Dr. Sutan Emir Hidayat

Contemporary Issues and Developments in Islamic Finance

Thoughts of an Indonesian Diaspora in Bahrain

The Embassy of the Republic of Indonesia Manama, Kingdom of Bahrain

Published by the Embassy of the Republic Indonesia in Manama, Kingdom of Bahrain.

No part of this publication may be reproduced, stored in retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, except as permitted under article 72, Act of the Republic of Indonesia number 19 year 2002 on Copyright, without either the prior written permission of the author, or authorization through the Chancery of the Embassy of the Republic of Indonesia in Manama, Bahrain.

Hidayat, Sutan Emir,

Contemporary Issues and Developments in Islamic Finance, Thoughts of an Indonesian Diaspora in Bahrain

Printed in Kingdom of Bahrain, 2016

Publishing Committee:

Chairman of the Committee: Chilman Arisman Ambassador of the Republic of Indonesia in the Kingdom of Bahrain

Editor: Chilman Arisman Hardiyono Kurniawan Nur Fitria

Layout: Addi Sahwani Abdul Manik

ISBN: 978-9958-946-0-3 443/ع.د/Deposit Public Library Number: 2016

FOREWORD

As the Minister of Foreign Affairs, Republic of Indonesia, I am very grateful to see a young Indonesian diaspora, Dr. Sutan Emir Hidayat, who continuously writes articles in international newspapers, magazines and reports. When I got this news from the Indonesian Ambassador in Bahrain and his plan to compile Dr. Sutan Emir Hidayat’s articles into a book certainly I offer my full support to this brilliant idea. I am also excited to know that Dr. Sutan Emir Hidayat has been listed by ISFIN, a leading advisory for the Islamic Markets, as one of the world’s top 50 influential personalities to the Islamic economy in 2015. Obviously, this prestigious award has been given to him due to his significant contribution to the Islamic economy through his multiple articles published in local and international newspapers, magazines, journals, reports and conference proceedings. I have gone through the book and found it very interesting and compelling. The book discusses the up to date developments and issues within Islamic financial industry covering all areas within the industry such as Islamic banks, Takaful and Sukuk and in many cases I also found the contents are very much relevant to Bahraini context. Therefore, I can say that the book is an example of how an Indonesian diaspora contributes to his country of resident. In addition, I also believe that Dr. Sutan Emir Hidayat’s works help us in enhancing the bilateral relationship between Indonesia and Bahrain. I hope the publication of this book will motivate Dr. Sutan Emir Hidayat and others to contribute more to the development of their field of specialization. Congratulations.

Retno L. P. Marsudi Minister of Foreign Affairs of the Republic of Indonesia

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PREFACE

It is my pleasure to welcome the publication of Dr. Sutan Emir Hidayat’s latest book which entitles “Contemporary Issues and Developments in Islamic Finance: Thoughts of An Indonesian Diaspora in Bahrain". The book covers almost all segments within Islamic finance including the principles of Islamic finance, Islamic banks, Sukuk, Takaful, Islamic finance education and other issues which are very relevant to the current development of the industry. As the First Resident Ambassador of the Republic of Indonesia to the Kingdom of Bahrain I realize that Bahrain is one of the international hubs for Islamic financial industry. Since the late 70’s, the government of Bahrain has considered Islamic finance as one of its main economic sectors that can be developed to differentiate itself from other countries. For that reason, in order to sustain the development of the industry, fresh ideas and thoughts from the industry stakeholders including the academician like Dr. Sutan Emir Hidayat becomes very important. As an academician in a local university in Bahrain, Dr. Sutan Emir Hidayat has shown his role in supporting the development of Islamic financial industry through his multiple articles published in renowned local and international newspapers, magazines and reports. Therefore, as the representative of the government of Republic of Indonesia in Bahrain, I took the initiative to compile his articles, which he published during his stay in Bahrain, into a book as an appreciation to his contribution to the Islamic financial industry and for his role in promoting Indonesia to the people of Bahrain and the world through his active participation in the development of Islamic financial industry. I hope this book will serve its purpose and I would like to congratulate Dr. Sutan Emir Hidayat for this achievement.

Chilman Arisman Ambassador of the Republic of Indonesia to the Kingdom of Bahrain

ACKNOWLEDGEMENT

Islamic banking and finance has become a global inevitable phenomenon in the present era. It has been well widen both in Muslim and non-Muslim countries and has become a subject of concern of many Muslims and non-Muslims around the world. As a result, Islamic financial industry has been growing significantly for the last decades. However, being a relatively new industry especially when it is compared to conventional financial industry, there are several issues that should capture the attention of Islamic finance stakeholders in order to propagate the industry to a higher realm of development. This book aims to highlight several contemporary developments and issues within Islamic finance which consists of 6 parts. The first part of the book deliberates the principles of Islamic finance and the current economic and financial developments. In this part, issues such as the original wisdom behind the establishment of Islamic banking and finance, an overview of debt from Islamic perspective, Riba awareness, and common misconceptions about Riba among Muslims are discussed in relation to the current economic and financial context.

The second part of the book discusses contemporary issues and developments in Islamic banking. Being the major segment within Islamic financial industry, Islamic banking is relatively more developed than the other segments. However, there are several issues such as liquidity management, expensive financing and corporate social responsibility that still essentially to be tackled in order to ensure sustainable growth of the segment. In the third part of the book, contemporary issues and developments in Sukuk market are elaborated. Sukuk market is a segment within Islamic finance with a remarkable progress. However, there are several issues such as risks behind Sukuk issuances, assets based vs asset backed Sukuk and the important role of Sukuk in Basel III era that need to be well understood by investors related to the Islamic security. The fourth part of the book discusses some contemporary issues and developments in the field of Takaful. Takaful is considered as the smallest segment within the Islamic financial industry. However, this segment has a lot of potential to be explored and developed. Several issues and trends within the segment such v as misconception about family Takaful, lower public awareness, Takaful student based finance and expansion of Takaful business are highlighted in order to provide inputs for industry stakeholders in making their decisions to boost the development of the segment.

The fifth part of the book discusses the modern-day issues and developments in Islamic finance education. In order to enhance the development of Islamic financial industry, sufficient number of talents is to be available and moulded. However, the current situation exhibits that the number of talents is still far away from the expected levels of expertise. Issues such as talent development and skill mismatch exist within Islamic financial industry and must be overcome through collaborative efforts between Islamic finance qualification providers and other industry stakeholders. The sixth part of the book or the last part discusses other progresses and concerns within Islamic finance. Issues such as the adoption of a common Shariah standard, the benefits and challenges in the adoption of international accounting standards for Islamic finance, Islamic microfinance and challenges in maintaining the growth of Halal products are discussed and the importance of addressing these matters in order to support the development of Islamic financial industry and Islamic economy in general are elaborated.

This book is a compilation of my articles published in Islamic Finance News (IFN), Thomson Reuters, Islamic Finance Today Magazine, Global Islamic Finance Magazine, the Bahrain Banker and Daily Tribune Newspaper. Some of these articles are co-authored. In part 1, the interest-based economy and public debt: An analysis of the US economy was co-authored with Dr. Ugi Suharto. In part 2, Islamic banking in Saudi Arabia: Grasping the non-Muslim segment was co-authored with Nouf Khalid Al-Bawardi while corporate Social Responsibility for Islamic banks was co-authored with Suliman Abdulrahman Al- Hur. In part 3, the risks behind Sukuk issuances was co- authored with Muhammad Musa Abu Bakar while understanding investor behavior from the variation of Sukuk spreads was co-authored with Dr. Maya Puspa Abdul Rahman, Dato’ Prof. Dr. Mohd Azmi Omar and Dr. Salina H Kassim. In part 4, issues surrounding the management of Takaful surplus vi was co-authored with Delil Khairat while MicroTakaful opportunities in the growing Indonesian Islamic banking sector was co-authored with Dr. Raditya Sukmana. There is no co- authored article in part 5. In part 6, there are several co- authored articles. Islamic microfinance: Challenges and the way forward and revitalization of Shariah compliant syndicated financing were co-authored with Dr. Ronald Rulindo, partnership through Islamic finance: Bahrain and Indonesia was co-authored with Imam Buchari, the Indonesian financial service authority (FSA): A new hope to boost the performance of Islamic finance was co-authored with Dr. Raditya Sukmana and challenges in advancing the growth of Halal products was co-authored with Dr. Ahmad Rafiki.

In the publication of this book, I would like to acknowledge the significant contributions offered by several personalities. My first and foremost appreciation goes to Her Excellency Retno Marsudi, Minister of Foreign Affairs of the Republic of Indonesia, who supports the publication of the book and put her treasonable foreword in the book. My gratitude also goes to His Excellency Chilman Arisman, Ambassador of the Republic of Indonesia to the Kingdom of Bahrain who has been benevolent enough to take the initiative of compiling my articles into a book and enabled the publication of the book. I also would like to express my indebtedness to Hardiyono Kurniawan and Nur Fitria, diplomats at the Indonesian embassy in Manama, who put incomparable efforts in ensuring the publication of this book. My sincere appreciation also goes to Addi Sahwani, a local staff at the Indonesian embassy in Manama who has put his best efforts to arrange my articles into a publishable book. I am surely obligated to all the co-authors mentioned above. Their thoughts and contributions have made the publication of this book possible. I also would like to thank the publishers of my articles specifically Sasikala Thiagaraja of Islamic Finance News, Mariam Ali of Thomson Reuters, Asiff Hussein of Islamic Finance Today, James Morris of the Bahrain Banker and Sree Sadan of Daily Tribune, who have given me opportunities to publish my works at their reputable magazines and newspaper. I also would like to thank Shemily P. John of University College of Bahrain for her help in English proofreading of my works. My continuous thanks go to my parents, parents in law, my wife, vii and my children who always support me in all the endeavours that I pursue including the publication of this book. They are the most meaningful people in my life. I am also very grateful to my employer, University College of Bahrain especially to its founder His Excellency Shaikh Dr. Khalid M. Al-Khalifa and his wife Her Excellency Shaikha Saeeda A. Al-Khalifa for their incessant support towards my publication. Finally, I would like to express my gratitude to all the parties who support the publication of this book whose names are not mentioned here. I hope the book can serve well its purpose and benefit its readers. May Allah the Almighty always bless us.

Manama, 2016 Dr. Sutan Emir Hidayat, University College of Bahrain

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Table of Content

Foreword iii Preface iv Acknowledgement v Part 1 Principles of Islamic Finance and the Current Economic and Financial Development ……….. 1 Common Misconceptions about Riba Among Muslims ………………………………...... 3 An Overview of Debt from Islamic Perspective .... 7 Islamic Finance: The Original Wisdom behind Its Establishment ……………...... 10 The Interest-Based Economy and Public Debt: An Analysis of the US Economy ……...... 14 Rules of Exchanging Money in Islam ……………. 28 Part 2 Contemporary Issues and Development in Islamic Banking…………………………...... 31 Why Do People Choose Islamic Banks? ...... 33 Promoting Effective Liquidity Risk Management for Islamic Banks ……...... 35 Islamic Bank's Financing: Why Is It Expensive? A 47 Conceptual Analysis ……...... Corporate Social Responsibility for Islamic Banks 55 Islamic Banking in Saudi Arabia: Grasping the Non-Muslim Segment ...... 63 Impact of Basel III on Islamic Banking Regulatory Requirements ...... 71 Islamic Bank’s Service Quality: A Winning Strategy to Achieve Customer Satisfaction ...... 75 Understanding Factors that Influence Customers’ Attitude towards Islamic Banking ………………… 77

Part 3 Contemporary Issues and Developments in Sukuk Market ...... 81 The Risks behind Sukuk Issuances ...... 83 Understanding Investor Behavior from the Variation of Sukuk Spreads ...... 90 Asset-backed Versus Asset-based Sukuk, the Dilemma between Sharia, Legal Framework and Market Demand ...... 96 The Importance of the Sukuk Market for the Takaful Industry ...... 101 Sukuk for Liquidity Management ...... 106 Good News from the Sukuk Market ...... 108 Part 4 Contemporary Issues and Developments in 111 Takaful Industry ...... Potential of Takaful within the GCC Insurance Market ...... 113 BancaTakaful: A Cost-effective Way to Promote Takaful Services ...... 115 Misconceptions about Family Takaful ...... 117 Expansion of Takaful Business ...... 120 Grasping Opportunities in the Malaysian and Indonesian Takaful Markets ...... 122 Room for Improvement and Opportunities for Growth in Bahrain’s Takaful Industry ...... 132 BancaTakaful: a Strategic Alliance within Islamic Finance ...... 141 MicroTakaful Opportunities in the Growing Indonesian Islamic Banking Sector ...... 143 Promoting Micro Takaful As a Means to Boost Market Share of Takaful ...... 145 An Issue in Takaful Practice: Low Levels of Public Awareness ...... 147

Takaful Investment Activities: Exploring Alternative Asset Classes ...... 149 Takaful Models in Practice: Why and What Are The Consequences? ...... 151 Takaful-based Student Finance Product: Applying Takaful beyond Insurance ...... 153 Takaful Window: Advantages and Disadvantages 155 The GCC and Southeast Asia: Two Takaful Hubs with Different Characteristics ...... 157 The Latest Trend in the Takaful Industry: Enhancement in Regulatory and Legal Frameworks ………………………………………… 159 Part 5 Contemporary Issues and Developments in Islamic Finance Education ...... 161 Talent Development: A Key Issue within Islamic Financial Industry ...... 163 Education and Its Role in Awareness Enhancement of the Takaful Concept and Principles ……………………………………………. 165 Islamic Economics and Finance Education in the Kingdom of Bahrain ...... 168 Skill Mismatch: a Talent Development Issue within the Takaful Industry ...... 173 Challenges Faced by Islamic Economics and Finance Qualification Providers ...... 175 Part 6 Other Issues ...... 179 Applying A Common Shariah Standard: Benefits and Challenges ...... 181 Maintaining Bahrain Position as the World’s Islamic Financial Hub ...... 188 Global Islamic Economy Indicators: Bahrain Position in 2015 ...... 190

Low Oil Price and Islamic Finance: Impacts and Opportunities ...... 193 Challenges in Advancing the Growth of Halal Products ...... 195 Bahraini Islamic Finance Outlook 2010: A Mixed Picture ...... 199 International Financial Reporting Standards for Islamic finance: Benefits and Challenges ……... 207 Islamic Microfinance: Challenges and the Way Forward ...... 218 Partnership through Islamic Finance: Bahrain and Indonesia ...... 225 Revitalization of Shariah Compliant Syndicated Financing ...... 233 The Indonesian Financial Service Authority (FSA): a New Hope to Boost the Performance of Islamic Finance ...... 241 Social Responsibility and Sustainable Development of Islamic Finance …………..…….. 247 About the Author ...... 251 Praises and Comments ...... 256

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Contemporary Issues and Developments in Islamic Finance | 1 Thoughts of an Indonesian Diaspora in Bahrain

Part 1

Principles of Islamic Finance and the Current Economic and Financial Developments

Contemporary Issues and Developments in Islamic Finance | 2 Thoughts of an Indonesian Diaspora in Bahrain

Contemporary Issues and Developments in Islamic Finance | 3 Thoughts of an Indonesian Diaspora in Bahrain

Common Misconceptions about Riba Among Muslims

Even though most Muslims are aware about the prohibition of Riba in Islam, unfortunately there are several misconceptions about Riba, which make them still trapped or involved in Ribawi transactions. For example, many Muslims take a loan with interest from conventional banks and don’t consider it as Riba. These misconceptions need to be tackled by Islamic finance stakeholders in order to move the industry forward. Therefore, this article attempts to highlight some misconceptions about Riba among the Muslims and provide the readers with brief answers to the misconceptions.

According to available literature, there are at least 5 common misconceptions about Riba which are currently spread among the Muslims namely (1) Interest charged by the conventional banks is only a small percentage out of the total loan not like the practice of Riba in ancient Arab society where the borrower was required to pay double and redouble if he defaulted; (2) Interest on loan is justified since interest is used to compensate the loss in the purchasing power of money due to inflation; (3) Riba is prohibited since it is against the principle of fairness (Adalah). Therefore, if the principle of justice can be established, for example by charging the interest on loan taken by the rich people only, Riba becomes permissible; (4) Interest on loan is justified since the banks assume many risks such as default risk to earn the interest. This is in line with the principle of “risk justifies return” and (5) Interest on loan can be considered as a reward for the banks’ efforts in channeling the money from the surplus units into the deficit units in the economy.

Contemporary Issues and Developments in Islamic Finance | 4 Thoughts of an Indonesian Diaspora in Bahrain

For misconception no. 1, a small percentage charged on the total loan doesn’t make interest on the loan permissible. In fact, if the interest is a compound interest, the total interest to be paid over the years will be a big amount. In addition, the general rule of Riba states that any loan that comes with “ According to conditional extra repayment available literature, whether it is small or big is there are at least 5 Riba. For misconception no. 2, common inflation cannot be used to misconceptions justify the interest charged on about Riba which a loan since in economy there are currently are two possible scenarios spread among the namely inflation which is an Muslims” increase in general prices, and deflation which is a decrease in general prices. In addition, in many cases the imposition of interest on loan is found to be the real cause of the inflation. This is because interest pushes the growth in monetary sector higher than the growth in real sector. As a result, more money is created than goods and services in a country.

For misconception no. 3, the prohibition of Riba is absolute and applicable to all people regardless of rich or poor. It is similar to Allah’s prohibition on gambling, which is applicable to all as well. For misconception no. 4, this statement is not consistent since it will be unfair for the banks to charge interest on the loan taken by a good borrower who always pays the debt on time. In addition, generally the default rate of banks’ financing is low. This is why interest based banking still exists. For the last misconception, it is true that the banks play an intermediary role. However, the reward on the banks’ efforts should not be computed based on how much the money that banks lend. Instead, the reward should be

Contemporary Issues and Developments in Islamic Finance | 5 Thoughts of an Indonesian Diaspora in Bahrain

computed based on the banks’ operational costs in conducting the intermediary role plus profits. In other words, the banks’ mode of operation should be profit on sale based rather than interest on loan based. This is in line with the Islamic teaching where sale or trade is allowed while interest on loan (Riba) is condemned.

Based on the above discussion, it is clear that common misconceptions about Riba hinder the development of Islamic banking and finance. It is important for the industry stakeholders to tackle these misconceptions through awareness and promotional campaigns. Integrating Fiqh Muammalah (Islamic commercial jurisprudence) course at high school level or at the universities is also encouraged in order to minimize these misconceptions.

Riba Awareness

Even though Islamic banking and finance has been growing significantly for the last decades, it still represents a smaller market share of the total banking sector in most Muslim countries as compared to its conventional counterpart. In Bahrain for an example, the market share of Islamic banking is around 13% according to the latest CBB data despite 99% of its citizens are Muslim. One of the possible reasons to the above is low level of public awareness towards Riba.

Actually, majority of Muslims are aware of the prohibition of Riba by the Shariah. However, they don’t really understand what it means by Riba, its categories and types. Many Muslims are unconsciously dealing with conventional banking financial transactions without knowing that those transactions fall under the category of Riba. Some of them even are in the opinion that there is

Contemporary Issues and Developments in Islamic Finance | 6 Thoughts of an Indonesian Diaspora in Bahrain

no difference between conventional and Islamic banking. Obviously, this misconception needs to be addressed by Islamic banking and finance stakeholders in order to move forward. More awareness campaigns have to be done through organizing conferences, trainings, seminars, forums and other forms of educational activities. For examples, conducting short Islamic banking and finance trainings or courses for secondary school economics and commerce teachers can be considered as one of the alternatives. It is expected that after taking the courses the teachers will disseminate the knowledge to their students and families. Engaging community through conducting riba awareness forums or seminars is another considerable alternative. Having programs about Islamic banking and finance on TV and radio should also be considered. Regular educational columns about Islamic banking and finance on local newspapers are also an effective way to increase public awareness.

Why awareness is so important? Referring to the literature, awareness has been found by many empirical studies to have a positive correlation to market preference. In addition, market preference is also positively correlated to market share. In other words, as higher the awareness as higher the market preference which will lead to a higher market share. Therefore, improving public awareness will result in higher market preference thus higher market share of Islamic banking and finance. This article attempts to draw the attention of Islamic banking finance stakeholders about the issue. It is expected that Islamic banking and finance stakeholders will put more efforts towards improving public awareness given its importance to bring the industry to a higher phase.

Contemporary Issues and Developments in Islamic Finance | 7 Thoughts of an Indonesian Diaspora in Bahrain

An Overview of Debt from Islamic Perspective

In today’s world, debt has become a part of most people’s life. Normally, people are indebted either because of taking a loan or as a result of a credit purchase. English dictionary defines debt as a sum of money that somebody owes or the situation of owing money. As Islam is a comprehensive way of life, it is important for a Muslim to understand the Islamic point of view about debt. In Islam, debt has been given a special attention. There are many verses of the Quran and Hadith of the Prophet Mohammad (p.b.u.h) that address the issue of debt. In general, debt in Islamic perspective can be defined as borrowing a sum of money or a part of creditor’s properties with proper offer and acceptance (Ijab and Qabul) where the debtor is in a state of willing to pay back without adding Riba.

From the definition it is clear that debt is permissible in Islam as long as it doesn’t contain the element of Riba. Debt is seen as a means of helping people in need which is a noble practice and pious act. This is the reason why the act of lending someone in need in Islam is called Qard Al-Hasan which can be translated as a benevolent or virtuous loan. Debt can help the poor and the needy to fulfill his basic needs (Daruriyyat) which is in line with the objectives of Shariah. However, Islam at the same time also highlights the dangers of being indebted. The Prophet in his Hadith even seeks refuge from Allah the Almighty from debt since a debtor tends to tell lies and break promises. In addition, an indebted person will not be forgiven his sins until he paid back his debt. Heavily indebted also causes the debtor into a devastation and trapped in a cycle of poverty. In conclusion, debt must be paid back since it is considered as a trust (Amanah). Realizing the importance of paying back a debt, in Islam

Contemporary Issues and Developments in Islamic Finance | 8 Thoughts of an Indonesian Diaspora in Bahrain

an indebted person has been listed as one of the eligible recipients of Zakah which is known as Al-Gharim. Al- Gharim is a Muslim who carries burden of debt in order to fulfill and enhance his basic needs or for the other Muslims in which he doesn’t have the capacity to repay the debt.In addition, Islam encourages the lenders to be patient with the debtors and even encourages the lenders to cancel the debt in case the debtors are genuinely unable to pay the debt.

In the current practice of Islamic banking and finance, debt has also been given a special attention. Beside being a commercial entity, an Islamic bank is also required to fulfill its social and religious obligations. Bahrain based standard setting body, the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) requires Islamic banks to prepare two additional statements namely “statement of sources and uses of Qard fund” and “statement of “ It is clear that debt sources and uses of Zakah is permissible in and charity fund” as parts of Islam as long as it the banks’ financial reporting doesn’t contain the requirements. These two element of Riba. statements aim to disclose Debt is seen as a how Islamic banks discharge means of helping their social and religious people in need responsibilities. While the which is a noble Qard fund is a benevolent practice and pious loan given to the poor and the act” needy to help them in fulfilling his basic needs such as for marriage and medical treatment, the Zakah fund is given to the eight recipients which includes the Al-Gharimin (plural of Al-Gharim) to free them from the burden of debt. Obviously, through the funds reported in these two statements, Islamic banks will be able to improve the welfare of the society

Contemporary Issues and Developments in Islamic Finance | 9 Thoughts of an Indonesian Diaspora in Bahrain

(Maslahah) in general. Therefore, Islamic banks’ management needs to pay attention to this aspect. This aspect is not only expected to boost the confidence of Islamic banks’ stakeholders in dealing with the banks which subsequently enhances the banks’ performance but also make all Islamic banks’ activities, transactions, products and operations blessed by the Allah Almighty.

Contemporary Issues and Developments in Islamic Finance | 10 Thoughts of an Indonesian Diaspora in Bahrain

Islamic Finance: The Original Wisdom behind Its Establishment

Islamic banking and finance is growing globally in Muslim majority countries and non-Muslim countries. Many countries that previously objected the idea are currently showing their interest in the industry and have even been declaring their willingness to become an Islamic financial hub. For example, the world’s major financial centers such as London, New York, Singapore and Tokyo are competing with each other to attract wealthy Muslim investors by offering them so-called Shariah compliant investments. This phenomenon is further spurred by the increase in oil prices during 2007 to 2008 leaving Muslim oil producing countries in the GCC countries with excess liquidity to be invested.

Despite these positive signs, Muslim investors must critically know of the original wisdom behind the establishment of Islamic banking and finance. Islamic banking and finance was created as a result of Muslims’ efforts to dedicate all aspects of their lives to the teachings of Islam. Watt, a non-Muslim, did a comparative research on the meaning of religion for a secular westerner and the meaning of religion for a Muslim. He found that for a secular westerner religion has little or nothing to do with commerce or economics or politics or industrial relationships.

However, he found that for a Muslim, religion is seen as a complete way of life including forms of worship, political and economic theories, and detailed codes of conduct. One of the results of viewing religion as a complete way of life in the economy is the creation of Islamic financial institutions such as Islamic banks, Takaful companies and Islamic investment companies.

Contemporary Issues and Developments in Islamic Finance | 11 Thoughts of an Indonesian Diaspora in Bahrain

All the financial institutions mentioned above must comply with Shariah law in their activities. There should be no prohibited elements in Shariah such as riba, gharar and maysir involved in their operations. Besides that, most importantly, they must also direct their activities towards realizing the objectives of Shariah (Maqasid Shariah). In general, the objectives of Shariah can be divided into three categories namely education (Tarbiyah), justice (Adalah) and the welfare of the society (Maslahatul Ammah).

Each objective of Shariah should be reflected in the operations of Islamic financial institutions (IFIs). For an example, the role of an Islamic bank in education is to increase the awareness of its staff and the public on Islamic banking products. Practically, this objective can be achieved through close cooperation with training institutes, the mass media and higher learning institutions. In a collective action, IFIs can establish an endowment fund intended to sponsor potential students to attend Islamic finance programs held by reputable higher learning and training institutions.

In fact, the Central Bank of Bahrain has initiated the establishment of a Waqf fund funded by IFIs in Bahrain with the purpose of sponsoring top graduates in accounting, economics and finance from the University of Bahrain to attend a diploma in Islamic finance program at the Bahrain Institute of Banking and Finance along with internship programs in the respective IFIs.

The program is intended to solve the shortage of qualified human resources in the Islamic finance industry. The program is also expected to be a continuous bridge that connects practitioners and academicians in order to

Contemporary Issues and Developments in Islamic Finance | 12 Thoughts of an Indonesian Diaspora in Bahrain

update the public with the latest developments in the Islamic finance industry. Adalah (justice) principle implies that all IFIs must establish justice in their operations. This objective can be achieved through transparency in financial reporting, fair distribution of profits from the investment, and fair charges on services provided to the customers. In practice, IFIs should take care of the interests of all stakeholders equally. Unlike a conventional financial institution whose main goal is to maximize the shareholders’ wealth, IFIs’ main goal is to ensure fairness to all parties dealing with the institutions. This is also due to the fact that in Islamic economics all factors of production have equal weight.

The welfare of the society (Maslahah) can be achieved through allocating financing to the area that can enhance Islam and Dakwah in general and benefit a large number of people. It is not supposed to “ In fact, the focus only on areas that improvement in the benefit a few, even though welfare of society they are the most profi table in which IFIs are ones. For example, if a large operating is one of number of people in the the more important society need agricultural success indicators financing, there must be a of the operations of significant percentage of IFIs” financing allocated by an Islamic bank to the sector, although real estate financing offers the highest rate of return. In fact, the improvement in the welfare of society in which IFIs are operating is one of the more important success indicators of the operations of IFIs.

However, the objectives of Shariah described above do not mean that Islam is against the principle of profit maximization. Basically, an IFI should only be involved in

Contemporary Issues and Developments in Islamic Finance | 13 Thoughts of an Indonesian Diaspora in Bahrain

profitable businesses since it holds a significant amount of public money that can be considered as a trust (Amanah). Therefore, in order to ensure the sustainability of the trust, being profitable is a must for IFIs.

However, the profit should not be achieved at the cost of other stakeholders’ interests. In conclusion, there must be a balance between commercial objectives (profit maximization) and social and religious objectives promulgated in the teachings of Islam. The description of the objectives of Shariah above is intended to ensure no deviation in the operations of IFIs from the original wisdom of their establishment.

Contemporary Issues and Developments in Islamic Finance | 14 Thoughts of an Indonesian Diaspora in Bahrain

The Interest-Based Economy and Public Debt: An Analysis of the US Economy

UGI SUHARTO and SUTAN EMIR HIDAYAT look at the American economy as a real-life case study that reflects the economic interpretation of riba.

As stated in the Quran: “When you give interest (riba) with the goal of growing public property then it will not grow in the sight of Allah.” This verse has a very important economic interpretation. Interest, which is initially seen as a tool to accelerate the economic growth by its proponents, has failed to perform its job.

At the end, interest could even ultimately destroy the economy itself. Let us take the US economy as a real case study that reflects the economic interpretation of this verse.

Highlights of the US economy and its public debt

The US is currently the world’s largest economy. According to IMF data, the country’s GDP in 2010 stood at around US$14.6 trillion. Yet ironically, the US is also the largest debtor in the world.

Total US debts have reached US$14.3 trillion. This means the debt to GDP ratio of the US is nearly 100%. Due to the ever increasing amount of debt, the US government is currently debating the debt ceiling (debt limit): whether it should be raised so that the government can legally borrow more or vice versa.

The country has set the legal limit for public debt at US$14,294 trillion. This means that the current level of

Contemporary Issues and Developments in Islamic Finance | 15 Thoughts of an Indonesian Diaspora in Bahrain

US debt does not allow the government to make another loan since it has already exceeded the legal limit. It was on the 16th May 2011 that the US debt exceeded this legal limit.

Political dissent and opposition parties are currently trying to block the government’s proposal to raise the debt ceiling. As the result, the Treasury secretary, Timothy Geithner, recently threatened the Congress that if by the 2nd August 2011 the debt ceiling is not raised, the US government might declare a ‘default’. Of course if this happens, investors will lose their confidence in the US economy. Investors who are holding US securities will soon be selling them, thus forcing the price to fall. Surely, in order to combat the capital outflows, the US government will raise interest rates – likely to be followed subsequently by an increase in interest rates worldwide.

Once this happens, another global financial crisis will occur because banks around the world will be reluctant to extend loans to businesses except with relatively high interest rates. This situation will obviously discourage firms from obtaining bank loans, reduce investments, paralyze businesses and trigger lay-off s. As a result, the unemployment rate will increase significantly and the economy will experience a recession again.

The above scenario would be a possibility only if the debt ceiling is not raised and the US government therefore declares a ‘default’. However, if the ceiling is increased, then US debt will grow steadily. Historically, the US debt has never decreased because the prosperity of Americans is actually financed through budget deficits (US expenditures are more than US revenues).

Contemporary Issues and Developments in Islamic Finance | 16 Thoughts of an Indonesian Diaspora in Bahrain

Total US debt always rises from year to year and the amount of interest also increases steadily. In 2010, the US government owed interest of up to US$414 billion on its debts. The amount paid in interest is equal to the overall GDP of Norway – ranked the world’s 25th largest economy (based on GDP) in 2010 – and is greater than the GDP of 155 other “ The US Economy countries. would have been

bankrupt long time In 2011, it is estimated that ago if the Bretton interest payments for US Woods agreement debts will increase to US$431 was still in place” billion and by 2019 reach US$700 billion. In fact, it has been estimated that in the next 10 years, or by 2021, interest on US debts will increase to US$1.1 trillion.

Public debts of other developed countries

The US debt economic dependent is also copied by many countries that adopt its development model. Japan, for example, is a developed country which follows this model and is another of the world’s major debtors. Japan’s debt to GDP ratio in 2010 was 225%.

This means Japanese debt is 2.25 times greater than its total production of goods and services.

However, unlike the US, most of Japan’s debts are supplied by its own citizens, while most of US debts are supplied by foreign lenders.

In fact, the debt based economic model has been practiced by most developed countries in the world. For example, in 2010, the total debts of countries in the Eurozone were US$14.1 trillion (120% of GDP): UK debt

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was US$8.9 trillion (398% of GDP); Germany owed US$4.7 trillion (143% of GDP); France owed US$4.6 trillion (188% of GDP) and the Netherlands owed US$2.3 trillion (344% of GDP).

This data indicates that the debt level of developed countries is greater than their productivity level. Based on the above figures, it is clear that the interest-based economy in reality will never grow. Even if macroeconomic indicators of those developed countries show positive statistical figures, they only portray a ‘bubble economy’ that will burst at some point in the future.

US dollars and the global monetary system

The US is now facing a huge debt crisis. As long as creditors have confidence in the US economy, the US government can feel safe for the time being. But to enjoy continuous borrowing and leveraging without any eff orts to cut its own spending is not “ The central bank only self-destructive, but will and commercial also destroy the confidence of banks are actually others. moneymaking

machines both in Now, the creditors might still the sense of be happy with the interest rate currency and of they earn, but there will come money supply” a time when creditors will demand higher interest rates for the loans they provide to the US government. If this demand cannot be fulfilled then that is the beginning of the relationship crisis between the debtor and its creditors.

Uniquely, the US debt is related to the US dollar as the world’s reserve currency, and in reality the US dollar is

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also printed on the basis of debt. Since the breakdown of the Brett on Woods agreement in 1971, the US dollar no longer is no longer tied to gold. This means the US government can simply print US dollars at will. As the debt keeps increasing, more and more US dollar will be printed to pay the debt and its interest. The question is, how long would the world still be willing to accept the debt-backed US dollar?

This is the web of debt faced by the world largest economy today. Americans owe in US dollars and will pay in US dollars, while the US dollar at the same time is printed through debt. As a consequence, there always be the government’s fear of the world community losing confidence in the US dollars as the reserve currency.

In fact, the signs are already visible. On the 18th April 2011, Standard and Poor’s Ratings Services changed the outlook of US debt from ‘stable’ to ‘negative’. This is the first time in 60 years that a negative outlook has been given to US debt securities, which are perceived as some of the world’s safest.

If the quality of US debt indeed declines, then the risk of giving debt to the US government will be considered higher, and consequently investors will demand a higher interest rate to compensate. Interest is prohibited under Shariah rules.

Interest can stimulate productive debts. Both lenders and debtors can become addicted to these debts. The US economy, for example, is addicted to debt since it is constantly using the funds of other countries to finance its developments. The creditor countries are also addicted to US debt since they enjoy earning interest from loans. This process runs continuously, resulting in a

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bubble economy that will burst in the future. However, when the US economy erupts, this will no longer be a usual business cycle.

The US economy would have been bankrupt long time ago if the Brett on Woods agreement was still in place. During the implementation of the agreement, the US government was willing to trade US$35 with 1 oz of gold.

Because of this willingness the US dollar gained the confidence of the world and began the journey towards becoming the world’s reserve currency. But by the 1971, the US economy had plunged into recession and the world community started to question the US’ ability to fulfil its commitment to exchange 1 oz of gold for US$35.

Now, in 2011, the value of 1 oz of gold is already more than US$1,500. This means that the US has experienced devaluation of over 4,200% since 1971. Imagine if the US dollar was still pegged to gold: obviously those countries which hold the US dollar as their reserves would exchange every US$35 with 1 oz of gold. With gold price now higher than US$1,500, surely the US gold reserves would not be sufficient to cover this exchange demand.

As a result, the US dollar would become worthless paper. 1971 was an historic year for the world monetary system as for the first time the world’s currency was detached from gold. From that year, printing money was no longer based on the availability of gold reserves. The US government in particular can print US dollars at its own will. Every US dollar printed is a proof of US government debt to the holders of US dollars. If we hold US$100, this means that we have proof that the US government owes us US$100. The problem is when we redeem US$100 to the US government, what will we get? Are we going to

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get gold in exchange of the US$100? No. Instead we will get another newly printed US$100.

If so, why does the world community still accept the US dollar? There are many factors that can explain this phenomenon. Among others, the US dollar is still the most widely used currency in the international trades. For example, if a country wants to buy oil from another country, the price must be in US dollars. In addition, OPEC countries have promised that their oil will always be sold in US dollars.

Dilemma: US dollars or gold

The signs of the dilemma are already visible. It is no surprise today that many central banks have quietly begun storing their gold reserves and started to release US dollars.

Recently, it was reported that Mexico’s central bank has bought as much as 100 tons of gold in just over two months (February-March 2011). This is the biggest gold purchase in the history of the central bank. The Chinese government in 2009 announced that they have 454 tons of gold as the result of six years accumulation. India bought 200 tons of gold from the IMF in October 2009, and Russia over the last five years has bought about 400 tons of gold in the free market. These series of purchases are among the causes of the increase in world gold prices recently.

High demand from central banks around the world along with limited supply has pushed up gold prices. In contrast, the demand for the US dollar has declined and large- scale printing of US dollars makes the currency depreciate sharply. Despite the above actions, the US

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itself is actually the largest gold depository country in the world. US gold deposits are now estimated at around 8,134 tons.

The process of printing the US dollar actually involves an element of interest (riba). There are three institutions that play an important role in printing the US dollar: namely Congress, the Treasury department and the Federal Reserve (Fed) (central bank). If Congress agrees to raise the debt limit, then the Treasury will issue bonds and/or T-bills. Like other debt securities, the bonds and/or T-bills will provide interest to the purchaser (implicit or explicit interest). This is where the element of riba originates.

An example of implicit interest exists when the debt is repurchased at a higher price. For an example, suppose the price of bonds/T-bills was US$100; and the Treasury is willing to buy it back at a price of US$103. The interest is therefore 3%. This is equivalent to the US government borrowing US$100 and paying back US$103.

However, in finance terms this action is not called a loan, but the buying and selling of bonds. The Treasury department as the issuer of the bond is perceived as the seller of bonds. Then who will buy the bonds? In the US context, the Fed is an institution that will buy the bonds in the open market.

In order to buy these bonds, the Fed needs to print new US dollars. So, the US government will receive fresh funding from the Fed for running the country. The Fed is a private institution that is owned by major US banks. The Fed has two big powers in money creation. First, it prints new coins and notes for the country, and second, it acts as the ‘lender of last resort’ for other banks. The Fed

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extends loans to commercial banks by charging an interest called ‘discount rate’.

Through a system of fractional reserve banking (FRB), debentures or bonds that have been purchased from the US government will be held as ‘reserves’ and using this reserve the Fed gives credits to commercial banks in amounts much larger than the value of the reserve itself. The system is then followed by commercial banks inflating the ‘money supply’ into the economy.

The more loans given by commercial banks, the greater is the bubble money supply in the economy. It is necessary for us to distinguish between the money supply and the currency in circulation. Actually, the amount of money supply is much larger than the amount of currency in circulation.

Through FRB, the money that we save in the bank is actually not available in its hard form since most of it has been lent to someone else. Therefore, if all depositors withdraw their money, then the banks would not be able to fulfil the demands.

If excessive withdrawal happened then the banks will experience a ‘bank run’ or go bankrupt. Why? Because the money that we save in the bank has been melting into a ‘money supply’ that exists only in numbers in bookkeeping accounts and in banks’ computers. The central bank and commercial banks are actually moneymaking machines both in the senses of currency and of money supply.

Call for a more Comprehensive implementation of Islamic finance to solve the world’s problematic monetary system

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Based on the above explanations, it is clear that the interest-based economy is not in line with Shariah. Therefore, there should be more eff orts to comprehensively implement the principles of Islamic finance in the monetary system including how a government budget should be financed. One practical solution offered by Islamic finance is the issuance of Sukuk. In practice, there are two categories of Sukuk: debt- based and equity-based. A debt-based Sukuk is normally used to finance short-term government budget deficits while equity-based Sukuk is for financing long- term government projects.

In a debt-based Sukuk, one of the essential requirements is the availability of underlying assets. This requirement at least contractually limits the amount of funds that can be raised through the issuance of Sukuk (subject to the value of underlying assets), thus preventing the government from over borrowing.

In an equity-based Sukuk, the Sukuk does not represent a debt, so it will not burden the government with the obligations to pay the interest and principal. Instead, the Sukuk represents the participation (investment) of Sukuk-holders in the government’s projects. Thus the return to Sukuk-holders is subject to the actual outcome of the projects. Therefore, in order to make the Sukuk marketable, the government should only come out with profitable projects.

This requirement will force the government to become more efficient since this is the only way to attract investors. As a result, the government will try its best to minimize corruption and other forms of misusage of public funds.

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With this scenario in place, the acute problems in the world’s monetary system as explained earlier will be solved since public finance is no longer raised through debt which is backed only by trust.

However, currently, Sukuk still represents a much smaller portion of public finance instruments than conventional securities in most countries. Therefore, in order to accomplish the mission, Muslim countries should increase gradually the volume of sovereign Sukuk issuances in place of conventional bonds, notes and bills.

At the end, it is expected that all interest-based instruments will be eliminated from the monetary system. As a consequence, a 100% Shariah compliant monetary system will be in place.

Money from Islamic Perspective

As we are all aware, money is an important element of an economy. Like a car engine that needs oil to be operated, an economy will not be run without money. However, most of us understand money in the context of its form as banknotes and coins only. Actually, the definition of money is much broader than that. Money can be defined as anything that can be accepted as a means of payment for goods and services in an economic system. In fact, in ancient times people used stones, animal skins, salt, and shells as money. At the time of the Prophet (SAW), gold coins (Dinars), which are derived from the Roman and silver coins (Dirhams), which is originated from Persia are considered as a currency. In the current era, paper money (fiat money) has become a common means of payment used in every country around the world.

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Originally, money has three important functions, namely as a medium of exchange, store of value, and measuring the value of a commodity. However, with the widespread of interest system in today’s financial transactions, function of money has expanded into a commodity.

The function of money as a commodity is supported by several contemporary financial theories such as the Loan-able Funds Theory. In this theory, interest is considered as the price of the funds available for lending (loan-able funds) which became one of the variables that affect supply of and demand for loan-able funds. Based on the above theory, it can be concluded that the supplier of loan-able funds would be willing to lend money to a borrower only if the borrower is willing to pay back the loan in an amount larger than the principal. The difference between the amount borrowed and due is called the interest. In other words, the interest is the price paid for a commodity called money (loan-able funds).

Here, it is clearly seen that in the current financial system, money is regarded as a commodity that can be traded. This is in contrast with the view of Islam that does not accept the function of money as a commodity. That is because money does not qualify as a commodity. According to Sheikh Muhammad Taqi Usmani, a renowned Shariah scholar, there are at least three factors that distinguish money to commodities. First, money has no intrinsic utility. Unlike commodities, money cannot be eaten, worn, or used directly. Money can be exchanged with commodities, and commodities that will be eaten, worn or used. In economic terms, the money only has value in exchange while commodities have value in exchange and value in use at once. In addition, the banknotes and coins (fiat money) became legal

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tender due to law issued by the government that declared the validity of them. This shows that the acceptance of fiat money as a means of payment is only due to the government deceleration that ensures its validity. If the trust is lost or weakened, the value of the currency will be depreciated since more people sell of the currency, than demand for it.

Second, the money does not need a quality to determine its value. For example, an old USD 100 note issued in 2010 has the same value and purchasing power as the newly issued USD 100 in 2016. Third, money does not require the specification when the enactment of the transaction, while commodities have specific properties when enactment of the transaction takes place. For example, if we wanted to buy a good we will choose the thing that we really want in terms of color and other complementary accessories. If the seller offers the same good but different color which does not suit our taste, we have the right to reject it. On the other hand, money is not specific. For example, for the payment of monthly electricity bills amounting to BHD 30, we can pay these bills by using three BD 10 notes or six BD 5 notes. For the recipient, there will be no any difference in value of the two above ways of payment.

However, it should also be emphasized that fiat money is a valid form of money according to Shariah. The author does not agree with the view that gold and silver are the only valid forms of money according to Shariah. It is true that gold is the most stable form of money, and if we could go back to the era where the gold was used as money, of course, the world’s financial system will be far better. However, the claims made by some scholars mentioning only gold and silver are recognized in Islam as money are too extreme. As a proof, Caliph Umar ever

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intended to make camel as a currency, but was later advised not to do it, because eventually the camel will be vanished if it was applied. In addition, Imam Malik once said that if people make the animal skin as a currency, he undoubtedly would prohibit the sale and purchase of the animal’s skin unless with cash due to its new role as a currency.

Conclusion

The Quranic verse quoted above can be understood well in the light of the current US debt predicament. Riba encourages and stimulates these so called productive debts. It appears on the surface to help economic growth, but essentially it creates a debt-ridden economy whose productivity will be diminished continuously by the ever growing non-repayable amount of debt. Riba is the source of systemic economic crises which undermine the production of goods and services.

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Rules of Exchanging Money in Islam

Islam as a complete way of life has clear rules on the exchange of money which is known as the Bay ‘Al-Saraf in Islamic jurisprudence. In general, the rules of money exchange in Islam can be divided into two categories, namely the rule of exchanging money in the same currency, and the rule for two different currencies. For the first category, the exchange must be done on the spot and in the equal value. For example, a BHD 1 note must be exchanged for ten 100 fills coins. For the second category, the exchange must be done on the spot, and there should be no Khiyar Shart (a conditional option). For example, BHD 1 note can be exchanged for IDR 34,560 (according to the prevailing rates when the exchange occurs). This means that the value is not necessarily the same, but it must be done on the spot.

The exchange of money in the second category is known as foreign currency exchange (FX). Foreign currency exchange transactions are usually done either in money changer or Foreign Exchange Market (Forex). FX transactions in the money changer are usually done to meet the demand of individuals in relatively small amounts and usually do not involve any financial derivative instruments. Thus, FX transactions in the money changer do not have Shariah issue. Meanwhile, foreign currency exchange transactions that occur in the Forex are mostly done by the institutions and typically involve financial derivative contracts such as currency forward, currency futures, and currency option. The existence of financial derivative contracts in Forex requires research on its validity from the standpoint of Shariah.

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First, currency forward. Currency forward is an agreement between two parties to buy or sell a currency in the future specified date and specified price known as forward rate. Participants in derivative contracts are mostly multinational companies who want to minimize foreign exchange rate risk. For example, Company A will require EUR 1,000,000 in the “ The existence of next three months to pay financial derivative suppliers in France. With the contracts in Forex volatility of the exchange rate, requires research Company A decides to enter on its validity from into a currency forward the standpoint of agreement with Bank Y where Shariah” in the next three months Company A will buy EUR 1,000,000 from Bank Y with the exchange rate of 1 BHD = EUR 2. It is clear that in the currency forward, the exchange will take place in the future (next three months) although the contract is done now. This certainly violates the rules of on the spot outlined by Islam in exchanging of two different currencies.

Second, currency futures. Currency futures is similar to currency forward. However, currency futures is traded in an organized exchange, in a standard unit, and there is an involvement of clearing house that guarantees completion of the transaction thus, eliminating counterparty risk through margin requirement (deposit). In addition, most transactions in currency futures are settled by entering into another futures contract to cover the obligations arising from the previous futures contract (offsetting). It is well known that a currency futures contract involves a lot of speculation. Therefore, it contains elements of Gharar and Maysir which are not accepted by Shariah.

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Third, currency option. Currency option is a contract in which one party agrees to pay a premium to another for a “right” (but not the obligation) to buy or sell a currency in a particular price (exercise price) within a specified period. In other words, the option holder doesn’t have an obligation to use the option. That means, foreign exchange transaction could happen or not depending on the situation whether it is profitable for the option holder to exercise the option or not. Regarding its validity in Shariah, Some scholars argue that the option has commonalities with the Bay Al-Arbun. However, it is important to note that in option, the premium is not a part of the price, while Bay Al-Arbun is a part of the contract price.

In addition to the above discussion, it can also be concluded that in most derivative contracts there must be gainers and losers from the transactions. The spirit is not win-win solution but it is win-lose which is similar to gambling. Moreover, the above contracts provide ample room for speculation against some currencies. Although it cannot be denied speculation has benefits such as adding liquidity to the financial market, but the damage (harm) caused by speculation especially in illiquid currencies such as the Indonesian Rupiah (IDR) is more than its benefits. The amount of damage that may arise from the derivative transactions are recognized even by the world’s best investor Warren Buffet. In a statement he once called derivative contracts as financial weapons of mass destruction.

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Part 2

Contemporary Issues and Development in Islamic Banking

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Why Do People Choose Islamic Banks?

Islamic banking and finance has now become a global phenomenon. It exists in both developed and developing countries. One thing that we want to know is why it is becoming people’s choice. In other words “why do people choose Islamic banks?”

Review of literature reveals that there are several determining factors that drive someone in patronizing Islamic banking services. This article attempts to elaborate 4 of the most important factors namely (1) Religious factor; (2) Service quality; (3) Product’s features and; (4) Family and friends’ recommendation.

Religious factor has been found by many studies to be one of the most important factors since the establishment of Islamic banking and finance itself is due to the desire of Muslims to comply all aspects of their life with shariah. Therefore, in order to avoid prohibited elements in financial transactions such as riba, maysir and gharar, a new banking paradigm which is based on shariah was created. For that, it is very important for the Islamic banks to ensure that they are continuously shariah compliant in their operations. Any shariah violation will surely have a serious consequence.

Beside religious factor, service quality has been identified by many studies as a factor that cannot be ignored by Islamic banks in order to move forward. This factor becomes very important especially for non-Muslim customers and even some Muslim customers who are still not shariah conscious. Operating in a dual banking system where conventional and Islamic banks are competing to attract customers, service quality becomes a winning factor.

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Next, many studies also list product’s features as a determining factor. It is common for a customer to look for a banking product that caters his or her needs. Therefore, product development is very crucial in banking industry. As a result, Islamic banks must be able to come out with banking products that are not only shariah compliant but also needed by the people that the banks serve. In fact this is in line with “ There are several the objective of shariah determining factors namely maslahah (public that drive someone interest). in patronizing

Islamic banking Last, many people choose to services” deal with Islamic banks because of family and friends’ recommendation. This factor is very much related to awareness campaign. As we know awareness positively influences preference. In addition, mouth to mouth promotion has been proven as an effective way to market a product. When a family member or a friend becomes aware of Islamic banking services he or she might be interested in patronizing Islamic banking services. In addition, he or she also will try to convince his or her family members and friends to deal with Islamic banks too. This domino effect will surely boost Islamic banking and finance development.

This article is expected to draw the attention of Islamic banking and finance stakeholders to the above factors that influence people in choosing Islamic banking services. Considering the above factors in their decision making process will help Islamic banking and finance to flourish.

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Promoting Effective Liquidity Risk Management for Islamic Banks

Liquidity management by its very nature must be different for Islamic banks than for their conventional counterparts. SUTAN EMIR HIDAYAT explores the most important features from the viewpoint of IFSB- 1 risk management standards.

Liquidity risk is one of the big perils in banking operations. Similar to conventional banks, liquidity risk also exists in Islamic banking operations. Due to different business models, the way of managing liquidity risk in Islamic banks to some extent is different from the way of managing business risk in conventional banks.

Therefore, in order to promote effective liquidity risk management in Islamic banks, Islamic bankers should understand comprehensively three issues:

1. The specificities of Islamic banking and how they impact liquidity risk management process within their institutions; 2. The application of operational considerations in developing liquidity risk management policies based on IFSB-1 risk management standards; and 3. The limitations in liquidity management infrastructures for the Islamic financial services industry.

The specificities of Islamic banking and how they impact the liquidity risk management process within their institutions

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In general, the risk management process can be categorized into risk identification, risk assessment, measurement and monitoring, as well as risk mitigation and control. For risk identification, Islamic bankers should understand when liquidity risk may occur in their banking operations. Similar to conventional banks, liquidity risk in Islamic banks also occurs due to two reasons: first, if Islamic banks are unable to “ Liquidity risk in meet their obligations, and Islamic banks also second if they fail to fund the occurs due to two increases in assets as they fall reasons: first, if due without incurring Islamic banks are unacceptable costs or losses unable to meet (IFSB, 2005; Para 81). their obligations, and second if they While the way to identify the fail to fund the second source of liquidity risk increases in assets is not very different from the as they fall due conventional banking without incurring practice, there are some unacceptable costs additional considerations in or losses” identifying liquidity risk if it comes from the first source: namely the expectation of investment accountholders (IAH). IAH are the owner of profit-sharing investment accounts (PSIA). PSIA are the biggest source of external funding for most Islamic banks. Most of the IAH think that PSIA are similar to saving or investment deposits in conventional bank, which in fact is not the case. The IAH sign an investment agreement based on a Mudarabah or profit-sharing contract where the IAH will share the profit of the investment with the bank and bear the losses of their investment unless the losses are due to misconduct and negligence. Under this circumstance, the return received by the IAH is determined by the profit of their respective Islamic banks, especially if the IAH sign a Mudarabah

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Mutlaqah, where they give no restriction to the Islamic bank as to how the bank should invest their money.

Islamic banks have to manage their portfolio so that they are able to generate adequate profits to meet account holder expectations

How does such an arrangement affect liquidity risk identification in Islamic banks? In the case of conventional banks, they have relatively fewer problems in managing depositors’ expectations than their Islamic counterparts. If interest rates in the market increases, the bank may easily increase “ For effective interest rate paid to its liquidity risk depositors. Although this assessment, practice causes interest rate measurement and risk in conventional banks, monitoring, an such a practice cannot be Islamic bank executed in Islamic banks should be able to because it would be identify any future considered as non-Shariah shortfalls in compliant. The Islamic banks, liquidity and therefore, need to understand calculate the net the IAH expectation which funding demands a more or less equal requirements return as compared to the (NFR)” interest rate offered to depositors by the conventional banks. Due to this reason, Islamic banks have to manage their portfolio so that they are able to generate adequate profits to meet such expectations. The IAH are always concerned with Islamic bank’s financial condition. Some of the IAH are also concerned with the Shariah compliance of the bank. If they feel that the Islamic bank has an unfavorable financial situation or is not fully compliant, they may withdraw their funds and this may trigger a liquidity crisis.

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This is also the reason why many Islamic banks implement profit equalization reserves (PER) and investment risk reserves (IRR).

For effective liquidity risk assessment, measurement and monitoring, an Islamic bank should be able to identify any future shortfalls in liquidity and calculate the net funding requirements (NFR). In identifying future shortfalls in liquidity, an Islamic bank can use maturity ladders based on the appropriate time bands and should classify its cash flows based on behavioral method. According to behavioral method, the cash flows can be classified into:

1. Known cash flows – the maturities and the amounts are known in advance. This category includes receivables from Murabahah, Ijārah, Ijarah Muntahia Bittamleek receivables and diminishing Mushārakah. 2. Conditional but predictable cash flows – conditionality is defined in terms of the type of contract or performance of work based on the agreed terms and conditions over an agreed period. This type of cash flows can be found in Salam and Istisnah-based financings. 3. Conditional and unpredictable cash flows – the redemption of invested capital and possible levels of return on investment is conditional upon the performance of the activities.

This type of cash flows is embedded in equity based financings (Mudarabah and Musharakah). In some cases, a Musharakah investment is for an open-ended period. Therefore, an exit strategy may be assessed periodically. Each category explained above has different weight in measuring the liquidity risk. The known cash

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flows should get the lowest weight, while the conditional and unpredictable cash flows should get the highest.

In order to calculate NFR, an Islamic bank should model its current account behavior, consider IAH expectation and analyze cash flows periodically under various market scenarios and conditions: namely normal operating environment and adverse circumstances. Current accounts are the cheapest source of funding for an Islamic bank. Monitoring their movement is important to keep the cost of financing competitive. In considering the IAH expectations, it is assumed that funds are repaid at contractual maturity date. In analyzing the cash flows periodically, the analysis shall include assumptions about the repayment of invested capital to the IAH. It also includes the extent to which the losses will be mitigated by IRR in the event of investment losses.

In addition, the scenarios shall be based on relevant assumptions which are derived from the factors affecting the Islamic banks’ on and off -balance sheet exposures. Liquidity levels and early withdrawal profiles computed under these scenarios will also be back-tested periodically to validate the underlying assumptions of the measurement process. In analyses based on behavioral assumptions and scenarios, Islamic banks will assess and apply the liquidity measures that reflect the specificities of each portfolio. In the case of certain market practices, Islamic banks may have different types of portfolios, such as restricted investment accounts, that are treated as off -balance sheet items. In this case, the size, proportion and characteristics of the assets, which Islamic banks hold in relation to the restricted investment portfolios, will determine their specific liquidity profiles.

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For effective liquidity risk mitigation and control, an Islamic bank should set a limit for maximum amount of cumulative liquidity mismatch and ensure that liquidity risks should meet the bank’s ability to provide sufficient Shariah compliant funds. The limit for the maximum amount of cumulative liquidity mismatch has to be manageable based on different time bands, as percentage of total funds available, type of fund providers and it must be regularly reviewed considering liquidity situation, economic climate and market condition. In addition, Islamic banks shall assess the necessity and extent of their access to available funding sources. In managing their liquidity, Islamic banks have the following possible funding sources:

1. Cash flows arising from their usual banking activities such as acceptance of deposits. 2. The realization of tradable invested assets such as selling of marketable securities 3. Asset securitization, such as issuing asset-backed Sukuk. 4. Capacity to access shareholders’ and/ or head office funds.

The application of some operational considerations in developing liquidity risk management policies based on IFSB-1 risk management standard

In their operations, all banks, including Islamic banks, must have liquidity management policies (LMP). The international banking standards suggest that banks should have robust liquidity risk management policies, a responsive asset and liability committee, effective information and internal control systems and methods for managing deposits to reduce on-demand liquidity, in order to manage liquidity risk. In general, to manage

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liquidity effectively, there is a need for visibility of cash positions, good forecasting, a way to concentrate funds, and the ability to negotiate foreign exchange and get it done before cut-off times.

In setting up their LMP, Islamic banks should include some forms of contractually agreed orderly liquidation procedures based on IFSB-1 risk management standard. In addition, Islamic banks must have a liquidity contingency plan addressing various stages of a liquidity crisis. One important note is that Islamic banks’ management should clearly define the classification of these stages. The stages can be classified as follows:

1. Identification of a liquidity gap or a situation which acts as a triggering event where withdrawals do not follow predictable patterns. For example, if Islamic banks may suffer an institutional rating downgrade. 2. A need to liquidate assets or investments in an orderly manner to meet such a liquidity gap or situation; and 3. Emergency measures to be taken in the event that the previous steps fail to meet the liquidity gap adequately.

Current Accounts are the cheapest source of funding for an Islamic bank. Monitoring their movement is important to keep the cost of financing competitive

Where appropriate, Islamic banks shall include in their contingency plans the following factors and define appropriate action points at each stage:

a. Holdings of tradable high quality liquid assets, which may be readily disposed of in sizeable amounts in

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deep markets taking into account the likelihood that it will not be possible to realize book value; b. Profile of other assets and the degree of liquidity of these assets; c. Assessment of Shariah compliant and available funding products in the market including possible cooperation agreements with either other Islamic banks or conventional institutions on an interest-free basis for accessing temporary funding, or sale and leaseback arrangements for longer term funding; d. Possible liquidity arrangements with the central bank (on an interest-free basis); e. Establishment of a crisis management team or personnel responsible for taking actions at different stages of the liquidity crisis; and f. Notification procedures for communication with Islamic banks’ head office and/or supervisory authorities.

Due to the unique characteristics of Islamic banks, their management needs to pay attention to some operational considerations in developing their liquidity risk management policies. Among them are:

1. Liquidity management framework; 2. Quantitative and Qualitative Considerations; and 3. Local requirements for liquidity management.

A liquidity management framework consists of liquidity management policies with the objective to maintain adequate liquidity at all times, taking into account Islamic banks’ business activities and the capital market environment. The LMP shall cover a strategy for managing liquidity involving effective board of directors’ and senior management oversight, a framework for developing and implementing sound processes for

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measuring and monitoring liquidity, adequate systems in place for monitoring and reporting liquidity exposures on a periodic basis, adequate funding capacity, with particular reference to the willingness and ability of shareholders to provide additional capital when necessary, access to liquidity through fixed asset realizations and arrangements such as sale and leaseback and liquidity crisis management.

In term of quantitative considerations, Islamic banks must consider the diversity of the sources of funds, the concentration of the funding base, the reliance on marketable asset and the availability of standby line of external funding. In term of qualitative consideration, Islamic banks must assess the management performance in terms of treasury operations, public relations, management information systems, the banks’ reputation in the market, willingness of shareholders to provide additional capital and willingness of the head office or parent company to provide liquidity aid.

Lastly, Islamic banks must also consider the local requirements for liquidity management. For an example, Islamic banks must be able to stand alone, and to monitor and manage their own liquidity.

The limitations in liquidity management infrastructures for Islamic financial services industry

In general, in order to assist banks and other financial institutions in managing their liquidity several money market instruments such as repurchase agreements (Repo), treasury bills (T-bills), commercial paper and interbank loans were created.

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However, Islamic banks are not allowed to participate in the conventional money market since all the instruments are deemed to be non-Shariah compliant due to the existence of the Riba element in their contracts. Therefore, “ The numbers of Islamic money market Islamic money instruments such as market instruments commodity Murabahah are still very interbank (CMI), Mudarabah limited, especially interbank investment (MII) as compared to and short-term maturity Sukuk conventional (Sukuk al-salam) were instruments. The created as facilities for Islamic limited availability banks and other Islamic of instruments may financial institutions to expose Islamic manage their liquidity. banks to higher liquidity risk than However, the numbers of conventional Islamic money market banks” instruments are still very limited, especially as compared to conventional instruments. The limited availability of instruments may expose Islamic banks to higher liquidity risk than conventional banks.

Therefore, regulators need to increase the number of money market instruments available for Islamic banks to manage their liquidity. The efforts made by Bahrain- based International Islamic Financial Market (IIFM) to create a range of liquidity management instruments should be appreciated.

However, more effort should be made to increase the numbers. This is very important since with more available instruments, surplus Islamic banks can invest their temporary idle funds for a lawful profit and deficit Islamic banks can get temporary funds to cover their shortages.

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Again, it is very important that the products should be highly differentiated from conventional money market instruments in order to create awareness of the public on the differences between Islamic and conventional banking operations.

Conclusion

Liquidity management is very important in any banking operation since serious illiquidity can cause bankruptcy. Like their conventional counterparts, Islamic banks need to have good liquidity risk management (LRM) in order to be solvent.

However, somewhat different from conventional approaches on managing liquidity, Islamic banks need to construct a liquidity management program which complies with their characteristics and risk profiles.

In general, there are three things that must be taken into consideration by the Islamic banks management in order to develop an effective liquidity management: namely the specificities of Islamic banking and how they impact liquidity risk management process within their institutions, the application of operational considerations in developing liquidity risk management policies based on IFSB-1 risk management standards and the limitations in liquidity management infrastructure for the Islamic financial services industry.

An effective liquidity risk management program will prevent banks from the negative impact of unfavorable economic conditions. It will also assist the banks to balance liquidity on the liability and asset sides, and most importantly will prevent a bank rush and minimize the risk of a government bailout to defaulting banks.

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Islamic banks should adopt adequate internal controls over their liquidity risk management processes which should be a part of the overall system of internal control to avoid liquidity problems in the future.

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Islamic Bank's Financing: Why Is It Expensive? A Conceptual Analysis

Islamic banking and finance has been in the operations since 1970s as the answer for Muslims around the world who want to adhere all aspects of their life to the teaching of Islam (shariah). However, the market share of Islamic banking is still relatively small as compared to conventional banking in most Muslim countries. For example, Islamic banking represented 20 percent of total banking assets in Malaysia (2010), 11.1 percent in Bahrain (2009) and 3.5 percent in Indonesia (2010). The same trend is applied in other Muslim countries with the exception of those countries that changed their banking system into Islamic such as Iran and Sudan. One of the reasons why most Muslims still prefer to take loan from conventional banks than financing from Islamic banks is the cost of financing (profit rate) for Islamic banks in many cases is higher than the interest rate on conventional banks' loan. This fact has led thousands of Muslims retain the conventional banking services despite their awareness on the prohibition of interest (riba) according to shariah. Using conceptual analysis approach, this article attempts to explain the reasons behind this phenomenon.

Determining Factors

Among the factors that cause Islamic bank's financing to be more expensive than conventional bank's loan are (1) The size of Islamic banks, (2) Costs structure of Islamic banks, (3) The nature of Islamic financing contracts and (4) Liquidity management instruments available for Islamic banks. The following paragraphs explain in details each factor.

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The size of most Islamic banks is relatively much smaller than the size of conventional banks. Standard & Poor’s (S&P) estimates that shariah compliant assets are currently about $1 trillion worldwide. The amount is still smaller than the total assets of the world’s biggest bank, BNP Paribas that stood up at $ 2.9 trillion in 2010 (Global Finance Magazine, 2010). In addition to that, around 40 percent of the total assets of “ Factors that cause the world's top 500 Islamic Islamic bank's banks are controlled by Iranian financing to be banks (The banker, 2010) more expensive leaving Islamic banks in dual than conventional banking systems with much bank's loan are (1) smaller total assets. This The size of Islamic situation has made Islamic banks, (2) Costs banks worldwide unable to structure of Islamic capitalize on the economies of banks, (3) The scale resulting in higher nature of Islamic average operational cost than financing contracts conventional banks. One of and (4) Liquidity possible reasons to the management situation is the relative short instruments period of Islamic banking available for existence as compared to Islamic banks” conventional banking. Modern conventional bank has been established since 14th century, while the first modern Islamic commercial bank was established in 1975 (Dubai Islamic Bank). Since operational costs are accounted in the computation of base financing rate (BFR) or base lending rate (BLR), higher operational costs per unit of Islamic banks than conventional banks has led to higher BFR as compared to BLR. As the result of higher BFR than BLR, Islamic banks' financing rate will be higher than interest rate on loan in conventional banks.

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The costs structure of both banking types is also different due to the differences in the modes of operations. First, the cost of deposit funds in conventional banks (interest rate on deposit) is predetermined and normally based on market interest rate. On the other hand, the cost of deposit funds (return on depositors' funds) in Islamic banks is based on the actual outcome of the banks' business rather than prefixed. This is because the relationship between the banks and their depositors is based on profit sharing (mudarabah) contract. Even, under profit sharing agreement, the depositors may lose part or full amount of their capital. It means contractually there is no guarantee on the principal and the return of depositors' funds in Islamic banking. This situation ultimately exposes Islamic banks' depositors to more risks as compared to conventional bank's depositors. As the compensation for more risk exposure, Islamic banks' depositors expect to get higher rate of return on their savings or investments in the banks. In order to fulfill the depositors' expectation, Islamic banks normally charge higher profit rate on their financings than the interest rate on conventional banking loans. This is actually in line with finance theory of "high risk high return".

In addition to the above fact, Islamic banks also have to pay some additional costs that do not exist in conventional banking operations. For example, in order to ensure compliancy to shariah, Islamic banks are obliged to have shariah supervisory board (SSB) as part of their organizational structure. This board consists of Islamic scholars (ulama) in the area of Islamic commercial jurisprudence (fiqh muammalah). However, the industry is now still lacking of qualified shariah scholars. The limited numbers of qualified shariah scholars in the area have forced some Islamic banks to hire the same shariah scholars to seat in their SSB. Since

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the scholars are highly demanded, they have strong bargaining power to get highly paid resulting in more overhead expenses that must be borne by Islamic banks. Beside that, Islamic banks also have to hire some shariah compliance officers that function as the assistants to the shariah scholars. These officers are the one who monitor the operations of Islamic banks and ensure that there is no violation of shariah by the banks in their daily operations. Again, the existence of these officers increases the staff costs of Islamic banks. The unavoidable additional costs above are the other possible reasons why Islamic banks' financing is more expensive than conventional loan.

Looking at the components of Islamic banks' assets, it is found that murabaha financing is still the biggest asset for most Islamic banks worldwide. Murabaha financing is a sale with a profit, but the cost price is informed to the buyer. One of the rules in a sale contract is once the price is agreed by the buyer and the seller, it cannot be changed. This condition has made the profit rate on murabaha financing is not adjustable, thus exposing the Islamic banks into greater interest rate risk as compared to loan in conventional banks. The higher interest rate risk in murabaha financing is compensated by the higher profit rate charged by Islamic banks to their customers.

Liquidity management is very important in any banking operations since serious illiquidity can cause the bankruptcy of the bank. In order to assist banks and other financial institutions in managing their liquidity several money market instruments such as repurchase agreement (Repo), treasury bills (T-bills), commercial paper and interbank loan were created. However, conventional money market instruments are deemed to be non shariah compliant due to the existence of riba

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element in their contracts, thus restricting Islamic banks to participate in the market. Therefore, Islamic money market instruments such as commodity murabaha interbank (CMI), mudaraba interbank investment (MII), short term maturity sukuk “ One strategic (sukuk al-salam) were created priority for Islamic as the facilities for Islamic banks to have banks and other Islamic highly financial institutions to differentiated manage their liquidity. products is to shift However, the numbers of their financing Islamic money market concentration from instruments are still very sale based contract limited especially in (murabahah) into comparison to conventional equity based instruments. The limited contracts numbers of the instruments (mudarabah and may expose Islamic banks musharakah)” into higher liquidity risk than conventional banks. This condition is surely compensated by higher profit rate on the financings of Islamic banks.

Future Directions

Even though the above factors clearly explain the reasons why Islamic banks' financing is more expensive than conventional banks' loan, it doesn't mean that Islamic banks should take this situation for granted. Serious efforts must be taken in order to improve the disadvantages. Relying only on the religious basis to promote Islamic banking is proven to be not effective. Other factors such as good quality services and cheap cost of financing should be the objectives of all Islamic banks to win the competition against conventional banks. In order to achieve these objectives, the supports from all

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Islamic banking stakeholders are highly needed. For a greater size of assets, Islamic banks must increase their deposit base. This is due to significant positive relationship between deposit (source of funds) and financing (asset) as proven by some empirical studies (see for example Ibrahim, 2006; Rukmana, 2010). Therefore, Islamic banks must come out with more products and services that do not only fit the needs of depositors but also not just simply replicate the existing conventional products. It means the products and services of Islamic banks must be highly differentiated, so the blurry perceived by some people on the differences between Islamic and conventional banking products will be resolved.

One strategic priority for Islamic banks to have highly differentiated products is to shift their financing concentration from sale based contract (murabahah) into equity based contracts (mudarabah and musharakah). Deputy Governor of Bank Negara Malaysia (BNM), Mohammad Razif in his presentation slides (Financial Sector Master Plan 2001-2010 in retrospect) mention some of the reasons why this strategy should be taken by Islamic banks.

1. The shift towards equity based financings will enable Islamic banks to move away from ‘mirror- imaging’ conventional and attain authenticity. 2. The shifts will foster entrepreneurial spirit to unlock potential for wealth creation and economic growth. 3. The shift will enable Islamic banks to develop niche and attain competitive edge in socially- inclusive and entrepreneurial banking (SMEs and micro financings)

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In addition to the above reasons, the shift will also remove or at least reduce the impact of interest rate on Islamic banks' financings thus reducing interest rate risks. As the result, Islamic banks may have their own benchmarks for pricing their financings.

Increasing numbers of qualified sharia scholars to seat in the SSB is also another important agenda. The efforts made by Bahrain based Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) offering professional certificate for shariah auditor and advisor (CSAA) should be appreciated. However, more efforts must be put in place to increase the numbers. One possible way is through intensive cooperation with training institutes and higher learning institutions. Shariah scholars who are not well equipped with finance and economics knowledge should be trained intensively to understand the subjects. Once they understand the subjects, they will have sufficient basis to release good rulings (fatwa) on any financial or economic transactions. This is also expected to fasten the approval process of new products, so more products can be launched to fit the needs of the public with more efficient costs.

Lastly, increasing the numbers of money market instruments available for Islamic banks to manage their liquidity is another way to reduce cost of financings. The efforts made by Bahrain based International Islamic Financial Market (IIFM) creating ranges of liquidity management instruments should be appreciated. However, more efforts should be put in place to increase the numbers. This is very important since with more available instruments, surplus Islamic banks can invest their temporary idle funds for a lawful profit and deficit Islamic banks can get temporary funds to cover their shortages. Again, the products should be highly

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differentiated from conventional money market instruments in order to create awareness of the public on the differences between Islamic and conventional banking operations.

Conclusion

This article provides some justifications to why Islamic banks' financing is more expensive than conventional loan. The article also provides some suggestions to be put as the future strategic directions of Islamic banks to solve the problem and gradually separate Islamic banking from the shadow of conventional banking. However, future empirical researches should be taken to prove the significance relationship between the determining factors described in this article to the cost of financing (profit rate) charged by Islamic banks to their clients.

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Corporate Social Responsibility for Islamic Banks

SUTAN EMIR HIDAYAT and SULIMAN ABDULRAHMAN ALHUR explain the concept of corporate social responsibility for Islamic banks based on AAOIFI’s governance standard for Islamic financial institutions.

Corporate social responsibility (CSR) has become an important issue in the corporate world. Corporations are realizing the need to run their operations not just to make profit but also to contribute to the betterment of society. Theoretically, corporations may gain various benefits from pursuing CSR: such as increased profits, customer loyalty, trust, positive brand attitude and combating negative publicity. Similar to other corporations, Islamic banks also have to comply with this issue. This is due to the fact that Islamic financial institutions (IFIs) were established with the aims of achieving the objectives of Shariah. One of these objectives is to improve the welfare of the society, which is very much in parallel with the concept of CSR.

However, due to its unique features, the concept of CSR for Islamic banks is somewhat different from the general concept of CSR. Unity, justice, free will and responsibility are the axiomatic principles upon which the conceptual framework of the Islamic perspective of CSR rests. As a result of the differences between CSR for Islamic banks and general concepts of CSR, there are several CSR activities required for Islamic banks which are not required for other corporations.

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General concept of CSR

There is no a single definite definition of CSR. On the local level, it refers to the relationship between a corporation and the local society in which it resides or operates. It can also refer to the relationship between a corporation and its stakeholders. All CSR activities operate on three basic principles: namely sustainability, accountability, and transparency. Sustainability requires that no resource shall be used by society more than it can be regenerated. Accountability refers to the responsibility of a corporation for the effects of its activities on the external environment. Transparency means that the corporation has the necessary mechanisms to disseminate to the public truthful information about its operations. Graph 1 summarizes the three basic principles of CSR activities:

It is thus clear that society is now looking at CSR as a corporate activity that goes beyond making profits. These include caring for employees, being ethical in trading, protecting the environment, and getting involved in the local community. It also refers to a set of standards of behavior that should be followed by any company that desires to have a rightful place in the business world.

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AAOIFI’s Governance Standard No. 7: Corporate social responsibility conduct and disclosure for IFIs AAOIFI’s Governance Standard No. 7: Corporate social responsibility conduct and disclosure for IFIs

AAOIFI defines CSR for IFIs as all activities carried out by an IFI to fulfill its religious, economic, legal, ethical and discretionary responsibilities as financial intermediaries for individual and institutions. “ However, due to its The definition above unique features, differentiates the concept of the concept of CSR CSR for IFIs (including Islamic for Islamic banks is banks) from the general somewhat different concept of CSR, as the former from the general includes the religious aspect concept of CSR” as one of the basic principles of CSR activities. As a result, AAOIFI includes in its standards some religious activities (based on Shariah) in CSR activities for Islamic banks. In addition, discretionary responsibility for Islamic banks is also based on Shariah teaching.

AAOIFI also explains in more detail each aspect of CSR for Islamic banks. Religious responsibility refers to the overarching obligation of Islamic banks to obey the laws of Islam in all dealings and operations. Economic responsibility refers to the obligation for Islamic banks to be financially viable, profitable and efficient. Legal responsibility refers to the obligation of Islamic banks to respect and obey the laws and regulations of the country of operation. Ethical responsibility refers to the obligation of Islamic banks to respect the mass of societal, religious and customary norms which are not codified in law. Discretionary responsibility refers to the expectation from stakeholders that Islamic banks will perform a social role in implementing Islamic deals over and above the

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religious, economic, legal and ethical responsibilities. Graph 2 summarizes the aspects of CSR for Islamic banks.

Referring to the above five aspects of responsibility, AAOIFI identifies 13 activities for Islamic banks to perform in order to fulfill their CSR. The 13 CSR activities of Islamic banks can be divided into two categories: namely mandatory and recommended conducts. There are five activities under mandatory conduct and eight activities under recommended conduct.

1. Policy for screening clients: Among the responsibilities of Islamic banks under this category are to ensure that the clients’ investments are compliant with Shariah, the clients are not using the Islamic banks to engage in any criminal activities such as money laundering and the clients’ investments are not negatively impacting the economy, society and environment. 2. Policy for responsible dealing with clients: Among the responsibilities of Islamic banks under this category are to avoid the imposition of onerous terms and conditions to clients, ensure that all marketing campaigns and documents are ethically balanced, promoting business without an exclusive focus on

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profits, the implementation of responsible financing practices in all types of transactions with clients, and fair dealing with late repayment and insolvent clients. 3. Policy for earnings and expenditures prohibited by Shariah: Among the responsibilities of Islamic banks under this category are to specify the reasons for undertaking such prohibited transaction and how Islamic banks intends to dispose of such revenues, assets and liabilities created from the prohibited transactions. Islamic banks are also responsible under this category for finding viable permissible alternative transactions to the current ones. 4. Policy for employee welfare: Among the responsibilities of Islamic banks under this category are to stipulate provisions for the rights and obligations of employees, avoidance of discrimination and child labor, expected behavior of all employees, and merit-based salary and promotion structure for all employees. 5. Policy for Zakat: Among the religious responsibilities of Islamic banks is to collect and distribute Zakat revenues on behalf of clients, customers, or shareholders (subject to the approval of Shariah supervisory board).

Recommended conduct

1. Policy for Qard Hasan: Islamic banks are encouraged to establish a Qard Hasan fund, circumstances in which such loans are distributed, maintain its record of sources and uses, establish write off conditions for debtors unable to repay the loans and develop strategy to increase the fund amount. 2. Policy for reduction of adverse impact on the environment: Islamic banks are encouraged to reduce the impact of their operations on the environment

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including minimal usage of non-renewable resources, incentives and initiatives to find alternatives to non- renewable sources of energy and materials for operations. 3. Policy for social, development and environment based investment quotas: Islamic banks are encouraged to assist poor and needy individuals, orphans, heavily indebted individuals, development of research and education facilities. 4. Policy for par excellence customer service: Islamic banks are encouraged to establish a code of conduct for all employees and contractors in dealing with customers, develop customer service skills of employees and conduct surveys on customer service feedback from the clients. 5. Policy for micro and small business: Islamic banks are encouraged to assist micro and small businesses through special features and terms of these types of investment depositors. 6. Policy for social savings and investments: Islamic banks are encouraged to offer social savings for marriages, children’s education, community-based programs, and other social welfare programs with the aim of improving the welfare of the society. 7. Policy for management of Waqf properties: Islamic banks are encouraged to manage Waqf properties on behalf of their beneficiaries. One of the possible Waqf to be managed is cash Waqf (Waqf al-Nuqud). 8. Policy for charitable activities: Islamic banks are encouraged to establish charity funds and avenues for voluntary donations by donors, establish fund raising drives from banks’ clients through existing operational means and identify target groups, communities and institutions that require assistance.

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The importance of public awareness on CSR activities of Islamic banks

It is clear that CSR is part of Islamic banks’ activities. However, there is a question on how to measure the success of CSR activities undertaken by Islamic banks. One way to measure the success of CSR programs of Islamic banks is by evaluating the public awareness of CSR activities conducted by “ Studies on CSR in these banks. Among the Islamic banks objectives of public awareness reveal that Islamic are: to bring out the best banks do have a advocacy results, to make good start on most people aware of a new piece aspects of social of information, fill a knowledge responsibility” gap in understanding an issue, stimulate the change of public attitudes and ultimately change public behaviors. However, to the best knowledge of the authors, there are only a few studies that track the public awareness of Islamic banking activities and its role in the enhancement of society.

CSR survey

One of these studies was a research paper recently conducted which related to awareness on CSR activities of Islamic banks using AAOIFI’s Governance Standard No. 7 as the basis. The survey was conducted through a questionnaire distributed to 154 CEO of large IFIs worldwide. However, only 29 institutions completed the questionnaire. Using the ‘yes’ and ‘no’ approach, the survey revealed that 100% of respondents answered yes to having a policy to screen prospective clients which is actively implemented. Similarly 97% have an organizational policy that deals with client responsibly. Eighty three percent of the respondents stated that they

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had policy that provides equal opportunities to all their employees. Seventy six percent indicated that they had policies for charitable activities. Overall, the results suggest that IFIs are in general performing well regarding most aspects of social responsibility, contrary to criticisms that have been leveled at the industry.

However, this varies widely between institutions. Also, the IFIs have yet to move from the negative screening framework, which is primarily based on avoidance (first generation), to the positive action framework, which is based on both avoidance and engagement in socially responsible activities (second generation).

Conclusion

Studies on CSR in Islamic banks reveal that Islamic banks do have a good start on most aspects of social responsibility. However, they have yet to move from the negative screening framework to the positive action framework. In addition, they should intensify their efforts to make their clients more aware of the CSR programs undertaken by them.

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Islamic Banking in Saudi Arabia: Grasping the Non- Muslim Segment

SUTAN EMIR HIDAYAT and NOUF KHALID AL- BAWARDI identify the perceptions of non-Muslim customers towards Islamic banking and the factors which motivate them to use Islamic banking services in Saudi Arabia.

During the last two decades there has been a rapid expansion of banking services in Saudi Arabia. The kingdom’s financial scene has been transformed due to the tremendous proliferation of local banks, a rapid expansion of branch networks and privately- owned banks and an enormous widening in the range of financial services provided by financial institutions. Saudi Arabia has a well-developed banking system consisting of 11 commercial banks.

These include a number of local banks which are wholly- owned by Saudi nationals/entities and joint-venture banks which have foreign stakeholders. Three of the commercial banks are wholly Saudi-owned, including the largest, National Commercial Bank (NCB) and second largest, Riyad Bank. Unlike Kuwait, which effectively expelled foreign banks in the 1970s, Saudi Arabia allowed foreigners to maintain a stake in the kingdom’s financial system. City Bank (SAMBA); HSBC (Saudi British Bank); Banque Indo-Suez (Al-Bank Al–Saudi Al- Fransi); ABN AMRO/RBS (Saudi Hollandi Bank) and Arab Bank (Arab National Bank) continue to have investment in Saudi banks.

This has facilitated the introduction of modern technology and the development of competitive banking services and products. The 1990s produced a more flexible

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attitude to foreign management of Saudi banks. Currently, seven of the foreign banks have non-Saudi chief executives or general managers.

As a result of the expansion in banking services in Saudi Arabia, the consumption of banking products and services has exhibited an extraordinary increase in the recent years. This increase has also been evident in the realm of Islamic banking. The past few years have also seen an expansion in the range of Islamic banking products which are offered to customers in Saudi Arabia.

Out of the 11 banks operating in Saudi Arabia, three (Al Rajhi, Al Jazira and Al Bilad) are operating their businesses in accordance to Shariah. The popularity of the Islamic banking system is not limited to the local Saudi banks. Instead, increasingly conventional foreign banks also show an interest in Islamic banking system. Al Rajhi, the main player, has been active in promoting its Islamic positioning in the market.

The National Commercial Bank (NCB) has also extended its Islamic off erring in the last two years, by opening more Islamic branches. Saudi British Bank has also been active in promoting Islamic banking products and has opened/ converted four branches to Islamic and planning to convert more Islamic branches. At the end of 2006, 45.4% of Saudi banks’ credit facilities were extended through Shariah compliant facilities. Through the system as a whole, Murabahah is by far the most commonly used credit instrument by banks in Saudi Arabia. The break-up of the Shariah compliant credit facilities of Saudi Banks in 2006 is presented in Table 1.

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Leaving aside the three wholly Shariah compliant banks, it can be seen from Table 1 that 34.7% of loans and advances extended by the eight conventional banks were Shariah compliant in 2006. Saudi British Bank (SABB) leads the pack with just over half of its credit facilities being Shariah compliant, closely followed by National Commercial Bank with 44.5%. Riyad Bank and Samba Financial Group had 38.2% and 33% respectively.

The consequence of this is that Islamic (local) banks operating in Saudi Arabia are faced with strong competition not only from Islamic banks but also from non-Islamic rivals (multinational joint-venture banks). However, foreign banks operating in Saudi Arabia are not generally perceived as leading banks in terms of Islamic banking products (5% of the market share). Currently, Al-

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Rajhi and NCB continue to dominate a large part of the Islamic banking market in Saudi Arabia.

Non-Muslim expatriates in Saudi Arabia

The population of Saudi Arabia was estimated to be about 27.1 million in 2010. This includes an estimated 8.4 million resident expatriate workers. The largest expatriate communities in Saudi Arabia include 1 to 1.5 million people each from India, Philippines, Bangladesh and Pakistan, and another 900,000 each from Egypt, “ The social benefits Sudan, Yemen and Lebanon. offered by Islamic banks are the key There are also some people elements that from North America, South influence the America and Europe. A large perception of segment of the Saudi customers” expatriate population consists of non-Muslims. In 2009, the Saudi non-Muslim expatriate population included about 1.5 million Christians and 1.3 million Hindus. Both Saudi and foreign Islamic banks have been trying to market their Islamic banking products to this significant non- Muslim expatriate population in order to capture a larger market share of the Islamic banking market in Saudi Arabia.

Keeping in view the rising expectations of customers in the face of stiff competition it is necessary for Saudi Islamic banks to understand non-Muslim customers’ perceptions of the banking services offered and refine their approach in dealing with the customers. It is due to the fact that the customer is the nucleus around whom the banks must operate and develop.

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When competition intensifies and when banks start to offer more or less similar products and services, it is the customer’s satisfaction and his perceptions about the nature of the bank products that can influence the bank’s performance and determines its competitiveness and success. Hence it is of paramount importance to assess the perceptions of non-Muslim customers towards Islamic banking products and services in order to successfully grasp the segment.

Factors that influence customer perception towards Islamic banking

There are few studies available on customer perceptions towards Islamic banking services. Most of the studies are survey-based with the purpose of evaluating customers’ satisfactions towards Islamic banking services. In the studies, several factors that influence the perception of customers towards Islamic banking services are identified. Based on the studies reviewed by the authors, it is found that there are five important factors that influence the perception of customers towards Islamic banking services:

1. The provision of a fast and efficient service; 2. The bank’s reputation and confidentiality; 3. Religious belief; 4. Social benefits; 5. Service quality.

Several studies have found that the provision of a fast and efficient service is the key element that influences the perception of customers towards Islamic banking services. It is also found that slow and inefficient service has distracted many customers from utilizing Islamic banking services despite their religious belief. This really

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makes sense especially in the globalization era where fast and efficient transactions are highly required. Efficiency here also means Islamic banks should offer competitive charges for their services as compared to conventional banks.

Several studies also have found that a bank’s reputation and confidentiality are important factors that influence the perception of customers towards Islamic banking services. Everyone wants to get assurance that his/her Islamic bank is a trustworthy and reputable institution.

Damages in reputation can bring any bank to bankruptcy due to excessive withdrawals by its savers/depositors. In addition, savers also require all banks to keep their confidentiality. In fact, this is one of the reasons why savers deposit their money in the banks.

Religious belief is still seen as one of the factors that influences the perception of customers towards Islamic banking services. However, several studies have indicated that religion is found to play a less important role in customers’ decisions to transact with an Islamic bank. The studies also reveal that one of the factors that contributes to the decline of religion’s role is lack of awareness and understanding towards the Islamic banking products among the Muslim customers. Obviously, the situation is even worse in the case of non- Muslim customers.

Several studies have also found that the social benefits offered by Islamic banks are the key elements that influence the perception of customers towards Islamic banking services. This is due to the fact that Islamic banks in their operation should aim to achieve the objectives of Shariah and one of the objectives of Shariah

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is the welfare of the society. After understanding the factors that influence the perception of customers towards Islamic banking services, the authors conducted a survey to test non- Muslim’s perceptions towards Islamic banking services in Saudi Arabia. The results of the survey are described in the next section.

Non-Muslim’s perceptions towards Islamic banking services in Saudi Arabia

A survey using a questionnaire was conducted to test non-Muslim’s perceptions towards Islamic banking services in Saudi Arabia. Using 103 respondents that completed the questionnaire, “ The majority of the study concluded that non- non-Muslim Muslim customers in Saudi customers are first Arabia use Islamic banking exposed to Islamic services because of cheaper banking at their costs (efficient), and a better places of work” quality and range of services provided by the Islamic banks. The main Islamic banking principle of avoidance of Riba is not the major motivating factor for non- Muslim customers to use Islamic banking services.

The study also concludes that the majority of non-Muslim customers are first exposed to Islamic banking at their places of work where corporate Islamic banking products/services are utilized regularly by their employers. The majority of these non-Muslim customers perceive the social benefits of Islamic banking as good.

Overall the majority of non-Muslim respondents perceive Islamic banking services as satisfactory. The respondents are of the opinion that Islamic banking services can cater to their banking needs.

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Conclusion

The above discussions indicate that non-Muslim customers in Saudi Arabia constitute a potential market to be grasped by Saudi Islamic banks. Therefore, understanding the factors that influence their perception is indeed very important.

Based on the survey conducted to test non-Muslim’s perceptions towards Islamic banking services in Saudi Arabia, it is found that majority of the respondents express satisfaction at the quality and professional nature of services offered by the Saudi Islamic banks.

Therefore, Saudi Islamic banks have to seriously look at exploiting this segment of customers. They should tailor their non-Muslim customer acquisition strategies accordingly and ensure that more and more non-Muslim expatriate customers embrace and use Islamic banking services.

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Impact of Basel III on Islamic Banking Regulatory Requirements

The Basel III Accord was released in 2010-2011 by the Basel Committee on Banking Supervision (BCBS) following the devastating impact on banks of the 2008 global financial crisis. Basel III is a global regulatory standard on bank capital adequacy, stress testing and liquidity risk that aims to “ On the micro- enhance banks’ capability to prudential level, absorb financial and Basel III focuses on economic shocks, strengthen amending the risk management and requirements for corporate governance capital and practices and improve leverage and transparency and disclosures. quantitative It complements forerunners liquidity standard” the Basel I and Basel II accords by demanding higher capital requirements on banks especially for Tier 1 capital (Total Common Equity), increasing the capital charge for derivatives and securities transactions (trading book exposures), increasing liquidity coverage ratio and changing the definitions of capital.

As part of the global banking system Islamic banks are also required to comply with the accord especially if their local jurisdiction adopts Basel III rules as part of their regulatory framework. However, Basel III does not differentiate Islamic banks from conventional banks despite their different financial structures. There is hence a need to further interpret and modify the new regulations to fit the specificities of Islamic banks. As they stand, Basel III impacts differently on Islamic banks than conventional banks.

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Basel III reforms

Basel III’s reforms can be categorized into micro- prudential and macro prudential measures. Micro- prudential measures address risks at the individual bank level, while macro-prudential measures address risks at the systemic level. On the micro-prudential level, Basel III focuses on amending the requirements for capital and leverage and quantitative liquidity standard. For capital and leverage, Basel III requires more restrictive definitions of capital, higher capital ratios, bigger capital buffers, higher capital charges for counterparty risk and a formal leverage ratio. For the quantitative liquidity standard, liquidity coverage and net stable funding ratios are introduced. The former is used to measure a bank’s short-term liquidity profile (30-day period) which is an indicator of the liquidity buffer held by a bank to cover short-term funding gaps during severe liquidity stress. The latter is used to measure a bank’s medium and long- term liquidity (31-days to 1-year time horizon).

On the macro-prudential level, Basel III focuses on how to protect the banking sector from periods of excessive credit growth. In addition, it also promotes the accumulation of capital buffers in good times that can be used in bad times (stress period). The new accord also promotes clear capital conservation requirements to avoid the improper distribution of capital.

Costs to banks

The adoption of Basel III will require banks to increase their equity capital by at least 25%. The extra equity capital obviously comes with higher cost of funds as compared to debt capital. In addition, it also lowers tax advantages and results in the fall of the Return on Equity

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(ROE). Basel III also requires an additional 40% liquidity buffer and extra 10-15% stable funding over current requirements. The more stringent liquidity requirements may also have a direct impact on banks’ incomes since more investment in liquid assets means lower incomes (low risk low return). The implementation of Basel III will also add compliance costs by 30-50%.

Impact on Islamic banks

CAR and Leverage Ratio: The literature reveals that Islamic banks are in general better capitalized than their conventional counterparts. As a result, higher capital requirements (Capital Adequacy Ratio) as proposed by Basel III will affect conventional banks more than Islamic “ On the macro- banks. In addition, Islamic prudential level, banks are also less exposed to Basel III focuses on derivative and securitized how to protect the products (trading book banking sector exposures) than conventional from periods of banks. As a result, Islamic excessive credit banks in general need a growth” relatively lower level of risk- weighted assets (RWA) than conventional banks. Due to their higher levels of capitalization, Islamic banks also do not face problems with leverage ratio requirement (set at minimum 3% under Basel III).

Treatment of PSIAs: Due to the nature of sharia- compliant deposits in the form of profit-sharing investment accounts (PSIAs), there is an additional loss buffer for Islamic banks as the underlying mudaraba contract places loss on the investment account holders (rab ul mal) unless the loss is due to the negligence of the bank (mudarib). So, PSIA does not qualify as

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additional Tier 1 capital according to Basel III. As a result, PSIA and its related assets are excluded from the calculation of CAR.

Liquidity: Basel III requires more stringent liquidity requirements, and this has emerged as a critical challenge for Islamic banks. Liquidity is still a major challenge for Islamic banks worldwide due to a limited number of available sharia-compliant liquidity instruments. In this regard the short term sukuk issues from the International Islamic Liquidity Management Corporation (IILM) has helped address the shortage. Overall, however, the current Islamic money market instruments are still relatively less liquid as compared to conventional money market instruments and most Islamic money market securities are either not highly rated or not rated at all. As a result, in certain jurisdictions Islamic banks might be forced to place their funds in conventional money market instruments.

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Islamic Bank’s Service Quality: a Winning Strategy to Achieve Customer Satisfaction

In today’s tough competition within banking industry, customer satisfaction becomes a very crucial factor. This is also very much applicable to the Islamic banks especially those are operating in countries with a dual banking system like the Kingdom of Bahrain. In a dual banking system, conventional and Islamic banks are operating side by side. Therefore, understanding factors that influence customer satisfaction is very important for Islamic banks to successfully compete with their conventional counterparts. “ There are 5 One of the most important dimensions of factors which influences the service quality level of customer satisfaction according to according to literature is SERVPERF scale” service quality. Many empirical studies found that greater service quality eventually leads to higher customer satisfaction and loyalty, higher readiness to propose to others, decrease in objections and complaints, and enhanced retention rate of customers. In other words, Islamic banks management must pay attention to service quality and must put it as a priority to better serve their customers.

Service quality is a result of the comparison that customers make between their expectations about a service and their perception of the way the service has been performed. There are 5 dimensions of service quality according to SERVPERF scale namely Tangibles, Reliability, Responsiveness, Assurance and Empathy. Each dimension is discussed below to show how the management of Islamic banks can improve their banks’ overall service quality. In term of Tangibles dimension, Islamic banks must ensure that they have the latest and

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modern looking equipment, attractive physical facilities, interesting pamphlets, appealing brochures and well- dressed employees. For the reliability dimension, Islamic banks must ensure that they always deliver their promises on time, make no recording mistakes and always attempt to solve the customers’ problems in the best possible way.

In term of Responsiveness dimension, Islamic banks must ensure that their employees address the customers’ request promptly and they are always available to respond to the customers’ request. In other words, the banks must ensure that all the employees are always at the service of the customers. For Assurance dimension, Islamic banks must ensure that their employees are well manner and knowledgeable about the banks’ products. They have to make sure that the customers’ confidentialities are well kept and financial transactions performed through the banks are safe and secured. On top of that, Islamic banks must ensure that all their transactions are Shariah compliant. The bank also must have a corporate governance system in place. The last dimension, Empathy stresses on the banks’ ability to understand the customers’ specific needs. For example, the banks should have working hours that are convenient for the customers. In addition, the employees of the bank must be willing to give personal attention to their customers. It is expected that by taking care the 5 dimensions of service quality, Islamic banks will be able to enhance their overall service quality and subsequently improve the level of their customers’ satisfaction. In the long run, it has been empirically proven by many studies that higher customer satisfaction will bring higher market share for the Islamic banks.

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Understanding Factors that Influence Customers’ Attitude towards Islamic Banking

Islamic banking and finance has recently gained good global acceptance. It is currently not only promoted by and practiced in Muslim majority countries but it also has attracted many non-Muslim majority countries to join the industry. This situation has drawn the attention of many researchers to identify the factors that affect the customers’ attitude towards Islamic banking and finance. It is important to note that understanding the factors that affect the customers’ attitude is very important since it might help Islamic banks and other Islamic financial institutions (IFIs) to better understand their customer behaviour. Therefore, this article attempts to summarize the major factors that influence or affect the customers’ attitude towards Islamic banking based on available literature.

Customers’ attitude can be defined as a mind set to act in a particular manner towards products and services due to both an individual’s experience and knowledge. Based on the definition, it is very clear that creating positive customers’ attitude is very important for any companies including Islamic banks and other IFIs in order to continuously grow their businesses. According to available literature, there are many factors that affect the customers’ attitude towards Islamic banking. Among them customers’ satisfaction and service quality have been empirically found by many studies as the two main factors that positively affect customers’ attitude towards Islamic banking.

Customers’ satisfaction can be defined as a behaviour or a feeling that a person has for any product or/and service related to its quality attributes. Many empirical studies

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reveal that when a customer is satisfied, he or she will feel that he or she has made a right decision which will make him or her to repurchase the product or/and service and in many cases, he or she will recommend the products to other people based on his or her personal experience. The letter indicates a positive customer’s attitude. It also shows that customers’ satisfaction works as an antecedent of future positive customers’ attitude. It also has been proven by many studies that obtaining customers’ satisfaction will “ Customers’ help a company to maximize satisfaction and its profit, spread positive word service quality of mouth and minimize have been marketing related empirically found expenditures. by many studies as the two main Another antecedent of factors that customers’ attitude towards positively affect Islamic banking is service customers’ attitude quality. According to literature, towards Islamic excellent service quality can banking” create a more positive attitude towards purchasing a product or/and a service. This is because, excellent service quality will enhance the perceived value of a product or/and a service provided by Islamic banks. It is also found by many studies that Islamic banks cannot solely rely on religious factor in promoting their products and services. Service quality has been found to play crucial role in pushing customers to patronize with Islamic banks. In other words, as more customers evaluate the quality of Islamic banks’ services positively as better customers’ attitude towards the Islamic banks.

This article is expected to draw the attention of Islamic banks’ management on the importance of customers’

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attitude towards Islamic banking and understanding the main factors that influence customers’ attitude. By understanding the factors well, the management of Islamic banks and other IFIs can set up proper strategies and action plans that help their institutions in obtaining positive customers’ attitude.

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Part 3

Contemporary Issues and Developments in Sukuk Market

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The Risks Behind Sukuk Issuances

SUTAN EMIR HIDAYAT and MUHAMMAD MUSA ABU BAKAR explain the risks associated with Sukuk along with the description of the recent events related to each category of risks. Sukuk are one of the important instruments in the Islamic capital and money markets. Although there has been tremendous growth, it does not mean that Sukuk are risk-free investment instruments. In fact, Sukuk investors face most of the risks that the traditional bondholders do such as market, credit and liquidity risks. Sukukholders may also face Shariah compliance risk caused by any violation of Shariah principles in structuring the Sukuk. The above mentioned risks were not clearly apparent in the Sukuk market within the 2002-2007 periods. But, from 2008 until now, we have witnessed the appearance of those risks in the market.

Market risks in Sukuk

Market risks are the risks on instruments (securities) traded in well-defined markets. In general, market risks can be categorized into rate-of-return risk, foreign exchange risk and price risk. The Islamic Financial Services Board (IFSB) defines it as the potential impact of adverse price movements such as benchmark rates, foreign exchange rates, equity prices and commodity prices on the economic value of an asset. Rate-ofreturn risk is risk caused by the changes in the benchmark rate.

Since some Sukuk in practice still use interest rate as the benchmark to determine the rates-of-return, the movement in interest rates will surely affect the Sukuk value.

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All fixed-return Sukukholders (Sukuk Ijarah, Sukuk Istisnah, Sukuk Salam or any other fixed income origins) will face the rate-of-return risk. Furthermore, the rise in market interest rates leads to the fall in those fixed income Sukuk values.

For example, the recent US debt crisis has resulted in the downgrading of the US securities rating. As the biggest economic power, the “ The recent downgraded rating will force Depreciation of the the world’s cost of borrowing US dollar has made (interest rates) to soar. the US-denominated

Sukuk becoming The increase in the interest unfavorable to rates will result in the decline investors” of the value of the fixed return Sukuk. One possible way to minimize or mitigate this risk is to adopt a variable rate Sukuk (e.g. a variable rate on Sukuk Ijarah).

Another possible way is to adopt IFSB’s guiding principles on operational considerations such as that the Islamic financial institutions should develop appropriate strategies which include sound information system to allow a swift identification of the risk, monitoring it and appropriate framework for its pricing, valuation and reporting.

Similarly, foreign exchange rate risk (currency risk) is the risk, which arises from unfavorable exchange rate fluctuations.

This type of risk exists if Sukuk are issued not in the home currency of obligor/originator or when an investor invests in Sukuk issued not in his/her home currency.

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The recent depreciation of the US dollar has made the US-denominated Sukuk becoming unfavorable to the investors.

This is due to the lower amounts of return that they receive in their home currency as a result of the declining value of the US dollar.

Since the usage of conventional derivatives is prohibited under Shariah, one practical way to minimize such currency risk is through diversification of Sukuk issuance into multiple currencies.

Moreover, price risk arises as the asset value falls reducing repayment amount on maturity. It also relates to the prices of the underlying commodities or assets in relation to the market prices.

Almost all types of Sukuk structures expose their investors to this type of risk. Sukuk Ijarah, for example, exposes its holders to the risk as the values of the underlying assets depreciate faster as compared to market prices.

The 2008 global financial crisis, for example, has resulted in the decline of property value worldwide. Obviously, the investors in Sukuk Ijarah that use property as their underlying assets are affected.

In the same way, the investors in Sukuk Salam are also exposed to this risk if market price of the commodity falls on maturity. However, through parallel contracts and relatively short-time maturity, the risk can be relatively overcome.

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Investors in Sukuk Mudarabah and Sukuk Musharakah (equity-based Sukuk) are also exposed to this risk since the repayment of the principal is subject to the value of the assets on the maturity.

The pronouncement of fatwa released by Shariah board of AAOIFI in 2008 that prohibits the usage of some credit enhancements mechanisms in equity-based Sukuk due to its non-compliancy with Shariah has increased the exposure of equity-based Sukuk investors to this type of risk.

Credit risk in Sukuk

Credit risk refers to the probability that an asset becomes irrecoverable due to a default or delay in settlements. It also refers to delay or default on payments/repayments by the originator. Similarly, it is that potential loss arising from the inability of a counter party fulfilling its obligations according to the agreed terms.

This risk is related to business and management risks of the originator. All Sukuk structures invariably may expose their investors to this kind of risk. For example, investors in Sukuk Salam are exposed to this type of risk as the commodities will not be supplied on time or to the agreed quantity.

In Sukuk Ijarah, this risk arises when the originator/obligor is unable to pay the periodic rental or exercise purchase undertaking (waad) at the maturity.

In Sukuk Mudarabah and Musharakah, this type of risk exists when the originator as mudarib misuses the funds, hence unable to return the principal and provide the expected returns.

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Unlike in conventional finance where the investors have access to derivative instruments such as credit default swap (CDS) and other credit risk management mechanisms to hedge their positions, investors in Sukuk do not have those facilities due to Shariah considerations.

Consequently they become vulnerable to such risk. As such, in order to minimize this risk, hybrid Sukuk is used, combining equity contract such as Musharakah with fixed income generating contract such as Ijarah. Operational consideration requires a sound strategy which blends Shariah compliance with mitigating qualities.

The Nakheel Sukuk default in 2009 raised more questions than answers. It has been a real example of the occurrence of credit risk in the Sukuk market. Nakheel as the originator was unable to pay the principal on the maturity date and requested for rescheduling.

The default has raised some questions such as the issue as to who was in control over the ownership of the asset. Since the Sukuk was asset-based, the Sukuk-holders do not have the right to dispose of the asset.

The asset in the Sukuk was simply viewed to facilitate the Shariah requirement. The return that the Sukuk-holders obtained also had little or nothing to do with the asset used in the deal.

Liquidity risk in Sukuk

Liquidity risk is the risk associated with tradability of the security in the secondary market. The IFSB defines it as the potential loss to an institution arising from their

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inability either to meet their obligations or to fund increases in assets as they fall due without incurring unacceptable costs or losses.

In Sukuk, this risk exists clearly for some structures in which the Sukuk contractually cannot be sold in the secondary market (e.g. Sukuk Salam, Sukuk Murabahah and Sukuk Istisnah, if the asset has not yet completely been manufactured). “Liquidity risk is the Some Sukuk cannot be risk associated easily sold to other investors with tradability of with a favorable price either the security in the at a premium or discount. secondary market” This is because there is insufficient numbers of well- structured and sufficiently liquid secondary markets for Sukuk.

Therefore, there is a need to create active and vibrant secondary markets for Sukuk to minimize this kind of risk. Similarly, more grounded research and investments in research and development are needed to unlock the more products that will allow the much needed vibrancy in Sukuk tradability.

With these initiatives, liquidity risk can also be mitigated. Sukuk has been one of the driving forces in the industry of finance. The lack of instruments affects the efficiency of the market.

Shariah compliance risk in Sukuk

Shariah compliance risk refers to the loss of asset value as a result of the issuers’ breach of its fiduciary responsibilities with respect to compliance with Shariah.

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Shariah compliance is the key element that differentiates Sukuk from other conventional instruments.

Therefore, any violation of the Shariah principles either in the system or operations hampers the essence of Sukuk. For an example, AAOIFI Shariah board’s announcement in 2008 on the wrong practice of the usage of some credit enhancements in equity-based Sukuk such as Musharakah and Mudarabah.

The pronouncement has led to the decrease in the number of these kinds of Sukuk issuances from 2008 until 2010.

To ensure proper Shariah adherence, the IFSB suggested that Islamic financial institutions to constantly review their operations.

Conclusion

Sukuk may be affected by an additional risk called Shariah compliance risk. As such, risk cannot be avoided but rather it can be managed.

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Understanding Investor Behavior from the Variation of Sukuk Spreads

The mechanics of Sukuk investment are a mysterious and complicated subject for many investors. From the Sukuk structure and the pricing methodology, to its risks and trading strategy, we often leave it to the experts to handle. However with its position as an essential asset class in the mandate of Shariah funds, understanding Sukuk structure is important for all participants. DR MAYA PUSPA ABDUL RAHMAN, PROF DR MOHD AZMI OMAR, DR SALINA H KASSIM and DR SUTAN EMIR HIDAYAT attempt to unravel the management of a Sukuk portfolio and how investor behavior can be assessed based on the variation of the Sukuk spreads.

Technically, Sukuk that are traded in the secondary market are quoted based on the spreads to a particular risk-free security, such as government investment issues (GII). In the conventional bond market, these spreads are known as credit spreads. The credit spreads are the main focus of investors in corporate bonds. Similarly, the Sukuk spreads indicate the compensation to risk, referred to as the risk premium.

The risk premium is the factor that makes investors willing to invest in Sukuk despite the risks that they may encounter. Even though Sukuk are structured based on the different kinds of contracts, which can be sale-based, leased-based, partnership-based or agency-based, the associated risks to Sukuk is mainly reflected in the spreads, which is comparable with other Sukuk that

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possess similar rating, duration and outlook for trading purposes.

For example, a fund manager observes that the 10-year ‘AAA’ Idaman Sukuk is trading at a spread of 108bps above the 10-year GII. If another corporate Sukuk with similar credit rating, duration and outlook were trading at a 115bps on a relative value basis, the second Sukuk would be a better buy. Why? This is because with the same risk, the investor could get a higher compensation or premium (115bps vs 108bps) by investing into the second Sukuk. This is one of the strategies carried out by the fund manager in an active Sukuk portfolio management.

Now, let us assess on the investor behavior by examining the pattern of Sukuk spreads from 2005-11. The higher investment grade bonds (‘AAA’, ‘AA’) for both short-term (three years) and long-term (10 years) Sukuk spreads appeared to have a stable trend until they steeped upward in the middle of 2008, as shown in Figure 1/Figure 2.

As for the lower investment grade (‘A’, ‘BBB’), the Sukuk spreads of both the short and long-term demonstrated an upward trend with the spike of the spreads also observed within 2008-09. As the spreads represent the risk premium to investors for holding corporate Sukuk (against the risk-free government Sukuk), the sharp increase suggests that the risk premium for holding such Sukuk had increased significantly, especially during the financial mayhem in 2007-08. Practically, the trends observed in the charts above may be explained by the shift of investment preference by the Sukuk investors.

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As corporations struggled with declining revenue and cash flows during crisis, profits payable to the Sukuk- holders may also be interrupted. Hence, as investors opt for a much safer instruments like government Sukuk, the higher demand is translated to a lower yield of government Sukuk causing the spreads (against the yield of similar maturity corporate Sukuk) to increase further. For example, on the 1st January 2007, the yield of ‘AAA’ 10-year corporate Sukuk stood at 4.55% whilst GII of similar maturity yields stood at 3.82%, giving spreads of 73bps. Two years later on the same day in January 2009, following the shock of the global financial turmoil which had altered the US financial system and shook the economies of almost every country in the world, the yield of the similar rated Sukuk climbed up to 5.35%, while the GII, being the safe haven instrument, fell to 3.26%, causing the spreads to widen to a massive 209bps. This reflects the higher compensation demanded by the investors for holding a much riskier corporate Sukuk, during economic downturn.

Subsequently, the spike recorded in early January 2009 was also due to the plunge in the yields of Malaysian government bonds generally. In consideration of the sharp deterioration in the global economy following the global financial crisis, Bank Negara Malaysia slashed the overnight prime rate (OPR) by 75bps to 2%, larger than the anticipated decrease of 50bps. As a result, the conventional Malaysian government securities (MGS) dropped by 40bps, led by the three year MGS (-40bps) and the 10-year MGS (-10bps) on a month-to-month basis (RAM Ratings, 2009). The sudden decrease in the MGS yields also triggered the plunge for the yields of GII, causing the Sukuk spreads to widen further.

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The different trends as depicted by the spreads of the non-investment grades (‘BB’) in Figure 3 as compared to the investment grades (Figure 1/Figure2) also reflects the preference of Sukuk investors on different classes of Sukuk. In consideration that investment grades are generally much preferred than the non-investment grades, the spreads for the latter are much higher than the former. For example, the long-term spreads of a ‘BB’ 10-year paper was recorded at 148bps on the 1st August 2005, reflecting the higher risks possessed by the lower- grade Sukuk relative to the investment grade Sukuk (‘AAA’ 10-year: 120bps). A spike in the Sukuk spreads is also visible in early 2009, most probably also due to the worries on the state of the global financial crisis. It is also observed that post-crisis, the noninvestment grade Sukuk spreads appeared to chart a different pattern than previously.

As such, it is obvious that the investor behavior is driven by the state of economy. During good economy, investors tend to invest more into corporate Sukuk, pushing its yield downward and tightening the spreads. Conversely, at times of crisis, investors remain sidelined on corporate Sukuk and prefer the safer government Sukuk, causing the yields to move in a different direction hence widening the spreads. In addition, with the high speculative nature of the non-investment grade Sukuk,

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any changes in the monetary policy driven by the changes in interest rates during the different state of the economy may cause the spreads of the non-investment grades to be deterred significantly relative to the spreads of the investment grades. This is also in line with the empirical evidence of the highly-cited work of Longstaff and Schwartz in 1995 where firms with higher default probabilities (lower grade bonds) are more susceptible to changes in interest rates.

Hence, an understanding of the risk premium reflected by the Sukuk spreads is essential to comprehend how the trading and management of Sukuk portfolio are undertaken. More importantly, the variation of Sukuk spreads, which are derived from the movement of the yields of corporate Sukuk against government Sukuk, is also able to signal trends in investor behavior during different states of the economy.

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Asset-backed Versus Asset-based Sukuk, the Dilemma between Sharia, Legal Framework and Market Demand

In Islamic finance the sukuk – sometimes erroneously called an Islamic bond – is the blue ribbon product by a long distance. The fact that sukuk issuance in 2012 is expected to reach US$ 130 billion – around 60 percent higher than the volumes in 2011 – gives an indication of its importance as a financial instrument in the Islamic finance sector.

However at its very heart there is a fierce debate amongst scholars, investors and regulators about the core structure of sukuk. Should it be ‘asset-based’ or ‘asset- backed’? This is not nit picking. The structure of sukuk has come under scrutiny after some high-profile defaults and near-defaults in the global financial crisis – most recently Dana Gas, a natural gas producer based in the United Arab Emirates, which failed to redeem a $920 million Islamic bond in October.

Much controversy has arisen in determining the rights held by the investors of various sukuk structures in the event of default. In enforcing rights under sukuk, the challenge of the courts will be to determine the rights of investors in each of ‘asset-based’ versus ‘asset-backed’ structures. In particular, the courts will need to resolve the ongoing legal debate on the rights of sukuk holders under transactional documents that incorporate an asset- based structure akin to a conventional bond that may not be consistent with Sharia principles.

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It is clear that there is a dilemma between Sharia concerns, the legal framework and market demand surrounding the issue of asset-based versus asset- backed sukuk. The legal framework of sukuk is typically based on the common law used in most jurisdictions where special purpose vehicles (SPVs) are registered and this is currently more suitable to the asset-based structure rather than the asset-backed structure. The majority of recent sukuk “ In an asset-based structures have been asset- sukuk, the based sukuk ijara where the originator typically originator seeking financing transfers only the transfers certain of its assets beneficial to the SPV that is often ownership or incorporated as an offshore equitable interest in company. the assets to the

SPV issuer; In an asset-based sukuk, the therefore, there is originator typically transfers no true sale” only the beneficial ownership or equitable interest in the assets to the SPV issuer; therefore, there is no true sale. To maintain Sharia compliance there must be a transfer of assets, however, since investors have no recourse to the assets, the transaction does not focus on asset risk, but rather on the credit worthiness of the sponsors of the sukuk. If the originator fails to pay any amount payable pursuant to the transaction documents, the certificate holders normally have no recourse against the originator or the issuer/trustee. These types of sukuk do not grant the certificate holders the right to cause the sale or other disposition of any of the trust assets on default.

Typically they can cause the trustee to call a meeting of the certificate holders and exercise their rights under the transaction documents including issuing notice to the

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originator pursuant to its undertaking to repurchase the assets on maturity or default of the sukuk. In structuring the sukuk, additional security could also be granted by the originator including share charges, mortgages and guarantees provided by related parties in the originator group. Alternatively, upon a default, the parties may agree to restructure the debt and related obligations including an agreement to reduce the principal sums outstanding or granting standstills on exercising any rights under the transaction documents. Ultimately, asset-based sukuk are based upon the credit of the issuer, guarantor or other co-obligors.

Alternatively, in an ‘asset-backed’ sukuk, legal title to the underlying assets will typically pass by way of a true sale from the originator to the issuer SPV. On default by the borrower, sukuk holders are able to exercise certain rights of ownership and control over such assets. The elements of true sale, fundamental to a securitization, must be present in an ‘asset-backed’ sukuk. An asset- backed sukuk is similar to a securitization in that it is a non-recourse obligation and credit risk performance is determined solely by the underlying asset.

Currently some 90 percent of transactions are still structured as asset-based sukuk and provide no recourse in the event of a default. This has led to a push to promote asset-backed sukuk which are seen closer to the spirit of Islamic law as they involve a transfer of tangible assets and investors become the legal owners of these in the case of default.

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Islamic finance industry body the Bahrain-based International Islamic Financial Market (IIFM) is developing a template that will help mitigate some of the legal and operational complexities surrounding asset- backed sukuk by putting in place a master agreement which will help spur demand for securitized paper in the fast-growing industry. This master agreement would aim to provide a standardized “ In an ‘asset- platform from which issuers backed’ sukuk, could structure the sukuk in legal title to the line with their own jurisdictions underlying assets and increase awareness will typically pass about the product. by way of a true

sale from the The issue of asset-based originator to the versus asset-backed sukuk issuer SPV. On has been one of the hot topics default by the in the Islamic finance industry borrower, sukuk since 2008. It is clear that the holders are able to asset-backed sukuk structure exercise certain is more compliant to Sharia rights of ownership both in form and substance and control over than the asset-based such assets” structure but there is a lack of legal clarity and limited issuance to date which has held it back. It is important to urge legislators in countries where Islamic finance is operating to come out with legal frameworks that promote the development of asset- backed sukuk.

The continuing success of Islamic finance will depend on structuring Islamic securities that strikes a balance between originator and investors rights while maintaining Sharia compliance. Invariably these challenges will result in the evolution of sukuk that should strengthen the confidence of investors in Islamic finance structures.

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Differences between Asset-based and Asset-backed Sukuk

Categories Asset Based Asset Backed Source of The source of The source of Payment payment comes payment comes from originator from the or obligor's revenue cash flows. generated by underlying asset. Presentation/dis The asset stays The asset is closure of the on the balance separated from asset sheet of the originator's originator or book. obligor. Type of Sukuk Beneficial Legal holders' ownership with ownership with Ownership no right to right to dispose dispose the of asset. asset. Recourse Purchase Sukuk holders undertaking at only have par from obligor recourse to is the ultimate asset thus asset recourse. The plays genuine recourse is only role in defaults. to obligor and not the asset.

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The Importance of the Sukuk Market for the Takaful Industry

Being the Shariah compliant alternative to insurance, the activities of Takaful are also divided into underwriting and investment. Like insurance companies, Takaful companies also invest the funds collected from policyholders into an investment portfolio. The difference is that the Takaful fund can only be invested in Shariah compliant investment avenues.

One of the important investment avenues for Takaful companies is the Sukuk market. Currently, despite its double-digit growth during recent years, the Sukuk market is still far less developed than the conventional bond market. This situation leaves Islamic financial institutions (IFIs) including Takaful companies with limited investment options. As a result, the situation creates difficulties for the operators to establish a good Sukuk portfolio.

The situation gets worse when there is a default or near- default case made by a Sukuk originator. The recent case of 1Malaysia Development (1MDB) can be used as an example. In 2009, Syarikat Takaful Malaysia invested RM85 million (US$23.3 million) in a 30-year tenure Sukuk issued by Terengganu Investment Authority, now known as 1MDB. This long-term investment currently represents around 2-3% of the total company’s assets. Even though it is relatively small, the default of 1MDB in servicing its obligations to Sukukholders somewhat affects the financial performance of Syarikat Takaful Malaysia and other IFIs that invested in the Sukuk.

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A similar case happened in November 2009 when Nakheel announced the delay in the repayment of its US$4 billion Sukuk. The delay affected the financial performance of IFIs including “ Sukuk default or a Takaful companies that near default case invested their funds in the will surely affect Sukuk. Sukuk default or a near the investment default case will surely affect income of Takaful the investment income of companies” Takaful companies. In addition, more provisions allocated by the companies will in turn affect the profitability, asset quality and liquidity of the companies.

All of these clearly show the importance of the Sukuk market for the Takaful industry. In the event of a Sukuk default or a near default, a clear mechanism for the protection of Sukukholders should be in place to minimize the impact on the Takaful fund.

The Important Role of Sukuk in the Basel III Era

The implementation of Basel III rules has created several challenges to Islamic financial institutions (IFIs) especially with regards to capital adequacy and liquidity requirements. Basel III primarily requires all banks, including Islamic banks, to strengthen their capital and liquidity positions by holding higher quality capital, which would enable banks to absorb financial shocks, and maintain higher level of liquidity, which enables banks to reduce their dependency on money market instruments.

Basel III requires all banks to maintain the minimum ratio of 4.5% for Tier 1 common equity capital, an increase from 2% required by Basel II. Basel III also changed the

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minimum requirement for additional Tier 1 capital and Tier 2 capital to 1.5% and 2%, respectively, from 2% and 4% previously required by Basel II. In addition, Basel III requires banks to maintain 2.5% capital preservation buffer and 0-2.5% countercyclical capital buffer. In addition, Basel III also redefines the meaning of capital. According to Basel III, the components of Tier 1 capital consist of common equity as core capital, and preferred stock and hybrid securities as additional capital. Subordinated bonds and loans are counted as Tier 2 capital.

Given the uniqueness of Islamic banks’ products and operations, the implementation of Basel III rules for Islamic banks and other IFIs requires more clarification. The Islamic Financial Services Board (IFSB) released IFSB-15 in December 2013 with the purpose of introducing a framework for capital adequacy and liquidity requirements to suit the uniqueness of IFIs.

IFSB-15

The IFSB-15 is an amended and improved version of two previous IFSB standards on capital adequacy, namely IFSB-2 and IFSB-7. IFSB-2 focused on capital adequacy standards for IFIs while IFSB-7 focused on capital adequacy requirements for sukūk, securitizations and real estate investments. IFSB-15 also provides guidelines for the components of regulatory capital (Tier 1 and Tier 2). Like Basel III, IFSB-15 also defines common equity as the Tier 1 core capital and preferred stock as the additional Tier 1 capital. However, it is important to note that preferred stock is only considered a Shariah-compliant instrument in some jurisdictions such as Malaysia.

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In addition, perpetual musharakah sukuk is also counted as additional Tier 1 capital, while mudarabah and wakalah sukuk with maturity of five years or more are counted by IFSB-15 as components of IFIs’ Tier 2 capital. However, in practice, other types of sukuk may also be classified as either additional Tier 1 or the component of Tier 2 capital as long as the sukuk fulfill IFSB-15 requirements for each category of capital. In summary, the IFSB-15 has stressed the important role of sukuk in the Basel III era.

BASEL III-Compliant Sukuk

From the above explanation, it is clear that the implementation of Basel III and IFSB-15 has opened the way for sukuk to be used by Islamic banks and other IFIs as the alternative instrument to comply with regulatory requirements. Certainly, the adoption of Basel III will boost the number of sukuk issuance and their transactions value.

Basel III has already created a new trend in the sukuk market with the birth of so-called "Basel III-compliant sukuk". There have been nine issuances of such instruments since Basel III's initial implementation which kicked off in January 2013 with total deals worth more than $4.93 billion, according to Zamya Sukuk Monitor.

The first issuance of Basel III-compliant sukuk came from Abu Dhabi Islamic Bank (ADIB) in November 2012, even before the initial implementation of the accord. ADIB issued perpetual mudarabah sukuk with the purpose of raising its additional Tier 1 capital. Following ADIB's success, Dubai Islamic Bank (DIB) issued the second Basel III-compliant sukuk in March 2013 for the same purpose. At the end of 2013 and at the beginning of 2014,

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three issuances of such sukuk occured in Saudi Arabia, from Saudi Hollandi Bank (SHB), Saudi British Bank (SAAB) and National Commercial Bank (NCB). Unlike the Emirati banks, the Saudi bank issued the sukuk to increase their Tier 2 capitals.

The successful experience in the GCC has been followed by Islamic banks in Southeast Asia especially in Malaysia with the issuances of Basel III-compliant sukuk by AmIslamic Bank, Maybank Islamic, RHB Islamic and Public Islamic (using the murabahah structure) which aim to boost the banks' Tier 2 capital. Many more issuances of such sukuk are expected in the years to come.

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Sukuk for Liquidity Management

The implementation of Basel III also poses challenges to the liquidity position of Islamic banks. For example, Basel III and IFSB-15 demand Islamic banks manage their liquidity through holding highly-rated sovereign and corporate sukuk (investment grade). This should be done in order to comply with the Liquidity Coverage Ratio (LCR) introduced by Basel III. However, currently there is only limited number of these sukuk available in the market. Investment grade sukuk are much more liquid than junk or unrated sukuk, and they can only be issued by highly-rated governments and companies (which are lacking across Muslim-majority countries).

As the demand for these sukuk increases due to Basel III requirements, the opportunity opens up for highly-rated governments and companies to issue sukuk. In fact, this is already becoming a trend. The UK government issued £200 million of sovereign sukuk in June 2014, which, among other reasons, aimed to capture the strong demand for highly-rated sukuk. The issuance was oversubscribed. The latest AAA-rated non-Muslim government which issued sovereign sukuk was Hong Kong.

Issued in September 2014, the sukuk was oversubscribed 4.7 times, indicating very strong demand for the security. The Sukuk from these countries are very important for IFI's liquidity management and will be a driver for global sukuk market growth.

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The strong demand for highly liquid sukuk by IFIs in order to comply with Basel III requirements has also pushed the International Islamic Liquidity Management (IILM) to issue its first $490 million worth of three-month sukuk in August 2013 (the sale was oversubscribed). About a year later, the IILM issued its “ However, despite second 2400 million worth of this encouraging six-month sukuk in order to trend, more effort is accommodate market need needed to develop and preference; the issue was more highly-rated again oversubscribed. liquidity

management However, despite this instruments to help encouraging trend, more effort Islamic banks and is needed to develop more other IFIs fulfill highly-rated liquidity their liquidity management instruments to regulatory help Islamic banks and other requirements” IFIs fulfill their liquidity regulatory requirements. With more issuances of sukuk expected in the years to come, the cost of sukuk issuance is also expected to fall. One factor contributing to this drop in cost is that more countries are expected to amend their regulatory and tax laws to ensure sukuk have the same advantages as conventional bonds.

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Good News from the Sukuk Market

After nearly two consecutive years of drops in the growth rate of Islamic financial industry which were caused by the significant decline in oil price, good news finally came especially from the Sukuk market. Even though it is still far away from the peak level in 2014, where total global Sukuk issuance reached USD 116.4 billion, the first quarter of 2016 has shown an exciting comeback of the Islamic security.

In the first three months of the year, both sovereign and non-sovereign issuers from across the world issued and/or plan to issue Sukuk. In the sovereign space, beside the continuous success of Kingdom of Bahrain in its monthly Sukuk Ijarah issuance, the largest Muslim country, Indonesia also successfully launched and sold its IDR sovereign Sukuk to both retail and institutional investors. The country managed to sell IDR 31.5 trillion (USD 2.37 billion) Sukuk to retail investors which was the highest retail Sukuk sale since its first issuance in 2009. The sale also constituted a growth rate of 43.42% from the previous best performance. For the institutional investors, the auction for its sovereign Sukuk has resulted in an oversubscribed. In February 2015, IDR 9.85 trillion (USD 739.73) million bids were received for IDR 4 trillion (USD 300. 4 million) target. Following this success, the country is planning to auction around USD 302. 4 million worth of Sukuk on 22nd March 2016. Pakistan is also in the pipeline planning to issue PKR 80 billion (USD 762.06) worth of Sukuk by the end of March 2016.

In the non-sovereign space, the Islamic Development Bank (IDB) has completed several issuances during the first quarter of 2016. After successful issuance of USD

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1.5 billion Sukuk, the bank also issued USD 1.5 billion trust certificates mature in 2021 and EUR 300 million (USD 333.16 million) trust certificates mature in 2023 in March 2016. In Malaysia, Sunway Treasury Sukuk managed to raise MYR 100 million (USD 24.07 million) worth of Sukuk several times and Perdana Petroleum raised MYR 650 million (USD 156.46 million) through its Sukuk Murabahah program during the first quarter of 2016. It is also expected that some institutions will soon issue Sukuk. For example, Dubai Islamic Bank (DIB) plans to issue a USD Sukuk soon which is part of its USD 2.5 billion Sukuk program. In Turkey, Ziraat Bank and Kuveyt Turk are also planning to issue TRY 1.5 billion (USD 513.31 million) and TRY 1.85 billion (USD 633.08 million) worth of Sukuk respectively.

Overall, Malaysia is still the biggest Sukuk issuer representing around 53% of global Sukuk issuance despite the decline in the number of issuance in the country as compared to the previous year. In February “ Overall, Malaysia is 2016, Malaysia managed to still the biggest sell MYR 3.5 billion (USD Sukuk issuer 845.95 million) government representing investment issue (GII) around 53% of Murabahah. The comeback in global Sukuk the Sukuk market is really a issuance despite good momentum for the the decline in the Islamic financial industry. In number of issuance addition to the above positive in the country as developments in the Sukuk compared to the market, there are also several previous year” enhancements in the regulations of Sukuk during the first quarter of 2016. For example, the Egyptian Ministry of Finance is currently working on the amendments of its laws to facilitate Sukuk

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issuance in the country. Similar development is also going on in Kyrgyzstan, where a meeting of the Parliamentary Committee on Economic and Fiscal Policy has been held to discuss the introduction of Sukuk in the country. With these positive announcements, it is expected that Sukuk market will remain strong and has a bright prospect in the years to come.

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Part 4

Contemporary Issues and Developments in Takaful Industry

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Potential of Takaful within the GCC Insurance Market

Gulf Cooperation Council (GCC) is a region with predominantly Muslim population. The region has been showing positive economic growth over the last decade. However, the insurance market in the region is still far from grasping its immense potential. In general, the insurance penetration rate is still relatively low in most of the Muslim majority countries including countries within the GCC region. According to “ One way to achieve available literature, one of the it is by linking up reasons for the low offered solutions penetration rate is due to the lack of market driven or with region's market oriented product needs, culture and innovation. Actually, many values” studies have empirically found a positive correlation between market orientation, innovation and a firm’s performance. In other words, Market driven firms are able to quickly respond to the market needs by producing innovative products and services that fit the market needs and at the same time meet the firms’ commercial and financial objectives. As a result, those firms will achieve better operational performance.

Actually, the GCC insurance market has some characteristics that are somewhat different from the other regions. First, the insurance penetration rate in the region is still relatively lower than other regions and other emerging markets. For example, Malaysia has 4 times higher insurance penetration rate than the GCC countries. Second, life insurance still remains far from its potential. This is mainly due to the misconception about life insurance which is perceived to be questioning the religious values as well as the lack of awareness among public on the potential benefits of the life insurance.

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Third, with significant number of high worth individuals within this region, insurance products for this segment becomes very important. However, it is still relatively less explored. Fourth, energy is a major sector and contributing big chunk of premium to the region insurance industry. Last, lack of talents has been attracting foreign professional to the regions insurance industry, but it is still inadequate to support the industry growth. In other words, knowledge and expertise deficit and skill mismatch exist.

Based on the above characteristics, insurance market in the region needs to build a better authoritative value proposition in order to move forward. One way to achieve it is by linking up offered solutions with region's needs, culture and values. In this regard, Shariah compliant alternatives namely Takaful, Re-Takaful, Bancatakaful and Microtakaful that are tailored to the specific needs of the customers in the region are believed to be the key success factor for insurance companies operating in the region. However, review of the literature reveals that the intensity of public awareness on Takaful concept and principles is still relatively low. In addition, despite of the importance of product innovation, there have been inadequate studies worldwide (including in the GCC region) about the product innovation for Takaful products. Therefore, In order to move forward the insurance market in the region needs to create more knowledge, expertise and talents, educate public on the benefits of Takaful, tackle religious issues related to insurance through public awareness campaign on Takaful concept and principles, improve regulation policies which are not only investor friendly but also ensure customers protection, and conduct more aggressive research and development (R&D) on Shariah compliant alternatives.

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BancaTakaful: A Cost-effective Way to Promote Takaful Services

Takaful is one of the areas in Islamic finance which has seen substantial growth over the last decade. According to the Ernst & Young World Takaful Report 2012, global gross Takaful contributions grew at a compound annual growth rate of 29% during 2005- 09. The number of Takaful operators worldwide also increased from 196 operators in 2012 to 200 operators in April 2013. These developments have resulted in a significant increase in the market share of Takaful.

Despite the positive signs, there are still untapped potential markets that need to be explored by Takaful operators in order to sustain the growth. In exploring those markets, Takaful operators need to establish an effective distribution channel. One of these distribution channels is bancaTakaful.

BancaTakaful is defined as a strategic alliance between a Takaful operator and an Islamic bank, where the latter markets the Takaful products underwritten by the former. The alliance is considered as cost-effective since Takaful operators can use relatively more established Islamic banking channels in marketing their products. BancaTakaful is not a new concept. MNI Takaful, a Malaysian Takaful operator licensed in 1993, was perhaps the first company in the world that entered into bancaTakaful business.

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BancaTakaful offers benefits to Takaful operators, Islamic banks and the customers. Among the benefits for Takaful operators are access to Islamic banks’ ready customer database and strong brand identity. For Islamic banks, bancaTakaful is an additional source of funds and a means to mitigate risk (such as credit risk). Customers “ The alliance is also benefit from considered as cost- bancaTakaful since the effective since alliance allows them to access Takaful operators integrated financial services in can use relatively one place. more established Islamic banking However, it is believed that channels in bancaTakaful is applied only marketing their by a few Takaful operators, mostly in Southeast Asia. products” There are still many Takaful operators that still do not apply this mechanism. In order to increase the application of bancaTakaful; strong support from the regulators, commitment from both Takaful operators and Islamic banks, the development of human capital and product innovation are necessary.

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Misconceptions about Family Takaful

Among the sectors within Islamic financial industry, Takaful is considered as the least developed sector. In the Gulf Cooperation Council Countries (GCC) particularly, insurance in general is still far from its maximum potential. This becomes more obvious in the life insurance and family Takaful segment. The Takaful sector in the GCC including Bahrain is still mainly driven by the general Takaful segment. This is mainly due to the mandatory motor accident policy for all vehicles and mandatory health insurance for expatriates working in the kingdom.

The relatively less developed of family Takaful segment as compared to general Takaful segment in the kingdom is partially due to some misconceptions among the public about family Takaful. According to available literature among the major misconceptions are (1) Risk protection is against the concept of total dependence upon the Almighty God (Tawakkul); (2) No difference between Insurance and Takaful; (3) All kinds of life insurance including family Takaful aims to maximize profits by taking away as much as possible benefits from the policyholders; and (4) Takaful scheme is a modern form of invention (Bid’ah). These misconceptions if not properly addressed could be serious obstacles to the development of Takaful industry. Therefore, this article intends to correct the misconceptions.

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For misconception no. 1, the concept of Takaful is actually not against the concept of Tawakkul. In fact, it is very much in line with the correct understanding of the Tawakkul concept. Tawakkul means taking the best precautions to minimize the risks and then fully depend upon Allah the Almighty. By participating in the family Takaful scheme, the “ The relatively less policyholders have put their developed of family best precautions from risks Takaful segment as that might affect their heirs’ compared to future. Therefore, it is actually general Takaful a form of Tawakkul. For segment in the misconception no. 2, Takaful kingdom is partially and insurance are clearly not due to some the same. Takaful is based on misconceptions the concept of risk sharing among the public where participants mutually about family guarantee each other by Takaful” creating a pool of Tabarru’ fund while insurance is based on the concept of risk transfer where the policyholders buy insurance policy from insurance company for financial protection provided by insurance company upon occurrence of a specific risk. In Takaful, participants are insured and insurer for their fellows at the same time while the Takaful company only acts as the fund administrator. In insurance, the insurance company plays the role of insurer and all premiums collected are considered as revenue for the insurance company.

For misconception no.3, Takaful scheme principally aims to establish a caring society. Profit is not the ultimate goal. In fact, all Takaful surplus belongs to the policyholders and not an operating profit for the Takaful company. Takaful company might be allowed to share some of the surplus with policyholders provided it is

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approved by the Shariah Supervisory Board (SSB) of the company. For point no. 4, obviously Takaful is not a form of modern invention since it is a kind of transaction (Muammalah) where everything is permissible unless there is a source of Shariah which indicates it as unlawful. In addition, it is very much similar to the practice of Aqila which has been approved by Prophet Muhammad during his life. Aqila is an ancient Arab tribal practice where the paternal relatives of a killer donate money for the payment of blood money (Diya) requested by the family of the deceased. It is clear that the concept of mutual guarantee (Takaful) existed in the Aqila practice.

Based on the above discussion, addressing the above misconceptions is very crucial for the development of Takaful industry. Even though the misconceptions are not newly revealed but they still exist and hinder the development of Takaful industry. It is important for all Takaful’s stakeholders to work on it in order to move forward.

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Expansion of Takaful Business

The first quarter of 2013 has so far shown good signs for the development of the Takaful and re-Takaful industries worldwide. It started with the enhancement in the regulatory framework in January and was followed by an expansion of Takaful businesses in the following month. In general, the expansion can be categorized into adding new products, adding more branches, spinning off Islamic windows and seeing more conventional insurers plan to venture into Takaful business.

Takaful Ikhlas in Malaysia, for an example, has just added hospitalization and surgical products into its product lines. The new group “ The expansion can product is expected to be categorized into increase the company’s adding new contributions this year. In products, adding Bahrain, Takaful International, more branches, which is the country’s first spinning off Islamic Takaful Company, recently windows and opened a new branch in the seeing more country’s northern conventional governorate. The new branch insurers plan to is expected to attract more venture into customers to participate in the Takaful business” Takaful scheme as well as a way to better serve their requirements and needs.

In Indonesia, the new rule that requires conventional insurers to spin off their Shariah business units (windows) is expected to increase the market share of Takaful in the country. With this rule in place, most probably more fully-fledged Takaful companies will be established during 2013.

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Lastly, Oman United Insurance Company, a leading conventional insurer in the Sultanate of Oman, is in the process of establishing a Takaful company this year. This development indicates a growing interest from conventional insurers in venturing into the Takaful business.

The above developments indicate the expansion of the Takaful industry worldwide during February. The expansion is expected to boost the annual growth rate of Takaful market in 2013.

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Grasping Opportunities in the Malaysian and Indonesian Takaful Markets

Malaysia and Indonesia are seen by many experts as two Takaful markets with plenty of opportunities to grasp. This is due to strong growth of the Takaful industry in both countries. The Ernst & Young World Takaful Report 2012 concludes that both countries, along with Brunei, recorded around US$2 billion gross written contributions (GWC) with a 28% compound annual growth rate (CAGR). The figures are convincing enough to point out that in addition to the GCC; the two countries are important markets for the Takaful industry. Some even predict that they could be the next primary hubs for the Takaful and re-Takaful industry, given the fact that the ASEAN community will be effective in 2015.

Malaysia is a relatively developed market with a high ratio of average GWC per operator driven mainly by the Family Takaful business line. Up to 2011, Takaful operators in Malaysia in general still had a better combined operating ratio than their conventional counterparts. This indicates better underwriting practices. Exploring the opportunities in General Takaful should be considered by Takaful operators in Malaysia to boost their performance. On the other hand, Indonesia, despite being the largest Muslim state in the world, still has a relatively low insurance penetration rate (1.7% in 2010). Limited ranges of micro- Takaful products for low income people in the country and a limited awareness of the Takaful concept and of insurance in general are among the reasons why the penetration rate is still relatively low in Indonesia. Therefore, developing Takaful products that suit the low income market and launching an awareness campaign

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should be the focus of Takaful operators in the country to improve their performance.

On top of the above, support from the regulators in both countries is necessary. The establishment of separate regulatory frameworks for Takaful is expected to accelerate the growth in these markets. Improvement in regulatory frameworks will create better financial stability and higher consumer confidence.

Takaful: Establishing a Caring Society

The concept of insurance is not something new in human civilization. It can be dated back as early as 600 years BC in the Babylonian society and known as the bottomry contract. A kind of insurance “ Improvement in can also be found during the regulatory life of the Prophet Muhammad frameworks will in the implementation of the create better aqila system. Aqila is a kind of financial stability Arab tribal social insurance in and higher which if any member of a tribe consumer was killed by a member of confidence” another tribe, the heir of the victim would be paid blood money (Diyat) as compensation by close paternal relatives of the killer.

Another kind of social insurance in early Islamic society can be found in the concept of fidyah (ransom). This was paid by the spouse, family, tribe or a friend to free a captive of an enemy. Beside that, the prophet also encouraged society to take care the needy, widows and the poor.

These practices had created a self-reliant society in Madina and across the Muslim world for centuries. The

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practices are also proof that Islam does not object to the concept of insurance. However, it’s very difficult to find such practices and other kinds of social insurance in today’s societies.

Insurance is currently managed mostly by a joint stock company whose main objective is to maximize the wealth of its shareholders. The practice of conventional insurance also consists of elements of riba (usury), maysir (gambling), gharar (ambiguity) that are against Shariah. With the existence of these elements in the practice of conventional insurance, many fatwas (rulings) were released by Islamic jurists (ulama) considering insurance as prohibited (haram).

However, based on the above facts and explanation, it is clear that the prohibition here is not for the concept of insurance; rather it is for the practice of today’s conventional insurance. For that reason, contemporary Islamic jurists have performed Ijtihad that resulted in the creation of the first Islamic insurance (Takaful) company in Sudan in 1979. The main objective of the establishment of the Takaful company is to strengthen solidarity, brotherhood and mutual cooperation among the members of a society.

Foundations and operations

In its operations, a Takaful company eliminates the prohibited elements inherent in the practice of conventional insurance. The element of riba that exists in the investment activities of conventional insurance has been eliminated by the strict restrictions imposed on a Takaful company to only invest the policyholders’ funds in Shariah compliant avenues. As a result, the company

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is not allowed to invest the funds in interest-bearing securities such as bond and mortgage-backed security.

The company is also not allowed to invest the funds in the stocks of non-compliant Shariah companies. The element of gharar exists in conventional insurance at the time the policyholders pay the premium. The policyholders pay the premium to the insurance company “ The main objective as the price for the of the compensation against establishment of financial loss given by the the Takaful insurance company upon company is to occurrence of specified strengthen unexpected tragedy. solidarity, brotherhood and However, the compensation mutual cooperation may be delivered or not and among the the date of delivery is not members of a defined in the insurance society” contract (policy). As a result, there is a high degree of ambiguity or uncertainty on the delivery of the service. In case nothing happens until the maturity of the policy, the policyholders actually don’t know why they had paid the premium. In case the loss occurs, the policyholders receive compensation in an amount higher than what they had paid.

The latter also raises an issue of riba since the amount of money paidis smaller than amount of money received. In order to eliminate gharar and riba as explained above, the Takaful company in practice uses the concept of cooperative risk sharing by using charitable donations (Tabarru) as the method for collecting the contribution (premium) from the policyholders.

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The implementation of cooperative risk sharing places the Takaful company as the administrator of the policyholders’ funds. Unlike a conventional insurance company which acts as the insurer for the policyholders (insured), in the Takaful system, policyholders are the insured and the insurer at the same time. This is because, in the Takaful system, the insurance benefits for the deceased policyholders are taken out from the policyholders’ funds, not from the shareholders’ funds. Therefore, the Takaful company must segregate between shareholders’ funds and policyholders’ funds in its financial report.

The segregation of the funds is very important to ensure transparency in the utilization of the two funds and to protect the interests of the participants and shareholders of the company. Therefore, according to financial accounting standard no 12 of AAOFI, a Takaful company should prepare seven financial statements for the purpose of financial reporting. These are:

• Statement of Financial Position (Balance Sheet). On the liability side of the statement there is an additional account called policyholders’ equity that is located in between liabilities and owners’ equity. • Statement of Policyholders’ Revenues and Expenses. It consists of insurance revenues and insurance expenses as well as net investment income related to policyholders’ funds. The last result is either policyholder’s surplus or policyholder’s deficit for the year. • Statement of Policyholders’ Surplus or Deficit. The statement shows the movements in the balances of retained policyholders’ surplus.

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• Income statement. It represents the revenues the Takaful company earns during a financial period and the expenses it incurs. • Statement of Cash Flows. This statement shows the cash outflows and inflows for the year from and into the company resulting from the operating, investing and financing activities of the company. • Statement of Changes in owners’ equity. The statement presents the changes in paid up capital, reserves and retained earnings accounts during the financial period. • Statement of Sources and Uses of Zakat and Charity Funds. The statement discloses all sources and uses of zakat and charity funds during the financial period.

Based on these principles, it is clear that the Takaful system focuses more on establishing a caring society rather than being a pure commercial entity. Unlike the conventional insurance company that makes profit through the implementation of the law of large number, the Takaful company makes money through charging underwriting fees for managing the cooperative funds and sharing the profit from the investment of cooperative funds.

The Takaful company also doesn’t make money from the underwriting profit (surplus) since all the surplus belongs to the policyholders. However, it does not mean the Takaful company is not allowed to make a profit. The difference is that the Takaful operator should not place the profit motive as the prime objective of its operation.

Beside that, in order to ensure its conformity to Shariah, a Takaful company in its operations must be supervised by a Shariah supervisory board (SSB) consisting of

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Islamic jurists with strong knowledge in Islamic commercial jurisprudence (fiqh muamalat).

The supervisory role of the SSB is conducted by reviewing all insurance contracts, clauses and reinsurance treaties made by the company.

The board of directors and the employees of the company also should be able to answer any questions related to Shariah matters. In addition to its supervisory role, the SSB should also play an innovative role by offering constructive and creative ideas to develop new products which are not only Shariah compliant but also marketable.

Obviously, the board needs the assistance of the underwriters and insurance experts to undertake this role. Another role that should be played by the SSB is to calculate the amount of zakat due from shareholders and policyholders. This role is only to be performed if the shareholders and the policyholders of the company authorize it to do this on their behalf. Therefore, this role is supplementary in its nature.

Growth and opportunity

The Takaful industry recently has become one of the promising sectors of the financial services industry across the world. There are currently more than 60 Takaful operators in the world, mostly in Muslim countries such as Malaysia and Bahrain and also in non-Muslim countries such as the UK.

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The global Takaful market is expected to grow between 15% and 25% per annum, with the GCC markets expected to be the main driver of the growth, especially the Saudi market. Another “ The main challenge potential market is Indonesia, for Takaful which is the world’s most operators is how to populous Muslim country. raise the Both markets have much awareness of the potential but are relatively people on the untapped. benefits of the

Takaful system. The main challenge for Beside that, Takaful operators is how to governments’ raise the awareness of the commitment to people on the benefits of the support the Takaful system. Beside that, insurance sector is governments’ commitment to also needed to support the insurance sector spread the is also needed to spread the message of message of Takaful. For Takaful” example, the introduction of compulsory motor accident insurance and health insurance for expatriates across the GCC countries has clearly boosted the insurance penetration rate in the member countries.

Obviously, the development of the non-life insurance market or general Takaful in the region is strong. However, there are still plenty of opportunities to grasp in the family Takaful (Islamic life insurance) line. The sector is relatively underdeveloped in the region. One of the determinants that contribute to the low penetration rate of life insurance is the perception among many people in the region towards life insurance which is considered to be haram. The perception was embedded partly due to

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the fatwa released by many Islamic jurists condemning life insurance as being against Shariah.

“The Takaful industry recently has become one of the promising sectors of the financial services industry across the world”

However, this is not supposed to be the case anymore with the existence of the family Takaful product. This is basically a combination of long-term investment and a mutual financial assistance scheme. Its objectives are to:

• Save regularly over a fixed period of time. • Earn investment return in accordance with Islamic principles. • Obtain coverage in the event of death prior to maturity from a mutual aid scheme.

In family Takaful, the participants’ contributions are divided into two accounts — participant account (investment account) and participant special account (Tabarru). The fund in the Tabarru account is used to pay the Takaful benefits to the beneficiaries concerned.

Based on the above explanation, it’s clear that the family Takaful scheme benefi ts society in general in at least two aspects: encouraging the habit of saving among members of society and establishing a caring society through a mutual aid scheme.

One way to raise the people’s awareness of the Takaful concept in the long run is by spreading the message of Takaful through the education system. Currently, there are only a few universities in the world that offer principles of Takaful as a subject. Another effective way is through the concept of bancaTakaful, a cost-effective way to

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promote Takaful services through relatively more established Islamic banking channels.

Developing an extensive network of Takaful agents and brokers is also another important way to boost the industry’s growth. Finally, the author truly believes that if the Takaful system is widely applied in Muslim society, the vision of a caring society can be realized.

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Room for Improvement and Opportunities for Growth in Bahrain’s Takaful Industry

SUTAN EMIR HIDAYAT highlights the development of Takaful in the kingdom and describes some opportunities that can be taken by Takaful operators to increase the industry’s growth.

Bahrain’s position as one of the world’s Islamic financial centers has made the development of Takaful industry in the kingdom very important. Takaful is an integral part of the Islamic financial system. Thus an effective and efficient Islamic financial system cannot exist without the support of a well-developed Takaful industry.

Realizing the importance of the Takaful industry, the Central Bank of Bahrain (CBB) has issued a comprehensive regulatory framework for the industry. As a result, Bahrain is known to have a better regulatory system for Takaful than other GCC countries.

Bahraini insurance and Takaful industry highlights

Bahrain’s insurance industry consists of conventional and Islamic (Takaful) companies. According to CBB’s data, the conventional insurance firms sector consists of 15 locally incorporated firms (including two pure reinsurers), 11 foreign branches (including three pure reinsurers) and six representative offices of foreign insurance companies.

The Takaful segment has nine companies including two re-Takaful fi rms. In addition, there are a substantial number of firms with licenses limiting their business to

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outside Bahrain, mainly in Saudi Arabia, including 38 conventional firms and nine Takaful companies.

The figures above clearly indicate that Bahrain has significant large numbers of insurance and Takaful players relative to its small size. This is due to high dependency of Bahrain’s economy on the financial services industry. In 2010, financial services represented 21% of total GDP.

Furthermore, the insurance industry (including Takaful) in Bahrain continued to grow in recent years despite the financial crisis.

The industry is also still considered as sound since solvency margins of insurance players remain substantial. Below are some major performance indicators that reflect the soundness of insurance industry in Bahrain (according to CBB data in 2009 and 2010):

1. Total gross premiums underwritten in the kingdom grew by 7.5% to register BHD 200.56 million (US$532.02 million) in 2009 from BHD186.64 million (US$495.09 million) in 2008. Remarkably, the gross contributions of Takaful firms operating in Bahrain have risen significantly over the last five years; Takaful firms’ gross contributions reached BHD 32.67 million (US$86.66 million) in 2009 compared to BHD26.75 million (US$70.96 million) in 2008, an increase of 22%. 2. Long-term insurance (life and savings products) increased from BHD51.57 million (US$169.8 million) in 2008 to BHD57.31 million (US$152.02 million) in 2009, an 11% increase. The Family Takaful business (Islamic life insurance) line also increased from

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BHD5.47 million (US$14.51 million) in 2008 to BHD 5.66 million (US$15.01 million) in 2009, a 3.5 % increase. However, the Family Takaful business line only represented 17% of the total Takaful businesses in 2009. 3. Total assets of conventional insurers rose by 21% to register BHD841.62 million (US$2.23 billion) in 2009. Total assets of Takaful firms increased to reach BHD99.41 million (US$263.7 million) in 2009 compared to BHD90.18 million (US$239.22 million) in 2008, an increase of 10%. In 2009, Takaful assets represented 10.56 % of the total insurance assets in Bahrain. 4. Bahrain’s insurance penetration rate increased from 2.27% in 2008 to 2.59% in 2009. However, the figure is still much lower in comparison to insurance penetration in other markets such as Malaysia which had 3.72% in 2009. 5. The available capital still exceeded the required margins of solvency in 2010 for both general and life business lines reflecting no financial stability concern within the insurance industry. 6. Net income remains positive despite a decline in the first quarter of 2010 due to the increase in both expense and claims ratios.

Due to the well-established Takaful regime, a number of leading international insurance companies have established their Takaful and re-Takaful operations in Bahrain.

Currently, major insurance and reinsurance international players such as Allianz and Hannover Re have their Takaful and re-Takaful operations in Bahrain.

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Most Takaful and re-Takaful companies in Bahrain are adopting a hybrid Wakalah-Mudarabah model in their operations. In this model, a Wakalah contract is used in underwriting activities while a Mudarabah contract is used in investment activities. “ One potential threat to the growth of The application of a Wakalah insurance and model allows Takaful Takaful industries operators to charge a fee for in Bahrain is the administering the Takaful promulgation of the funds for the benefits of insurance laws in participants. Saudi Arabia in 2003” The application of a Mudarabah contract allows the Takaful operators to share the profit from the investment of Takaful funds. All Takaful companies in Bahrain are obliged to follow AAOIFI standards for financial reporting purposes. In addition, each licensed Takaful firm will be required to have a Shariah supervisory board (SSB) to direct, review and supervise the activities of the company in order to ensure that they are in compliance with Shariah.

However, despite the above good performance indicators for Takaful industry in Bahrain, there is still much room for improvement.

Opportunities and challenges

Although it has increased from previous years, Bahrain’s insurance penetration rate is still below developed markets. The main cause is the low level of public awareness of the benefits of insurance/Takaful.

This is not to say that many Bahrainis are not aware about the differences between conventional insurance

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and Takaful. In addition, more than 70% of insurance business in Bahrain comes from general insurance, leaving life insurance (including Family Takaful) relatively underdeveloped.

One of the determinants that contribute to the low penetration rate of life insurance is the perception among many people in the country that life insurance is haram. The perception was embedded partly due to the fatwa released by many Islamic jurists in the past condemning life insurance as being against Shariah.

Besides that, the compulsory motor accident insurance for all vehicles and health insurance for all expatriates in Bahrain have pushed up the amount of general insurance premiums much higher than life insurance premiums.

There are eff orts made by both regulator and players to enhance public awareness of insurance benefits such as the establishment of the Bahrain Insurance Association (BIA), Insurance Learning Center (ILC) and Gulf Insurance Institute (GII).

BIA was established in 1993 by insurance companies and organizations that are actively involved in insurance market. Being an insurance society, BIA aims to promote the interests of its members, further develop the insurance industry and enhance insurance awareness in the market place.

The ILC, which was set up in 1986, is considered as one of the biggest specialized insurance training centers in the Gulf and the Middle East region. The center caters for all the training and development needs of the insurance industry to enable its staff to acquire advanced insurance

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qualifications such as advance insurance diploma and Exams of the Chartered Insurance Institute.

The GII was established in June 2007, providing an additional source of training for the insurance and Takaful industries. It aims to serve the “ Low public growing needs for human awareness of capital development in the insurance benefits insurance (including Takaful), has resulted in a risk management and lower insurance financial services sector in the penetration rate in region. the country as

compared to more However, despite the developed existence of the above markets” institutions, more eff ort needs to be taken to increase public awareness of Takaful concept and to increase market share of Takaful in Bahrain’s insurance market.

One way is by spreading the message of Takaful through Bahrain’s educational system. Currently, there are only a few universities and institutes in the country that offer principles of Takaful as a subject: such as University College of Bahrain and Bahrain Institute of Banking and Finance.

One effective way to increase the Takaful’s market share is through the concept of bancaTakaful, a cost-effective way to promote Takaful services through relatively more established Islamic banking channels.

So far, the concept of bancaTakaful has not been widely practiced in Bahrain. Therefore, it is expected that as more people become aware of insurance in general and

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Takaful in particular, the insurance penetration rate in Bahrain will increase significantly.

One potential threat to the growth of insurance and Takaful industries in Bahrain is the promulgation of the insurance laws in Saudi Arabia in 2003. So far, Bahrain still enjoys a good reputation and prominent position as a regional financial and insurance center. The country plays host to many insurance and Takaful companies carrying on business outside Bahrain.

As mentioned in the previous section, most of these companies are conducting insurance and Takaful operations in Saudi Arabia. However, during 2008 and 2009, several companies who obtained a license from Saudi authorities transferred their whole insurance portfolio from Bahrain to the newly licensed companies in Saudi Arabia during 2009.

The above situation should force both the regulator and insurance/Takaful players to work hard to find ways to maintain Bahrain’s status as a regional insurance center.

Both regulator and players must ensure that Bahrain is still the most effective and efficient place to be the home base for insurance and Takaful firms that serve the insurance needs of companies in neighboring countries.

Another potential opportunity for Bahrain is to be the home base of more reinsurance and re-Takaful companies. It is well known that the risk retention ratio of most insurance/Takaful companies in Bahrain is low. It is also reported that after the crisis the risk retention ratio continued to decline.

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This trend is attributable to uncertainties in the operating environment, which has encouraged Bahraini insurers to pass along more underwriting risks to reinsurers, thus sharing risks more broadly in the current challenging environment.

Therefore, this situation is clearly a business opportunity for reinsurance and re-Takaful companies to increase their gross premiums/contributions.

On the top of the above opportunities and challenges, it is the duty of the Bahraini government to create a conducive and business friendly environment. Any political instability surely affects the whole business in the country, including insurance “ Bahrain’s and Takaful. insurance/Takaful

industry is still in The recent uprising surely has good shape despite affected to some extent the the financial crisis” kingdom’s insurance and Takaful businesses. Analysts polled by Reuters in March 2011 decided to cut their real GDP growth forecast for Bahrain to 3.4 % for 2011, from the 4.2 % expected in December 2010, following the unrest.

It is clear that if stability and security are not in place, Bahrain’s dream of becoming a business friendly country will be difficult to achieve.

Conclusion

Based on several performance indicators, it can be concluded that Bahrain’s insurance/Takaful industry is still in good shape despite the financial crisis. However, low public awareness of the insurance benefits has

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resulted in a lower insurance penetration rate in the country as compared to more developed markets.

Therefore, more effort still needs to be taken to improve the situation. In addition, CBB as the sole regulator has to ensure that regulations and business environment in Bahrain are still the best within the region for the operations of insurance and Takaful businesses.

The assurance is also aimed to maintain Bahrain’s status as regional insurance center and one of the world’s Islamic financial centers.

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BancaTakaful: a Strategic Alliance within Islamic Finance

In today's competitive financial market, strategic alliances have become one of the most important solutions to ensure the sustainability of Islamic financial institutions’ operations. As the smallest segment within Islamic finance, Takaful needs to form strategic alliances with other segments of the industry, especially Islamic banking. For example, Takaful operators can market their products using more developed channels of distribution through Islamic banks. This arrangement, known as bancaTakaful, is becoming increasingly popular with a growing numbers of deals across the world: including in Pakistan, Malaysia and the UAE.

In practice, there are two types of bancaTakaful models: namely direct and indirect bancaTakaful. Direct bancaTakaful means a Takaful operator and an Islamic bank make a deal where the Islamic bank includes the Takaful operator's products into its range of products. The bank offers the products to its customers and receives premiums directly from them. The bank later forwards the premiums received from the customers to the Takaful operator at the net of commission.

On the other hand, in indirect bancaTakaful, the Islamic bank only agrees to promote the Takaful operator's products to its clients in return for a commission. The bank will refer any client interested in the Takaful products to the operator, who will than issue the Takaful policy at a special rate. In indirect bancaTakaful, the Takaful products are normally attached to the Islamic bank's financing schemes: such as home, project, personal and corporate financings.

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BancaTakaful benefits all parties involved. For the Islamic bank, it is an effective and efficient means of product diversification and a “ BancaTakaful will new source of revenue. For flourish in the near the Takaful operator, this future, provided the mechanism is a cost efficient products offered distribution channel for its are customer- products. In addition, the centered and the operator also derives benefit bank's employees from the reputation of the are aware of and Islamic bank. This is because able to promote the in general public are more Takaful products” aware about Islamic banking than about Takaful. For the customers, this arrangement offers convenient solutions to their financial needs since two products are now offered through the same distribution channel. For these reasons, it is believed that bancaTakaful will flourish in the near future, provided the products offered are customer-centered and the bank's employees are aware of and able to promote the Takaful products.

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MicroTakaful Opportunities in the Growing Indonesian Islamic Banking Sector

As has been discussed across a variety of literature, Islamic finance was established with the aim of improving people’s lives: known in Islamic jurisprudence as the concept of Maslahah. One of the most important things in the context of Maslahah is for poor people to have access to Islamic financial services. In this situation, the existence of Islamic microfinance, including microTakaful, becomes very important.

The aim of microTakaful is essentially to help Islamic microfinance institutions to reduce their credit risk. Hence, the performance of microTakaful depends on the performance of these institutions. Therefore, microTakaful operators have to collaborate with Islamic microfinance institutions. This collaboration is called the Partner Agent Model (PAM). “ Although the This model allows the market share of institutions to deduct funds Islamic banking is from the financing given to the still small (less client for their microTakaful than 5% of total contribution. In others words, banking assets), the client will not receive the the growth of this full financing amount as a industry is partial deduction has been immense, made which represents recording 30% payment for participating in the annual growth” microTakaful scheme. In this case, the institution is acting as the agent for the microTakaful operator. This collaboration basically benefits all parties. A practical example of how this model operates well is represented in the Indonesian Islamic banking industry. Although the market share of Islamic

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banking is still small (less than 5% of total banking assets), the growth of this industry is immense, recording 30% annual growth. In June 2012, Islamic banking assets were IDR155 trillion (US$12.95 billion) while in June 2013 they stood at IDR218 trillion (US$18.22 billion).

Looking at the sectors financed by Islamic banks in Indonesia, it further strengthens the argument that microTakaful is important. In June 2013, the micro, small and medium enterprise (MSME) sector and the non- MSME sector received financing of IDR103 trillion (US$8.61 billion) and IDR67 trillion (US$5.6 billion) respectively. The fact that Islamic banks focus predominantly on the MSME sector is in line with the nature of Islamic finance which is to support the real sector and empower MSMEs. This also suggests that the Islamic banking industry has a promising future in Indonesia.

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Promoting MicroTakaful as a Means to Boost Market Share of Takaful

It is well known that around one-fifth of the world's population is Muslim. Unfortunately, most of them live in the low-income or lower-middle income countries. As a result, most of them are unable to participate in normal insurance or Takaful schemes.

The World Takaful Report 2012 released by Ernst & Young indicated that insurance penetration rates in Muslim countries are still very low. For example, in 2010, the insurance penetration rate for Indonesia, the world’s most populous Muslim country, only stood at 1.5% while in Pakistan, the penetration rate stood at 0.7%. These figures are still below their potential levels. With relatively “ Through close high population growth rate in cooperation with most Muslim countries, this the Islamic rural situation should be seen as an banks, BMT, opportunity for Takaful cooperatives and operators to explore the other Islamic microTakaful segment. microfinance institutions, MicroTakaful can be defined microTakaful can as a Takaful scheme for low- offer substantial income people. This segment business is relatively untapped despite opportunities for it having the potential to boost Takaful players” the Takaful market share. One of the practicable implementations of microTakaful is to support an Islamic microfinance scheme offered by Islamic rural banks and Baitul Mal Wat-tamweel (BMT). This policy is also known as credit life microTakaful.

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The policy is used to protect against the death risk of a person who takes microfinancing from an Islamic microfinance institution. This scheme obviously benefits both the heirs of the deceased and the Islamic microfinance institution itself.

Through close cooperation with the Islamic rural banks, BMT, cooperatives and other Islamic microfinance institutions, microTakaful can offer substantial business opportunities for Takaful players. Another effective distribution channel is through microTakaful agents. In addition, educating the target market on the importance of having a Takaful policy should be the focus of microTakaful operators in order to successfully attract customers to participate in the scheme.

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An Issue in Takaful Practice: Low Levels of Public Awareness

Takaful is an area in Islamic finance that has been growing significantly for the last decade. The World Takaful Report 2012 indicates that the compound annual growth rate of the industry stood at 29% from 2005-09. Despite the convincing figure, it is believed that there is still a lack of public awareness towards Takaful. Actually, in many Muslim countries the above case is not only applicable for Takaful but also for insurance in general. As a consequence, many Muslims around the world have misconceptions about Takaful.

According to literature, there are two general misconceptions about Takaful. First, Takaful has been considered unnecessary. Many Muslims believe that the true belief in Allah means there is no need for any such cover against death or losses “ Many Muslims to a man himself or his wealth. believe that the true In other words, the Takaful belief in Allah mechanism is in contradiction means there is no with the principle of Tawakkul. need for any such This principle urges Muslim to cover against death only put his trust in Allah. or losses to a man Actually however, the Takaful himself or his concept is in line with this wealth” principle since Islam asks its followers to find ways to avoid catastrophe whenever possible, and to lighten one’s burden should an unexpected event occurs.

Secondly, despite Takaful being promoted as being free from Riba, Gharar and gambling, there are many who still believe that there is no difference between conventional

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insurance and Takaful in practice. This is because they don't understand how a Takaful scheme works. In addition, it is also partially because many customer service officers in Takaful companies always use conventional terms when they explain Takaful products to their clients for simplicity reason.

Therefore, the issue of lack of public awareness must be addressed seriously by all industry stakeholders. Integrating Takaful courses into higher learning institutions should be encouraged and Takaful regulators must work on this by holding courses, conferences, studies and researches about how to create public awareness on Takaful.

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Takaful Investment Activities: Exploring Alternative Asset Classes

Like their conventional insurance counterparts, Takaful operators also generate revenues from their investment activities. However, due to Shariah constraints, Takaful operators have hitherto had relatively limited alternative investment asset classes as compared to conventional insurers.

The lack of Shariah compliant investment alternatives was recently pointed as the biggest challenge which Takaful operators face in their operations. Generally, a Takaful operator channels its funds into Sukuk, equity, real estate and deposits asset classes.

According to Ernst & Young World Takaful Report 2012, so far the biggest portion of Takaful operators’ investment in the GCC is in equity. In 2007, 68% of Takaful operators’ investment was in equity. However, the equity portion of the portfolio declined significantly to 38% in 2011, indicating Takaful operators are exploring other alternative asset classes – most notably Sukuk.

In contract, over the last five years Sukuk has become the favorite asset class for Takaful operators in Malaysia. In 2007, Sukuk represented 44% of Takaful investment portfolio. The portion of Sukuk in the portfolio increased to 57% in 2011. The dominance of Sukuk in Malaysia is due to a relatively more developed Sukuk market in the country as compared to the GCC.

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In addition, the increase in the Sukuk portion over the total Takaful investment portfolio both in the GCC and Malaysia is mainly due to the good performance of most Sukuk for the last two years, along with a remarkable “The lack of improvement in Sukuk Shariah compliant liquidity. investment alternatives was Despite the above trend, recently pointed many Takaful stakeholders as the biggest still believe that Takaful challenge which operators must explore other Takaful operators alternative asset classes for face in their diversification purposes. operations” Allocating more funds into real estate (property) and private equity has been suggested by some experts in the industry. However, the decision has to be made carefully since it contains a risk return trade off.

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Takaful Models in Practice: Why and What Are the Consequences?

It is well-known that in practice, Takaful schemes can be structured using one of the following four models:

1. Pure Wakalah 2. Pure Mudarabah 3. Hybrid (Wakalah and Mudarabah) 4. Waqf

The various Takaful models above appear due to two reasons: namely 1. Differences in the interpretations of Shariah by scholars in countries where Takaful is available; and 2. Differences in the insurance regulations in each country.

Despite the differences, in all the above models there are some common features, such as: 1. The separation between participants' and shareholders' accounts as reflected in two separate sets of financial statements; 2. A Shariah compliant investment strategy; 3. The existence of a Shariah supervisory board; and 4. Internal Shariah compliance department.

The differences between the four models can be generally summarized in Table 1.

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As a consequence of the different Takaful models in practice, there are at least two main issues that must be tackled by industry stakeholders. 1. Accounting risk; and 2. Product development.

Both issues become a major hindrance especially when a Takaful operator has operations in many jurisdictions. For the first issue, the question is how the operator can consolidate its subsidiaries' “ A product in one financial statements, which country does not practice different models from always fit the their parent company. The models in other second issue forces the countries” operator to put a lot of effort into creating new products, as a product in one country does not always fit the models in other countries.

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Takaful-based Student Finance Product: Applying Takaful beyond Insurance

It is well known that Takaful is used as the alternative to the conventional insurance concept. As a result, in many cases Takaful is also understood and translated as Islamic insurance. Actually, the Takaful concept is not restricted only for insurance-related transactions. Since the aim of the Takaful concept is to establish a caring society where solidarity, mutual cooperation and other virtues are enjoyed, Takaful can also be applied to other Islamic finance products.

The initiative taken by the government of the UK to propose a Takaful-based student finance is a good example of the possibility of the application of the Takaful concept beyond insurance segment. The proposed product is intended to help Muslims and others in the UK who wish to pursue higher education but are unable to take the interest-based student loan from the government due to religious belief.

The Takaful-based student finance is to be established based on the concept of mutual finance assistance among the group participants. The Takaful fund will initially be established through the donation (Tabarru') or Qard Hassan from the government. A student who wishes to participate in the scheme will apply this alternative student finance through Student Loans Company (SLC), the same way as the conventional student loan. SLC will undertake the role of Takaful fund administrator and it is entitled to a specified fee (Wakala fee).

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Once the application is approved, the student will sign the contract and make a unilateral promise to pay a Takaful contribution (Tabarru') at the time he/she is employed with earning above the repayment threshold. Immediately after the signing of the contract, the student will get the needed money on yearly basis to cover his/her “ The contribution tuition and maintenance made by the costs. student will be used to help other The contribution made by the students who student upon his/her participate in the employment will be used to scheme” help other students who participate in the scheme and wish to accomplish the same purpose as the student did. If everything goes well, the scheme is planned to be introduced in early 2016.

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Takaful Window: Advantages and Disadvantages

Offering Takaful products via the Islamic windows of conventional insurance companies has become a never-ending debate among scholars. Some countries, such as Pakistan for example, have recently opened the way for Islamic windows; while other countries such as the UAE prohibited the practice following the introduction of its Takaful regulations in 2010. These different approaches taken by Muslim countries with regards to Takaful windows are inevitably due to the advantages and disadvantages of offering Takaful products via Islamic windows.

Those countries which allow the practice of Takaful windows believe in the advantages more than the disadvantages. Among the advantages are: (1) windows allow Takaful products to be sold using the already established distribution channels of conventional insurance products since the same company is offering both products; (2) establishing Takaful business via Islamic window requires less time to achieve breakeven point than via a separate Islamic subsidiary since a Takaful window does not require a lot of separate new infrastructure to be acquired. In other words it allows the company to capitalize on its existing infrastructure to develop Takaful business. This situation is favorable, especially when the Takaful market is newly established.

On the other hand, the countries which prohibit the practice believe in the disadvantages more than the advantages. Among the disadvantages are: (1) a Takaful window can create public misunderstanding with regards to the differences between Takaful and conventional insurance since public may view Takaful as just another

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type of product from conventional insurance. In addition, (2) there is also a possibility of the comingling of funds between conventional insurance and Takaful in the sense that the Takaful funds might be used for non- Shariah compliant investments by the insurance company. In other words, an “ If Takaful agency problem with regards windows are to Shariah compliance exists allowed, it should with a Takaful window. only be on a Therefore, allowing Takaful temporary basis windows is considered by its as a catalyst for opponents to open the the development possibility of Shariah violation. of the overall In summary, the author Takaful market” believes that even if Takaful windows are allowed, it should only be on a temporary basis as a catalyst for the development of the overall Takaful market. Once the market has accepted Takaful, ‘spin-off’ should be encouraged.

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The GCC and Southeast Asia: Two Takaful Hubs with Different Characteristics

In the last decade, Takaful has become a global business. In 2010, global gross Takaful contributions reached US$8.3 billion, with more than 50% of the amount contributed by two regions: namely the GCC and Southeast Asia. These two regions have been the centers for Takaful development in recent years.

The GCC, which consists of six wealthy Arab Muslim countries including Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, the UAE, is the top region in terms of Takaful contributions. By the end of 2012 there were 77 Takaful operators operating in the region. However, it is estimated that around 95% of total Takaful contributions in the GCC comprise of General Takaful business due to the fact that motor accident insurance for all vehicles is mandatory along with compulsory health insurance for all expatriates working in the region.

Family Takaful business is relatively untapped, with plenty of opportunities to be explored. Some regulatory concerns have however been “ Once consumer identified as a factor acceptance grows contributing to the slow growth and more of Family Takaful business in products that suit the region. Therefore there is the needs of a need to amend some consumers are regulations in order to boost developed, the growth. growth of General

Takaful business On the other hand the will be immense” Southeast Asian market, with Malaysia, Indonesia and Brunei as the major drivers, is dominated by Family Takaful business. In Malaysia for

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example, Family Takaful controls 77% of the total Takaful market. These three countries booked around US$2 billion in gross Takaful contributions in 2010. Despite this convincing figure, General Takaful business in the region is still far below its potential level. This is due to relatively low public awareness on the benefits of General Takaful. Therefore, effective awareness programs should be the priority of Takaful operators in the region. Once consumer acceptance grows and more products that suit the needs of consumers are developed, the growth of General Takaful business will be immense.

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The Latest Trend in the Takaful Industry: Enhancement in Regulatory and Legal Frameworks

The beginning of 2013 witnessed many worldwide insurance and Takaful regulators enhancing their regulatory and legal frameworks for the Takaful industry.

Firstly, the Central Bank of Bahrain (CBB) is currently preparing draft rules intended to improve the operational model for the Takaful industry. The upcoming rules are expected to update issues related to solvency, corporate governance and actuarial reporting requirements in Takaful business. The rules are intended to facilitate a faster growth of the Takaful business in Bahrain and to protect the interest of all stakeholders.

Secondly, the insurance authority in Dubai is also currently drafting a Shariah compliant standard to clearly differentiate registered businesses. This law will require all industry players to choose either to structure their operations as a Takaful operator or as a conventional insurance company. This legal “ The upcoming framework is intended to boost rules are expected market confidence in Dubai to update issues Islamic products. related to solvency,

corporate Thirdly, Bank Negara governance and Malaysia, the central bank, is actuarial reporting also in the process of requirements in introducing new Islamic Takaful business” banking and Takaful Acts. The new acts are expected to better reflect the features and the nature of Shariah contracts and ensure that the degree of regulation is commensurate with level of risk

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that Takaful markets and products pose to the overall financial system.

Lastly, there are also calls for Takaful regulators worldwide to harmonize legal frameworks and ensure that supervisory standards are at par with best international standards with the intention to promote collaboration, transparency and adoption of international standards among regulators in the region.

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Part 5

Contemporary Issues and Developments in Islamic Finance Education

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Talent Development: A Key Issue within Islamic Financial Industry

Islamic financial services industry has been growing significantly for the past decades. However, one of the key issues that needs to be addressed in order to sustain the solid growth is talent development within the industry. It is estimated that the industry will need around 50,000 professionals in order to sustain the current growth. This need is expected to rise in the coming years. Bahrain as one of the world’s Islamic financial hubs is also facing the same issue.

Actually, insufficient number of talent is not the only issue. A survey made by the Finance Accreditation Agency (FAA) and Islamic Finance News (IFN) in 2014 also found that there is incompetency of Islamic finance knowledge among the current workforce. This is partially because a lot of the current practitioners don’t have a formal Islamic finance qualification. They are simply conventional practitioners who shifted their career into Islamic financial services industry. As a result, they are less capable of performing their jobs than those with proper Islamic finance qualifications. In addition, it will be difficult for the Islamic financial institutions (IFIs) to achieve the objectives of Shariah (Maqashid Al-Shariah) if the IFIs are operated by those individuals since they might not have or understand the Islamic worldview properly. On the other hand, there are graduates of Islamic finance qualifications that cannot get a job within Islamic financial services industry. They couldn’t get the place because they don’t have necessary skills required by the IFIs. In other words, there is a skill mismatch between what Islamic finance qualifications offer and what the industry needs.

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In order to address the above issue, integrating Islamic finance and Islamic economics into academic curriculum is important. Currently, there are higher learning institutions in Bahrain that offer Islamic finance programmes. However, it is still insufficient given the fact a lot of Islamic finance qualification holders working in Bahrain obtained their “ It is estimated that degrees from outside the the industry will country. In order to move need around forward, it is also important for 50,000 the industry players to support professionals in this integration. IFIs through order to sustain collaboration with Islamic the current finance qualification providers growth. This need might allocate part of its is expected to rise corporate social in the coming responsibility’s budget for years” sponsoring their staffs in taking formal Islamic finance qualifications and sponsoring Islamic finance research activities. In addition, Islamic finance qualification providers should have industry practitioners sitting in their program advisory board. This is to ensure the necessary skills required by the industry are embedded as part of their program intended learning outcomes (PILOs). This kind of continuous engagement must be there to ensure sustainability of the industry’s solid growth and to maintain Bahrain’s position as one of the leading Islamic financial centres.

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Education and Its Role in Awareness Enhancement of the Takaful Concept and Principles

Among the Islamic finance segments, Takaful is the one which has been growing significantly for the last decade. According to an EY report in 2014, the industry grew globally at a growth rate of 14%, which, however, is actually still far from reaching its maximum potential. This is because in general, the insurance penetration rate is still relatively low in most of the Muslim majority countries. In 2012, the insurance penetration rate in Muslim majority countries stood at an average of 2% compared to 4.5% in Europe during the same year. Literature reveals that one of the reasons for the low penetration rate is the low level of public awareness towards insurance in general and Takaful in particular. Therefore, in this article, DR SUTAN EMIR HIDAYAT attempts to highlight the results of some studies around the world that measured the level of public awareness on the Takaful concept and principles and the role of education in awareness enhancement.

Awareness has been empirically proven as one of the important factors that influences market preference. There are many studies that empirically find the positive influence of awareness on market preference. In other words, as awareness increases, market preference also increases. Despite the importance of public awareness, there have been only limited studies worldwide that measured the level of public awareness on the Takaful concept and principles. Actually, in general, scientific studies on Takaful are much less than the studies on Islamic banking for instance. A review of literature reveals that most studies that measured public

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awareness on the Takaful concept and principles were conducted in Malaysia. In addition, there were also empirical studies on the same topic conducted in Bahrain, Bangladesh, Brunei Darussalam, Kuwait, Pakistan and other countries. In general, those studies found that the level of public “ Education plays a awareness on Takaful significant role in concepts and principles is influencing the relatively low. Only a study level of done in Bahrain by Sutan Emir awareness on the Hidayat and Ameena Rafeea Takaful concept (2014) found the level of public and principles” awareness on the Takaful concept and principles is moderately high especially with regards to the basic concept and principles. However, when it came to technical issues such as surplus distribution and Takaful business models, the study revealed a low level of public awareness.

A review of previous studies also revealed that education plays a significant role in influencing the level of awareness on the Takaful concept and principles. Therefore, spreading the message of Takaful through the educational system has been scientifically proven as an effective way to increase public awareness on the Takaful concept and principles. Integrating Takaful courses into the academic curriculum of universities and training institutes across countries where Takaful is in existence is believed to be very important in enhancing public awareness, market preference and thus the market share of Takaful.

In addition, integrating Takaful into the academic curriculum of institutions of higher learning is also important in ensuring the sustainable growth of the industry. This is due to the fact that Takaful growth

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sustainability depends on the availability of talents to meet the industry’s needs. In fact, one of the challenges in the Islamic finance industry in general (including Takaful) is the lack of adequately trained human resources. Obviously, the challenge can only be overcome by producing more qualified people through the educational systems.

However, in the process of integrating Takaful, it is important to ensure that the learning outcomes of the Takaful courses are in line with what the industry needs. This is because there are cases where there are graduates with Islamic finance qualifications (including Takaful) who face difficulties in getting jobs within the industry since they do not have the level of skills and specialization that their prospective employers need. Therefore, in order to move forward it is important for the Islamic finance qualification providers to continuously revise their curriculum in order to meet the industry needs and to obtain accreditation not only from academic-based accreditation agencies but also industry-based accreditation agencies.

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Islamic Economics and Finance Education in the Kingdom of Bahrain

Islamic finance is one of the fastest-growing industries. The industry has been growing rapidly from its appearance in the late 1960s and it has changed from being only a rural banking system at the beginning into a complete financial system since the 2000s. A remarkable growth of the industry happened between 2006 and 2013. During that period, the compound annual growth rate (CAGR) of the industry stood at 16% and as a result, by the end of 2013, total global Islamic finance assets stood at US$1.3 trillion. DR SUTAN EMIR HIDAYAT provides an overview of the Islamic economics and finance education landscape in the Kingdom of Bahrain.

Despite the convincing facts, there are several challenges that need to be tackled to move forward. One of the challenges is the lack of human capital. There are many studies which found that education plays an important role in solving the lack of human capital. It is very important to note that the sustainable growth of Islamic finance depends on the availability of talent to meet the industry’s needs. The lack of adequately trained human resources within Islamic finance can only be overcome by producing more qualified people through the educational system.

A survey conducted by Finance Accreditation Agency (FAA) and IFN in 2014 on human capital development within the Islamic finance industry indicated that 75% of the respondents believed that practitioners without a formal Islamic finance qualification are less capable of doing their job than those with a formal education. In

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conclusion, the industry is still in need of more qualified people to boost its growth.

The issue exists in almost all countries where Islamic finance is implemented including the Kingdom of Bahrain. Bahrain is known as one of the world’s Islamic financial centers. The Central Bank of Bahrain (CBB) through its comprehensive regulatory framework has opened its gate to local and international Islamic financial institutions to operate in the “ The lack of country. The Kingdom is also adequately trained the host to several human resources organizations central to the within Islamic development of Islamic finance can only be finance, including: i) AAOIFI ii) overcome by the Liquidity Management producing more Center iii) the International qualified people Islamic Financial Market and, through the iv) The Islamic International educational Rating Agency. The financial system” services sector is among the highest contributors to the country’s overall GDP representing around 27% of the GDP of the country. In addition, financial services is the largest sector that absorbs the workforce in Bahrain. Up to September 2014, the number of financial institutions in the country is 404 and the total workforce is 14,009. Out of this, Islamic financial services represent around 12-18% of the market share.

In order to support the development of Islamic finance in the Kingdom, human capital development is vital. Realizing the importance of human capital, CBB has established a special fund to finance research, education and training in Islamic finance (the Waqf Fund). In addition, three accredited higher learning institutions in

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the Kingdom, namely the University College of Bahrain (UCB), the University of Bahrain (UoB) and the Bahrain Institute of Banking and Finance (BIBF), are offering Islamic economics and finance (IEF) education and training within their academic curriculum. In terms of Islamic economics and finance (IEF) education, the Kingdom of Bahrain is categorized as a country where IEF education is well established during the Islamic Economics and Finance Education Symposium held in Doha on the 23rd March 2015 by the International Association of Islamic Economics and Finance, the IDB, and the Qatar Faculty of Islamic Studies.

In UCB, Islamic finance is only contained in both the Bachelor and Master of Business Administration programs which are under the Department of Business Administration. In UoB, the Islamic finance program is only at the undergraduate level under the College of Business Administration. In BIBF, the Islamic finance programs come under the Center for Academic and Executive (University of Bangor’s diploma in Islamic finance and De Paul University’s Master of Science degree in Islamic finance) and the Center for Islamic Finance (advanced diploma in Islamic finance, advanced diploma in Islamic commercial jurisprudence, diploma in Islamic finance from the Chartered Institute of Management Accountants and the Islamic finance qualification).

In UoB’s case, it is quite different since the program is relatively new as compared to the other two institutions. UoB’s Islamic finance undergraduate program is focused on Fiqh which is intended to prepare students primarily those seeking to find career opportunities in Shariah departments and in the areas of Shariah review and

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Islamic product development. Until now, none of the institutions offers a PhD program in Islamic finance.

In terms of funding and scholarships, only UCB provides them at the institutional level (full and partial scholarships for Bahrainis). However, BIBF and UoB have a very good relationship with the Waqf Fund of the CBB. Individuals working for Islamic financial institutions get funding from the Waqf Fund to enroll in the Islamic finance programs at BIBF. In UoB’s case, the Waqf Fund provides financial support for its four-year Bachelor’s degree program in Shariah for banking and finance. The support has so far been used to develop the curriculum design.

In terms of accreditation, all three institutions are accredited by the Higher Education Council of the Ministry of Education in “ Offering a Bahrain. The three institutions standardized IEF acknowledge the importance international of international accreditation. qualification that For example, UCB is currently exists globally, in the process of obtaining full which is equivalent accreditation from the FAA for to the CFA Institute its MBA program in Islamic for example, finance. This is in addition to becomes a need” the application made by UCB for the Association to Advance Collegiate Schools of Business (AACSB) accreditation for all programs in the Business Administration Department accreditation (the Department of Islamic Banking is part of the College of Business Administration).

Despite the aforementioned convincing development in IEF education in Bahrain, there are still several challenges and problems faced by IEF education providers in the Kingdom. Among them are the lack of

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textbooks and supporting materials for Islamic finance- related subjects and limited career opportunities for Islamic finance graduates. In addition, the lack of close collaboration between the industry and Islamic finance education providers is also another problem in the implementation of IEF education. As a result, there is a mismatch between the attributes of Islamic finance graduates and the specialization that the industry needs. Therefore, there is a need for greater coordination and cooperation between the course providers and the industry practitioners in the Kingdom.

A closer networking and support mechanism has to be put in place. Offering a standardized IEF international qualification that exists globally, which is equivalent to the CFA Institute for example, becomes a need. In addition, integrating research and teaching more closely is also very important since many programs are mushrooming without a proper foundation and linkage with research. The first step would be to encourage the faculties to conduct research-related activities and include them as a part of their key performance indicator or annual appraisal.

Embedding research skills into Islamic finance graduates is also vital to support the sustainable growth of the industry.

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Skill Mismatch: a Talent Development Issue within the Takaful Industry

Despite its significant growth for the last decade, Takaful is still the smallest segment within Islamic finance. KFH Research in 2014 reported that in 2013 Takaful only contributed 1% of global Islamic finance assets. In addition, the market share of Takaful within the total insurance industry is also still relatively small.

One of the challenges that may hinder the development of Takaful is the lack of adequately trained human resources. Most practitioners within the Takaful segment do not have a formal Islamic finance or specifically Takaful qualification. They use their experience in conventional insurance companies before embarking into this Islamic finance segment.

In fact, this issue is applicable in all segments of Islamic finance. A survey conducted by the Finance Accreditation Agency (FAA) and Islamic Finance News this year on human capital development within Islamic finance industry indicates that 75% of respondents believe that practitioners without a formal Islamic finance qualification are less capable of doing their job than those with a formal education.

However, surprisingly it was also found that there are many Islamic finance qualification-holders who find difficulties in getting a job within the industry. Thus, it is clear that there is a skill mismatch within the Islamic finance industry in general.

The issue of skill mismatch becomes worse in the case of Takaful. PwC reported in 2012 that the biggest deficit

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of skilled candidates among Islamic finance segments existed in Takaful. It is more difficult to hire a qualified person in Takaful than in Islamic banking, Islamic capital markets and asset management.

As a result, the development of Takaful is still far from its maximum potential. In order to overcome the challenge, intensive collaboration between Takaful qualification providers and Takaful practitioners is needed. Takaful qualification providers should continuously revise their curricula in order to meet the industry needs. They have to ensure that their graduates hold certain specific skills that the industry is looking for.

In addition, every Takaful qualification provider should get full accreditation not only from an academic accreditation agency but also from an industry-based accreditation agency such as “75% of respondents the FAA. This is because believe that accreditation has been proven practitioners by many studies to be an without a formal effective method of quality Islamic finance assurance. qualification are

less capable of Therefore, the involvement of doing their job than industry-based accreditation those with a formal agencies is important to help education.” the qualification providers in ensuring their syllabus and their programs' intended learning outcomes are up to date and in line with what the industry needs.

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Challenges Faced by Islamic Economics and Finance Qualification Providers

Islamic economics and finance (IEF) has been recognized as one of the fastest growing industries. For example, the Islamic financial industry remarkably grew during 2006-2013 where the compound annual growth rate (CAGR) of the industry stood at 16%. It has been noted in many studies that human capital development is the key in order to sustain the remarkable growth of the Islamic financial industry. However, the current status of the industry’s human capital is still far away from its need. Surprisingly, despite there is a lack of talent within the industry, many Islamic finance qualification holders find difficulties in finding the jobs within Islamic financial indus try. The above developments raise at least two questions related to Islamic finance “ Among the education. What is the current common status of Islamic finance challenges are lack education worldwide? And; of standard what are the challenges faced curriculum for IEF by Islamic finance qualification education, lack of providers worldwide that need course materials, to be tackled in order to solve lack of relevant the issue of human capital market skills, lack within the industry? This article of funding, lack of attempts to provide the research quality answers for the two questions and lack of human based on the results of resources or discussion held among Islamic sufficient number finance educators worldwide of qualified Islamic at the Islamic Economics and finance educators” Finance Education Symposium held on March 23, 2015 at the Qatar Faculty of Islamic Studies, Hamad Bin Khalifa University, Doha, Qatar and other literature.

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At the symposium, the status of Islamic finance education worldwide is divided to three categories namely countries where IEF education is well established, country where IEF education is growing and countries where IEF education has potential. IEF education in Bahrain, Egypt, Indonesia, Malaysia, Qatar and Saudi Arabia is categorized as well established. IEF education in India is categorized as growing and IEF education in Algeria, Kazakhstan, Morocco, Oman, Spain and Tunisia is categorized as has potential. It is important to note that even though the IEF education is classified into the above three categories, there are common challenges faced by IEF qualification providers all over the world. Among the common challenges are lack of standard curriculum for IEF education, lack of course materials, lack of relevant market skills, lack of funding, lack of research quality and lack of human resources or sufficient number of qualified Islamic finance educators. In addition, for countries with “growing and has potential” status three additional challenges are existing for IEF qualification providers namely lack of available jobs for IEF graduates, lack of demand for IEF education, and IEF is still not a recognized business.

In order to tackle the identified challenges, several recommendations have been made. For the lack of standard curriculum, it is important for all IEF qualification providers to coordinate and offer a standardized international qualification that exist globally which is equivalent to the standards of for example a CFA. For the lack of course materials, more of joint efforts among the leading universities in IEF education is needed to produce more IEF textbooks especially at the advanced level. For the lack of relevant market skills, intensive collaboration between industry practitioners and IEF

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qualification providers through two ways communication must be taken place to ensure the IEF programs produce market matched graduates. In addition, necessary skills such as soft skills must be incorporated in the academic curriculum and should be set as parts of the program intended learning outcomes. For the lack of funding, the cash waqf model of the Central Bank of Bahrain (CBB) can be used as a good reference to establish similar schemes in other countries. For the lack of research quality, joint publication and organizing more research forums & competition which are fully sponsored by international bodies such as the IRTI-IDB are believed as good ways to attract better quality research within Islamic financial industry. For the lack of qualified Islamic finance educators, certification for IEF educators issued by an internationally recognized professional body will ensure those involved in the IEF education are only qualified educators. In addition, training of trainers (TOT) modules are encouraged especially to be given by senior educators to junior educators. For the challenges faced by countries categorized as “growing and has potential” status, collaboration with the countries where IEF education is well established is needed to learn from their experience in developing the Islamic financial industry and its education infrastructure.

It is expected that by addressing the above identified challenges, the IEF education worldwide will be better and the IEF qualification providers will be able to produce qualified graduates which are market matched. This will ensure the sustainability of the industry in the long run.

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Contemporary Issues and Developments in Islamic Finance | 179 Thoughts of an Indonesian Diaspora in Bahrain

Part 6

Other Issues

Contemporary Issues and Developments in Islamic Finance | 180 Thoughts of an Indonesian Diaspora in Bahrain

Contemporary Issues and Developments in Islamic Finance | 181 Thoughts of an Indonesian Diaspora in Bahrain

Applying a Common Shariah Standard: Benefits and Challenges

Introduction

Islamic financial industry can be considered as a new industry especially when it is compared to its conventional counterpart. Since its appearance in the late 1960’s, the industry has been growing significantly. For example, during 2009-2014, the Cumulative Average Growth Rate (CAGR) of the industry stood at 17.3%. Despite it has been spread across the globe, the industry is still mainly concentrated in the South East Asia particularly in Malaysia and in the Middle East especially in the Gulf Cooperation Council (GCC) member countries. All those countries are Muslim majority countries which adopt different Fiqh schools of thoughts (Mazahib) in the interpretation of Shariah. As a consequence, there are differences in the types of products offered by Islamic financial institutions (IFIs) in those countries. In other words, a Shariah compliant product in a country doesn’t mean a Shariah compliant product in other countries. The situation is getting worse when it comes to countries which do not have a national Shariah supervisory council. In those countries, Shariah matters in an IFI are decided by the Shariah Supervisory Board (SSB) of each IFI. As a result, a product might be approved by the SSB of an IFI in that country and not approved by the SSB of another IFI in the same country.

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Realizing the consequences of the above issue, Islamic financial industry standard setting bodies like the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) and the Islamic Financial Services Board (IFSB) have come out with a complete set of Shariah standards and guiding principles on Shariah governance systems for IFIs respectively. The purpose is to come out with a global Shariah standard and guiding principles that can be applied universally across “ In fact, when a IFIs. However, despite the comparative standards and the guiding analysis made on principles have been available the guiding for quite sometimes, only few principles of jurisdictions which made them Shariah obligatory or suggested to be governance adopted. In the case of the between the AAOIFI AAOIFI Shariah standards, and the IFSB the standards are made either standards, it is obligatory or suggested only found that there are in Bahrain, Brunei, Indonesia, several differences Jordan, Malaysia, Lebanon, between them” Saudi Arabia, Sudan, Syria, UAE and Qatar. In addition, some countries like Malaysia also have created their own Shariah governance guiding principles which have several differences from the AAOIFI standards and the IFSB guiding principles. In fact, when a comparative analysis made on the guiding principles of Shariah governance between the AAOIFI and the IFSB standards, it is found that there are several differences between them. For example, the definition of Shariah governance is only provided by the IFSB. On the other hand, the AAOIFI standards discuss in more details about the importance of Shariah review and audit functions than the IFSB guiding principles. One important note to take is none of them discusses the Shariah risk

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management and research functions. As a result, both of them have still not yet been viewed as comprehensive enough by industry stakeholders.

Actually, the above highlights have been discussed by many industry practitioners and academics and they have made calls for one standardized and comprehensive guideline or framework that can be used as a universal reference for all Islamic financial industry’s stakeholders. Obviously, a universally comprehensive Shariah standard has a lot of benefits for the industry. However, in order to fully apply it, there are challenges that must be tackled. Based on this background, this article attempts to identify several benefits and challenges in the application of a common Shariah standard based on review of the available literature and opinion of some qualified Shariah scholars.

Benefits and Challenges Based on the above approaches, several benefits of and challenges in the application of a common Shariah standard have been identified. In terms of benefits, there are at least seven benefits identified namely (1) Applying a common Shariah standard will significantly help the promotion and spread of Islamic finance globally since it looks more organized than having several standards in place. In addition, the common standard will also boost customers’ confidence towards IFIs since they have an assurance that IFIs’ products that they use are universally Shariah compliant; (2) The common standard will also improve harmonization in the practice of Islamic banking and finance among Muslim countries thus minimizing Shariah risk for the international investors; (3) Applying a common standard will ensure fairness for all Islamic finance’s stakeholders. Mr. Khalid Hamad, Executive Director, Banking Supervision, Central Bank of

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Bahrain (CBB) recently has emphasized on the importance of applying all universal Shariah standards in their real essence by IFIs to ensure fairness for all stakeholders. He said it is not correct for an IFI to apply one standard and for another IFI competing in the same industry to apply another standard; (4) The common standard will ensure the best practices are adopted by IFIs worldwide since it was developed based on consultations made with scholars from all over the world and thorough review “ The common procedures; (5) The common standard will standard will reduce possible reduce possible conflicts and disputes between conflicts and IFIs and customers and it will disputes between ease in solving any legal IFIs and customers disputes between IFIs and and it will ease in customers globally since a solving any legal reference will only be made to disputes between a single standard rather than IFIs and customers many standards; (6) Applying globally” a common Shariah standard will help the regulators of Islamic financial industry to set up comprehensive regulatory and supervisory frameworks for IFIs in their jurisdictions since an easy reference has been provided by the common standard; and (7) The common standard will promote efficiency in Islamic financial industry. Currently, it is costlier to structure Islamic financial products than conventional financial products since Islamic financial products normally require more documentation than their conventional counterparts. In addition, separate documentation is also required for different contractual relationship. A common standard will provide economies of scale since it distributes the costs over a number of transactions.

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However, despite the above identified benefits, there are several identified challenges to the full application of a common Shariah standard to all IFIs worldwide. This article managed to identify at least five challenges namely (1) Muslim countries, where IFIs are operating, are adopting different Fiqh schools of thoughts (Mazahib) in order to interpret Shariah. The question is how to incorporate all those differences in a single Shariah standard?; (2) Every country, where IFIs are operating, has different public interest due to the differences in the economic condition and other demographic characteristics. As a result, IFIs in a particular country normally develop products based on the public interest (Maslahah) of that country and Istislah is known as one of the secondary sources of Shariah which might influence the decision on the ruling (Hukm) of a particular financial product or transaction; (3) Applying a common Shariah standard might be viewed by some of the currents Shariah scholars as a threat to their roles in the industry since the scholars only need to refer to the standard for each Shariah matter which might be not in their favor. Therefore, there is a possibility of firm opposition from those scholars towards this idea; (4) If a common Shariah standard to be applied, the question is how the details of the standards to be developed. In other words, how a particular Shariah matter will be decided given there are differences in the opinion regarding the same matter. Should it be taken from the opinion of the majority of the scholars (Jumhur) or should it be taken from the practicability point of view even though it is derived from the opinion of minority? The case of unilateral promise (Wa’ad) in Murabahah contract can be used as an example. It is actually derived from the opinion of minority of scholars (a small fraction of scholars from Maliki Fiqh School of thought) not from the opinion of majority (Jumhur). As a result, the validity of

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the opinion is still debatable; and (5) lastly, the biggest challenge is the lack of a unified authority to enforce the application of a common Shariah standard. In fact, this has been the biggest hurdle for all Islamic financial standard setting bodies like the AAOIFI and the IFSB. They don’t have the authority to enforce their standards to be adopted by IFIs worldwide. As a result, even though a common Shariah standard is available, without the implementation of the standard, it will be meaningless since it is not put in practice.

Conclusion and Recommendation

Islamic financial industry has been growing significantly since its inception in the 1960’s. One of the issues that has not yet been resolved within the industry is Shariah harmonization. There are efforts made by Islamic financial industry standard setting bodies like the AAOIFI and the IFSB to address the issue, however, it seems a universally comprehensive Shariah standard is still not yet in place. This article “ The biggest attempts to identify several challenge is the benefits and challenges of the lack of a unified full application of a common authority to enforce Shariah standard for IFIs the application of a worldwide by reviewing common Shariah available literature and the standard” opinion of Shariah scholars about the subject. It is found that there are many benefits that a common Shariah standard offers to Islamic financial industry’s stakeholders. Those benefits are believed to be significant enough in boosting the development of the industry to a higher phase and ensuring sustainability of the industry. Therefore, this article like several similar other articles proposes to bring the idea of a common Shariah standard to be

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implemented for all IFIs through intensive collaborative efforts of all industry’s stakeholders. However, in order to realize those benefits, several identified challenges must be overcome. It is expected that this article can draw the attention of the industry regulators, players (IFIs) and other stakeholders to the issue for further actions.

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Maintaining Bahrain position as the World’s Islamic Financial Hub

Kingdom of Bahrain is known as one of the world’s leading Islamic financial capitals (hubs). The Kingdom is the host to several important Islamic financial infrastructure organizations such as the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), International Islamic Financial Market (IIFM), Islamic International Rating Agency (IIRA) and General Council of Islamic Banks and Financial Institutions (CIBAFI). In addition, Central Bank of Bahrain (CBB) as the sole financial regulator in the country is very supportive to the industry and have a comprehensive regulatory framework for the Islamic financial industry.

This is the reason why last year Thomson Reuters ranked Bahrain no. 2 after Malaysia as the world’s leading financial center. One aspect where Bahrain is lacking from Malaysia is in term of research and publication in the area of Islamic finance. Bahrain has many annual industry based conferences “ Intensive such as the World Islamic collaboration Banking Conference (WIBC) between industry and the AAOIFI - World Bank players and higher annual conference on Islamic education Banking and Finance. institutions should However, the number of be encouraged” academic and research based conferences and journals is relatively low especially when it is compared to Malaysia. In addition, only three higher learning institutions in the country which offer Islamic finance program namely University College of Bahrain (UCB), Bahrain Institute of Banking and Finance (BIBF ) and University of Bahrain (UoB). As a note none of those institutions have PhD program in Islamic finance.

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Therefore, in order to maintain and improve Bahrain position as one of the world’s Islamic financial hub the above remarks should be tackled. Intensive collaboration between industry players and higher education institutions should be encouraged. Industry players might give research grant to the university as part of its corporate social responsibility (CSR). With that, it is expected Bahrain will remain as the world’s Islamic financial hub.

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Global Islamic Economy Indicators: Bahrain Position in 2015

Since Bahrain is known as one of the world’s promoters of Islamic economy, evaluating Bahrain performance as compared to other countries and its performance in the previous year becomes very important for decision makers in the country to maintain the prestigious status. One of the reliable ways to perform a comparative analysis is by referring to the Global Islamic Economy Indicators (GIEI) of Thomson Reuters.

GIEI has been used to rank the countries in the world in terms of their Islamic economy quality. There are 6 indicators used to evaluate the countries namely halal food, travel, media & recreation, Islamic finance, fashion and pharma & cosmetics. As per the report, Bahrain was ranked in the 3rd place consecutively in 2014 and 2015 for the overall results. In other words, the kingdom is regarded as the top 3 centers of Islamic economy in the world along with Malaysia and the United Arab Emirates (UAE). This is surely a big achievement for the country. However, referring to the report, it is important to note that the overall scores of Bahrain dropped from 64.8 in 2014 to 58 in 2015. The following paragraphs will elaborate the results for each category.

In term of halal food, Bahrain’s score dropped significantly from 46 in 2014 to 38 in 2015. As a result, Bahrain is now out of the top 10 countries for this category while it was in the 9th place in 2014. With regard to travel, Bahrain’s score also dropped from 47.8 in 2014 to 40 in 2015. The drop also caused a decline in Bahrain’s position in this category from 6th place in 2014 to 8th place in 2015.

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Bahrain’s score is relatively stable for media & recreation at the level of 43 in both 2014 and 2015. However, in term of rank, Bahrain managed to climb one position to 7th place in 2015 from 8th place in 2014 since many countries also have lower scores for this category in 2015. For Islamic finance, even though Bahrain’s score dropped significantly from 94.7 in 2014 to 84 in 2015, Bahrain still secured 2nd place for this category after Malaysia. However, it is important to note that the gap between Bahrain and Malaysia in this category is getting wider. In other words, more “ Bahrain’s efforts need to be taken to performance in catch up Malaysia if Bahrain 2015 declined in wants to be in the first place most indicators” for this category. For fashion, Bahrain managed to have a better score in 2015. It increased from 11 in 2014 to 17 in 2015. Despite the improvement, Bahrain is still not listed in the top 10 countries for this category. For the last category, pharma and cosmetics, a slight decline in the score happened in 2015. Bahrain’s score was 37.2 in 2014 and 36 in 2015. In addition, Bahrain is not in the top 10 countries list for this category.

Based on the above results, it is clear that Bahrain’s performance in 2015 declined in most indicators. The only indicator that showed an improvement in 2015 is fashion. Bahrain managed to maintain the 3rd place in 2015. This is because in Islamic finance the kingdom is still in the 2nd place and this sector has the highest weight in the composite index of GIEI. It is also important to note that the gap between Bahrain and the winner Malaysia is getting wider in the overall scores. Unlike Bahrain, Malaysia managed to improve its score from 111.5 in 2014 to 116 in 2015. Obviously, the results of this year should draw the attention of decision makers in

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Bahrain in order to come out with strategies and solutions to improve Bahrain’s overall scores and position in the years to come. Otherwise, Bahrain’s position as one of the world’s Islamic economy hubs might be at stake.

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Low Oil Price and Islamic Finance: Impacts and Opportunities

The recent oil prices drop has significantly affected the economy of the Gulf Cooperation Council (GCC) countries. Since all the GCC countries depend heavily on oil, their revenues are also highly dependent on the oil price. At the point where the oil price is much below the expectation, the GCC governments have to take actions to cover their budget deficits. According to literature, among the countries in the GCC region, in term of budget, Kuwait is the most prepared for the current situation. This is partially because the country spends relatively lower amount on infrastructure projects than the other countries.

For the governments of the GCC countries, the current phenomenon means cancellation or postponement of some infrastructure projects, cutting the subsidies and increasing the public debts. Obviously, the actions taken by the GCC governments give “ There are also significant impacts to the opportunities for Islamic financial industry. This the Islamic is because more than 40% of financial industry” the Islamic finance’s assets are held by the GCC countries. Cancellation or postponement of the infrastructure projects by the governments means less financings and investments are pumped by Islamic banks to the companies involved in the projects which subsequently result in lower revenues of the banks. Takaful companies are also affected due to less contributions received.

Cutting the subsidies also means lower governments’, citizens’ and residents’ savings which turns into lower sources of funds for the Islamic banks and lower

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contributions for the Takaful companies. This situation might affect the GCC Islamic banks’ and Takaful companies’ performance and ratings. In conclusion, being one of the most important regions for the Islamic financial industry the drop in oil price gives significant impacts to the development of the industry.

However, behind all these negative impacts, there are also opportunities for the Islamic financial industry especially in the Sukuk segment. As it has been mentioned earlier, the drop in oil price has created budget deficits in the GCC countries. The deficits have put pressure on the governments to increase public debts. Here, sukuk can play its pivotal role as a Shariah compliant instrument and the alternative to conventional bond. During this uncertain economic condition, the investors normally prefer to invest their funds in secured securities issued by the governments. With significant numbers of high net worth individuals living in the region, retail government sukuk has the potential to be one of the preferable securities. This is because many of the investors in the GCC region are Shariah conscious and only want to invest in Shariah compliant securities.

The retail sukuk can be an alternative instrument for the GCC governments to cover their budget deficits. In order to successfully utilize the retail sukuk, effective channels of distribution must be established and extensive promotional and awareness campaigns on the retail sukuk must be held by the GCC governments and other stakeholders. If the retail sukuk is successfully launched and used by the governments of the GCC, not only the budget deficits issue can be solved but also the development of Islamic financial industry in the region will continue. It is always good to say “behind any problems there is always an opportunity”.

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Challenges in Advancing the Growth of Halal Products

The Halal industry and the general Halal markets have become established elements and had a significant impact on the economic landscape of many countries over the past decades. According to Thomson Reuters and DinarStandard, the Halal food and beverage market valued at US$1.37 trillion in 2014 which represented around 18.2% of the total global food and beverage market and grew by 6.2% from the 2013 figure. Based on total food consumption, the top four countries with Muslim food consumption in 2015 are Indonesia (US$158 billion), Turkey (US$110 billion), Pakistan (US$100.5 billion) and Iran (US$59 billion), while total OIC countries’ consumption stood at US$947 billion. DR SUTAN EMIR HIDAYAT and DR AHMAD RAFIKI delve further.

Given the importance of the market, hundreds of journal articles have been published within five years (2012-16) discussing about the Halal industry and Halal markets. For example, 548 and 207 articles related to the topic have been published in two leading sources of research which are also scholarly publishers: Science Direct of Elsevier and Emerald Group Publishing respectively. In addition, Halal food consumption has been listed as one of the indicators in the Global Islamic Economy Indicator.

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The topic has become significantly important recently due to better Muslim consumers’ awareness of the Halal industry. The increase in consumers’ awareness is a result of the lifestyle changes across generations which have been reflected by the changes in shopping, cooking “ Support in terms of and dietary habits, health access to Shariah consciousness and the need compliant funding for processed convenience could be another foods. Despite the significant concern in positive trends within the encouraging industry, based on the applications of available literature, there are Halal certification, at least two common particularly by challenges faced by small and medium stakeholders in progressing firms” Halal market growth, namely, the lack of support from governments and the lack of collaboration among the world’s Halal certification authorities.

Lack of government support

It has been revealed in many articles about the imperative role the government plays in supporting the Halal industry. The dissemination of information on Halal food consumption and certification by a government agency is deemed pivotal. The government’s policies through academic institutions could be emphasized. For example, understanding the concept of Halal products as well as widening societal campaigns can be done through academic institutions. The lack of knowledge among non-Muslims on Halal principles and insufficient information on the benefits of the Halal process have made Halal principles unable to become a major element in the fabric of non-Muslims’ lives.

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The reliance on an independent agency is not sufficient. Due to rising demand and trade in Halal products, consistency in regulations would avoid the abuse and misuse of Halal certification such as corruption among certifiers and ignorance among producers. Extensively, the government proposes to construct a new formula to upgrade efforts on the protection of consumer rights. Moreover, support in terms of access to Shariah compliant funding could be another concern in encouraging applications of Halal certification, particularly by small and medium firms. Therefore, in order to overcome these issues the government’s support is very important.

Lack of collaboration/clear leadership

Another issue is the lack of collaboration among the world’s Halal certification authorities. This could create doubts among Muslim consumers who demand more transparency for product ingredients and who do not trust simple Halal logos. Not even one unified Halal standard of mutual recognition exists between certification bodies. Currently, it is estimated that there are more than 300 listed and recognized Halal certification bodies available worldwide. For instance, Malaysia approved 45 Halal certification bodies, Indonesia approved 40 while GCC countries approved 52. Thus, private organizations and independent Halal certification bodies; national standards bodies; regional bodies such as ASEAN and the EU; and international bodies such as the SMIIC/OIC initiative play a very crucial role in overcoming the lack of collaboration and clear leadership.

The reliance on local certification practiced by a variety of indigenous Islamic associations and for-profit firms may be a weak link in the chain. In fact, a global

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integrated standard may provide wider market access and avoid confusion in applying multiple certificates that are necessary for businesses. This means total integrity in the Halal supply chain must be preserved.

In summary, there are at least two major challenges in advancing the growth of Halal products. Overcoming these two challenges will bring the Halal industry into a better phase of development. While many initiatives have been undertaken to strengthen consumers’ acceptance of Halal products, Muslims must be at the forefront of eff orts to support the adoption of Halal certification.

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Bahraini Islamic Finance Outlook 2010: A Mixed Picture

The 2008 global financial crisis has brought a significant impact on the financial system worldwide without exception including the financial system of the kingdom of Bahrain. Both conventional and Islamic financial institutions in the kingdom still suffer the pain of the crisis. However, recent developments indicate that the global revival is turning out better than expected in 2010, as illustrated by the revision of world output growth forecast from 4.1% to 4.2%, according to the IMF World Economic Outlook published in April 2010. As one of the leading centers of Islamic finance in the world, keeping a close watch on the sectors in Bahrain is important. This article describes the latest developments in the Islamic financial system in the kingdom up to mid-2010.

The analysis on the performance of the Bahraini Islamic financial system during 2010 can be described according to the following segments: (1) Islamic retail banks (2) Islamic wholesale banks (3) Islamic insurance or Takaful and (4) Sukuk issuances.

Islamic retail banks

Currently, there are six Islamic retail banks operating in the kingdom. Based on a financial stability report by the Central Bank of Bahrain (CBB), up to the middle of 2010, the financial condition and performance of the Islamic retail banks in general can be characterized by a decrease in capital positions, an increase in non- performing financings (NPF), high assets concentration, a decline in earnings and deterioration of liquidity. The capital adequacy ratio (CAR) of Islamic retail banks in

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Bahrain fell to 20.7% in March 2010 from 24.5% in September 2009.

Subsequently, the core capital ratio (tier 1 capital to risk weighted exposures) also dropped from 22.2% in September 2009 to 19.7% in “ The uncertainties March 2010. The decline in the market are implies the deterioration in the still high leading to ability of Islamic retail banks to high probability of absorb any future shocks. In default” contrast, the CAR of conventional banks in the kingdom increased from 19.8% in September 2009 to 20.0% in March 2010.

Non performing financings of Islamic retail banks in Bahrain increased from 5% in September 2009 to 11.1% in March 2010. Most of the NPF comes from the services sector (21.9% of the total NPF) followed by consumer finance (11.6%) and real estate (12.1%). The fact above shows the deterioration of the asset quality of Islamic retail banks during the period. In contrast, the non- performing loans (NPL) of conventional retail banks decreased from 6.2% in September 2010 to 5.9% in March 2010.

The increase in NPF is further worsened by the high concentration of Islamic retail banks’ assets in property financing (35.5% of the total financing). According to the Bahrain ministry of industry and commerce, even though there is a significant improvement in the construction and real estate sector during the year as shown by the increase in the number of new commercial licenses for construction and real estate activities released, the uncertainties in the market are still high leading to high probability of default.

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Despite the signal of recovery in global output, Islamic retail banks’ earnings in Bahrain deteriorated in March 2010. The return on assets (ROA) and return on equity (ROE) of the banks fell to 0.4% and 2.5% in March 2010 from 0.8% and 5% “ Another sign of respectively in September recovery is found 2009. The decline in the in the decline of profitability indicators is NPF of Islamic mostly due to the decline of wholesale banks in Islamic retail banks’ income. March 2010” Even though the banks managed to improve their operating costs as shown by the decline in the ratio of operating efficiency from 70.2% in September 2009 to 54.6% in March 2010, the last result shows the banks’ profitability has not yet shown an improvement sign.

The decline in earnings is worsened further by the deterioration of the liquidity position of the banks. In March 2010, the volume of liquid assets available to Islamic retail banks fell to 12.2% from 16.5% in September 2009. The weakening of the liquidity is further supported by the increase in the financing to deposit ratio (FDR) of Islamic retail banks to 83.3% in March 2010 from 79.2% in September 2009. Overall, until the middle of 2010, there are no significant signs of recovery for Islamic retail banks.

Islamic wholesale banks

Currently, there are 18 Islamic wholesale banks in Bahrain showing a high profile of the country as the leading financial center in the region. Until the middle of 2010, the performance of the sector in general can be characterized by improvement in capital position, decline in non-performing financings, increased asset

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concentration, negative earnings and improvements in the liquidity position.

The improvement in capital position of Islamic wholesale banks in 2010 is shown by the increase in the CAR of the banks to 24.6% in March 2010 from 22.7% in September 2009. The inference is further strengthened by the increase of the core capital ratio from 22% in September 2009 to 24.3% in March 2010. Unlike Islamic retail banks, the ability of Islamic wholesale banks in absorbing future shocks improved in early 2010.

Another sign of recovery is found in the decline of NPF of Islamic wholesale banks in March 2010. The NPF declined to 8.1% from 10.7% in September 2009. The decline shows an improvement in the quality of the banks’ earning assets during the period. In contrast to the above fact, conventional wholesale banks in Bahrain experienced an increase in non-performing loans (NPL) during the period. However, most of the financings given by Islamic wholesale banks in Bahrain during the period went to the financial and services sectors which accounted for 51.7% of the total financings in March 2010. This situation clearly indicates high concentration of the banks’ assets.

The liquidity position of Islamic wholesale banks in Bahrain also improved in the first quarter of 2010, strengthening the signs of recovery in the sector. In March 2010, liquid assets of Islamic wholesale banks in Bahrain represented 24.9% of the total assets, an increase from 21.3% in September 2009. FDR of the banks stood at 82.7 % in March 2010, a decrease from 86.6% in September 2009 showing an improvement in liquidity position of the banking sector.

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Despite the positive signs of recovery mentioned above, Islamic wholesale banks in Bahrain still experienced negative earnings (losses) up to March 2010. In fact, the loss worsened as shown by the decline in ROA from - 0.3% in September 2009 to -1.3% in March 2010. The ROE also deteriorated from -1.2% in September 2009 to -5.5% in March 2010. One of the main factors that caused the negative earnings is the significant increase in the percentage of operating expenses to the total operating income of the banks as shown by efficiency ratio. Operating expenses of Islamic wholesale banks in Bahrain stood at 785% of the operating income in March 2010 compared to 82.2% in September 2009. Overall, 2010 is still seen as the recovery year for the Islamic wholesale banks in Bahrain.

Islamic insurance (Takaful)

Currently, there are 19 Islamic insurance companies operating in Bahrain consisting of nine locally incorporated companies including two re-Takaful firms and the remaining are offshore Takaful companies. According to CBB’s financial stability report of June 2010, there is no significant financial stability concern in the insurance industry in Bahrain. In general, insurance companies in Bahrain including Takaful companies were still in a good position up to the middle of 2010. However, based on the author’s observation on financial statements of Takaful companies in Bahrain, the performance of Takaful companies can be characterized by a decrease in retention ratio, a decrease in earnings (profits) and high dependency on general Takaful business.

The decrease in the retention ratio of Takaful companies in Bahrain is attributable to uncertainties in the operating

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environment which has encouraged the companies to share more underwriting risks to re-Takaful companies. The decrease in the earnings is due to the decline in Wakalah fee, investment income and other incomes. In 2010, the general Takaful still contributes most of the Takaful companies’ businesses. This is due to mandatory motor insurance for all vehicles in Bahrain along with mandatory health insurance for all expatriates in the country. Family Takaful business still leaves the Takaful companies with more opportunities to grasp in the future. However some challenges such as low awareness on family Takaful products, lack of creative distribution channels and misconception of insurance concept must be tackled in order to boost the performance of the sector in the following years.

Islamic securities (Sukuk)

The kingdom of Bahrain is well known as one of the pioneers in the issuance of Sukuk. In fact, the government of Bahrain through CBB actively issues the securities both in capital and money markets. Until the middle of the year, the kingdom of Bahrain has emerged as the most active Sukuk issuer with the country issuing 37 bonds and Sukuk, representing 45.1% of the total number of issuances in GCC, and raised US$2 billion (Kuwait Financial Center).

Most of the Sukuk issuances in Bahrain are sovereign Sukuk. Currently, there are two short term Sukuk and one long term Sukuk issued by the CBB. The short term Sukuk are Sukuk Salam and Sukuk Ijarah. Sukuk Salam is a BHD-denominated security issued on a monthly basis through a fixed-rate tender procedure and has a three-month (91 days) maturity. All eligible financial

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institutions are invited to participate in auction for regular issuance amounting to BHD12 million (US$32 million).

The issuance of Sukuk is intended to facilitate liquidity management facility for Islamic financial institutions that are not allowed to invest their excess cash in conventional money market instruments such as treasury bills. Until September 2010, CBB has issued 113 series of Sukuk Salam. During the year, CBB Sukuk Salam issuances were always oversubscribed showing high market demand for the security.

Short term Ijarah Sukuk is a BHD-denominated leasing instrument issued in accordance with Shariah standards. Short term Ijarah Sukuk is issued on a monthly basis through a fixed-rate tender procedure and has a six- month (182 days) maturity. The issue amount is normally “ Overall, the year BHD10 million (US$27 2010 is seen as the million). Sukuk Ijarah is issued to compliment Sukuk Salam global recovery for which is non-tradable in the Sukuk issuances” secondary market. Until September 2010, CBB has issued 61 series of short term Ijarah Sukuk. The issuances are almost all the time oversubscribed in 2010. In addition to short term Ijarah Sukuk, CBB on behalf of the government of Bahrain issues long term Ijarah Sukuk maturing from three to10 years based on specific needs.

Overall, the year 2010 is seen as the global recovery for Sukuk issuances. This phenomenon is also expected to boost Islamic funds’ performance in the future since more portfolios can be established and give more options for other Islamic financial institutions to diversify their investments.

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Overall assessment

Even though the global recovery process from the crisis is faster than expected in 2010, the picture is not applied to all segments of the Bahraini Islamic financial system. Based on short research conducted by the author, a mixed picture is found for each segment of the system. Islamic retail banks in general have not shown signs of recovery from the crisis while Islamic wholesale banks have shown significant improvements in their financial conditions. Despite the financial stability of Takaful companies in Bahrain, the earnings of the companies in general still need to be improved. The Sukuk market in Bahrain has recovered and it is expected to boost the performance of Islamic financial institutions in the near future.

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International Financial Reporting Standards for Islamic Finance: Benefits and Challenges

SUTAN EMIR HIDAYAT provides a comparative analysis on the benefits and challenges in applying the International Financial Reporting Standards for Islamic finance.

Islamic banking and finance has experienced a tremendous evolution from the 1960s to the 2000s. The spread of Islamic banking and finance across the Muslim world has created the need for an accounting standard for Islamic financial institutions (IFIs).

The turning point came in the 1990s, when AAOIFI was established as a standard setting body of accounting, auditing, ethics, governance and Shariah compliance for IFIs. Since the 2000s, Islamic banking and finance has been integrated into the “ The IFIs, mainstream financial market, shareholders and with the emergence of Sukuk investors of in the capital and money accounting markets. The period also information have a witnessed the involvement of primary objective major conventional financial of entailing institutions in the industry, compliance with through the opening of Islamic the precepts of subsidiaries and windows. Shariah law in conducting their Now, modern Shariah financial activities” compliant products have come to cover the full spectrum of banking, capital markets, asset management and Takaful business. As Islamic banking and finance moves into the mainstream, a key challenge is identifying a suitably relevant and intelligible accounting framework that is comparable with

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conventional finance without tainting compliance with Shariah. This challenge is even more vital for global financial services groups that include Islamic finance among their diverse services (e.g. HSBC).

As a result, there is a call within the Islamic finance industry to apply the International Financial Reporting Standards (IFRS) for IFIs in order to align accounting practices.

Tabel 1 Issues IFRS Islamic Principles Deposit Contract Conventional Islamic banks use banks generally Mudarabah for rely on structuring their contractual deposit. liability plus Mudarabah is not interest for their liability since the deposit contract. bank (Mudarib) is Therefore, all not obliged to deposits are guarantee the treated as a capital and the liability under return to the IFRS. depositors. Contractual Treating the obligation to pay deposit as a depositors will liability in some clearly be extent will liabilities of the eliminate the institution essence of Shariah.

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Ijarah Muntahia Ijarah Muntahia Shariah requires Bittamleek – Bittamleek is a Ijarah asstets to Financial Lease lease contract be reported in the that ends with the lessor’s (bank) transfer of book. All ownership. Under ownership risks the IFRS, this such as contract falls maintenance under the costs are borne category of by the lessor financial lease. (bank) during the Under the lease term. financial lease, the inherent risks The presentation and rewards of the lease as a associated with loan/receivable the asset have on the bank’s been transferred book and an to the lessee, ownership who in substance interest being is deemed to be recorded by the the owner. lessee (as practiced under Financial leases the IFRS) clearly are reported as contradict the receivables/loans principles of on the bank’s Shariah. Shariah book and an stresses that as ownership set ownership interest recorded rests with the by the lessee. lessor throughout the lease term.

Recognizing a The IFRS The treatment of sale of goods with requires the Murabahah as a

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deferred payment reporting for all financing (Murabahah) Islamic financial transaction is transactions as opposed by at financing least two transactions. In accountant addition, the associations in international the two biggest accounting Muslim countries standard requires (Indonesia and the differences Pakistan) between the fair value and the The Indonesian nominal amount Accountant of consideration Institute states in a sale of goods that: “According to be recognized to Shariah rules as interest in Indonesia, revenue. Murabahah cannot be accounted for as a financing transaction. This kind of transaction should be treated as a sales transaction. Treating it as financing will eliminate the essence of Shariah principle.”

The Institute of Chartered

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Accountants of Pakistan states that: “Deferment of profit is allowed by scholars, but it should be separately recorded as a deferred profit not as interest.”

Takaful Under the IFRS, Takaful is not the premium insurance as it is received is a mutual treated as the protection part of the scheme where insurance the underwriting company’s fund does not revenues. belong to the Takaful company but to the policyholders. Hence we actually have two account entities. Therefore, the Takaful company must segregate between shareholders’ funds and policyholders’ funds in its financial report. Implementing the

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IFRS will not fully cater for the contractual relationship between the operator (Takaful company) and the policyholders.

Conceptual Substance over From an Islamic aspects form principle. point of view, This principle although reality recommends (what is) should recording a be taken into transaction account into according to its deciding reality (what is) strategies, it not to its legal cannot be a form (what ought substitute for to be) what ought to be. The reality may reflect a deviation from normative precepts of Islam

1. Benefits of applying the IFRS for IFIs

The application of the IFRS for IFIs obviously will generate some benefits. Among the benefits are: (1) Enhancement in transparency and international comparability; (2) International recognition and usage; and (3) Cost efficiency.

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Firstly, using a common framework to account for Islamic and conventional products and transactions would enhance the transparency and international comparability of financial reporting for Islamic finance and hence provide an important boost for further investment in, and the development of, the sector. Once a universal accounting standard is achieved, the users of accounting information will be able to make an effective comparison with minimum accounting risk.

Secondly, applying the IFRS would give the benefits of international recognition and usage, making it the most suitable framework for global institutions with Islamic and non-Islamic products and multinational stakeholders. The application of the IFRS is also expected to increase the confidence of more market players to take part in the Islamic finance industry. This is due to their familiarity with the accounting and reporting standards that will help them make an effective decision.

Lastly, since the IFRS focuses on the economic substance of a product or transaction rather than its legal form, the standard can easily be applied in any jurisdictions, thus minimizing the cost of financial reporting for global financial institutions with Islamic and non-Islamic products. The cost efficiency can be achieved since the IFRS principles rather than the Islamic legal form will ultimately determine the accounting treatment. As a result, there is no need for global financial institutions to prepare a separate section or statement for their Islamic finance activities. However, there are challenges in applying the IFRS for IFIs.

2. Challenges in applying the IFRS for IFIs

There are two major issues in applying the IFRS for IFIs:

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1. Differences in the objectives between the users of IFIs’ and the users of conventional financial institutions’ (FIs) accounting information.

2. Differences in the contractual relationship between the IFIs and their clients as compared to the contractual relationship between conventional FIs and their clients.

Differences in the objectives between the users of IFIs’ accounting information and the users of conventional FIs are due to the differences in their world view. The IFIs, shareholders and investors of accounting information have a primary objective of entailing compliance with the precepts of Shariah law in conducting their financial activities. In fact, the original wisdom behind the establishment of IFIs is to realize the objectives of Shariah. On the other hand, the ultimate purpose of conventional financial accounting users is to efficiently allocate scarce resources to their most efficient and profitable uses based on an informed decision.

The differences in the objectives of the users have resulted in various consequences. Firstly, the types of information identified. Conventional accounting concentrates on identifying economic events and transactions (financial information). On the other hand, the users of IFIs are not only interested in financial information, but are also interested in non-financial information such as Shariah compliance, specific religious requirements and the discharge of social responsibilities.

Secondly, the way that assets, liabilities and equities are measured, valued, recorded and communicated.

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Conventional accounting mainly uses historical cost (or lower) to measure and value assets and liabilities. Although the idea of introducing fair value measurements is there, its implementation is quite difficult due to its complexity and presumed lack of verifiability. On the other hand from an Islamic point of view, at least for the computation of Zakat, current valuation is obligatory.

Another major issue is the differences in the contractual relationship. IFIs have different contractual relationship with their investors, depositors and customers compared to the relationships which exist between conventional financial institutions and their investors, customers and depositors. Conventional FIs mostly use loan-plus- interest contracts when they deal with their clients. In comparison, IFIs use various forms of Islamic commercial contracts. For example, IFIs use the profit sharing contract Mudarabah in the case of deposits mobilization; and other instruments such as Murabahah, Ijarah, Istisnah, Salam and Musharakah in the case of customer financing.

As a consequence of the differences, there are some potential issues that have been identified when the IFRS are applied for IFIs. Table 1 describes the issues.

In addition, there are some accounting issues that an IFI needs to disclose which the IFRS does not address. Among them are:

1. Income incidentally generated from transactions or relationships, which contradict Shariah (e.g. late penalty). The users of IFI accounting information may be interested in more details about the causes of such earnings, their sources, how they are disposed of and

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procedures established to prevent entering into transactions prohibited by Shariah. 2. Funds paid out as Zakat and/or charity. The users of IFI accounting information may be interested in additional analysis of sources of Zakat funds, methods of collection and uses. 3. Restricted investment accounts. Islamic banks raise deposits through restricted profit sharing contracts (Mudarabah Muqayyadah). In this kind of contract, Islamic banks don’t have full control over the funds since the depositors (Rab al maal) put restrictions on where the money should be invested. As a result, the funds from this contract cannot be treated as an asset. A separate statement to disclose the transactions using this contract is needed. 4. Socially responsible financing (i.e. Qard Hasan) is not catered for by conventional accounting standards. One of the important functions of IFIs is social services. Failure to perform this function essentially renders the IFIs capitalist financing institutions. Even the IFRS in this case does not encourage the FIs to put any corporate social responsibilities in their additional note.

The IFRS may disclose the above transactions on additional notes. However, the additional notes will not provide the details of those transactions as required by the IFIs’ accounting information users.

Conclusion

Despite the benefits that IFRS offers, applying these standards to IFIs will to some extent inevitably eliminate the essence of Shariah principles. Compliance with Shariah is the main reason for the IFIs’ existence. The full application of the IFRS will also hold back our

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progression in developing accounting standards that adequately cater for Shariah compliant transactions, thus ignoring the significant contributions made by AAOIFI.

The IFRS were written with conventional products and operations in mind. When they are applied to Islamic products, typically they will treat the products, in economic substance, as equivalent to their conventional counterparts. Therefore, obviously, there are huge impediments in fully applying the IFRS for IFIs. However, a broad harmonization can be reached by the application of the relevant aspects of the IFRS, as long as they do not conflict with Shariah.

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Islamic Microfinance: Challenges and the Way Forward

RONALD RULINDO and SUTAN EMIR HIDAYAT discuss ways to enhance market awareness of Islamic microfinance and evaluate the challenges faced by the sector.

Stakeholders of the Islamic financial services industry are trying to look into the possibility of a socio-business model of microfinance based on Shariah compliant principles.

The establishment of Islamic microfinance institutions (IMFIs) is supported by the fact that over 1.2 billion Muslims, stretching from Indonesia to Senegal, are living below the poverty line in both urban and rural parts of the world. These Muslims not only need access to financial services, but want services that are Shariah compliant.

Although the development of IMFIs started a long time ago, many people are still unaware of the business model of this institution.

Business model of Islamic microfinance

Microfinance is defined as a form of financial development that primarily focuses on alleviating poverty through providing a broad range of products to micro and small-sized enterprises. These include financing, insurance, transactional services, remittance and most importantly, savings. The term microfinance is often used interchangeably with microcredit. However, the activities of microcredit are basically limited to giving small loans to low-income individuals.

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A similar definition of microfinance can be applied to Islamic microfinance. However, products and services of Islamic microfinance have to be compliant with Shariah principles. For example in “ Although the savings, instead of offering development of the interest-bearing deposits, IMFIs started a long Islamic microfinance can off er time ago, many Wadiah, Qard or Mudarabah people are still deposits. unaware of the

business model of Similar to the practice of an this institution” Islamic bank, in a Wadiah deposit, Islamic microfinance plays a custodian role to the depositors’ funds. In this contract, the principal of the fund is guaranteed, but not the return. However, based on the discretion of an Islamic microfinance management, depositors may receive some return as a gift (Hibah) on their deposits.

Different to general practice in Islamic banks, Islamic microfinance (due to its socio-business model) can offer a Qard savings account. In this model, depositors technically provide a Qard Hassan (benevolent loan). Funds generated from this model, therefore, can be used to finance poor micro-entrepreneurs. The duration of this Qard, however, should be clearly stated, and it can be renewed after due dates.

The practice of a Mudarabah deposit is similar to the practice of Islamic banks. It is a profit sharing ratio contract whereby depositors invest their funds in Islamic microfinance as a Rab al Maal and the Islamic microfinance acts as a Mudarib. In a Mudarabah deposit, depositors may receive return on their investments and at the same time may bear some losses unless the losses

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are due to the misconduct and negligence of the Islamic microfinance management.

Similar concepts and techniques to Islamic banks also apply on the asset side of Islamic microfinance. Most Shariah compliant contracts such as Mudarabah (profi t sharing and loss bearing), Musharakah (profi t/loss sharing), Murabahah (sale plus profi t), Ijarah (lease) as well as Salam and Istisnah (ordered sales), can be equally applied in an Islamic microfinance setting. The main difference is the amount of financing in Islamic microfinance, which is significantly smaller than in an Islamic bank. In addition, Islamic microfinance may collect the daily instalment from the clients and in many cases the financing does not require physical collateral as it is replaced with a social capital, i.e. a guarantee from other potential clients.

IMFIs may also utilize Islamic charitable funds such as Zakat, Infaq Sadaqah and Waqf to finance the consumption of the poorest of the poor (consumer financing), while funds from savings deposits can be used to finance productive activities of those people. The utilization of these funds is very beneficial since the poorest of the poor are commonly excluded by IMFIs as they are often not in a position to undertake business.

Challenges

There are some issues that challenge the development of IMFIs. One of these is the legal status of the IMFI. In Indonesia for example, there are many cooperatives known as Baitul Maal wa Tamwil (BMT) that are not registered as legal cooperatives. This is because these BMTs were established prior to the government’s decision to categorize them as Islamic cooperatives.

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These BMTs disagree in converting their status to Islamic cooperatives and prefer to be unregulated as their organizational structure does not fi t with a cooperative model. Basically, these organizations are more appropriately categorized as micro-banking rather than as cooperatives.

Unfortunately, these institutions are not qualified to be considered as banks. As a result these institutions, together with self-help groups, NGOs and other IMFIs, are not under the supervision of the central bank, the ministry of finance, or the ministry of cooperatives. This is a serious regulatory and supervision issue. This situation could result in prudential issues for these institutions and may challenge their acceptability in the market and affect their financial sustainability.

Another key issue is the lack of capital versus excess liquidity. Lack of capital can cause IMFIs to have difficulty in scaling up. Thus, they neither grow out of retained earnings nor can they raise capital in financial markets. Some of the IMFIs that lack capital also find difficulties in meeting the capital requirement set by regulators.

Therefore, there are prudential problems in the operation of IMFIs. In contrast to the IMFIs which lack capital, there are other IMFIs that have successfully accumulated a significant amount of savings from members and communities but have problems in distributing the funds. These IMFIs, therefore, are experiencing excess liquidity. This contradictory situation, however, can be managed by the presence of an apex institution. This institution can channel funds from those have excess liquidity to those that have limited funding.

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The nature of a microfinance business that requires IMFIs to collect daily or weekly instalments leads to higher operational costs for IMFIs as compared to Islamic banks. As a result, given the higher cost for supervision and administration, the IMFIs have to charge higher profit rates to their clients. This “ Some IMFIs are practice, therefore, gathers lacking in much criticism from the innovation in communities it is attempting to providing services support. to their clients.

Capacity building To some extent this may for IMFIs has reduce people’s interest in become urgent to and support for IMFIs. A overcome this higher operational cost is an problem” indication of higher risk. In relation to credit risk, a limited market leads IMFIs to have a high concentration of homogeneous clientele. Therefore, IMFIs are prone not only to credit risk but also to systemic risk due to a lack of diversification.

In terms of market risk, IMFIs are also susceptible to both rate of return risk and foreign exchange risk. For rate of return risk, the IMFI has to ensure a higher rate of return to the depositors or they may transfer their funds to the Islamic banks. Foreign exchange risk, on the other hand, is experienced by institutions that acquire funds and provide savings as well as credit facilities in foreign currency.

Another issue is the capability of the microfinance management. Some IMFIs are lacking in innovation in providing services to their clients. Capacity building for IMFIs has become urgent to overcome this problem. However, lack of capacity building has become another problem because IMFIs have limited resources as they

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rely too much on donors to support training for their staff. To compound this problem qualified staff, when available, often prefer to work in more established and prestigious institutions such as Islamic banks, rather than in IMFIs.

Last but not least the IMFI has difficulties in terms of Shariah consistency. There is inconsistency in Shariah rulings issued by the Shariah supervisory boards of IMFIs which have resulted in the non-standardization of products across IMFIs. This is mainly because members of the Shariah supervisory board of an IMFI lack knowledge in finance and instead rely on their religious knowledge to perform their duties.

The way forward

For further development, IMFIs should consider the trilogy of microfinance in their objectives in addition to compliancy with Shariah.

The first thing that needs to be done by IMFIs is to increase capacity building for their staff in the organization. All IMFI staff must have an understanding of Islamic finance. They also should be equipped with managerial skills in terms of business and management, product development and legal and corporate governance, as well as bookkeeping. They also should master how to perform financial analysis at least at a basic level such as to conduct investment analysis, due diligence, and to ensure adequate risk management is in place within the institutions.

Secondly, an IMFI should able to achieve financial soundness. Financial soundness is not only about profitability, but also incorporates the ability to be

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transparent in all aspects of the organization. The IMFI should disclose adequate information in its financial report with regards to its financial position. If the infrastructures are available, they should be audited and rated in order to promote the confidence of its existing and prospective investors.

Conclusion

IMFIs are vital institutions established to alleviate property in Muslim countries through Shariah compliant methods. However, in some cases the activities of IMFIs still have not reached the poorest of the poor in the society they serve. They still have a long way to go before they achieve their aims.

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Partnership through Islamic Finance: Bahrain and Indonesia

SUTAN EMIR HIDAYAT and IMAM BUCHARI explore the Islamic finance partnership opportunities between Bahrain and Indonesia.

Among Muslim countries, Bahrain and Indonesia are currently viewed as two of the most important countries to the development of the Islamic finance industry. While Bahrain is considered as one of the established Islamic financial hubs in the world, Indonesia, being the world’s largest Muslim country by population, is seen as a strong potential market for the industry. However, it is surprising that the amount of bilateral trade between the two Muslim nations is relatively still very small as compared to its potential.

One of the potential sectors that could be explored by both countries to increase their bilateral trade is Islamic banking and finance.

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1. Islamic banking and finance in Bahrain

Bahrain is an island kingdom in the Middle East. Besides the oil and gas sector, the financial services sector is among the highest contributors to the kingdom’s overall GDP. The sector contributed 25% to the GDP of the kingdom in 2010. As at June 2011, the number of financial institutions in Bahrain was 411 and the total financial sector workforce was 14,137.

The banking system in Bahrain is the largest component of the financial system. The banking sector represents over 85% of its total financial assets. Furthermore, the banking system comprises both conventional and Islamic banks. The sole regulator is the Central Bank of Bahrain (CBB). In 2011, there were 27 Islamic banks accounting for around 12% of Bahrain’s banking sector. The high numbers of Islamic banks show the country as the leading Islamic financial center “ In order to support in the region. Table 1 the development of summarizes the Bahraini Islamic banking financial sector. and finance in the

kingdom, human The importance of Islamic capital banking can be further development is substantiated with the very important” increasing contribution of Islamic banking assets to the total banking system. The total assets of the Islamic banks have grown at a much faster rate than the overall Bahrain banking system assets. The growth of Islamic banking in particular was remarkable between 2000-2008, with total assets in this segment jumping from US$1.9 billion in 2000 to US$27.12 billion at the end of 2008, an increase of over 500%. However, in 2009 the total assets decreased to US$25.4 billion as a result of the financial crisis.

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Bahrain’s insurance industry also consists of conventional and Takaful companies. According to the CBB’s data, the conventional insurance sector consists of 15 locally incorporated firms (including two pure reinsurers), 11 foreign branches (including three pure reinsurers) and six representative offices of foreign insurance companies. The Takaful segment has nine companies including two re-Takaful firms. In addition, there are a substantial number of firms with licenses limiting their business to outside Bahrain, mainly in Saudi Arabia, including 38 conventional firms and nine Takaful companies.

Bahrain is also well known as one of the pioneers in the issuance of Sukuk. In fact, the government of Bahrain through the CBB actively issues the securities both in capital and money markets. By the middle of 2010, Bahrain emerged as one of the most active Sukuk issuers, with the country issuing 37 bonds and Sukuk, representing 45.1% of the total number of issuances in GCC, and raising US$2 billion.

Most of the Sukuk issuances in Bahrain are sovereign Sukuk. Currently, there are two short-term Sukuk and one long-term Sukuk issued by the CBB. The short-term Sukuk are Sukuk Salam and Sukuk Ijarah. The issuance of short-term Sukuk is intended to facilitate liquidity management facility for Islamic financial institutions that are not allowed to invest their excess cash in conventional money market instruments such as treasury bills.

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For Islamic mutual funds, Bahrain is also regarded as one of the most developed markets. According to the CBB, up to 2010 there were 106 Islamic funds out of 2,767 mutual funds schemes in the country. The Islamic mutual funds’ investments stood at US$1.57 billion in 2010.

In order to support the development of Islamic banking and finance in the kingdom, human capital development is very important. Realizing the importance of human capital, the CBB has established a special fund to finance research, education and training in Islamic finance (the Waqf fund). In addition, in Bahrain there are two higher learning institutions that offer undergraduate, masters and training programs in Islamic finance: namely the University College of Bahrain and the Bahrain Institute of Banking and Finance.

Bahrain is notably is one of the world’s most developed countries in terms of Islamic finance infrastructure. The kingdom actively promotes itself as an international hub for Islamic finance. In order to achieve this goal, the CBB through its comprehensive regulatory framework opens

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its gate to local and international Islamic financial institutions to operate in the country.

Challenges

However, despite the above facts, there are some challenges and issues that should be tackled in order to maintain the kingdom’s position as the international hub for Islamic finance.

The biggest challenge is the small market size for the retail banking sector in Bahrain. Therefore, there is a need for cross-border expansion to increase its market size. It is also observed that wholesale banking activities of Islamic banks in Bahrain should be expanded into international markets to grasp more opportunities for the industry growth. In addition, diversification of investment types and geographical spread for Islamic mutual funds are among the important issues that must be taken into consideration by Islamic mutual funds players in Bahrain. Therefore, increasing bilateral trade with Indonesia through Islamic banking and finance may help Bahrain in tackling the above challenges and issues.

2. Islamic finance in Indonesia

Indonesia is the most Muslim-populated country in the world. Indonesia’s population is approximately 240 million comprising 85% Muslims. Based on the central bank, Bank Indonesia’s, latest publication, the country has had a strong fundamental economy for the last two years with economic growth of about 6.5% in 2011, predicted to be around 6.4- 6.95% in 2012; with single digit inflation at 4.7% in 2011 and still less than 5% in 2012.

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Another credential for Indonesia is its achievement in managing the impact of the recent global economic crises, and the country’s sound economic and financial system management, which is reflected in the improvement of its country rating by prominent international rating agencies up to ‘investment grade’ category. In December 2011, Fitch upgraded its sovereign rating of Indonesia for foreign currency long- term senior debt into ‘BBB-‘with a stable outlook. Meanwhile, Moody’s recently “ Increasing bilateral upgraded sovereign credit trade with rating of Indonesia into ‘Baa3’ Indonesia through with a stable outlook on the Islamic banking 18th January 2012. and finance may help Bahrain in The first Islamic bank, Bank tackling challenges Muamalat Indonesia, was and issues” established in 1991. Following the issuance of the Islamic Banking Act No. 21/2008, Islamic banking was formally placed together with conventional banking as the two alternatives in the country’s dual banking system. As a result, it paved a way for local as well as international players to establish Islamic banks in Indonesia, and the industry continues to grow.

3. Ongoing and potential partnerships between Bahrain and Indonesia related to Islamic banking and finance

Taking advantage of the huge potential market of Indonesia, combining it with the experience and advancement of the Islamic finance sector of Bahrain, this could possibly be the underpinning factor for a bilateral economic cooperation that will in turn further

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strengthen the two countries in becoming the leading hubs of Islamic banking in their respective regions.

The following points mention some recent collaborations between the two countries in the area of Islamic banking and finance.

1. The most recent collaboration between Bahrain and Indonesia related to Islamic banking and finance was in the field of training and education. An MOU was signed in February 2012 between the Indonesian Banking Development Institute and the Bahrain Institute of Banking and Finance which are both established for providing training and education intended specifically for the banking sector. 2. AlBaraka Islamic Bank, headquartered in Bahrain, has chosen Indonesia as one of the 12 countries in which it operates. The AlBaraka representative office in Indonesia was established in 2008 acting as a lookout post to seek potential business in Indonesia, including the possibility of buying one of the banks in Indonesia that has potential to be developed into an Islamic bank. 3. Al-Ijarah Indonesia Finance is an Islamic financial institution that was established to provide financing through the Islamic nominate contract of Ijarah. It started its operations in 2006 through joint capital contributions of Bank Muamalat, Bank Boubyan – Kuwait and Alpha Lease and Finance Holding, Bahrain. 4. With the assistance of Al Baraka Islamic Bank, one of the largest textile companies in Indonesia, Apac Inti Corpora is set to establish a manufacturing plant in Dammam, Saudi Arabia, with a representative office in Bahrain by the end of 2012. 5. There are currently five Indonesians who are working in Bahrain at jobs

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that are related to Islamic banking and finance. Four of them are currently working as teaching staff at reputable universities in Bahrain and another is the head of legal at Capinnova Investment Bank.

Conclusion

It is clear that bilateral trade between the two countries is still far below its potential. Both countries can increase their ties through Islamic banking and finance for their own mutual benefits.

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Revitalization of Shariah Compliant Syndicated Financing

SUTAN EMIR HIDAYAT and RONALD RULINDO look at how Shariah compliant syndicated financing can meet the objectives of both Islamic bankers and Islamic economists.

For decades, syndicated financing has been regarded as an important element of the financial services industry. This financial arrangement promotes effectiveness of financial services particularly for a deficit unit, for both business entities that demand huge amount of funds to energize their business, and government agencies that require enormous resources to promote the country’s development.

In modern Islamic banking practices, Islamic banks have collaborated to come out with Shariah compliant syndicated financing. A number of projects have been completed using such an arrangement. Prior to the financial crisis that hit the GCC in 2008, the total amount of Islamic syndicated financing in the region reached US$26.5 billion; up from US$19.6 billion in 2007. However, the performance of Shariah compliant syndicated financing has declined recently due to the turmoil. Despite that, the prospect for Shariah compliant syndication business is still promising.

Syndicated financing and Islamic economics

Islamic banking and finance were created as a result of Muslims’ eff orts to dedicate every aspect of their lives to the teachings of Islam.

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As an example of how Shariah compliant syndicated financing can meet the objectives of both Islamic bankers and Islamic economists, let us look at the eff orts by the IDB. The IDB was established in 1975 with the goal to “ A syndicated improve the lives of ordinary financing is people across the Islamic normally needed to world by eradicating poverty, finance a large or raising economic standards sophisticated and increasing prosperity project that within the member countries of requires a group of the OIC. In order to achieve financiers known this goal, advancing trade as a syndicate” within the Islamic world and the development of intra-trade between OIC member countries is highly desired. Recognizing the importance of intra-trade between OIC member countries, the IDB created a special autonomous body called The International Islamic Trade Finance Corporation (ITFC) in 2005. The ITFC started its operations in 2008 with the mandate to advance trade by contributing to the development of markets and trading capacities in order to help all OIC member countries do business more effectively with each other and the rest of the world.

In its operations, the ITFC identifies and nurtures trade complementarities, introduces new Shariah compliant products to the trading process and acts as a catalyst to bring together international, regional and local organizations to develop intra-trade between member countries.

A syndicated financing is normally needed to finance a large or sophisticated project that requires a group of financiers known as a syndicate. A syndicate agreement simplifies the financing process as the deficit unit (the

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borrower in conventional term) uses one agreement covering the whole group of banks and different types of facility rather than entering into a series of separate bilateral financings, each with different terms and conditions. In other words, instead of dealing with many institutions to obtain the financing, the deficit unit just needs to deal with an agent or lead arranger(s) to set up terms and conditions of the financing.

The ITFC has shown an excellent example of how the practice of Shariah compliant syndicated financing may reach the Maqasid as Shariah. In 2009, the board of directors of the ITFC approved a trade finance operation for Bangladesh valued at US$400 million to support the country’s strategic sectors. The ITFC managed to mobilize more than 60% (US$250 million) of the total amount from external banks for this trade finance operation (a syndicated financing). This financing is in line with the ITFC’s mandate to support member countries’ strategic sectors and to improve their trading capacity. In addition, it allowed the Bangladeshi government to fulfill its requirements in financing vital imports of crude oil and refined petroleum products. Indirectly, this operation provides a critical support to Bangladesh’s farming and garments sectors, considered a vital export-driven industry employing over two million people and indirectly supporting an additional 15 million jobs.

The above example clearly shows us how a syndicate financing can change lives. Nevertheless, although there are many Shariah compliant syndicated financings in practice across the OIC countries, more arrangements are required – particularly for activities that require labor incentives in order to reduce unemployment and provide

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more working opportunities to the Muslim community in various Muslim majority countries.

Challenges

While the ITFC perhaps has fewer challenges to provide Shariah compliant syndicated financings, Islamic commercial banks have more difficulties in developing such arrangements as they have to meet their shareholders’ objectives in addition to their ideological objectives. Although the banks may agree to participate in Shariah compliant financing at a certain point in time, there is a possibility that they may in the future have to take their funds out from the syndication. At this point, several issues arise if the syndication is not developed based on appropriate contracts.

A syndicated financing in Islamic banking and finance can be structured using the Musharakah (partnership), Wakalah (agency), or Tawarruq or commodity Murabahah contracts. For Musharakah, each syndicated bank contributes capital (financing) to the pool of funds (total financings) and share both profit and loss from the actual outcome of the business. The profit is shared based on a pre-determined ratio but for the loss must be shared according to the capital contribution. In order to conclude the deal with the deficit unit, one of the financiers involved is appointed as the agent with the tasks to maintain contact with the deficit unit, monitor the compliance of the deficit unit, record-keep documents and act as a paying agent. For those services the agent deserves to get annual fee. A simple structure of a syndicated financing based on Musharakah contract among Islamic banks is shown in Diagram 1.

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The above diagram clearly indicates that a Shariah compliant syndicated financing can be done using a Musharakah contract. However, a little adjustment can be made among the Islamic banks in case that they want to put their funds in a pool based on a Wakalah or agency contract. In contrast, the structure of Tawarruq or commodity Murabahah is very different as it consists of the sale and purchase of underlying assets where there is (are) third party (ies) involved in the arrangement.

If the Shariah compliant syndicated financing is based on a Musharakah contract, while there is certificate of ownership of certain amount of funds that reflect a certain percentage of partnership in the syndication, it would be easier for banks to sell down their ownership in the syndication to other parties. Similarly, if the syndication is based on a Wakalah agreement, if the legal document write downs a certain percentage of the ownership

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belonging to the Islamic banks in the syndication, it is also easy for an Islamic bank to sell down its ownership as its portion is written clearly in the contract. However if it is based on Tawarruq or commodity Murabahah, the bank has to resell the ownership to other parties. However, the selling price should be at par and cannot be made at a discount since this is regarded as Riba.

From a new investor’s perspective, Islamic banks that want to take part in an existing syndicated financing can provide Qard to the deficit unit in order to assist them to repay their obligation to the existing investors. After giving Qard to the deficit unit, the Islamic banks will enter into a new Tawarruq or commodity Murabahah with the deficit unit. This practice, however, it is slightly complicated as compared to the sell down practice in a conventional syndication. The barrier comes when the deficit unit is not willing to do so as it creates additional work and cost for them which does not occur in conventional syndication.

Possible solutions

There are two major challenges on how to match the objectives of Islamic bankers with the objectives of Islamic economists through Shariah compliant syndication financing. First, there should be a prospective project where the income streams meet the shareholders’ expectations; and at the same time should able to create significant benefits to Muslim community, particularly the lower income streams.

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International initiatives through the IDB and its subsidiaries could provide a solution. The IDB could develop bank data for prospective projects in the OIC member countries that meet the above requirements. The IDB and its subsidiary could act as arranger or Wakil (agent) to the Shariah compliant syndication. It would not be difficult for the IDB to come out with such data as they have strong links with many Muslim governments. What the IDB needs to do is to select and classify the business proposals that meet the “ The second commercial criteria and will challenge is to bring benefits to the provide a Shariah community at large. compliant exit

mechanism for an The second challenge is to Islamic bank that is provide a Shariah compliant willing to sell down exit mechanism for an Islamic its ownership in the bank that is willing to sell down syndication” its ownership in the syndication. Contractually, it is quite simple if the syndication is based on Musharakah or Wakalah. There should be a clear segregation of ownership so that it is easier to transact the ownership. The transaction then can be similar to selling or buying shares at the stock market, with the difference only in terms of the limit of the collaboration.

Unfortunately, there is still a debate among Shariah scholars as to whether such a certificate, although it is based on Musharakah or Wakalah, can be traded or not at par. This is because some scholars argue that the different could be considered as Riba due to the absence of the underlying asset. However, if we can put the same perception that the selling of a certificate reflecting ownership in a Musharakah agreement means buying the ownership not buying the commodity, there would be

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no problem to buy such a certificate at fair value. This assumption is developed by using Shariah compliant stocks as the benchmark for Qiyas.

Conclusion

There is always a way to improve the development of Islamic banking and finance in order to meet the Maqasid as Shariah. The major challenge is not only to find business opportunities that are profitable, but also able to provide benefits to the community. With consistency and persistence, the ideal model of Islamic banking and finance can be achieved; and revitalizing Shariah compliant syndication financing is the first step in completing this journey.

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The Indonesian Financial Service Authority (FSA): a New Hope to Boost the Performance of Islamic Finance

The 3rd December 2013 marked the last day that the supervision of banks (including Islamic banks) in Indonesia remained under the central bank, Bank Indonesia (BI). Effective from the 2nd January 2014, banks and other financial institutions are now supervised and regulated under a new institution, the Financial Service Authority (FSA). DR SUTAN EMIR HIDAYAT and DR RADITYA SUKMANA discuss the implications of this move for the Islamic finance industry in the country.

The discussion to establish the FSA has been underway for almost a decade, as the need for the new institution was debated. Among the issues was whether the FSA would be truly effective given that all its intended functions were already conducted by various institutions.

Another issue at that time was the financing or funding to establish FSA as an establishment requiring new human resources as well as office buildings in the capital, Jakarta, as well as in various other locations all over Indonesia. Certainly, a significant government budget had to be allocated at the initial stage. Later, when the FSA had already started its operations, it had to find its own financial sources through various means such as membership fees charged to its members (which are financial institutions such as banks and insurance companies).

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Another reason for the postponement was due to the un- readiness of the banks. At the beginning of the 21st century, banks in Indonesia had not fully recovered from the financial crisis. Hence, the regulator preferred to focus on creating a conducive banking climate. To cut the story short, eventually the FSA only officially started its operations at the beginning of 2014.

2014 is a new year with a new mega regulator for the financial industry in Indonesia. Many Indonesians have big expectations for this, particularly on the impact of effective coordination between the related institutions. Previously, BI only catered to the supervision of banks. The supervision of other financial institutions and the

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capital market was done by the Ministry of Finance through a board called BAPEPAM. In addition, ministry of cooperatives only handled the cooperative institutions. The existence of various regulators raised questions on the issued policies from regulators, which may not always have been in line with the policy made by others.

For example, an Islamic bank attempted to create more facilities to its customers by accommodating Islamic insurance (Takaful) services by joining with an Islamic insurance operator in forming bancaTakaful service. The aim of bancaTakaful is to make the customers comfortable. Instead of visiting separately Islamic bank and Islamic insurance operator to get the two services, through bancaTakaful, both services are available in one place. The issue was then raised - when there is a dispute, to which party can the customer send his complaint. If he complained to BI as he assumed that the Islamic insurance product was offered by an Islamic bank, the central bank would not accept the complaint as the product is insurance and not originally a banking product. Meanwhile, if he wanted to complain to the Ministry of Finance as he thought that Islamic insurance was under this ministry, they would also not serve him as the product was offered by a bank which is by law under the central bank’s supervision. Under such condition, it is clear that the customer was at a disadvantage as no institution was clearly responsible for his complaint. This has led to the clear need for the FSA, as an institution that could comprehensively manage all financial institutions.

Another hopeful facet of the FSA could be the development of the micro, small and medium industries (MSMEs). Data shows that MSMEs contribute significantly to the Indonesian GDP.

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Table 1 looks into three important things with regard to the MSME sector. First is the number of the institutions within the sector. Second is the number of workers, while the last is the contributions of MSME to the GDP. In terms of the number of the institutions, it is revealed that MSMEs contribute about 99.99% of the total enterprises in the country. The remaining percentage is the number of big enterprises. Within the “ This shows the MSME sector itself, it shows importance of the that the number of units for MSME sector to the micro firms is dominant, Indonesian market. comprising up to 98.85% of The sector has also total MSMEs, while the been relatively remaining small and medium unaffected by the businesses represent only recent global about 1.07% and 0.08% of the turmoil – largely total MSMEs in the country due to the nature of respectively. the business”

With regard to the amount of labor absorbed by MSMEs, the data implies that MSMEs absorb a much bigger chunk compared to the big enterprises. Labor in the MSME sector contributes about 97.22% of the total labor market in Indonesia. Again, labor in micro enterprises is the biggest contributor. Labor in small and medium enterprises stood only at around 3% or 2% respectively. The last part of Table 1 is about the contribution of MSMEs to GDP. MSMEs contribute more than 57.12% of Indonesian GDP, with the contributions of micro, small and medium standing at 33.81%, 9.85% and 13.46% respectively.

This shows the importance of the MSME sector to the Indonesian market. The sector has also been relatively unaffected by the recent global turmoil – largely due to

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the nature of the business. One characteristic of MSMEs in Indonesia is that majority of MSMEs are domestic players. This means they get their raw materials from local suppliers and manufacture their products locally and sell their products to local buyers. As a result, they are not much affected by the international environment or the fluctuations in the exchange rate.

For example, the recent European crisis has resulted in a significant decline in export volume of many countries in Asia to the European market. As a consequence, the exporters in those countries (mainly big corporations) are at a disadvantage as their sales are falling. Fortunately, this is not the case for majority of Indonesian MSMEs.

However, although the MSME sector proved to be a buffer during the economic crisis, it does not mean that this sector is free from any risk. In fact, the risk in the MSME may be even higher than the risk in the big enterprise sector. This is because MSMEs, in many cases, cannot provide collateral for loans, which is very important for the financiers. Secondly, the owners of MSMEs are normally also at the same time the sole runners of the business. That is why his absence from the company at any day normally results in the closing of the business on that day. As a result the family cannot earn money for that day.

From the MSME profile above, it is expected that microTakaful could offer an opportunity to assist them. Not falling into the same hole as in its past experience, the regulatory body on the Islamic banks which provide financing to MSMEs must be under one roof with that for the microTakaful operator. Therefore, the newly established FSA is mandated for that purpose. If the FSA is able to conduct better supervision as compared to the

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two separate regulatory bodies in the past, then it is expected that the future of Indonesian MSME industry and also the Islamic finance industry as a whole will be very bright.

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Social Responsibility and Sustainable Development of Islamic Finance

On 3-4 May 2016, the General Council for Islamic Banks and Financial Institutions (CIBAFI) organized a Global Forum in Manama, Kingdom of Bahrain. One of the sessions at the forum discussed the hot topic of social responsibility and sustainable development of Islamic finance. The panelists at the session were required to explain shariah principles on responsible business, the concept of sustainable development in Islam and how to incorporate the best practices of sustainability into Islamic finance framework. This article highlights the topic based on the panelists’ explanation during the session and available Islamic finance literature related to the topic.

Sustainable development or sustainable growth can be defined as growth that will continue and can be passed to the future generation. From the definition, it is clear that the concept of sustainable development fits very well the Islamic finance principles. For example, one of the Shariah principles is “To avoid harming the others”. This principle includes not harming the environment or protecting the environment which ensures that the future generation will be able to enjoy a good living. In addition, one of the essential aspects of Maqashid Al-Shariah (objectives of Shariah) is preserving the wealth (Hifzul Maal) which includes preserving natural resources or environment. The principle of avoiding Israf (wasting the resources) also stresses the importance of effective and efficient usage of natural resources to ensure it can be passed to future generation. It also can be concluded that in order to realize sustainable development, the current generation must conduct socially responsible businesses and activities.

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The above principles also apply to Islamic financial industry. For example, conventional financial derivative instruments such as forward, future and options are not acceptable in Islamic finance because it is not in line with the Shariah principles and also not in line with the “ First challenge is concept of sustainable how the IFIs development. This is because transform those of the zero sum game which is social applied in those instruments. responsibility and In other words, there will be a sustainable growth gainer and a looser in into strategies and derivative contracts which action plans” fulfills the criteria of Maysir, a prohibited element in any transaction according to Shariah. In Islamic finance, investors are required not only to invest in Halal (approved) instruments but also in instruments that do not harm others. This is the reason why both qualitative and quantitative screenings are conducted to any companies wish to be listed in a Shariah index. The qualitative screening is conducted not only to ensure the core business of the company is Shariah compliant but also to ensure the business is socially responsible which has social impacts, environmental impacts and stakeholders’ engagement. The quantitative screening is conducted to ensure the company’s sources and uses of funds are socially responsible as reflected by and disclosed in its financial statements.

However, there are challenges faced by Islamic financial institutions (IFIs) with regard to social responsibility and sustainable development issue. First challenge is how the IFIs transform those social responsibility and sustainable growth into strategies and action plans.

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Second, IFIs must also know how to measure the success of the transformation. In other words, what are the key performance indicators (KPIs) to evaluate the performance of IFIs with regard to social responsibility and sustainable development issue? For the first challenge, IFIs need to establish clear policies, procedures and mechanisms to develop, implement and evaluate the strategies and action plans related to social responsibility and sustainable development. For the second challenge, available literature reveals that there are studies which recommend the usage of Maqashid Al- Shariah Index to evaluate the IFIs’ performance.

This is because the concept of social responsibility and sustainable development is a part of Maqashid Al- Shariah. Therefore, any IFIs have a good score in the Maqashid Al-Shariah surely have implemented strategies that are in line with social responsibility and sustainable development. It is expected that this article can draw the attention of Islamic finance stakeholders including IFIs management since it has been proven that social responsible business, which leads to sustainable growth, has a positive correlation with return and performance of a company. Therefore, being socially responsible is no longer considered as a cost but it is a means to achieve long term value creating and excellent performance.

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About The Author

Dr. Sutan Emir Hidayat is currently the Head of Business Administration and Humanities Department at the University College of Bahrain (UCB). In UCB, Dr. Hidayat is also a member of several important committees such as University College Council (UCC/Senate), Academic Research (ARC), Quality Assurance and Accreditation (QA C) and Examination Committees (EC). He joined UCB in September 2007 after spending two academic years at International Islamic College Malaysia (IIC) as the lecturer and subject coordinator for Islamic Finance courses.

Dr. Hidayat obtained his PhD in Islamic Banking and Finance in 2013 and his MBA in Islamic Banking and Finance in 2005 both from the International Islamic University Malaysia (IIUM). In Bahrain, Dr. Hidayat is also a member of advisory committee for Centre of Islamic Finance and External Research Associates at Bahrain Institute of Banking and Finance (BIBF). In BIBF, Dr. Hidayat is also a part-time faculty member teaching Islamic accounting standards, Sukuk Portfolio and understanding of Islamic banks’ financial statements at Advance Diploma in Islamic Finance (ADIF) program and CIMA Diploma in Islamic Finance (CDIF) program, Sharia Reviewer Development (SRD) Program and Public Lecture (PL).

Dr. Hidayat is actively engaged with academic research in his field. He has presented several research papers at reputable international conferences namely the 11th Harvard University Forum on Islamic Finance (2014) at Harvard Law School, Massachusetts, the USA, the Gulf Research Meeting ( 2012 and to be in 2016) at University

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of Cambridge, United Kingdom, International conferences and workshops held by Islamic Research and Training Institute (IRTI) of Islamic Development Bank (IDB) in Jakarta, Kuala Lumpur, Khartoum and Doha (2007, 2008 and 2014, 2011, 2014, 2015), Qatar Foundation (2011). He was also invited to speak at renowned industry based conferences such as the AAOIFI - World Bank Annual Conference on Islamic Banking and Finance (2011 and 2012), Deloitte- IRTI Executive Workshop 3 on Talent Development in Islamic Finance (2014) held in Manama, Bahrain and the 11th Middle East Insurance Forum (2015) held by Mega Event and Central Bank of Bahrain. On 5 - 6 October 2015, through collaboration with IRTI- IDB, as the Chairman of the Organizing Committee, Dr. Hidayat successfully held a thematic workshop on Macro prudential policies and regulations for Islamic financial industry: Theory and applications. The selected workshop papers are published by Springer International Publishing in an edited book where Dr. Hidayat is one of the book's co- editors.

Dr. Hidayat has published several research papers in peer reviewed international journals. Among them are Journal of Islamic Economics, Banking and Finance, IBTRA, International Journal of Excellence in Islamic Banking and Finance, Journal of Economics and Finance, International Research Journal of Finance and Economics, International SAMANM Journal of Finance and Accounting, and Journal of Pedagogical Innovations. In addition, he is also a reviewer for the International Journal of Islamic and Middle Eastern Finance and Management, Emerald Publishing Ltd, UK, a reviewer of the Review of Financial Economics, Elsevier and a

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member of editorial board of SAMANM group research publications. During his academic career, Dr. Hidayat has contributed chapters in four books titled Islamic Finance Political Economy, Performance and Risk" Vol. 3 (Performance and Efficiency) (Gerlach Press, 2015), "Issues in Islamic Management: Theories and Practices" (IIUM Press, 2011), "Muhammadiyah dan tantangan abad baru" (Matan press, KL, 2010) and "Islamic Capital Markets, Products, Regulation and Development" (IRTI- IDB, 2008). During his service at UCB, Dr. Hidayat managed to completely supervise 22 MBA theses (UCB) and 5 graduation projects at the New York Institute of Technology (NYIT) and examined 15 MBA theses and 3 graduation projects both as Internal and external examiners in Bahrain and in Brunei Darussalam.

Dr. Hidayat is also an Islamic finance journalist. He regularly publishes articles in Islamic Finance News (IFN- Red Money), regularly publishes articles about Islamic finance in Daily Tribune Newspapers (Every Thursday), an English newspaper in Bahrain, published an article in Global Islamic Finance Magazine, UK and The Bahrain Banker (Winter 2012). At the IFN Red Money, He is currently the sector correspondent for Takaful and Re- takaful. He is also a contributor to Thomson Reuters. Many of Dr. Hidayat's writings are available at Thomson Reuters through its Islamic finance gateway, Zawya.com and some of his presentations are also available on YouTube. Dr. Hidayat also has contributed articles to reputable Indonesian newspapers such as Republika, Koran Tempo and even detik.com. Recognizing his contribution to Islamic finance, the Ambassador of the Republic of Indonesia to the Kingdom of Bahrain, H.E. Mr. Chilman Arisman has taken the initiative to compile

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Dr. Hidayat’s articles into a book which is expected to be published in the middle of 2016.

In early 2013, Dr. Hidayat was involved in developing examination questions for Certified Islamic Professional Accountant (CIPA), a professional certificate offered by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI). AAOIFI and the International Accounting Standard Board (IASB) also invited him to an outreach meeting to discuss the convergence possibility of IFRS of IASB and FAS of the AAOIFI in April 2015. In addition, he was also involved as the external validation and revalidation committee for Advanced Diploma in Islamic commercial Jurisprudence at BIBF. He is also involved as a part-time teaching staff at the Islamic Online University (IOU) which is the brainchild of Dr. Bilal Philips. He is also an active member of Indonesian community serving as the vice president of Indonesian community in Bahrain (Nov 2012- Oct 20013), a commissioner of the special task force for the 2014 Indonesian general election (PPLN) held in Bahrain (Apr 2013 -Jul 2014), the chairman for the Indonesian Association of Islamic Economists (IAEI)-Bahrain (April 2012 - present) and a founding member of Bahrain - Indonesia Business and Friendship Society (BIBFS).

Finally, ISFIN, a Brussels based leading advisory firm for Islamic markets, recognized Dr. Hidayat's contribution to the Islamic Economy by listing him in a directory named Islamica 500 as one of the top 50 personalities who actually influences or symbolizes the Islamic economy on a global scale in 2015. The announcement and launching of Islamica 500 was made on November 4, 2015 during the 11th World Islamic Economy Forum (WIEF) in Kuala Lumpur, Malaysia. In addition, Dr. Hidayat was ranked in

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the top 50 out of the 500 personalities and awarded by ISFIN on 1st December 2015 during the 22nd World Islamic Banking Conference (WIBC) held in Manama, Bahrain. Among the media partners of the event was FORBES Middle East, a renowned publisher.

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Praises and Comments

This book gives a clear overview about almost all aspects of Islamic finance. It is clearly written and easily understood. It also comes out with the recent issues and developments within Islamic financial industry. Some articles in the book also provide in depth analysis on the challenges within the industry that must be tackled in order to sustain the development of Islamic financial industry.

Prof. Dr. Bambang P.S. Brodjonegoro Minister of National Development Planning, Republic of Indonesia and Chairman of the Indonesian Association of Islamic Economists

The book contains a collection of Dr. Hidayat’s views on almost all segments of Islamic finance. It discusses the current issues and development within Islamic financial industry both globally as well as specific countries. The style of writing of the book makes it appealing to Islamic finance practitioners, academicians, students and public in general. It is truly a worthwhile addition to Islamic finance literature.

Prof. Dato’ Dr. Mohamed Azmi Omar Director General, Islamic Research and Training Institute, Islamic Development Bank Group

Dr. Sutan Emir Hidayat deserves our compliment for making a valuable contribution to the Islamic finance literature through the publication of this book. This book is written in a writing style that can be easily understood by anyone interested to know about Islamic finance. This

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approach will help the development of Islamic financial industry in term of raising public awareness towards the subject.

Shaikh Dr. Khalid M. Al-Khalifa Executive Chairman and Founder, University College of Bahrain. A Member of Bahrain’s Ruling Family

The coverage of this book in terms of topics is comprehensive which include principles of Islamic finance, Islamic banking, Takaful, Education, Islamic capital market instruments including Sukuk and other relevant topics. I highly recommend this book as it provides valuable information and latest developments in the industry. I am confident that the readers will appreciate the great effort put in by Dr. Sutan Emir Hidayat.

Ijlal Ahmed Alvi Chief Executive Officer, International Islamic Financial Market