The Difference Between Shari’a-compliant and Shari’a-based Islamic Finance Institutions

The Difference Between Shari’a-compliant and Shari’a-based Islamic Finance Institutions
Natalie Schoon, The Bank of London & The Middle East – 22 Jan 2008

This article considers the subtle differences between the two key players within the Islamic finance industry – Shari’a-compliant banks and Shari’a-based banks – and how they could co-operate to achieve the real potential of this market.

On 9 July 2007, the Bank of London and The Middle East (BLME) was launched in London. BLME is the second wholly Shari’a-compliant investment bank authorised and regulated by the UK’s Financial Services Authority (FSA). This brings the number of fully Islamic banks in the UK to three, with the total number of financial institutions offering Islamic financial services in the UK at 24. Another three Islamic financial institutions are in the process of applying for a licence with the FSA, showing the strength of the UK as the largest Islamic finance hub outside Muslim geographies.

Although a young segment of the financial industry, Islamic finance has gone through an exceptional growth period. Over the past 10 years, the industry has grown at a rate of 15-20% per year. This level of growth is expected to continue in the coming years and by far exceeds the rate of growth in conventional finance. The increase in wealth resulting from the rise in oil prices and the subsequent requirements for investment in oil-producing countries is a large contributor to the expansion of the Islamic finance industry. Coupled with relatively high returns, this attracts banks and investors alike.

Islamic financial products are not only offered by fully Shari’a-compliant banks but also by conventional banks employing specific distribution channels, such as Islamic windows and Islamic branches. The issue that arises is whether Islamic financial products offered by a conventional bank are equally acceptable to Muslims as those offered by fully compliant Islamic financial institutions. There is, after all, a difference in the level of Shari’a compliance of conventional and Islamic banks.
Shari’a Supervision

Islamic financial institutions have an additional layer of corporate governance over and above the governance mechanisms in place for conventional financial institutions. In addition to a supervisory board, independent external auditors, adequate policies and procedures and other governance mechanisms, Islamic financial institutions also have to ensure compliance with the Shari’a principles, which are reviewed and monitored by the Shari’a Supervisory Board (SSB). The role of the SSB is to issue fatwa (opinions) setting out how the bank’s operations should be carried out in order to be consistent with Shari’a rules and principles (ex-ante compliance). In addition, because of its role within the corporate governance framework, the SSB is also responsible for the monitoring of the institution’s Shari’a compliance in applying the fatwa in practice (ex-post compliance).
Shari’a Compliance

In order for a financial product to be Shari’a compliant, it needs to satisfy, at a minimum, the criteria of Shari’a law regarding the avoidance of Riba, Maysir and Gharar. Once these are satisfied and the bank obtains Shari’a supervisory board approval, the product or structure can be marketed as Shari’a compliant. As far as conventional banks are concerned, this is where Shari’a compliance stops. It does not constrain the bank from employing non-Islamically raised funds to invest in Islamic structures.
Shari’a Based Banks

A fully Shari’a-compliant or Shari’a-based bank takes the compliance with Shari’a law a step further. Not only do individual products have to meet all requirements but also all operations within the bank are required to be compliant with Shari’a law. This extends to contracts with suppliers, rental contracts and labour contracts. The bank is completely set up to work in line with the ethical framework of Shari’a, which makes it more likely to be able to structure all products to meet the requirements. In addition, there is no co-mingling of conventional and Islamically raised funds, since all funds are raised in line with Shari’a requirements.
Impact on Investment Decisions

The decision any investor, depositor, Sukuk issuer or other client of a bank will have to make is related to the trade-off between the level of Shari’a compliance and the reputation and historic track record of the bank.

A large conventional bank with a proven track record will provide a relatively higher degree of certainty than a newly established Islamic bank. In addition, large conventional banks have the advantage of the backing of a big balance sheet and structuring capabilities that are well beyond the potential of Islamic banks, at least at the moment. This becomes immediately clear when comparing the total assets of the largest Islamic bank with total assets of large conventional banks. At the end of 2006, the largest Islamic bank (Al Rajhi) had total assets of US$28.1bn. The likes of HSBC, Barclays and Citi, on the other hand, each had a total asset base close to US$2 trillion at the end of December 2006.

As a result, it is much easier for conventional banks to underwrite large Sukuk issues and to structure sizeable project finance structures than it is for Islamic banks. Between June 2006 and June 2007, five of the 10 biggest Sukuk arrangers were conventional banks. Issuers choose conventional banks for their proven track record, their ability to raise large sums of money and, most importantly, their competitive pricing.

Conventional banks, however, provide Islamic finance as part of a broader range of financial products and although the individual offerings are Shari’a-compliant and the distribution channel is different from other financial products, a conventional bank is likely to co-mingle funds raised in an Islamic manner with conventionally raised funds. In addition, conventional banks can hedge positions using innovative financial products that are often not allowed in Islamic banks, given the speculative nature of the majority of hedging products.

A small, relatively young Islamic bank does not have a long track record and can hence be seen by investors and depositors as carrying a higher risk. Although some comfort can be found in the fact that the bank is regulated, conventional banks are regulated in the same way. As a result of the smaller balance sheet size, Islamic banks are not currently in a position to underwrite large Islamic finance transactions unless they are part of a syndication effort and, even then, some transactions are out of their scope due to large exposure regulations and size limitations.

On the other hand, a Shari’a-based bank operates completely within the remit of the ethical framework defined by Shari’a law, something that could be of significant interest for Muslims. A fully Islamic financial institution will not only be audited internally and externally, but will also be subject to an annual review by the Shari’a supervisory board as an independent third party to ensure ongoing Shari’a compliance for the whole of the business. An Islamic window or branch of a conventional bank does not necessarily go through this type of ex-post compliance audit, and in any case does not have to report the results in its annual report.
Compete or Co-operate?

There is a strong call in the market to form an Islamic ‘mega’ bank but given the size of the individual Islamic banks, this appears to be quite a way off.

Although the number of Islamic banks is growing exponentially, their balance sheet size on a consolidated basis is not even remotely close to the size of any of the large conventional banks on their own. Thus, the two types of players operate in different market segments, which actually make them very complementary. In the end, there is a place for both Shari’a-compliant and Shari’a-based banks. By working closely together, they can achieve high market penetration and work on reaching the full potential of the market.

Source: http://www.gtnews.com/article/7055.cfm

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