Issue #6 summary

The challenges that lie ahead
Islamic banks have enjoyed strong performance, which has been driven largely by positive external forces. The true underlying strength of incumbent Islamic banks will be tested as a new wave vie for market share, write Nasr-Eddine Benaissa, Dr Michael Wiegand and Dr Stephanie Hauser
Many celebrated 2004 as another great year for Islamic banking. Despite indications that growth will continue, the Islamic banks that have developed the industry need to be careful not to celebrate too soon. Their very success may be the source of future challenges, as new attackers move in to try to capture a share of this lucrative market.
The protections that most Islamic banks have enjoyed are quickly disappearing. They will have to improve their business model significantly if they are to compete and repeat or improve their performance. In fact, the recent performance of Islamic financial institutions may belie their real health.
It is often argued Islamic banks should not be compared to conventional banks because they are very different. Never­theless, the comparison is worthwhile and important for two reasons. First, there is a clear convergence of offerings, making conventional banks a direct competitor to purely Islamic banks. Second, and most importantly, customers compare the performance of all banks when choosing their financial institution.
A cursory comparison of the performance of Islamic financial institutions shows mixed results. On the one hand, most Islamic banks are growing faster than their respective markets as a whole. In some cases, such as the United Arab Emirates (Abu Dhabi Islamic Bank, Dubai Islamic Bank), Jordan (Jordan Islamic Bank), and Malaysia (Bank Islam Malaysia), growth was more than twice the market rate. On the other hand, comparing the return on assets of Islamic universal banks to leading conventional banks in their markets shows that, while some have had strong recent results, many others have not performed as well as their conventional competitors.

Sound product with room for growth
With its generally superior features, compared with conventional insurance and assurance properties, it is almost impossible for takaful to be out of the mainstream, writes Rob King
The global takaful market, despite having been around for more than 30 years, is still in its relative infancy. Some markets around the world are admittedly more developed than others, but in general the industry has further to go. The development of takaful offers more than one billion muslims the opportunity to help plan for their financial future in the knowledge that it is Shariah-compliant. The principle at the heart of takaful is to provide protection to those individuals who need it most: a principle in line with the fundamental tenets of Islam.
Regional economic growth and a greater understanding of takaful are set to see the industry expand exponentially, as people are coming to appreciate the virtue of fairness in this Shariah-compliant product.
There are a number of key drivers of demand. The economic outlook, for both the short and long term, is favourable. There is a greater awareness of the need for financial planning from every social class; a cultural resistance towards conventional planning makes takaful the preferred option.
To take advantage of this positive climate, financial service providers—mainly takaful companies—need to approach the market most professionally and create consumer confidence through the genuineness of their products and services. Educating the public about the concept, products, and benefits of this unique Islamic financial system will allow it to rise to the challenge of global competition by unleashing the creativity and entrepreneurial flair of financial service manufacturers who share and believe in the Islamic financial system.
Marketing through relationship building is paramount to the success of the industry. Relationship marketing is based on network interaction and recognises that marketing is rooted in the total management of the networks of the financial institution, the market and society. It is directed to a long-term win-win relationship with clients and distributors, a value jointly created between the parties involved. It transcends the boundaries between specialist functions and disciplines. This success will be mirrored in the global takaful industry, which is forecast to grow at a rate of 15-20 per cent annually.

Call for method in development
An accepted standardised system can accelerate the advancement of Islamic money and capital markets, grow takaful and nurture synergies, argues Essam Janahi. The Islamic money market must not be confined to geographical boundaries so that underutilised Islamic funds the world over are put to use
In the middle of sweeping change, Islamic banking and finance is now passing through a crucial stage of development and evolution driven externally and internally. To catch up with the sophisticated needs of investors, individual Islamic banking and finance entities are busy putting in place new systems to sharpen competitive skills, measure risks more precisely, and are looking at their business through an innovative eye like never before.
The changes are also forced by external factors wherein global regulatory authorities and banking bodies are becoming stricter on compliance issues and transparency in operations. These external pressures are common to Islamic banking and finance as well as its conventional counterpart, particularly in the Middle East and North Africa. Islamic banking and finance may have some more time to comply with Basel II, but certainly much more needs to be done in in the coming years if it is to stay integrated with the world.
These changes will augur well, catalysing the innovative forces and bringing the industry in line with the changing dynamics of the global and regional financial market-place. As a result, Islamic banking and finance will be refurbished, further strengthening its force of financial intermediation, which is spread over some 75 countries.

Imperative to build on earned trust
With more than $30bn in liquidity—as well as numerous regional investment opportunities—sound regulations help to create a
confident picture for Islamic finance, writes Anwar Al Sadah
Post-9/11 scrutiny has shown that the existing regulation in the Islamic banking industry is adequate and appropriate. Sound regulation is pivotal to its stability, credibility and is an essential pre-condition for a healthy financial system.
The development of the Islamic finance sector has posed new regulatory challenges, but it does not require any more regulation than conventional banking. However, regulators realise that Islamic banking requires different types of regulations and modifications to better understand and monitor risks.
The Bahrain Monetary Agency (BMA) has done some pioneering work in this area, with the development of prudential regulations specifically addressing the unique features of Islamic banking. Taking this one step further, the BMA is now working to develop a comprehensive regulatory framework for takaful.
There is not a substantial difference between the regulatory challenges facing Islamic banks and their conventional counterparts, as reflected in the debate over Basel II. The Islamic Financial Services Board (IFSB), which puts forward regulatory standards for Islamic banks, is working on a capital standard that takes into account what Basel II is doing.
But in the context of Islamic banking, it is likely that something similar to Basel II will evolve for Islamic banks. The BMA has stated it will follow whichever approach is adopted by the IFSB.

Making a return on compliance
Legal and practical considerations affect the growth potential of Islamic private equity investments, says Ayman H Abdel-Khaleq. Shariah law limitations and restrictions are another key consideration
The structuring and offering of Islamically compliant private equity and venture capital funds have undergone rapid growth. This has resulted from private equity and venture capital funds becoming increasingly sophisticated and innovative as they seek new pools of investors interested in Islamically compliant investments.
Shariah precepts encourage calculated and financially responsible risk-taking while prohibiting guaranteed and fixed-income returns on investment (whether interest-based or like interest). Private equity funds not utilising conventional leverage instruments have been able to invest in conformity successfully.
An indication of the acceptance of these vehicles for making Islamically compliant investments is the number of conventional private equity and venture capital funds that have passed Shariah-compliance tests with only minor adjustments made to the investment policies of the fund itself; for example, the appointment of a Shariah supervisory board and the incorporation of detailed Shariah-compliance criteria into the offering and operational documents.
An alternative to private equity funds are early stage investments in start-up companies. Early stage investments provide investors with considerable scope to negotiate the structure and conditions of their investment to ensure Shariah compliance because of the relative power of the investors as compared with the start-up entity.

Power for the people
Osama A Al Khajah details Kuwait Finance House Bahrain’s iniative as lead financier in the Middle East’s first combined petrochemical and power and water generation complex—a US$1.5bn project
Plans from Kuwait Finance House Bahrain to establish the Middle East’s first combined petrochemical and power and water generation complex are now well under way. KFH-Bahrain is arranging the financing of the US$1.5bn project and, unusually for a bank, taking the lead in its full conceptualisation, organisation and planning.
A feasibility study for the project was carried out with a world-class consortium of partners—General Electric (GE) Energy, Weir International, Stone & Webster, Uhde GmbH and Chicago Bridge & Iron Company—in cooperation with the government of the kingdom of Bahrain.
To develop the project, the bank engaged Jacobs Consulting as independent consultant, Norton Rose as legal counsel, and Posford Haskoning Environment Gulf as environment consultant. At the moment KFH-Bahrain is managing the project in association with a team of the project consortium. The main challenges include the complexity of project integration and interfaces between the plants and production units, a requirement to produce low-cost electricity and water to enable satisfactory supply to the Government and a restriction on utilisation of local-feed stock natural gas. A project management contractor (PMC) contract will be awarded in a few months to a suitable PMC. We simplified complexity of the project by segregating it into several modules such as power plant, water desalination, gas separation, and assigned responsibility of feed and EPC for each module to a member of the consortium. With respect to production of low-cost electricity and water, we adopted a co-generation concept for the production of energy and integrated it with production of petrochemicals for overall production at maximum efficiency.

Driven to succeed by pure force
An Islamic stock index has restrictions imposed on it that could inhibit performance. Ethical purity is not a liability, however, as such an index has outperformed many western indices, writes Rushdi Siddiqui
Moral behaviour is a core component of Islamic finance for the world’s 1.2 billion Muslims. With holdings in excess of $100bn and an annual growth rate of 25 per cent, the Islamic finance sector is fast becoming a force in international markets.
The US alone is home to at least six million Muslims; a community growing at 2.5% a year and with a median income estimated at between $50,000-$70,000. Add the $860bn the Saudi kingdom has already invested stateside ($200bn in managed funds), and Islamic finance looks less like a niche sector and more a like backyard market the size of Russia.
Outside their faith, Muslims are identical to their Christian, Jewish and secular neighbours in the need to build college funds, purchase homes, access credit and create nest eggs for retirement. And yet this market is woefully underserved because of widespread misconceptions of Shariah law. Education and a willingness to explore this topic will allow financial institutions not only to grow market share and demonstrate leadership but also to help Islamic communities realise their dreams of economic enfranchisement.