Blue Mosque, Istanbul, Turkey










The Arab Spring and Milton Friedman

Usman Hayat asks whether reducing MENA’s unemployment is a social responsibility for the Islamic finance industry.

Turkey’s Islamic Finance Journey

Until recently Turkey’s banking system was firmly rooted in the secular, European model that goes back to the days of the Ottoman Empire. In the last 10 years that has begun to change with the establishment of a handful of Islamic banks and most recently the issue of a sovereign sukuk. Andrea Wharton reviews progress and the challenges to further growth.

An Islamic Solution to the Present Policy Dilemma

Azura Othman takes a critical look at the apparent inability of interest-rate-based debt systems to stimulate strong economic recoveries. She asks whether an Islamic solution involving a reform of the tax system and the way governments finance their spending could provide an answer to the dilemma.

Certifying Shari’ah Compliance in Islamic Financial Products

Sheikh Yusuf Talal DeLorenzo considers the issue of financial products that are delivered by halal means, but which ultimately derive from investments that are not Shari’ah compliant.

An Interview with Humphrey Percy, CEO, Bank of London and the Middle East

Bank of London and the Middle East is now the largest Islamic Bank in Europe. Humphrey Percy talks about the bank’s journey since its foundation in 2007, some of the challenges it has faced and prospects for the bank and the Islamic finance industry in general in the coming years.

The Best of All Worlds

Dr Murat Űnal argues for a global financial system that draws on the strengths of the conventional, Islamic and ethical banking models to create a more robust and sustainable system.


Executive Editor’s Note

Is Islamic finance all about delivering a Shari’ah-compliant imitation of conventional finance in order to maximise profits or is it about more; is it about real wealth creation and the benefits to society at large, which derive from that? Perhaps the answer to that question depends on who you ask. Usman Hayat suggests in this issue that if you ask any of the thousands of men and women who flooded on to the streets during the Arab Spring, they would tell you that their hope is that Islamic finance will help to create a fairer society, in particular one where people can reasonably expect to find work to maintain themselves and their families. At the same time Islamic financial institutions (IFIs) need to be profitable for their shareholders but they do not have to chase profits at any cost. Islam stands for the middle path. IFIs should not allow decisions to be determined by what would maximise their profits, rather the Shari’ah decrees on which they should base their decisions on morality, justice and participation for the overall well-being of society.

Barclays Bank’s involvement in manipulating LIBOR with other banks is reprehensible and without any sense of morality. It may, who knows, prove criminal. Governments have attempted to introduce more regulations, but faced with the lack of attention to moral education can rigorous regulation succeed without attempting to address moral failures? Imposing penalties can have little effect as the banks will typically recover the penalty payable by the bank from customers by simply increasing interest rates and bank charges.

The dilemma that faces Islamic financial institutions in the 21st century is whether they can adhere to the rules of morality, justice and participation prescribed by the Shari’ah, rather than just observing the letter of the law. The solution does not, however, lie in the sort of deceptions outlined by a distinguished Shari’ah scholar, Sheikh Yusuf Talal De Lorenzo, in this issue. As he says in conclusion to his article, ‘Modern Islamic finance has proved itself to be viable, innovative and profitable. The question it faces now is whether it can prove that it is moral and responsible.’ IFIs must dare to be different and learn to think outside the box, demonstrating to their own customers and to the world at large that it is possible to behave with integrity and deal justly with one another and still succeed in the modern world.

Qayyum Signature

Mohammad Ali Qayyum
Director General

Deal not unjustly, and ye shall not be dealt with unjustly.

Surat Al Baqara, Holy Quran

Mohammad Ali Qayyum,
Director General, IIBI

Andrea Wharton

Rahim Ali


Mohammad Shafique
Mohammed Amin
M Iqbal Asaria
Richard T de Belder
Ajmal Bhatty
Stella Cox
Muhammad Nasir
Iqbal Khan
Dr Imran Ashraf Usmani

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This magazine is published to provide information on developments in Islamic finance, and not to provide professional advice. The views expressed in the articles are those of the authors alone and should not be attributed to the organisations they are associated with or their management. Any errors and omissions are the sole responsibility of the authors. The Publishers, Editors and Contributors accept no responsibility to any person who acts, or refrains from acting, based upon any material published in the magazine. The Editorial Advisory Panel exists to provide general advice to the editors regarding matters that may be of interest to readers. All decisions regarding the published content of the magazine are the sole responsibility of the Editors, and the Editorial Advisory Panel accepts no responsibility for the content.

AlixPartners Sound a Cautionary Note for the GCC

At around the same time as the largely upbeat forecast from Ernst & Young, advisory firm AlixPartners sounded a cautionary note for GCC banking in general – Islamic and conventional. They comment that the macroeconomic environment in the GCC region remains precarious and industry specific risks need to be addressed to ensure that recent growth and increasing profitability are sustained.

The report suggests that significant risks in the economic environment remain, requiring immediate counter-measures by bank managers. First, the recovery in banks’ net interest margin (the difference between the interest income generated by banks and the amount of interest paid out to their lenders, relative to the amount of their interest-earning assets), which the report says has been driven mostly by government infrastructure projects, underscores that the link between banking performance and oil prices is too close. Heavy government involvement in such projects, which guarantees free capital to the system, coupled with protection at home, has resulted in safe and stable returns, notes the study. In order to be successful globally, however, GCC banks must learn to survive without these securities and compete internationally.

Second, the-still cheap funding that has sustained GCC banks’ lending is constrained by the withdrawal of Western banks’ lending and by an underdeveloped interbank financing market. Other significant risks highlighted in the report include the stark contrast between the sector’s relatively strong capital base and improved credit ratings, and GCC banks’ underlying non performing loans in some countries and contradictory lending practices that often intertwine personal and business dimensions – coupled with government intervention, generates inefficient asset allocation at best and fosters moral hazard at worst. Finally, the concentration of GCC banks in a few geographies and those countries’ limited populations may seriously constrain future wealth generation, notes the study.

Claudio Scardovi’

Claudio Scardovi, managing director at AlixPartners and author of the report, said, ‘Certain banks remain crippled by a real estate overhang, asset quality concerns and a post credit bubble legacy. For those banks, restructuring is essential sooner rather than later. Similarly, nearly all GCC banks suffer from various ‘concentration issues’ underpinned by a false dependency on high oil prices. Significant benefits could be achieved if restructuring and diversification were pursued independently; however, even greater benefits would ensue if these issues were addressed simultaneously. On the restructuring side, opportunities lie in the ability to implement a hard and fast strategy, while on the diversification side, opportunities lie in exploiting any potential competitive advantages beyond the Gulf region.’

Although crude oil futures will continue sustaining the current levels of free capital, GCC banks need to reach out more aggressively to new sources of sustainable and profitable growth, says the study. These sources include not only lending assets and net interest margin, but also services and fee income. Further bubbles and bursts could result from renewed, uncontrolled asset growth and loss of status could follow poorly pronounced strategies and implementation.

In order to successfully enter the next stage of development, titled the ‘Diamond Age’ by the report, the authors suggest that policy makers as well as the management bodies of banks must be prepared to address issues of the past and to build a new stage for GCC banks. It maps out four key strategic objectives. First, consolidation can be achieved through mergers and acquisitions or by organically merging similar entities to exploit economies of scale and scope. Second, greater development is needed, which would result in greater commercial effectiveness allowing the sale of more goods and services to an increasing number of clients and markets. Third, an escalation in productivity, through an increase in the quality and quantity of desired output, while maintaining the same level of input, is needed. Fourth, innovation that aims to exploit current pools of profit while simultaneously creating new ones through new business concepts, is also called for.

The study further emphasises that international diversification and proactive internal restructuring, when necessary, could circumvent current constraints and shifts in the region that are creating new structures for markets and societies.

Scardovi added, ‘The power shifts that have taken place in the MENA region are redistributing wealth across countries, companies and individuals, which will eventually lead to banks needing to adopt new wealth and investment management services. Shifts have also taken place on the economic powers scene and are creating more opportunities for GCC banks to adopt the right timing and strategy for their oil-driven excess free capital.’

Ernst & Young Forecasts Expanded Role for Islamic Banks

As 2012 drew to a close Ernst & Young issued a report that claims Islamic banking assets will grow to $1.8 trillion in 2013 as they compete more strongly with conventional banks, attracting customers who expect competitive financial products and services rather than just Shari’ah compliance. The report also suggested that wholly Islamic banks will tend to do better than Islamic window operations.

The bad news is that, although Islamic banks have grown on average 16.2% year on year over the last three years, they lag behind conventional banks in terms of return on equity and return on assets and their operating expenses are 50% higher. It is, therefore, unsurprising that the report observes that the profitability of Islamic banks has, in fact, declined.

Clearly there are both opportunities and challenges for Islamic banks. While it is possible that restrictions on Islamic banks in terms of some of the more speculative and therefore potentially higher return investments available to conventional banks may account for the performance deficit in returns on equities and assets, there is no excuse for apparently inefficient operation. This is undoubtedly an area that Islamic banks need to address.


Harmonising Accounting Standards

Following a series of high level, international roundtable meetings, KPMG and the Association of Chartered Certified Accountants (ACCA) have issued a report calling for the International Accounting Standards Board (IASB) and the Islamic finance industry to work together to achieve greater harmonisation of financial reporting standards.
It says: suggests:

• The IASB should consider issuing guidance on the application of International Financial Reporting Standards (IFRS) when accounting for certain Islamic financial products which are offered by Islamic financial institutions and conventional banks.

• It should also consider issuing guidance on additional disclosures that could be made for stakeholders who are seeking information on the entity’s Shari’ah compliant operations.

• The IASB should work with the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) and other leading Islamic finance standard setters and regulators globally to establish the gaps between IFRS and Islamic accounting standards and to review the needs of users. This should also include a review of terminology used in IFRS, and consider whether such sensitive terms as ‘interest’ – forbidden in all forms in Islamic banking- can be amended or added to.

• If Islamic finance is to be part of the IASB agenda, the IFIs should support IASB by forming an expert advisory group, including Islamic scholars from various jurisdictions, which could contribute to the development of new standards and help with the overall review or provide advice on an ad hoc basis.

• The IFIs need to conduct further outreach and education, particularly with the investor community, while providers of professional qualifications should look into the relevance of Islamic finance to their syllabuses and the members.

• The industry needs to engage more with local regulators to understand their expectations of financial reporting and the disclosure of Islamic financial instruments.

Commenting on the report, Samer Hijazi, a director in KPMG’s Financial Services Audit practice, and co-author of the report, said, ‘The Islamic finance industry has reached a new stage of maturity. It has a wider variety of customers and stakeholders and a presence in more countries around the world than ever before. As the IASB seeks to establish IFRS as a single high quality set of global financial reporting standards now is the right time to consider how Islamic finance fits into this global framework. Greater comparability and consistency in financial reporting will benefit not only the IFIs but also the international banks which offer Islamic financial services around the world.’

Aziz Tayyebi, head of international development at ACCA and its expert in Islamic Finance, and report co-author added, ‘One of the key challenges facing Islamic finance and global standards setters is how to resolve the fact that IFIs in different countries can report transactions in different ways, which creates uncertainty for organisations which are trying to assess and compare them not only with each other, but with conventional counterparts. If they are to remain competitive with conventional counterparts, their financial reports need to be comparable. This will involve a great deal of work and education, but should be beneficial for IFIs and those who rely on their reports.’

The Islamic finance industry has reached a new stage of maturity

The Islamic Financial Services Board Issue Draft Guidelines on Capital Adequacy

The Kuala Lumpur based Islamic Financial Services Board (IFSB) have acted to bring their guidance on capital adequacy into line with Basel III recommendations that will be phased in over the next few years. There will be a five month consultation period on the new guidelines. The IFSB propose that any asset backed sukuk used to meet capital adequacy requirements should have a duration of at least five years; that banks should not include any features encouraging early redemption such as periodic increases in the rate of return and capital raised through sukuk issuance should not form part of capital buffers required under Basel III. The responsibility for implementing the IFSB’s advice and deciding which sukuk structures may be counted as capital will, however, be in the hands of national regulators.

New Rules for Mudarabah in Pakistan

In November 2012 Pakistan’s central bank issued a detailed set of instructions for the distribution of profits and losses from mudarabah based deposits held by Islamic financial institutions. Their rationale is that the prevalence of this type of contract makes it important ‘to have well defined, transparent and standardised policies and practices for profit and loss computation and distribution across the Islamic banking industry.’

The instructions were to take effect immediately and supersede any previous instructions.

The instruction says, ‘IBIs (Islamic Banking Institutions) shall have a well-defined profit and loss distribution and pool management framework for creation of one or more pools of assets to be financed by different types of mudaraba-based (individual, corporate or financial institutions) deposits. The framework shall interalia specify the objectives, investment strategy and risk characteristics of each pool. It shall also explicitly define the basis for (i) allocating different types of deposits to different pools (ii) assigning weightages to each deposit category of a particular pool. The framework shall be approved by the Shari’ah Advisor and Board of Directors (BOD) of the IBI and a duly approved copy of the same shall be submitted to Islamic Banking Department, SBP (State Bank of Pakistan) within three months of issuance of these instructions. Further, changes (if any), warranted in the framework shall also be approved by Shari’ah Advisor and BOD under intimation to SBP within 15 days of such change(s).’

The instruction goes on to specify among other things the types of investments that are allowed; comingling of bank funds with depositor monies; the separation of and accounting for different asset pools; rules for the calculation of profits and losses and the basis on which these will be distributed and limitations on when and how the contractual terms may be varied.


Malaysia Signal Legislative Changes to Foster Growth in the Islamic Finance Industry

Speaking at the Islamic Development Bank’s Regional Lecture Series in Jakarta, Indonesia, Dr Zeti Akhtar Aziz, Governor of Bank Negara, Malaysia’s central bank, said that the legal, regulatory and supervisory framework would need to be adjusted to accord greater clarity to the appropriate legal and regulatory treatment in order to foster the sound and orderly growth of risk-sharing structures and activities, both in terms of the funding and the assets side of Islamic banks. She indicated that in Malaysia, steps were currently being taken to provide a conducive enabling environment for this next phase of development to spur more risk-sharing transactions through the formulation of new legislation for Islamic banking and takaful.

Dr Zeti Aziz

This new law, now close to enactment, aims to promote certainty in the legal and regulatory treatment of Islamic financial transactions by providing legal recognition to Shari’ah. Dr Aziz said, ‘This provides a comprehensive legal environment under which effective risk and profit sharing activities can take place, encompassing all aspects of Islamic financial transactions, from its prudential and business conduct requirements to the legal treatment of Islamic banking assets upon its resolution, to be fully consistent with the distinctive elements of the respective Shari’ah contracts employed in these transactions.’

This legal framework also aims to further enhance the capacity of the regulatory and supervisory framework for the Malaysian Islamic finance industry to evolve in greater alignment with the international regulatory and the supervisory standards and best practices issued by the Islamic Financial Services Board (IFSB) to govern the specifics of Islamic financial transactions. (To complement the efforts to strengthen the regulatory law for Islamic finance, Malaysia established the Law Harmonisation Committee in 2010 to undertake objective reviews on other relevant laws and recommend legislative changes to ensure that the laws in the country would allow for Islamic financial transactions to take place effectively and efficiently.)

GFH Capital Seal Deal with Leeds United Football Club

After protracted negotiations and questions as to whether Leeds United FC would be a Shari’ah compliant investment (sales of alcohol, pork products and gambling machines at Leeds United’s ground), a deal has been sealed with GFH Capital, a subsidiary of Bahrain based Gulf Finance House (GFH). The deal has, however, yet to be approved by the Football League and there will be a one month transitional period before ownership formally changes hands on 21 December 2012. There is also the question of the ownership of the Elland Road ground and the training facilities at Thorp Arch, which are owned by third parties and rented by Leeds United, although it is believed that GFH will be negotiating to buy both.

Leeds United

Perhaps just as critical as the issues of Shari’ah approval is the fact that GFH do not have quite the deep pockets of say, Roman Abramovich, the Russian oligarch who owns Chelsea. In a note to GFH’s annual report, auditors, KPMG, said, ‘Due to a lack of sufficient liquid assets, and inability of the group to generate sufficient liquidity from its operations, the ability of the group to meet its obligations when due is dependent on a timely disposal of assets.’ The problems stem back to the severe downturn in the property market in 2008/2009, which resulted in GFH having to write off billions of its assets. Sources inside GFH insist that the bank is asset rich with cash on the balance sheet and in the light of GFH’s restructuring it is understood the auditors are reviewing this statement. For Leeds United and its supporters, however, it is now a case of hoping their white knight does not turn out to be Don Quixote.

In Brief

Two new Islamic banks are planned for 2013 by the Islamic Corporation for the Development of the Private Sector. The banks will be in Benin and Mali. There are also plans to issue a $200 million sukuk on behalf of the government of Senegal to improve liquidity for Islamic banks. The Asian Development Bank is supporting the development of Islamic banking in Pakistan, Bangladesh, Indonesia and Afghanistan with a grant of $750 million. The grant is targeted at helping the banking systems in these countries meet the regulatory standards of the Islamic Financial Services Board (IFSB).

In early December 2012 South banking systems in these countries meet the regulatory standards of the Islamic Financial Services Board (IFSB).

African banking group, ABSA signed a deal with Barclays to take over the latter’s operations in nine African countries. In the wake of the announcement ABSA announced that they intended to launch Islamic banking in Ghana. Ghana’s central bank has apparently indicated a willingness to license Islamic banking in the country. ABSA are also looking at Islamic banking opportunities in Egypt, Tanzania, Zambia and Uganda.

Qatar Exchange (QE) and Al Rayan Investment have announced the 7 January launch of the QE Al Rayan Islamic Index. The index is based on QE listed stocks of minimum free float size and liquidity that are Shari’ah compliant according to the Al Rayan’s Shari’ah Supervisory Board. The index is intended to support the creation of a Shari’ah-compliant exchange traded fund by Al Rayan Investment and has been issued with a fatwa by its Shari’ah Board.

A weighting scheme for the index has been customised to ensure both tradability and diversification across individual stocks and sectors. Qualifying stocks are ranked according to liquidity adjusted free float market capitalisation and then a tiered-weighting methodology is applied where fixed allocations are assigned to individual sub-segments of the basket. QE’s independent Index Committee governs the index’s weighting methodology and adherence to index rules. The index is total return based, reflecting dividend reinvestment and has been calculated back to January 2007. Since inception, the index has provided a more than 148% return.

Oman Applies Strict Islamic Banking Rules

When Islamic banks open in Oman in 2013, they will be subject to a set of regulations that are generally stricter than those in many neighbouring states. Despite intense lobbying from Omani banks, the central bank has stated that ‘Commodity murabaha or tawarruq, by whatever name called, is not allowed for the licensees in the Sultanate as a general rule.’ They say that in one off, exceptional circumstances tawarruq may be approved for a maximum period of three months.
Other rules include the following:

• Banks will be required to comply with AAOIFI standards and only where there is no relevant AAOIFI standard will they be permitted to use International Accounting Standards.

• Islamic window operations wil be required to produce a separate set of financial statements and banks will be expected to make changes to their accounting systems to comply with this requirement. Windows will also be expected to have dedicated staff, except in the case of support functions such as human resources, where they will be permitted to share the facilities of the parent bank.

• Banks will be expected to have their own Shari’ah supervisory board (SSB) comprising at least three members, whose names have to be submitted to the central bank for approval. Voting members must be experienced in Islamic commercial jurisprudence and members with an expertise in finance, law, economics or other disciplines will be non voting members. In very exceptional circumstances the central bank may approve the outsourcing of the SSB function.



Thomson Reuters Publish Report
on the Sukuk Market

According to a recent study conducted among sukuk lead arrangers and investors by Thomson Reuters and Zawya in August and September 2012, global captive sukuk demand is expected to double from $240 billion in 2012 to reach $421 billion by 2016. Supply is also forecast to grow but the spread between demand and supply is expected to widen even further to more than $280 billion within the next four years.

On the demand side, respondents in the survey expected 50% of their portfolios to be allocated to Islamic finance investments, out of which between $200 million and $800 million, or an average of 35-40%, would be allocated to sukuk. Notably, real estate is the least preferred sector for investors, while arrangers expect the lowest level of issuances from the oil and gas sector.

On preferred currencies, GCC investors overwhelmingly prefer USD sukuk, while Asian investors are split between USD, Malaysian Ringgit and other currencies. Asia Pacific investors voted overwhelmingly for domestic local currency issuances.

‘2012 was officially the Year of the Sukuk with more than $121 billion worth of issuances and the sukuk market officially achieving parity in pricing with conventional bonds. Yet, both demand and supply side factors suggest it will grow even further to reach $292 billion in issuances by 2016,’ commented Dr Sayd Farook, Global Head Islamic Capital Markets at Thomson Reuters.

Dr Sayd Farook

He continued, ‘The sukuk market is witnessing extensive growth and is finally breaking out from its shell of being a niche market instrument to enter a new era as a global alternative to conventional bonds. However, beyond rose-tinted spectacles, the sukuk market faces challenges that may slow or even clog growth channels. Deficiencies persist in the areas of sukuk structures and their associated documentation, investor rights, transparency and illiquidity in the secondary market due to the shortage of dedicated market makers and the lack of an Islamic mega bank.’

The study suggests there is a wide gap between the expectations of the sell and buy sides. For example, lead arrangers outside the GCC and Asia Pacific favour the wakala structure, but the majority of investors in all regions prefer ijara. Asia Pacific investors also show a taste for hybrid structures, with their sell side counterparts overwhelmingly expecting the hybrid structure as well.

Another notable mismatch was found in sukuk tenors - the majority of lead arrangers expect tenors to be between five and 10 years while the majority of investors prefer their tenors to be within the three to five year range.

In emerging markets, the study found that arrangers are more in favour of the Central Asian countries of Kazakhstan and Azerbaijan than investors, who lean more towards the North African countries of Morocco and Tunisia.

Focusing on the supply side, most lead arrangers consider the additional cost of issuing sukuk (over issuing conventional bonds) to be from less than $50,000 to $199,000. On average, 2% is the additional cost of a single sukuk issue as a percentage of its total size.

Dana Gas – There is Good
News and Bad News

The bad news is that in mid November 2012 Dana Gas missed repayment of the $920million still outstanding on their five year $1 billion sukuk and won the dubious honour of being the first UAE company to fail to redeem a sukuk on time. The good news is that the rest of the sukuk market barely blinked.

Three years ago, when the Dubai property bubble burst and state owned property developer, Nakheel came very close to defaulting on a $3.5 billion sukuk (ultimately they were bailed out by the government of Abu Dhabi), the sukuk market shuddered to a near standstill. The problem was not that there was anything inherently wrong with sukuk or indeed Islamic finance in general; the issue was that this still relatively immature market had no experience of how to handle a potential default. Since 2009 there have been a number of restructurings, some of them still ongoing, and the market is now more comfortable that these situations can be resolved without too much blood on the floor

This is the first ever corporate sukuk from a German company and believed to be the largest European corporate sukuk to date.

In the case of Dana Gas it looks as though the company may be able to negotiate a solution with creditors involving a partial repayment and two new sukuk to finance the rest of the debt. (Creditors may have been motivated to take a co-operative stance by suggestions that liquidating the assets of Dana Gas would result in a substantial loss on their original investments. London based investment house, Exotix estimated the recovery rate would be approximately 47% of par.) If, however, negotiations fail, there is now legal precedent to resolve the issue in the courts.

Sukuk Innovation at Abu Dhabi
Islamic Bank

In November 2012 Abu Dhabi Islamic Bank (ADIB) successfully issued the world’s first Shari’ah compliant hybrid tier 1 sukuk and the region’s first publically issued perpetual and tier 1 instrument. (Perpetual bonds have no fixed redemption date, although a bond issuer can call for the bond under certain circumstances. In addition, holders of perpetual bonds do not normally receive periodic coupons; coupons are received only when shareholders receive dividend payments.) The $1 billion (US) perpetual non call six-year issue was priced at an expected profit rate of 6.375%, which ADIB claim is one of the lowest rates achieved for any perpetual instrument by a global bank.

Tirad Mahmoud

The issue was 30 times oversubscribed with demand coming primarily from Asia (38%), the Middle East (32%) and Europe (26%). Private banks were the biggest class of subscriber (60%) with asset and fund managers accounting for a further 26% and commercial banks 11%. The sukuk will be listed on the London Stock Exchange.

Commenting on the transaction, Tirad Mahmoud, CEO of ADIB, said, ‘The success of this unprecedented transaction in the Middle East will enable the industry to realise the benefits from raising capital through the issuance of hybrid instruments as a cost efficient and non dilutive capital raising solution that lowers the cost of capital.’ He added that the new issue is designed, among other things, to boost Tier 1 capital to comply with Basel III global standards in anticipation of its implementation in the UAE.

An European Milestone

FWU Group AG, a Munich based financial services company primarily involved in takaful have issued a $55 million sukuk through the Dubai branch of its subsidiary, FWU Dubai Services GmbH. This is the first ever corporate sukuk from a German company and believed to be the largest European corporate sukuk to date. It is particularly interesting because it uses a software programme and intellectual property rights as the assets backing the ijara structured sukuk.

Commenting on the sukuk issuance Dr. Manfred J. Dirrheimer, Chairman of the Executive Board of FWU said, ‘This is a landmark transaction for the FWU Group, which, we believe, confirms our commitment to the growth of the global takaful industry on two levels: first the financing will expand our global network and broaden our takaful offering and second in providing an investment product for takaful companies who are often starved of such products. The fact we have achieved this through using an innovative structure and a first of its kind asset class makes the successful closing of this transaction all the more memorable. We are delighted by the confidence shown in us by investors and look forward to forging continued relationships with them and the industry as a whole.’

Saudi Arabia Plan to Issue Sukuk to
Finance Two Airport Developments

In a television interview at the end of 2012 Saudi Arabia’s Finance Minister, Ibrahim Alassaf said that the government will issue bonds in 2013 backed by the Kingdom’s Ministry of Finance to fund construction work at airports in Riyadh and Jeddah.

A first sukuk, launched in 2012, fully guaranteed by the Saudi Ministry of Finance, raised 15 billion Saudi riyals to help fund the Jeddah airport development and raise its annual capacity to 30 million passengers.


The Arab Spring and Milton Friedman: Is Reducing MENA’s Unemployment a Social Responsibility of Islamic Finance?

Usman Hayat,

There is buzz about the prospects for Islamic finance in parts of the Middle East and North Africa region (MENA) impacted by the Arab Spring. News reports suggest that, as a consequence of change in public policy, the market share of Islamic banking in Egypt will grow to ‘35% in five years from 5% now.’ Interestingly, it is Egypt, where a well-known initial experiment in modern Islamic finance was conducted in the 1960s. Much attention in Islamic finance circles is also falling on the relatively smaller markets, including Oman and Morocco. Observers, including researchers from Credit Suisse, are also pointing to Islamic finance as a potential spur to economic growth in the Arab Spring countries.

A question that arises out of all this buzz is this: Will the rise of Islamic finance address the problem of high unemployment among the Arab youth? After all, it is the Arab Spring that has created this shift in public policy in favour of Islamic finance.

MENA’s Unemployment and Finance

The countries in the MENA region are diverse in many ways including geography, economic resources and demographics but face, with few exceptions, a common challenge of high unemployment. The economic literature on MENA tends to see it as the region’s greatest challenge. It is difficult to exaggerate its scale and socioeconomic implications. According to Global Employment Trends 2011 by the International Labour Organisation, youth unemployment in the MENA region is estimated at 24.8% compared to the world average of 12.6%.

While economic growth is considered necessary for creating jobs, the unemployment problem may persist unless growth is employment-intensive. The public sector has played a much greater role in the economy in MENA than in other regions and public sector jobs are often preferred by youth, probably because securing and retaining them does not pose the same challenges as private sector jobs. It is unlikely, however, that the desired job growth will come from the public sector. The region is associated with low numbers of businesses in general and an unusually high proportion of relatively old businesses in particular.

There is a need to increase the role of the private sector and research shows that it is rapidly growing small and medium size enterprises (SMEs), particularly those in manufacturing, that are an important source of job growth. According to one estimate, in 2003 the combined manufactured exports of the entire Middle East were less than those from just one South-East Asian nation, the Philippines. Public policy has a critical role in creating the enabling environment for the SMEs such as providing the rule of law, sound taxation and regulation. Finance is often geared towards established and large business as opposed to SMEs and due to loss of trust, finance is often seen as part of the problem rather than part of the solution. It is frequently argued that job growth in MENA is best expected from high-growth SMEs. According to research by the World Bank, these SMEs consider limited access to finance to be a significant constraint. The buzz about Islamic finance is building expectations that it could help tackle unemployment in MENA by doing things, such as financing the underfinanced SMEs, that will create jobs.

Taking Responsibility for Unemployment

But is helping create more jobs a social responsibility of for-profit, shareholder-owned institutions offering Islamic financial services? Or, does this responsibility only belong to others, such as governments and development finance institutions?

The issue is not, ‘Can Islamic finance solve MENA’s unemployment problem?’ It cannot. Even governments are finding the challenge overwhelming and Islamic finance is but a niche within the financial sector. The issue is whether the Islamic finance sector should consciously attempt to contribute to tackling unemployment, to a reasonable extent, as part of its business strategy rather than as a by-product of its activities.

Will the rise of Islamic
finance address the
problem of high unemployment
among the Arab youth?

Why are such expectations of actively doing good for society not automatically triggered by conventional finance? That’s because conventional finance does not associate itself with a moral purpose, at least not explicitly and not to the same extent. Where conventional finance also uses terms like ‘ethical’ or ‘community banking’, it is faced with similar expectations — an implicit social contract between finance and society.

Friedman and CSR

If you are a follower of the economist and Nobel laureate Milton Friedman, you will probably think that tackling unemployment is not the business of for-profit finance, conventional or Islamic. According to Friedman, the social responsibility of business is to increase its profits, as he argued in an article published in the New York Times Magazine in 1970. Friedman’s core argument is simple and powerful: Management of for-profit, shareholder-owned companies should do what these companies are meant to do — maximize profits for shareholders.

Friedman’s argument is often invoked in Islamic finance. In a recent blog post, a London-based Islamic finance practitioner writes:

‘Islamic financial services providers, whether they are banks, takaful operators, asset managers or real estate fund providers, are normally companies with shareholders. Accordingly their prime responsibility is to maximise shareholder value while conducting their operations in accordance with the requirements of their Shari’ah supervisory board. Consequently any expenditure by Islamic financial services firms must be directed towards building their businesses either directly or indirectly.’

Those who disagree with this line of reasoning point out that Friedman also qualified his position by saying that ‘responsibility [of a corporate executive as an agent of shareholders] is to conduct the business in accordance with their desires, which generally will be to make as much money as possible while conforming to their basic rules of the society, both those embodied in law and those embodied in ethical custom.’ One can argue that today if the ethical custom of a society requires avoiding harm and doing good to society and the environment, then the corporate executive should not ignore the same in his decisions.

Islamic Finance and CSR

A somewhat different view of corporate social responsibility (CSR) is taken by the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI), the Bahrain-based standard setter in Islamic finance. The AAOIFI’s standard on CSR is not confined to simply acting responsibly while going about business as usual — a common notion of CSR — but goes far deeper into actively doing good as well as avoiding harm. For instance, its ‘mandatory conduct’ includes impact assessments of financing on the economy, society and environment, while its recommended ‘voluntary conduct’ includes assisting small and micro businesses.

Some of the messages coming out of Islamic financial institutions also suggest that they do not exist solely to maximise shareholder’s wealth. For instance, Kuwait Finance House (KFH), a prominent institution in the Islamic financial sector, reports that in 2010, among other philanthropic activities, it donated US$2 million for flood victims in Pakistan. Giving away such a sum to the poor in a country where KFH does not even operate is unlikely to increase the wealth of KFH’s shareholders, directly or indirectly.

AAOIFI’s CSR standard and philanthropy are materially different from some of the modern notions about CSR. For instance, in its 2011 Environmental, Social and Governance Report, Goldman Sachs says, ‘We define our social value by what we contribute to making markets robust and economies strong.’ Such modern notions of the role of corporations in society will likely be seen as consistent with Friedman’s position of maximising profits.

The Choice for Islamic Finance

Should Islamic finance follow Friedman’s position or should it align itself with the social cause of tackling unemployment?

The answer to this question probably lies in how the term ‘Islamic’ is interpreted by the financial institutions, their stakeholders, and society. The term Islamic, just like other terms regularly used in finance, such as sustainable, responsible, or ethical, does not mean the same thing to everyone!

To some, it may only mean avoiding financing businesses built around ‘sins’, such as drinking alcohol and gambling and giving lending the form of sales or leases while retaining its economic substance. This minimalist and form-oriented approach, while not uncommon, also explains much of the criticism that is frequently levelled at the industry.

It is safe to assume that to others, particularly the enthusiasts for Islamic finance in MENA, the term Islamic means more. While what exactly that ‘more’ is remains amorphous, AAOIFI’s standard on CSR, despite lacking regulatory power, helps us understand some of the expectations associated with it.

The institutions eager to capitalise on the renewed prospects of Islamic finance in parts of MENA will do well to clarify their position. Will they consciously channel financing to such sectors as SMEs to align with the social cause of tacking unemployment, even if it involves compromising some financial return? Or, will these institutions invoke Friedman’s argument and only maximise profits, because this is what they believe to be their raison d’être?

Both paths will have their challenges. Those wishing to address unemployment on a sustainable basis will probably need a clear mandate from their shareholders and account holders to do so. Those wishing to only maximise profits while using the term Islamic will probably find it hard to maintain support from policymakers and society, because conventional finance is already maximising profits.

Against the backdrop of the Arab Spring, it will be interesting to observe if and how far Islamic finance is willing to go beyond maximising shareholder’s wealth to tackle MENA’s unemployment.

Usman Hayat, CFA,
is director of Islamic finance & ESG at CFA Institute.

Any views expressed here are solely those of the writer.

Turkey’s Islamic Finance Journey

Andrea Wharton,


The modern Turkish state came into being in 1923 with the Treaty of Lausanne, which effectively stripped away the last remaining vestiges of the once mighty Ottoman Empire, settled the borders of Turkey and recognised the government of Mustafa Kemal Atatűrk. Atatűrk effectively turned Turkey into a democratic, secular state. (It was democratic in that citizens had the right to vote, but until 1945 they could only vote for one party, the Republican People’s Party.) He abolished all Islamic institutions, as well as Westernising dress codes and the legal system and replacing Arabic script with the Latin alphabet. He even established a Directorate of Religious Affairs to supervise and monitor religious activities. He also pursued a policy of centralised economic control and state ownership and management of business and finance. There was no need to westernise the banking system, because, even during the Ottoman period, this had been based on the European model.

Although Turkey became a multi party democracy in 1945 and Muslim political parties began to emerge in the 1970s, culminating in a landslide election victory for the Justice and Development Party (AKP) in 2001, the secularist tradition established by Atatűrk has remained largely intact. It is perhaps unsurprising, therefore, that Turkey does not use the epithet ‘Islamic’ to describe banks structured in accordance with the Shari’ah; they are called participation banks.

The Evolution of Participation Banking

By the 1980s Turkey along with many other countries was becoming disillusioned with tight state control of the economy and motivated by poor economic performance the Turkish government began to introduce liberalisation measures, which included the legalisation of ‘special finance houses’ to provide interest free banking. These institutions were, however, second class citizens in the Turkish banking world; they operated outside the regulatory control of the central bank; they were not included in the central bank’s insurance programme, which guaranteed customer deposits up to a certain level and they were not allowed to invest in government securities.

A watershed was reached in 2001 when Turkey suffered a major economic crisis with more than 20 banks failing, including one participation bank. This led to a new banking law which among other things brought participation banks under the regulatory control of the central bank through compulsory membership of an organisation called the Union of Private Finance Houses, although, once again, this still fell short of equal status with state and conventional banks, e.g. deposits were still not guaranteed. In 2006 further legislation changed the name of the Union of Private Finance Houses to the Participation Banks Association of Turkey (TKBB), a sort of regulatory body for participation banks and levelled the playing field in terms of introducing deposit insurance and protection under Turkey’s bankruptcy laws. They are still, however, not regarded as full banks and are not members of the Turkish Association of Banks. The cynical view of these modest changes would be that the government did just enough to begin to attract more inward investment from the oil rich states of the region.

While sukuk are important for the further development of participation banking in Turkey, they are also key to Turkey’s ambitions to attract more investment from wealthy Middle Eastern and Gulf investors

Today there are four participation banks in Turkey – Kuyvet Turk owned by Kuwait Finance House; Turkiye Finans, which is majority owned by Saudi Arabia’s National Commercial Bank; Albaraka Turk Participation Bank, which is a subsidiary of the Bahrain based Albaraka Banking Group and the home grown Asya Bank established by a consortium of businessmen in 1996. Asya Bank and Albaraka Turk command the retail banking business with 91% and 81% of their loans respectively going to individual customers, although there is a subtle difference between the two banks in that 95% of Albaraka’s loans are in the form of mortgage finance, while the figures for Asya Bank are 39% mortgages and 58% straight consumer loans. Turkiye Finans and Kuyvet Turk with 89% and 75% of their loans respectively going to commercial customers are the commercial banking specialists.

By 2009 the four participation banks held just over 4% of the total banking market in Turkey. (There growth, interestingly, was largely unaffected by the 2008 global financial crisis.) The most recent estimates suggest that this has risen to between 5% and 6% at the end of 2012. The participation banks have not been slow to position themselves as a less risky, more ethical form of banking in the wake of the global financial crisis in an effort to attract business. In an article published in the Chinese Business Review in June 2012, Dr Lamiha Gun of the Turgut Ozal University, Ankara suggests that this may be something of a chimera. She comments that ‘that risk taking by the participation banks is in general much more important than that realised by the traditional banking sector. This result could lead to a questioning of the idea that the market of Islamic finance is safer and less risky than classical financial institutions.’

In practice the participation banks face strong competition from the conventional sector, which, unlike many other countries in the region, became entrenched in the 20th century, alongside well developed conventional capital markets. Beyond the purely practical issues, there is the much more emotive issue of conflict between Islamic finance and Turkey’s secular identity, established by Atatűrk in the 1920s; there is deep suspicion among many of the urban Turkish population about the intentions of the AKP in relation to the secular state. Islamic finance will not achieve the growth top which it aspires based on the support of poorer rural populations alone; they need to have the wealthier urban businessmen on side.

The Retail Banks

Asya Bank

Asya , the largest of the Turkish participation banks, is seen as home grown and it was certainly set up in 1996 through the offices of a consortium of local businessmen, but only 14.5% of its shareholders are identified as domestic, with 85% being unspecified according to the BDDK, Turkey’s Banking Regulation and Supervision Agency. Asya went public in 2006, when it floated 23% of its shares, raising that to 52.5% in 2010. By the end of 2011 it had 200 branches and aims to increase this to 300, although no timeframe for this expansion was mentioned.

Although its total assets grew between 2010 and 2011 to Turkish Lira (TRY) 7.2 billion (18.4%) and deposits to TRY 12.4 billion (11%), net profit fell by 16.9% to TRY 216 million, which may be due to actions taken by the regulatory authorities to ensure the Turkish banking sector remains strong in the face of continuing turbulence in global financial markets and increased costs of foreign borrowing.

Today, Turkey is facing west with its pursuit of EU membership and its membership of NATO and east as it strengthens its ties with Arab neighbours.

Asya’s ambitions are, however, not limited to Turkish expansion. In 2009 they entered into an agreement with the Jeddah based Islamic Corporation for the Development of the Private Sector to set up Tamweel Africa SA to support Islamic financial institutions in sub-Saharan Africa. Tamweel’s first move was to buy majority shares in two African Banks, the Islamic Bank of Niger (66%) and the Islamic Bank of Senegal (77.5%) and 100% of the Islamic Bank of Guinea. Towards the end of 2012 they also opened their first branch in Erbil in Northern Iraq.

Asya Bank’s expansionist strategy means, of course, that the bank needs capital. They flirted with the idea of issuing a sukuk in 2011, but backed away claiming market conditions were not right. In the late summer of 2012 there were again strong indications that the bank would go ahead with a sukuk by the end of 2012. The plan was for a much smaller issue ($84 million) than the $300million sukuk that was abandoned in 2011, but in mid December there was still no sign that the issue would take place in 2012. In an interview with Reuters in mid December 2012, Abdullah Celik, Asya’s CEO claimed that the Turkish lira denominated sukuk would go ahead by the end of January 2013 and that a further, larger (around $200 300 million), dollar denominated sukuk would follow hot on its heels.

While Asya Bank is the largest and most profitable of the four participation banks in Turkey, Dr Lamiha Gun comments, ‘...analysis of risk-taking and managing risk exposure reveals that the Bank Asya has the riskiest position and the Capital Adequacy Ratio (CAR) of this bank is the lowest one.’

Albaraka Turk Bank

Albaraka Turk bank, the oldest of the participation banks, was established in 1984 and opened for business in 1985. It has 134 branches across Turkey and at the end of 2011 it had total assets of TRY 10.5 billion, an increase of 24% over 2010. Profits were up 19% in 2011 at TRY 160.5 million. Although it is the oldest of the four participation banks it is also the smallest in terms of assets, loans and deposits. The majority shareholder of Albaraka Turk is the Bahrain based Albaraka Group with minority shareholdings held by the Islamic Development Bank and the Alharthy Group. Domestic Turkish shareholders make up between 11% and 13% of the total. Just over 22% of the shares are publically traded on the Istanbul Stock Exchange following an Initial Public Offering (IPO) in 2007.

The bank has been raising money to fund expansion and diversify its funding sources through syndicated murabaha facilities $240 million in 2010, $350 million in 2011 and the latest in 2012 raising £450 million.

Turkiye Finans

Turkiye Finans came into being at the end of 2005 with the merger of two organisations – Family Finans and Andolu Finans. Early in 2008 60% of Turkiye Finans shares were acquired by the National Commercial Bank (NCB) of Saudi Arabia. (This holding by NCB has since grown to 64.7%.) Turkiye Finans serves an estimated 1 million customers through 178 branches. The most recent published financial results for the half year to June 2012 show the bank’s profits grew 61% compared to the same period in 2011. Predictions of full year growth were 25%. It is believed to be the fastest growing of the participation banks and is the second largest of the participation banks currently.

In May 2012 the bank raised $350 million through a murabaha loan and said at the time that they also planned a $300 million dollar denominated sukuk in early 2013.

Kuyvet Turk

Kuyvet Turk, a subsidiary of Kuwait Finance House, is 70% foreign owned and has an estimated 288 branch offices. It also has the highest proportion of foreign deposits among the participation banks at 48%. It is, in some respects, the most conservative of the participation banks, being considered to be the most risk averse with a Capital Adequacy Ratio that is correspondingly high.

While the other participation banks are talking about issuing a sukuk, Kuyvet Turk have actually done this with a $100 million issue in 2010 and a further $350 million issue in 2011. They also have ambitions of overseas expansion and in 2012 applied for a full banking license in Germany, which has a significant population of Turks, estimated to be around 2.7 million. (The bank already has a partial banking licence in Germany, which allows them to accept deposits.) If the experiment is successful, they have said that they will consider opening branches in other European countries. They also have a subsidiary in Dubai’s International Financial Centre (DIFC) and a representative office in Kazakhstan and are considering opening a branch in the Kurdish region of Northern Iraq.

Sukuk in Turkey

A key development for participation banking in Turkey was the announcement in April 2010 by the Capital Markets Board that private companies would be able to raise capital through leasing certificates, which is a bond without interest. Kuveyt Turk was the first of the participation banks to take advantage of the change in the regulatory framework issuing a corporate sukuk in September 2010.

More contentious was the issue of a sovereign sukuk and whether this would contravene Turkey’s constitution and its policy of state secularism. In the event, these problems were overcome and in September 2012 the Turkish government issued its first sovereign sukuk. Worth $5 billion, the sukuk was five times oversubscribed. While sukuk are important for the further development of participation banking in Turkey, they are also key to Turkey’s ambitions to attract more investment from wealthy Middle Eastern and Gulf investors.

The Bigger Picture

Economic Factors

Islamic banking does not exist in a vacuum; the economic, political and legal and regulatory environment in which it operates affect its growth. In economic terms Turkey has experienced mixed fortunes over the last 10-15 years. In that period Turkey has experienced two financial crises. The first in 2001 was largely a domestic issue, triggered by weak regulation, the accumulation of bad debts and a loan book that was heavily skewed to the public sector. In February 2001 the Turkish lira became a free floating currency and fell 40% in three days leading to rampant inflation and a liquidity crisis. More than 20 banks failed in this crisis, including one participation bank, Ihlas Finans.

The actions taken in the wake of this crisis had a dramatic effect and World Bank data on Turkish Gross Domestic Product (GDP) shows GDP rising from $196 billion in the trough of the 2001 crisis to $647 billion in 2008. The 2008 global financial crisis caused a blip in the growth with GDP falling back to $615 billion, then recovering to 2011 when GDP was $773 billion. Concerned about overheating in the economy and particularly the level of the current account deficit, the government took action, doubling interest rates and restricting lending growth. The result by the end of 2012 was a fall in industrial production and a lower than anticipated rate of GDP growth, the slowest since 2009, leading analysts to question whether Turkey will be able to reach its 4% growth target for 2013. The problem is compounded by the fact that Europe, Turkey’s biggest trading partner, is still fighting off the Eurozone crisis, with growth rates in economies across Europe either dismally low or non existent.

Turkey’s government point to their success in reducing the current account trade deficit, but, this is not due to booming exports, which are actually falling; it is due to even faster falling imports. Against this economic background, it is difficult to see the finance sector, whether that is conventional or Islamic finance, enjoying strong growth.

Political Factors

The current AKP led government has shown a willingness to support Islamic finance and has introduced a number of measures to level the playing field for participation banks. It has also supported other measures that will help Islamic finance such as the establishment of a Shari’ah compliant ‘participation index’ on the Istanbul Stock Exchange in 2011 and, perhaps most importantly, the issue of a sovereign sukuk in 2012. As long as the government continues in office it is reasonable to assume that there will be further structural and regulatory support for Islamic finance. The elephant in the room, however, is the Turkish military. They have traditionally been strong supporters of the secular state and down the years have staged a number of coups, when they felt this position was threatened. In 2011, the government took pre emptive action against a number of senior military officers accused of plotting the overthrow of the government, which resulted in the jailing of three generals for 20 years and lesser sentences for more than 300 others. Whether this action has neutralised the threat from the military or simply driven it deeper underground, only time will tell.

In terms of foreign affairs, tensions have arisen with NATO (North Atlantic Treaty Organisation), of which Turkey has been a key member, over Turkey’s transfer of support from Israel to the Palestinian cause and more recently their diplomatic backing for the Syrian rebels trying to oust the government of President Assad. At home the Kurdish question is also far from completely resolved, although the present government have taken a more conciliatory approach to the issue.

The Future for Islamic Finance in Turkey

The present government has taken important steps to make Turkey a friendlier environment for Islamic finance and it is reasonable to assume that they will continue along this path, particularly encouraged by the success of the country’s first sovereign sukuk. The threats to further progress are both external and internal. Stable political and economic environments are essential for banks, conventional and Islamic, to flourish. Any hint of instability will affect both domestic and international confidence in the system.

The problem for Turkey is that some of the factors affecting stability are beyond their direct control, for example, a return to solid economic growth in Europe, Turkey’s major trading partner and political unrest in the region such as the Syrian situation. If the economic and political situation is not adversely affected by any of these factors, then there is every reason to be optimistic about Turkey’s future as a major financial centre in the region, with Islamic finance perhaps benefiting disproportionately as religiously observant Turks move increasingly towards Islamic finance and Gulf investors become ever more comfortable with investing their funds in Turkey. Given, however, Turkey’s long history of conventional banking and well established financial structures, it is difficult to foresee Islamic finance dominating the Turkish financial scene any time soon, even if, as is rumoured, a number of Gulf financial institutions are expressing strong interest in setting up operations in Turkey.

Turkey has been viewed as the bridge between Europe and Asia since antiquity. The Romans even called the region, Pontica Asiana, the Asian bridge. That is both Turkey’s strength and its weakness. Today, Turkey is facing west with its pursuit of EU membership and its membership of NATO and east as it strengthens its ties with Arab neighbours. If it can successfully balance these two aspects of its personality, in the long term Turkey could become a very important financial centre for the Middle East and the Gulf with local strength in both conventional and Islamic finance.

Turkey has been viewed as the bridge between Europe and Asia since antiquity.
Map Of Turkey

An Islamic Solution to the Present Policy Dilemma

Azura Othman
Abbas Mirakhor


One important consequence of the global financial crisis has been a growing uncertainty about the adequacy of policy regimes whose central anchor is the interest rate based debt system. It appears that such regimes have not managed to stimulate stable and strong recoveries; instead they seem to have enhanced the vulnerability of economies to shocks. In most situations budget deficits, arising from deficiencies in revenue to fund increased government spending to stimulate post crisis growth, have been financed through increased borrowing. More often than not the present and prospective rates of growth are lower than the interest rate on the growing debt. In theory a stimulus is supposed to be financed by the subsequent growth; it now appears that in many economies, growth will not be large enough or fast enough to validate the debt levels approaching, or in some cases exceeding, 100% of GDP. The solution of austerity, higher taxes and lower spending suggested by the dominant policy regime takes strong political consensus, which does not appear to be forthcoming in many crisis countries. Increased borrowing via bond issuance or long term government borrowing also does not appear to be a desirable solution as it increases vulnerability, creates a burden on future taxpayers and has adverse distributional implications. All in all, a change in policy regime seems to be in order.

An Islamic Solution

An Islamic perspective would propose a two pronged solution reform of the tax system and a radical change in the way governments finance their spending. The result of these reforms would lead to a change in the design and implementation of fiscal and monetary policies. The cornerstone of this view is the way the Islamic view envisions financing of economic activities, be it the private sector or government. A compelling case can be made that Islamic finance is all about risk sharing. Government as the ultimate risk manager should ensure that risk sharing is promoted throughout society. It should also find ways and means of sharing the risk of its operations with the public at large. To a large extent, governments do share risk; they are the silent partners in the private sector through the tax and spending administration. For example, if the private sector does not perform well, governments share in the losses through a reduction in their tax revenues and an increase transfer spending. What the Islamic view would suggest is that this approach needs to be expanded considerably. Let us first consider the required tax policy changes and then proceed to the reform of government finances.

The Ideal Tax System

Summarising tax structures progressive tax schemes charge lower tax rates to the poor and then the tax rate becomes progressively higher from the middle to upper class brackets; regressive tax schemes reverse this order and flat rate tax schemes charge all economic classes the same percentage. A good tax policy is envisioned as one that balances simplicity, efficiency, fairness and revenue sufficiency. It is one that will induce social solidarity and increase tax compliance. It will also have rules that are sufficiently simple and transparent to attract voluntary declaration from taxpayers. A simple tax system, as opposed to a complex one, would result in cost efficiency and increased tax collection.

The growth benefits of a flat rate system have been demonstrated in some Eastern European countries.

Based on the above premise a flat tax system, composed of a 20% income tax and a 2.5% wealth tax that is simple and can reduce tax avoidance, has the potential to be ideal as it reflects the rate structure of Khums (Verse 41 of Chapter 8) and Zakat prescribed by the Qur’an and the Sunnah. The growth benefits of a flat rate system have been demonstrated in some Eastern European countries. In order to address the issue of the tax burden on low-income earners, a minimum exemption level of income similar to the concept of nisab, can be determined corresponding to the level of the minimum, current standard of living. As wealth generally represents a much larger tax base than income, the rate of taxation can be kept low, but still raise substantial tax revenue. It is also argued that a wealth tax may encourage people to transfer their assets from less to more productive uses and from idleness to income producing capacity.

Public Sector Financing

It is acknowledged that at times tax revenue may not be sufficient to fund all the desired development expenditure, therefore the government has to borrow to cover gaps in the budget. The current public sector borrowing policy that is based on debt has placed countries in highly leveraged positions; in some cases nearly all growth goes to debt servicing. High debt levels constrain a government’s ability to take on additional risk in its balance sheet and reduce fiscal space, impairing the ability of the policymakers to respond effectively to shocks.

Experience has shown that excessive debt relative to GDP has been one of the roots of the financial crises. It is perhaps time for public sector financing to be reformed with a move away from a debt based system toward an alternative system based on risk sharing. The benefits of risk sharing are manifold; the growth of the economy would be based on the growth in the real sector of the economy, rather than the growth of financial activities; social solidarity would be enhanced through the sharing of risk and return and, in the long run, a better distribution of income and wealth would result.

By issuing risk sharing instruments to fund development expenditure, the burden of debt can be reduced.

Collaborations between the population, the private sector and governments can be developed through risk sharing instruments. Instead of borrowing, risk sharing government securities (effectively equity shares) to finance development projects can be issued in low enough denominations to allow access to the general public. Reforming public sector borrowing policy as such enables the utilisation of high private sector savings, putting them into productive uses. By issuing risk sharing instruments to fund development expenditure, the burden of debt can be reduced. At the same time, the household sector would be able to enjoy a higher rate of return on their savings. The rate would be driven by the return to the real sector. In every economy the rate of return to the real sector is larger than that earned currently in saving accounts.

The instruments can be openly traded in the secondary market; therefore holders can redeem or liquidate the instruments through sale at the prevailing market price. At the same time, these instruments can also serve as monetary policy measures. For money supply expansion, the instruments can be bought from the open market thereby increasing the amount of money in circulation. This way, monetary policy becomes more potent as it would directly influence private sector portfolio adjustment. Governance would also improve as governments would be more accountable to the general public.

Fiscal Sustainability

Such proposed tax reform could well increase government revenue. Financing of government via risk sharing would have a positive distributional impact, improve governance as citizens will become more involved in directly financing government projects, provide greater fiscal space and flexibility to policy, reduce the burden on the future generations, enhance social solidarity and provide effective tools for monetary policy. As things stand today, in most crisis countries, monetary policy’s transmission mechanism is impaired as quantitative easing just adds more liquidity to financial intermediaries who do not lend to the private sector to stimulate growth, but instead invest in low risk government paper. Under the new regime, monetary policy can directly affect the private sector’s portfolio adjustments through the sale and purchase of low denominated, risk sharing instruments that are traded in the secondary markets. There will be a strong incentive for the citizens to invest their savings in government, risk sharing securities rather than depositing them in banks with no or very low rates of interest. The participants can reduce the risk of income volatility and allow consumption smoothing, which increases the welfare of society. Based on these premises, the overall combined effect of the proposed fiscal policy is expected to generate a higher GDP for the country. By generating increased tax revenue and tapping private sector savings, the government will not only avail itself of a source of funding for its expenditure, but also provide a more equitable opportunity for the public to have access to the wealth of the nation. How could such a solution resolve the European crisis? If all the creditor governments and agencies, instead of making loans to bail out crisis countries, pooled their resources and issued long term sukuk with rates of return tied to future rates of GDP growth in these countries, the international community, including Europe itself, would share the risks and benefits of the future growth without creating a greater debt burden that only kicks the can down the road to future disasters.

Azura Othman

Azura Othman is currently a PhD candidate in Islamic Finance with the International Centre of Education in Islamic Finance (INCEIF). Her area of interest is macroeconomic policy. She was an Executive Director with PricewaterhouseCoopers Taxation Services, Malaysia and has over 18 years experience as a tax consultant with extensive involvement in engagements relating to Islamic Finance. She holds a degree in Accounting and Finance from the London School of Economics, a Fellow of ACCA (UK), member of Malaysian Institute of Accountant and Association of Chartered Islamic Finance Professional.

Dr. Abbas Mirakhor

Dr. Abbas Mirakhor is the first holder of the chair of Islamic Finance at the International Centre for Education in Islamic Finance (INCEIF) in Malaysia. From 1969 to 1984, he taught at a number of universities in the US and in Iran He served on the staff of the International Monetary Fund (IMF) from 1984 until 1990 and as an Executive Director at the IMF from 1990 to 2008 and also as Dean of the Executive Board for much of that time. He has received several awards, including the Islamic Development Bank Annual Prize for Research in Islamic Economics in 2003.


Certifying Shari’ah Compliance in Financial Products:
The Role of Islamic Values in Financial Decision Making

Sheikh Yusuf Talal DeLorenzo

This article looks at Islamic values in financial decision making by considering whether or not Shari’ah supervisory boards will approve any financial product that is delivered by halal means, even if what is delivered by those means, the end product, is derived from non compliant investments. This may be characterised as a quasi philosophical question, yet, it is one that carries a myriad of practical implications, not to mention far reaching ramifications for the growing Islamic financial industry.

This is a case study and not a theoretical article. Its focus is a particular product; and in studying it, we shall attempt to shed light on the place of law and morality in the deliberations of modern Shari’ah supervisory boards and the bodies of Muslim jurists who oversee and certify the products, services, and operations of modern Islamic banks and financial institutions.

Part of the reason for writing this paper is to draw the attention of scholars and industry experts to the importance of making a distinction between bringing returns from Shari’ah compliant investments and bringing returns from non Shari’ah compliant investments. If care is not taken, this ‘mechanism’ represents a great danger to modern Islamic finance. My own reaction to this threat, initially, was to suggest recourse to sadd al-dhara`i, the instrument in Islamic jurisprudence that blocks ostensibly legitimate means to illegitimate ends. On closer study, however, I have concluded that there is no need to resort to this instrument as the matter is simply one of distinguishing between what is truly lawful, halal, and what is truly unlawful, haram. In what follows, I will explain exactly what led me to this conclusion and why I think it necessary to share my thoughts on the matter.

While the approach outlined above is based on law rather than morality, it remains to be seen whether or not Shari’ah supervisory boards will agree with it.


Recently, a financial ‘mechanism’ was developed, the purpose of which is to ‘wrap a non Shari’ah compliant underlying into a Shari’ah compliant structure.’ (These words were actually included in a document from a multinational bank seeking Shari’ah board approval for a structured product based on this mechanism.) In other words, the objective of the mechanism is to use non compliant assets and their performance to bring returns into a so called Shari’ah compliant investment or investment portfolio. This point is key to the entire transaction and for that reason it needs repeating. What the product proposes to accomplish is to bring to the Islamic investor returns from investments that are not compliant with Shari’ah principles and precepts. The questions that such a product immediately brings to mind are: How can Shari’ah boards approve such returns? Does the circumstance of direct or indirect delivery to the Islamic investor change the ruling? When the Shari’ah of Islam is understood to differ from other legal systems, because it may be characterised as both positive law and morality, is it possible to ignore the moral aspect of a financial transaction like this?

The means of delivery, a wa’d or promise, is widely seen to comply with Shari’ah norms. Since it is compliant, at least to the letter of the law, some Shari’ah scholars see no difficulty in approving products that use a wa’d to deliver returns from non compliant investments. By doing so, however, they fail to consider the purpose of the transaction, the movement of the cash and, most importantly, the ramifications for the industry as a whole. At a very fundamental level, the reason for these failings is that the approving scholars have not discerned the difference between the use of LIBOR as a benchmark for pricing and the use of non-Shari’ah compliant assets as a determinant for returns.

In June of 2007, a pioneering Islamic bank in the Gulf launched a principal protected note that was the first product to use this ‘mechanism’ to be offered to the public. That product was followed by others that used the same mechanism. Prior to this retail offering, the mechanism had only been used in structured products offered by multinational banks to institutional investors and the treasuries of Islamic banks and finance houses. All of these products, retail and institutional, have been approved and certified by qualified Shari’ah supervisory boards. Not all of these products, however, bring to the Islamic investor returns from investments that are compliant with Shari’ah.

A Few Explanations

Before examining the mechanism from an Islamic legal perspective, however, it may be helpful to make a few preliminary remarks.

1. There should be no reason to object to the use of a wa’d on its own. The use of promises is a matter that the Shari’ah boards of modern Islamic financial institutions have studied in detail. It will not, therefore, be necessary to discuss the definition of a promise, the conditions for its use, its purpose or its legal characterisation (in terms of wajib, makruh, etc.).

2. The financial instrument that the wa’d structure seeks to facilitate is called a swap. Swaps are arrangements between counterparties to exchange cash flows over time and they are very flexible. The most popular forms of swaps are interest rate swaps and currency swaps because these allow effective management of both balance sheets and risk profiles. In an interest rate swap, for example, no principal is exchanged between the counterparties; only interest is exchanged. The utility of a swap comes from the ease with which it is entered into, as opposed to the numerous steps required to accomplish the same thing by other means.

3. LIBOR (the London Interbank Offered Rate) is the rate at which international banks charge one another for dollar denominated loans in the London market and is therefore used widely as a reference for any floating-rate loan. Depending on the credit rating of the borrower, that rate may vary from LIBOR to LIBOR plus one or more points over LIBOR.

Before discussing the purpose of the transaction, the movement of the cash and, most importantly, the ramifications for the industry as a whole, it will be well to look first at how the wa’d mechanism is actually employed and then at the difference between the use of LIBOR as a benchmark for pricing and the use of non Shari’ah compliant assets as a determinant for returns.

The Wa’d Mechanism

The product developed for the exchange of non Shari’ah compliant returns for Shari’ah compliant returns generally begins with the purchase by the Islamic investor of Shari’ah compliant assets by means of a murabaha contract. In most cases, these will be commodities or base metals. Through a murabaha contract, the bank can offer Shari’ah compliance and fixed returns of, say, 5%. Then, to give the investor the ability to enhance the returns from the investment, the bank arranges to swap the returns from the murabaha with returns from another investment. The way it does this is by means of a promise, a wa’d. Effectively, what the promise says is that at maturity, or at the end of a certain period of time (generally three to five years) the counterparties promise to swap their returns, sometimes with certain conditions attached. The bank then takes the further step of protecting the principal invested by the Islamic investor by one means or another.

Shari’ah boards have approved any number of less than ideal devices if they have been convinced that these will assist in promoting the industry in general.

The benefits to the Islamic investor are obvious; the principal is protected, the returns will almost certainly be at least 5% (from the murabaha) and there is a good possibility that the assets in the other basket will outperform the murabaha. The benefits to the bank may not be quite so obvious, but in fact they are far greater than the benefits to the Islamic investors as we shall see later in this paper when we ‘follow the money’.

Most importantly, however, the Islamic investor is told that the investment is completely Shari’ah-compliant. This is because the money invested has been used for nothing other than the purchase of Shari’ah compliant commodities. The return on the investment, if it comes from the murabaha, is clearly compliant with Shari’ah principles and precepts and if the return comes from the other investment, by means of the promise to exchange returns, then those returns may be considered legitimate, halal, even if the investment is non Shari’ah compliant. According to the Shari’ah boards that have approved such exchanges, the non Shari’ah compliant assets have been used to establish a price and the promised exchange is for the value of the returns established by the performance of the non Shari’ah compliant assets. This, they reason, is no different than using LIBOR, an interest rate, to establish the price for a murabaha or an ijara. If the use of LIBOR has been nearly universally approved by Shari’ah boards, then the swap achieved by a promise should also be approved.

LIBOR and How Returns are Determined

Let us now consider the difference between the use of LIBOR as a benchmark for returns and the use of non Shari’ah compliant assets as a determinant for returns. Shari’ah boards have approved any number of less than ideal devices if they have been convinced that these will assist in promoting the industry in general. A good example is the use of LIBOR as a benchmark for pricing a murabaha or an ijara when floating rates are to be preferred over fixed rates. In the absence of a viable and widely published alternative, LIBOR has been used repeatedly. (With the launch by Thomson Reuters in November of 2011 of the IIBR or Islamic Interbank Benchmark Rate, however, it may be hoped that the use of LIBOR will be phased out). In the final analysis, the LIBOR benchmark is no more than a standard or measure and therefore non objectionable from a Shari’ah perspective. If it is used to determine the rate of repayment on a loan, then it is the interest bearing loan that will be haram. LIBOR, as a mere benchmark, has no direct effect on the actual transaction or, more specifically, with the creation of revenues.

In modern Islamic financial transactions, LIBOR has been used to facilitate the closing of literally hundreds, if not thousands, of Shari’ah compliant financings. It should be noted, however, that these do not involve interest. As explained above, LIBOR is merely a convenient measure of the financial markets. Most importantly, the use of LIBOR as a benchmark for pricing in no way means that interest has entered the transaction itself. This is because LIBOR is a notional rate. The bank loans that determine this rate will under no circumstances become a part of the Shari’ah compliant ijara or murabaha transaction that is benchmarked to LIBOR. Finally, the money paid into an ijara investment using LIBOR will never pass through to the banks whose rates contribute to the setting of LIBOR and will certainly never finance or serve as collateral for, either directly or indirectly, assets whose performance or credit rating will set that rate.

When a Muslim investor invests in a product that uses a promise to swap returns from a non Shari’ah compliant investment, however, the matter is quite different. For, while LIBOR is a benchmark used to set a price by marking value, the wa’d is used to actually deliver that price, even if it does so synthetically. By means of the wa’d, the unwitting Muslim investor actually participates in the non Shari’ah compliant investment, however indirectly. This is because, when the investor agrees to exchange murabaha returns for returns from another investment, the investor indicates qubul or approval of the other investment. If that investment includes non compliant assets and instruments, like conventional bonds or treasury bills, then the investor is approving the same and the transaction must be considered unlawful. Finally, and perhaps most significantly, the money paid into the wa’d investment will most certainly be used to finance the other investment(s), however indirectly. Even if the Muslim investor is not, therefore, directly financing non Shari’ah compliant transactions, if the investment with the swap had not been made, those non Shari’ah compliant transactions would not have taken place. This will be clarified later when we consider how the cash in such a transaction actually moves.

The attempt to draw a legal analogy, qiyas, between the use of LIBOR for pricing and the use of the performance of non Shari’ah compliant assets for pricing is both inaccurate and misleading. The only similarity is that both are used for pricing. Where LIBOR is used to indicate the return, however, the other is used to deliver the return or, as we shall see, the other is the return. It is, therefore, simply incorrect to justify the swap of returns from non Shari’ah compliant assets by comparing the same to LIBOR and then saying that since the one is approved by Shari’ah supervisory boards, the other should also be approved. Using the same faulty logic, one might argue that since Shari’ah boards have approved LIBOR, an investment in a British bank that contributes data to LIBOR should likewise be approved by Shari’ah boards.

The Purpose of the Transaction

The purpose of the transaction was clarified by a spokesperson for the bank offering the product to the public who explained that it was designed to allow Muslim investors access to funds that operate in a non Shari’ah compliant manner by ‘reflecting their performance.’ The euphemistic description of what the product aims to achieve, like the simplistic explanation of how the money in the investment remains exclusively in compliance with Shari’ah rules, is in my opinion a manipulation and, ultimately, a misrepresentation of the truth. The term sheet for one such product states unequivocally that its purpose is to ‘wrap a non Shari’ah compliant underlying (asset) into a Shari’ah compliant structure.’ Nothing could be clearer. When this is the purpose, how can a Shari’ah board possibly approve? Does it matter if the structure and the transactional basis of these schemes are compliant with established Shari’ah rules if the end product is the result of prohibited investments? Does it really matter if that result is direct or indirect if the returns are from investments that do not discriminate between right and wrong, halal and haram, good and harmful? What the public is invited to invest in is a basket that will ‘reflect’ returns from anything from wineries, to pork futures, to casinos, to who knows what else? At the present time, the matter is in the hands of the investors, many of whom are institutional investors with their own Shari’ah supervisory boards; and it is still unclear as to how those boards have decided to view the matter. In my opinion, this particular issue will answer the question of how modern Shari’ah boards will actually deal with matters of morality.

The Movement of the Cash

Before the reader begins to suppose that this discussion is more about taqwa and less about fatwa, or morality rather than law, let us now consider the movement of the cash. The Islamic bank that offers this product insists that the Muslim investor’s money is invested in a Shari’ah compliant product and that the returns are completely halal. Their claim is that the investor’s money is used to purchase a principal protected note, structured by a multinational bank, which invests in simple murabaha contracts. The contract for the note includes an agreement, no more than a promise actually, that if the returns from the murabaha are less than the returns from an internal hedge fund index, then the structuring bank will pay the investor an amount equal to the returns from the index. To be more precise, if the hedge funds outperform the murabaha, the investor will earn returns that are better than murabaha returns. Since the bank will pay investors with its own money, the investors will not receive returns directly from the conventional hedge funds. (These hedge funds may be using strategies that are non Shari’ah compliant, investing in stocks that have never been screened and selling securities that they borrowed but never owned, to say nothing of investing in interest bearing bonds, futures and a host of derivative instruments. As the Islamic bank’s Shari’ah board quite correctly pointed out, however, it is generally of no consequence to the Islamic investor where the bank’s money comes from. That is not the issue here.) In fact, the Islamic bank is happy to point out that it is not investing in any of these prohibited things and, technically, the bank may be right. However, as we shall see, the matter is not this simple.

Obviously, if fund managers are given no guidelines to follow for Shari’ah compliance, they will surely make investments that are not Shari’ah compliant; they will surely manage their cash in ways that are not Shari’ah compliant and they will surely transact in ways that are not Shari’ah compliant.

When the Islamic bank takes in the investor’s money, what actually happens? Let’s imagine that the investor, say an Islamic pension fund, places $100 million in this product. The first thing that happens is that the Islamic bank passes the money to the structuring bank. That bank will do two things. Firstly, it will invest $100 million, after deducting some fees for management, into murabaha contracts. Using the murabaha as collateral, it will then make a loan to an asset managing bank, one with a prime brokerage of its own that works with hundreds of different hedge funds. The asset managing bank will then allocate that money to a selected group of investment fund or asset managers. In the absence of any mandate to transact in compliance with Shari’ah, the asset managing bank will choose managers and strategies solely on the basis of performance; and from a risk perspective, this means that the bank will seek to diversify its allocations. Of a certainty, what this means is that some of the money allocated will certainly go to bonds, treasuries, debt instruments, and derivatives like futures, options, and swaps. Also, the loan made by the structuring bank to the asset managing bank will be made for interest at the same rate as the murabaha. In this manner, the asset managing bank suffers no gap between the murabaha swap rate and its borrowing costs.

In the middle of the transaction, the structuring bank is fully secured for its loan, because the rates for the murabaha and the loan are matched. This means that the structuring bank, likewise, takes no risk. The structuring bank will also earn fees for the notes it has structured for the Islamic bank.

The money of the client of the Islamic bank, the Islamic investor’s money is in a murabaha. By means of the note provided by the structuring bank, the investor’s principal is protected as well. The client pays fees for both of these. Some fees go directly to the Islamic bank; others go to the structuring bank, to the asset managing bank and to the managers of the various hedge funds. In this transaction, the greater part of the returns is shared by the hedge funds, the asset managing bank and the structuring bank. The Islamic bank’s earnings are significantly less than all these.

The reason for detailing the money trail here is to point out how the investor’s money, even though it remains in murabaha contracts, is actually put to work in ways that are clearly not in compliance with Shari’ah principles and precepts.

It may be argued that this will happen anyway; that it happens whenever an Islamic bank or institution has dealings with a conventional bank. This may be so. Ultimately, what the conventional bank does with its money, when it becomes the bank’s money, is its own business. The transaction we are considering here, however, has direct, predictable and immediate consequences. In other words, the Islamic client’s investment in this product triggers a series of transactions, none of which is Shari’ah compliant. Moreover, these produce fees and earnings for parties other than the Shari’ah investor. Can the Shari’ah board of the Islamic bank ignore all of this and approve the entire transaction, because the first link in the series is basically a murabaha? Or is the Shari’ah board compelled to consider the transaction in its entirety?

Consider the parties to this series. There is an investor, an Islamic bank, a structuring bank, an asset managing bank and a number of hedge fund managers; then consider how the money passes from one to the other, all the way to the fund managers and then how it passes all the way back. With each pass, more fees are added to the transaction. Consider also how the Islamic investor’s money is the beginning point for the entire transaction. Without this initial investment, none of the rest will take place; no one will earn fees. It is this initial investment which ensures the participation of the structuring bank, the asset managing bank and the fund managers, because it is the initial transaction, the simple murabaha, which effectively creates and guarantees the capital. The irony is that no one, other than perhaps the unwitting Islamic investor, considers this transaction to be only a principal-protected note with a murabaha and a promise. On the contrary, this is a highly complex and profitable transaction involving several different parties at many different levels. In short, it is a golden opportunity for the banks, because the money is virtually guaranteed and their risk is next to nothing.

It is, therefore, simply incorrect to justify the swap of returns from non Shari’ah compliant assets by comparing the same to LIBOR and then saying that since the one is approved by Shari’ah supervisory boards, the other should also be approved.

In short, the Muslim investor is assured that the investment product is Shari’ah compliant because the swap mechanism, which involves a promise, apparently ensures that the Muslim investor’s money never goes directly into anything prohibited. So, the Muslim investors’ money may not be invested directly into the part of this transactional series that is actually performing and earning returns. Instead, a mechanism is required to bring the returns from that product to the Muslim investor indirectly. It is also clear, however, that an asset managing bank would not be allocating money to managers unless that money came from somewhere. Between the Muslim investor and the fund manager there may be an indirect link, but the cause and effect relationship is nonetheless present. In a very real sense, the promise to exchange the returns from the hedge funds establishes a direct link between those funds and the investor. It also identifies the series as a single transaction. As such, then, it cannot be ignored by the Shari’ah board. The Shari’ah board must consider every step in the transactional series; and when this is done, the Shari’ah board must reject the product.

Ramifications for the Industry

When a Shari’ah board gives consideration to only one part of the transactional series, it is only natural that it should fail to consider the consequences of the product for the industry as a whole. It is an unfortunate shortcoming on the part of the Shari’ah board in this transaction that it has failed to consider the context of the offering. It is an even greater shortcoming when it fails to consider the consequences the product will have for the entire industry. When it is clear that a product cannot be offered in its own form or, in other words, when it cannot be offered directly, but must be offered by means of a derivative like a swap, red warning flags should go up. In such situations, the Shari’ah board must pay careful attention to the circumstances of the offering. If the circumstances can be found to justify such a product, then it may be possible to grant approval. If not, however, approval must be withheld. In the case of promised returns from a referenced basket of assets, the assets must be Shari’ah compliant in order for the returns to be Shari’ah compliant. It really cannot be otherwise.

If consideration is not given to the underlying assets, or to the assets referenced by the swap mechanism, it could spell the end of the need for authentic Islamic products, services and methodologies. Why should a bank bother to spend the extra time and money required to make a securitisation into a sukuk? For less money and in less time, it can simply offer conventional bonds and then use the ‘mechanism’ to match performance, appear to sanitise the money and satisfy the investor that the investment is lawful. If such a mechanism is available at lower costs, then why license an Islamic index for Shari’ah compliant stocks? Why use mutual funds that follow guidelines laid down by Shari’ah supervisory boards? Why bother with all the complex structuring and documentation that go into Shari’ah compliant real estate deals, infrastructure projects, private equity or home finance? Why expend the resources required to develop new and innovative Islamic financial products and tools? The swap/wa’d ‘mechanism’ makes all of that unnecessary. At a very fundamental level, however, this mechanism seeks to make the haram, halal. This is the nature of the threat to our industry. The fatwa giving mechanism may well be referred to as the Doomsday fatwa for Islamic finance.

If the product described in this paper is successful, managers of all manner of funds, not just hedge funds, will never be motivated to do what is necessary to manage and invest in ways that comply with Shari’ah, but then why should they, if all they need to do is agree to swap performance? Asset managers can continue as before, buying and selling interest bearing bonds, debt based derivatives, pork futures, and bank, casino and brewery stocks. They can trade these however they wish, even by borrowing stocks and then selling them into the market without ever owning them or by leveraging them and incurring interest on the leverage! In other words, Islamic investors will not know what managers are doing because an Islamic bank and its Shari’ah board have assured them that by means of a special ‘mechanism’ their money will remain separated and pure.

Sadd al-Dhara`i:
Blocking Ostensibly Legitimate Means to Illegitimate Ends

When I first became acquainted with the details of the swap ‘mechanism’ (when I was invited to approve it by a huge multinational bank), I had thought that the best way to combat it was to have resort to sadd al-dhara`i, the legal device from our classical jurisprudence that blocks ostensibly legitimate means when these are employed for illegitimate ends. In other words, in the same way that the digging of a well in the middle of a road may be declared unlawful for the reason that it may lead to great inconveniences and economic losses by those who travel the road, I thought that this mechanism might be declared unlawful by Shari’ah boards for the reason that its use may lead to prohibited investments. So, while a promise to exchange returns may be lawful, if the returns promised have been earned by illegitimate means (by funds that invest in Treasury futures, for example), then that promise may be declared unlawful as it has become a means, an ostensibly legitimate means, for illegitimate ends.

It is, therefore, simply incorrect to justify the swap of returns from non Shari’ah compliant assets by comparing the same to LIBOR and then saying that since the one is approved by Shari’ah supervisory boards, the other should also be approved.

I am now convinced, however, that the wa’d transaction I have described above is prohibited outright; and that the application of sadd al-dhara`i in this instance is unwarranted. This is because of a subtle point of law regarding the application of when it is possible to resort to sadd al-dhara`i. The classical jurists have stated that whatever leads to involvement in the unlawful will either lead to the unlawful as a certainty or lead to the unlawful as a possibility. This product includes investments, even though they are entered into indirectly, that are clearly unlawful. Moreover, there is no doubt whatsoever that the transactional series leads inevitably, and repeatedly, to what is unlawful. That being the case, that which leads to involvement in the unlawful does so as a certainty and not as a mere possibility, then sadd al-dhara`i is inapplicable. There is no need to resort to sadd al-dhara`i because the transaction is clearly unlawful.

I quote, in what follows, from al-Bahr al-Muhit, Kitab al-Adillah al-Mukhtalif fiha by Badr al-Din al-Zarkashi, on the subject of Sadd al-Dhara`i: Blocking Ostensibly Legitimate Means to Illegitimate Ends.

‘Know that whatever leads to involvement in the unlawful will either lead to the unlawful as a certainty or lead to the unlawful as a possibility.

‘The first of these two (that it will certainly lead to commission of the unlawful) is not to be discussed under this heading. Instead the proper place for its discussion is under the heading of ‘That Which there is No Way to Escape the Unlawful Except by Avoiding It’. The commission of such an act (whatever will certainly lead to involvement in the unlawful) is unlawful for the reason that whatever is required to ensure the performance of a required act is itself required. (And here the required act is that one avoids what is unlawful; and what is required to ensure that it is avoided is avoidance of the act that will certainly lead to it.)’

To clarify this point, the product we are discussing leads, without a doubt, to the unlawful. Obviously, if fund managers are given no guidelines to follow for Shari’ah compliance, they will surely make investments that are not Shari’ah compliant; they will surely manage their cash in ways that are not Shari’ah compliant and they will surely transact in ways that are not Shari’ah compliant. The statements given to the press by the Islamic bank offering this product admit as much. This being the case, that the product leads surely to the unlawful, there is no need to resort to sadd al-dhara`i to prevent the proliferation of the product, because the product is already unlawful, owing to its leading directly and without doubt to what is unlawful. If there were some doubt about this, such that the product’s leading to the unlawful was only a possibility, whether likely or unlikely, a strong possibility or a slight possibility, then recourse might be had by the jurists to the device known as sadd al-dhara`i. When the assets referenced by the swap mechanism are known to be unlawful, however, the transaction is unlawful and there is no need for recourse to any legal device for its prohibition. This being the case, there is also no need to discuss the opinions of the various classical scholars in regard to sadd al-dhara`i and its use.

It is an established principle of Islamic Law that whatever is required to ensure the performance of a required act is itself required. When the avoidance of the unlawful is a requirement, if there is an act that will surely lead to the unlawful, then the avoidance of that act too is a requirement. It is for this reason that it is essential, wajib, to avoid or to reject, the ‘mechanism’ in this product. This is because the ‘mechanism’ is what allows the asset manager to deploy money gathered through this transaction, however indirectly, in funds that operate in ways that are non compliant with Shari’ah and that invest in businesses that are non compliant with Shari’ah, ignoring all guidelines for Islamic investing that have been developed at great expense by businesses that respect the Muslim investor’s need to transact and to invest only in ways that accord with the principles and precepts of the Shari’ah.


My own feeling, as I considered the problem, was that Shari’ah boards would have difficulty making a decision on the basis of purely moral considerations. As jurists, Shari’ah scholars are trained to look at texts and at classical models, especially in regard to transactions. If a question of law is not answered directly in the texts, jurists are trained to seek indirect answers, often by drawing parallels from the body of accumulated jurisprudence or through recourse to legal maxims and principles. Then, while Islamic law may be characterised as both a moral and a legal system, the jurisprudence that has developed around modern trade and commerce relies almost exclusively on derived legal considerations; even if these may be characterised as legal means to moral ends. (While the prohibition of riba may be characterised as a moral prohibition, the prohibition itself is a legal matter. Once the prohibition is incorporated into law, all riba related issues become subject to legal classification and the element of morality is marginalised.) Thus, it is difficult to suppose that jurists will make decisions on the basis of purely moral considerations.

From a practical perspective, the question may be referred to the Auditing and Accounting Organisation of Islamic Financial Institutions (AAOIFI), the standard setting body for the entire industry. Since the ‘mechanism’ that drives the product is based on a promise or wa’d, which has applications in many modern instruments including the modern murabaha, AAOIFI might be requested to promulgate a standard dealing with every aspect of the wa`d and its uses’.

The product described above presents Muslim jurists with a real challenge. If investor confidence is to be maintained, the industry must demonstrate its ability to regulate itself and insist upon the Islamic authenticity of all that it does or allows to be done in its name. In the past few years, modern Islamic finance has proved itself to be viable, innovative and profitable. The question it faces now is whether it can prove that it is moral and responsible.

Yusuf DeLorenzo

A scholar of Islamic Transactional Law, Yusuf DeLorenzo serves as Chairman of the Shari’ah Board for the Dow Jones Islamic Market Indexes, the Islamic Interbank Benchmark Rate (IIBR), Wafra (the Kuwait Investment Advisory Group), Oasis Asset Management (South Africa), The Kotak Mahindra India Shari’ah Fund (Singapore), Guidance Financial (USA), the Navis Asia Fund (Malaysia), and several others. He is also a member of the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) and a member of the Council of Scholars, International Shari’ah Research Academy (ISRA), the Central Bank of Malaysia.


An Interview with Humphrey Percy, CEO, Bank of London and the Middle East

Bank of London and The Middle East (BLME) is an independent UK, wholesale Shari’ah compliant bank based in London. It received FSA (Financial Services Authority) authorisation in July 2007 and is now the largest Islamic bank in Europe.

How would you assess the impact of the global financial crisis on BLME? To what extent have you been helped or hindered by the fact that you are a Shari’ah compliant financial institution?

The financial crisis has impacted all financial institutions across the board. Being a newish bank we did not have a legacy book with a lot of difficult things, but, of course, we were not sufficiently well established to benefit significantly from the flight to quality, a safe haven for funds. We are a bought money bank; we do not have any free balances and endowment effects that an older, more established bank would have, neither do we have a credit rating or a stock market listing; we are completely new. Also, as an Islamic bank we did not have a lot of transactions that were opaque or toxic or rebased and re-valued as was the case with more conventional banks. We were, however, exposed to some quite volatile aspects of the market such as commodities and transportation, which have been quite significantly hit by the slowdown in world trade and the global economy and in particular China. That has had its own challenges and, of course, like any bank, an Islamic bank like BLME is affected by credit risk; that is our principal risk.

Prior to BLME you had spent your career in the conventional financial sector with some big name merchant banks. What made you decide to be part of setting up BLME in 2006?

I simply saw an exciting and new era opening up for the Middle East with its young population and immense wealth continuing to be generated from oil. It is definitely a geographic region that is going places, with Dubai recently becoming a major trading hub and financial centre, plus the fact that the Gulf countries have a lot of aspirations for the development of their economies. The initial appeal for me was to establish a predominately Kuwaiti-owned modern merchant bank in a world financial centre –London – that could provide products and services to the Middle East and the GCC for the benefit of its shareholders. Our principal shareholders are GCC-based, and naturally they wanted the bank to be an Islamic institution. This involved some thought on my part as to where I was going to get the human capital, because, clearly, you need experience. The pool of experience in Islamic finance was quite small, so we took the decision early on that we would develop bright young people from the GCC and UK and tap the market where we could for experienced Islamic bankers. Predominantly we would take experienced conventional bankers and train them in Islamic finance. Most of us have taken the CISI’s Islamic Finance Qualification (IFQ) and we continue to study and develop our understanding of the markets with the support of our in house Shari’ah lawyer and Shari’ah Supervisory Board. Of course, if you have been in conventional finance, it is entirely possible and relatively easy to retool as an Islamic banker.

Do you think there is any way to accelerate the growth of the human capital pool?

Well, in Malaysia there is a university, INCEIF, sponsored by the Malaysian central bank. There are also universities in the UK that provide Islamic finance qualifications. That will help immensely, but I think it is really a matter of organic growth. That being said, do remember that it is reasonably quick and easy to retool people as Islamic bankers, if they have a background in finance, so in reality the pool of human capital is huge. This is the case particularly in a centre like London, which has access to a very broad range of skills.

In your 2011 statement in BLME’s report and accounts you said you were hoping to establish a presence somewhere in the GCC by the end of 2012. I do not believe there has been an announcement so far. Are you still pursuing that aim and what progress have you made?

We were actually granted a licence in the GCC, which we did not take up for various reasons, primarily due to political and demographic developments in specific parts of the region. Recently we have concluded that we would like to establish a presence elsewhere and we are very close to being able to announce that.

In the financial system as a whole, apart from sukuk, what we need in the UK, which would help London as a financial centre, is for our central bank to have an Islamic finance capability.

Why do you think it is important to have a presence on the ground in the GCC?

There are a number of advantages. BLME is clearly providing the bridge between London and the Middle East and as such we have to have our own people on the ground. In addition, it removes the considerable expense involved in sending people backwards and forwards and frankly we need to be there more often. Having a presence on the ground in the GCC is also invaluable in increasing the recognition of the BLME name and brand, although we are certainly better known now better known than we were in the Middle East. Overall it will be very beneficial and helpful to the bank.

Presumably when the bank was set up you could have chosen to establish it in many different places. Could you ever see a situation where you decided you were going to be headquartered somewhere other than London?

I think it unlikely, due to the benefits of being in London. There is a strong regulatory regime, political support for Islamic finance, considerable expertise in the accounting, legal and banking professions, the favourable time zone and legal certainty. It is a friendly and good place to do business. What could change that is an overburden of regulation and, of course, unfriendly tax rates that would make it uneconomic to be here.

You just touched on political support. The ultimate piece of political support that a lot of banks would like to see is a UK sovereign sukuk and the government has drawn back from that on several occasions, citing the cost and value for money. How do you view that?

I would echo the sentiments of my colleagues from other banks. We do personally feel that we have been left slightly high and dry by the authorities and the political establishment here in that it was indicated quite strongly that there would be a UK government sukuk. I think it will come in the next year or two. I believe there is definitely growing support for it and also it is more relevant to the UK in 2013/14 than it was in 2008, when we had an extremely strong financial position; we have a less strong financial position now and I think it is important for London to underpin its foothold as a major financial centre by having its own sukuk.

There seems to be something of an overlap between Shari’ah compliant banking and ethical banking. Do you believe that Islamic banking can successfully appeal to ethical customers as a way of broadening its base?

I think there is quite a lot of overlap. Certainly in the wake of the financial crisis there is a much greater desire among the public to have transparent finance and you could argue that Islamic and ethical finance have that; they are involved in activities that are fully understood by shareholders and depositors. I think overall that Islamic finance has a complementary role to play with ethical finance. It is not so much that we are competing with each other, but rather that there is quite a good fit.

Can Islamic banking claim to offer a moral alternative to conventional banking and if so is this a message that is likely to resonate with customers?

I think the question says a lot about conventional banking. The easy answer is to say, ‘Yes, of course we can claim that.’ Realistically, Islamic finance applies the principles of fairness and transparency. We also apply a financial screen to identify what proportion of a client’s or counterparty’s activities are generated from riba and then there is the industry screen. Frankly, people in the conventional banking industry spend a lot of time telling me as an Islamic banker that it must be a big disadvantage, but it is not.

In terms of what resonates with customers, at BLME we concentrate on four sectors – healthcare, energy, real estate and transportation. All of them work extremely well for us; they are relevant to today’s market, they work for Islamic finance and they are not controversial. I would say we are happy with our business and our sectors. The reason we get business is because we can provide a solution to what clients want economic delivery in the time and at the cost they find acceptable. That is how you win business and why people come to see us.

If an Islamic scholar is exposed to a variety of different entities, they are more likely to have a greater knowledge, which may make them more effective as scholars.

Recently there have been calls from several quarters to tighten Shari’ah approval processes. How do you view this debate?

There is a shortage of Islamic scholars, which is why scholars are on so many boards, and you could argue that this might make a less effective organisation, but I would argue the opposite. If an Islamic scholar is exposed to a variety of different entities, they are more likely to have a greater knowledge, which may make them more effective as scholars. In addition, it is a fact that, while BLME’s supervisory board may approve a product or service, it is redundant unless the Shari’ah board of the people to whom we are delivering it is going to approve it. It is because of this that there has to be some assumption of a collegiate approach. That is not to say it is all cosy and everyone agrees; there are some very hotly contested debates on products. I think overall it is an advantage to have a Shari’ah supervisory board, that comes from more than one country with diverse views, as we do, as it makes our products more transportable not only when delivering to the GCC, but also to South East Asia.

Malaysia has their central body to which everyone has to go and that is clearly an advantage, but, due to the number of Middle Eastern, North African and other nations involved in Islamic finance, it would be very difficult to get a single board across all of those regions. It may be that over time regional boards will be established.

The industry faces a similar problem with a professional standards body – due to the differing nationalities and Islamic schools of thought. The schools and movements among the scholars do unofficially exercise that role. Realistically, however, we are some way away from a single professional body. It would, of course, be helpful to the industry, but it is perhaps not particularly necessary at this time and it is certainly not a priority compared to the standardisation of documents. On that front the IFSB and AAOFI are forces for good in the industry. It is somewhat galling to invest so heavily, as we have, in a range of documents to cover all the products we deliver, knowing that they have a built-in redundancy, because one day there will be something similar to ISDA (International Swaps and Derivatives Association) that will deliver standardised documentation across the industry. I think that must be the goal for the industry.

Do you view HSBC’s recent restructuring announcement and the pruning of their operations in the GCC and the Middle East as an opportunity for organisations such as BLME or is the withdrawal of such a large bank a bad thing for the industry in general?

I think that was a natural commercial decision by HSBC, which is a huge, worldwide organisation. As an outsider it seems they may have grown too big and are now trying to concentrate on a smaller number of core activities. They seem to be saying that providing Islamic banking across the board is not something they want to do and that they will be concentrating on a smaller number of centres in larger markets, for example, Saudi Arabia rather than Dubai. I think you will find, however, that HSBC will be keeping a close eye on places such as Indonesia. Islamic finance only accounts for 4% of the total financial system currently, but when that starts to change, I think they will be back there pretty quickly. It is possibly an opportunity for BLME and other banks. The removal of a very significant competitor from the market has to be an opportunity.

Liquidity issues are a concern for all banks, especially at the present time, but it is suggested that it is a particular problem for Islamic banks, because of the limitation on the instruments that they can hold. Would you agree that it is a particular problem and what would make a real difference in this situation for you?

It is a problem, which we continue to address with the authorities here and in other countries such as France, which has also toyed with the idea of issuing a sovereign sukuk. The fact is that a conventional bank that offers Islamic finance via a window has no requirement at all to maintain liquidity in Islamic finance instruments, which puts them at a significant advantage. We do not have that choice and the number of Islamic instruments acceptable to regulators for liquidity purposes is very limited. That means there are costs of using those, because they are so much in demand. Secondly, unlike conventional banks, Islamic banks do not have access to derivatives and futures markets, for example, to hedge while holding liquid instruments and as a result they are subject to mark to market and volatility in their earnings. This is a significant disadvantage, which could so easily be resolved by the UK and other highly-rated countries issuing sovereign sukuk

Are there any changes you would really like to see made in the UK legal and regulatory frameworks that would help Islamic banks?

In the legal framework a lot of the difficult things have been done already and there is much more of a level playing field now. In the financial system as a whole, apart from sukuk, what we need in the UK, which would help London as a financial centre, is for our central bank to have an Islamic finance capability. That does not exist at the moment. I am optimistic that there will be a growing support and willingness to take Islamic finance in the UK to the next stage within a couple of years.

Finally, what factors are going to bring about the biggest changes in Islamic finance in the next 5-10 years?

It remains a constant surprise to me that a significant proportion of the investments made by the sovereign wealth funds of countries with majority Muslim populations are not invested in an Islamic way. I think sovereign wealth funds across the MENA region will come under increasing pressure on this issue from local populations, although change will happen faster in some parts of the region than others. There is also increased interest in Islamic finance in Asia-Pacific, most notably in Indonesia, which is also going to have an impact on Islamic finance.

Humphrey Percy

Humphrey Percy joined BLME as Chief Executive Officer in August 2006. He has more than 30 years of international banking experience. In the course of his career he has worked at J. Henry Schroder Wagg, Barclays Merchant Bank (later Barclays de Zoete Wedd/BZW) and WestLB where he held positions including CEO, Managing Director, General Manager, and Head of Global Financial Markets.


The Best of all Worlds – Towards
a more Sustainable Financial System

By: Dr. Murat Ünal, M.B.A., LL.M
Funds@Work AG

Islamic finance currently plays a minor role in the financial world compared to conventional and ESG (Environmental Social Governance) based investments. Its principles though have the potential to form the basis of a global financial system that relies less on debt/leverage and is closer to real economic activity, ensuring that economic transactions are underpinned by real assets and that profit and loss sharing is the norm.

The financial world needs to ‘connect the dots’ in network analytic terms and build on the best of all worlds from conventional, ESG and Islamic finance investments to make the system more sustainable, stable and resilient. The mainstream conventional system has too long depended on easy money and high debt levels, and developed a detachment from real economic activity. There is a clear call for change.

Islamic Finance on the other hand has to become more socially responsible and apply ESG and other non financial criteria in its investments. Islamic investors should not only care for zakat (i.e. the distribution to the needy), but also ensure that environmental, social and governance criteria are considered. Here both conventional as well as Islamic investors can learn a great deal from those that apply ESG criteria and who increasingly act as ‘active shareholders’, engage with the companies in which they invest and take care of their fiduciary duties. This is particularly important in our modern capital markets where the people owning the companies are generally detached from the ones who manage them, creating a corporate governance vacuum that needs to be more strongly addressed. We all know the moral hazards that can arise from principal agent related issues, but still today the level of control and incentives (sticks and carrots) in order to align interests between principals and agents is very different among conventional, Islamic and ESG investors with the latter being the most advanced, seeing themselves as active shareholders and not just investors in ‘financial instruments’, which carry an ISIN (International Securities Identification Number).

ESG investors, for example, exclude companies that do not meet their ESG criteria, as do those in Islamic finance, but the latter should also develop a tool set to include ‘non financial factors’ in their decisions as ESG investors do when they consider environmental, social and governance criteria, as well as engaging with companies by voting, based on their shares.

A focus on ESG factors alone, however, would not have prevented the current financial crisis as it is predominantly based on financial factors such as the level of debt, leverage and the mere speculation/short-termism of market participants with a major detachment from real economic activity. Of course, algorithmic trading, but also basket trades on behalf of exchange traded funds add to the reduced holding periods. Our vision of the financial services industry, therefore, is one which connects the dots between the conventional investment industry, ESG related investments and Islamic finance. An approach, where investors use ‘Islamic principles’ and start incorporating ESG factors on top of zakat (where part of the income is distributed to the people in need), can help create a more equitable system with greater transparency. To get there, conventional, ESG and Islamic finance should learn more from each other and combine the best of all worlds when it comes to using financial and non financial factors.

The Status Quo

We know from network theory that the openness of groups to outsiders’ views is a crucial element in being more innovative, so diversity pays off. The following simplified graph shows us the three groups, namely Islamic Finance (light green), ESG (dark green), and conventional investors (red), which are communicating more densely within their groups, but less so between the individual disciplines.

There are a few boundary spanners that connect the individual groups but that is certainly not enough. This pattern can even be seen in major conferences, which are either dedicated to ‘conventional’, ‘ESG’ or ‘Islamic Finance’ topics, but do not provide an equal platform for all disciplines to engage in dialogue and learn more from each other. Merely communicating with people that are alike does not help to move knowledge beyond individual networks, which could greatly profit from new perspectives. In order, therefore, to advance mutual learning, people from the individual disciplines should look beyond their own borders, something that is rarely seen.

A simplified network graph of ‘current’ interaction
between Islamic finance, ESG and conventional investors

Graph 1

There is certainly more learning going on when we talk about the value added of Islamic finance principles to ESG and conventional investors and ESG investors highlighting their tool sets to the other two disciplines. The paucity of interaction, as usual, creates prejudices and leads to less sophistication for all. We should not argue about which system is more powerful than the others but look for common denominators which make all disciplines stronger. The middle of the road approach has always proven to be more successful.

The Desired State

In the future a greater convergence and interaction among the three disciplines would be more desirable with the relevant groups

being less distinguishable leading to a more ‘sustainable finance’ industry.

Islamic, conventional and ESG investors should be more open to each other, enter into a mutual dialogue and transfer learning for the sake of a more resilient and sustainable financial system. As the following graph shows we should not be able to distinguish the individual players or create subgroups, which are detached and act in an almost isolated fashion.

In such an environment the label ‘Islamic’ or ‘ESG’ will be less important as it is the value added that each discipline brings to the table from which all can profit leading to a more sustainable finance industry where the individual disciplines borrow greatly from each other.

A simplified network graph of a desired “future”
interaction between Islamic Finance, ESG, and conventional investors

Graph 2

The Best of All Worlds

The following network graph focuses on the distinctive approaches (blue squares), which the individual disciplines, specifically Islamic and ESG investors apply. It treats conventional investments (red circle) as an isolate, which builds predominantly on financial factors in the investment decision making process. It can be seen that there is an actual link between Islamic and ESG investors, namely the usage of negative lists where certain sectors or companies are clearly excluded. This applies to companies such as those involved in the weapons, gambling, tobacco and other industries, which both disciplines would exclude in their investments. Whereas ESG investors focus mainly on non financial factors when it comes to environmental, social and governance standards, Islamic finance’s focus is more on financial criteria and specifically the avoidance of debt/leverage. The emphasis on transactions that are backed

by real assets making them closer to real economic activity are certainly also a cornerstone. An important element is also zakat, the distribution to the needy based on a specific percentage of the profits made.

ESG investors’ interest is particularly in non financial factors and apart from acting as an active shareholder by voting at annual general meetings of companies in which they are invested, they engage actively with companies to minimise risks, but also to enhance value in the long term. Furthermore they apply positive lists to consider sectors in which investments are particularly worthwhile or to determine which companies are best in their class in terms of ESG standards, such as in the automotive sector and then directing their investments into the single company, which is best of class in a given area. The tool sets developed by sustainable investors are more varied and lend themselves perfectly to conventional and Islamic investors alike.

A simplified network graph of the “current” major approaches
Islamic Finance, ESG, and conventional investors apply

Graph 3

Our Vision of a Sustainable Investment Industry

The individual approaches and the wealth of knowledge that the conventional investment industry created need to converge more strongly to contribute to a more resilient, stable and sustainable financial system. In the following graph we highlight what this system should look like; where all the individual disciplines borrow from each other to provide a more sustainable environment. When it comes to the exclusion of companies, even conventional players should exclude weapon manufacturers, which have a negative impact the industry on all lives. Conventional, Islamic and ESG investors should also become active shareholders and address the vacuum that has been created by modern capital markets. Engaging with the companies in which they invest, voicing concerns at annual general meetings and entering into a dialogue with the companies into which they have invested should be the norm. We should move away from short termism by not looking at companies whose equities and bonds we hold as mere financial instruments, but see ourselves as shareholders and fiduciaries. If ESG and conventional investors address the issue of leverage and debt more strongly, ensure that transactions are no longer naked but asset based and linked to real economic activity, we can transition into an era where equity is on the agenda again and the focus is on profit and loss sharing rather than central counterparts, who provide guarantees and become too big to fail.

Islamic finance investors should borrow from ESG and develop positive lists for sectors in which investments are really worthwhile. This could be a way to prioritise areas such as microfinance, alternative energy, health, education and other relevant sectors, which are necessary for the societies in which they operate. And of course why should the concept of zakat not be one applied by all three industries where we give back to society. Islamic finance is not just a religious concept but should rather be seen from the perspective of the contribution it makes to a more resilient financial system; therefore we need to educate ESG as well as conventional investors about its virtues. It cuts both ways, however, as Islamic finance can learn greatly from ESG investors, develop more sophisticated approaches in investing and at the same time move away from its focus on financial factors to become more socially responsible.


The aim of this article was to show that we should never look at phenomena in an isolated manner. Islamic, ESG as well as conventional investors can greatly learn from each other by being more open. Islamic finance should not be looked at from a religious perspective alone, but rather from what it brings to the table from which ESG and conventional investors can profit. Our finance and investment system globally will be more resilient if individual participants approach each other more openly and share ideas converging into a mainstream ‘sustainable finance system’, which incorporates the best of all worlds.

From a network analytic perspective we should be aware that openness leads to greater innovation and stability and creates more opportunities to interact. In this context we need to address prejudices, which stem from mere ignorance and act as barriers to cooperation, because, ultimately, what the world needs is a greater integration of networks such as the Islamic finance, ESG, and conventional investment communities to make their individual achievements accessible to a broader audience. What we do not need are sectors that act in isolation and pride themselves on being superior vis-a-vis the other disciplines. Ultimately each of us and any organisation that we represent are embedded into a wider social ecosystem; if we start actively learning from and talking to each other we can bring about greater stability.

Dr Murat Ünal

Dr Murat Ünal is the founder of Funds@Work AG, a research based strategy consultancy focussing on the investment industry. He had previously worked with organisations such as Citibank and Fidelity Investments.

A simplified network graph of the “current” major approaches
Islamic Finance, ESG, and conventional investors apply

Graph 4

IIBI Monthly Lecture Series – October to December 2012

October: Enhancing Shari’ah Assurance and Compliance in Islamic Finance

Omar Shaikh’s lecture was based on a report, ‘Enhancing Shari’ah Compliance’ issued jointly by the Islamic Finance Council UK (IFC) and the Malaysia based International Shari’ah Research Academy (ISRA). The report was based on experience of working in conventional audit with some of the leading, global accounting firms such as Ernst & Young, PwC, KMPG and Deloitte and an analysis of the world of Shari’ah compliance and compared the two to highlight those areas where Islamic finance could learn from conventional practice. In addition the standards of key central banks such as Bank Negara Malaysia and standard setting bodies such as AAOIFI (Accounting and Auditing Organisation for Islamic Finance Institutions) and the report and accounts of a sample of leading Islamic banks were reviewed. This analysis of literature and the expertise of the report’s authors led to six recommendations for enhancing Shari’ah assurance and compliance.


From modest beginnings in the 1970s the Islamic finance industry has grown to an estimated $1.3 trillion and despite the global financial crisis, the industry has continued to grow with commentators suggesting that the industry will grow to $3-5 trillion in the next few years. To be classed as an Islamic financial institution (IFI), the products and services offered by that institution need to be assessed and certified by Shari’ah scholars acting either in an individual capacity or by a Shari’ah supervisory board comprising a number of scholars. Ongoing assurance of Shari’ah compliance is provided through Shari’ah compliance certificates, which are typically issued within the annual reports of IFIs.

There are two interesting points about ongoing Shari’ah compliance. Firstly, the process of assessing compliance needs to be dynamic, because Shari’ah standards are not static; they change. In Arabic ‘Shari’ah’ literally means ‘the watering hole’, the source from which laws come, whereas Fiqh and the resulting fatwa are the process of deriving rulings from Shari’ah. These rulings are dynamic and can change from place to place, so, for example, a scholar may allow a certain product to be used in the UK, but he will not allow the same product to be used in Saudi Arabia or scholars may allow products to be used on a short term basis to help the industry become established, but may require it to be replaced with an alternative, more compliant product after that time. The fundamental fact that the situation is dynamic is often missed by people in the industry.

Second, there is the question of the letter of the law and the spirit of the law. There has been significant criticism of the Islamic finance industry, because it has been alleged that it has failed to observe the spirit of the law by imitating conventional products and not innovating. This is particularly regrettable in the current climate where conventional finance is widely seen as morally bankrupt.

The Role of the Shari’ah Scholar

Islamic financial bodies employ Shari’ah scholars as consultants, as members of Shari’ah supervisory boards (SSBs). The role of a scholar typically involves advising on product design and also testing for ongoing compliance. The design and compliance activities are both being performed by the same Shari’ah scholar, in effect a dual role, but each role has its own professional requirements. The compliance role in particular gives rise to a number of challenges, which the SSB members must now consider more seriously.

A parallel can be drawn between this compliance activity and the requirement for assurance and compliance in the regulatory requirement for external audit in the conventional finance sector, where auditors come in, examine the financial statements and write a report for the financial report saying whether they believe the statement to be a true and fair representation of the state of the organisation. It is important not to become confused between internal and external audit. These are two very separate procedures and today external auditors rely very little on the work of internal auditors. External auditors report back to the audit committee, but also make their own independent statement. The breadth and depth of guidance on this activity continues to grow to enhance the independence and objectivity of the external audit. The continuing evolution of these safeguards is rooted in the accounting scandals that came to light around 10 years ago resulting in the failure of companies such as WorldCom and Parmalat and the break up of accounting firm, Arthur Anderson.

The Islamic finance world is not immune to controversy. Recently there have been increasing operational concerns including conflicting Shari’ah opinions; individual scholars being members of multiple SSBs and confidentiality concerns around sukuk default and the associated legal actions. In the light of these issues IFC and ISRA feel that the need to apply professional standards to the Shari’ah compliance arena has become increasingly urgent. The importance of the six recommendations made in the report cannot be underestimated.


Auditing Your Own Work

Members of the SSB are concerned with both product design and the audit of ongoing compliance. Clearly, if scholars are auditing their own products, they are in an invidious and impaired situation. This impairment is not just in practice, but also in perception and both need to be managed. Mr Shaikh referred to his own experience with Ernst & Young, where the organisation had taken the positive decision to step back from auditing work in certain cases where they had had a significant consultancy role on the grounds that it was not reasonable for the company to audit its own work.

A similar situation can arise for scholars extensively involved in both product design and development and Shari’ah assurance. There is a fine line to be drawn between the two roles. It is important to establish the level of product advice given in order to define where exactly the line should be drawn. Suppose, for example, a scholar has told a bank that a product is not Shari’ah compliant and the bank then asks the scholar for advice on how to make it Shari’ah compliant, the line between product design and compliance has been crossed. Unfortunately many Shari’ah scholars may be totally unaware that there is a problem, because they have not spent two decades auditing.

This is an area where Shari’ah scholars need to be a lot more careful about their activities. The report has, therefore, recommended that guidance notes should be provided by AAOIFI, IFSB (Islamic Financial Services Board) and central banks. Mr Shaikh recommended that one member of the SSB be appointed the lead for audit and be excluded from any discussions related to product design.

The Use of Shari’ah Audit Opinions

The report recommends that scholars should be able to use qualified Shari’ah opinions. It is believed that this will significantly empower Shari’ah scholars and give the keys users of the financial statement and stakeholders the necessary information that they require. For example, an opinion might be qualified with information about the types of Shari’ah structure used given that structures acceptable in one jurisdiction might not be acceptable in others.

External Shari’ah Auditing

The process of auditing needs a certain skill set and experience; it should be undertaken by suitably qualified and regulated individuals. Shari’ah scholars involved in internal compliance units cannot be expected to have the skills and experience required to undertake such audits and the reality is that many of them do not. Can accountancy and auditing firms, therefore, extend their services, at least to a limited extent? Audit and test plans could be tailored to pick up on particularly sensitive issues that could then be reported back to the SSB.

Transparency and Disclosures

In professions such as accountancy and the law practitioners are required to be objective. Any perception of impairment of a professional’s independence can lead to concerns that adequate due diligence and professionalism has not been applied in the performance of their work. It is equally important to apply the same requirements to scholars providing Shari’ah audits. In addition to the challenges of self review discussed earlier, the impartiality of SSB members can be impacted by the threats of self interest and familiarity. The International Accounting Standards rule 24 sets out the disclosures required in respect of an entity’s transactions with related parties. In addition legislation in the US in 2000 now requires transparency on audit fees. If you look at any annual report you will see an item entitled ‘fees charged by the auditor’, which will detail both the audit fees and other, non audit fees, so, for example if audit fees are $50,000 and non audit fees are $2 million it allows readers to ask whether the auditors are truly independent. Mr Shaikh suggested that this was something that should be looked at for Shari’ah audit – fees paid to Shari’ah supervisory board members, split between audit and non audit fees. This information could be disclosed to a suitable professional body or board member.

Supervisory board members should also declare, before taking on their role, any potential conflicts of interest. All such disclosures are beneficial for the industry.

Competency and Standards

The professional bodies within accountancy all have ‘fit and proper’ standards for anyone involved in audits. These standards are quite light within Islamic finance. Continuous professional development is critically important, regardless of length of experience or seniority. The report suggests that these same standards should be applied to the scholars, because everyone needs to have their knowledge updated.

Income Purification

Islamic financial institutions are expected to conduct their business in a particular way, which is halal, but there are situations where unlawful income can be generated. This is allowed where it happens inadvertently. For example, Islamic banks are allowed to charge fees for late payment in order to deter clients from missing payment dates, but they are not allowed to benefit from these fees, which must be given away to charity minus allowable expenses. The report found that there was very little disclosure and transparency on this issue and has recommended that the situation be remedied with greater disclosure of actual amounts of non permissable income and the disbursements made, to which charities they have been made and a report on the impact of these donations.


The report’s recommendations highlight some of the best practices in conventional audit and the way in which these could be applied beneficially to Shari’ah assurance audits. The authors hope that some of these practices will be adopted voluntarily by scholars; they should not wait for bodies such as central banks to revise their guidelines.

The lack of a professional body for Shari’ah scholars is a clear gap in Islamic finance. In other professions such bodies accredit, regulate and support individual members. There are, in fact, discussions on this issue in Malaysia and some exploration of whether an international body would be possible.

The journey of Islamic finance over the last decade has been extremely exciting; it has demonstrated positive growth and attracted global interest. Shari’ah integrity has now become a central issue for the next phase, particularly in view of the moral bankruptcy of the prevailing, unchecked capitalistic model and the near collapse of the global banking system. Islamic finance has a genuine opportunity to present an alternative approach. The principles underlying Islamic finance, if properly applied, can lead to a more equitable distribution of wealth, a high degree of systemic stability and more regard to social impact in financial products. These are solutions that everyone in society is seeking. Ensuring that the highest principles of Shari’ah are embedded in the structures of Shari’ah are embedded in the structures of the Islamic finance industry is the responsibility with which today’s Shari’ah scholars are tasked. The IFC and ISRA are committed to empowering and assisting the scholars and by working together and providing mutual support they believe they can help to promote the further growth of the industry.

Omar Shaikh

Omar Shaikh is a member of the board of the UK’s Islamic Finance Council. He sits on the UK Treasury Advisory Sub-Committee advising the UK Government on fiscal policies for Islamic products and the UKTI’s advisory working group responsible for establishing the UK’s strategy for making the City a leading hub for Islamic finance. Omar Shaikh has worked with Ernst & Young where he was recognised as the UK firm’s Subject Matter Expert for Islamic finance.


November: Sukuk – Potentials for Partnership Financing and Genuine Islamic Risk Sharing

Dr Volker Nienhaus began his lecture by briefly reprising the journey of Islamic finance over the last 30 years. He said that proponents of the Islamic finance industry frequently claim that it finances the real economy; supports economic development; is a better alternative for everyone, not only for Muslims and is based on the concept of risk sharing. It is not clear, however, just how much risk sharing there really is. When Islamic financial models were first developed 30 years ago, risk sharing was one of the key principles embedded in them, but since then practice has diverged substantially. Had these early models prevailed, the world would look very different now with Islamic finance being able to finance the advanced economies and support the development of emerging markets. To do this Islamic finance would need to have instruments to support knowledge driven economies. Germany, for example, is no longer an industrial economy with manufacturing and construction accounting for only 30% of the gross national value added; Germany now has a service orientated economy with engineering, research, healthcare and education now being major contributors. Supporting these types of products is something of a challenge for Shari’ah scholars.

The Question

The question is can Islamic finance support these knowledge orientated economies, where the products are, in effect, intellectual property rights. How do you value patents for genetic resources or the knowledge of indigenous people, which can be critical in pharmaceutical research? Genetic resources and knowledge do exist, but are they assets? They only become assets when they are recognised by the legal system, but not all legal systems recognise them and from a Shari’ah point of view the situation is particularly complex. Can these intellectual properties be considered to be assets, which can be used to back securities and other forms of finance?

Even if you accept that they are assets, there are huge problems in attaching a value to them. Computer software is a good example. Companies, such as Microsoft, who are first to the market with a good product, tend to establish monopolies and later, perhaps superior products may not succeed because of the locked in effect. Furthermore, is it possible to trade these products? Mobile communications operators, for example, can raise finance based on their air time rights, which are granted by governments, effectively creating monopolies and locking out potential competition. How can a monetary value be attached to such ‘products’, particularly given that without the necessary infrastructure such as transmitters, the ‘product’ has no value? It is not clear whether these are classical assets and if they are whether they can be priced without a high degree of speculation.

Are these types of assets suitable for traditional forms of Shari’ah compliant, asset backed or asset based financing? Conversely, how flexible or adaptable is Islamic financing to knowledge driven economies? It is easy to finance bricks and mortar and in Islamic finance there is a strong preference for bricks and mortar, but these products will not drive an economy forward. There has to be someone sitting in these buildings creating new ideas, products and technologies. These and other issues create a range of challenges for Shari’ah complaint finance.

Forms of Islamic Financing

Islamic retail banking has mainly short term instruments designed to deal with traditional assets; medium and long term financing is mainly confined to home financing and so that can be ignored. Islamic investment banks are mainly involved in ‘bricks and mortar’, government project financing and commodity trading. There have been very few venture capital initiatives probably due to the fact that there is a strong risk aversion in Islamic finance, at least in markets beyond the real estate market.

Looking at capital markets, there is probably limited potential, because, before companies can go to the stock market, they have to develop something and probably get through the early commercialisation of that development. This route to financing is, therefore, difficult.

That leaves sukuk, but sukuk require to be backed by well defined assets that can be sold or leased. They are not, therefore, a suitable vehicle for financing the early stages of knowledge orientated businesses, because the assets do not yet exist. Today 90% of the sukuk market does not have suitable instruments for this type of finance. That leaves mudarabah and musharakah sukuk, which are participatory forms of finance.

Mudarabah and Musharakah Sukuk

Mudarabah and musharakah sukuk are presented as equity based instruments, which are very flexible. If there are currently no assets, but there is an intention to create assets, what is needed is corporate finance, not asset backed finance and this type of participatory sukuk might be a very good approach, if applied properly.

Two AAOIFI standards, numbers 12 and 17, are relevant. They say that an investment sukuk is a certificate of equal value, representing undivided shares in ownership of tangible assets, usufructs and services or in the ownership of rights in particular projects or special investment activities. Rights are not mentioned specifically, but they may be included in services.

Take, for example, a pharmaceutical company that wants to explore the genetic resources of the rain forests. They have assets, knowledge and experience. They could set up a special investment activity in which others could participate by contributing money. Assets then begin to be created, but this takes place after the money has been raised by the sukuk issuance.

Musharakah certificates are defined as certificates which have the aim of using the mobilised funds for establishing a new project, developing an existing project or financing a business activity based on any partnership contract so that the certificate holders become the owners of the project, asset or activity according to their respective shares. (In the case of an activity they become owners of the corporation involved in the activity.) Mr Nienhaus said that he would favour musharakah as the instrument of choice.

There are a number of options in the AAOIFI standards for designing such sukuk structures. A structure for the purpose of corporate or project financing could be designed so that the focus shifts from the underlying asset to the underlying business or business strategy. The entrepreneur, usually the obligor in a conventional sukuk, and the financiers, the sukuk holders, share returns and risk. This sharing of returns and risk is often described as the essence of Islamic finance. This instrument could be used for innovative start ups, the growth of established companies and the expansion of successful corporations.

Musharakah sukuk were being widely used and then in 2007 Taqi Usmani in a paper on contemporary sukuk questioned their Shari’ah compliance. Effectively these sukuk were being structured in such a way that the risk sharing element was being significantly down played. They were being structured as fixed income investments with a benchmark return, usually Libor linked and any profits over and above this level were going to the obligor as an incentive fee for good management; it was not being shared among all participants. This was and is perfectly permissible according to AAOIFI standards, although the wording of these standards is far from clear and open to interpretation and, therefore, potentially weak. The standards simply say that profits must be shared according to what is stipulated in the agreement; they are not prescriptive about what is permissible in the agreement. They further say that the agreement on the distribution of profits may be amended on the days of distribution.

This, however, is the only instrument available to finance ventures where the assets are intangible, e.g. knowledge rather than bricks and mortar and Dr Nienhaus suggested, therefore, that such sukuk need to be structured so that profit sharing incentivises both equity holders and sukuk holders. If sukuk holders have no expectation of receiving profits over and above an agreed benchmark level, assuming that the project company is particularly successful, there is little incentive for investors to buy the sukuk, except in the case of Islamic financial institutions, where the choice of assets in which to invest is limited. The traditional incentive fee model is definitely not attractive to conventional investors. Risk conscious investors require more.

Dr Nienhaus suggested that a methodology that offers a level of certainty about returns and also allows sukuk holders to participate in the leverage benefits is needed and he illustrated his lecture with various possible alternatives approaches. He noted that he had found nothing in AAOIFI standards that would preclude the use of such alternative approaches and he felt that a pre-determined formula for the distribution of profits was preferable to manually fine tuning returns once a company knew what level of profits it had achieved. At the same time he suggested that such an approach would come much closer to the original intention of risk and profit sharing and would create a vehicle more suitable to financing 21st century, knowledge based businesses with their rather intangible assets.

Dr Volker Nienhaus

Dr Volker Nienhaus is a professor of economics. He has held an honorary professorship at the University of Bochum since 2004 and is also a visiting professor at ICMA Centre, Henley Business School, University of Reading. He is a member of several academic advisory committees and boards and has published numerous articles and books on Islamic economics and finance since the 1980s.


December: Paradigm Shifting Islamic Solutions to the Global Financial Crisis

This lecture was a joint presentation by Sheikh Bilal Khan and Sheikh Badrul Hasan.

A Clarification of Shari’ah Law

Sheikh Badrul Hasan began the lecture with a brief clarification of Shari’ah law. As an English lawyer and also someone trained in Islamic law, he said that he was struck by the extent of the parallels between English and Islamic law. One of the parallels was with English insurance law, which says that the insurance contract can only be executed if the person purchasing the insurance has an insurable interest in what is being insured. Second, the contract must be based on the principle of indemnity and not profit.

Those two principles were embedded in English law to protect society from the use of contracts of insurance for the purposes of gambling. They worked effectively until 30 years ago, when some clever lawyers realised that if they could characterise a contract as not being a contract of insurance, they did not have to apply those principles. Effectively they said, as long as there is no insurable interest and it is not a contract of indemnity, it is not a contract of insurance, therefore the law of insurance does not apply. They managed to persuade English society and the English legal system that this was a fair way of reasoning and that led to the proliferation of what are now called swaps and derivatives, which would previously have contravened of the law of insurance.

Another common principle is the freedom of contract. The Prophet (pbuh) famously said that we do not fix prices in the market; the fixing of prices is the prerogative of God, i.e. it must be left to the market. In a sense Adam Smith’s invisible hand in the Islamic tradition is the invisible hand of God and it is sacrosanct, so much so that in Islam there is something called zakat, which is a savings tax. The way that works is every single Muslim is obligated to donate 2.5% of their savings to the poor every year. Zakat is not an income tax, so it does not interfere with an individual’s purchasing power. The individual simply pays zakat on what is left at the end of the year after they have deducted what they have spent from their earnings; zakat does not interfere with the market. It is this ethic of freedom of contract that also runs through capitalism, although we would argue that Islamic law is truer to this principle than capitalism as we know it today
In 2008 the British government banned the short selling of stock in certain financial institutions. That, effectively, was the implementation of an Islamic law. The Prophet (pbuh) said, ‘Do not sell that which you do not have.’ That means that much of the speculation inherent in today’s futures and derivatives markets that we have today would not be able to operate, because they sell things that do not exist or which they do not own and because they are able to do that, they are able to gamble.

A Myriad of Global Crises

Sheikh Bilal Khan said that most people would tell you that global financial problems of 2007/2008, the worst since the Great Depression of the 1930s, stemmed from the subprime mortgage scandal, but he suggested that perhaps the cause was something more structural in the current socio-economic system. There is no doubt, however, that whatever the cause, it led to the collapse of large financial institutions with some such as Lehman disappearing and other absorbing huge amounts of money in bail out funds and also to a serious downturn in stock markets. Every segment of the modern financial economy suffered.

We read in Islamic literature that there are two types of economy – the financial economy and the real economy. In the Western economy today, and in the last 30 years in particular, there has been a huge shift to service based businesses, particularly financial services and a lot of that industry is about repackaging instruments and selling them to someone else.

Many commentators will say that the solution to the problem is regulation, while others say there is too much regulation. Governance models are questioned and the industry is now talking about a move away from stakeholder models towards stewardship, which is actually closer to the Islamic ideal. Bringing ethics back into economics is another discussion thread. There are any number of reports from the EU (European Union) and the US and UK governments suggesting ways to regulate the behaviour of banks and other financial institutions. These, however are merely scratching the surface. The answer is that this is a systemic problem; the whole economy is based on debt. If the roots of the problem are not addressed, there will never be a real solution. Islam, not just in finance and economics, but in every aspect of life, goes to the root of the problem.

Facts and Figures

The US is the largest economy in the world and 80% of that economy is service based, with financial services making up the largest portion. It is difficult to regulate, because most bank activities are off balance sheet such as structured finance and securitisation. The banks use special purpose vehicles (SPVs), which are entities that typically do not own any assets and therefore there can be no true sales. In addition they use certain jurisdictions such as the Cayman Islands to avoid tax. The financial sector has now become a parallel economy and people no longer look at things such as productivity, the real economy and assets.

There are two types of capital markets, the equity markets or stock markets and the bond markets trading debt securities. The size of the world’s bond market is $45 trillion, with stock markets slightly higher at $51 trillion. The world’s derivatives markets, however, are worth £480 trillion, which is 30 times the size of the US economy and 12 times the entire world economy. He added that in one law firm alone in 2012 there were 1,211 derivative deals and each one was worth a minimum of $15 billion. There is no activity behind this, no financial need.

Islamic Law

Sheikh Hasan said that Islamic law is not just a law relating to finance; Islamic law is a faith, which involves belief in God and submission to God. When it comes to financial dealings a Muslim treats those financial dealings as an act of worship, as they do every other act in their lives. Going to work in the morning is an act of worship for a Muslim in the same way that going to the mosque to pray is an act of worship.

The way God has structured his commandments about financial dealings is that he has given us a general freedom of contract; go out there and do what you like, but with certain prohibitions. It is a bit like the Garden of Eden. You can roam around the Garden and eat whatever fruit you like, as long as you stay away from the forbidden tree. The first fruit of the forbidden tree is gharar, trading risk; the second is riba, interest and then there is theft and fraud and the eating of forbidden things such as pork and wine.


Islamic law says that gharar invalidates a contract. It is actually sinful as an article of faith for a Muslim to continue with that contract, so it has both spiritual and legal consequences.

One of the most striking examples of gharar is gambling. There are very striking verses in the Qur’an relating to gambling. One verse says, ‘Oh, you who believe, intoxicants and gambling and sacrificing to false gods and divination by arrows are the filth of Satan’s work. Keep away from them so that you may prosper.’ There may be some benefits in intoxicants and gambling, but the sin is greater than the benefits.

The reason why gambling is so stridently prohibited is that it creates an absolute loss to society. The prohibition of gharar and riba is the principle of efficiency and the purpose of Islamic law is to promote efficiency in the market, which is why Islamic law is loathe to interfere with the market mechanism, except to ensure freedom in the market. An Islamic government may interfere with the market, where the market is being corrupted or manipulated, to ensure freedom. Islamic law likes to promote market efficiency through the market mechanism.

How do we define that efficiency? In principle a transaction in the market is efficient when the right price is paid. If that price is interfered with in some way, through some form of fraud, market interference or undue influence, then you have the unlawful devouring of wealth by one party to the detriment of another. This is what God warned us against, because it leads to great suffering
Gambling involves the creation of a risk, where no risk existed previously. It involves an absolute loss to society, because both energy and time are expended in the process of gambling and nothing is produced. It is a pure transfer of wealth, a bit like theft, which is generally agreed to be an immoral activity.

Why does the trading of risk cause mispricing? All the assets and wealth that exist on earth are subject to certain risks. God says that, if you want to trade those risks and put a price on them, you cannot, because you do not know the mind of God. If you enter into the trading of risk, you will inevitably misprice it. One party will gain from a risk they did not take and another will not. The basic principle that the Prophet (pbuh) taught is that benefit should derive from the assumption of risk and there should be a balance between the two. We do not really know the price of risk, it is at best an informed guess and we often get it wrong.


Sheikh Khan cited a hadith that lists six commodities – gold, silver, wheat, barley, dates and salt. Jurists have created modern parallels, so, for example, gold and silver would equate to currencies today. There are two rules in relation to these commodities, which are very important. First, if there is any exchange between one of these commodities, the counter values must be equal – one ounce of gold for one ounce of gold. Second, the exchange must not be on a deferred basis; it has to be on the spot. If the exchange is between gold and silver, the first rule ceases to apply, but the spot condition stays.

We are told that interest relates to and controls inflation, but interest actually causes inflation. Debt and interest are the roots of the current problem. Society needs wealth creation rather than wealth transfer, although Islam does allow wealth transfer through charitable giving.

Sheikh Hasan concluded by saying that many people claim a completely different financial system is being suggested, a paradigm shift, which is going to cost a lot of money. They say they can get by with the current financial systems, despite its boom and bust characteristics, but the Prophet (pbuh) says that in the end usury leads to utter poverty.

Sheikh Badrul Hasan

Sheikh Badrul Hasan is Co-Chairman at Dome Advisory and is both a Shari’ah scholar and an Islamic finance lawyer. He is a Solicitor of the Senior Courts of England and Wales and was called to the English bar in 2001. He was formerly an associate at the international law firm, Simmons & Simmons, based in Dubai. He is a Certified Shari’ah Advisor and Auditor with the AAOIFI in Bahrain and has sat on several Shar’iah Supervisory Boards.

Sheikh Bilal Khan

Sheikh Bilal Khan is Co-Chairman at Dome Advisory and is both a Shari’ah Scholar and an Islamic finance and takaful lawyer, currently working with Linklaters LLP. He received the ‘Young Takaful Scholar of the Year’ award at the 2012 International Takaful Summit and the ‘Zaki Badawi Shari’ah Scholar of the Year’ award at the 2011 London Sukuk Summit as well as being nominated by the Securities Commission Malaysia as the 2012-2013 Oxford Visiting Fellow of Islamic Finance.


Islamic Finance Qualifications awarded by IIBI

In order to offer wider choice to potential applicants, IIBI launched its Diploma in Islamic Banking (DIB) by distance learning in January, 2010. The course builds candidates’ knowledge of Islamic banking concepts as well as their practical applications. It supports candidates seeking a career in Islamic banking and also their career progression in the Islamic finance industry.

Candidates having a graduate degree may take up the IIBI Post Graduate Diploma in Islamic Banking and Insurance (PGD), however those who wish to build a good foundation of Islamic banking concepts and operations, may opt to take the DIB course and later on progress to the PGD. DIB holders wishing to take up the PGD course will get an exemption from some of the Post Graduate Diploma modules.

Post Graduate Diploma in Islamic Banking and Insurance (PGD) Awards

To date students from more than 80 countries have enrolled in the PGD course. In the period October to December 2012, the following students successfully completed their studies:

► Abdul Latif Parkar, Business Development Manager, E Zy Travel, Qatar

► Alhaji Abbas Hruna Ginsau, Senior Supervisor, Securities and Exchange Commission, Nigeria

► Asif Mohamed, Senior Executive – HR and Administration, Amana Takaful (Maldives) Plc, Maldives

► Babar Hussain, UK

► Isa Ahmed, Chairman, Nasarawa Microfinance Bank Ltd, Nigeria

► Jimoh Aliyu, Operations, United Bank for Africa Plc, Nigeria

► Housna B Rasool, Saudi Arabia

► Kassim Ahmed Abeid, Tanzania

► Medina Yunus Mohamed, Graduate Clerk, National Bank of Kenya, Kenya

► Mohamed Zawahir Shakir Mohamed, Senior Accountant, Amana Takaful (Maldives) Plc, Maldives

► Muhammad Imran, Account Assistant, Al Roqa Fashion LLC, Dubai, UAE

► Muhammadh Alfin Mohamed Omar, Underwriting Officer, Abu Dhabi National Takaful, UAE

► Musa Yakubu, Retail Branch Manager, Bank PHB, Nigeria

► Omar Haji Hussain Omar, Chief Executive Officer, Omer Hashi Company, Somalia

► Salisu Saad, Manager/Head, Quality Assurance Unit, IAD, Federal Inland Revenue Service, Nigeria

► Sharjeel Shahid, Head of Personal Banking, Standard Chartered Bank, Pakistan

► Sheriff Mustapha, UK

► Shpetim Lleshi, Account Manager, Mazkan International, UK

► Suhail Mohamed, Shariah Products, Stanlib, South Africa

► Thair Ahmed El Heri, Purchasing Officer, Arabian Gulf Oil Company, Libya

► Asfand Zubair Malik, Pakistan

Kawsar Ahamad

Kawsar Ahamad, Relationship Manger, Prime Bank Ltd, Bangladesh The course materials and the presentation are well designed to provide a clear understanding of Islamic banking and insurance. Being a student of banking as well as a practitioner, I have learned a lot from the course. I got the opportunity to learn how Islamic banking is being practiced around the globe and the challenges it is facing with its conventional counterpart. This will definitely help me to understand the role of Islamic banking and finance more clearly. I enjoyed the course very much.

Lateefat Oba,

Lateefat Oba, Principal Consultant, Ruby Ethical Services Ltd, Nigeria I liked the flexibility in study time and I was able to complete the course at my own pace. The nature of the assignments encouraged me to do a lot of research, which I found stimulating. I was able to gather a lot of material to which I can continually refer. The feedback from the tutor was beneficial.


Diary of Events


18-19: International Takaful Summit, Cairo
The annual International Takaful Summit has traditionally been held in London, but in 2013 it will take place in Cairo, with the opening address being given by Egypt’s Minister of Finance, H.E. Mr Momtaz El-Saied. The decision to relocate was in part due to the belief that the Egyptian market exhibits the greatest potential for takaful growth in the region and also because geographically the country is conveniently located for access to the Middle East and Africa where the industry is flourishing.

Contact: Randa Buaras
Tel: +44 (0)20 8861 2012

26-27: 12th Annual Islamic Finance Summit, London
The plenary session on the first morning of the conference will take a look at emergent Islamic finance in three countries – Turkey, Oman and Kazakhstan and later in the day one of the streams examines the situation in the UK and in Egypt. A half day is dedicated to sukuk and the issues surrounding them. On day two the morning is given over to the Shari’ah panel discussion, which has become an established highlight of this event.

Contact: Stacey Kelly
Tel: +44 (0)20 7779 8515


12-13: 3rd Annual World Islamic Finance Conference, Dubai
Subtitled ‘Linking Europe to the Middle East and Asia’, this conference includes sessions on standardising global Islamic banking regulations, building a robust regulatory framework for Islamic finance and updating information technology to enable growth. Speakers include Dr Johannes Engels of Germany’s Federal Financial Supervisory Authority and Anass Patel of AIDIMM, an organisation that promotes Islamic Finance in France.

Contact: Karthik Naik
Tel: +971 4609 1570

17-18: Oman Second Islamic Banking Conference
This essentially domestic event will look at the progress Oman has made in the establishment of Islamic banking with sessions on the legal and regulatory structure, marketing and branding and the challenge for Shari’ah boards.

Tel: + 961 1 780200

19-20: KL Conference on Islamic Finance 2013
This two day event has a strong regional focus with most of the speakers coming from Malaysian organisations. It will include sessions on Shari’ah and Product Development, Islamic Capital Markets and Takaful.

Tel: +60 3 2168 1879


14-16: International Islamic Finance Conference, Abu Dhabi
Subtitled ‘Islamic Finance in a Changing World’, speakers at this conference include Dr Henry Azzam, Deutsche Bank’s advisor on the MENA region; Professor Fouad Beseiso, former Palestinian Central Bank Governor; Dr M Kabir Hassan, a financial economist and consultant, who has provided advice to the World Bank, the Islamic Development Bank and the Organisation of Islamic Conferences, among others and Waheed Qaiser, who was instrumental in setting up the UK’s first Islamic bank and is currently working on another Islamic bank set up in Europe.

Tel: +44 (0)1274 777700

15-16: 8th Annual World Takaful Conference, Dubai

The theme of this year’s conference is ‘New Strategic Imperatives for the Takaful Industry: Sustaining Growth and Improving Profitability’ and as usual will feature the launch of the Ernst & Young World Takaful Report for the current year.

Contact: Edwin Johnson
Tel: +9714 343 1200

25-26: MEFTEC, Dubai

MEFTEC, the financial technology event for emerging markets, moved from Bahrain in 2012 to Dubai and has chosen to hold its 2013 event there again. Admission to the conference, exhibition and networking events is via the MEFTEC Hosted Delegate Programme.



An Islamic version of option, a deposit for the delivery of a specified quantity of a commodity on a predetermined date.

bai al-ina
This refers to the selling of an asset by the bank to the customer on a deferred payments basis, then buying back the asset at a lower price, and paying the customer in cash terms.

commodity murabaha
A murabaha contract using certain specified commodities, through a metal exchange.

A ruling made by a competent Shari’ah scholar on a particular issue, where fiqh (Islamic jurisprudence) is unclear. It is an opinion, and is not legally binding.

Lit: uncertainty, hazard, chance or risk. Technically, sale of a thing which is not present at hand; or the sale of a thing whose consequence or outcome is not known; or a sale involving risk or hazard in which one does not know whether it will come to be or not.

A record of the sayings, deeds or tacit approval of the Prophet Muhammad (PBUH) halal Activities which are permissible according to Shari’ah.

Activities which are prohibited according to Shari’ah.

A leasing contract under which a bank purchases and
leases out a building or equipment or any other facility required by its client for a rental fee. The duration of the lease and rental fees are agreed in advance. Ownership of the equipment remains in the hands of the bank.

ijara sukuk
A sukuk having ijara as an underlying structure.

ijara wa iqtina
The same as ijara except the business owner is committed to buying the building or equipment or facility at the end of the lease period. Fees previously paid constitute part of the purchase price. It is commonly used for home and commercial equipment financing.

A contract of acquisition of goods by specification or order, where the price is fixed in advance, but the goods are manufactured and delivered at a later date. Normally, the price is paid progressively in accordance with the progress of the job.

Gambling – a prohibited activity, as it is a zero-sum game just transferring the wealth not creating new wealth.
A form of business contract in which one party brings capital and the other personal effort. The proportionate share in profit is determined by mutual agreement at the start. But the loss, if any, is borne only by the owner of the capital, in which case the entrepreneur gets nothing for his labour.

In a mudarabah contract, the person or party who acts as entrepreneur.

A contract of sale between the bank and its client for the sale of goods at a price plus an agreed profit margin for the bank. The contract involves the purchase of goods by the bank which then sells them to the client at an agreed mark-up. Repayment is usually in instalments.

An agreement under which the Islamic bank provides funds which are mingled with the funds of the business enterprise and others. All providers of capital are entitled to participate in the management but not necessarily required to do so. The profit is distributed among the partners in predetermined ratios, while the loss is borne by each partner in proportion to his contribution

musharakah, diminishing
An agreement which allows equity participation and provides a method through which the bank keeps on reducing its equity in the project and ultimately transfers the ownership of the asset to the participants.

qard hasan
An interest-free loan given for either welfare purposes or for fulfilling short-term funding requirements. The borrower is only obligated to pay back the principal amount of the loan.

In a mudarabah contract the person who invests the capital. retakaful Reinsurance based on Islamic principles. It is a mechanism used by direct insurance companies to protect their retained business by achieving geographic spread and obtaining protection, above certain threshold values, from larger, specialist reinsurance companies and pools.

Lit: increase or addition. Technically it denotes any increase or addition to capital obtained by the lender as a condition of the loan. Any risk-free or ‘guaranteed’ rate of return on a loan or investment is riba. Riba, in all forms, is prohibited in Islam. Usually, riba and interest are used interchangeably.

Salam means a contract in which advance payment is made for goods to be delivered later on. Shari’ah Refers to the laws contained in or derived from the Quran and the Sunnah (practice and traditions of the Prophet Muhammad (PBUH)

Shari’ah board
An authority appointed by an Islamic financial institution, which supervises and ensures the Shari’ah compliance of new product development as well as existing operations.

A contract between two or more persons who launch a business or financial enterprise to make profit. sukuk
Similar characteristics to that of a conventional bond with the key difference being that they are asset backed; a sukuk represents proportionate beneficial ownership in the underlying asset. The asset will be leased to the client to yield the return on the sukuk.

A principle of mutual assistance. tabarru A donation covenant in which the participants agree to mutually help each other by contributing financially.

A form of Islamic insurance based on the Quranic principle of mutual assistance (ta’awuni). It provides mutual protection of assets and property and offers joint risk sharing in the event of a loss by one of its members.

A sale of a commodity to the customer by a bank on deferred payment at cost plus profit. The customer then a third party on a spot basis and gets instant cash.

The diaspora or ‘Community of the Believers’ (ummat al-mu’minin), the world-wide community of Muslims.

A promise to buy or sell certain goods in a certain quantity at a certain time in future at a certain price. It is not a legally binding agreement.

A contract of agency in which one person appoints
someone else to perform a certain task on his behalf, usually against a certain fee.

An appropriation or tying-up of a property in perpetuity so that no propriety rights can be exercised over the usufruct. The waqf property can neither be sold nor inherited nor donated to anyone.

An obligation on Muslims to pay a prescribed percentage of their wealth to specified categories in their society, when their wealth exceeds a certain limit. Zakat purifies wealth. The objective is to take away a part of the wealth of the well-to-do and to distribute it among the poor and the needy.