Handbook On Islamic Banking For Sme Managers

HANDBOOK ON
ISLAMIC BANKING
For SME Managers
manual IDD_newlayout.indd Sec1:1 6/19/2009 4:11:41 PM

Contents
Foreword Page 1
By Dr Mohamad Nedal Alchaar
Introduction to the Handbook on Islamic Finance Page 2

By AbdulKader Thomas
Basic Principles of Islamic Banking Page 10

By Shabnam Mokhtar
Islamic Banking as an Alternative to Conventional Banking Page 16

By Nik Norishky Thani and Nik Norzrul Thani
Islamic Banking for SMEs Page 25

By Natalie Schoon
Islamic Microfinance: An Emerging Market Niche Page 37

By Nimrah Karim, Michael Tarazi and Xavier Reille
Islamic Banking for Women: Case Study of Malaysia Page 48

By Jamelah Jamaludin
Regional overviews
a. North America by David Loundy Page 58
b. Europe by David Testa Page 66
c. Africa by Nathif Adam Page 78
d.Gulf States by Global Investment House Page 84
e. Malaysia by Badlisyah Abdul Ghani Page 90
f. Indonesia by Mahmoud Abushamma Page 98

Foreword
An important facet of Islamic banking is that it enables real economic development as it is directly linked
to productive economic activities by way of transactions that are based on trade, rental of assets or genuine
partnerships. The direct link also extends to the real sharing of risks and rewards of the economic activities.
Islamic banking mechanisms are also structurally appropriate to be applied as financing tools for economic
development activities and have the capacity to create additional value for economic development efforts.
Rather than operating as a mere intermediary between the provider and user of funds, Islamic banking
principles require Islamic financial institutions to be active functioning entities involved, for example, in
managing construction and developmental risks in Istisna, asset risks in Ijarah and Murabahah, and business
risks in Mudarabah and Musharakah.
Consequently, Islamic banking can be a conduit for developing the small and medium-sized enterprise
(SME) sector, which has always been an important component of the developing economy.
This book gives an extensive explanation on Islamic banking and facilitates its application to the SME
sector. It also helps both providers and users of banking to appreciate the Shariah principles that underpin
Islamic banking.
Islamic banking not only provides tangible support for the growth of the overall economic system, but also
promotes equitable creation of wealth. It should be noted, however, that while Islamic banking can enhance
the effectiveness of economic development efforts, this will take place only if the Islamic banking practices
genuinely reflect the Shariah principles.
It is also noteworthy that its economic development objectives echo the Islamic principles for the economic
advancement of the Ummah, and for the attainment of social harmony globally.
I would like to congratulate the Islamic Development Bank, International Trade Centre, contributing
authors and the publisher for this very important publication and hope it will contribute toward further
development of the international Islamic banking industry.
Dr Mohamad Nedal Alchaar

Secretary general
Accounting and Auditing Organization for Islamic Financial Institutions
Handbook on Islamic Banking for SMEs | Page 1

Introduction to the Handbook
on Islamic Finance
By AbdulKader Thomas
This manual wishes to provide you with a deep sector is incapable of making credit and investment
overview of the field of Islamic banking and errors. Rather, Islamic financiers have no capacity to
finance. Islamic finance is an industry that enjoys create exponential levels of leverage, directly or via
rapid growth. As much as the recent petroleum derivative structures. This should mean that Islamic
boom has been helpful to the expansion of Islamic banking and finance will provide a stable alternative
finance in the past few years, there are other more financial choice to small and medium-sized
important factors. For instance, Islam is a rapidly enterprises (SMEs), other businesses and consumers.
growing faith, the revival in observance is drawing
Muslims to seek practical answers in the Quran, and Lets examine how this market is developing, and
the revealed text speaks directly to business ethics. then preview the contributors.
Or consider this, most Muslims live is less developed

countries. Traditional banking is either poorly KEY ISSUES
established or incapable of addressing a number of
social economic issues in these emerging economies. The rapid growth of Islamic market means that
But, the different concepts and rules of Islamic the universe of Islamic banks is more responsive
banking allow for a more inclusive banking system. to the needs of businesses than ever. Until recently,
products and services in the Islamic market were
In this manual and the accompanying User Guide, driven from the top down.
we look forward to providing you with practical
examples of how the Islamic system provides clear Today, the Islamic space is increasingly a bottom-
and useful alternatives for the emerging markets. up market: Users of Islamic financial services
are placing significant demands on the banks and
And, now that we are improving our understanding pushing for usable solutions to their daily business
of the many causes of the 2008 economic crisis, we and financial problems.
see that the types of leverage possible in traditional
banking are not possible in the Islamic context. As Nonetheless, this expansion brings problems along
described in this manual and the accompanying User with it. For instance, what can an Islamic bank
Guide to Islamic Banking, the methods of Islamic do with its cash since it is not permitted to earn
banking and finance are much more tightly linked to interest? The method for interbank and customer
assets and real cash flows. This is not to say that the deposits is often based upon either the existence
Page 2 | Handbook on Islamic Banking for SMEs

Introduction to the Handbook on Islamic Finance
of assets which may be bought and sold, or on the a tailored solution that is practical and Shariah
participation in the operating risk of the deficit compliant.
bank, the receiver of the funds.
Although impressive compared to the early days
Although we will focus on the questions of SME of Islamic finance, product development and
operators, they share similar challenges to those service quality in the Islamic financial network are
of the retail sector. Often, one simply needs not yet as good as they should be. This is because,
cash or credit. But, the selling of an asset or the until recently, there was no systematic training,
participation into ones business is not logical. transparency or regulation.
What, then, are the tools to solve this problem?

Creative solutions are being tested in the main CREATING THE CONTEXT
markets for Islamic finance including Malaysia, Saudi
Arabia, Bahrain, the UAE, Kuwait and the UK. The SME sector is the most important driver of
Indeed, regulatory reform and tax modification have economic growth and jobs. Indeed, many important
launched the UK into the spotlight as a center of innovations were first discovered in the SME sector.
excellence in Islamic finance along with Bahrain and The emerging Islamic financial market is ideally
Malaysia. suited to serve this sector.
The Islamic banking industry was born first with As discussed in this manual and the accompanying
trade finance in mind. Then, real estate emerged as User Guide, the methods and tools of Islamic
an important driver of the business. The lessons finance are undergoing a rapid evolution and
learnt include the use of agency, partnership and popularization which makes these tools increasingly
sales concepts to a very high level of sophistication. relevant to the SME market.
As a result, Islamic bankers are now offering the What is the best way to understand the Islamic
SME and micro sectors important new tools for market and its relevance to SMEs? The Islamic
secured and unsecured investment. These tools, banking sector focuses on assets and business
which are described below, mean that Islamic banks activities. One might compare it to asset financing,
are very competitive in the SME and microfinance except that Islamic finance can be a crossover to
sectors. equity and cash flow finance as well.
As a result of the seismic shift in the formation of These developments in Islamic finance mean that
demand, new product development has become a well-established global banks like Citibank are in
dynamic focus of Islamic banking and finance. In a position to offer Islamic products in emerging
the last five years, the Wakalah funding concept, markets, just as de novo Islamic banks like Kenyas
Islamic bonds (Sukuk) and Islamic forms of hedging First Community Bank are able to compete in the
have been introduced on a wide scale. SME and micro finance sectors.
The successful scaling of these innovations has There are several key trends defining the
allowed mass market distribution of these tools to opportunities for SMEs in dealing with the Islamic
increase investment in and liquidity of the Islamic financial sector, as well as some that will help
market. Now, many Islamic banks pride themselves us understand the limitations of growth. In this
on moving closer to their clients to understand their introduction, we will summarize these opportunities
core business needs, and then being able to innovate and limits, as well as the contents of this manual.

Then, we will close out with some thoughts about This product development in response to bottom-
your next steps in dealing with the Islamic financial up demand means that SMEs now enjoy a diverse
sector. choice between asset and working capital financial
instruments. As we describe in the accompanying
User Guide, SMEs may now acquire assets on
TRENDS AFFECTING THIS a recourse and non-recourse basis from Islamic
MARKET providers as well as conventional providers
operating Islamic windows.
There are important trends defining the rise of
the Islamic market and how it serves the SME These solutions provide for construction, pre-
sector. These include the rise of regional and local export manufacturing and other alternatives. On
Islamic banks, a greater focus on the sector and the the working capital side, the use of Musharakah,
enhanced product development skills of institutions Mudarabah both business participation methods
serving the sector. But, the industry faces some and Wakalah (a form of investment agency) has
important challenges, which include a shortage of allowed for Islamic providers to compete efficiently.
skilled staff, the need for training, and better risk
measurement and regulation. But, there is a difference. The Islamic provider
is procedurally bound to examine the role of its
Fortunately, the market, as discussed below, money in the asset process or the business activity
addresses these problems with clarity. of the investee. This means that the Islamic provider
faces clear limits on the quantity of leverage that
In the past decade, Islamic financial institutions it can provide, arguably a true benefit under the
and investors have broadened their horizons to circumstances of the financial crisis of 2008.
the capital markets and to microfinance. Indeed,
some of the stronger offerings in the Islamic capital The rate of product development is sometimes
market represent securitized assets generated in both criticized on two fronts: It is apparently slow paced
the SME and microfinance sectors. compared to the conventional sector, and the
seemingly copycat product development process
This increased specialization in the micro and SME followed by some Islamic providers.
sectors incorporates lessons from important micro
markets like Bangladesh where Citibank, Prime This reflects a severe shortage of trained people in
Bank and Islami Bank Bangladesh have developed the Islamic banking field. The explosive growth of
robust Islamic offerings; as well as leading emerging the sector is such that there people with meaningful
markets like Malaysia, where the government- work experience and proper training are stretched
controlled Bank Pembangunan Malaysia, and the thin. This applies equally to bankers and Shariah
private sector are actively pursuing the development scholars supervising the industry.
of products and services for the SME sector.
Fortunately, this is changing in a number of
When the Islamic banking industry started, the focus important ways. With respect to Islamic acedemics,
was on trade finance and then it branched to wealth the degree of formal training available to them
management and big ticket corporate finance. But, at key centers of traditional learning, as well as
in the past decade, consumers and business owners numerous universities means that aspiring young
have been creating demand for new products and scholars may participate in proper training in Islamic
services. law and its modern applications in commerce.

In addition, the Accounting and Auditing with form, causing all Islamic methods to be tested
Organization for Islamic Financial Institutions generally across many markets, and perfected in
(AAOIFI) has introduced formal training for certain countries.
scholars in the review of Islamic financial
institutions and their compliance with Shariah, This process has pushed a growing community of
namely Islamic financial rules. And, the universe regulators to address the question of Islamic finance
of aspiring scholars pursuing these studies includes and its related challenges. We will discuss this
representatives from Muslim communities around when we cover regulation and the Islamic Financial
the world. Services Board (IFSB).
For bankers, there is strong growth in training An additional payoff from the Sukuk
opportunities. The traditional executive training experimentation is that the tools that allow
provided by international training and specialized securitization of SME transactions now exist in
regional firms is now supplemented by new credible jurisdictions as diverse as Malaysia and the UAE.
certification and training programs. Some of these More importantly, these provide a clear model of
are government-sponsored: e.g the International the ways that Islamic securitization could be applied
Center for Education in Islamic Finance (INCEIF) in any common law or civil law jurisdiction. As a
falls under the purview of the central bank of result, the exportation of these concepts to new
Malaysia (Bank Negara Malaysia). markets has become much easier.
The Securities & Investment Institute in London An additional risk dispersion characteristic of
offers the Islamic Finance Qualification, and the Islamic finance is the concept of Mudarabah and
Chartered Institute of Management Accountants Wakalah deposits, often characterized as profit
offers the CIMA Certificate in Islamic Finance. sharing investment accounts (PSIAs). These
These and proposed assessment-based training accounts allow a bank to collect funds from the
programs in the pipeline promise better public on the basis that participates in the operations
opportunities for bankers and clients alike to obtain of the bank, or even to specific clients.
the correct qualifications to deal with Islamic
financial concepts. These loss absorbing accounts might periodically
generate higher yields than traditional interest-
With stronger public training, SMEs can expect to bearing deposits. Yet, if the bank or the underlying
be better informed when dealing with more soundly business does not perform, then the risk of loss
rooted bankers. The entire industry anticipates that may be passed to the depositor. Such a feature is
this will enrich the market in terms of product unique to Islamic banking and may mean that the
development efficiency and relevance. systemic risks of Islamic finance are much lower
than traditional banking as losses are absorbed at the
The early payoff of various training programs is the point of loss.
invention of Sukuk. These are instruments akin to
bonds that have allowed for a significant expansion Measuring the risk of Islamic transactions is an
of the Islamic marketplace in the last five years. The important challenge not only due to Basel II
Sukuk experiment started in Malaysia, where the requirements, but also because of the unique form
scholars have undergone systematic training and the of these concepts compared to traditional banking.
first serious systematic efforts at public and private Members of the IFSB include central banks from
training of bankers in Islamic finance were initiated. Islamic countries, the International Monetary Fund,
Sukuk transactions have allowed experimentation the Bank for International Settlements, and other

important central banks such as the UKs Financial centers like the Dubai International Financial
Services Authority (FSA) and the Monetary Centre and the Qatar Financial Centre lead the way
Authority of Singapore. The IFSB is mapping in designing the appropriate means of regulating
out a clear means to measure the risk of Islamic Islamic tools and banks. The FSA is not far behind.
transactions in a manner comparable to traditional
banking deals. The development of suitable regulation means that
SMEs will be able to find more Islamic choices
Supporting the IFSB is AAOIFI. Although set out in a clear and logical manner in almost
AAOIFI provides its own independent governance every country. Two factors that should help global
standards, two of its most important contributions regulators integrate Shariah compliant finance
are the formulation of accounting and Shariah and savings are the true asset orientation of the
standards for Islamic financial transactions. AAOIFI business proposition combined with the profit and
accounting standards provide best practices for loss sharing concepts. These may mean that a single
accounting when dealing with Islamic transaction deal is less likely to threaten a bank or a system than
structures. These best practices are designed in we saw with the collapse of banking subsystems in
the International Accounting Standards (IAS) 2008.
framework and modify the expected IAS accounting
treatment whenever the Shariah compliant structure Within the perspective of the overall development
so requires. of the industry, the Islamic Development Bank
(IDB) has played a critical role. Originally
AAOIFIs second and, perhaps most important established as a multi-functional body, the IDB
contribution is its set of Shariah standards, which has been instrumental in channeling development
represent the consensus of modern Islamic scholars and trade finance to member states of the
with respect to Islamic financial transactions. Organization of the Islamic Conference (OIC).
They take into account accounting, regulatory and Its Islamic Research and Training Institute is an
business factors under the application of Islamic important knowledge resource center that allows the
juristic rules or Fiqh. Transaction concepts covered exploration of new products and analysis of Shariah
in the AAOIFI Shariah standards are the most rules relevant to commerce.
widely used and agreed tools of the Islamic finance
business. As a multi-state body, the IDB benefits from the
proximity of its head office in Jeddah to the OIC
With respect to actual risks, the structure and Fiqh Academy headquarters in Makka. This provides
characteristics of Islamic instruments mean that an a fertile atmosphere for the exchange of relevant
Islamic financial institution should not be able to ideas to propel the growth of the industry.
repeat the same errors that led to the financial crisis
of 2008 such as excessive leverage and derivatives. The IDB has also been a key promoter of the
Nonetheless, this does not mean that the Islamic leading industry bodies AAOIFI and IFSB as well
sector will not commit such errors. But, these will as an active supporter of Islamic financial ideas in
be distinctive. With respect to the SME sector, this key financial and political centers around the world.
should mean that the risk of a total liquidity collapse On a micro level, the IDB counts several developing
in the Islamic sector is prospectively lower. nations in Africa, Asia and Europe as members and
is able to provide useful support in multiple ways as
Because of these structural challenges, the regulatory only a development bank can, in the implementation
infrastructure is slowly but surely strengthening. Key of SME and other forms of Islamic finance on
jurisdictions like Malaysia and Bahrain and offshore those countinents.

There is one lingering challenge beyond the finance, and continue with regulatory and regional
regulatory: taxation. The asset orientation and reports which should bring a clear value to the
merchant style of Islamic finance often requires SME banker and manager in understanding Islamic
assets to be owned or to pass through the ownership finance and its widening applications in the market.
of the Islamic financier.
Basic Principles of Islamic Banking One of the
This often triggers value added, stamp and other promising lights of Islamic finance research and
taxes that would not normally apply to banking training, Shabnam Mokhtar has prepared an
transactions. introduction to the basic principles of Islamic
finance. This initial review of the principles of
Several different approaches have been taken to Islamic finance will enable you to understand the
alleviate this problem, including: the removal of context of this manual as well as to take efficient
taxes on Islamic deals by legislatures in countries advantage of the User Guide.
as diverse as the UK, Malaysia and Singapore, for
example; the exemption of such taxes by executive Islamic Banking as an Alternative to Conventional
decree as in most of the Gulf Cooperation Council Banking Nik Norishky Thani is the Excutive
states; and stated incorporation of approved Islamic Director of Islamic finance at the Dubai
deals under the regulatory framework applicable to International Financial Center (DIFC). Nik
banks, as in the US. Norzrul Thani is the chairman & senior partner
of the largest law firm in Malaysia, Zaid Ibrahim
With the increasing importance of AAOIFI and & Co. Both men have extensive experience in the
the IFSB, it is expected that Islamic financial Islamic finance industry and in this chapter, they
transactions will achieve global tax parity in the elaborate on how Islamic banking differs from its
next decade. Separately, the importance of doreign conventional counterpart.
direct investment from the GCC to many emerging
markets also bodes well for the achievement of Islamic Banking for SMEs Natalie Schoon is
tax neutrality for Islamic finance in countries head of product development at the Bank of
where these ideas are currently not well known or London and the Middle East. This recently
practiced. established UK bank has enjoyed success
introducing Islamic tools into the SME markets
in Europe and the UK. Her insights help
CONTRIBUTORS us understand the practical applications of
Islamic tools in the SME markets of developed
A stellar team of contributors provided important
countries.
outlooks from the perspectives of bankers,
regulators and academics. Their views provide us
Islamic Microfinance: An Emerging Market Niche
with defining concepts of Islamic finance as applied
The authors of this chapter are Nimrah
globally. This means that we are able to enjoy the
Karim, Michael Tarazi, CGAP senior policy
experience of a de novo Islamic financier from the
specialists and Xavier Reille, lead microfinance
UK such as the Bank of London and the Middle
specialist at CGAP. Consultative Group to
East, and important emerging market specialists like
Assist the Poor (CGAP) is a consortium of
HSBC Amanah and Standard Chartered Bank.
public and private agencies working together to
expand access to financial services for the poor
The overviews of our industry begin with a
in developing countries. This chapter hopes to
summary of the important principles of Islamic
update readers on developments and trends in

Islamic microfinance by providing a host of East and North Africa (MENA) regions. In
facts and statistics gleaned from CGAP research, this chapter, Global provides an overview
in particular a 2007 global survey of over 125 of Bahrain, Kuwait, Oman, Qatar, Saudi
Islamic microfinance institutions and experts Arabia and the United Arab Emirates these
from 19 Muslim countries. countries are often referred to as the GCC
States.
Banking for Women Jamelah Jamaludin,
managing director of RHB Islamic Bank, offers Malaysia Badlisyah Abdul Ghani, CEO
an insight into the importance of developing of CIMB Islamic, is one of the leading
banking for women and womens leadership in innovators in a market known for cutting
banking. edge thought. He provides us with a clear
understanding of the dynamic and influential
Regional overviews: In order to give a greater Malaysian market: Indeed, this is the market
context for this manual, views from all of the that can provide useful examples for the SME
key international markets where Islamic finance sector on a global basis.
is active are also included. These should surprise
you with their breadth and depth of Isalmic Indonesia Mahmoud Abushamma of
solutions in global markets. HSBC offers a review of developments in
this dormant market. But, with the recent
North America David Loundy of Devon passage of banking and securities reforms,
Bank in Chicago, provides an overview of the Indonesian Islamic finance and securities
real estate and SME experience from the markets are about to take off.
perspective of a US institution that has been
one of the few pioneering specialized Islamic
products in a highly regulated market with a
YOUR NEXT STEP
limited set of regulatory rules.
As you read this manual, you should gain a deeper
understanding of the practical tools that you now
Europe David Testa of Gatehouse Bank,
have at your finger tips to be an effective user of the
another de novo UK-based Islamic bank with
Islamic financial services. The accompanying User
strong SME and securities experience, gives
Guide will give detailed descriptions of the Islamic
his view of developments on the continent.
financial tools used in a regulatory and tax neutral
SME environment.
Africa Nathif Adam is the CEO of
First Community Bank, the pioneer Islamic
In this manual, we hope that you will better
banking institution in Kenya and arguably the
understand the trends and relevance of the growing
fastest growing Islamic bank in Kenya and
Islamic finance industry. Perhaps the most relevant
East Africa. This chapter offers a unique view
of these are the innovative approaches that are
into the slowly awakening African Islamic
delivering new financing tools to all markets,
finance market.
especially the SME and microfinance markets.
Gulf Cooperation Council (GCC)
The development of Sukuk or debt securities and
Founded in 1998, Global Investment House
securitization enables a larger global universe of
has grown to become one of the leading
investors to participate in the risks and rewards of
asset management and investment banking
Islamic concepts.
companies in the GCC and the wider Middle

The conversion of Islamic commercial ideas into

financial products should help a larger group of
SMEs to access finance. Historically, many Muslim
business owners have avoided bank financing or
have been forced to deal with banks on one-off
transactions.
The world of Islamic finance, its profit and loss

sharing ideas and its asset orientation creates more
opportunities for all business people, regardless
oftheir faith or creed. And, these ideas are
increasingly becoming a part of the regulated global
business and finance scene.
As the IDB, AAOIFI and IFSB help define the

intellectual and regulatory environment, they create
a true template for all business people and regulators
to understand the risks and the applications of
Islamic financial structures. This is critical to the
future health of the global markets, which, in a time
of shaken confidence, require a viable alternative
tool to use.
Indeed, Islamic finance has emerged as a truly useful

way of engaging in business. The Islamic sector
offers new ideas, different risk sharing concepts
and new financial resources. We hope that you will
find this manual and the accompanying User Guide
beneficial in understanding the intricacies of the
industry.

Basic Principles of
Islamic Banking
A simple definition of Islamic banking is a banking operation that abides

by Shariah (Islamic law), under which a key tenet is the prohibition of
riba (interest). Generally, Islamic banking is understood to mean interest-
free banking. However, this sometimes creates the misconception that
Islamic banks operate by giving out charitable loans.
Chapter 1
Loans are the rice bowl of conventional banks. They borrow from
depositors and lend to people in need of finance. Conventional banks
thus make money from the difference between the interest that they pay
the depositor and the interest that they charge their customers. Islamic
By Shabnam Mokhtar banks, on the other hand, are prohibited from engaging in interest. They
cannot pay or receive interest. However, this does not mean Islamic
banks give out charitable loans. Prohibition of riba means a loan is not
a profit making vehicle in Islamic banking. Shariah compliant banks
dont give out loans; instead,they use other modes sale-, lease- and
partnership-based instruments to make profit.
Besides the prohibition of riba, Islamic banks also cannot engage in

haram activities such as pork, alcohol, pornography and gambling. They
cannot buy stocks of wine and sell it to a client. Nor can they lease a
gambling slot machine to a gaming company, for example. In addition,
these banks must also minimize gharar (ambiguity) in their contracts. To
achieve this, Islamic banks must clearly state four elements in a sale and
lease transaction: price, quantity, quality and time of delivery.
This chapter will briefly highlight the evolution of the Islamic banking
industry and then shed light on the instruments used to finance clients.
EVOLUTION OF ISLAMIC BANKING

Islamic economists and jurists initiated critique on the interest-based
operation of conventional banks in Muslim countries in the 1900s and a
number of savings institutions were established in the 1960s. However,

Basic Principles of Islamic Banking
the first Islamic commercial bank only kicked off activities such as Islamic fund management and
in 1975, when Dubai Islamic Bank commenced Islamic bonds (Sukuk) began to boom after the
operations. The 1980s then saw a proliferation of 1990s. With the development of capital market
Islamic banks around the globe. Currently, there are activities, more and more countries are jumping
more than 300 Islamic financial institutions across on the bandwagon. Singapore established its first
over 50 countries. Islamic bank, The Islamic Bank of Asia, in 2007
and aspires to become the Islamic financial hub [in
The Middle East and Asia are two main markets Asia?]. Hong Kong and Japan have also expressed
where Islamic banks have flourished. Bahrain, the similar hopes. Capital market development would
UAE, Kuwait, Saudi Arabia and Qatar are active allow these non-Muslim countries to tap cash rich
players in the Middle East while Egypt, Oman, Syria GCC investors and to continue playing a major role
and Lebanon are catching up. in the international capital market.
In Asia, Malaysia has a fully developed Islamic

financial system (consisting of banking, Takaful,
FOUNDATION OF ISLAMIC
capital market and money market components) BANKING
while other developing players include Indonesia,
Brunei, Pakistan, Thailand and the Philippines. Prohibition of interest means money cannot be
simply traded for money. However, money could
The growth in these markets is fueled in part be used to first buy goods that can subsequently be
by natural demand from the Muslim population sold or leased. Money could also be pooled into a
within those countries. As awareness increases and business venture, with the partners sharing the profit
Islamic banks buckle down on their service, even generated from the effort. Let us now understand
non-Muslim customers have opted for Islamic the financing instruments available from Islamic
banking facilities. This is normal in Malaysia, for banks.
example, where sometimes half of an Islamic banks
customer base is non-Muslim. Besides the Middle i. Sale-based instruments
East and Asian countries, the Western banks are Murabahah (Cost plus financing)
also competing for a piece of the lucrative Islamic This is a sale contract where the cost and the profit
banking business pie. margin are disclosed to the buyer. Thats why
Murabahah is usually called cost plus because the
The first Islamic Finance House was established in bank tells the client exactly that the cost and how
Luxembourg (in 1978), followed by Islamic Bank much they are adding to it. I bought this machine
International of Denmark; Islamic Investment at US$10,000 and Im going to sell it to you at
Company in Melbourne, Australia;and American US$15,000. You can pay me within a year.
Finance House LARIBA in the US. The Islamic
Bank of Britain was founded in the UK in 2004, and This is unlike a normal sale, where the vendors
by 2008, five Islamic banks had been established in profit is not disclosed. The normal sale where
the country. Citibank, HSBC, Standard Chartered, only the end selling price is stated is known as
ABN Amro and Deutsche Bank, for example, are Musawwamah. In this type of sale, the bank
among conventional banks that have entered the would only tell the client the sale price. Ill sell
Islamic space. this machine for US$20,000 and you can pay in 15
months. Would you like to buy this? The buyer can
The industry initially focused on retail and agree to the price or negotiate until the parties reach
commercial banking activities while capital market an agreement.

Murabahah is the more common instrument used not interested in the underlying commodities in
by Islamic banks although some banks do use the transaction. This same reason (intention of the
Musawwamah. Bear in mind that in Murabahah, the parties) is the basis for prohibiting Bai al Inah (sale
bank buys an underlying asset and then sells it. Thus and buyback). Bai al Inah is, however, allowed in
there is an exchange of asset and money, unlike a Malaysia on the basis of Maslahah (public benefit).
loan, where money and money is exchanged.
In commodity Murabahah, the bank buys from one
What is vital about the implementation of broker and the client sells to another broker (i.e. more
Murabahah by Islamic banks Is that they use than two parties are involved). In Bai al Inah, the
Murabahah in two ways. First, Murabahah is utilized exchange is between two parties only (the bank and
in asset acquisitions where the client wants to own the client). The bank sells its asset (building, land lots,
certain tangible asset be it a piece of machinery, shares and so on) to the client on a deferred basis
a building or inventory. Lets call this true trade (say, at US$10,000 to be paid in six months). Since
Murabahah, where the client is interested in owning the client has bought the asset and now owns it, he
the subject matter acquired by the bank. You sells back the same asset to the bank on spot basis
cannot use true trade Murabahah to finance business and gets the cash he seeks (say, US$8,000). Just as
expenses like salary and overhead expenses since the commodity Murabahah is popular in the Middle East,
bank cannot buy and sell those. Bai al Inah holds wide appeal in Malaysia because
both instruments give the client cash.
Under commodity Murabahah (also known as
Tawarruq or reverse Murabahah), Islamic banks Simply put, Murabahah is a sales transaction. It is
buy certain commodities (metals, CPO and so on) currently implemented in three forms:
from a commodity broker, then sell them at cost
plus profit on a deferred basis. Since this is a credit a. True-trade Murabahah: The bank buys
sale, the client does not have to pay now. certain tangible asset and sells it to the
client, who wants to own this asset.
However, the client does not want this commodity.
He wants cash. The client thus sells the commodity b. Commodity Murabahah: The bank buys a
(either on his own or more commonly via the bank certain commodity from a broker and sells
on his behalf) to another commodity broker. The it to the client, who does not want to own
client now gets the cash he was after. He uses this the commodity, so he sells it to another
for his business and pays the bank the deferred broker to get cash.
payment that he owes.
c. Bai al Inah: The bank sells its asset to the
In commodity Murabahah, the client is not client (on credit), whoimmediately sells back
interested in owning the subject matter of the same to the bank (on cash basis) and
Murabahah that the bank acquired. He does not obtains the sum that he seeks. Bai al Inah
want to own the metal or the CPOs, he only wants only involves two parties while commodity
cash. Commodity Murabahah is popular in the Murabahah involves more than two.
Middle East because it facilitates cash financing. The
client can use the cash for working capital purposes. Murabahah could be used to fund the purchase of
an asset already in existence a car, a completed
Although commodity Murabahah is allowed by building, machinery and so on. To fund an asset
Shariah scholars, they frown upon it because the that is not yet in existence (agricultural produce
intention of the parties is just to get cash. They are that needs to be cultivated or properties under

construction, for example), we have to resort to yet in existence; however, it does not require
Salam or Istisna. full payment upfront (the payment is flexible).
Salam (Advance purchase) Lets say an SME wants to start a shipping
This is a forward sale contract used for business and in connection thereof wishes
generic goods (i.e. commodities). Salam was to purchase a ship. The SME could approach
an exemption to the general rule of sale an Islamic bank for help with the acquisition.
because the vendor is allowed to sell on a The SME could order the Islamic bank to
forward basis, meaning the subject matter has construct the ship. In effect, the SME is
yet to exist on the day of sale. buying the ship to be constructed from the
Islamic bank (an Istisna transaction).
The prophet allowed farmers to sell their
agricultural produce (which is not yet The SME thus would be paying the Islamic
cultivated) on a forward basis as the buyer bank the purchase price (the cost to the bank
pays the full price on day one and the parties to buy the ship and the profit margin it is
agree on the quantity and time of delivery. charging). The bank, of course, does not
The farmers could use the money paid as have the capacity to build the ship and thus
their capital to start the cultivation. Upon would file an order with the shipbuilder. This
maturity, the farmer delivers the agreed is another Istisna contract where the Islamic
quantity of the produce to the buyer. bank now buys the ship to be constructed
from the shipbuilder.
In the banking scene today, Islamic banks
could use this instrument to fund small The second leg of the transaction is the cost
farmers, for example. This would be a natural of the ship that the bank is paying to the
fit for the agriculture sector. A wheat farmer shipbuilder. Simply put, in this parallel Istisna,
can sell one ton (1,000 kg) of wheat to an the bank buys the ship under construction
Islamic bank, to be delivered in six months. from a shipbuilder (cost to the bank) and
The bank pays the total purchase price (say, sells it to the SME (selling price, i.e. cost
US$10,000) today. plus profit). The SME then makes a deferred
payment to settle what it owes the bank.
After six months, the farmer delivers the
wheat to the bank, which can sell this on the ii. Lease-based instruments
open market or to any interested third party Islamic banks can also use leasing as an alternative
to gain profit. Salam, however, is not popular to sale-based instruments. Both sale and lease
with Islamic banks. It is widely used in Sudan transactions involve an exchange. In a sale
but not elsewhere. transaction, the ownership is transferred to the
client. Thus money (price) is exchanged to own
Istisna (Advance purchase of goods or the asset. In a lease transaction, ownership does
buildings) not transfer to the client but remains with the
Istisna is an extension of the Salam concept. lessor. Therefore, under a lease, money (rental) is
Salam was limited to generic goods and exchanged with the right to use an asset (usufruct).
requires full payment upfront. Istisna, on
the other hand, is used for the construction Ijarah (Lease)
or manufacturing of unique goods (which Similar to Murabahah, the Islamic bank first
require certain specifications). It is similar to buys the asset from a supplier then leases it
Salam because it is used to finance goods not to the client. However, unlike Murabahah, the

bank continues to be the owner of the asset. Mudarabah (Trust financing)

The client only has the right to use the asset. In a Mudarabah financing, only the bank
Upon the expiry of the lease, the client is to provides capital (Rab al maal or capital
return the asset to the bank. provider) while the client manages the
business (Mudarib or entrepreneur).
In the Islamic space, all leases are treated
like an operating lease. If the client wishes The bank cannot interfere in the day-to-day
to own the asset at the end of the lease, then running of the business. The profit would
the parties need to enter into an additional be shared while the bank (as the sole Rab al
contract. Usually, there will be either a sale maal) would have to absorb the losses (i.e.
or gift at maturity. Thus the lease will be monetary losses). The client is not paid a
followed by ownership transfer at the end. salary and if he does not make a profit, he
would lose all the time and effort focused on
This is known as Ijarah Muntahiyyah bi the venture.
Tamleek (lease ending with ownership).
Some markets refer to it as Ijarah Thumma
Bai (lease then sale) or Ijarah wa Iqtina
CONCLUSION
(lease and acquisition).
The exchange-based instruments (sale and lease)
result in pre-determined returns to Islamic banks,
iii. Partnership-based instruments which are not exposed to the business risk of the
Unlike sale and lease transactions that involve client. On the other hand, these banks would be
exchange, the third category of instruments involves exposed to such risk via the partnership-based
pooling assets. instruments (Musharakah and Mudarabah).
These are partnership-based contracts in which the Therefore, in practice, Islamic banks prefer to
Islamic bank invests capital to become partners with finance their client using sale and lease instruments.
the client. The return to the bank depends on the This way, they can limit their risks to the default
actual business performance of the client. There are risk of the client. Partnership-based instruments are
two basic instruments in this category: usually reserved for clients that have demonstrated
good business performance and repayment ability.
Musharakah (Profit and loss sharing)
Under this mode of financing, both bank and Table 1 summarizes the features of a benevolent
client contribute capital and agree to a profit loan, exchange contracts and mixture contracts that
sharing ratio. Capital does not necessarily are used to finance clients. A benevolent loan is
refer to cash; it can also be capital in kind. not used for financing purposes as it is not a profit
Thus, an Islamic bank could provide cash making vehicle.
capital while the client could use its tangible
asset as capital in the partnership. Exchange contracts are the most popular form of
financing as they limit the risk exposure of Islamic
The bank as one of the partners has the right banks while mixture contracts are provided on a
to make strategic decisions and manage the selective basis as they would expose the banks to the
business. The bank could also choose to be a clients business risk.
sleeping partner. Based on the performance
of the business, both partners would share
the profit and losses.

Table 1: Financing instruments in Islamic banks

A benevolent loan Exchange contracts Mixture contracts
Exchange money with Sale and lease contracts (Murabahah, Salam, Pooling of money (i.e. capital) and
money Istisna, Ijarah) agree to a profit sharing ratio
Guarantee of principal Exchange money with asset Partnership contracts (Musharakah,
No extra charges Must determine price for exchange to take Mudarabah)
allowed place Capital needs to be invested
Not-for-profit Once price is determined, return to bank is No guarantee on principal and return
transaction (Tabarru) certain Return is uncertain; it depends on actual
Result in debt that rise from sale and lease business performance

Islamic Banking as
an Alternative to
Conventional
Banking
Chapter 2 The presence of Islamic finance in the international financial scene

became more prominent following the recent global economic turmoil.
At this juncture, it would be timely to have a balanced analysis of the
By Nik Norishky Thani fundamental principles of Islamic finance in light of the current
global economic crisis that focuses on specific elements of the industry
and characteristics that have so far proven to be successful in shielding
Nik Norzrul Thani Islamic financial institutions (IFIs) from exposure to toxic financing
products.
Analogous to the objective of profitable organizations, Islamic banks

and conventional banks, in essence, aim for profit maximization.
However, the contrasting factor demarcating the entities is well defined
in the mechanics of achieving this common objective.
Islamic finance is committed to achieving social justice and equitable

wealth distribution in a society, while the core concept of conventional
finance is the theory of market efficiency between the capital seeker and
the capital provider.
The theory of market efficiency itself does not postulate any religious or
spiritual dimensions. Markets are assumed to be efficient if all available
information is reflected in the current market price.
The conventional system operates within a market economy where the

allocation of resources is accomplished by forces of demand and supply.
The balance of demand and supply minimizes the mismatch of liquidity
in the market. Notwithstanding the overlapping objectives between the

Islamic Banking as an Alternative to Conventional Banking
two financing systems, the mechanics ensure that the of knowledge will lead to an understanding of the
results will differ. distinctive concepts of al-Din, the oneness of God,
man as khalifah, the universe and the prophethood.
This chapter will look at the fundamental principles
in Islamic finance, its rationale and how it works In the economic sphere, the concepts of
in practice. The fundamental principles are the key khalifah and ownership are not absolute, but
mechanism in Islamic finance, and they characterize merely a trusteeship. As such, the principle of
the industry and differentiate it from conventional trustworthiness (amanah) surfaces as the lifeline of
finance. The conclusion will show that Islamic all human activities, including muamalat (economic
finance operates in a prudent manner and that the transaction). This means man has been given
fundamental principles are designed and applied to resources and properties to utilize to meet his own
ensure that financing activity benefits society overall. needs, as well as the needs of others.
FUNDAMENTAL In the words of Ibn Qayyim, The basis of Shariah

is wisdom and welfare of the people in this world
PRINCIPLES as well as hereafter. The duties and responsibilities
performed by khalifah must conform to the Maqasid
Although the practice of Islamic finance is open to all al-Shariah (Basic Principles of Shariah), or the
in developing a thought parallel to Islamic finance goals and objectives of Islamic law. Ultimately,
and the rationale underpinning the system it helps Shariah aims to promote human welfare through
if one can appreciate the foundation established the fulfillment of specific necessities, needs and
within the context of the Islamic world view. comfort. This is evident in the Quran and the
teachings of the Prophet.
We must also note that for Muslims, adherence to
Shariah is compulsory and, therefore, for them, Maqasid al-Shariah outlines five distinctive
Islamic finance is a religious duty and not simply an parameters; preservation of religion, life, intellect,
alternative to financing needs. The Islamic world lineage and wealth. The Shariah protects these
view recognizes man as khalifah, or vicegerent, of necessities in two ways: firstly, by ensuring its
God with defined purposes corresponding to his establishment and secondly, by preserving them.
various capacities. Basically, to hold an Islamic worldview will impress
upon one the fact that he or she is given the trust
Khilafah refers to a mans responsibilities to himself by God to manage resources in the most efficient
and to the ummah (Muslim community) as a whole. manner.
According to Abdalati (1994), khilafah denotes
the relationship between man and God, man As such, making decisions and managing
and his fellow men, man and the other elements transactions within the financial domain constitute
and creatures of the universe, and man and his an act of ibadah (obedience), which clearly
innermost self. demonstrates the fundamentals of the Islamic
worldview in connection to the unified existence of
The Islamic worldview encompasses both the world the world and the hereafter.
and the hereafter (akhirah). This simply means that
the worldly aspect must be related in a profound Thus, Islamic finance is built upon certain
and inseparable way to the akhirah, which is the restrictions with a view to preserving the economic
ultimate. Knowledge is the epicenter of the Islamic well-being of society. Essentially, Islamic banking
worldview and, in an ideal situation, acquisition instruments must not contravene prohibitions

against riba, gharar, and haram transactions. These enrichment in the market. Transactions involving
broad Shariah principles distinguish Islamic finance gharar can potentially lead to unfair and unethical
from its conventional counterpart. dealings. Uncertainties in an Islamic contract could
include the parties involved, the price and the
One of the main tenets upon which Islamic banking subject matter of the sale, its delivery and quality,
law rests is the prohibition on riba. Literally, among others.
riba means to increase, to grow, to rise, to swell.
The prohibition of riba is meant to structure an Risk, on the other hand (and from the Islamic
economy and society based on risk sharing, fair standpoint), is linguistically recognized as ghorm,
dealing and equity. In Islamic law, the justification implying systematic risks that are constructive in
that riba is the cost of using money, or that a loan is nature. Ghorm, in the financial context, cannot be
an investment, is rejected in favor of ethics. controlled or eliminated due to its natural volatility
in market movements.
However, Islamic banking encourages Al Bai
(trading) as the basis for all commercial transactions. Investments in businesses dealing with alcohol,
The legitimacy of Al Bai, in contrast to riba, gambling, drugs or anything else that Shariah
is founded upon the presence of iwad (equal considers unlawful are deemed undesirable and
countervalue) in a transaction. In an Al Bai prohibited. This represents the prohibition of
transaction, iwad consists of two main components: involvement and engagement in socially detrimental
market risk (ghorm) and work and effort (kasb). A business and haram (forbidden) transactions in
third component, liability (daman), should also be Islam.
taken into account.
The three principles translate into a financing
In many instances, gharar has been termed system, characterized by debt financing, with assets
interchangeably as risk or uncertainty. The backing the transaction and financing, and one in
prohibition of gharar refers to uncertainty about the which both the capital providers and capital seekers
subject matter and terms of contract, which include take risk. The financial crisis has demonstrated the
a prohibition on selling something that one does resilience of the Islamic financial market against
not own. For ease of understanding, gharar refers to financing products that rely primarily on structuring
contractual ambiguities. technology, as opposed to actual value of assets in a
securitized transaction.
Technically, gharar is the sale of probable items
whose existence or characteristics are not certain, Islamic finance, therefore, provides a viable
due not only to their risky nature but also to alternative to investors who prefer investment
elements in the transaction that speculate on products that are simpler and more reliable; this
unbundled risks which, in the most extreme form, is likely to provide growth in the demand for
render the trade similar to gambling. Due to the Shariah compliant products which avoid excessive
foreseen magnitude of risk, avoidance of gharar is speculation and are backed by real economic
essential. transactions.
The majority of Islamic jurists agree that any ETHICS ANGLE

contract is deemed null and void in the presence
of gharar, which would render no legal protection The philosophy of Islamic finance is beyond
for the transacting parties. The prohibition on muamalat. This is evident from the earlier analysis
profiting from gharar, ultimately, is to prevent unjust of the Islamic worldview, where the cornerstone

of a balanced and equitable economy is founded In brief, Islamic economy is a system that adopts its
on the inextricable relationship between ethics and guidelines from the Quran and As Sunnah, which
muamalat. seeks to achieve the following goals:
Islamic finance offers a fruitful compromise (i) economic well-being within the framework of
between finance and ethics. In his article, The moral norms;
Prophet and the Profits: Islamic Finance, Islamic (ii) universal brotherhood and justice;
finance expert, Ibrahim Warde, said Islam has a (iii)equitable distribution of income; and
positive view of economic activities, while providing (iv)freedom of the individual within the context
for a strict ethical framework. of social welfare.
The fundamental principles of Shariah in Islamic The goals ultimately represent universal values,
finance are predominantly formulas to achieve a irrespective of religiosity, one of the key factors that
financing system that focuses on developmental and underlie the global acceptance of Islamic finance.
social goals. In Islamic banking, muamalat activities In general, it is a system that consciously seeks ways
are instrumental in promoting social justice and real and means of ensuring fairness in transactions
economic growth, while ethics is inherent in Islamic by regulating itself. Ethical banking, meanwhile,
finance to safeguard the interests of all stakeholders. was introduced into the mainstream conventional
financial system with the main objective of
Disclosure and transparency, the fiduciary role and cultivating social and environmental responsibilities
the responsibility of the board of directors, integrity among the corporate community.
and ethical behavior, as well as accountability to
shareholders, are some components of corporate This new business model manifested a gradual
governance that conform to the Islamic perspective. departure from the strict interest-based commercial
activities regime. An ethical bank, also known as a
The importance of ethics incorporated in any social, alternative, civic or sustainable bank, is one
business model can never be overemphasized, concerned with the social and environmental impact
notably in the wake of the corporate governance of its investments and loans. The ethical movement
failure of Enron in the US. The collapse of this within the financial setting became the impetus for
energy company led to the enactment of the the development of modern concepts of ethical
Sarbanes-Oxley Act 2002, which introduced ethical investment, socially responsible investment, and
principles to the US corporate environment through corporate social responsibility, among others. This
the application of various rules. trend runs parallel to the social values embedded
in Islamic finance. The presence of ethical banking
Though certain behavior is expressly prohibited in the system is, in reality, a blessing to the finance
in Islam in order to maintain societys communal industry. Still, the notion that divine guidance is not
behavior for example, prohibition on alcohol limited to the spiritual realm is deeply revolutionary.
consumption and gambling the religion
recognizes that while financing can spawn social Having this idea accepted by staunchly secular
injustice, it is nonetheless necessary in society. institutions such as states, governments, banks,
Hence, the fundamental principles were drawn up to investment houses and other corporations is not
ensure that while financing may take place, certain an inconsequential change. The presence of ethical
safeguards were put in place to ensure that financing banking, therefore, supports the notion of morality
relates to real economic growth, as opposed to in a commercial environment advocated by Islamic
having a financing system with moral hazards. finance. Market development, too, contributed to

the wider acceptance of Shariah compliant products In an extreme situation, it is possible for a
and services by the global community, including transaction that charges 0% to still fall foul of
those from non-Muslim jurisdictions. Shariah compliance. This is because the transaction
may not reflect the true value of the risk taken by
the financiers. The issue of form over substance
SUBSTANCE OVER FORM has attracted divergent opinions, mainly on the
issue of the continuous use of the London
The biggest hurdle for Islamic finance revolves Interbank Offered Rate (LIBOR) for the pricing of
around the issue of form and substance of the Islamic-based products and the treatment of debt
system. The issue is complex and demands a provision in Shariah-compliant equity transactions.
redefinition of approach. At its infancy stage, the Conversely, this also means that the ability to make a
products and services of Islamic finance launched transaction meet the technical yardstick of Shariah
into the market were vastly derived from the compliance through innovative structures can still
replication of conventional models. fail the overall objective of providing a financial
system that is socially just.
The justification for such an adoption was to ensure
that Islamic financial products were able to compete Instead, there needs to be a substance over form
with their conventional counterpart. Even Shariah approach when applying Shariah principles for
compliant banks offer products that are shaped various products and services, as Shariah principles
around their conventional banking counterparts. by themselves cannot determine the substance of
Assets and liabilities are priced off the yield curve a transaction. Industry practitioners can look for
and remain dependent on the term structure of ways to serve the needs of their customers in a
interest rates for the purpose of benchmarking and Shariah compliant way, while regulators can provide
calculation. an enabling framework to meet customer needs.
A paradigm shift is pertinent for the industry to
This is also a common source of confusion because advance and still safeguard the sanctity of Islamic
the prohibition of riba or usurious transaction is finance.
generally understood to mean a mere prohibition
on using or dealing in interest. Nonetheless, Islamic
financial products do reward investors or financiers
ISLAMIC FINANCE IN
with profits, which are equivalent to the prevalent PRACTICE
interest rate in the financial market. Hence, critics
view Islamic finance as smoke and mirrors that does The wide gap that exists between the philosophical
not meet the lofty objectives of Islamic finance. and practical dimensions of Islamic finance is still
the subject of heated debate. The philosophy of
The common practice of benchmarking the Islamic finance is criticized as unrealistic. With
performance of Islamic financial instruments its lofty ambitions, it is understandable that there
against the current interest rate compels further were, and still are, many critics of the practicality
clarification. In this circumstance, there is a crucial of Islamic finance. While the system is not perfect,
distinction. The prevalent interest is just form, that statistics have shown that Islamic finance is,
is, a benchmark for marking profits or a return on nonetheless, gaining serious attention in the global
investments to investors or financiers. Meanwhile, financial market.
the substance of Islamic finance is to ensure that the
transaction itself is fair by adhering to fundamental According to the International Islamic Financial
principles. Market, Shariah compliant assets, which have

been growing over the last 20 years, represent standards have been issued based on Ijtehad
an estimated US$300 billion banking assets and (intellectual endeavor), which is a vital aspect of
approximately US$400 billion capital market assets. Islamic finance. These standards govern banking
From provincial beginnings in the form of a savings and Takaful practices in Islamic finance, and have
bank in the Egyptian town of Mit Ghamr in 1963, been adopted by government and central banks in
Islamic finance has since evolved into one of the certain jurisdictions.
fastest growing segments in the global financial
world. There are now over 300 IFIs operating in Putting in place a financing system, that is compliant
about 75 countries with an expected global growth with both Shariah and the relevant laws and
of 15% to 20% per annum. regulatory constraints, but which also produces
a return for investors, is a challenge. It is for this
The industry is driven by strong fundamental reason that effective interfacing between Shariah
factors, ensuring its explosive growth in the future. and the civil law system is imperative within a legal
According to Iqbal Khan, who was the founding framework, so as to allow the enforcement of
chief executive officer of HSBC Amanah (the global Islamic finance contracts. Realistically, there will still
Islamic banking division of HSBC Group), the be challenges in creating a diversity of products and
growth potential of Islamic finance can be attributed availability of information on Islamic finance.
to the economic resilience of the Organisation of
The Islamic Conference (OIC) countries, innovative As the industry enters the fourth wave, where
product development, resurgence of Muslim the real potential lies, the dynamic participation
cultural values, solid retail customer commitment, of financial institutions in the West and Muslim-
liberalization of capital markets and availability minority countries will push Islamic finance towards
of institutional capital. These factors are highly a new frontier. However, there will be trials and
capable of driving the industry forward, especially tribulations in crystallizing this potential to its fullest.
in an environment supported by a sound legal and
regulatory framework.
SUCCESS UNDER
In spite of the growth potential in Islamic finance, STRESSFUL CONDITIONS
the industry faces several challenges. Currently,
there is an acute shortage of talent. The supply To a certain extent, the resilience of Islamic finance
of trained and experienced Islamic finance talent was measured and validated under the stressful
in the market cannot match the rapid and global environment of the current crisis. Nonetheless, as
expansion of the industry. Another huge challenge a complementary system rooted in a competitive
is the lack of standardization in various aspects of conventional landscape, Islamic finance is not
the practice, such as the acceptability of Bai Dayn isolated from global economic development.
(short-term debt financing facility) in Malaysia and
Gulf Cooperation Council (GCC) jurisdictions, but Still, commentators have pointed out that IFIs
not elsewhere. have escaped relatively unscathed from the severe
downturn. In his keynote address for the 2008
Another challenge is Shariah standards and World Islamic Banking Conference, Rasheed Al
interpretations applicable in various jurisdictions. Maraj, governor of the Bahrain Central Bank,
At present, Accounting and Auditing Organization highlighted the importance of risk diversification,
for Islamic Financial Institutions (AAOIFI) prudent liquidity management and sound corporate
activities are considered a fundamental groundwork governance, if Islamic finance is to continue
that underpin Islamic banking activities. Various enjoying a framework of stability against the

backdrop of global financial turmoil. In general, subprime mortgages, due to the nature of Shariah
Islamic finance is in a better position due to its focus compliant finance, which prohibits IFIs from
on real assets, which naturally serves as a protective engaging in debt trading activities and speculative
mechanism. financial transactions.
The fact that IFIs have avoided substantial losses However, IFIs cannot escape the overall global
by avoiding investments in toxic debt products does impact and the liquidity crisis, as can be seen from
not mean that the Islamic finance industry should the slowdown in the Sukuk (Islamic bond) market.
be complacent. For example, the asset-backing
requirement in Islamic finance reveals a bias towards While IFIs have avoided the problems associated
real property, and potentially renders IFIs with a risk with toxic assets, Sukuk holders may discover, in a
of overexposure to certain market segments. liquidity crisis, that the assets they rely on to provide
steady cashflow may dry up. Of course, strict
What is important to note is that there are many observance of the conditions related to the status of
valuable lessons that IFIs, and conventional assets is significant in this context.
financing houses alike, can learn from the recent
fallout. The after-effects of the global financial Fundamentally, assets to be sold or leased must be in
turmoil must be acknowledged as an opportunity existence, the seller or lessor must possess actual and
to reinforce Islamic finance, both its form and legal ownership over the assets, and there must be an
substance. However, to determine whether intention to conduct a genuine trading transaction.
the principles embedded in Islamic finance are
successful in ensuring growth, Islamic banks Islam also prohibits the trading of debts. Thus, any
will need to conduct ongoing analyses of their risks associated with the debt must be fully borne
performance and the asset quality of their finance by the lender himself. Based on this formula, CDOs
products. are alien within the spectrum of Islamic finance.
One of the most important lessons from the current
Due to the limited or non-exposure of Shariah credit crisis is that the financial sector became too
compliant banks to collateralized debt obligations far removed from the real world economy and that
(CDOs), the issue of write-offs for these institutions gap now needs to be narrowed.
is irrelevant for deliberation. Most Islamic banks
in the Gulf Cooperation Council (GCC) region
achieved double-digit gains in 2008 while many
ROLE OF SHARIAH
conventional banks (particularly in the Western ADVISORY BOARDS
world) face their biggest losses in history. Huge
write-offs for financial institutions like Barclays A key factor that differentiates a conventional bank
(US$37.4 billion), Bank of America (US$5.3 billion) from its Islamic counterpart is the role of Shariah
and Merrill Lynch (US$22 billion) demonstrate the scholars in providing Shariah supervision, which
instability of the conventional financial system. provides for an additional protective layer over and
above corporate governance. In practice, the Shariah
In Malaysia and Indonesia, for instance, CIMB advisory board decides whether a product is Shariah
Islamic and Bank Muamalat, respectively recorded compliant by measuring a proposed product against
impressive profit growth; both are leading Islamic the fundamental principles of Islamic finance.
banks in their home countries. IFIs all over the
world have been largely untouched by exposure to In the Malaysian context, the prominence of
CDOs, backed by interest-bearing assets, such as the Shariah Advisory Council (SAC) of Bank

Negara Malaysia, the central bank, in ensuring the In the conventional financial world, however, the
stability of Islamic banking and Takaful activities is creation of CDOs by mixing prime and subprime
irrefutable. debt by banks has made it possible for mortgage
originators to pass the entire risk of default of
The SAC is responsible for matters relating to even subprime debt to the ultimate purchasers, who
Islamic banking and Takaful businesses, or any would normally be reluctant to bear such a risk.
other Islamic finance area that is supervised and
regulated by the central bank. In executing its duties Mortgage originators had, therefore, less incentive
and responsibilities, the SAC examines and endorses to undertake careful underwriting. The result is that
the validity of the application of Shariah in Islamic a number of banks have either failed or have had to
financial products which are submitted by IFIs. be bailed out or nationalized by governments in the
US, the UK, Europe and a number of other places.
At the Dubai International Financial Centre (DIFC),
the regulatory approach is to require all financial Most of the time, a Shariah board has considerable
institutions dealing in Islamic finance to have a discretion in the interpretation of Islamic law
three-member Shariah board. The sole regulator and may choose any school of thought to aid its
of DIFC, the Dubai Financial Services Authority decision-making process.
(DFSA), takes on the role of a systems regulator and
not a Shariah regulator. Thus, the DFSA does not However, this lack of standardization of Shariah
regulate the finite points of Shariah but safeguards board rulings is the Achilles heel in the global
and supervises the system put in place to ensure that acceptance and growth of Islamic finance.
Islamic finance products comply with Shariah.
A consistent ruling on the religious compliance of
This approach places greater emphasis on the role certain assets and transaction structures in terms of
of the Shariah board of each IFI to be sensitive Shariah law has yet to emerge.
to market demands in terms of the general
acceptance level of Shariah compliance when Standardization is necessary to circumvent the
issuing pronouncements on products. This will contradictions and inconsistencies arising from
result in a level of uniformity in terms of product different fatwa (religious decree) rulings, which will
acceptance. have an impact on IFIs.
In either case, Shariah scholars focus on There has, therefore, been a collective movement
preserving the sanctity of the fundamentals of among Islamic practitioners, on a global platform,
Islamic principles, and the Shariah rationale on advocating for international harmonization of
developmental and social goals, as opposed to Shariah. This is in view of gaining wider acceptance
analyzing a product solely for its utilization in of Islamic financial products and services among
meeting specific financing requirements. the global community.
For example, in practical terms, the fact that Islamic Lack of Shariah harmonization is recognized as
banks are protected from exposure to CDOs the major cause that impedes the development of
and doubtful stock counters is mainly attributed the Sukuk market. Given the complexity of Sukuk
to decisions made by the scholars. In addition to structures, the need for standardization is critical.
prohibiting riba, Islam requires Sukuk to be fully Integral to the Shariah harmonization advocacy is
backed by real assets. This forms the basis for the also the promotion of the establishment of Shariah
non-involvement of IFIs in CDOs. boards at global and central bank levels.

CONCLUSION
Today, even if we isolate the Islamic fundamental
principles on the prohibition of riba, gharar and
haram in our evaluation of the Islamic financial
system, we will clearly find that Islamic finance is a
system seeking to accomplish that:
(i) borrowers do not borrow more than they can
afford;
(ii) lenders do not extend credit without
thorough due diligence;
(iii)borrowers and lenders do not take excessive
and unquantifiable risks;
(iv)borrowers and lenders do not create
economic wealth from socially ill activities;
(v) borrowers are not put in a position where
lenders can profit from their weaker
bargaining position.
These are core and universal values imperative for

prudent banking and finance, which are not limited
to the exclusive domain of Islamic finance.
In the final analysis, the principal difference between

Islamic and conventional finance boils down to the
mechanics of achieving the desired objectives of
the two distinct systems. As systems that are parallel,
overlapping objectives are inevitable. Nonetheless,
the mechanics are dependent on the value, role and
function of man as an economic agent.

Islamic Banking
for SMEs
ISLAMIC BANKING FOR SMES

Within Islamic finance, there is a variety of transaction types to cater to a
wide range of financial instruments. Each has a specific purpose. One of
the most important issues when considering Islamic finance is to ensure
that the instrument that is used is suitable for the economic purpose the
Chapter 3 company wants to achieve.
There are two main categories of transaction types:

Profit and loss sharing partnership methods which can be
By Natalie Schoon compared with equity investments; and
Transactions with a predictable or fixed return structure.
Other financial instruments such as foreign exchange, letters of credit,

agency contracts and guarantees are also available in Islamic finance. This
chapter is divided into four categories: partnership contracts, structures
with predictable returns, other contract types and Sukuk.
Partnership contracts
There are two types of partnership type transactions, the joint venture
(Musharakah) and the passive partnership (Mudarabah). The main
difference between the two structures is related to what the partners
contribute to the partnership.
3.1.1 Joint venture

The Arabic term Musharakah means sharing and is used in financial
transactions to identify joint ventures or partnerships. More than two
parties can be involved and generally, each provides knowledge and skill
as well as a share of the capital. Knowledge and skill can take the form
of management or advisory services or even doing the actual work itself.
It is possible for one of the partners to only provide capital, in which
case he becomes a sleeping partner. The profit ration is pre-agreed in
the contract and reflects the level of capital provided, effort, and skill

Islamic Banking for SMEs
and expertise the partners bring to the joint venture. (shares) that are bought by one of the partners
Losses are borne by the partners in proportion to over the life of the transaction. In a diminishing
the capital they have provided. The liability of the Musharakah, the repurchasing agreement is part of
partners is technically unlimited. the contract.
The purchasing party will gradually own a larger

share of the joint venture and, as a result, his share
Partner 1 Partner
of the capital increases. With the increase of his
capital, he will be liable for a larger proportion of
2. Profit 1. Cash and 1. Cash and 2. Profit
any loss. Profit ratios will be revised either with each
and loss expertise expertise and loss purchase or on a periodic basis as agreed between
the partners.
Project 3.1.2 Passive partnership

The Mudarabah transaction is a partnership
transaction in which only one partner contributes
capital (the investor or Rab al maal), and the other
Figure 1: A simple Musharakah transaction (the business manager or Mudarib) contributes skill
and expertise.
Once the contract has been agreed between the
partners, the process can be broken down into the The investor has no right to interfere in the day-
following two main components: to-day operations of the business, although the
contract between the partners can contain mutually
1. Cash and expertise agreed conditions the business manager has to abide
All partners contribute to the capital as well as by. The relationship between the partners is founded
expertise to the business or project. They do upon trust, with the investor having to rely heavily
not have to provide equal amounts of capital or on the business manager, his ability to manage the
equal amounts of expertise. business and his honesty when it comes to profit
share payments.
2. Profits and losses
Any profit earned from the joint venture is to The passive partnership transaction can be used for
be shared between the partners according to the private equity investments, but is also often used
ratios agreed in the original contract. Any losses when clients deposit money with a bank. When
borne by the partners strictly in proportion to used for deposits, the bank contributes its skill and
the amount of capital they have contributed. It is expertise in identifying appropriate investment
not permissible to fix a lump-sum profit for any opportunities.
single partner.
Once the contract has been agreed between the
Diminishing Musharakah partners, the process can be broken down into the
The diminishing Musharakah is a variation of following main components:
partnership in which it is agreed between the parties
at the start that one partner will, over time, purchase 1. Capital injection
units in the joint venture from the others at a pre- The investor provides capital to the project or
agreed unit price. At the start of the agreement, company. Generally, an investor will not provide
the project is divided into a number of equal units any capital unless a clearly defined business plan

is presented to him. In this structure, the investor 3.2.1 Deferred payment sale
pays up 100% of the capital. Deferred payment sale or installment credit sale
transactions are known as Murabahah. They
2. Skill and expertise are mainly used for the purchase of goods for
The business managers contribution to the immediate delivery with payment to be settled at a
partnership is his skill and expertise in the later date. In its most basic form, this transaction
industry or area. involves the seller and buyer of the merchandise as
illustrated below:
3. Profit and loss
Similar to the joint venture, profits are shared
according to a pre-agreed ratio; losses are Seller
1. Sell goods today
Buyer
distributed in proportion to the capital provided. 2. Pay for goods later
Since only one party provides all the capital, he
bears all the loss. Figure 3: A simple Murabahah structure
In the event of a loss, the business manager does As part of the contract between the buyer and
not receive any compensation for his efforts. the seller, the price of the goods, the mark-up,
The only exception to this is when the business the delivery date and the payment date are agreed.
manager has been negligent, in which case he will The seller takes immediate possession of the
be liable for the total loss. goods, against future payment. The buyer has full
knowledge of the price and quality of the goods
he buys. In addition, the buyer is also aware of
the exact amount of mark-up he pays for the
Investor Business manager convenience of paying later. In the context of
Rab al Maal Mudarib trading, the advantage to the buyer is that he can use
the goods to generate a profit in his business and
3. Profit 2. Skill and 3. Profit use the profit to pay the original seller.
1. Cash
and loss expertise and loss
Example of a deferred payment sale

Project
Asian ExIm imports linen from Italy on a
wholesale basis and sells it to local shops in the
region. One of its clients, newly incorporated
Figure 2: A simple Mudarabah structure Beds Inc, has purchased 500 sets of bed linen at a
price of US$25 each. Beds Inc, having just started
The investor is only liable for the amount of capital operating, needs to generate a profit from selling
he has provided, which means that the Mudarib the linen to clients and has requested that Asian
cannot commit the business to any sum that is over ExIm pay in three months time. Asian ExIm
and above the capital provided. agrees, and charges Beds Inc a fixed mark-up of
US$160.
Instruments with predictable returns
These are favored by banks and their regulators Asian ExIm delivers the linen today, and three
since the reliance on third party profit calculations is months later, receives US$12,500 for the bed
eliminated. There are four main instruments in this linen supplied, plus a mark-up of US$160. The
category: Murabahah, Iijarah, Istisna and Salam. payment from Beds Inc totals US$12,660.

The underlying asset can vary, and can include raw At the end of the period, the lessee can either
materials and goods for re-sale. request to extend the lease or hand the asset back
to the lessor. The lessor takes a view of the residual
In Islamic finance, the Murabahah transaction can, asset value at the end of the lease term, and takes
for instance, be applied to trade finance and working ownership risk. When the asset is returned to the
capital financing. lessor at the end of the period, he can either lease it
to another counterparty, or sell the asset on the open
3.2.2 Leasing market. If the lessor decides to sell the asset, he may
An Ijarah transaction is to a lease and in which offer it to the lessee.
one party (lessor) allows another party (lessee) to
use his asset against the payment of a rental fee. A financial lease, as depicted below, has an additional
Similar to conventional finance, two types of leasing step, which is the sale of the asset to the lessee at
transactions exist: financial and operating . the end of the period.
In a financial lease (Ijarah wa Iqtina or Ijarah 1. Lease of asset

Muntahia bittamleek), the lessee provides a purchase Lessor Lessee
2. Periodic Rentals
undertaking at the start of the transaction, stating
that he will buy the asset at the end of the lease 3. Sale of asset
period. Figure 5: A financial lease
In an operating lease, such a purchase undertaking is As with an operating lease, rentals can be fixed for
not included. Under no circumstances can the lease the period or floating based on a bench mark. As
be conditional on the purchase undertaking (i.e. the part of the lease agreement, the lessee provides
lessor cannot stipulate he will only lease the asset if the lessor with a unilateral purchase undertaking
the lessee signs a purchase undertaking). which specifies the amount at which the lessee will
purchase the asset upon expiry of the lease.
Not every asset is suitable for leasing. The asset
needs to be tangible, non-perishable, valuable, Three options are possible:
identifiable and quantifiable. 1. Gift. In this case, the lessor has gradually paid for
ownership of the asset during the lease period, as
1. Lease of asset
Lessor Lessee part of the rental fee. Once all rentals are paid,
2. Periodic Rentals there is no further payment required from the
lessee to obtain the asset.
Figure 4: Operating lease
2. Against fixed payment. At the end of the lease,
In an operational lease, depicted in the figure the lessee becomes the owner of the asset once
below, the lessor leases the asset to the lessee, for he has paid the purchase amount agreed in the
a pre-agreed period and the lessee pays pre-agreed contract.
periodic rentals.
3. Against market value. At the end of the lease, the
The rental or lease payments can either be fixed for lessee becomes the owner of the asset once he
the period or floating with periodical re-fixing. The has paid the market value to the lessor.
latter is usually done by linking it to a conventional
index such as the London Interbank Offer Rate In practice, options 1 and 2 are the most common.
(LIBOR), which represents the cost of capital.

In both cases, the lessor owns the asset and runs all 3.2.3 Short-term production finance
risks associated with ownership, and is responsible Short-term production, construction and agriculture
for major maintenance and insurance. contracts can be financed using a Salam contract.
Due to the fact that the lessee is using the asset on a In this type of contract, a payment is made today
daily basis, he is often better positioned to determine against future delivery of the asset. As the purpose
maintenance requirements, and is generally of the funding is to construct or produce the asset,
appointed by the lessor as an agent to ensure all the asset itself does not have to be in existence, and
maintenance is carried out. In addition, the lessee is, the seller does not need to have ownership. In its
in some cases, similarly appointed as an agent for the simplest form, Salam is a contract between a buyer
lessor to insure the asset. and a seller as shown below:
In the event of a total loss of the asset, the

1. Pay agreed price today
lessee is no longer obliged to pay any rentals. The Buyer Seller
lessor, however, has full recourse to any insurance 2. Deliver specified goods later
payments.
Figure 6: A simple Salam structure
Example of a lease
The contract is typically short term (one to three
months in duration), but could be entered into for
Early Bird Transport is looking to extend its
longer periods.
distribution network and wants to invest in new
delivery trucks. Instead of tying up a significant
The type, quality and quantity of the asset need to
amount of money in new trucks, it decides to
be clearly specified in the contract. Any asset that
lease them instead from Lease-A-Truck on an
cannot be specified in this way such as precious
operational lease basis.
stones cannot be made the subject of a Salam
transaction.
Lease-A-Truck provides Early Bird with two
trucks against a monthly rental fee, which
The seller has a contractual obligation to deliver the
covers maintenance, depreciation and insurance.
specified quantity and quality at the agreed delivery
Lease-A-Truck retains ownership throughout
date. If he cannot deliver from his own production,
the duration of the transaction, and informs
he will have to buy the remaining quantity and fulfill
Early Bird which garage to take the trucks to for
his contractual obligation. The goods involved must
maintenance and repairs. Lease-A-Truck settles
be commodities that are freely available.
any bills directly with the garage.
The seller will have the funds to enable him to
At the end of the lease period, Early Bird has one
produce the underlying asset, the buyer obtains an
of the following choices:
asset in the future at which time he expects the price
of the asset to be higher than what he is currently
1. Extend the lease for a further period;
paying for it.
2. Purchase the trucks at current market value
Because the buyer takes a business risk, the
from Lease-A-Truck; or
transaction is not subject to any of the prohibitions
on uncertainty and gambling.
3. Hand the trucks back to Lease-A-Truck.

Example of short-term production Buyer

1. Pay as agreed during development
Seller
finance 2. Deliver specified goods later
Farmer Malik has noticed a substantial demand Figure 7: A simple Istisna structure
for pumpkin seeds and wants to enter this market.
In order to be able to harvest the pumpkins in Under the simple structure shown in the above
November of the following year, extract the figure, it is assumed that the buyer will have the
seeds and package them, he requires an upfront money to pay for the asset during its construction.
investment of US$2,500. However, this is not necessarily the case and a
financier could be involved. He will finance the
Malik comes to an agreement with Super Duper construction and consequently sell or lease the asset
Supermarkets, which wants to buy 100kg of to the buyer for a pre-agreed period.
quality A pumpkin seeds, packaged in 100g bags
for US$2,500, for delivery in November. Malik Like the Salam transaction, the buyer takes a
receives the US$2,500 and starts the process of business risk in this transaction, and it is therefore
making the soil ready and planting the seeds. not subject to any of the prohibitions on uncertainty
and gambling.
Come November, Malik harvests the pumpkins,
extracts 150kg of seeds and packages 100kg of
quality A seeds, which he delivers to Super Duper. Example of long-term production finance
The seeds are sold for US$3 a packet, generating
a revenue of US$500 (US$3,000 US$2,500) for Build A Doll is expanding and in need of a
Super Duper. new manufacturing plant with a total cost of
US$500,000, which will be built by Considerate
The remaining 50kg varies in quality from A to Builders Inc. Build A Doll negotiates the
C, which Malik then sells for a total amount of following payment schedule and pays Considerate
US$1,000. Builders upon completion of each phase:
1. 10% of the amount to be paid up US$50,000

3.2.4 Long-term production finance front to prepare the site:
Like a Salam contract, Istisna is a purchase contract
2. 10% once the foundation is laid US$50,000
for future delivery of an asset, and is exempt
from the same two conditions regarding the asset, 3. 25% once the walls are built US$125,000
ownership and existence. 4. 20% once the roof is finished and US$100,000
the windows are put in
The contract is typically for a longer term and pay- 5. 15% once the plumbing and US$75,000
ment to the producer or contractor of the asset does electricity is finished
not have to be in full in advance. Payment is likely to 6. 15% when the interior decorating US$75,000
be in various installments in line with the progress is finished
made on the development of the asset and is, there- 7. 5% when the final issues are US$25,000
fore, well suited to project finance and construction. resolved
Total paid at end of construction US$500,000
The asset typically needs to be manufactured,
constructed or processed, and is of a significant size
and capital outlay.

Other instruments parents provide a guarantee to the bank for their

Besides the profit and loss sharing instruments childs payments under a home purchase plan. In the
and the financing options with a predictable return event the child misses a payment, the parents will
outlined above, there are other financial structures automatically be liable.
that do not necessarily fall into either of these
categories. Contrary to conventional finance, in Islamic finance,
guarantees cannot be used to assure profits or
to guarantee business performance, but only to
3.3.1 Foreign exchange
guarantee payment in the event of a shortfall or
Foreign exchange or Sarf is a transaction in which
default by a named counterparty. In Islamic finance,
one person buys an amount of a specific currency
the guarantor cannot charge a fee for providing the
against an equivalent amount in another currency.
guarantee.
This is similar to foreign exchange contracts offered
by conventional banks and money changers. Within
Islamic finance currently ,only spot transactions are 3.3.4 Unilateral promise
permissible and forwards, options and futures are A Wad is a unilateral promise from one party to
deemed to be speculative. another, and can, for example, be structured along
the lines of, I promise to pay you 15 next week if
you help me organize my brothers birthday party.
3.3.2 Letters of credit
Islamic letters of credit are similar to conventional
Acceptance by the other party is not required, since
letters of credit and are an undertaking by a bank
this is not a bilateral contract. The conditionality in
to make a payment to a named party against the
this phrase is also acceptable for the same reason.
presentation of the stipulated documents.
However, in order for this to turn into a contract,
the second party needs to accept.
Letters of credit are often used in combination
with trade type transactions such as Murabahah
and Salam, and, depending on which party requests 3.3.5 Down payment
it, provide certainty that the goods are delivered An Bai al Arboon (down payment) represents a
prior to payment being made or transfer the risk of non-refundable down payment on a purchase which
non-payment to the financial institution issuing or signifies the buyers intent to buy the asset and is
confirming the letters of credit. typically made toward goods that will be delivered at
a later date. It is depicted in its most simplistic form
Letters of credit are highly standardized and in Figure 8 below.
typically subject to international regulations as
described in detail in the Uniform Customs and
1. Make down payment
Practice for Documentary Credits issued by the Buyer 2. Deliver asset Seller
International Chamber of Commerce. 3. Pay remaining purchase price
Different types of letters of credit exist, such as Figure 8: A simple Bai al Arboon structure
irrevocable, confirmed and stand-by.
The down payment forms part of the overall price
3.3.3 Guarantee agreed between the buyer and the seller, but is non-
A financial guarantee is a guarantee provided by one refundable in the event the buyer later does not take
party (the guarantor) to cover any payment default delivery of the asset. Simplified, the steps are as
by another party. An example of a guarantee is when follows:

1. Buyer and seller agree on a price and the is entitled to a fee for his services. In addition, he
buyer makes a down payment (e.g. 20% of the can keep any profit he makes over and above a
purchase price). The asset is specified and the pre-agreed anticipated profit rate as an incentive. In
delivery date is agreed; Islamic finance, the agency agreement is often used
to govern restricted and unrestricted investment
2. On the agreed delivery date, the seller delivers accounts.
the asset to the buyer, or the buyer collects it
from the seller; 3.3.7 Investment certificate
Sukuk is probably the most well-known instrument
3. On the agreed delivery date, after inspecting the in Islamic finance and is most correctly identified
asset, the buyer pays the balance of the purchase as an investment certificate. It is often called a
price (e.g. 80% of the original purchase price). bond-type instrument because it has some similar
characteristics.
Example of Bai al Arboon
However, unlike the holder of a conventional bond,
My brother recently agreed to buy a motorbike a Sukuk holder also owns a proportional part of the
from Bikers Best, a specialist motorbike garage, underlying asset. Sukuk is not a separate instrument
for 4,995. The motorbike is not new, and has in itself, but more like a structure facilitating the
been in the showroom for a few weeks. The funding of large projects that would be beyond
seller needs to check the motorbike before it the capabilities of an individual or a small group
is collected and service it to ensure that it is of investors. Sukuk can be listed on recognized
roadworthy. exchanges and is, with a few exceptions, generally
tradable. In its simplest, generic form, Sukuk can be
Although the deal is done, the seller would like depicted as on the next page.
some sort of guarantee, and does not want to be
in a position where he has done all the work only The special purpose vehicle (SPV) purchases the
to find the buyer has changed his mind. The seller asset from the original owner on behalf of the
requests a down payment and they agree on 995. Sukuk holders. The SPV is often set up as part of
When my brother went to collect the motorbike, the group of companies selling the asset and hence
he paid the remaining 4,000. raising the funds.
If he had pulled out of the purchase, the 995 In the interest of the Sukuk holders, it needs to be
would have been forfeited by the seller to cover ensured that the SPV is bankruptcy-remote, which
the cost of work he had done in getting the means that insolvency of the original seller of the
motorbike ready for sale. asset will not affect the SPV.
In addition, the SPV should not be subject to

3.3.6 Agency agreement any negative tax implications and will need to
Wakalah is the agreement that governs the principal- be established in what is known as a tax-friendly
agent relationship between two parties, where one jurisdiction.
party is requesting another to act on its behalf. The
application of the Wakalah is varied and can range Like conventional bonds, Sukuk can be bought from
from appointing an agent (wakil) to purchase or the issuer or on the secondary market. Unlike the
sell an asset, to the investment of funds. The agent conventional bond market, however, Sukuk tends to

3. Invest
Corporation Shariah compliant
4. Returns investment
1. Sell
asset
2. Transfer
funds
6. Sell
asset
7. Payment
1. Sell Sukuk certificates
Sukuk 2. Payment
5. Coupon payment SPV 4. Returns
holders/Investors 6. Sell asset
7. Payment
be held to maturity and the secondary market is not managing the SPV, the legal documentation and
very active. Although quotes are provided by some issuance process can be prohibitive for relatively
market makers, the spreads between bid and asking small amounts of funding.
price are particularly wide and availability of issues is
still thin. Which transaction type?
With the exception of Sukuk, the examples provided
The Sukuk holder owns a proportional share of in section 3.3 above are based on two organizations
the underlying asset and has a financial right to the or individuals dealing directly. As companies grow,
revenues generated by the asset. their financial requirements go beyond what can be
arranged between parties and financial institutions
However, as mentioned before, the holder is also become involved to provide the funding.
subject to ownership risk, which means that he is
exposed to any risk associated with the share of Each of the transactions mentioned can also have
the underlying asset that he owns. Conventional a bank or financial institution involved, which will
bonds, on the other hand, remain part of the issuers then act as an intermediary to mobilize funds and
financial liability. apply them to investments in businesses.
Sukuk always has one of the following underlying When considering Islamic finance as an alternative
transaction types as a basis: funding source, what needs to be taken into
consideration is the business requirement. The
Mudarabah following are examples of the different ways Islamic
Musharakah financial structures can be applied to SMEs:
Ijarah
Salam Partnership contracts
Istisna Joint ventures or passive partnerships can be
applied for private equity participations. The
The Murabahah transaction is generally not deemed bank takes a share of the ownership of the
feasible for securitization since it would be akin to organization and shares in the profits and
debt trading. Arguably the most well-known Islamic losses. Partnership transactions are favored
investment tool, Sukuk might not be suitable for by scholars due to the fact that they are
smaller businesses. The cost of setting up and designed to share risk and reward, which is

in line with Islamic economic thought. From of a huge scale and is often combined with a
the banks perspective, the disadvantage lies lease.
in the effort required to ensure all partners The last three of the above can also be classified as
are comfortable with the way the project predictable return structures and are preferred by
or company is run and its profitability. banks and regulators due to the fact that they do not
Regulators typically do not prefer banks require significant monitoring to ensure they receive
taking equity positions in companies due to the correct profit share.
the potential additional risk associated with
non-arms length trading. Which mode is most suitable is, in addition, guided
by taxation and legal issues in the jurisdiction where
Deferred payment transactions a company is operating.
When including a financial institution in
a deferred payment transaction, the bank When Islamic finance may or may not
purchases the asset against a cash payment
from the seller and subsequently sells the
be the best choice
Parallels are often drawn between Islamic finance
asset to the buyer against future payment of
and socially responsible investing, which is also
the principal, plus a pre-agreed mark-up to be
referred to as sustainable or ethical investing.
paid on a pre-agreed date.
Socially responsible investing encompasses an
Typically, the bank instructs the seller to
investment strategy that seeks to maximise both
deliver the asset directly to the buyer although
financial returns and socially responsible or ethical
ownership is transferred to the bank before
behaviour. Generally, people who make such
being passed on to the buyer. This transaction
ethical investment decisions rely on their faith and
type is particularly suited for working capital
conscience.
and export finance.
Socially responsible investors also favour
Leasing
investments that promote environmental
Leasing transactions are suitable when there
stewardship, consumer protection, human rights and
is a need for a particular asset such as vehicles
diversity.
or equipment, but the company prefers
to rent or lease the equipment rather than
In addition, some investors actively avoid investing
owning it outright with all the associated
in businesses that are involved in alcohol, tobacco,
ownership risk. The bank purchases the asset
gambling, and weaponry and defence. Shariah
and acts as the lessor. The client is the lessee
acknowledges the right of an individual to create
and pays for the use of the asset.
wealth, but discourages hoarding, monopolistic
activities and excessive materialism. Generally,
Production finance
Shariah encourages social justice without hampering
Production finance transactions are
entrepreneurship.
suitable for financing of assets that need
to be manufactured or built. The bank in
Generally, investors do not have to be Muslim. The
this case acts as an intermediary between
principles of Shariah tend to fit in very well with
the contractor and the ultimate buyer
non-Muslim investors seeking socially responsible
and facilitates the payments. Long-term
investment opportunities and offer a viable
production finance is usually applied to
alternative to other opportunities available in the
construction and project finance transactions

market. SMEs seeking funding do not have to be Tobacco

owned by Muslims either. However, the principles As with alcohol, this includes the production,
regarding the strength of the business plan and the marketing and sale of tobacco and associated
value of the underlying assets do apply. products.
This section will review what SMEs need to be Adult entertainment

aware of if they are considering using Islamic Any activity associated with adult
financial services. entertainment, including escort services,
brothels and movies with explicit sexual
1.5.1 Prohibited Industries content.
Within the framework of Shariah, a number of
industries are prohibited and, any SME which is Weapons, arms and defence
involved in these industries will not be able to apply manufacturing
for Islamic finance. The following industries do not
qualify for Islamic finance: In addition, Islamic financial institutions do not
invest in companies that are highly leveraged using
Conventional banking and Insurance conventional financial instruments, due to the
Conventional banking and insurance are interest component associated with the debt.
associated with interest and are therefore not
permissible. 3.5.2 Transaction Type Considerations
Although the identification of SMEs in the table
Alcohol and alcohol production below applies specifically to Europe, it provides
This includes any distilling, marketing or sales a rough indication on when a company can be
activities. considered a small- or medium-sized enterprise.
Pork-related products and non-compliant Given the size of an SME, its requirement for
food production financing is typically not very high, and the issuance
Non-compliant food production covers of corporate bonds or its Islamic finance alternative
everything which is not prepared in a Sukuk would generally not be recommended.
halal (permissible) way and covers, among
others, meat which is not slaughtered in an The types of Islamic financial transactions that
acceptable manner. would be most suitable for an SME are detailed in
Chapter 3.4. An SME would benefit most from a
Gambling standard financial solution, occasionally coupled
This covers not only casinos and betting with minor amendments to cater for specific
shops, but also bingo halls and on-line company requirements, which are more made-to-
betting. measure rather than tailor-made.
Enterprise category Headcount Turnover or Balance sheet total

medium-sized < 250 50 million 43 million
small < 50 10 million 10 million
micro < 10 2 million 2 million
Source: European Commission Recommendation 2003/361/EC; effective 1 January 2005

Although it is the banks responsibility to ensure For example, it is highly unsuitable for a bank to
that the client is provided with all the required suggest that an SME issues Sukuk as an instrument
information to enable him to make the right to raise US$500,000 in financing. Sukuk issuances
decision regarding the transaction type, the are generally geared to larger transaction sizes
level of funding, cost, among others the SME of US$10 million or more. Not only would this
is responsible for ensuring that the recommended transaction type be unfit for the purpose, but it
financial solution is the right one. would also lead to an unacceptable increase in cost.
If the company is not satisfied with the solution Information

offered, the level of information provided or any The relationship between the bank and the client is
other element of the transaction or relationship, it a two-way street, and just as the bank requires the
will need to address these concerns prior to entering client to provide information about his business,
any contractual arrangement. the lender should also provide clear and sufficient
information on charges, structures, and the most
3.5.3 Other General Considerations appropriate transaction type. If the bank declines to
Many of the reasons why Islamic finance might provide this information, the client should consider
not be the right avenue for an SME, or any changing to another financial institution that he is
other company, are similar to the reasons why a more comfortable with. The fact that an SME is a
conventional product offering should be rejected. smaller-sized company is not a valid reason for the
bank to withhold information.
Cost
The financing arrangement offered by a financial Legal and Tax
institution should not be cost prohibitive. Whether Legal and tax requirements, which unnecessarily
it is a conventional or an Islamic bank offering, increase the cost of funding, should be avoided in
the cost should be competitive with regard to the any case. Because the Islamic finance industry is
investment opportunity, size of the transaction, the still relatively young, the legal and tax frameworks
banks cost of funds and the level of perceived risks. are not always adapted to cater for these transaction
types. If the framework does not allow for Islamic
SMEs typically require smaller-scale financial financial transactions, the SME is definitely better
solutions, which are generally more expensive than off applying for a conventional financial structure.
the larger sized transactions. However, the cost the
bank charges the SME should be competitive for the
service it offers.
Purpose
The financial instrument that is offered by the bank
to an SME should be suitable for its purpose and
meet its business requirements.
When the offered product does not appear to

be correct for the purpose and the bank cannot
satisfactorily explain why it suggested the product in
the first place, it is obviously not the right mode of
financing.

Islamic Microfinance:
An Emerging
Market Niche
An estimated 72% of people living in Muslim-majority countries do not

use formal financial services. Even when financial services are available,
some people view conventional products as incompatible with the
Chapter 4 financial principles set forth in Shariah (Islamic law). In recent years,
some microfinance institutions (MFIs) have stepped in to service low-
income Muslims who demand products consistent with Islamic financial
principles leading to the emergence of Islamic microfinance as a new
By Nimrah Karim, market niche.
Michael Tarazi and
Xavier Reille Islamic microfinance represents the confluence of two rapidly growing
industries: microfinance and Islamic finance. It has the potential to not
only respond to unmet demand but also to combine the Islamic social
principle of caring for the less fortunate with microfinances power to
provide financial access to the poor. Unlocking this potential could be
the key to providing financial access to millions of the Muslim poor who
currently reject microfinance products that do not comply with Shariah.
Islamic microfinance is still in its infancy, and business models are just
emerging.
The supply of Islamic microfinance is concentrated in a few countries,

with the top three Indonesia, Bangladesh and Afghanistan
accounting for 80% of global outreach. Nevertheless, demand for
Islamic microfinance products is strong. Surveys in Jordan, Algeria
and Syria, for example, revealed that 20% to 40% of respondents cited
religious reasons for not accessing conventional microloans.
This chapter provides an overview of the current state of the Islamic

microfinance sector and identifies possible challenges to its growth. It
is intended as an introduction to Islamic microfinance primarily for the
donor community and other potential entrants into the market.

Islamic Micronance: An Emerging Market Niche
BASIC ISLAMIC MICROFINANCE CONTRACTS

There is only one type of permissible loan according to Shariah: the Qard-Hassan (or Benevolent) loan, which is
interest-free and often considered a form of charity because it is typically forgiven in the event of default. All other
mechanisms are better termed financing agreements, or contracts. However, for the purposes of this chapter, the
term loan may be used to denote financing arrangements within the Shariah context.
There is only one type of permissible loan according to advance to avoid speculation. For the transaction to be
Shariah: the Qard-Hassan (or Benevolent) loan, which considered Islamic (and not a sale with camouflaged
is interest-free and often considered a form of charity interest), the Ijarah must specify that ownership of
because it is typically forgiven in the event of default. the asset, and responsibility for its maintenance,
All other mechanisms are better termed financing remains with the financier. It may be followed by a sale
agreements, or contracts. However, for the purposes contract, in which event ownership of the commodity is
of this chapter, the term loan may be used to denote transferred to the lessee.
financing arrangements within the Shariah context.
Musharakah and Mudarabah (profit and loss
The following are the most widely available types of sharing)
Islamic microfinance contracts. Each can either operate The profit and loss sharing (PLS) schemes are the Islamic
individually or be combined with other contracts to financial contracts most encouraged by Shariah scholars.
create hybrid instruments. Musharakah is equity participation in a business venture,
in which the parties share the profits or losses according
Murabahah sale (cost plus financing contract) to a predetermined ratio. It can be used for assets or for
The most widely offered Shariah compliant contract working capital.
is Murabahah, an asset-based sale transaction used to
finance goods needed as working capital. Typically, the Mudarabah denotes trustee financing, in which one
client requests a specific commodity for purchase, which party acts as financier by providing the funds, while the
the financier procures directly from the market and other provides the managerial expertise in executing the
subsequently resells to the client, after adding a fixed project. Profits are shared according to a predetermined
mark-up for the service provided. ratio; any losses are borne entirely by the financier.
It is permissible for the financial institution to appoint If the Mudarabah joint venture results in a loss, the
the client as an agent on its behalf (by means of a financier loses the contributed capital and the manager
contract) to directly procure the commodity from the loses time and effort. Both PLS schemes require
market. However, ownership of the commodity (and particularly vigilant reporting and a high level of
the risk inherent thereto) strictly lies with the financier transparency for profits and losses to be distributed
until the client has fully paid the financier. In most justly. Consequently, though promoted strongly by
cases, clients repay in equal installments.The mark-up Shariah, they result in substantial operating costs
is distinct from interest because it remains fixed at the particularly for micro and small enterprises that are not
initial amount, even if the client repays past the due accustomed to formal accounting.
date. Among the primary conditions for a Murabahah
sale to remain Shariah compliant are: (i) the financier Takaful (mutual insurance)
must own the commodity before selling it, (ii) the The equivalent of Islamic insurance, Takaful is a mutual
commodity must be tangible; and (iii) the client must insurance scheme. The term originates from the Arabic
agree to the purchase and resale prices. word kafalah, which means guaranteeing each other
or joint guarantee. Each participant contributes to a
Ijarah (leasing contract) fund that is used to support the group in times of need,
Ijarah is a leasing contract typically used for financing such as death, crop loss or accidents. Paid premiums
equipment, such as small machinery. Duration of the are invested in a Shariah compliant manner to avoid
lease and related payments must be determined in interest.

HOW DO SAVINGS WORK?

Islamic savings products are deposits that are invested Such a savings arrangement could be considered a
pursuant to the principles set forth in this paper. A form of Musharakah because other depositors are also
typical savings product is a form of Mudarabah, in depositing funds for investment in the same financial
which the saver invests his deposit in the business of institution. Even Takaful can operate as a savings
a financial institution. The financial institution invests product because premiums are invested in a Shariah
its managerial expertise and intermediates the deposits/ compliant manner and are often disbursed at the end of
investments in a Shariah compliant manner. Profits (or an agreed term, regardless of any insurance claim.
losses) are shared pursuant to prior agreement.
DEVELOPMENT ISLAMIC scope expanded, they presented several regulatory

challenges that governments have attempted to
FINANCE INDUSTRY address, to varying degrees. One approach has been
to proactively encourage, even mandate, Islamic
Global expansion financial services by law.
Despite its origins in the Persian Gulf, Shariah
compliant banking has proved popular with Northern Sudan, for example, adopted Shariah
Muslims in other countries as well, leading to the compliant regulatory frameworks for the entire
development of new Islamic banks across North banking sector in 1984. Indonesia broke new ground
Africa and Asia. Of the total US$500.5 billion global in the realm of Islamic finance by creating in 1992 a
Islamic finance market, 36% is parked in Gulf formal, regulated Shariah banking sector alongside,
Cooperation Council (GCC) countries (Bahrain, and not instead of, its conventional banking sector.
Kuwait, Oman, Qatar, Saudi Arabia and the UAE),
35% in non-GCC Southwest Asia and North Africa, New regulations in Malaysia, Brunei and Pakistan
and 23% in Asia (primarily Malaysia, Brunei and have also supported the expansion of an Islamic
Pakistan). finance industry alongside conventional financial
services.
Over time, Islamic financial services also have
expanded well beyond the Muslim world and Another regulatory approach addressed growth by
are offered not only by Islamic banks, but also separately regulating the unique aspects of Islamic
by Islamic subsidiaries of international financial banking via Shariah supervisory boards (SSBs).
institutions. Islamic financial services are currently
available in India, China, Japan, Germany, For example, countries such as Kuwait, Jordan,
Switzerland, Luxembourg, the UK, the US and Lebanon and Thailand have regulated the
Canada. The UK, which was ranked 10th on The competence and composition of SSBs, as well as
Bankers list of Top 15 Countries by Shariah related rules governing the appointment, dismissal
Compliant Assets in 2007, recently announced its and qualifications of SSB members.
aim to turn London into a global center for financial
markets in the Muslim world. However, to date, no country has been known to
regulate the Shariah jurisprudence to be used by
Government regulation SSBs in judging Shariah compliance (though Jordan
Islamic financial services originally operated in an and Kuwait do impose SSB member unanimity or
unclear regulatory landscape. However, as their majority vote requirements).

International organizations Yunus. Islamic countries such as Indonesia and

In tandem with the increased attention by regulatory Pakistan have a vibrant microfinance industry;
authorities, international organizations have been set approximately 44% of conventional microfinance
up to create Islamic finance accounting and other clients worldwide reside in Muslim countries. Yet,
standards: conventional microfinance products do not fulfill
the needs of many Muslim clients.
The Islamic Financial Services Board
(IFSB) Just as there are mainstream banking clients who
Based in Malaysia, issues prudential demand Islamic financial products, there are also
standards and guiding principles for Islamic many poor people who insist on these products.
finance. IFSB has issued guidelines on risk Indeed, Shariah compliance in some societies may
management and capital adequacy for Islamic be less a religious principle than a cultural one
banks. and even the less religiously observant may prefer
The Accounting and Auditing Shariah compliant products.
Organization for Islamic Financial
Institutions (AAOIFI): A number of International Finance Corporation
Based in Bahrain, promotes financial (IFC)-commissioned market studies suggest strong
reporting standards for Islamic financial demand for Islamic microfinance products, as well
institutions. as a Bank Indonesia report in 2000 that indicated
The Islamic Development Bank (IDB): that 49% of the rural population of East Java
A multilateral body headquartered in considered interest prohibited and would prefer to
Saudi Arabia, fights poverty and promotes bank with Shariah compliant financial institutions.
economic development in Islamic country
members. It promotes microfinance and Although there is a market of poor clients who
poverty alleviation programs through its strictly engage in Islamic transactions, there is also
Islamic Solidarity Fund for Development a category of Muslim clients who use conventional
(ISFD), which recently committed US$500 products but prefer Islamic ones. Microfinance
million to microfinance development through practitioners in Muslim-majority countries indicate
its microfinance support program. that in Afghanistan, Indonesia, Syria and Yemen,
some conventional microborrowers tend to switch
Despite a shared core of Islamic values, these institu- over once Islamic products become available.
tions often diverge from national regulators (and each
other) over Shariah standards. For example, AAOIFI Government promotion of Islamic microfinance
standards are mandatory in only a handful of coun- As in the case of the larger Islamic banking industry,
tries and are selectively implemented elsewhere. government regulation can play a significant role in
the expansion of Shariah compliant microfinance.
ISLAMIC MICROFINANCE
Indonesia:
Demand The government has actively promoted Islamic
Conventional microfinance products have been microfinance. In 2002, Bank Indonesia prepared
successful in Muslim-majority countries. One of a Blueprint of Islamic Banking Development in
the earliest microfinance programs originated Indonesia, in which it outlined a nine-year plan
in Bangladesh with the setting up of Grameen for the development of the Islamic finance sector,
Bank, initiated by Nobel Prize winner Muhammad including support for the 105 Shariah rural banks.

The republic now provides a supportive regulatory credit cards, remittance and currency exchange, and
framework and has licensed 35 new Islamic rural salary payments.
banks in the past five years. Bank Indonesia is
also spearheading efforts in capacity building by Also in January 2008, Allianz Life Indonesia
establishing a center in Medan to offer training in announced that, after an 18-month pilot project,
and certification on Islamic financial operations to the Shariah compliant microinsurance Family
Shariah rural bank staff, managers and directors. Umbrella product would become an established
line.
Pakistan:
The State Bank of Pakistan, which already has CGAP SURVEY RESULTS
a legal and regulatory framework in place for
conventional MFIs, also developed guidelines CGAP conducted a global survey on Islamic
in 2007 for the rapid expansion of Islamic microfinance in 2007, collecting information on
microfinance. The guidelines stipulated four over 125 institutions and contacting experts from
types of institutional arrangements for offering 19 Muslim countries. This section presents the
Islamic microfinance, i.e. via: (i) the creation of principal findings of this first global survey on the
Islamic microfinance banks; (ii) Islamic banks; performance and outreach of Islamic microfinance.
(iii) conventional banks; and (iv) conventional
microfinance banks.
Current performance
The outreach of Islamic finance is limited.
The guidelines set forth requirements on licensing,
According to the CGAP survey, Islamic MFIs reach
appointment of Shariah advisers to rule on Shariah
300,000 clients through 126 institutions operating in
compliance, and segregation of Islamic product
14 countries and an estimated 80,000 clients through
funds (and related documentation) by banks and
a network of Indonesian cooperatives. According
MFIs that offer both conventional and Shariah
to the survey, Bangladesh has the largest Islamic
compliant products.
microcredit outreach, with over 100,000 clients
and two active institutions. However, it is also the
Banks downscaling and expanding product line country where conventional microfinance products
An encouraging development in the growth of have the largest outreach nearly eight million
Islamic microfinance is that Islamic commercial borrowers and Islamic microfinance represents
banks have begun offering Islamic microfinance only 1% of its microfinance market.
services. Yemens Tadhamon International Islamic
Bank (TIIB), for example, set up a micro and In Muslim countries, Islamic microfinance still
small enterprises division in late 2006. In addition, accounts for a tiny portion of the total microfinance
some Islamic banks are planning to offer Islamic outreach. For example, in Syria and Indonesia,
microfinance products beyond just microcredit. Islamic financing instruments comprised only 3%
and 2%, respectively, of outstanding microfinance
On the 20th January 2008, Noor Islamic Bank and loans in 2006.
Emirates Post Holding Group announced plans
to establish a company offering Shariah compliant The supply of Islamic microfinance is concentrated
banking services to the low-income segment of in a few countries. Indonesia, Bangladesh and
the UAE population. The proposed company Afghanistan account for 80% of the global outreach
would provide a wide array of Islamic microfinance of Islamic microfinance. In all other countries,
products, including microcredit, insurance, debit and microfinance is still in its infancy, with no scalable

institutions reaching clients on a regional and microfinance products (65.7% globally, and 65.4% in
national level. For most countries, the average the Arab world).
Islamic microloan amount (with respect to primarily
the Murabahah product) is similar to conventional Finally, the CGAP survey identified that over 70%
microloans. of the products offered are Murabahah. Islamic
MFIs generally offer only one or two Shariah
compliant products. Concentrating primarily on
LETS LOOK AT IRAN asset financing, the industry still lacks product
diversification to serve the various financial needs of
The Iranian government requires all of its
the poor.
commercial banks to provide Shariah compliant
non-interest-bearing loans to the low-income
population. Typically, these loans are disbursed
to cover personal expenses such as wedding
expenses, repayment of outstanding debts, home
rental and repair costs, medical expenses, tuition
fees and the purchase of consumer goods.
Outreach is significant and as at March 2008, the

Central Bank of Iran estimated that three million
families benefited from approximately 6,000
Qard Hasan institutions (benevolent loan funds
known in Iran as Qarzul-Hassaneh funds), with a
total outstanding loan amount of IRR50 trillion
(US$5.5 billion).
However, Qarzul-Hassaneh Funds are most

often considered charities, and not MFIs, because
loans are typically: (i) made for large one-time
expenditures; and (ii) forgiven in the event of
default. They are not generally considered to
provide access to finance in a sustainable manner.
Outside the Qarzul-Hassaneh Funds,

microfinance in Iran is informal, though a
number of originally charitable organizations
have reportedly started microfinance operations.
Like conventional microfinance, Islamic

microfinance tends to focus on female clients a
majority of Islamic MFI clients according to the
CGAP survey were women (59% on average, but up
to 90% in Bangladesh). Overall, the percentage of
female clients using Islamic microfinance products
(59%) is comparable to those using conventional

Table 1 includes the outreach data of only the Islamic microfinance by institution type
institutions that CGAP was able to contact during Among the institutions that offer Islamic
its survey, except with respect to those institutions microfinance products, non-governmental
in Indonesia (about which information was obtained organizations (NGOs) are the dominant players in
from Bank Indonesias 2007 statistics), and in the reaching the largest number of clients, with just 14
West Bank and Gaza (about which information institutions reaching 42% of clients. Commercial
was provided by the Deprived families Economic banks (represented by only two institutions, Yemens
Empowerment Program, or DEEP). TIIB and Bangladeshs Islami Bank Bangladesh)
have the second-largest outreach with over 87,000
The table excludes the outreach of Indonesias clients.
4,500 Islamic cooperatives. However, according to
experts in Indonesia, only 60% of these Islamic Interestingly, the 105 Shariah compliant rural banks
cooperatives are still active, and their total outreach in Indonesia account for 25% of total clients, but
is estimated at 80,000 clients. 62% of the outstanding loan portfolio because of
their significantly higher average loan size and focus
As in the rest of this chapter, an MFI is defined as on small and microenterprise financing.
an institution targeting the poor and whose average
loan size is less than 250% of the countrys gross
domestic product per capita.
Table 1. Outreach of Islamic Microfinance, by Country

Region # of Included % Female Total # of Total Outstanding Avg. Loan
Institutions (Avg.) Clients Loan Portfolio (US$) Balance (US$)
Afghanistan 4 22 53,011 10,347,29 162
Bahrain 1 n/a 323 96,565 299
Bangladesh 2 90 111,837 34,490,490 280
Indonesia* 105 60 74,698 122,480,000 1,640
Jordan 1 80 1,481 1,619,909 1,094
Lebanon 1 50 26,000 22,500,000 865
Mali 1 12 2,812 273,298 97
Pakistan 1 40 6,069 746,904 123
West Bank and Gaza** 1 100 132 145,485 1,102
Saudi Arabia 1 86 7,000 586,667 84
Somalia 1 n/a 50 35,200 704
Sudan 3 65 9,561 1,891,819 171
Syria 1 45 2,298 1,838,047 800
Yemen 3 58 7,031 840,240 146
TOTAL 126 59 302,303 197,891,882 541
*
Micro and rural banks only.
**
There were seven MFIs in the West Bank and Gaza that offered, with the help of training and funding facilities offered by the Islamic
Development Bank, a total of 578 Islamic loans between 2005 and 2006. Data on only one of these seven are displayed in the table
because the remaining six MFIs were disbursing Islamic loans with average loan sizes higher than 250 percent of the regions gross domestic
product per capita.

Table 2. Outreach of Islamic Microfinance, by Institution Type

Total Outstanding Loan Avg. Loan Size
# of Total # of Clients Portfolio (Islamic) (Islamic)
Institution Type Institutions # % of Total US$ % of Total US$
Cooperative 1 6,671 2 926,251 <1 132
Village Bank (Syria) 1 2,298 1 1,838,047 <1 800
NGO 14 125,793 42 41,421,580 21 303
Rural Bank (Indonesia) 105 74,698 25 122,475,158 62 1,640
NBFI 3 4,293 1 1,893,207 <1 595
Commercial Bank 2 87,569 29 29,030,997 15 305
TOTAL 126 305,237 100 198,090,268 100 629
Note: This table reflects the data of only those institutions (mixed and fully Islamic) that provided reliable outreach information to CGAP
during its 2007 global survey of Islamic microfinance. Data regarding the 105 rural banks in Indonesia were obtained from the Indonesian
Central Banks 2007 Statistics. This table excludes data on the outreach of Indonesias 4,500 cooperatives. As in the rest of this Focus
Note, an MFI is defined as an institution targeting the poor and whose average loan size is less than 250 percent of the countrys gross
domestic product per capita.
Focus on Indonesia vary widely depending on the specific BPRS. BPRSs

Indonesia gives an insight into the development primarily offer Murabahah products and savings
of Islamic microfinance because of its dual services based on a revenue-sharing model.
conventional/Islamic microbanking system, which
includes both conventional rural banks (Bank They have been quite successful at mobilizing
Perkreditan Rakyat or BPRs) and Shariah compliant savings for the community, and their loan-to-deposit
rural banks (Bank Perkreditan Rakyat Syariah or ratio is higher than 110%.
BPRSs).
BPRSs are still young institutions without a proven
The latter are privately owned and regulated and track record. It is too early to draw conclusions on
supervised by Bank Indonesia. They are licensed to BPRS profitability; however, several factors might
offer banking services (loans and savings facilities, explain a lower return on assets (ROA), including
but no payment services) in a district area only. As the social mission of BPRSs.
at December 2006, there were 1,880 BPRs and 105
BPRSs. BPRSs are meeting a growing demand for Shariah
compliant microfinance products. Their rate of
BPRSs are more socially oriented than BPRs. growth has been impressive: From March to
Their mission statement calls for supporting the December 2007, Murabahah receivables increased
community, in particular micro-entrepreneurs. They by 26%, Musharakah financing increased by 27%
also have strong links with Indonesian Muslim and Mudarabah financing increased by almost 50%
mass movements such as Nahdlatul Ulama or (Bank of Indonesia data).
Mohammedia. Each BPRS has a Shariah board to
monitor the conformity of products to Islamic BPRSs can be profitable but nevertheless, like many
principles. microfinance providers, they face several challenges
in reaching sustainable scale (see Tale of two
However, board rulings are not consistent, and Islamic microfinance banks).
consequently, Islamic microfinance products can

Possible challenges to the growth of Islamic Risk management.

Another important factor to building
microfinance
sustainable institutions. The conventional
Islamic microfinance could potentially expand access
microfinance industry has developed a set
to finance to unprecedented levels throughout the
of good practices to manage credit risk, and
Muslim world. However, the industry has yet to
MFIs boast excellent portfolio quality.
demonstrate it can provide financial services that
meet the needs of poor people on a large scale. A
Conventional MFIs generally do not secure
deeper base of market research and proven business
loans through collateral but instead rely
models are very much needed. Nevertheless, several
on peer pressure and strict discipline for
possible challenges to scale up Islamic microfinance
collection. Such techniques should be
can be identified.
adapted to comply with the risk sharing, and
no-interest principles embedded in Islamic
Islamic microfinance business models are still
finance. For example, some suggest that
being developed and no performance benchmarks
pressure from the religious community and
have been established. However, two areas are of
appeals to a sense of religious duty should
particular importance: operational efficiency and risk
complement reliance on peer pressure.
management.
Operational efficiency.
This is key to providing affordable financial
services to the poor. Managing small
transactions is expensive, and MFIs must
innovate to reduce transaction costs.
In Murabahah or Ijarah transactions, the

provider of funds purchases a commodity
(such as equipment or inventory) and resells
or leases it to the user with a mark-up.
Islamic MFIs may benefit from cheaper

prices on the wholesale market, but the costs
associated with purchasing, maintaining,
selling or leasing a commodity (such as a
sewing machine) are expensive, and the added
costs are often passed on to clients.
However, some institutions have cut their

costs in Murabahah transactions by requiring
the end user to search for and identify the
desired commodity. Islamic institutions
should consider developing similarly novel
techniques and practices to minimize costs
and offer more attractive pricing to their
clients.

TALE OF TWO ISLAMIC MICROFINANCE BANKS

BPRS Wakalumi in Ciputat, Indonesia was established of 20.3%, 21.05% and 24.1%, respectively, the bank is
in 1990 by a foundation (Yayasan Wakalumi) as highly profitable.
a conventional BPR; for religious reasons, it was
converted into a BPRS in 1994. It has 118 shareholders, BPRS Artha Fisabililah in Cianjur was established in
among which are Bank Muamalat Indonesia (19%, 1994 by nine shareholders. By 1997, as a result of lack
down from 49%), the former Minister of Cooperatives of management experience, it was technically bankrupt
(23.5%), a Citibank manager (26%), Yayasan Wakalumi and was restructured. The new management was not
(5.6%) and more than 100 individuals, mostly Muslims very dynamic and was replaced in 2001 by a retired bank
working at Citibank. credit officer.
The bank seems to have a successful staff promotion The bank, located next to a local market, has 1,150
strategy: The president director, who has a Bachelors savers and 163 clients. With a staff of 11, including six
degree in agriculture, has been with the bank since loan officers, it offers doorstep collection services to
1994, learning on the job and climbing up the ranks; about 200 clients a day. It also offers deposit services to
the director, a woman with a diploma in accounting, schoolchildren and institutions. Total assets are IDR1.4
has been an employee since 1997 and was promoted to billion (US$126,290), deposits total IDR620 million
director in 2003. The bank has expanded rapidly, and (US$56,000) and financings outstanding equal IDR1.21
now has five branches and a staff of 38, including 13 billion (US$109,160).
loan officers.
Its overall performance is not yet satisfactory. Its main
Its 2,000 clients are mostly small traders on traditional problem is lack of funds because of a shortage of
markets, to whom it sells its financings as Islamic deposits and capital from the owners. The bank was in
products. It has four financing products, with the black for the years 2001, 2002 and 2003, with ROAs
Murabahah being the dominant one. Through eight of 2.3%, 1.7% and 2.4% and ROEs of 7%, 4.3% and
savings products and four term deposit products, it 8.75%, respectively. Its main future strategy to improve
has attracted 5,000 savers. With ROAs in 2001-03 of efficiency is staff upgrading through training.
4.1%, 3.65% and 3.35% and return on equity (ROEs)
Question of authenticity Consequently, low-income populations, who often

Although there is ample evidence of demand rely on local religious leaders to address questions of
for Islamic microfinance products, meeting religion, must be convinced of the authenticity of
such demand requires that low-income clients Islamic financial products if Islamic microfinance is
are comfortable that the products offered are to reach its full potential.
authentically Islamic. Critics of Islamic finance
products suggest that the pricing of some products Greater efforts should be explored to: (i) increase
offered as Shariah compliant too closely parallels the collaboration between financial experts and Shariah
pricing of conventional products. experts on product authenticity; (ii) encourage
exchange of experiences among religious leaders
For example, some institutions offer Murabahah (particularly those serving poor populations at
where interest appears to be disguised as a cost the local level) relating to Shariah compliance of
mark-up or administration fee. Islamic finance microfinance products; and (iii) educate low-income
sometimes suffers from the perception that it is populations, in collaboration with local religious
simply a rebranding of conventional finance and leaders, on how financial products comply with
not truly reflective of Islamic principles. Shariah.

Building capacity zakat (funds donated pursuant to the Muslim

Capacity building is needed at all levels to realize obligation to pay alms) as a source of funding.
the full potential of Islamic microfinance. At the
macro level, the IDB and Islamic financial standard Indeed, given the underlying principle of Islamic
setters (such as IFSB or AAOIFI) should consider finance to promote the welfare of the community,
developing global financial reporting standards zakat funds appear ideally suited to support
adapted to microfinance to build the infrastructure Islamic microfinance. However, a heavy reliance
for transparency in the global Islamic microfinance on charity is not necessarily the best model for the
sector. development of a large and sustainable sector, and
more reliable, commercially motivated streams of
This infrastructure would entail comprehensive funding should be explored.
disclosure guidelines on Islamic microfinance
accounting principles, pricing methodologies,
financial audits and, eventually, rating services.
At the micro and institutional levels, international

donor agencies can play a major role in expanding
access to finance in Muslim countries by helping
existing institutions reach scale and funding pilot
projects testing various business models. In addition,
more efforts should be made to train Islamic MFI
managers and staff through, for example, the
development of operational tools and manuals
(such as those developed by Deutsche Gesellschaft
fr Technische Zusammenarbeit, or the German
Agency for Technical Cooperation, for use in
Indonesia).
Product diversity
Islamic MFIs rely heavily on the Murabahah
product. However, poor people have diverse
financial requirements, and for many, savings or
housing products may be more urgent needs. The
innovative design of a range of Shariah compliant
products and services would provide greater
financial access to a broader segment of Islamic
microfinance customers.
Leveraging Zakat and Islamic funds

Islamic Microfinance: An Emerging Niche
Throughout the Muslim world, microfinance
Market. Tarazi, Michael, Xavier Reille, and
(Islamic or otherwise) is still seen as a
Nimrah Karim. 2008. Focus Note 49 excerpt
philanthropic activity rather than a business
reprinted with permission. Copyright CGAP,
enterprise. Consequently, in the context of Islamic
2008. Washington, D.C.: CGAP
microfinance, there is a growing tendency to view

Islamic Banking for
Women: Case Study
of Malaysia
More than half of the Malaysian population is made up of women and

current statistics show that universities are churning out more female
graduates than males into various sectors. Yet, not much has been done
Chapter 5 to cater to the financial needs of women at large. Banking for women
can be considered a new market segmentation, which can be tapped into
as a blue ocean market.
By Jamelah Jamaluddin In Malaysia, policies, strategies and programs for gender mainstreaming
are incorporated in the countrys five-year development plans and in
the longer-term 10-year Outline Perspective Plan. The current Ninth
Malaysia Plan (2006-10) continues to address womens concerns on their
role, position and status to ensure participation as equal partners to their
male counterparts in national development.
Under the current plan, women will be equipped with the necessary
skills and knowledge to prepare themselves for globalization and to
fulfill the needs of a knowledge-based economy. The key policy thrusts
of the Third Outline Perspective Plan (2001-10) are inclusive of a
resilient nation by fostering unity and enhancing the role of women in
development.
This effort is not only being practiced locally but tremendous similar
efforts have been continuously carried out to promote the well-being
of society and to improve the role of women be it in the economic,
social or political arena.
With reference to Table 1, female percentage over the total population

for the 10 selected countries indicates that women represent half of the
population. In addition, the life expectancy for the countries as listed
shows that females are more likely to outlive males.

Population Structure
Table 1: Socioeconomic indicators of selected countries, July 2007 (estimated)
Country Malaysia Indonesia Thailand Philippines Singapore Brunei Vietnam Myanmar Cambodia Lao PDR
Population (000) 27,173.6 234,694 65,068.1 91,077.3 4,553 374.6 85,262.4 47,374 13,995.9 6,522
Female (000) 13,340.6 117,295.6 32,887.5 45,552.6 2,330.3 185.2 43,015.1 23,931.3 7,166.5 3,287.4
manual IDD_newlayout.indd Sec2:49

%Female % 49.1 50 50.5 5 51.2 49.4 50.5 50.5 51.2 50.4
Sex ratio (every 100 104 100 98 100 95 102 98 98 95 98
females)
Annual popula- % 2 1.2 0.7 1.8 1.3 1.8 1 0.8 1.7 2.4
tion growth rate
Life years 70.2 72.6 70.5 81.8 75.3 71.1 62.5 61.3 55.9
expectancy at
birth
Male years 71.9 67.7 70.2 67.6 79.2 73.1 68.3 60.3 59.3 53.8
Female years 76.4 72.8 75 73.6 84.6 77.6 74.1 64.8 63.4 59
Crude birth rate every 1000 18 19.7 13.7 24.5 9.2 18.6 16.6 17.5 25.5 35
Crude death every 1000 4.5 6.3 7.1 5.4 4.4 3.3 6.2 9.3 8.2 11.3
rate
Infant mortally every 1000 6.7 32.1 18.9 22.1 2.3 13.1 24.4 50.7 58.5 81.4
rate
Total fertility birth per 2.6 2.4 1.6 3.1 1.2 2 1.9 2 3.1 4.6
rate women
Literacy (age 15 % 89.7 90.4 92.6 92.6 92.5 92.7 90.3 90 73.6 68.7
Islamic Banking for Women in Malaysia
and above)
Male % 92 94 94.9 92.5 96.6 95.2 93.9 93.9 84.7 77
Female % 85.4 86.9 90.5 92.7 89.6 90.2 86.9 86.4 64.1 60.9
Source: CR World Factbook
6/19/2009 4:12:32 PM
As will be seen from Chart 1, there is an equal Chart 3: Distribution of female employment by
distribution in terms of the proportion of males occupation (2006)
and females residing in urban and rural areas.
Plant and machine Elementary
High population in urban areas could be a result operators and workers Legistrators, senior officials
11.4%
assemblere and managers
of vast opportunities in the employment market, Craft and related
10.5% 5.3%
Professionals
trade workers
notwithstanding the development of the area in 4.2% 6.9%
terms of infrastructure. Skilled agricultural

Technichians and
associate professionals
and fishery workers 13.9%
9.4%
Chart 1: Population by stratum and sex (2007) Service worker, shop Clerical workers
and market sales workes 18.6%
19.4%
30000 27,173.6
(100%)
25000 Source: Department of Statistics Malaysia
20000
17,221.6 With reference to both charts, the proportion of
(63.4%) 13,833 13,340.6
15000
9,952
(100%) (100%) male and female employment in the managerial and
(36.6%) 8,727 8,494.6 professional capacities shows equal distribution. In
10000 (63.1%) (63.7%)
5,106 4,846 terms of gender proportion, it is 26.5% and 26.1%
5000 (36.9%) (36.3%) for males and females, respectively.
0 Chart 4: Public sector personnel by service group
Total Male Female
and sex (June 2006
Total Urban Rural
371,032
Source: Department of Statistics Malaysia 400,000 331,540
350,000
300,000
Occupational structure 250,000
Number
200,000 132,227
111,392
150,000
In the employment market, career development was 100,000
recorded in the occupational structure, with more 50,000
1,529 425
women moving into managerial and professional 0

Top management Professional Support
positions. Charts 2 and 3 illustrate the distribution and management
of male and female employment in Malaysia, Male Female
categorized by occupation as at 2006. Note: Data exclude armed and police force
Source: Public Service Department Malaysia
Chart 2: Distribution of male employment by
occupation (2006) Referring to the statistics appended above, the
Legistrators, senior officials following conclusions can be made:
Plant and machine Elementary workers and managers
operators and 10.5% 9.6% i) The gender-mainstreaming program carried
assemblere Professionals
10.5% 4.8% out by the government of Malaysia has
Technichians and shown improvement as indicated by equal
Craft and related associate professionals
trade workers
15.1%
12.1% distribution in terms of male and female
Clerical workers employment by occupation in managerial and
Skilled agricultural 4.4%
and fishery workers Service worker, shop
and market sales workes
professional positions. A similar distribution
15%
13.4% trend was also identified for both genders
under the professional and management
Source: Department of Statistics Malaysia group in the public sector (see Chart 4).

ii) Women also hold decision-making power in Women were also more inclined to keep their
both the public and corporate sectors (see income in savings accounts as a form of investment,
Tables 2 and 3). which acts as a buffer against unexpected incidents.
This type of saving provides low returns as
Based on the above, the ladies banking segment compared to real estate property investment and
represents a potential market to tap into with its vast ownership of stocks or businesses.
product development and marketing opportunities.
As women today move away from their Research also indicated that womens tendency to
contemporary role as wife and mother, to leaders spend now and save later stood at 66.1%, which was
of industries and managers, Malaysian women form at a higher range. For big ticket items, about 27.3%
a significant group that calls for unique attention and 26.8% saved for real estate property investment
when it comes to their future financial well-being. and cars, respectively.
It has also been demonstrated that womens top

INVESTMENT HABITS OF priority in savings and insurance or Takaful are their
WOMEN childrens health and education less priority was
given to their own. Women are also generally vague
Research by the Ministry of Women, Family and about coping strategies in times of hardship or
Community Development in 2005 on the female calamity.
investment habit showed that about 38.7% of
investments were made through the employment When it comes to financial responsibilities, women
provident fund. About 69% kept their money in today have proven their capabilities in everyday
savings accounts while 39.9% continued to invest in management of money including daily budgeting,
gold, silver or jewelry. credit financing and managing debt for themselves
Table 2: Women at decision-making level in the public sector (2007)

Position 2007
Total Male Female % Female
Secretary general 27 23 4 14.8
Director general (federal) 68 60 8 11.8
Chief executive (federal statutory bodies) 64 55 9 14.1
Note: As at 25 July 2007
th
Source: Cabinet Division, Prime Ministers Department
Table 3: Women at decision-making level in the corporate sector (2007)

Position 2001 2002 2003 2004 2005 2006 2007
% Female
Members of Board of directors 10.1 10.5 10.1 9.9 10.2 7.6 5.3
President, vice-president, managing director, 12.0 12.1 12.3 13.5 13.9 14.3 24.0
chief executive officer, chief operation offi-
cer, senior general manager, general manager
Note: As at 25th June 2007
Source: Survey by Ministry of Women, Family and Community Development (MWFCD) on 50 companies listed under Bursa
Malaysia

as well as for the family. However, with reference b) Multi-tasking dimension of women
to the above findings, investment activities are As career women with high net worth status, women
still not a popular option among women despite today face much bigger challenges.
the potential returns. Continuous awareness and
education programs need to be in place in order to The tradition of women being looked after
educate women on its benefits and advantages. financially by their father, husband or brother has
changed dramatically over the years. Nowadays,
women have started looking after their own affairs,
NEED FOR ISLAMIC which has accorded them a certain measure of
BANKING FOR WOMEN independence.
a) Female civilization Generally, women are more particular about their

Women are increasingly in the forefront of money cash flow than men. Hence, banks that
civilization. All over the world and at every stage, provide special ladies facilities will be able to resolve
women are at the helm of every crucial role. Women their issues, and it is a big opportunity to cater to
business leaders have penetrated many realms of demand from the rising number of high net worth
businesses, including those traditionally considered women.
male bastions.
With the presence of a dedicated financial
Statistically founded, women are the driving force consultant to manage their financial matters, their
behind the economy. They make most of the needs are taken care of. This is not only confined to
money-based decisions globally today. They make personal wealth management but also encompasses
most of the choices relating to purchases on credit credit, investment and potential business
and investments. It can be summarized by the requirements. For the consultant, good networking,
following data. an ability to work long term and ability to listen
Chart 5: Percentage of purchasing decisions made by women
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
All Home Vacations New DIY Consumer Cars Choose Healthcare
consumer furnishings homes home electronics which new
purchases projects bank
account to
open
Women Men
Source: Re-imagine! by Tom Peters

to clients on their needs are essentially due to the through the provision of easy access to capital.
nature of womens needs on personalized service. The Women Entrepreneurs Fund, for example, was
established in 1998 with an allocation of RM10
As for the true Muslim woman, offering sincere million (US$2.76 million). A new initiative is a
advice is not just a matter of volunteering to do proposal to set up a bank for SMEs with a special
good out of generosity but a duty enjoined by Islam. window for women entrepreneurs.
c) Financial planning purpose In an effort to further assist women in becoming

Many are confused about the concept of financial successful entrepreneurs, various training and
planning, thinking that it is only for a target group. development courses have been designed. These
In actual fact, it is about the management of ones include courses in business management, marketing,
finances and planning with regard to investment, sales, packaging and labeling. In addition, courses
estate planning and private banking with the goal of in good manufacturing practices and business
sustaining and growing long-term wealth. networking are conducted for women who are
interested in the manufacturing sector.
Financial planning, therefore, should start as early as
possible. At each stage, there are new challenges. For
a young woman who has just landed her first job, the
AZ ZAHRA PRIVILEGE
priority might be giving herself a treat. Others might LADIES BANKING
be helping out with the household bills or their
siblings with their education. Acknowledging the growing needs of todays
women, RHB Islamic Bank launched Az Zahra
When a woman enters marriage, her needs and Privilege Ladies Banking on the 30th April 2008.
priorities might change. A new addition to the Comprising a set of privilege banking services for
family will also see the need for the couple to high net worth women, it is the first and only such
make adjustments to meet increasing financial service in Malaysia.
requirements not only for today but also for the Adapted from the name of Prophet Muhammads
future; that is, education, medical, insurance and daughter, Saidatina Fatima Az Zahra RA, Az Zahra
setting aside for rainy days. means the shining one. The introduction of
Az Zahra Privilege Ladies Banking has set a new
Financial and investment plans need to be flexible milestone for the local banking industry; through
enough to anticipate and adapt to change. As todays Az Zahra, the bank is enthusiastically looking at
women are generally more educated and hold high enhancing its wealth management offerings to cater
positions, and given the higher number of high for this untapped market with high potential.
net worth women, understanding and having good
financial planning is essential. Concept and strategy
As the concept of ladies banking is mooted on the
d) Women as entrepreneurs basis that women in general are becoming more
As seen in many developing countries, women have visible in the market, it is a positive development
always been the backbone of small and medium- which allows RHB Islamic Bank to serve their
sized enterprises (SMEs). The prospects for women growing financial and banking needs.
in business are bright.
Another key reason is that in many areas, women
The Malaysian government has taken measures to and men are segregated to enable each party to
facilitate the involvement of women in business perform their tasks more efficiently. Given their

feminine nature, services provided to women can ladies branch and open to all women in the future.
be tailored, with their banking needs seen to by an
all-female staff, where such differentiated service The ladies banking section targets women at
cannot be afforded to all types of customers. the executive and professional level, as well as
businesswomen and high net worth women. In line
RHB Islamic made several visits to banks in the with RHB Groups synergy, the invitation is also
UAE, namely those in Dubai and Abu Dhabi, extended to existing group customers, by identifying
between the 4th and 7th November 2007. Its findings its existing female customers such as gold and
are as per Table 4. platinum card holders, automobile financing of
RM150,000 (US$41,439) and above, home financing
Table 4: Presence of ladies banking in the UAE of RM250,000 (US$69,065) and above, Infinity
Islamic banks Presence of ladies Banking members and female executives who form
branches the corporate clientele of RHB Islamic.
Dubai Islamic Bank Yes
Abu Dhabi Islamic Bank Yes Products and services offered
Emirates Islamic Bank No Under the Islamic banking arm of RHB Banking
Conventional banks Presence of ladies Group, Az Zahra offers a customized set of
branches Shariah-based products and services for ladies, who
Abu Dhabi Commercial Bank No will enjoy personalized and confidential services,
access to RHB Islamics dedicated Privilege Ladies
First Gulf Bank No
Banking lounge and products at preferential rates
Emirates Bank No
and discounts specially dedicated to high net worth
women.
For female-only banks, it found that:
a) The branches are not just only open to high
Among the new privilege financing services are:
net worth customers.
(i) Az Zahra Equity Home Financing-i;
b) The set-up is similar to that of a normal
(ii) Az Zahra Mudharabah Current Account-i;
branch. In some spacious ladies branches,
(iii)Az Zahra Mudharabah General Investment
there is even a customers seating lounge
Account-i;
where drinks are provided. A childrens play
(iv)Az Zahra Hire Purchase-i.
area has also been set up at one branch.
c) No men, including male staff, are allowed.
(i) Az Zahra Equity Home Financing-i
Therefore, if male staff wish to visit the
Using the concept of Musharakah Mutanaqisah or
ladies branch, they would first need to inform
diminishing partnership, this enables the customer
the said branch.
to enter into a co-ownership agreement with the
d) The ladies branches are manned by female
bank to own a house. As one of the partners
staff and headed by a female branch manager.
(musharik), the customers share of the property will
e) No standard attire is observed for the staff.
progressively increase, until he finally acquires full
ownership.
Customer profile
Based on the above analysis, RHB Islamic came
The minimum amount is RM250,000 (US$70,000)
up with its own banking concept. While catering
for a financing period of 30 years, with free
exclusively for ladies, the bank intended to start with
acquisition cost. Benefits include Takaful coverage
selected high net worth female clients. The success
with extra term, flexible payment plans, longer
of this concept will be expanded into a full-scale
tenure and convenience of payment at more than

196 RHB Bank and RHB Islamic branches and 540 project financing and deposits, respectively, during
ATMs. the first year of Az Zahras operation. Currently,
Az Zahra lounges can be found at its main branch
(ii) Az Zahra Mudharabah Current Account-i in Kuala Lumpur, Johor and Kelantan. Expansion
Funds provided by the customer will be invested plans for other branches are under way.
in activities that are permissible under Shariah. The
profit gained from these investments will then be
shared between both parties at a pre-determined
LADIES BANKING IN
profit-sharing ratio (PSR). The initial deposit is OTHER COUNTRIES
RM50,000 (US$14,000) with higher PSR.
Masrafy Bank, Bahrain
Benefits include a dividend paid monthly on the In June 2006, the Bahrain Monetary Agency granted
daily balance at a pre-determined PSR, free Takaful Abu Dhabi Investment House (ADIH) a license to
personal accident protection up to RM100,000 open the worlds first Islamic investment bank for
(US$28,000) and a 25% discount on commission women, with an authorized capital of US$1 billion
fees for travelers checks from the bank. and a paid-up capital of US$500 million.
(iii) Az Zahra Mudharabah General Investment The bank, which was to be known as Masrafy
Account-i and located at the Bahrain Financial Harbour,
Capital provided by the customer will be invested targeted wealthy women in the region, providing
for a fixed duration. The profit earned will be shared much-needed Islamic banking products and wealth
as dividends between the customer and the bank management services.
according to a pre-determined PSR.
Many banks provide commercial banking services
(iv) Az Zahra Hire Purchase-i for the regions women, but we do not have a bank
Based on the Ijarah Thumma Bai (hire purchase) dedicated to them for investment services and
concept, this allows customers to hire, and products. We consider Masrafy as the first bank
subsequently purchase, their dream vehicle. The in this field, which will be run by women banking
customer who purchases a car of a premium brand experts with high qualifications, offering women an
will enjoy attractive financing rates with special opportunity to take part in regional investments,
Takaful coverage. The minimum financing amount is said Rashad Yousef Janahi, CEO of ADIH.
RM150,000 (US$41,543).
Masrafy targets women investors who tend to shy
At Az Zahra, the ladies banking section is also away from investments for lack of privacy, thus
equipped with share trading and Bloomberg enhancing their role in the finance and business
terminals, Internet browsing, media displays, sectors. Some women like privacy in transactions,
magazines, daily newspapers and journals, with which is why they need their own bank run by
ample seating. Furthermore, existing customers qualified women. Rashad said the bank would
with aggregate deposits of at least RM50,000 adhere to Islamic and Arabic traditions.
automatically qualify as Az Zahra members. The
Az Zahra Privilege Ladies Banking is open to all He explained Bahrain was chosen because the
Malaysians. kingdom is considered the financial hub of the
region. It is also a regional center of Islamic
RHB Islamic is targeting RM22 million (US$6.09 banking. Rashad added that Arabian women have
million) and RM24 million (US$6.64 million) of played a major role in the finance and business

sectors in the last few years and Masrafy would give appreciation of its symbiotic link to real economic
them an opportunity to participate in all investment activities. As the financial crisis spreads to even
opportunities in the region in line with their more areas around the world, some financial and
expectations. related Islamic institutions are feeling the effects,
though not to the extent that has crippled many of
Rashad also pointed out that studies and statistics their conventional counterparts.
from the region showed that women in the region
held funds worth US$38 billion and there were no This naturally means that the Islamic finance
credible investment avenues for them to maximize community should not be complacent; rather, it
returns from investing such funds in a professional must continue to critically evaluate its performance.
manner. Masrafy would bridge this gap because Have we truly established an alternative system, or
the bank would have the expertise to launch many are we still very much mimicking the established
projects in the region. conventional systems?
In order to strategize and expand bank presence, Therefore, with the growing demand for Islamic
Masrafy has tied up with international banks for finance, and the rising number of women working
asset management, banking services and so on to in the field as well as the higher number of high net
serve women investors in Bahrain and the region. worth women, it is the next stage of opportunity for
bankers.
The bank will also tie up with institutions for risk
management and deploy corporate governance However, in moving forward to penetrate Islamic
practices. The shareholders of Masrafy consist of banking for women, focus should not only be on
high net worth individuals and financial institutions the high-end group, it should also be on the low-
such as Qatar Islamic Bank and Kuwait Investment end group. The success of Grameen Bank, which
Company. led to its founder Prof Muhammad Yunus being
recognized as a Nobel Peace Prize winner in 2006,
Emirates Islamic Bank, UAE should be emulated.
In June 2007, Emirates Islamic Bank (EIB) launched
Al Reem, a specialized banking service dedicated to Muhammad Yunus has shown himself to be a
women. The new branch marked EIBs 25th in the leader who has managed to translate his vision into
UAE. practical action for the benefit of millions, not only
in Bangladesh, but also in other countries. Grameen,
Al Reem offers benefits such as staff consisting only and the concept and methodology of microcredit
of women, exclusive lounges and service areas, a that have formed the cornerstone of his work for
special discount on bank products, discounts at retail 30 years, have contributed to the peace process by
outlets, a special chip-based debit card, customized reducing poverty.
checkbook, road side assistance program and
invitations to attend ladies only social events. The success story of Grameen should be translated
from the Islamic financing point of view, where
there should be more efforts to bridge the gap
NEXT STAGE OF between the high net worth group and the lower
OPPORTUNITY income group who are capable of doing business.
Interestingly, the Grameen methodology is
Today, the Islamic financial system is viewed with almost the reverse of the conventional banking
a measure of envy and respect. There is a growing methodology. Conventional banking is based on the

principle that the more you have, the more you can
get.
In other words, if you have little or nothing, you

get nothing. As a result, more than half of the
global population is deprived of financial services.
The reverse practice of Grameen in providing loan
services to the poor is not a failure as it has already
proven to be reality.
Interestingly, 97% of its borrowers are women,

with a loan recovery rate of 98.24%. Hence, if
conventional banking is able to perform, it follows
that Shariah compliant banking, with its Islamic
virtues, should be able to replicate the success story
but in the Islamic financing context.

North America
North America has fairly limited options available for Islamic financing,
despite its advanced financial systems. Shariah compliant financing has
been available, to some extent, since the 1980s, though development
since that time has been very slow in coming. Although there have been
signs of this growth accelerating in the last few years, due to the US
subprime mortgage crisis and the accompanying global credit meltdown,
development has currently reversed course to some extent. As the credit
markets thaw, this is again likely to reverse, and a broader range of
products will likely be made available.
Chapter 6 When looking at the availability of Islamic financing, there are several
sub-markets to consider, some of which are well-represented, and
Regional Overview some are entirely missing. Specifically, the markets are home financing,
commercial real estate financing, business equipment and trade goods
financing, consumer goods financing, private investment funds, public
By David Loundy investment funds, private equity, Takaful, and Islamic banks and bank
deposits.
POPULATION
Before looking at availability, let us look at the background in which
the products are offered. In Canada, the 2001 national census showed
the Muslim population to be about 600,000. This number has been
growing significantly, and is now estimated to be close to one million,
and is expected to approach between 3.5% and 5% of the Canadian
population by 2017. Sixty-one percent of Canadian Muslims live
in Ontario, primarily in the Toronto metropolitan area. Ninety-one
percent of Canadian Muslims are first generation residents. The highest
representations are South Asians, making up 37% of the Muslim
population, and Arabs comprising 21% of the population.
The Muslim population in the US has not been accurately measured,

and estimates vary widely, ranging from about two million to about
12 million. Because religion is not a statistic that is collected in the
US Census, the numbers are collected through examining masjid
membership and other demographic surveys. The Muslim population

Regional Overview : North America
is, however, considered to be growing, due to easier to match investment products with lending
family dynamics and immigration. The US Muslim products, as is done with housing cooperatives,
population is also predominantly foreign born an discussed later in this chapter. It is also easier to
estimated two-thirds with more than half of the have true profit and loss sharing banking products.
remainder primary consisting of African-American In the US, there is much more diversity in banking
converts. Of the total Muslim population, Arabs institutions totaling several thousand banks.
comprise one quarter, African Americans make up
one fifth, and South Asians add another 18%. There is also a much more rigid distinction between
industries and their regulators. Thus there are
Geographically, the largest Muslim populations banking regulators, securities regulators, insurance
are in California, New York and Illinois, but with regulators, a financial institution insurance company
large groups also present in New Jersey, Indiana, (which considers itself a regulator), trade regulators,
Michigan, Virginia, Texas and Ohio. Often, there and some or all of these regulatory categories may
are clusters based on origin for instance, on apply at a federal level or at an individual state
the North side of Chicago, many of the Muslims level. In some cases, there may even be turf wars
are South Asian, Bosnian or other East European, between regulators, where a product may fit within
while on the South side of Chicago, there are more the jurisdiction of more than one regulator. Tax
African American and Arab Muslims. questions can also be very complex, as there are
nearly 8,000 tax jurisdictions alone in the US. Thus,
to offer Islamic finance products in the US, you
REGULATION must look at what the product is, who is providing it
and in what state.
Neither the US nor Canada has a uniform system
of regulation that applies to Islamic financing. In
Because of this complexity, there are fewer
Canada, however, the regulatory system is much
providers willing to navigate this maze than there are
simpler than it is in the US, and the banking system
in some less-regulated countries, and products that
is much more concentrated there are only six big
may be available in one state may not be available in
banks and several dozen banks in total.
another. Costs may also vary widely by state, which,
in part, may dictate the use of a different financing
All banks and investment banks, insurance
structure.
companies, credit unions and cooperatives are
regulated by the Department of Finance Canada,
For instance, a Murabahah transaction performed
and more specifically, by the Office of the
on residential real estate in New York state would
Superintendent of Financial Institutions Canada.
require the payment of a mortgage tax on the gross
The individual provinces may have taxing authority,
amount of the Murabahah debt, not based on the
which potentially impacts an Islamic financing
equivalent conventional loan amount making
transaction, but the regulation of the structures and
such a transaction very expensive, whereas there
a companys ability to offer them are most likely a
may be no mortgage tax owed at all on an Ijarah
federal matter under the umbrella of one central
transaction.
agency. (Additional protections are to consumer
transactions by the Financial Consumer Agency of
The full scope of Islamic finance regulation is
Canada [FCAC].)
well outside of the scope of this book. It is also
unfortunate that the complexity is so high because
As a result of having a more globally-applicable
it is also outside of the scope of many practitioners.
regulator to the universe of product types, it is
Islamic finance is very much a matter of fitting a

square peg into a round hole in North Americas In 1980, there were experiments started on a more
interest-based economies, and it is safe to assume formal basis in Indiana, with the creation of the
that pretty much everyone working on Islamic Indiana State licensed Muslim Students Associations
finance, the author included, is missing some Credit Union, as well as the Islamic Housing
aspect of how the law applies to Shariahcompliant Cooperative of Indiana, both now defunct. The
products and services. Indiana banking regulator described the demise of
the credit union as due to the organizations lack of
profitability apparently not collecting interest also
PROVIDERS OF ISLAMIC translated into a lack of operating income.
FINANCE
There are two historical events that really spurred
US the growth of Islamic financing that occurred in
In the US, the first attempts to provide Islamic the late 1990s: the launch of the Dow Jones Islamic
finance came from cooperative efforts. Initial Indexes, and the two interpretive rulings released by
ventures in the early 1990s included MSI Finance the US Office of the Comptroller of the Currency
Corporation, with offices in California and Texas, relating to Murabahah and Ijarah. These events
which was a division of ICNA (Islamic Circle of captured some attention and put in the platform for
North America) and BMI Incorporated in New growth.
Jersey. Both entities provided leasing funds for cars,
and MSI, at least, assisted with home purchases on a The Dow Jones Islamic indexes, coordinated by
cooperative basis. Rushdi Siddiqui and launched in 1999, were based
on the fatwa of notable Shariah scholars that agreed
The Ameen Housing Co-opin California was on the screening criteria to be used when examining
another early effort begun in 1996. American a universe of stocks to find which were acceptable
Finance House (LARIBA) predated these operations under Islamic law, and how to address near misses.
and began operations in 1987, and the company Specifically, the fatwa put in the framework for
remains an active provider of services to the examining a companys balance sheet and business
Muslim community today, and has expanded its and allowing for some amount of unacceptable
reach through an affiliation with the Bank of business/income.
Whittier, which is under common ownership.The
company provides residential and commercial real This allowed for the inclusion, say, of a company
estate, business and auto financing. Samad Group, that runs a halal business, but has cash on hand
headquartered in Ypsilanti, Michigan, which is in interest-bearing bank accounts that generate
also still operating today, began providing home unacceptable income. Rather than eliminate the
financing in 1996. entire business as unacceptable, the fatwa established
thresholds below which such income would be
On the investment side, the Amana Income Fund, treated as not sufficiently material and would not
managed by Saturna Capital, launched in 1986, disqualify the company as an acceptable investment.
with the Amana Growth Fund later added in 1994.
The Amana funds were motivated by the North The Dow Jones Islamic Index screens eliminate
American Islamic Trust (NAIT), which looked to companies in certain lines of business, and the
Nicholas Kaiser, the founder of Saturna, to manage screens filter based on certain financial ratios such
money for it. NAIT also provides a cooperative as debt, cash and interest-bearing securities, and
fund for buying masjid and school properties, and a accounts receivable all measured against market
waqf (trust) for holding title to such properties. capitalization. The creation of the indices, and

the screening methodology, led to their licensing The entry of others into the market was also
by two of the three early US Islamic mutual fund accelerated by not just the development of the
companies the Dow Jones Islamic Index fund Manzil USA program, but also by its demise.
(now the Iman Fund, a subsidiary of the North When the United Bank of Kuwait got bought out,
American Islamic Trust launched in June 2000) and the acquirer discontinued its US operations and
the Azzad mutual funds (also launched in 2000). encouraged its US customers to find other financing
arrangements.
The Dow Jones Indexes have now expanded to
cover markets all over the world, and have been Customers then went to other institutions with
widely adopted (as cataloged by another US effort which they had relationships and asked them if they
Failaka, headquartered in Chicago and in could help fill the gap created by United Bank of
operation since 1996 which strives to be the top Kuwaits exit. This, for instance, led to the creation
research and advisory firm on Islamic investment of the Devon Bank Islamic finance program.
funds around the world).
HSBC began providing residential Islamic financing
The true foundation for bank-based Islamic finance in the US in 2002, (as did Guidance Financial
in the US came from the efforts of the United Bank Group, a non-bank mortgage broker, through its
of Kuwaits Manzil USA program. This program Guidance Residential division).
was the first major attempt to provide retail-level
Islamic finance broadly across the US. Devon Bank created an Islamic financing subsidiary
in April 2003, began by providing both residential
Importantly, it also involved the first interpretive and commercial real estate financing on a compliant
letters to be released publicly by a federal banking basis in June of that year, with limited business
regulator, and thus it created a precedent that could equipment and trade goods financing added shortly
then be looked to by other institutions facilitating thereafter.
others entry into the market. Specifically, the Office
of the Comptroller of the Currency, which regulates It also offers limited stand-by letters of credit, real
national banks (as opposed to state chartered banks estate construction financing, lines of credit, cash
and some other types of banking institutions such management, institutional deposit and investment
as thrifts and credit unions), released Interpretive products, and some trust and advisory services on a
Letter #806 on the 17th October, 1997 on the Shariah compliant basis.
permissibility of Ijarah transactions, and Interpretive
Letter #867 in November 1999 on the permissibility University Bank followed suit in 2004 and created its
of Murabahah transactions. University Islamic Financial division in December
2005. It provides residential real estate financing and
These interpretive letters looked at the transaction deposit products. Other banks have also dabbled
forms and, using a substance over form approach, in Islamic finance including, at least, LaSalle Bank
held that the transaction forms were the functional (now subsumed into Bank of America), which
equivalent to traditional lending, and thus fit within provided commercial real estate financing, Cole
the allowed powers of banks. This was a particularly Taylor Bank (commercial real estate financing),
profound conclusion because, in part, it allowed Mutual Bank in Chicago (commercial real estate
banks to buy and own property, which is something financing), Broadway Bank of Chicago (commercial
that they are otherwise prohibited from doing except and residential real estate financing), and Lincoln
as a result of a foreclosure or to use to operate State Bank in Rochelle, Illinois (residential real estate
banking facilities. financing).

Non-bank originated commercial real estate Investment House, which has been operating with
financing is also provided by Zayan Finance, which offices in the US since 2004.
began operations in December 2007.
Even local governments have shown some interest HDG Mansur began providing Shariah compliant
in Islamic financing in the US. At the urging of real estate funds and advisory services after the
the African Development Center, the City of company was formed in 2000. It, along with
Minneapolis, Minnesota, which has a large Muslim investment management companies such as Calyx
Somali immigrant population, began providing Financial and Shariah Capital are headquartered in
through its Alternative Financing Program non- the US, but do not offer their products publicly in
interest-based financing for equipment purchasing the US, and are thus not discussed in detail here.
and for making building repairs.
Finally, an early (now defunct) attempt to provide
The State of Minnesota has just begun offering Takaful was started by Dr Omar Clark Fishers First
low income home financing on a Murabahah basis Takaful USA, which aimed to provide insurance for
through the Minnesota Housing Finance Agency businesses, homes, schools, vehicles, and community
in conjunction with Devon Bank and the African centers. The company operated between 1997 and
Development Center. Minnesota Housing will also 2000.
provide interest-free loans for limited down payment
assistance. Summary of Public Financing Options in the US
Residential Real African Development Center
In Nashville, Tennessee, Shariah compliant Estate Ameen Housing Co-Operative
microfinance is available for refugees starting new Broadway Bank
businesses through World Relief, which receives Devon Bank
some funding from the US Department of Guidance Residential
Health and Human Services Office of Refugee LARIBA
Resettlement. Lincoln State Bank
University Bank
In addition to World Relief, other community Commercial real Broadway Bank
estate Cole Taylor Bank
development institutions have also been working to
Devon Bank
help small businesses with compliant financing, such Mutual Bank
as the African Development Center in Minneapolis Zayan Finance
mentioned above, and also the riba free program Real estate Devon Bank
of the Neighborhood Development Center, also in construction City of Minneapolis (repairs
Minneapolis (and which has received funding from of certain local properties)
the Community Development Financial Institutions Lines of credit Devon Bank
Fund of the US Treasury to develop its Islamic
Cash management Devon Bank
financing program).
Business and trade Devon Bank
goods LARIBA
On the other end of the spectrum, Shariah
Microfinance African Development Center
compliant investment banking settled into the
Neighborhood Development
US with the opening in 1997 of Crescent Capital, Center (Minnesota)
now re-named Arcapita after its Bahraini parent, City of Minneapolis
Unicorn Investment Bank also of Bahrain, which World Relief
opened UIB Capitals Chicago office in 2005, and
Innovest Capital, a wholly owned subsidiary of Gulf

Public investment The Amana Mutual Funds Shariah compliant retirement investment program.
funds (Saturna Capital) These three ventures were all the by-products of an
The Iman Fund (NAIT/AAA initiative of the Muslim Community of Quebec that
Advisors) formed a task force in the 1980s to create Shariah
The Azzad Mutual Funds compliant financial institutions. It appears that only
(Azzad Asset Management) the housing co-op is currently operational.
Private equity Arcapita
Innovest The An-Nur (Ontario) Housing Co-Operative began
UIB Capital Takaful operations around 2005, and promises to eventually
N/A have available car and business equipment financing.
It also offers some investment options.
Canada
In Canada, Islamic finance also started to take root A Canadian housing cooperative is a regulated
beginning a quarter of a century ago, though it has structure that takes in investor money and puts it
developed more slowly in Canada than it has in out to finance homes. Typically, there will be two
the US. This is due in part to the smaller Muslim classes of shares, one dividend paying, and one that
population, and in part to the difference in banking/ does not pay a dividend.
mortgage financing systems that has left the country
with a less accommodating infrastructure. Members will pay a membership fee and make
regular contributions to purchase shares. These are
As was the case in the US, Islamic finance began the investment shares that pay a dividend coming
with cooperative ventures, beginning in 1980 with from the rent charged to those members who are in
the Housing Co-operative Corporation, known as the process of buying homes through the co-op on
Islamic Co-operative Corporation Ltd. Housing a rent-to-own basis.
cooperatives were started by the Canadian chapter
of the Islamic Society of North America, specifically When a member has enough money invested in
the Islamic Co-Operative Housing Corporation, shares to equal a down payment on a home, and the
which was size-constrained, the Ansar Co-Operative co-op has funds available, the shares are converted
Housing Corporation, which continued the Islamic or swapped for the non-dividend paying shares
Co-Operative Housing Corporations efforts, and that become the initial equity of the member in
most recently, the ISNA Housing Co-Operative. the members new home. The co-op provides the
balance of the funding.
Using the same cooperative framework, ISNA
Canada is expanding the scope of available financing The member then buys the home over time on an
through the provision of what it refers to as first Ijarah or a Musharakah basis, with the rent being
generation Islamic financial services with the paid to the investment share owners. Thus the co-op
launch of Ansarco Inc providing car and equipment provides opportunities on both sides of the balance
leasing and a retirement investment program sheet a financing product to buy homes, and an
through the Al-Amin Association. It appears that investment product to finance their purchase.
these two organizations are not yet operational.
The first large-scale provider of residential home
In 1991, the Qurtuba Housing Co-Op began financing in Canada is United Muslim Financial, now
operations using a Musharakah-based model, called UM Financial, a division of the UM Group.
accompanied by Al-Ittihad investments and Al- This company began operations in 2004 offering
Yasur investments, providing a tax-advantaged a Murabahah product, but it has migrated toward

a Musharakah model. Funding for the company Salam Financial aims to be one of the competitors
was arranged through a Mudarabah line from a to UM, and has been working on creating a
consortium of credit unions; however, as at the residential financing product for some time (along
time of this writing, it has hit capacity at CA$120 with an Islamic bank), but in the meantime, it
million (US$96 million) and UM has been exploring has been providing limited commercial financing.
alternative funding arrangements in order to be able However, its growth has also been constrained by a
to again accept new applications. lack of resources.
Specifically, the UM Group launched a $100 million On the investment side, the first Shariah compliant
real estate fund (UM Real Estate Investments) to mutual fund was established in 1999 by the
further finance its residential housing transactions, Navigator funds, a division of Nova Bancorp Group
and privately placed more than another CA$5 Company. The SAMI (Socially Acceptable Market
million (US$4 million) over the last few years. Investments) Fund was launched in 1999, and later
sold to the Dynamic Mutual Funds.
While UM has investment products for retirement
savings and is supposedly working on other projects In 2006, Dynamic closed the fund (with a bit
such as deposits, venture capital, credit cards, and less than $7 million in assets). Of note, the fund
Takaful, it illustrates the current liquidity problems was shut down rather than merged into the
affecting North American Islamic finance providers. sponsors other funds to avoid contaminating the
The market is large enough to generate real dollars, SAMI shareholders funds with the unacceptable
but not large enough to have developed the investments they would wind up owning in the other
secondary market structures, such as the creation of Dynamic funds.
mortgage backed securities, to allow for the handling
of this volume. After the sale of the SAMI fund to Dynamic, one of
the funds founders, Asif Khan, went on to launch
In the meantime, prospective consumers are FrontierAlt in Toronto in 2003. In 2006, FrontierAlt
frustrated that UM cant handle their particular needs launched the Oasis Global Income Fund, and later
for financing. This, in turn, is motivating the creation added the Oasis Canada Fund and the Oasis World
of other competitors to UM; however, they also must Fund (all using the Dow Jones Islamic Market
arrange the necessary liquidity, which is a challenge in Indices). The company is looking to help Gulf
the face of the current global liquidity crisis. investors invest in Canada, as well as to provide fund
listing and operating services to Gulf funds, as well
While larger institutions such as the Royal Bank of as allow Canadian investors to invest in and out of
Canada have ventured into Islamic financing briefly Canada.
in the past, they decided there wasnt a sufficient
market to warrant their resources. To address private equity and asset management
needs, Ittihad Capital was formed in 2004, and,
The Royal Bank of Canada is again looking into shortly after, Ittihad Securities was added to provide
Islamic financing, but not necessarily looking at investment banking services in Canada. The
providing it in Canada; rather, it is looking to take companies now have offices in Calgary and Toronto.
advantage of the growth occurring overseas. The
Bank of Montreal is in the same position in its Canada, with its abundant natural resources, has
investigations into Islamic financing it sees also focused on this area in a Shariah compliant
opportunity, but perhaps not large enough in its manner, though not necessarily focused on Canadian
home country. commodities. The Miraj Sharia Gold & Precious

Metals Private Portfolio will arrange investments in progress difficult. This is temporary. Once credit
precious metals equities and bullion to meet investor markets begin to thaw, the gaps in product and
needs. service availability will begin to fill.
Finally, Canada has pulled ahead of the US in

Takaful operations, though that is not hard to
do. Co-Operators Group Ltd has developed
a homeowners Takaful product to add to its
conventional insurance line-up.
Summary of Public Financing Options in Canada

Residential real estate An-Nur (Ontario)
Housing Co-Operative
Ansar Cooperative
Housing
ISNA Housing Co-
Operative
Qurtuba Housing Co-Op
UM Financial
Commercial real estate Salam Financial
Real estate construction Ittihad Capital (real estate
development, not pure
financing)
Lines of credit N/A
Cash management N/A
Business and trade goods N/A
Microfinance N/A
Public investment funds The Oasis Funds
(FrontierAlt)
Private equity Ittihad Securities
Takaful The Co-Operators Group
SUMMARY
As can be seen, although there are growing Muslim
populations in parts of North America, there is
much work to be done in providing an array of
financial services that would be needed by people
living and working in these countries.
While the need is recognized, and there are

companies interested in responding to the demand;
current world economic conditions are making

Europe
Islamic finance is one of the most exciting areas of the global financial
sector at the beginning of the 21st century, and Europe is playing a vital
part in the industrys development in the new millennium.
The petrodollars that have boosted the Gulf countries over the last
five years, together with the vibrant economies of Southeast Asia, have
combined to bring Islamic finance to the forefront of the international
financial community. In the leading Islamic centers of the Gulf,
Southeast Asia and London, issuers are seeking to tap the financial
markets in a Shariah compliant manner. The rest of the world is catching
Chapter 6 on as well in what has been called a new Silk Road from Europe to
Japan and back across the Pacific Ocean to the US, issuers are looking
Regional Overview to take advantage of increasing investor demand for Shariah compliant
investment products.
By David Testa Oft-quoted figures from World Bank cite some 300 Islamic financial
institutions and funds with over US$250 billion of assets, growing at
10% to 15% per year, with a further US$200 billion worth of assets
located in the Islamic windows or divisions of conventional banks.
A report from Standard & Poors in November 2006 estimated the
potential of this market at US$4 trillion.
The backbone of this growth comes from a burgeoning global

population, with more than a billion Muslims worldwide. This includes a
rapid increase in non-Muslim countries and the following table outlines
the distribution of the Muslim population across various European
countries:

Regional Overview : Europe
Country Population (mil) Muslim population (mil) Percentage (%)

France 61.00 6.10 10.0
Germany 83.60 3.25 3.9
The UK 60.00 1.80 3.0
Italy 56.00 1.39 2.5
Netherlands 16.20 0.95 5.9
Spain 42.10 0.60 1.4
Sweden 9.30 0.40 4.3
Belgium 10.70 0.39 3.7
Greece 11.00 0.36 3.3
Austria 8.50 0.34 4.0
Denmark 5.60 0.19 3.4
Switzerland 7.80 0.25 3.2
Sources: OECD World Factbook 2005; EUMC report, Muslims in the European Union (2006)
This chapter will give a brief overview of relevant Structures involve the utilization of assets,
Shariah principles, examine the history of with an Islamic bank earning money through
Islamic banking in Europe and include an outline the provision of goods and services (rather
of the products available, highlighting recent than making money from lending money and
groundbreaking deals and the current market charging interest).
regulations as applicable to Islamic banking. It will Risk sharing the investor and investee
also look at the size of the European market with a must share the risk of all financial
final summary of the ways in which Islamic banking transactions.
products can be utilized by small and medium-sized Use of capital should not be left idle but
enterprises, going forward. put to use while profit is encouraged all
Islamic structures generate a return; for
example, rent or profit.
OVERVIEW OF SHARIAH Existence of assets Assets should be in
PRINCIPLES existence and rightfully owned before sale
for example, this prevents Islamic financial
The Shariah (the way or path) guides Muslims institutions (IFIs) from short-selling.
in all aspects of life, including financial and
commercial activities. Islamic finance applies the There are restrictions on what may form part of any
Shariah to the modern-day financial activity of Shariah compliant financing transaction:
Muslims and is derived primarily from the Quran
and the Sunnah, as recorded by the Hadith (sayings Interest (riba) The best known restriction
of Prophet Muhammad). Secondary sources of is that Shariah compliant transactions
Shariah are devised by scholars through consensus cannot earn interest but, as noted above, the
(ijma), analogy (qiyas) and extrapolation (ijtehad). generation of profit from the use of an asset
is encouraged.
There are five key characteristics of Islamic finance: Uncertainty (gharar) All parties to a
transaction should be adequately informed
Contract-based: Contracts are given great and not cheated or otherwise misled.
importance in the Quran and the Hadith.

Gambling (maysir). pro-rata portion of the income stream of the

Sector restrictions (for example, no pork, underlying asset.
alcohol, armaments or tobacco).
The application of these structures in corporate
The key structures are as follows: financing transactions is described in greater detail
later in this chapter.
Murabahah: The sale of an asset between
two parties where the seller of the asset
discloses the original cost price of the asset to
HISTORY OF ISLAMIC
the purchaser, often referred to as a cost- BANKING IN EUROPE
plus contract. The sale of the asset must
be immediate, although invariably the price It was illegal in Christian medieval Europe to charge
payable by the purchaser is deferred either interest on a loan of money, for much the same
by way of installment or bullet payment on reason Shariah principles forbid it: that, as money
maturity. is intrinsically unproductive, it is ethically wrong
Ijarah: A lease in which the owner of the to make money from money. The ecclesiastical
asset transfers its usufruct to another person loophole was that the Church allowed modest
for an agreed period and for an agreed rent. compensation over and above the amount due on
The subject of the lease should be valuable, a loan for the hazards and delays of repayment or
identifiable and quantifiable which has an any legitimate reason providing it was not intrinsic
usufruct during the lease terms and is not to the contract.
perishable such as consumer goods. The
Ijarah structure is the most widely used in Accordingly, there developed an array of structures
Islamic finance. designed to exploit this loophole, one of which
Musharakah: A form of partnership; and was the contractum trinius. This replicated a fixed-
in the context of a financing, the financier interest loan by combining three simultaneous
provides capital to the joint venture (JV) transactions,: an investment by the lender in the
partner, who may also contribute cash and/or borrower, an insurance contract and a profit-share
in kind but in all cases takes the responsibility arrangement for a fee, each acceptable in their own
of managing the new venture. The parties right under canon law. The simultaneous contracts
agree to share the profits of the JV between could be arranged to replicate any agreed interest
them and must also share the losses of the JV. rate while providing legal protection against default
Mudarabah: A form of limited partnership on one side and cover modest compensation on
where one partner gives money to another the other.
to invest in a commercial enterprise. The
profits generated by the investment are shared Nevertheless, it took centuries for usury laws to
between the partners on a pre-determined disappear in Europe and, indeed, Dante reserved
ratio. a special place for usurers in the seventh circle
Sukuk: Commonly referred to as an of Hell in Canto XVII of his Divine Comedy.
Islamic bond, a Sukuk is a certificate Pope Benedict XIV promulgated an encyclical Vix
which represents a proportional beneficial Pervenit: On Usury and Other Dishonest Profit as
ownership in the asset(s) underlying the issue late as 1745, and it has yet to be formally retracted.
(the singular form of Sukuk is Sakk, possibly
the source for the English word, check). In Medieval Latin, the term usuria was used
The Sukuk holder has a right to receive a interchangeably for interest and excessive interest;

much like the Arabic word riba is used today. But To accommodate the new and growing demand for
adherence to the Catholic Churchs proscriptions Islamic products, they have established business
had faded long before, as the Church retreated from lines known as Islamic windows, namely units
actively enforcing its social teachings on finance. or divisions which focus on Shariah compliant
banking inside a conventional financial institution.
By the time of the Enlightenment, the provision of This in turn has facilitated the growth of Islamic
credit and the practice of charging interest on loans banking in non-Muslim countries, including those in
had already become universally accepted as an issue Europe. Islamic banking and financial principles are
of political economy rather than theology. now applied in more than 70 countries, and some
300 institutions consider themselves to be Shariah
The conventional banking system that subsequently compliant.
developed expanded globally on the trade routes
of the great European empires. It was not until All this has meant that, in recent years, Islamic
the late 20th century that Shariah principles began banks have become increasingly sophisticated and
to be applied to the banking sector, with the first Shariah compliant structures can now be utilized for
initiatives taking place (not surprisingly) in largely a wide variety of purposes acquisition finance,
Muslim countries. project finance and asset finance, as well as balance
sheet financings. Transactions can be secured or
Dr Ahmad El-Naggar initiated the first modern unsecured, asset-based (fixed income equivalent
experiment with Islamic banking in 1963, in Mit products) or asset backed (securitizations requiring a
Ghamr, Egypt, when he began the Mit Ghamr minimum of 30% of physical assets).
savings project. Ahmads next initiative was of
even greater significance when, in consultation To date, in Europe, the UK has been the most active
with Tunku Abdul Rahman of Malaysia and country in the promotion of Islamic finance. Other
Prince Muhammad Faisal of Saudi Arabia, he set jurisdictions are now just beginning to explore
the framework for the creation of the Islamic the potential of Islamic finance. Four European
Development Bank (IDB) in 1975, based in Jeddah. jurisdictions are examined in greater detail below.
The mid-1970s also saw the first attempt at

the codification of Shariah principles with the
UK
formation of the Union of Arab Banks. Thereafter,
Since the early years of the new decade, the UK
the development of Islamic banking continued,
government, for reasons of wider public policy, has
albeit almost entirely outside Europe and at a slow
introduced a series of tax and legislative changes
pace until the burst of enthusiasm for the sector
specifically designed to remove obstacles to the
in the new millennium, with investors focused on
development of Islamic finance. The first significant
replicating traditional commercial banking functions
change came in the Finance Act 2003, which
in a Shariah compliant manner.
introduced relief to prevent multiple payment of
stamp duty land tax on Islamic mortgages.
The growth of Islamic finance, in particular its
spread across the globe, was assisted by interest in
The Finance Acts 2005 and 2006 contained
the sector from global banks. In particular, major
further measures aimed at widening the scope
international institutions have had a presence in the
of the legislation from retail to wholesale Islamic
Middle East and Southeast Asia for many years. As a
products and putting them on the same tax footing
result, they have developed considerable knowledge
as their conventional counterparts. More recently,
and experience of Islamic markets.

the Finance Act 2007 clarified the tax framework Any surplus in the Takaful fund is returned to
further, enabling UK corporates to issue Sukuk policyholders, while any deficit is protected by the
on the same footing (from a tax perspective) as a companys shareholders. The insurance company is
conventional bond issue. usually remunerated in one of two ways: either by
an agreed management fee (Wakalah) or a share of
The UK is home to the first wholly Shariah the surplus (Mudarabah). Principle Insurance has
compliant retail bank in the West, the Islamic Bank adopted the Wakalah model.
of Britain (IBB). This bank was authorized by
the Financial Services Authority (FSA) in August
2004. Since then, the FSA has also authorized the
FRANCE
European Islamic Investment Bank (EIIB, March
The Muslim community in France constitutes the
2006), the Bank of London and The Middle East
biggest Islamic community in Western Europe,
(July 2007), the European Finance House (January
numbering at just over six million, representing
2008) and Gatehouse Bank (April 2008).
approximately 10% of the countrys population.
As at the time of writing, the French financial and
Both the IBB and the EIIB are listed on the London
banking system does not offer access to a range
Stock Exchanges Alternative Investment Market,
of alternative products, although French financial
which is specifically designed for smaller, growing
institutions have been active in Islamic financing for
companies, combining the benefits of a public
some time, primarily outside the country.
flotation with appropriate levels of regulation.
Some UK financial institutions have also approached
Investment Dar, which owns half of British luxury
the French Banking Federation with a view to
car maker Aston Martin, plans to set up a bank in
offering Islamic financing and there are several
London to offer Shariah compliant services for
applications lodged with the central bank for
Gulf investors doing business in Europe. Other
licenses to operate Shariah compliant banks in the
Islamic banks are also thought to be in the process
country in order to tap the latent French market
of evaluating opportunities in London.
potential.
The Islamic insurance industry has also begun in the
In addition, the largest French banks have all
UK, with Principle Insurance Holdings being autho-
ventured into the Islamic finance sector. For
rized as the first dedicated Takaful insurance pro-
example, Socit Gnrale has funded several
vider in the UK in 2008. Principle Insurance (under
high-profile real estate deals in Paris and launched a
the consumer brand name Salaam Halal Insurance)
retail-focused Shariah compliant money market fund
provides unique, Shariah compliant (or halal) motor
in 2008.
and home insurance to British residents.
One of the most notable previous French Islamic
Takaful is different from conventional insurance in
syndications was the leveraged buyout by Innovalis,
that it is fully Shariah compliant and does not use
the property developer, of Castor and Pollux in
interest or invest in any industries that go against
2006. This was a EUR221 million (US$286 million)
Islamic teachings, although it bears some similarities
transaction with a term to maturity of four years.
to co-operative insurance.
The current French legislation and taxation system
As with co-operative insurance, policyholders
will, however, need to be amended to allow for
contribute money to a common pool (the Takaful
domestic Islamic financing transactions, services and
fund), which is then used to pay claims.

products. This will require several adjustments along Germany also requires legislative and tax
the lines of the UKs attempts at fiscal equalization, amendments to allow German Islamic banks to
although fresh challenges will be faced in adapting open. Considerations similar to those relating to
the Napoleonic code statutory framework France will apply and, although the government has
(compared to the common law system in the UK). not said it is looking at legislative changes, a number
of structures have been developed to address issues
Nevertheless, after the UK experience, France is lead- such as double real estate transfer tax.
ing the charge to be the next European country to
open up to Islamic finance. Indeed, in the second half However, it is worth noting that Germany saw the
of 2008, the French Ministry of Economy, Industry first quasi-sovereign Sukuk issue when the state of
and Employment and the French financial markets Saxony-Anhalt issued a EUR100 million (US$130
authority, the Autorit des Marchs Financiers, an- million) Sukuk Ijarah in August 2004.
nounced significant tax and regulatory changes aimed
at promoting Islamic finance in the country.
ITALY
These changes (confirmed in December 2008 by the
The current regulations do not allow banks to offer
publication of tax notices by the French Tax Ad-
Islamic banking services. Tax barriers include double
ministration) relate to the listing of Sukuk in France,
stamp duty (or registration tax) as well as value
the tax neutrality of Murabahah transactions (in the
added tax or VAT on Murabahah mark-up.
form of an exemption from registration duty) and
tax deduction on the remuneration of Sukuk.
There has, however, been recent talk of a Shariah
compliant financial institution being in the pipeline for
While further legislative changes for other products
Italy. What is beyond doubt is that in September 2007,
(notably Ijarah) will be required, there is little doubt
the Italian Banking Association and the Union of Arab
that the French government wishes to establish Paris
Banks entered into a memorandum of understanding
as a rival to London as a European hub for Islamic
to promote Islamic finance in Italy, including the
finance in Western Europe.
establishment of Islamic banks in the country.
GERMANY Consistent with these tentative steps at the

government level is the cautious approach to Islamic
With over three million Muslims, Germany offers finance adopted by the Italian banks. Of the leading
strong potential demand for banks providing retail institutions, Unicredit stands out as being the
Islamic financing. The German legal and financial most active, albeit primarily via its German bank
system, however, is not yet geared toward the subsidiary (formerly known as HVB).
development of Islamic domestic retail finance,
with many German Muslims putting their money
in savings banks. Islamic investors are beginning
OTHER EUROPEAN
to move into the German property market, if only COUNTRIES
tentatively. The presence of Islamic funds in the
German real estate market remains relatively small Historically, there have been one or two private
at the moment, although several leading German banks, established in Denmark and Switzerland, that
banks have been active in the capital markets and specialized in offering Islamic products and services.
wealth management sectors, perhaps most notably These institutions focused more on private banking
Deutsche Bank. and wealth management, however, than commercial

or wholesale banking. More recently, other Asset finance

European countries have also been looking at Asset finance on a Shariah compliant basis usually
Islamic finance offerings. Of note is the interest utilizes either a Murabahah or Ijarah structure.
currently under way in the Netherlands with Under an Ijarah contract, the financier will own the
several new initiatives expected in the foreseeable asset requiring finance and lease it in exchange for
future. periodic rentals. Once the cost price has been repaid
over the lease term, the title of the asset will be
transferred to the lessee.
PRODUCTS AVAILABLE
Products available to small and medium-sized Supplier
enterprises (SMEs) include trade/import finance,
asset finance, working capital, savings products,
commercial mortgages and Takaful. Also listed 1. Commodity purchase
below are some products that are applicable to more supplier
specialized financings.
Financier
Structure of Ijarah
Investors
2. Commodity 3. Deferred payment
$ investment to Lease proceeds
fund land plus repurchase
acquisition payment(s)
Purchaser
Sale of land and
lease back
SPV/Lessor
Land The principal amount of finance is equivalent to the
owner/Lessee value of the underlying assets
Service agency
agreement
Cost-plus: Deferred sale contract over a fixed
Ijarah closely reflects a conventional lease agreement,
period, with the bank marking up the price of the
applicable for property and capital goods
underlying asset when selling to the purchaser
The principal amount of finance is limited to the
value of the underlying assets A Murabahah transaction is a debt based transaction
and is therefore viewed in the GCC as not tradable
Whilst title does not pass to the lessee, the usufruct but can be transferred at par value
(benefit of use) does
NB: Difference between GCC and Southeast Asian
Day to day maintenance is the responsibility of the lessee interpretation over trading of receivables
Ownership related risks and expenses are borne by
The mark-up can, and usually does, relate to the
the lessor, unless an independent service agreement
prevailing LIBOR rate
is entered into between lessee and lessor
Subsequent to either a balloon or amortising pay- Payment default will require the buyer to cover the
ments, ownership can pass to the lessee at the end of sellers actual and proven cost of capital for this period
the lease period, if stipulated in a separate agreement
Heavily used in trade and export finance
Widely used in real estate and project finance
transactions NB: Not possible to revolve the structure

Trade/import finance asset is sold to the customer on a deferred payment

Import finance is based on the concept of Muraba- basis. The payment for the asset can be structured as
hah and is designed to finance the import of halal a bullet payment or through installments.
goods. In this instance, the financier will purchase
the goods and then sell them at a cost plus profit Depositor
on a deferred payment basis. The sale price of the (Rab al Mal)
goods is due either in a lump sum or installments.
Structure of Commodity Murabahah 1. Cash deposit on

4. Investment returns agreed terms
minus any agreedfees (restricted or
Participants unrestricted)
Step 1 to 6 are intra day

Investment manager
1. Participations (Mudarib)
2. Spot payment
Investment Metal 2. Cash investment
agent supplier on behalf of depositors,
3. Metals
3. Investment returns as per the agreed terms
4. Metals 7. Deffered
payment
Investment
5. Metals
Metals
Purchaser
buyer Savings
6. Spot payment These are offered for retail and wholesale
The entity requiring financing purchases a consumers. A standard method would be based on
commodity, often through an agent, on deferred Mudarabah (see diagram).
payment terms
Mudarabah is a form of limited partnership where
The purchaser of the commodity then immediately one partner gives money to another for investing in
sells it at spot to a third party a commercial enterprise. The first partner (Rab al
The purchaser has until the end of the deferred maal) provides the investment while the other partner
payment period to pay the original purchaser the (the mudarib) exclusively manages the investment.
agreed cost-plus price The profits generated by the investment are shared
between the partners in a pre-determined ratio.
Prime Islamic inter-bank liquidity product
Mortgages
Can be used as a revolving facility
Several banks in the UK offer Islamic mortgages,
including the IBB, Lloyds TSB and alburaq (owned
Working capital by Arab Banking Corporation [UK]). Ijarah and
This is financing for seasonality, growth, cash Diminishing Musharakah are the most commonly
management, consolidation, international and used methods, at least in the UK.
domestic market expansion, acquisitions and
receivables. This is often based on the concept of In an Ijarah contract, the finance provider buys
commodity Murabahah (or Tawarruq) where an the property and becomes the legal owner. The

customer agrees to buy the property from the erroneously, referred to as the Islamic bond.
provider at a defined price at the end of a set period, Strictly speaking, a Sukuk is not a debt product at all.
and signs a lease agreement to occupy the property.
At the end of the term, the legal ownership of the Another way of looking at it is to see the Sukuk as
property is transferred to the customer. a capital markets overlay to an underlying Islamic
structure. In that regard, it is clear that for a
In the case of Diminishing Musharakah (see corporate to consider issuing a Sukuk, it must be
diagram), the transfer of the ownership is gradual as able to satisfy certain essential criteria in relation to
the payments made by the customer gradually buys compliance with Shariah principles.
the providers equity in the property.
To begin with, the company must not engage in any
Structure of Diminishing Musharakah haram (forbidden) activity. Beyond that, the Sukuk
issue itself must be structured to ensure adherence
Bank to Islamic principles. The most famous of these
is perhaps the banning of riba, although profit
2. Home purchaser pays bank:
i) Amortising payments on principal is very much encouraged, as is risk sharing. One
ii) Rental amount on percentage of other major criterion is that an issuer must own the
home still owned by bank
asset or assets it intends to utilize in any particular
1. Bank
purchases
financing structure.
house House purchaser
Volume of Sukuk issued (US$ bil)
35
30
House
25
Source: alburaq
20
Takaful (insurance)
Like conventional insurers, Takaful companies can 15 32.5
generate a return based on an agreed management

fee (Wakalah) or a share of the surplus (Mudarabah). 10
There is one Takaful provider in the UK, Principle 14.6
13.6
Insurance Holdings (as mentioned above), with a 5
second having applied for authorization. 7.0
0.5 3.2 3.0
1.8
-
SUKUK 2001 2001 2001 2001 2001 2001 2001 2001
Sources: IFIS, Bloomberg

One of the most striking features of the recent
growth in Islamic finance has been the development
The Sukuk is nevertheless a highly flexible product.
of the market for issuance of Sukuk. This is
The Accounting and Auditing Organization for
the Shariah product used to access the capital
Islamic Financial Institutions (AAOIFI) lists 14
markets and (as mentioned earlier) is generally, if
authorized types of Sukuk, ranging from the familiar

Ijarah (sale and leaseback) and Sukuk Musharakah RECENT

(joint venture-based issues, a particular feature of
the Malaysian market), to more esoteric structures GROUNDBREAKING DEALS
such as Sukuk Muzraa (allowing Sukuk holders
to a share of the produce of agricultural land) or The volume of outstanding Sukuk issues
Sukuk Muqarasa (land and trees/crops). In the is estimated to be US$70 billion globally, a
brief history of the market to date, it is the Ijarah considerable portion of which is listed in Bahrain
structure which has featured most prominently. and Dubai. Europe has, however, started to follow
suit, with several issues now listed on the London
The Sukuk market is estimated to grow to Stock Exchange (LSE). The city recently took a
US$150 billion by 2010. Over the years, the Sukuk positive step toward becoming a global center for
market has become more diversified with new Islamic finance and a center of choice for listing
categories of issuers and more complex structures Sukuk by establishing the worlds first secondary
being used (securitization and convertibles in market for Sukuk.
particular). Historically, sovereign Sukuk, serving
as benchmarks, were immediately absorbed by the According to the Financial Times, trade volumes in
market, and demand has switched to alternative London rose from a trickle in December 2006 to
issuers of Sukuk (banks, corporates and structured). about US$2 billion in January 2007. The first Sukuk
The market has diversified away from the Asian was listed on the LSE in 2006. To date, 14 issuers
local currencies and US dollar, and offers more have chosen the LSE to list Sukuk, raising over
alternatives and diversification. US$5 billion.
The ball started to roll in Europe in August 2004,

DERIVATIVE PRODUCTS when the German federal state of Saxony-Anhalt
issued its EUR100 million Sukuk Ijarah (referred to
A small number of hedging products have been de- above). The issue was AA-rated and correspondingly
veloped by various banks for example, for man- was priced virtually flat to the Euro Interbank
aging currency and profit rate risk although the Offered Rate (EURIBOR) and this led to some
area of derivatives is a difficult one for Shariah and commentators to query the extent to which there
not without controversy in its product development. was widespread investor interest in this issue.
However, efforts are being made to advance these Nonetheless, it remains a landmark transaction in
instruments and the International Swaps and Deriva- Europe and the prime motives behind the issue were
tives Association (ISDA) and the International Islamic certainly satisfied, particularly in terms of investor
Financial Market (IIFM) have signed a memorandum diversification and in the words of the German
of understanding to develop a master agreement for regional minister putting the state of Saxony-
Shariah compliant derivative products. Anhalt in the limelight as a suitable and appropriate
area for economic investments.
FUNDS/HEDGE FUNDS
The obligor/guarantor in this instance was Saxony-
Several hedge fund managers have Shariah Anhalt, with the issuer being Dutch foundation,
compliant funds within their portfolios. In 2007, Stichting Sachsen-Anhalt Trust. The Sukuk was for
Amiri Capital was authorized in the UK by the FSA a maturity of five years with a lease and sublease
as a stand-alone Islamic hedge fund manager. There structure. The underlying assets comprised land
are in total nine Shariah compliant funds and one and buildings under the control of Saxony-Anhalt
hedge fund based in London. including tax offices.

Recourse to the issuer was limited to the trust assets eight-year commodity Murabahah facility used to
(to the extent they were contractual rights) and the acquire Aston Martin. This comprised a GBP200
proceeds of the trust assets were the sole source million (US$296 million) term facility and a GBP25
of payments on the trust certificates. Investors had million (US$37 million) working capital facility and
no recourse to any assets of Saxony-Anhalt. The was syndicated to banks both in Europe and the
issue was assigned an initial rating of AA- (S&P), GCC, as well as Southeast Asia.
was listed on the Luxembourg exchange and the
investor base comprised 60% from the Middle East Also worthy of mention in the UK was the recent
(particularly Bahrain and the UAE) and 40% from groundbreaking deal for Chelsea Barracks, signed
Europe. in 2008. This was a US$2.5 billion, 3-year Ijarah-
based Sukuk the largest wholly Shariah compliant
The first listing of a Sukuk in 2006 on the LSE was arrangement on a UK property transaction. It
for National Central Cooling Company (Tabreed). involved an innovative syndication and trust
As the contractor, Tabreed undertook to construct structuring to enable syndication within the UKs
and deliver, from time to time, three plants for alternative finance regime; thereby ensuring the
an agreed purchase price, payable in installments transaction receives the same tax treatment in the
by Tabreed 06 Financing Corporation, a special UK as for a conventional bank financing. The
purpose vehicle which was the issuer of the Sukuk. trust structure allowed pari passu hedging and
subordinated equity of redemption.
In order for the Sukuk to be tradable like
conventional bonds, from a Shariah perspective, the Syndicate
value of the assets held by the issuer had to be at
least one-third of the aggregate face amount of the
Investment agency
Sukuk to be issued. As Tabreed intended to deliver agreement
Rent
only one plant on the closing date, additional assets

needed to be identified for sale to the issuer on Vendor
Purchase price
Financier
the closing date. It was decided that commodities Title
(namely platinum) would be sold by Tabreed to the
issuer, pursuant to a commodity sale agreement, Lease Rent
thus ensuring tradability of the Sukuk from the
outset.
Customer
Even closer to UK domestic issuance was the

first-ever Sukuk issuance by Tesco. In 2007, Tesco The industry is also supportive of the idea of the
Stores (Malaysia) signed a RM3.5 billion (US$975 UK government issuing a sovereign Sukuk. Such
million) conventional and Islamic notes issuance an issue would provide a benchmark for pricing,
program. The inaugural RM700 million (US$195 enhance liquidity in the markets and boost Londons
million) Sukuk issue comprised a three-year RM400 ability to attract further Sukuk structuring activity,
million (US$111.5 million) Sukuk Musharakah and as well as further cement the citys prime position as
a five-year RM300 million (US$84 million) Sukuk the pre-eminent center for Islamic finance outside
Musharakah. Both had the corporate guarantee of of the Muslim world.
UK-based Tesco.
In April 2007, the UK government announced it
The first Shariah compliant syndicated acquisition would consider the feasibility of issuing wholesale
finance in the UK, signed in May 2007, was the sovereign Sukuk. After an extensive consultation

process during the second half of 2008, it finance and asset finance to fixed-income
concluded that doing so would not offer value for equivalent products. Islamic structures have also
money at the present time, while undertaking to been used in acquisition finance and leveraged
keep the situation under review. buyouts, as well as more traditional banking
products such as working capital facilities.
Though the government has postponed the issuance
of a sovereign Sukuk due to turbulent market condi- There are, of course, restrictions to bear in mind,
tions, it still supports the UK Islamic initiative with its not least of which is that the Islamic finance sector
continued program of tax and regulatory changes. globally is characterized by a substantial number of
small banks, with only a handful of Islamic banks
having balance sheets in excess of US$20 billion.
WHICH INDUSTRY SECTORS For that reason, at least initially, Islamic finance
WOULD BENEFIT FROM will be providing funding solutions for European
ISLAMIC BANKING? corporates in tens of millions of pounds, not
billions (not in itself a hurdle to financing the SME
One of the under-provided for areas of Islamic sector!).
financing in Europe after retail banking is that for
SMEs. This is somewhat of an anomaly as many In addition, there are sector restrictions which apply
Muslims in Europe run family or small businesses to Islamic finance: those corporates focusing on the
and one of the core tenets of Islamic banking is to production of alcohol, armaments or pork will need
work in long-term partnerships in order to ensure to look elsewhere.
profitable growth and benefits to both partners.
Those companies that do not operate in these
In the long run, Islamic banking should complement haram sectors will need to view the opportunity
its product offerings, particularly in Western represented by the Islamic finance sector as a long-
countries, where current offerings of Islamic term option (rather than simply opportunistic)
banking products are relatively low, with increased and will need to make assets available for use in
business in profit-and-loss sharing financing the structures; they will need to invest additional
techniques. This is likely to raise the attention of management time in closing their first Shariah
corporate and institutional investors and to stimulate transaction, and they will preferably already be active
competition. in the Middle East and Gulf countries (or otherwise
have links into or with those areas).
Another major consideration is the flexibility of
Islamic products, with Shariah compliant structures The potential for Islamic banks to work with the
able to be utilized in bilateral arrangements, club SME sector is profound. While many jurisdictions
deals, syndicated financings and Sukuk issues. In in Europe still have a great deal to do to catch up
addition, the structures can be used across the whole with the UK, the after-shocks of the cataclysmic
capital spectrum, from senior finance to mezzanine credit crunch will ensure the authorities will look
to equity positions, while Islamic funding can benefit to encourage and stimulate new sources of finance.
from security or be unsecured, and can be provided This will ensure that, although Islamic banking
on a drawn or stand-by basis. is still in its infancy, it displays a large potential
for growth. This growth potential is likely to be
There is also little limit to the purposes such particularly achieved in European countries with
financings can be used. This ranges from project significant Muslim populations, as well as in some
key Western financial centers, most notably London.

Africa
Home to nearly a billion people, the 54 countries that make up the

African continent are ushering in an era of liberty, democracy and robust
economic development. And with a predominant Muslim population of
about 490.92 million and an annual population growth rate of 2.5%, the
continent holds promising growth opportunities for Islamic finance.
However, as a prelude to assessing the expected penetration and growth

patterns for this industry in Africa, it is important to note that the
continent comprises a platform of vast contrasts. The differences range
from some of the worlds poorest countries, on a per-capita basis, to
Chapter 6 solid middle-income nations such as Botswana and Mauritius.
Regional Overview These contrasts are also evident in the financial sector where, for
instance, some countries such as South Africa boast a well-developed
and sophisticated financial system that is on a par with countries of
By Nathif Adam the developed world. For instance, more than 30 foreign banks have
branches and offices in the country and operate from there as their
regional headquarters.
CURRENT PRACTICES OF ISLAMIC

BANKING IN AFRICA
Even though Africa boasts the second most Islamized continent in the
world after Asia, Islamic finance on the continent is still in its infancy. At
the moment, active practice of Islamic banking and finance is existent
only in a handful of countries, as highlighted below.
1. Sudan
This is the only country in the entire Sunni Muslim world that boasts
a financial system wholly operational on the principles of Islamic law
(Shariah).
After Shariah was established in Sudan in 1984, the banking and financial
industry made appropriate reforms to operate in accordance with
government plans. However, complete conversion of the banking system
only occurred in 1993 when the Sharia High Supervisory Board or SHSB

Regional Overview : Africa
was established to ensure compatibility with Shariah was anathema to the political regime. The pioneering
principles. effort led by Ahmad El Najjar took the form of a
savings bank based on profit sharing in the Egyptian
Accordingly, the majority of financial institutions town of Mit Ghamr in 1963.
currently operating in Sudan, including the Bank
of Sudan (the central bank), adhere to Shariah This experiment lasted until 1967, by which time
principles. For instance, the central bank employs nine such banks had sprung up in the country. These
Islamic banking instruments to conduct its monetary banks, which neither charged nor paid interest,
policy operations. invested mostly in trade and industry, directly or in
partnership with others and shared the profits with
In this regard, the central bank does not issue their depositors. Thus, they functioned essentially
treasury bills and government bonds to raise as saving-investment institutions rather than as
money; instead, it sells financial certificates that commercial banks.
comply with Islamic financial principles. The most
prominent of the Sudanese Islamic banks include: The Nassir Social Bank, established in Egypt in
1971, was declared an interest-free commercial bank,
Faisal Islamic Bank of Sudan (FIBS); although its charter made no reference to Islam or
Islamic Cooperative Development Bank; Shariah.
Tadamun Islamic Bank of Sudan;
Sudanese Islamic Bank; It is certainly unfortunate that Egypts pioneering
Al-Baraka Bank; role in Islamic banking was not allowed to prosper
Islamic Bank of Western Sudan; and in the country but was instead turned over to the
Bank of Northern Sudan. Gulf states, where the system apparently found a
more welcoming environment.
However, following the comprehensive peace
agreement signed in January 2005, which ended 21 Currently, there are only two Islamic banks in Egypt
years of war between the Islamic north and south (Faisal Islamic Bank and the Egyptian Saudi Finance
Sudan, the southern part of the country was at Bank) in addition to some of the Islamic outlets of
liberty to implement conventional forms of banking. conventional banks.
In fact, in accordance with Article 14.1 of the A third Islamic bank, the Islamic International Bank
Framework Agreement on Wealth Sharing, the for Investment and Development, was merged a few
parties have a protocol agreement to have a dual years ago with two other conventional banks (United
banking system in Sudan during the interim period Bank of Egypt and the Nile Bank). Together,
in which an Islamic banking system shall operate in they constitute one financial structure working
Northern Sudan while conventional banking rules in conventionally under United Bank, of which 99.9%
Southern Sudan. is owned by the Central Bank of Egypt.
2. Egypt 3. Tunisia
It is widely accepted that Africa (in particular, Islamic banking in Tunisia was introduced by Bank
Egypt) paved the way for Islamic banking as Et-Tamweel Al-Tunisi Al-Saudi, a unit of Albaraka
an industry. The first modern experiment was Banking Group. Commencing operations in 1983 as
undertaken in Egypt under cover, without projecting an offshore bank permitted to accept deposits from
an Islamic image, lest the exercise would be seen as residents and provide a range of Shariah compliant
a manifestation of Islamic fundamentalism, which services, Et-Tamweel also took deposits, provided

finance facilities and invested in key economic etary Council or CMC to operate through a subsidiary
sectors such as agriculture, industry, tourism and (Al Salam Bank Algeria) in the Algerian capital.
export.
5. South Africa
It also undertakes investments by participating Al Baraka Bank is the only full-fledged Islamic bank
directly in the capital of Tunisian companies or in South Africa. It is owned by the Saudi Arabian-
indirectly through investment funds. It currently has based Dallah Albaraka group, South African
eight branches, having doubled its branch network investors, DCD London and Mutual, a company
steadily from four in 2003. incorporated in London and Wales. It is well
established in South Africa as a Shariah compliant
Also, in a recent development, Tunisia appeared to institution operating within the confines of the
give Islamic finance another nod in what was seen South African banking regulations.
largely as a gesture to encourage investment inflows,
on which the countrys fast-growing tourism and Al Baraka has its headquarters in Durban and six
real estate industries depend. Dubais Noor Islamic branches in different regions of the country. The
Bank opened a representative office there in 2008 to addition of a corporate branch attached to the
enable the bank to gain a foothold for opportunities existing Cape Town branch will bring its corporate
in the Maghreb. financing to two branches. The board of Shariah
advisors consists of South African scholars who
4. Algeria interact periodically with the international board of
Banque Al Baraka dAlgerie was the first banking advisors of the Al Baraka group.
institution to start operations in Algeria. Established
on the 20th May 1991 with a mixed capital (public In addition to the board of advisors, within the
and private) of DZD2.5 billion (US$33.2 million), precincts of each branch, a regulatory officer checks
it began operations in September 1991. Its each transaction for any irregularity that may have
shareholders are the Bank of Agriculture and Rural crept into a transaction.
Development (Algeria) and the Dallah Albaraka
group (Saudi Arabia). The bank has both Muslim and non-Muslim
clientele. A senior official at the bank attributed this
Governed by the provisions of Law No 90/10 of interest from non-Muslims to the better proposition
the 14th April 1990 relating to currency and credit, regarding asset financing as the bank offers a fixed
the bank is entitled to carry out all transactions of rate repayment scheme over a seven- and 10-year
financing and investment in conformity with the period.
principles of the Shariah.
6. Gambia
The bank, a subsidiary of Bahrain-based Albaraka Arab Gambian Islamic Bank (AGIB) is the sole
Banking Group, has 17 branches in Algeria with Islamic bank in Gambia. It was incorporated under
plans to open another 33 in the next five years. the Companies Act 1955 on the basis of Islamic
Earnings rose 34% in 2007, while total assets principles under the Financial Institutions Act 1992
increased by 35% to US$846 million. The return on and as amended in 1993. The amendment was
average shareholder equity was higher than 24%. enacted by Parliament to enable the establishment
of Islamic banks in Gambia.
The second Islamic banking institution to open in
Algeria is Al Salam Bank Bahrain, which in 2008 ob- AGIB commenced operations in January 1997 in
tained the approval of the Algerian Credit and Mon- accordance with Shariah principles and practices,

with a view to making a profit for its shareholders And with the release of the regulatory framework
and depositors, and to contribute to the socio- on Islamic banking by the Central Bank of Nigeria
economic development of the republic. (CBN) in February 2009, everythings set for its
first Shariah compliant bank to commence full
Apart from providing products and services commercial operations as soon as possible.
traditionally rendered by conventional banks, AGIB
grants financing facilities for short-, medium- and Alhaji Mohammed Mustapha Bintube, managing
long-term economically viable undertakings. director of Jaiz International, has confirmed that the
bank will open its doors before the end of the year.
The bank is thus mandated to carry on both
commercial and development banking activities and, Alhaji attributed the delay to a change in policy by
at the same time, trade in commodities. Additionally, the CBN, which had earlier raised the minimum
it assists the disadvantaged in the community. Until capitalization for new banks from US$17 million
recently, the banks ownership structure was as to US$170 million. He also cited the lack of a
follows: regulatory framework by the CBN and the global
economic crisis as other factors for the delay.
Shareholders Country
Islamic Development Bank Saudi Arabia Nigeria is not only the most populous country in
Social Security and Housing Gambia West Africa with a population of 140 million (about
Finance Corporation 60% of whom are Muslims), it is also the largest
Gambia National Insurance Gambia economy.
Company
Arab and Gambian Egypt & The Gambia 8. Kenya
businessmen Kenya entered the history books as the first country
in East and Central Africa to allow Islamic banking
However, the bank in October 2008 off-loaded up when the Central Bank of Kenya (CBK) formally
to 70% of its shares to a Nigerian bank (FinBank), licensed First Community Bank (FCB) on the
thereby reducing Islamic Development Bank (IDB)s 29th May 2007 as a full-fledged Shariah compliant
stake to 15%. The move to partner with FinBank commercial bank. This achievement was the
was a strategic one, geared at providing more culmination of concerted efforts spanning more
additional capital, and bringing in technological and than 20 years fronted by the writer, who is also the
human resource management. CEO.
Consequently, FinBank now has a controlling FCB, currently one of only two full-fledged Shariah
interest in AGIB although the bank will be run compliant banks in Kenya, is a private East African
purely on Shariah principles. business initiative owned mainly by business entities,
including major trading houses in the oil and
7. Nigeria petroleum industry, and by individuals in different
In response to demand from Nigerian Muslims professional fields. The bank kicked off operations
for a bank that meets their religious, moral and with an initial paid-up capital base of US$15 million.
ethical aspirations, a number of corporate bodies, This, however, is expected to be doubled in the next
individuals and Islamic organizations made few months.
concerted efforts, culminating in the incorporation
of Jaiz International Bank in 2003. To stamp its mark across the country, FCB fast
tracked the opening of branches which in nine

months numbered six across the country. Work is Gulf African Bank, which received CBK approval
under way on five more and the plan is at least 10 to later in 2007, is the second full-fledged Shariah
be operational by the end of May 2009. compliant bank in Kenya. The bank is owned by a
consortium of largely foreign investors including
The bank expects to stay on its expansion path Bank Muscat International and Istithmaar, a Dubai
until a proposed target of 20 branches is reached government agency. Another investor is the PTA
within its first two years of operation. A number of Bank of Kenya. The bank currently has eight
these branches will be located in the newly formed branches nationwide.
districts, particularly in the Muslim-dominated
North Eastern Province where banking services are
currently unavailable.
CONVENTIONAL BANKS
EMBRACE ISLAMIC
The bank is also in contact with its counterparts BANKING
in other East African capitals, and aims to roll out
branches in those places in the near future. A notable growth pattern for Islamic banking in
Africa is the many conventional banks turning to the
FCB has also moved quickly into the financing provision of Shariah compliant banking products
aspect of its business using the main Shariah through Islamic windows. Institutions such as the
contracts of Murabahah (cost plus mark-up), National Bank of Egypt, FinBank of Nigeria, ABSA
Mudarabah (working capital) and Diminishing Bank of South Africa and Barclays Bank of Kenya
Musharakah (partnership financing). are rushing to meet the demand from their Shariah-
conscious clients.
These contracts are used by the bank to meet all
the financing needs of its clients including personal In Egypt, there are 13 conventional banks with
finance, business finance, bridge finance for Islamic windows and Islamic finance products are
construction projects and trade finance. offered through 128 of these branches.
Similarly, the bank recently embarked on micro- In Kenya, as a precursor to the licensing of full-
credit finance through a dedicated product known as fledged Islamic banks, the CBK had in 2005 allowed
Boresha (empower in Kiswahili). The product Barclays Bank of Kenya to begin offering an
has received overwhelming response from clients interest-free current account. The account, which
especially womens groups, who have awaited the was called La Riba, was designed to address the
introduction of this sort of Shariah compliant sensitivities of the customers who adhere to the
initiative for so long. Islamic faith.
During 2008, the bank also made important strategic Other conventional Kenyan banks followed the
link-ups with development-oriented government Barclays example and have since established interest-
institutions such as the Youth Enterprise free current accounts, particularly so in the light
Development Fund, which selected FCB as one of competition from the new Islamic banks. They
of only four banks in the country to work with the include:
fund in the dissemination of its financing portfolio.
FCBs participation is aimed largely at ensuring Kenya Commercial Bank
that the financing support available from the fund National Bank of Kenya
reaches Muslim youth in the country in a Shariah Imperial Bank
compliant manner.

Dubai Bank continent awakens to the ideological and practical

Chase Bank richness as well as relevance of this form of
alternative banking.
IDB BOOSTS INITIATIVES With about half of the African population being
IN AFRICA Muslim, Islamic banking services are bound to
grow at a rapid rate. This will ensure satisfied clients
In addition to the countries discussed in this article, both financially and spiritually. Even in sub-Saharan
there are several on the continent where Islamic African countries, Muslim populations are sizeable
banking operations have been established, with seed and create a considerable demand for Islamic
capital coming from the IDB. These include Senegal, banking services.
Benin, Mali and Mauritania.
The avoidance of unethical investments (haram
Also, the increasing importance of Islamic finance products), discouraging of exorbitant interest
in Africa is reflected in IDBs enhanced status as rates and prohibition of speculative structures are
an investor in member states of the continent. For all virtues that should appeal beyond the Muslim
example, it has provided US$48 million to finance populations of the continent.
the construction of the 66MW Bel Air C6 power
plant in Senegal, which was completed by developer The system should equally be a powerful tool for
Wrtsil in February 2008. enhancing access to development finance and
empowering the poor and vulnerable, particularly
The Finnish company has already completed the if Islamic banks extend their reach in rural areas
Farcha plant in Chad with EUR22.9 million (US$31 that are currently not effectively served by the
million) in IDB funding and is expanding the conventional banking system.
Kounoune I power generation facility in Senegal,
this time with a EUR21 million (US$29 million) loan While progress is being made, several challenges
from IDB. need to be addressed to enable more penetration
of the offerings on the continent and to unlock the
By using its resources to help finance projects that potential of this growing industry. However, the
encompass both development and investment goals challenges may be transitory in nature and typical of
in sub-Saharan Africa, IDB is helping to achieve any new emerging industry.
its founding objectives. Hence, it seems clear that
IDB and Islamic financial institutions will play an In reality, the prospects for Islamic banking in Africa
increasingly important role in Africa over the next overshadow the challenges, and the terrain seems
decade. naturally conducive since there is high demand for
Islamic financial services, both among potential
POWERFUL TOOL customers and investors.
Traditionally, the banking and financial system in

Africa has been based on interest dealings. This,
of course, left no alternative for its huge Muslim
population. However, with the new wave of Islamic
banking in countries such as Kenya, the appetite
for such financial products is on the rise as the

Gulf States
Bahrain, Kuwait, Oman, Qatar, Saudi
Arabia and the United Arab Emirates
The global Islamic financial sector, which has seen encouraging growth
over the last decade, is estimated to be worth US$1 trillion, and looks
set to be the worlds fastest-growing financial sector in the coming years
with an estimated global potential of US$4 trillion.
Some latest statistics indicate that the number of Islamic financial
Chapter 6
institutions (IFIs) has exceeded 300, spread across more than 75
countries including 110 Islamic Takaful companies and other Shariah
compliant investment funds. Islamic bonds or Sukuk have turned out
Regional Overview to be an important driver in raising finance under the Islamic mode of
financing. However, the Islamic finance sector was not entirely spared
from the credit crunch either, as evident by the lower volume of Sukuk
By Global Investment issuance in 2008.
House The Gulf Cooperation Council (GCC) region accounted for 56% of
global Sukuk issuance. The UAE market continued to lead, with a total
of 10 Sukuk issuances worth US$5.3 billion during the first nine months
of 2008 (9M2008). Saudi Arabia was the hardest hit, witnessing a decline
of 70.8% (from US$1.66 billion worth of Sukuk up until 9M2008 as
compared to US$5.7 billion in 9M2007).
GCC Sukuk issuance

Country 9M2007 9M2008
No of issues Total size No of issues Total size
(US$ mil) (US$ mil)
UAE 6 6,590 10 5,300
Saudi Arabia 5 5,716 3 1,669
Bahrain 20 710 18 597
Qatar 1 300 2 301
Kuwait 4 835 1 190
Total 36 14,151 34 8,057
Source: Zawya Sukuk Monitor

Regional Overview : Gulf
SUKUK STRUCTURES Sukuk Murabahah: It is a process of direct

structuring of securities wherein a special purpose
In todays business practice, the term Sukuk vehicle (SPV) invests the funds raised through the
means a claim similar to that represented by a trust sale of Sukuk in Murabahah operations.
certificate. In essence, it is a financial instrument
that sits above a Shariah compliant underlying The company purchases the asset from the SPV
structure and generates an income for the holder. on a Murabahah basis, and the future periodic
Islamic finance has many qualities that could lend installments paid by the company to the SPV
themselves to securitization as a means of raising account for the repayment of the cost and the profit
funds. component.
There are many structures that can generate the Sukuk Ijarah: The company seeking to raise finance
revenue paid to Sukuk holders. Most issuances to through the issuance of Sukuk Ijarah (the originator)
date have been wholly asset-based rather than asset sells certain assets to the issuer. The issuer then
backed. In an asset-based Sukuk, Sukuk holders rely pays for the assets using the proceeds of the Sukuk
for payment on the company seeking to raise finance issuance and holds title to the assets on trust for the
(the originator), in the same way as they would under Sukuk holders.
a corporate bond issue.
The issuer leases the assets back to the originator
In an asset-backed Sukuk, the Sukuk holders rely for a stipulated period. Upon maturity, the originator
on the assets of the Sukuk for security. Incidentally, may have the right to repurchase the assets at a price
the issuance of convertible and exchangeable Sukuk that would represent the redemption value for the
constitute more recent developments. Sukuk holders at maturity.
The Accounting and Auditing Organization for Sukuk Musharakah: Several corporate entities refer
Islamic Financial Institutions (AAOIFI) is mainly to these as Musharakah Term Finance Certificates
responsible for formulating and implementing (MTFCs). Under Sukuk aMusharakah, the Sukuk
international Islamic finance standards in the holders contribute a capital amount to the issuer.
market. There are about 14 different types of Sukuk
described as permissible under the AAOIFI Shariah The issuer then enters into a joint venture with
standards on Sukuk. the party seeking finance (the originator) where
the issuer provides the capital received from the
AAOIFI, based in Bahrain, has issued 68 standards Sukuk holders, and the originator supplies the assets
and is supported by more than 160 institutional and/or its own capital required for the business to
members. In terms of the types of Sukuk issued, function.
Sukuk Ijarah was the most popular among corporate
and governments wanting to raise funds in the Profits from the Musharakah business are
Islamic debt markets. distributed to the issuer and the originator on a pre-
determined basis.
Sukuk Ijarah issues contributed 43.6% of total
issues, followed by Sukuk Musharakah at 27.5%, Losses, if any, are shared in proportion to the
and then Sukuk Mudarabah at 1 .4%Some of the capital contribution, and the issuer pays a periodic
popular types of Sukuk discussed here are Sukuk distribution amount to the Sukuk holders from the
Murabahah, Sukuk Ijarah and Musharakah. Musharakah profit distribution.

SUKUK POTENTIAL NOT TO According to London-based Trowers & Hamlins,

despite an increase in return from US bonds,
BE UNDERESTIMATED Western investors are keen about investing in Gulf
Sukuk because of their strong real value and low
The increase in demand, along with the risk. The international law firm said the issuance of
standardization of Islamic financial instruments, is corporate Sukuk in the region, which controls more
expected to fuel the growth of the Sukuk market in than 45% of the worlds recoverable oil resources,
the coming years. Moodys expects the Sukuk market has jumped nearly 20-fold over the past five years
to hit US$200 billion by 2010 and has predicted it because of strong appetites for such tools.
will expand by up to 35% during 2008. The UAE
and Malaysia remain the most active markets for Data from the Dubai International Financial Centre
Sukuk. indicates that the total value of Sukuk is estimated
at US$88 billion, while US$13 billion worth is listed
According to news provider the Zawya, Gulf states on the Dubai International Financial Exchange or
raised US$18.7 billion, or 55%, of the total US$33.4 DIFX .
billion Sukuk issued worldwide in 2007. With Sukuk
constituting more than 40% of all bonds issued A report by a Standard & Poors (S&P) analyst
in Malaysia, the country has rapidly developed its put total Sukuk issuance at US$14 billion in the
market name in the Islamic world. eight months ended the 31st August 2008 , down
from US$23 billion in the previous corresponding
In Malaysia, Sukuk had surpassed conventional period. Nevertheless, the analyst still expected Sukuk
bonds for three years running with an annual issuance to reach US$20 billion to US$25 billion in
turnover of above US$15 billion. Growing wealth in 2008, given the good pipeline.
the Gulf is stoking demand for Shariah compliant
products in the Middle East and Asian regions. GCC Sukuk issuance by sector
Such opportunities will also give investors the Congkinerates
opportunity to diversify their investments rather 2%
being concentrated in developed countries only. Construction
It is estimated that investors from the GCC and 3%
Financial services
Asia Pacific currently hold US$267 billion in Shariah 8%
compliant assets. Rising demand for Islamic financial
products has led financial managers to increasingly
look into innovative structuring of Shariah
compliant financial products that will better fulfill
Government
the needs of clients.
11% Real estate
42%
The prospects of Gulf-based pension funds and
insurance operators looking at investing in Sukuk
Oil and gas
as part of their investment strategy could provide 17%
an invaluable impetus to the development of the
Islamic finance industry. The Sukuk market is the Power and
utilities
fastest emerging form of Islamic finance, which is
17%
estimated to be increasing at an annual average rate
of 40% spurred by the high levels of surplus savings
and reserves in the Middle East and Asia. Source: Zawya Sukuk Monitor

With the development of secondary markets, Sukuk The DP World second Sukuk with an issue size of
offerings are appearing on specialized exchanges US$1.5 billion carried ratings of A1 and A+ by
such as the DIFX [NASDAQ Dubai?] and the Moodys and S&P respectively; DIFC Sukuk with an
Labuan Exchange in Malaysia. Even the Kuwait issue of US$1.25 billion was rated A1 by Moodys
Stock Exchange has indicated its interest in setting and A+ by S&P; Aldar Properties Sukuk II with
up a market for conventional and Islamic bonds. an issue size of US$3.75 billion carried ratings of
A3 by Moodys and A- by S&P; and DEWA
According to a study done for the International Sukuk with an issue size of US$3.2 billion carried
Monetary Fund, strong demand from Muslim ratings of A1 by Moodys and AA- by Fitch.
countries and conventional global institutions for
Shariah-principled bonds would boost the potential
for Sukuk despite the global credit crisis.
SHARIAH COMPLIANCE
RISK
However, it highlighted that some critical constraints
relating to continued legal uncertainty and regulatory Besides other risks related to financial products and
divergences ought to be addressed. services, Islamic financial products carry a specific
risk, known as Shariah compliance risk (broadly
Real estate companies dominated the Sukuk market, abiding by the Shariah laws). Specifically, this risk
with a total of eight Sukuk issuances worth US$4.85 refers to the loss of asset value as a result of the
billion raised during 9M2008 as compared to seven issuers breach of its fiduciary responsibilities with
worth US$3.42 billion raised during the previous respect to compliance with the Shariah.
corresponding period.
There could be several such instances of wilful or
Many corporate issues particularly large ones innocent breaches. The dissolution clauses of the
are quasi-sovereign and, as such, are seen to Sukuk prospectus define events that will render
benefit from an implicit sovereign guarantee. Thus, the Sukuk deed null and void due to Shariah non-
although these issues may be linked to an underlying compliance.
asset, investor appetite is driven primarily by the
sovereign nature of the risk. For example, if the Sukuk is based on a hybrid
of Ijarah and Istisna assets, Ijarah must always
It also helps explain successful large-scale outnumber Istisna in the pool; otherwise, the Sukuk
placements that have been made in recent years, deed will dissolve.
including two Dubai-based issues of US$3.5 billion
in 2006. Thus, broadly speaking, Shariah compliance risk
must be defined as a rate of return foregone in
Currently, the top originators are Nakheel, the Dubai comparison to the market rates, as a result of
Ports, Customs and Free Zone Corporation (PCFC), complying with the Shariah. The issue hence is that
Aldar Properties and DP World of the UAE; Saudi of competitiveness and survival in capital markets as
Basic Industries Corporation (SABIC) of Saudi a Shariah compliant asset class.
Arabia and Nucleus of Malaysia.
A recent controversy arose in the international
Together, they represent about 31% of total world markets following the news that the chairman of
Sukuk issues. The majority of these carry good the AAOIFI Shariah board had decreed most bonds
ratings from global rating agencies such as Moodys, issued as non-Shariah compliant.
S&P and Fitch.

INCREASING POPULARITY The demand for Islamic financial investment

structures continues to rise, particularly those
AMONG NON-MUSLIMS related to the property sector. In a global first,
Singapore-listed Cambridge Industrial Trust is being
Sukuk offerings, while still concentrated in the transformed into an Islamic property trust.
Gulf states and Malaysia, are a rapidly growing
business with involvement by private companies, National Australia Bank has also shown interest
state enterprises, sovereign governments, Islamic to invest US$35 million for a stake in one of
financial institutions and non-Muslim international the worlds first listed industrial property trusts
institutions. The increasing interest from non- according to Shariah law. It will be the first publicly
Muslim participants in the Shariah compliant listed Shariah compliant real estate investment trust
financial system further promotes the growth of (REIT) in Singapore.
such facilities.
Hong Kong is among the latest to announce its
The World Bank issued its first local-currency incursion into Islamic finance and plans to send
denominated RM760 million (US$200 million) missions to Kuwait, Saudi Arabia and UAE to
Sukuk in 2005. work more closely on such projects. It is also been
reported that the Hong Kong Airport Authority is
A noteworthy and pioneering sovereign Sukuk considering a Sukuk issuance.
offering was completed by the provincial
government of Saxony Anhalt in Germany. The In Japan, the Financial Services Authority has
German Sukuk raised EUR100 million (US$135 proposed an amendment to its banking law that will
million) from both Middle Eastern and European allow local banks to offer Islamic finance products
investors. Following these developments, UK prime through a subsidiary. Globally, it was during the
minister Gordon Brown expressed interest in last decade that multinational financial institutions
making London the gateway for Islamic finance in like Deutsche Bank, Citigroup, Barclays and HSBC
Europe. entered the sector.
Global Sukuk issuance

35,000
30,000
25,000
(US$ mn)
20,000
15,000
10,000
5,000
0
2004 2005 2006 2007 Sep 08
GCC International
Source: Zawya Sukuk Monitor

OUTLOOK FOR 2009

Going forward, we expect Islamic finance
instruments to maintain their appeal. According
to London-based Gatehouse, Islamic banking in
the UK with the backing of its government is
expected to esurpass its current level of 2% of the
countrys total banking assets in the coming years.
The outlook on Sukuk is still positive as demand for
these bonds may prove to be more resilient than that
for their conventional counterparts in 2009 as risk
appetite lowers.
The combination of the generally lower risk profile

of Shariah compliant instruments and relatively
higher liquidity in the Middle East, where the
majority of Sukuk are marketed and sold, could
lead Sukuk issuance to gain market share against
conventional debt instruments.
Overall, as the Islamic finance industry grows, higher

transparency and uniformity (as per the compliance
with Shariah rules) is required for its products. With
the increasing number of international financial
institutions participating in the industry, product and
service innovation will benefit both corporates and
consumers. Such ventures will not only boost the
development of the Islamic financial system but also
enable major world economies to tap capital from
the oil-rich Muslim states.

Malaysia
Islamic finance is now considered mankinds mega event of the

millennium, one that is clearly reshaping the worlds economic and political
strata. The huge paradigm shift experienced has the potential to strengthen
international financial linkages between countries, particularly the Islamic
ones, and also to help bring greater economic prosperity to all.
Islamic finance is intended to contribute toward a more optimum

allocation of wealth across borders and among the worlds population,
with at last a hope of seeing greater participation from the 1.8 billion
Muslims in economic activities along with everyone else on an equal
Chapter 6 footing.
Regional Overview Malaysia took it upon herself to rebuild and develop the Islamic finance
industry in the 1960s following independence from Great Britain in
1957. The industry was introduced purely from a developmental agenda
By Badlisyah Abdul perspective and has nothing to do with the growth of oil wealth in
Islamic countries. This has remained the agenda until now.
Ghani
At a time of adverse political and economic situations, the Malaysian
government boldly decided to build the industry through trial and
error. The effort was greeted with absolute cynicism globally and utter
disbelief locally.
It has been a great 46-year journey, and we are now seeing the regulatory,
legal and legislative model established in Malaysia used as a universal
model for the industry and is emulated by many jurisdictions all over the
world.
To appreciate the historic development of and milestones achieved

by Islamic finance in Malaysia, it is crucial that one understands the
origins. Islamic finance is a comprehensive financial system that adheres
to lifes principles as provided under the Quran (the words of Allah)
and the Hadith (the words, actions and acknowledgements of Prophet
Muhammad), known as Shariah.
It was the financial system of the known world developed under the
reign of the Muawiyad and the Abbasid Empires from the years 661

Regional Overview : Malaysia
to 850. It continued to be a vibrant and significant As such, great Malaysian thinkers both from the
financial system of the known world spearheaded by public and private sectors got together and agreed
great human civilizations in Andalusia (Spain) until that an immediate solution must be found. That
the year 1031, in Granada until 1492, in the Malacca solution came in the form of an Islamic finance
Sultanate (1511) and in the Ottoman (Turkey) until industry.
1918.
Although the solution was clear, it could not
It is a system that has existed over the last 1,426 be reintroduced immediately because a lot of
years but has been somewhat subdued for the last knowledge had been lost and the conventional
500 due to Muslims and their countries, the centers riba-based financial system inherited from the
of this civilization being colonized by foreign British prevented Malaysia from implementing the
powers. industry effectively and efficiently. The Malaysian
government, with quiet resolve, pushed the agenda
The world is only slowly relearning what has been through as it was crucial to survival as a new
available under the system in the last 80 years sovereign nation.
since these countries achieved independence from
the occupying powers. Malaysia, being the center Curiously, the beginnings of Islamic finance in
of Islamic finance throughout the empire of the Malaysia did not start from the formation of an
Malacca Sultanate, has been in the forefront of this Islamic bank. It started in 1963, after much debate,
modern-day development. when the Tabung Haji (Pilgrims Fund) was formed
and it was done outside of the financial market
After independence from Great Britain, Malaysia framework as it could not at that time facilitate the
was in rather bad shape, poor and burdened by a operation of an Islamic bank.
population that was segregated, from an economic
wealth perspective. The dominant Muslim-Malay Through Tabung Haji, Malays could for the first
majority was found to be predominantly poor and time save their money in a formal institution and
economically challenged. enjoy good returns on their deposit. Practically
overnight, millions and eventually billions of ringgit
One of the main reasons for this was because the were taken out from under pillows and mattresses
majority of Muslims in Malaysia, as is the case and pumped into the formal economy. For the first
in most other Muslim countries, could not and time, a lot of Malays participated in the nations
would not participate in the conventional financial economic activities.
system left behind by the foreign powers, due to
their religious beliefs. Many were keeping their Nonetheless, Tabung Haji was not enough to
money under the pillow or mattress, and even some cater to the needs of this group. This section
who were discerning economically sought out the of the population needed the same economic
services of post office or banks at the time but sophistication that can be found in the conventional
refused to accept any return payment derived from riba-based financial market. Tabung Haji was
interest charges. merely a savings institution.
As a result, their wealth became stagnant and the What was needed was a full-blown financial market
country could be said to have had a black economy. that adheres to Shariah within the nations broader
This was seen to be unhealthy and a threat to the financial market framework to give the Malays full
well-being of the new sovereign nation and her access to financing, investment opportunities and
people. proper financial advice.

It took another 20 years for Malaysia to figure out enabling the setting up of such Islamic finance
how to do this without bringing financial ruin to operations operating as a bank within a bank with
the country. Some countries at that time decided separate income statement and balance sheet to
to just convert their whole financial market to ensure segregation of the conventional riba-based
Islamic finance to the detriment of their economic businesses from the Islamic finance businesses.
well-being, and Malaysia could not afford to do
that. A way was needed for Islamic finance and The result of this development was the ability of
conventional riba-based finance to co-exist in the the Malaysian financial market to provide the Malays
same market. with the right choice and the non-Muslims an
enhanced choice in regards to choosing the financial
After years of research and through the well-oiled solution to meet their financial needs.
Malaysias public and private sectors partnership, the
Islamic Banking Act was enacted in 1983, which saw The introduction of the Islamic banking window
the immediate establishment of the countrys first scheme enabled the existence of a deep Islamic
Islamic bank. inter-bank money market. With greater ability to
manage business, Islamic financial institutions were
This was followed by the enactment of the 1984 able to garner a bigger market share, from a mere
Takaful Act and establishment of the countrys first 1% over the previous 10 years to about 6% within
Takaful company the same year. For the first time, the next one year.
Malays were able to obtain home financing, car
financing, personal financing and various financial Arising from these invigorated market activities,
solutions to facilitate their business as well as more competent Islamic bankers were needed
insurance coverage in a manner that allowed them and this was facilitated through the establishment
to comply with Shariah principles. of BIMB Islamic Banking Research and Training
Institute (now known as the Islamic Banking and
A decade after the incorporation of the first Finance Institute of Malaysia, or IBFIM) in 1994.
Islamic bank and Takaful company, the Malaysian
government realized that Islamic finance had more In 1997, by which time many players had made
to offer the country. It not only can co-exist with their presence known, there were issues concerning
conventional finance but could actually become a certainty of Shariah application in the industry. In
mainstay in the broader financial system. order to ensure a more effective management of
Shariah in the Islamic banking sector, the national
During the first 10 years of experiment, it was found Shariah Advisory Council was established at Bank
that Islamic finance was becoming increasingly Negara Malaysia (BNM).
popular not only among the Malay Muslim customer
base but also the non-Muslims. With these findings, BNM also introduced a standard list of generic
wider access to the industry had to be established. names for Islamic banking products using indicators
of i affixed to the end of the products or services.
As a result, the Skim perbankan tanpa faedah
(Islamic banking window scheme) was introduced in Greater clarity of the available products and
1993, which allowed all conventional banks to offer enhanced Shariah credibility spurred the industry
Islamic financial products and services. growth further arising from increased demand
among the consumers in Malaysia. A second Islamic
This was done by amending the Banking and bank, Bank Muamalat Malaysia, was set up in 1999;
Financial Institutions Act 1989 with provisions through further market liberalization in 2004, the

country saw the licensing of three foreign Islamic In 2005, with demand for Islamic finance by
banks from Kuwait, Saudi Arabia and Qatar, consumers becoming more sophisticated and astute,
respectively. the Malaysian government saw a critical need to
ensure that Islamic finance activities carried the
In 2005, the government further pushed the same transaction cost as that for the conventional
development of the Islamic finance industry by riba-based finance activities for the industry to
encouraging the conventional banks with the Islamic remain competitive in the long run.
banking window scheme to establish stand-alone
Islamic banking subsidiaries in line with the 10-year As such, a tax neutrality policy was announced
Financial Market Masterplan for the industry. wherein all costs such as tax, stamp duty and so
on incurred under an Islamic finance transaction
With the Islamic banking sector proving to be (approved by the regulator) over and above that of
an efficient and important component of the a similar conventional finance transaction shall be
overall financial market in Malaysia, the Malaysian exempted.
government decided that the market must also have
the full spectrum of Islamic financial products Since 1983, especially since the introduction of
and services so as to have a robust and sustainable the tax neutrality policy, Islamic banking assets in
industry. Malaysia have grown by leaps and bounds. As at
June 2006, total Islamic banking assets, deposits
It cannot just be limited to the Islamic banking and financings stood at RM117.5 billion (US$32.4
sector. As such, the government also introduced the billion), RM86.2 billion (US$24 billion) and RM69.8
Islamic capital market. billion (US$19.24 billion) respectively. In 2007,
total assets grew to about RM147 billion (US$40.5
The worlds formal modern-day Islamic debt capital billion), representing close to 13% of the Malaysian
market was first introduced and launched in 1984 banking sector while by end-2008, it closed the year
when the government enacted the Government at 17% market share.
Investment Act 1984, allowing the central bank of
Malaysia to issue the worlds first Islamic T-bill or Table 1: Malaysian Islamic banking sector statistics
sovereign Sukuk. Year Net Total Total asset
financing deposit
This was followed by the corporate sector in 1990 RM 000 RM 000 RM 000
when Shell MDS, the Malaysian subsidiary of Shell, 1983 249,800 274,900 369,800
issued the worlds first corporate Sukuk to the 1988 609,374, 1,022,231 1,133,955
amount of RM150 million (US$41 million). There
1993 1,065,210 2,259,886 2,009,088
was no fanfare, as is seen today every time a new
1999 13,751,571 24,804,855 36,136,488
Sukuk is issued but they were the predecessors of all
Sukuk issuances and it was first done in Malaysia 25 2000 20,816,092 35,918,401 47,013,583
years ago. 2001 28,317,570 47,106,506 59,353,187
2002 36,717,744 53,184,527 68,070,426
The Malaysian government also introduced in the 2003 48,615,000 60,212,000 82,196,000
1990s the worlds first Islamic index, which started 2006 71,631,000 90,249,000 131,908,000
the ball rolling for the Islamic equity capital market. 2007 81,704,000 107,362,000 157,157,700
In 1992, the first Islamic initial public offering was 2008 91,633,000 108,035,000 192,810.400
done when Bank Islam Malaysia, the countrys first (September)
Islamic bank, was listed.

Table 2: Domestic bonds outstanding Size and In 2008, the NAV of Shariah-based unit trust
composition (RM mil) stood at about RM10 billion (US$2.76 billion),
Year Conventional Islamic Total representing around 8% of the total industry.
2001 131,787.26 49,641.59 181,428.85 Islamic asset management has also gone beyond
mere unit trusts to include alternative investments
2002 112,256.28 64,116.91 176,373.19
such as private equity funds, property funds,
2003 125,564.60 75,792.81 201,357.41
infrastructure funds and hedge funds.
2004 116,587.68 80,809.41 197,397.09
2005 119,455.10 100,673.38 220,128.48 Between 2007 and 2008, Malaysia put the last few
2006 115,978.40 114,493.05 230,471.45 components needed for the industry in place. A
2007 114,970.58 148,597.98 263,568.56 formal Islamic derivatives market was set up, which
2008 124,658.46 163,236.37 287,894.83 allows Islamic finance players to manage risk better.
* Excludes government securities such as Islamic Malaysian
Treasury bills, Islamic BNM Notes and so on We also saw the introduction of the Islamic
Source: BNM/Fully Automated System for Issuing/Tendering structured products, which reflects the sophistication
(FAST) of the market today. The country also introduced
Asias first Islamic exchange-traded funds or ETFs
Malaysia is now home to the largest and most active in 2008.
Sukuk (Islamic bond) market in the world. Nearly
two-thirds of total outstanding Islamic bonds worth As at 2008, the reintroduction of the Islamic finance
US$92 billion are issued out of Malaysia and the industry in Malaysia which started 46 years ago can
country dominates the primary Sukuk market with be said to be completed comprising the banking
over half of all new Sukuk issuances done every sector, the interbank money market, the debt and
year. equity market, asset management, Takaful, other
non-banking financial institutions and the derivatives
Sukuk outstripped conventional bonds with more market.
than 50% share of total outstanding bonds in
Malaysia. This was due to Sukuk representing 70% Malaysias ability to achieve what it has in Islamic
to 80% of primary Sukuk issue since 2004. Last year finance over the years can be attributed to many
alone, there was RM76.95 billion (US$21.2 billion) reasons sound and effective legislative, regulatory,
worth of new Sukuk issued in Malaysia. legal and Shariah framework as well as strong market
infrastructure. Out of these, the most critical and
Malaysia is also home to the first and largest Islamic key reason for success is how Shariah was managed
stock exchange in the world with more than 85% of and regulated in the Islamic finance industry.
companies listed on Bursa Malaysia being Shariah
compliant. Malaysia when developing the industry has
never confused itself in seeing Islamic finance as
The Islamic asset management industry has something religious. A Muslim when deciding to
also seen phenomenal growth in the Malaysian do Islamic finance may be doing it because of his
market. As at December 2008, there were a or her religious belief as provided under Shariah
total of 136 Shariah-based unit trust funds. The within the ambit of Aqidah (that is, man and God
NAV of Shariah-based unit trust funds grew at a relationship).
compounded annual growth rate of more than 30%
from 1997 to 2008; outstripping the overall industry However, when Islamic finance activities are
growth rate of circa 15%. undertaken by a Muslim, or anyone else for that

matter, the activities are in fact commercial activities services in the world and is the single largest Islamic
that fall within the ambit of Muamalat (that is, finance market in the world, thanks to 46 years of
between man and man). effort.
Since commercial activities have an impact on public Islamic finance products in Malaysia have become
interest and market integrity, Islamic finance must be competitive and efficient, both in terms of
regulated to protect the interests of the consuming structure and pricing, to the point that it is giving
public and to protect the systemic integrity of the conventional riba-based finance a real run for its
overall financial market. money and is claiming a bigger portion of market
share every day. Due to competitive pressures
As such, very early on in the development stage globally, innovations in the Islamic finance industry
of the Islamic finance industry, the Malaysian seen in Malaysia over the years have always been
government has regulated Shariah. looked upon with envy.
The foundation was laid down in the Islamic There is a lot more to do, and Malaysia will continue
Banking Act 1983 itself wherein no person can to develop its Islamic finance industry beyond its
undertake Islamic banking or financial activities borders. The experience that it has gone through in
unless licensed by BNM as the central bank and building up an Islamic finance industry from scratch
these activities must be undertaken in such a way under a developmental agenda perspective can be
that they do not contradict Shariah. useful for many other jurisdictions. Malaysia will
continue to push for greater development of the
This was further enhanced through the setting up industry domestically and globally.
of the national Shariah Advisory Council in 1997
and, subsequently, in 2004 through the Guidelines
on Shariah Management, which provide that all
Shariah matters under the Islamic finance industry
in Malaysia are ultimately governed by the central
bank through the Shariah Advisory Council with all
licensed Islamic financial institutions in the country
required to have an in-house independent Shariah
committee.
The appointments on the committee are subject

to approval from the banks own remuneration
committee and board of directors as well as to the
approval of the central bank. In the industry only
the central bank can make Shariah pronouncements
and its decision is valid and applicable to all licensed
Islamic financial institutions.
All in all, the global Islamic finance industry has

evolved from a mere faith-based (tauhid) to a
business-driven industry for all communities as is
facilitated under muamalat. Malaysia is home to the
largest repository of Islamic finance products and

Financial Sector Masterplan Islamic skills and management teams with

Banking and Takaful continuous application of benchmarking to
elevate the performance level.
In order to compete effectively and become leaders Financial infrastructure development
in the industry, operators need to: Measures to promote healthy competition
Strengthen their institutional and operational and create sufficient market depth and
capacity and build their resilience to entailing issuance of new Islamic banking
operate successfully in a highly competitive licenses to qualified foreign operators.
globalized environment Regulatory framework development The
Improve their efficiency and effectiveness to legal, regulatory and Shariah framework
be at par with international best players for Islamic banking will be strengthened
Intensify research and development efforts through the review of existing laws and
and forge strategic alliances with research guidelines governing the industry.
bodies such as universities and so on (such
as the Islamic Banking and Finance Institute Institutional capacity enhancement
Malaysia [IBFIM], International Centre for 1) Benchmarking to be on a par with
Education in Islamic Finance [INCEIF] and international best practices
International Shariah Research Academy for 2) Enhance knowledge and expertise
Islamic Finance [ISRA]). Establishment of industry owned training
institute
The masterplan targets the Islamic finance industry a) requiring operators to commit adequate
would run parallel with conventional banking by budget allocation for skills development
2010, achieving the following: b) embark on regular promotional
Constitute 20% of the banking market share programs to create awareness and
Be represented by strong and highly introduce the teaching of Islamic
capitalized operators offering a complete banking in schools, colleges and
range of products and services universities
Supported by a comprehensive and 3) Build strong and committed management
conducive Shariah and regulatory framework teams
Establishment of a Shariah commercial 4) Granting incentives to structure Islamic
court in the judiciary system private debt securities (PDS), for example,
Supported by well-trained high-caliber allowing amortization of expenses for
individuals and management teams with the Mudarabah or Musharakah PDS.
required commitment
Affirm Malaysia as the regional Islamic Financial infrastructure development
financial center. 1) Increase the number of Islamic banks to
stimulate competition
In order to achieve the target, several 2) Deepen the Islamic financial market
recommendations have been made, focusing on a) Intensify research and development
three main areas: through IBFIM
Institutional capacity enhancement b) Devise mechanism to mitigate risk due
Strategic steps to be taken to prepare to the different relationship in Islamic
industry players to be among the best financial transactions
managed institutions, enhancing individual c) Encourage the application of

Mudarabah and Musharakah financing enhance efficiency and promote market

through joint ventures development.
Regulatory framework and management It is also recommended as follows:

1) Strengthening the regulatory framework,
separate from the conventional 1) Establish a Shariah commercial court to deal
a) Strengthening the Islamic Banking Act with legal matters on:
1983 to create a conductive environment a) Islamic banking transactions to seek
for the Islamic bank to move toward a legal redress handled by a sufficient
more supervised market approach number of competent judges and
b) Revising the Banking and Financial lawyers equipped with knowledge of
Institutions Act (BAFIA) to both Shariah and civil laws
accommodate the unique characteristic b) Design dedicated awareness and training
of Islamic banking especially with programs for judges and lawyers by
regard to risk management as the profile IBFIM/INCEIF/ISRA in consultation
differs from that of conventional banks with the judiciary and the Bar Council.
c) develop a regulatory framework 2) Formulate tax policies to avoid creating
by introducing a separate capital barriers in adopting Islamic banking
adequacy, statutory reserve and liquidity concepts and products; for example, double
requirement taxation (zakat and tax).
d) Harmonizing the Shariah opinions
on Islamic banking and finance to

Indonesia
GENERAL BACKGROUND
The Republic of Indonesia is the largest archipelagic nation in the world
comprising more than 17,000 islands. Its land area is nearly two million
square kilometers, with ocean areas twice the land. The nation spans
5,120km from east to west, which is more or less comparable to the
distance from the east coast to west coast of the US, or from the UK all
the way to Turkey, and 1,760km from north to south.
Chapter 6
Indonesia has a total population of around 235 million, about of 86% of
whom are Muslim. Indonesia is, therefore, the country with the worlds
largest Muslim population. It is also the worlds fourth-largest country in
Regional Overview terms of population, after China, India and the US.
Due to its large demographic pool, Indonesia is a potential market for

By Mahmoud various products and industries. Further, it is rich in natural resources
Abushamma such as crude oil, natural gas, lead, coal and gold, and blessed with fertile
soil and accommodative climate.
Indonesia is the only Southeast Asian country which is a member of the

Organization of Petroleum Exporting Countries. Currently, it is one of
the largest exporter countries for natural gas, producing approximately
20% of the worlds gas production in 2002. It is now the biggest
supplier of crude palm oil (CPO) as well as a major producer of rubber,
supported by the worlds largest plantation areas for CPO and rubber.
ECONOMIC BACKGROUND
Indonesia is Southeast Asias largest economy with a gross domestic
product, or GDP, of US$438 billion in 2007. The main contributors
to GDP were the manufacturing sector (27%), trade and hospitality
(14.9%), agriculture (13.8%), mining (11.2%) and services (10.1%).
The Indonesian economy has undergone various economic pressures

marked most recently by the 1997-98 Asian economic crises. During
the past decade since the crisis hit, the macroeconomic condition has

Regional Overview : Indonesia
steadily improved. In recent years, the inflation rate, Restoration of market confidence has also helped
which previously skyrocketed, has come down to direct private investment, both foreign and domestic,
single digits and the exchange rate has hovered at as well as stabilized the inflation rate and the rupiah.
IDR9,000 to IDR10,000 per USD.
Soaring and then declining international
In the past five years, the economy has commodity prices, led by oil, and the unfolding of
demonstrated resilient growth ranging between 4.9% the subprime mortgage crisis figured prominently
and 6% per year, and for the first time since the among the challenges confronting the Indonesian
Asian financial crisis, in 2007 the economy grew at a economy during the year.
rapid level above 6%, with macroeconomic stability
kept in check. In the face of these multiple adversities, the
domestic economy has so far appeared to show a
The favorable performances were reflected in higher level of resilience in support of economic
the significant surplus of balance of payments, growth, though in more recent weeks, the local
reinforcing the international reserves, exchange rate financial markets and the currency have taken a
stability, strong credit expansion and inflation kept severe beating following the deteriorating situation
under control. in the global financial markets.
For around four decades, foreign investment in

Indonesia has been dominated by 10 major investing
BANKING INDUSTRY
countries that contributed 72% of the number of
The banking industry has a strategic role to play in
projects and constitute 60% of the total value of
supporting a dependable payment system, acting
foreign direct investment. These top 10 investors
as an extension of monetary policy and achieving
listed in the order of value of projects are
overall financial system stability.
Japan, the UK, Singapore, Hong Kong, Taiwan, the
US, South Korea, Germany, Malaysia and Australia.
Conventional banking industry is regulated by
Banking Law No 7 1992 as amended by Banking
Banking deregulation has resulted in many corporate
Law No 10 1998, which introduced the dual
actions, as foreign investors have invested heavily
banking system; i.e. recognizing Shariah banking
in the Indonesian banking sector. As a result, the
as one method of banking. In both Shariah and
majority of the larger national private banks are now
conventional banking, banking institutions are
owned by foreign investors, often as the majority
divided into two types: commercial and rural.
shareholder. Total foreign ownership in national
private banks had reached 46.4% by 2006.
Rural banks, in the form of savings and loan
institutions, are barred from conducting payment
The country has continued its progress in the right
and clearing systems. As at April 2008, there were
direction for a stable macroeconomic condition, with
128 commercial banks (including three Shariah
stabilizing interest rates, maintained inflation rate and
commercial banks), of which the top 15 banks had a
the implementation of various government policies,
70% market share of total national bank assets.
deregulation measures, implementation of infrastruc-
ture projects and increased domestic demand.
The banking industry is regulated by the central
bank, i.e. Bank Indonesia, which is an independent
Growth of investment is predicted to be apparent
entity led by its own board of governors, with
in the base metal and steel industries, as well as the
minimal government influence.
telecommunication and infrastructure industries.

Non-banking financial institutions, however, are in the political mindset and showcases the countrys
regulated by a government agency under the min- greater receptiveness to the emergence of a rapidly
istry of finance, i.e. Bapepam (capital market and growing component of the global financial system.
financial institutions supervisory board). These insti-
tutions include insurance, mutual funds companies, The market has waited in anticipation for the
securities companies and multi-finance companies. passing of this law and has high expectations that
it will resolve a few long-standing issues that have
hindered the growth of Islamic banking in the
SHARIAH BANKING IN country.
INDONESIA
While SBL addresses several issues such as Islamic
The Indonesian Parliament recently passed the banking establishment, Shariah committees, Shariah
Sovereign Sukuk Law No 19/2008, which enables boards and dispute settlement, it still lacks clearer
the government to issue local and international direction on other aspects such as legal issues of
Sukuk. Shortly thereafter, Parliament also passed the ownership and taxation. Therefore, there remain
Sharia Banking Law No 21/2008 (SBL), 16 years uncertainties with regard to taxation of structures
after the establishment of the first Shariah bank underlying Shariah instruments and products, and
in Indonesia, and 10 years after the dual banking this limits feasible structures.
system (Shariah and conventional) was enacted by
the central bank. Bank Indonesia, as the central governing body
for the banking system, devised a Shariah banking
The SBL by itself is an important milestone for the blueprint which has set its vision horizon to 2015, in
development of Islamic finance in Indonesia, not synergy with the Indonesian Banking Architecture
only as a form of formalization of Islamic banking platform for the period of 2004-15.
but also a reflection of the political will from
Parliament and, indeed, the government to Meanwhile, Shariah compliance is under the
drive diversification in the banking system. The purview of the Indonesian Ulema Council, or MUI,
passing of the law demonstrates a significant change the countrys central council of Islamic scholars
Breakdown of Indonesian banking institutions as at April 2008
Commercial banks Rural credit

(128) banks (1930)
Private national
State banks (5)
banks (123)
Regional Private National Islamic Rural credit Islamic rural

Goverment banks commercial
(26) banks (94) banks (3) banks (1812) credit banks (118)
Islamic
banking unit (24)
Source: Bank Indonesia website (www.bi.go.id/web/en/Perbankan/Ikhtisar+Perbankan/Lembaga+Perbankan)

that collaboratively issues fatwa on various public tremendous boost to Islamic financial instruments in
matters. MUI formed the National Shariah Board, the domestic capital market.
or DSN, as the authority with the right to issue
fatwa in relation to Shariah financial instruments Islamic mutual funds face a similar situation. As at
as well as to appoint the Shariah supervisory board end-2007, the number of Islamic mutual funds was
of each Shariah financial institution (in the case 26. In terms of net asset value (NAV), however,
of banks, with the approval of Bank Indonesia). these funds have grown to only IDR946 billion
These Shariah boards in turn should ensure that (US$104 million), which is 1% of total mutual
the operation, products and services of a bank or funds NAV.
financial institution are in compliance with Shariah
and fatwas. Further, in the Takaful industry, as at end-2007,
there were three Takaful companies and 35 Takaful
Bank Indonesia has also been involved in or units, which by any means made Indonesia perhaps
is a member of the Islamic Financial Services the most crowded Takaful market in the world, at
Board (IFSB), and the Accounting and Auditing least in terms of market players. In terms of market
Organization for Islamic Financial Institutions share, however, this accounts for only 1.1% of the
(AAOIFI). national insurance market.
SHARIAH GROWTH STORY EFFORTS TO PROMOTE

Historically, the annual growth rate of Islamic
ISLAMIC BANKING
banking has averaged at 42% over the past four
In general, the government and regulators are taking
years. This can be attributed in part to the growth
a neutral position on the promotion of Shariah
in the availability of Islamic banking services. As
banking to the wider market, in the sense that there
at May 2008, there were 25 Islamic units within the
are no particular incentives for the industry or for
national and regional banks, and three full-fledged
market players.
Islamic banks in the country. In addition, there were
120 rural banks operating under Shariah to serve
There is no preferential treatment for Shariah, such
close-knit communities in numerous municipalities
as lower tax breaks or even small incentives, or any
and remote areas.
other form of governmental subsidies.
The local Islamic capital market has also
The government and regulators, however, are not
demonstrated similar growth. As at July 2008, there
hindering the growth of Shariah but rather, it is the
were 27 Sukuk and three Shariah medium-term
bureaucracy of the young democracy that renders
notes issued in the country with a total value of
the implementation of changes in regulations,
IDR4.9 trillion (US$436 million).
including in the field of Islamic banking, to take
place much slower than they should.
However, this represents a small amount (about
6.5%) in terms of outstanding value compared
Taking into account the rapid growth and huge
to the conventional bond market, whose total
potential of Shariah banking in the country,
outstanding value amounts to IDR75 trillion
Bank Indonesia has come up with an acceleration
(US$6.7 billion). Nevertheless, the issuance of
program that aims to increase the market share of
the first sovereign Sukuk of IDR4.9 trillion by
Shariah banks in the country to 5% by the end of
the Indonesian government in August 2008 was a
2008. To do so, the central bank focuses on a more

intensive mass education process to increase market Starting in 2007, however, OC branches now offer
awareness and affinity toward Shariah banking and Shariah financing.
finance, evaluation of Shariah banking products and
services as well as pushing the expansion of outlets
so that access to Shariah banks is more readily
PROMOTION AND
available, and participating actively in welcoming CAMPAIGN
foreign investment through Shariah financial
instruments. Generally, there is still insufficient understanding on
and knowledge of the various products and services
In an effort to promote Shariah banking to the available, no thanks in part to the lack of intensive
masses, a common logo for Islamic banking has promotion and education. The marketing expenses
been endorsed, the use of which is encouraged of Shariah banks and Shariah units of commercial
for brochures, marketing collaterals, public banks account for less than 2% of the total
communications and all visual appearances of Shariah marketing spending of national commercial banks.
products and services. The logo would help the Total promotion expenditures of Shariah banks in
masses recognize the presence of Shariah products 2007 were around US$15 million, compared to the
and services wherever they see the iB logo. nearly US$100 million spent by national commercial
banks.
The new SBL also attempts to promote the
development of Islamic banks by making it FUTURE GROWTH
obligatory for a bank to spin off its Shariah units
if its assets have reached half that of the banks or Apart from a more conducive macroeconomic
within 10 years of the units establishment. condition, dynamics within the Shariah banking
industry itself are also expected to boost growth.
OFFICE CHANNELING Within 2008-09, it is expected that several new
Shariah banks will be established and more national
Shariah banks in Indonesia are allowed to offer banks will open Shariah units. At least three
Shariah products and services through conventional new Shariah banks will open, through strategic
branches under the innovative scheme of office acquisition of smaller conventional banks to be
channeling, or OC. Since its inception two years converted into full-fledged Shariah banks.
ago, the number of Shariah outlets has more than
doubled; from 456 outlets in 2006 to 1,195 by the APPLICABLE ACCOUNTING
end of 2007. During the same period, the number
of branches also expanded by 66 offices. The Indonesian Institute of Accountants (IAI), a
governing body, has issued the Financial Accounting
The OC concept became an overnight success Standard No 59 (PSAK 59) for Shariah banking.
story with its effectiveness in reaching the masses This has been recently further evaluated, and IAI
and collecting third party funds. In 2007, one-third subsequently issued accounting standards Nos. 101
of the third party fund was derived from the OC to 107 in 2007, which addressed the accounting
network, despite still being in its infancy. treatment for different Shariah finance products.
The new recent accounting standard applies not
The scheme itself was originally conceived to answer only to banks but also to other entities conducting
the growing demand for Shariah banking services. Shariah finance activities.
Initially, it serviced customers receiving funds only.

CHALLENGES accounting expertise. The sharing of knowledge, the

incorporation of Shariah principles and values as
In the coming years, the Shariah banking industry well as good technical application would reinforce
still needs to overcome a few challenges to sustain the Shariah banking industry as a whole.
a high rate of growth. One of these is the capital
base. Typically, with new businesses undergoing Finally, the ongoing credit crisis in the financial
rapid growth, such as Shariah banking, a strong markets is only starting to take its toll on the
capital base is required to support asset growth. Indonesian financial markets, through the lack of
The country is in need of fresh capital to support liquidity and increased funding costs faced by the
adequate capital levels needed in a period of rapid banking sector, including Shariah banks.
growth.
The general view is that the real sector will be
A few Shariah banks have issued subordinated adversely affected starting in 2009. The local
Sukuk to increase their capital base. But the market Shariah banking industry was much smaller during
appetite for these instruments is still limited, and the 1998-99 Asian financial crisis, and did not
thus first-tier capital is required in the form of fresh suffer as badly as their much larger conventional
capital injection if the Shariah industry wants to counterparts. However, with more exposure to
sustain the rate of growth. Otherwise, the industry corporates nowadays, it will be interesting to observe
needs to be content with more moderate growth, how resilient Shariah banks will be in weathering a
driven mostly by retained earnings. new crisis should economic conditions continue to
deteriorate.
The rapid growth in the Shariah industry also calls
for sufficient supply of human resources. This need
is further increased by the expansion of branch
networks that is growing at an even faster rate than
the growth of Shariah banking assets.
The industry has suffered from deficiencies in

the availability of human capital, and if this is not
quickly addressed, it will continue to deteriorate.
Therefore, synergy is needed not only in the
development of human capital within the Shariah
banking industry itself, but also in the curricula
of tertiary and perhaps even basic or secondary
education.
In the short term, the needs might be fulfilled by

training and workshops on Shariah banking, but in
the long run, an integrated approach to education
must be introduced. The development of human
capital should cover not only core knowledge in
Shariah banking, but also building supporting
skills in legal aspects, prudential banking practices,
risk management, service excellence, and tax and

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HANDBOOK ON

manual IDD_newlayout.indd Sec1:1 6/19/2009 4:11:41 PM

Introduction to the Handbook on Islamic Finance Page 2

Basic Principles of Islamic Banking Page 10

Islamic Banking as an Alternative to Conventional Banking Page 16

Islamic Banking for SMEs Page 25

Islamic Microfinance: An Emerging Market Niche Page 37

Islamic Banking for Women: Case Study of Malaysia Page 48

manual IDD_newlayout.indd Sec1:2 6/19/2009 4:12:21 PM

Dr Mohamad Nedal Alchaar

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Or consider this, most Muslims live is less developed

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What, then, are the tools to solve this problem?

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The conversion of Islamic commercial ideas into

The world of Islamic finance, its profit and loss

As the IDB, AAOIFI and IFSB help define the

Indeed, Islamic finance has emerged as a truly useful

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A simple definition of Islamic banking is a banking operation that abides

Besides the prohibition of riba, Islamic banks also cannot engage in

EVOLUTION OF ISLAMIC BANKING

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In Asia, Malaysia has a fully developed Islamic

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bank continues to be the owner of the asset. Mudarabah (Trust financing)

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Table 1: Financing instruments in Islamic banks

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Chapter 2 The presence of Islamic finance in the international financial scene

Analogous to the objective of profitable organizations, Islamic banks

Islamic finance is committed to achieving social justice and equitable

The conventional system operates within a market economy where the

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FUNDAMENTAL In the words of Ibn Qayyim, The basis of Shariah

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The majority of Islamic jurists agree that any ETHICS ANGLE

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