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Challenges facing Islamic financial institutions

BY A STAFF REPORTER / 5 August 2005

DUABI — The emergence and growth of the Islamic finance industry is a phenomenon that has generated considerable interest in the financial world in recent years according to a recent report by the National Bank of Dubai.

Given its ability to offer innovative financial solutions to an under-served market, it is seen as a community banking niche with considerable growth potentials. In the Muslim world, and increasingly in the West, significant segments of the institutional and retail markets are actively considering this alternative for their financing and investment needs.

However, the general availability of information remains limited for what is still a young and evolving industry. The current Muslim population of the world is at least one billion. It is estimated that the Middle East houses around 15 per cent of the world's Muslims. This explains why the greatest concentration of Islamic financial activities is in this region.

Today, more than 250 Islamic banks (90 institutions of them are in the Middle East) are operating from China to the US. Western banks, through their Islamic Units in U.K, Germany, Switzerland, Luxembourg, and others countries also practice Islamic banking.

Growth prospects of Islamic financial institutions

Pure-play Islamic Banks and financial institutions manage over $250 billion of assets and a further $200- 300 billion is managed by the Islamic windows and subsidiaries of international banks. The GCC region has been the hotbed of activity as far as the Islamic Banking industry is concerned, where 41 Islamic financial institutions are currently operating in the GCC countries (of which 18 are banks). Qatar and Bahrain are the leaders and hold a 70 per cent share of the assets, while the UAE accounts for 19 per cent of assets. The growth in assets is estimated at 15 per cent and expected to remain so for several reasons. One is the growth in overall wealth in the Middle East. Two, is growing awareness about the Islamic products. Three is the fact that Islamic products are becoming more competitive compared to conventional products. Four, is the wider availability and variety of Islamic financial products.

In addition, the Equity / Asset ratio of Islamic banks stands at 13.10 per cent compared to 11.30 per cent for conventional banks in the GCC region. This indicates underutilization of capital and provides a lot of scope for taking on additional risk on the balance sheet.

Basic instruments in Islamic banking

Contemporary Islamic finance revolves around the following core instruments derived from Islamic commercial law.

Ijarah: Islamic leasing: Unlike capital itself, fixed payments can be determined for assets or rentals. An Ijarah contract is where the financier buys and leases equipment or other assets to the business owner for a fee or more often called rental income. The duration of the lease as well as the fee must be set in advance and mutually agreed. Sometimes there are two contracts involved in this concept.

The first contract, Ijarah contract (leasing/renting) and the second contract, Bai' contract (purchase) are undertaken one after the other. For example, in a car financing facility, a customer enters into the first contract and leases the car from the owner (bank) at an agreed rental over a specific period. When the leasing period expires, the second contract comes into effect, which enables the customer to purchase the car at an agreed price.

Mudarabah: investment partnership: The contract is between a financier and an entrepreneur or investment manager, where risks and rewards are shared. Both receive an agreed share in the case of profits. In the event of incurring a loss, the financier bears any loss of capital while the entrepreneur loses his time and effort.

Murabahah: purchase and resale: Instead of lending out money, the capital provider purchases the desired commodity (for which the loan would have been taken out) from a third party and resells at a predetermined higher price to the capital user. By paying this higher price over installments, the capital user has effectively obtained credit without paying interest.

Musharakah: profit and loss sharing: An equity financing arrangement widely regarded as the purest form of Islamic financing, where partners contribute capital to a project and share its risks and rewards. Profits can be divided up in any agreed ratio, while losses must be in proportion to the capital invested.

Differences between Islamic and conventional financial institutions

Although Islamic finance has generated substantial amount of literature coverage in the press and academic journals, there has been little study as yet on how Islamic financial institutions differ in practice from conventional banks. However, a recent study tried to cover this issue based on data from 15 interest-free (Islamic) banks and 15 conventional banks in countries where a dual banking system was in operation. The study tested for differences in liquidity, leverage, credit risk, profitability and efficiency. Its principal conclusions included the following:

  * Islamic financial intuitions relied more heavily on their equity than conventional banks.

  * Islamic financial institutions faced more difficulties in attracting deposits than interest-based banks.

  * Islamic financial institutions had higher cash/deposit ratios than conventional banks.

  * Islamic financial institutions tended to channel their funds into direct investment (using musharakah and mudarabah products), rather than personal loans.

  * Within the sample studied, there were no significant differences in profitability and efficiency between Islamic financial institutions and conventional banks.

  * Islamic financial institutions and conventional banks offered their depositors similar returns.

Challenges ahead

In spite of the growth potential in Islamic banking, there are several challenges facing Islamic Financial Institutions.

 — Shortage of experts in Islamic banking: The supply of trained or experienced bankers has lagged behind the expansion of Islamic banking. The training needs affect not only Arab domestic banks, both Islamic and non-Islamic, but foreign banks as well.

 — Absence of accounting (and auditing) standards pertinent to Islamic banks: Uncertainty in accounting principles involves revenue realization, disclosures of accounting information, accounting bases, valuation, revenue and expense matching, among others. Thus, the results of Islamic banking schemes may not be adequately defined, particularly profit and loss shares attributed to depositors.

 — Lack of uniform standards of credit analysis: Islamic banks have no appropriate standard of credit analysis. Similarly, there is a widespread training need involving related aspects such as financial feasibility studies, monitoring of ventures, and portfolio evaluation.

 — Potential conflicts with central banks: Islamic banks have been established as separate legal entities; therefore, their relationships with central banks and/or other commercial banks are uncertain. Problems may be further aggrivated when an Islamic bank is established in a non-Muslim nation, and is subject to that nation's rules and requirements.

 — Potential conflict between domestic banks, foreign banks, and Islamic banks: It appears that domestic banks and foreign banks will experience continuing difficulty in adopting Islamic banking practices until they can become more confident of the results of investing ventures.

 — Instruments that meet the demand of specific investment requirements: One of the biggest challenges facing institutions is the provision of shortterm investment instruments. Several institutions have tried to develop high quality short-term instruments, but have been hampered by their ability to generate assets, by their credit ratings, and by liquidity.

Given that necessity is the mother of all inventions, it is perhaps a good thing that Islamic bankers face a wide array of problems that they must surmount to guarantee the industry's future. Some of these are tangible and relate primarily to financial engineering and an inability to copy conventional products due to Shari'a laws. Other problems relate to varying interpretations of Shari'a laws, which lead to the inability of one Islamic bank to copy another Islamic Bank's products.

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