Theology Thursdays: Answering to a Higher Authority by Ahmed Namatalla

If 1400 years of Islamic history have failed in convincing non-believers, a new reality worth at least $200 billion is leaving many with little choice but to believe. No, not mass conversion to Islam, at least not yet: Islamic finance. Aside from the massive investments involved, some of the largest international financial institutions have jumped into the market here and abroad with little on which to base their beliefs — no uniform standards, no industry-wide recognition of a regulatory or governing body, and just a handful of specialized teaching institutions. In relative terms, most analysts agree Islamic finance is underdeveloped and unregulated.

That hasn’t deterred corporations such as Citigroup, HSBC, Deutsche Bank, Société Generale and BNP Paribas from betting that money flowing into the sector from the faithful will eventually force the system to develop: Each has established an Islamic banking subsidiary.

Islamic finance no longer belongs only to Muslims, who pioneered the first experimental banks in Pakistan in the 1950s, here in Egypt in the 1960s and in the Gulf in the 1970s. Despite a late start, with Bahrain-based Citi Islamic entering the scene only in 1996, subsidiaries of large Western financial institutions have in some cases grown well beyond their Arab competitors.

But how does a banking concept that forbids the accumulation or charging of interest in any of its financial transactions make such headway just 30 years after the establishment of its first official institution? And how does an investment concept that prohibits buying into companies that engage in Shariah-violating activities — such as trading in alcohol or tobacco, running hotel gambling casinos or producing ‘immoral’ films and other entertainment products — survive, considering the stringency of the rules and the relative rarity of companies that abide by all of them?

While the answers used to be found in a few regional banking options such as Al-Baraka of Bahrain, Dubai Islamic Bank and Faisal Islamic Bank of Egypt (FIBE), more than 200 institutions now offer Islamic banking services, insurance and equity funds in almost 50 countries, according to the London-based Institute of Islamic Banking and Insurance. On the investment front, most major indices have established Islamic indices.

The Dow Jones Global Indexes family, for example, has created 46 specialized Islamic indices to provide investors with companies approved by its six-member Shariah board. The broad-based Dow Jones Islamic Market Index (DJIMI) lists 1,760 companies from around the world; the seven others include the Down Jones Islamic Market Technology Index, the Islamic Market US Index and the DJ Islamic Market Extra Liquid Index. As Dow Jones declares: “Markets Fluctuate Principles Don’t.”

Profits, apparently, do: At press time, the broad-based DJIMI was up 11.75% in the past 12 months against just 4.4% for the Down Jones Industrial Average.

In all, Shariah-compliant investments worldwide totaled somewhere between $200 and $500 billion at the end of 2004, according to the Financial Services Authority of Britain, with an annual growth rate of about 15% per year.

But critics of such figures, including Safdar Mandviwala, director of HSBC’s Islamic subsidiary Amanah, contend that the wide gap in estimates indicates a lack of serious studies of the actual size of the sector globally; accurate numbers might be much higher if specialized evaluative institutions existed.

In Egypt, three players dominate the field: FIBE, Egyptian-Saudi Finance Bank, and Islamic International Bank for Investment and Development (IIBID). The last of that group is expected to be sold or forcibly merged in the coming months after years of struggling with high debt and, more recently, failing to increase its paid-in capital of LE 350 million to the Central Bank of Egypt’s new minimum of LE 500 million under capital adequacy requirements that came into effect this past summer.

According to a leading industry analyst, even FIBE has declined to bid for it, citing the severity of its debt problems.

Mohammed Abdel Halim, director of Al-Azhar University’s Saleh Kamel Center for Islamic Finance, says the expected folding of IIBID, coupled with the reluctance of the Central Bank to allow existing Islamic banks to expand, signals sharp setbacks for the local sector.

“You can see the popularity of Islamic banking in the crowds waiting in the lobbies of these banks,” says Abdel Halim. “Faisal Bank has been complaining for years about high volumes, but the Central Bank will not allow it to open new branches. If you’re a customer at Faisal, you can expect to wait from one to two hours now just to make a deposit.”

Ismail Hassan, chairman of Misr Iran Development Bank and the former governor of the CBE (1993–01), denies the allegation that the Central Bank is impeding the growth of Faisal Islamic or the sector as a whole. The reasons behind slow development are more natural than they are imposed by the Central Bank, he says.

“We have to remember that Islamic banking is a relatively new concept,” he says. “The oldest Islamic bank is 30 years old. So the industry’s advancement and development has to be measured relative to its age.”

Farid Mansour, a member of the board of trustees of the Bahrain-based Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) and chairman of Mansour & Co. PricewaterhouseCoopers, a leading Egyptian accounting firm, agrees, but says Central Bank policy is driven by political factors that have held the country’s Islamic banking sector much further behind its counterparts in the Gulf, Southeast Asia and even Europe.

“The government is wary of any financial institution that has any sort of association with the word ‘Islamic’ because of the connotation that it implies,” says Mansour. “Egypt has been left behind [in Islamic banking]. There’s very little lending, very little borrowing, and there’s very little capital accumulation of the size that makes it attractive for any bank to attract [large] capital sums and give a return on a Shariah basis.”

Established in Manama, Bahrain, in 1991, Mansour’s organization is widely considered the most powerful authority in setting standards regarding accounting, auditing, governance and Shariah compliance in Islamic finance. Now boasting the membership of 93 institutions in 23 countries, including all three Egyptian Islamic banks, AAOIFI draws its credibility from the diversity of its Shariah and financial scholars — and from the fact that it was established as a non-profit organization by regional Islamic banks for the purpose of codifying uniform standards.

Defining Islamic finance

Despite a glaring lack of uniform standards and regulatory institutions, one principle upon which all Islamic banks agree is the Qur’anic prohibition of usury. Even before the establishment of official Islamic financial institutions, the vast majority of Islamic scholars have declared riba, or usury, synonymous with interest.

But in 2002, a controversial fatwa issued by Al-Azhar’s Islamic Research Center (IRC, or Mugama Al-Bohuth), reversed the widely accepted prohibition on interest and differentiated between that concept and riba. The decision recognized that money loses value over time, which justifies returning a sum higher than that borrowed, and made a clear distinction between usury and accepting the concept of interest as a profit-sharing tool. The declaration, which had been supported by Grand Sheikh Muhammad Sayid Tantawy as early as 1989, seven years before he was appointed to his current post, drew the protests of Islamic scholars worldwide.

Today, most scholars have agreed on the prohibition of interest, although a minority has deemed it permissible, says Abdel Halim.

“The basic idea is there is always risk involved in business,” says Abdel Halim. “Conventional banks try to eliminate that factor for the depositor using a fixed or variable interest rate.”

That process, he says, is haram and unfair to the banks because deposits are considered loans, which are paid back with a markup regardless of whether the bank profited from investing those deposits. Moreover, he says, conventional banks are unfair in their dealings with investors because they do not share in their losses. That’s why Islamic banks operate on a profit-sharing basis in commercial dealings concerning borrowing and lending. These agreements usually revolve around one of two concepts: mudaraba and musharaka. (See glossary for brief definitions of these and other Islamic finance terms.)

According to HC Securities Brokerage’s definitions of the terms, in the case of mudaraba, the borrowing party, whether it is the bank or the customer, that intends to invest the sum lent from the capital provider is referred to as the mudarib. The arrangement allows the mudarib to invest the money in any Shariah-compliant activity or business, and profits are then divided according to a pre-determined agreement — real estate is by far the most common investment.

Any losses, however, are the sole responsibility of the capital provider.

In a case where the customer acts as the mudarib and the bank as the capital provider, the provider should, in theory, be solely responsible for all losses of a project under a mudaraba contract. But in such cases, Islamic banks will often seize assets related to the project from the client because “they have to guarantee their money is not lost,” according to HC Brokerage Banking Analyst Ahmed El-Ashram.

When the client acts as the capital provider and the bank as the mudarib, as in a deposit account, the bank pools all deposit assets to permit a diversified investment strategy. Any profits are shared in proportion to the investor’s contribution.Naturally, acting as a borrowing and lending institution, a bank simultaneously assumes the roles of mudarib and capital provider depending on the transaction. This arrangement, says Abdel Halim, puts pressure on the bank to research projects thoroughly before investing its clients’ money.

As for musharaka, the borrowing and lending parties enter a partnership in which plans for a client’s specific project are laid out, and profits, losses and even management are divided based on a pre-determined agreement. Should the project suffer a loss, that loss is shared in proportion to the capital participation ratio. Musharaka is essentially a less risky and more closely tied relationship between client and bank than mudaraba, although there is ample room in negotiation for the parties to agree upon their respective roles.

If both arrangements sound rather close to conventional banking, it’s because they are, says Abdel Halim. The only difference, and the driving factor behind the assumption that the lending party will always do its homework in research, is the fact that no fixed interest rate plays the role of minimizing or eliminating the risk for either side. Interest is not allowed to act as a ceiling on profits, so both sides can be expected to maximize their efforts to ensure the success of the investment, he says.

In other words: Because my success is directly tied to yours, I’ll do whatever I can to help you succeed. My profit comes from yours — not from interest on a loan you’re paying regardless of whether you’re in the red or in the black.

Other Islamic banking products that have been developed and marketed over the years include ijara wa iqtin, a simple lease-to-purchase agreement that differs from the traditional version in that it requires the leased commodity to be used in a Shariah-compliant manner, sukuk al-ijara and sukuk al-murabaha, both of which are bonds issued by the bank and backed by leased or sold assets.

But perhaps the most popular and prevalent product globally and in the Egyptian market is murabaha. Often used by individuals to finance real estate, automobiles and household appliances, the transaction involves the bank making the purchase for the client, then selling it to the client at a pre-determined markup. According to Abdel Halim, Shariah allows for the markup to increase gradually the longer it takes for the client to pay for the purchase.

Critics argue that, in essence, murabaha is no different from interest, except that it goes one step further in calculating the final cost instead of assigning a fixed or floating rate of interest for the bank on the purchase.

Although the markups Islamic banks charge vary widely because of a lack of standards, El-Ashram says that an average murahaba agreement sells commodities, such as cars and building materials, to clients with about a 20% hike on a two-to-three year agreement. How does that compare to borrowing from the bank? Lets say you want a car worth LE 80,000 at the CBE’s current prime lending rate of 11.0%. With a three-year repayment term, you’ll pay LE 94,287.49, or about 17.9% more than if you bought it outright in cash.

The opposition

Tarek El-Diwany, a London-based economist and editor of islamic-finance.com, is a leading voice against the current state of Islamic financial institutions. He has campaigned for years against the sector’s reliance on fixed returns, which he claims are identical to the conventional banking practice of collecting and paying interest.

In a widely circulated 2000 article titled “Islamic Banking Isn’t Islamic,” El-Diwany summarized the criticisms of a growing number of economists who saw virtually no difference between the Islamic banking model and that of traditional banking.

“Today, Islamic commercial banks indulge in money creation just as much as conventional commercial banks,” writes El-Diwany, who once served as the head of Islamic finance at Prebon Yamane, a major London financial services group. “This single sin is sufficient on its own to conclude that Islamic banking isn’t Islamic it is a sin that requires interest-based lending in order to make it profitable. Though Islamic bankers may not realize it, the business model of interest-based banking is forced upon them and it is putting true profit-sharing beyond their reach.”

True Islamic banking, according to El-Diwany, who is also a senior partner of the financial consultancy Zest Advisory, would involve the even exchange of money in lending and borrowing transactions and proportional profit and risk-sharing in all investment transactions, which would require the complete transformation of the global economic system.

That transformation, though, is far from becoming a reality, considering the money behind international financial institutions, he says in a phone interview from London.

“You have a banking system across the world which is making around $2 trillion in profit every year,” says El-Diwany. “That’s a very powerful lobby, and that lobby does not want things to change so it can continue to make its profits. So, if Islamic banking comes along and proposes change, you are going to have $2 trillion stand up and fiercely oppose it.”

If nothing else, though, perhaps one Islamic banking product qualifies under those rules: a simple current account treated as a wadiah left by the client. This product is offered by all Islamic banking institutions and allows the depositor to leave funds at the bank to be drawn at any time with no interest accumulation, although, in some cases, account maintenance fees are applied.

Mansour does not go as far as El-Diwany in condemning the entire business, but he expresses concern that the lack of regulation has been the cause of inconsistencies that have led many to distrust existing Islamic financial institutions.

“One of the weaknesses that has already existed is that we had no rules, which is a typical Middle Eastern attitude that everybody sees in himself that he has the wisdom to be able to issue a fatwa on a matter that is regulated by the Holy Book,” says Mansour. “I am supporting the trend to say that these are the rules, to say that it is no longer left up to a group of people or an individual to issue a fatwa as he feels [inclined].

“Even the Mufti of Egypt at one stage said that interest is ‘halal,’ or reasonable, and then said it’s not halal. This is the same man saying different things at different times depending on circumstances. This is not right.”

The organizational structure

In 1975, the Dubai Islamic Bank was the first and only official institution of its kind. The next eight years would see similar banks sprout in nearly every Arab country, with Faisal Islamic as Egypt’s first venture in 1978.

Still, little consensus has been reached in 30 years within the industry on setting uniform standards. The reason, says Mansour, is that each bank simply hires a Shariah board made up of Islamic scholars who are given the authority to issue fatwas regarding the Shariah-compliance of the products and services offered by their respective institutions.

Conflicting edicts have, over the years, created tremendous differences in the dealings of different banks, leading many to question the legitimacy of the sector as a whole, he explains. In addition, no consensus has been reached on the proper place for Shariah boards. While in some banks they are placed above the board of directors, other institutions place them below and still others grant them complete independence.

That’s where Mansour and his group come in.

“[Shariah boards] are made up of a bunch of mullahs who are very familiar with the religious requirements, but they have, I think, very little understanding of the intricate financial transactions that people like UBS and HSBC are familiar with,” says Mansour. “So we [in AAOIFI] are trying to bridge that gap by setting standards. And these standards are set by people from all over the world In the end, you should, as an investor, a borrower, a bank, or a financial institution, feel confident that if these rules are applied, that you are in accordance with Shariah rules.”

Today, Islamic banks rely on the reputations of members of their Shariah boards to market their products as Shariah-compliant. But with some board members commanding annual salaries of as much as $80,000, critics such as El-Diwany question the role of money in their decision-making processes. Although he says he respects scholars that serve on Shariah boards as competent individuals who issue sincere fatwas, he says the problem with the boards occurs on a much more fundamental level.

“The problem is [Sharia boards] are chosen and paid by the bank,” says El-Diwany, “and the bank is not going to choose a scholar who’s going to say its products are haram.”

In recent years, Mansour has lobbied heavily to have banks adopt AAOIFI’s practices and accounting standards, and while the AAOIFI has failed to convince the industry’s institutions to abandon their Shariah boards, the organization has succeeded in getting a few banks, including HSBC Amanah, to adopt its texts for use by their Shariah boards and employees.

But as long as Islamic financial institutions continue to offer competitive rates of return on their investments relative to their conventional competitors, Mansour is pessimistic about the chances of customers demanding that their banks standardize their practices according to a single authority. He says that most investors in Islamic banks care more about profit than complying with the teachings of Islam. The few that hold their convictions in high regard must constantly reevaluate the balance between their beliefs and profitability.

“People are driven by their creed and by their financial gain, and the balance varies from person to person,” Mansour says. “[Anyone who] sees that he has an advantage in buying an Islamic instrument for his financial transaction, will buy an Islamic instrument if on his scale financial interest [ranks] higher than his creed.”

Expansion beyond the Middle East and retreat at home

Call it opportunism, call it irony, but the fact is that the entire Arab banking industry is now calling the domination of Western financial institutions over Islamic banking a reality.

Similar to the 1970s oil boom that fueled the growth of the then-infant sector, many analysts see the current rise in oil profits as a factor that will drive Western institutions that offer Islamic products to take an even more commanding lead over their local rivals. Beyond possessing the experience and resources to offer more sophisticated investment options, Western giants offer household names that many Arab investors trust over their local alternatives.

Mandviwala, of HSBC’s Amanah division, says the secret of success for Western banks in the Islamic banking market has been in their ability to effectively promote their products.

“If [Islamic financial products] are marketed properly by reputable institutions, they will gain acceptance,” says Mandviwala. “If the [bank’s] sponsors are Shariah-minded, it satisfies their individual needs through their corporate [activities]. And by structuring transactions Islamically, you have access to wider pools of liquidity in the Middle East.”

Mansour agrees that Western corporations have been able to take advantage of quickly accumulating Gulf capital as a result of weak and unorganized local competition.

“HSBC is getting into this in a big way because they want to absorb all the Arab capital that’s available for investment,” says Mansour. “Particularly now that the price of oil has gone up, you can imagine how much more money there is available, how much more liquidity is available. They are setting up serious Islamic financial institutions, credible for people who have invested in the States to bring their money back to invest in Dubai and Bahrain.”

Amanah, for example, has financed everything from European aircraft for the Emirates to Brazilian buses for Saudi Arabia, an LNG tanker for Brunei and a $600 million sukuk issue for the government of Malaysia. Just months ago, in one of the largest deals ever recorded for a murabaha transaction, the UAE’s Etisalat contracted Amanah to finance the acquisition of a 26% stake in the Pakistan Telecommunications Company worth more than $2.1 billion (the markup was not made public).

“[Western banks] got involved in order to defend their existing business,” says a skeptical El-Diwany. “They realized if they did not, they were going to be left behind.”

Meanwhile, on the home front, the development of Islamic banking institutions has virtually come to a standstill in recent years despite the sector’s growth in popularity. After struggling to gain credibility in the 1990s following the LE 1 billion collapse of Al-Rayyan Islamic Investments as a result of the 1987 stock market crash, the sector has now grown to include 12 conventional banks that have chosen to open Islamic branches or offer Islamic banking products in their existing locations. (Although allegedly an Islamic investment house, courts have since found that Al-Rayyan was little more than a pyramid scheme. Its collapse has long tainted Islamic banking in Egypt.)

Bank Misr, for example, now offers Islamic services through 40 branches, while Al-Watany Bank for Development operates 19 Islamic branches. At least four more players — including the National Bank of Egypt, the leading state-owned bank, and Commercial International Bank (CIB), Egypt’s top private-sector bank — are expected to enter the market in the coming months and offer Islamic services as they acquire smaller banks.

“On the consumer level, the demand is very high and the [financial] market is ready to absorb Islamic banking capital,” says Abdel Halim of Al-Azhar’s Saleh Kamel Center. “On the institutional level, the current political atmosphere is simply not accepting of the concept, so we are not likely to see significant growth in the sector in the near future.”

Despite a growing network of branches, the local sector still lags behind regional and international growth because of the underdeveloped services they offer. For example, Faisal Islamic is the only institution known to offer an Islamic mutual fund, which only invests in Shariah-compliant companies. It was launched in 2004 in partnership with EFG-Hermes brokerage house.

As for sukuk bonds, they simply do not exist in Egypt.

“Even an Egyptian who has a large sum of capital will find it easier to go to Zurich, Geneva, London or New York to invest that money there in an Islamic fashion, not to mention Dubai and Bahrain,” says Mansour. “We haven’t got the capital, we haven’t got the infrastructure and we haven’t got the people who know what it’s all about.”

Nevertheless, Abdel Halim says the rapid rise of oil prices presents a golden opportunity for countries like Egypt to draw Gulf investments by setting up Islamic investment services such as bonds and mutual funds — if only the government will take advantage.

“In Bahrain, the government was able to attract $18 billion by selling Islamic bonds,” says Abdel Halim. “Most economists have estimated that we need about $10 billion in investments to energize our economy. We could have done this, but there is no will on the part of the Central Bank.”

Former Central Bank Governor Hassan rejects the claims of critics who accuse the government of intentionally impeding the progress of the Islamic banking industry. Hassan says the accusations are unfounded, as Central Bank policy has been consistent for two decades in its treatment of the entire banking sector.

“The lack of new Islamic banks is not an indication of the lack of interest or ability to create them,” says Hassan. “We simply do not see these institutions entering the market because it has been the policy of the Central Bank since the 1980s to limit the number of banks entering the market, whether they are Islamic or not. The policy is the same for everyone.”

The future of Islamic banking in Egypt

As pessimistic as market voices may sound about the future of local Islamic finance, they do concede that continued stagnation is unlikely considering the concept’s rapid advancement and exploding popularity regionally and globally.

For his part, Mansour is working to establish a team of young college graduates with good command of Shariah and banking regulations to be certified by the Banking Institute of the Central Bank of Egypt as Certified Islamic Public Accountants (CIPAs). The goal, he says, would be to use them as teachers of a single set of rules for Islamic finance.

In order for the local sector to snap out of its sluggish state, though, he says there needs to be more educated public demand for Islamic financial services. Only then can the proper conditions be set for the development of the sector.

“First of all, we have to forget Al-Rayyan and all the ripples that were created by that episode in our financial market,” Mansour says. “Secondly, we must have the infrastructure. And we must have the government saying these are the rules, everybody has to abide by them. Once you have all this, then you can start talking about Islamic banking.”

Although his company has yet to make plans to enter the Egyptian market, Mandviwala says the interest is there, which is why HSBC Amanah representatives attended last September’s Euromoney Conference in Cairo.

At the current reported industry growth rate, it is almost impossible to imagine that the local market will escape the inevitable arrivals of HSBC Amanah, Citi Islamic and others, perhaps even in the next 10 years, to compete and attempt to wrestle a majority market share, as has already occurred in Gulf States such as Bahrain.

The question is, by then, will local institutions finally be in shape to put up a fight, or will Western alternatives simply continue to offer superior services?

On a more fundamental level, will the future see the establishment of what some argue is the only Shariah-compliant model: one based on a non-fixed rate of return?“ There is always hope,” says El-Diwany. “I think you have to ask: Who is driving the industry?

This article appears in Business Today Egypt.

Ahmed Namatalla

Thursday, December 8, 2005