provide Islamic banking with suitable grounds for efficient operation, its wholesale adoption as the cornerstone of the financial system will face difficulty that will detract from its efficacy as an alternative system.

Distortions introduced into the economy by, inter alia, massive government intervention and controls, an inefficient and weak tax system, financial repression, lack of capital markets, unavailability of a well-targeted and efficient social safety net, lack of a strong supervisory and prudential regulatory framework in the financial system and, finally, the deficiency of a legal and institutional framework that provides Shariah-based definitions of property rights as well as the rights of the parties to contracts, does allow the efficient operation of an Islamic financial system. These distortions need to be removed from the economy to minimize waste and promote efficient resource allocation. Their removal prior to or in conjunction with the adoption of Islamic banking can be expected to create the dynamics necessary for non-inflationary and sustainable economic growth. These distortions by increasing the risks to price stability also increase the risk of contracts that do not promise a fixed nominal payoff. While Islamic moods of transaction shift more risks to the investor, the risk environment has to be such that the investor can count on credible government policies that would maintain stable prices. If we have learned anything since the break down of the Bretton Woods systems, it is that the choice of a monetary and fiscal system determines the types of risks and uncertainties that the society bears. Individuals reduce the cost of risks and uncertainties associated with a given monetary or fiscal regime by refusing to share in the risks of projects and opt instead for safe, rather than risky, assets with fixed nominal payoffs, rather than payoffs that are outcomedependent. It is unreasonable to assume that if provided with two instruments with similar risk characteristics but one with higher expected payoff, as is the case with Islamic instruments; people would prefer the one with the lower payoff. The problem is that in many Muslim countries people have to be concerned not only with the risks of the financial transaction itself but with price stability affected by a plethora government-induced distortions and inefficiencies. If in addition to the risks of the investment projects, the investor has to be concerned with the credibility of government policies, or arbitrary government decisions or distortions that threaten long-term price stability in the economy, he/she will be reluctant to invest in contracts that do not provide fixed nominal payoffs. * It is not an accident that, at present, Islamic banking is making its most promising progress in Malaysia. This country has one of the least repressive financial systems, no fiscal deficits, low inflation, low interest rates, and a dynamic and vibrant equity market as well as a strong private sector.

In Malaysia there is strong inherent demand for Islamic products and the country has rapidly developed as a centre for Islamic finance. Perhaps most importantly, the government has provided institutional support, particularly through Bank Negara Malaysia (the central bank) but also through favourable legislation and tax treatment, for Islamic products. Middle Eastern financial houses have recognised this, and hence have entered the Malaysian market either directly or through partnerships and joint ventures. Malaysia is also correctly perceived as a gateway to other Asian markets. Significantly too, Shariah-compliant financial products are now seen as competitive alternatives for non-Islamic people, who will happily buy them if they prefer the returns or their risk profiles compared with conventional products. Islamic finance is in the mainstream in Malaysia and is likely to become so elsewhere in the world even Europe. Product

standardisation will come through time, not by edict but through a wide acceptance of a particular norm. But, actually, the current conditions also offer the potential to take advantage of new opportunities and provide new products. With so much uncertainty, investors are seeking alternative havens for their capital, while depressed asset values of all kinds means there is a chance to build portfolios from a reasonable cost base. For instance, Islamic art funds are becoming popular. An essential role for us is to monitor the Shariah-compliance of funds which are advertising and marketing themselves to Islamic customers. Integrity and credibility is all important. Conclusion Islamic banking remained least affected by the global financial crisis. It experienced some problems only after this crisis had snowballed into a recession in developed economies affecting growth prospects of Pakistan and other developing countries. But the industry has almost overcome these problems and now most of its indicators are showing a reversion towards the usual high growth trend, according to the latest State Bank report. The share of the assets of Islamic banking in overall banking industry grew from 3.4 in June 2007 to 5.1 per cent in June 2009: In terms of value, these assets increased 97 per centfrom Rs159 billion to Rs313 billion. Total deposits jumped 120 per centfrom Rs108 billion or 3.1 per cent of the banking industry to Rs238 billion or 5.2 per cent. And the total financing and investment rose from Rs90 billion to Rs195 billion showing a handsome growth of about 117 per cent. In the last two years, the share of financing and investment of Islamic banks in overall banking industry went up from 2.6 to 4.2 per cent. Three things have apparently helped in this phenomenal growth. First, it had a narrow base in June 2007, says the head of a large local Islamic bank. Second, Islamic banking has a mass appeal. And third, it has some inbuilt characteristics that offer a better cushion against man-made crises. That the unique features of Islamic financing do protect banks from the elements of man-made crises is all but evident: Total assets of top 100 Islamic banks grew more than 66 per cent to $580 billion in 2008 from $350 billion in 2007. In contrast, the asset of top 100 commercial banks in Asia (the region that was not in the centre of the financial crisis) posted only 13.4 per cent growth. And according to reports in international media, global Islamic banking is set to grow up to 30 per cent in 2009 as well. What has boosted the reputation of Islamic banks as the institutions that can shield their clients against crises is their conservative approach to business, a balanced and ordered appetite for growth, a more equitable risk sharing and focus on the basics of banking as opposed to rapid innovation. All these factors, which used to be perceived as weaknesses before the credit

crisis began, are now being used as shields against the potential damages of imported stress, says a Moodys report adding that in the short-term, in times of crisis, clients may find it more comfortable doing business with an Islamic bank. In Pakistan, clients have really begun to find it comfortable doing business with Islamic banks as is evident from the growing numbers of the Islamic banking branches across the country. In June 2007 there were 162 bank branches providing Islamic banking. These included the branches of six fully-fledged Islamic banks as well as those of the conventional banks. In June 2009, the number of Islamic banks shot up to 18 and the number of total bank branches providing Islamic banking more than tripled to 528. Islamic banking facilities are available in almost all parts of the country and they have a strong presence in Karachithe hub of commercial banking. Besides, Islamic banking offers a wide range of products for both depositors and borrowers. The availability of suitable modes of financing has attracted corporates as well as consumers towards Islamic banks. These banks have also been able to attract deposits of various types and from different classes of bank clients. Lately, Islamic banks expanded their corporate clientele also because conventional banks became a bit averse to lending to the private sector after their non-performing loans (NPLs) went up. A conservative approach to banking has also kept consumer loans portfolio more stable than that of the conventional banks. And Islamic banks have a better mix of fixed and saving accounts than the conventional banks. This is primarily because it is possible for Islamic banks to design fixed deposits schemes without the element of Riba. Despite all these plus points of Islamic banking it did not entirely escape the after-effects of the global financial crisis and recession. The pre-tax profit of the industry declined about 18 per cent in the last fiscal year. But here again the rate of decline was lower than in case of conventional banks that saw their earnings fall by 31 per cent during this period. Officials of Islamic banks, however, point out that profitability of Islamic banking has picked up from April-June 2009 quarter wherein its pre-tax profit showed an increase of more than 150 per cent. They hope that the trend would continue as the economy is showing signs of improving after posting a growth of just two per cent in the last fiscal year. In case of Islamic banks, it is the domestic economic slowdown that directly affects them. Islamic bankers say that Islamic banking would grow faster in future once they are able to penetrate into so far unexplored areas of agricultural financing and increase their portfolio of SMEs financing. Till June 2009, the industry had very negligible exposure to agricultural financing and the share of SMEs in overall financing was a mere 8.6 per cent. Islamic bankers admit that despite a rapid expansion of Islamic banking branches, rural areas are still least-served by them. Wherever Islamic banking

outlets operate, they focus on consumer financing rather than on agriculture loaning. The State Bank has issued guidelines for agricultural financing by Islamic banks and they have made a modest Rs100 million agricultural financing, for the first time, in April-June 2009. Islamic banks are drawing strategies to tap this area of financing keeping in view the thorniest issue of recovery of loans.

REFERENCES: Islamic banking, a hedge against man-made crisis by Mohiuddin Aazim FinanceAsia.com, by Rupert Walker , 26.02.2009 http://www.financeislam.com, Progress and Challenges of Islamic Banking, International Monetary Fund, 1997, By Dr Abbas Mirakhor http://blog.finetik.com/category/countries/ Daily DAWN