diploma thesis final - assaif islamic... · liquidity management ... daruah doctrine of necessity...
TRANSCRIPT
GEORG-SIMON-OHM-HOCHSCHULE NÜRNBERG
Islamic banking – a worthwhile challenge for German banks?
The current supply situation of Islamic financial products in selected European markets and potential domestic market demand in
Germany.
Diploma Thesis
submitted to obtain the academic agree
“Diplom Betriebswirt (FH)”
Faculty of International Business
Prof. Dr. Klaus Stocker
handed in by
Kati Colditz
Matriculation Number: 2018613
Lößnitzer Straße 57
08297 Zwönitz
Nuremberg, 3 March 2009
ii
CONTENTS
FIGURES .................................................................................................................................................... VI
TABLES .................................................................................................................................................... VIII
GLOSSARY OF ARABIC TERMS..................................................................................................................... IX
ABSTRACT ................................................................................................................................................. XI
INTRODUCTION ........................................................................................................................................... 1
FOUNDATIONS AND BASIC PRINCIPLES OF ISLAMIC BANKING ....................................................................... 3
1.1. ISLAMIC LEGAL AND ECONOMIC SYSTEM ............................................................................................................. 3
1.1.1. Shariah and Fiqh .............................................................................................................................. 3
1.1.2. The four root transactions and the concept of partnership ............................................................. 5
1.1.3. Religious principles guiding investment behavior ........................................................................... 5
1.2. ISLAMIC FINANCING TECHNIQUES AND PRODUCTS ................................................................................................ 9
1.2.1 Equity-based financing techniques ................................................................................................ 10
1.2.2 Debt-based financing techniques .................................................................................................. 13
1.2.3 Leasing ........................................................................................................................................... 15
1.2.4 Capital market instruments ........................................................................................................... 17
1.2.5 Funding operations/ Accounts ....................................................................................................... 24
1.2.6 Takaful ........................................................................................................................................... 26
1.2.7 Use of Islamic financing techniques and products and profitability .............................................. 28
1.3. GOVERNANCE AND COMPLIANCE STRUCTURE OF ISLAMIC BANKS ........................................................................... 29
1.3.1. Shariah Supervisory Board standards ............................................................................................ 29
1.3.2. Characteristics of a Shariah Supervisory Board ............................................................................. 30
1.3.3. Functions of a Shariah Supervisory Board ..................................................................................... 31
1.3.4. Product innovation process ........................................................................................................... 32
1.3.5. Inconsistency of fatawa ................................................................................................................. 33
1.4. REGULATORY FRAMEWORK ........................................................................................................................... 34
1.4.1. Standardization and Harmonization.............................................................................................. 34
1.4.2. Regulation ..................................................................................................................................... 36
1.4.3. Accounting, Reporting and Zakat .................................................................................................. 36
1.5. RISK AND LIQUIDITY MANAGEMENT OF ISLAMIC BANKS ....................................................................................... 37
1.5.1. Liquidity Management .................................................................................................................. 37
1.5.2. Risk Management .......................................................................................................................... 40
1.6. HISTORY AND CURRENT DEVELOPMENT OF ISLAMIC FINANCE ................................................................................ 45
iii
1.6.1. Historical milestones...................................................................................................................... 45
1.6.2. Approaches to expansion and development .................................................................................. 48
1.6.3. Estimated size of the industry and growth trends ......................................................................... 49
1.6.4. Islamic financial centres ................................................................................................................ 53
1.7. LATEST DEVELOPMENTS IN MIDDLE EAST AND SOUTHEAST ASIA ........................................................................... 53
1.7.1. Geographical classification ............................................................................................................ 53
1.7.2. Financial markets in Middle East and Southeast Asia ................................................................... 54
1.7.3. Development of the Islamic banking sector in GCC countries and Malaysia ................................. 55
1.8. PROSPECTS FOR ISLAMIC FINANCIAL INDUSTRY .................................................................................................. 57
2. EVOLUTION OF ISLAMIC BANKING IN WESTERN EUROPE ...................................................................... 59
2.1. UNITED KINGDOM ............................................................................................................................................ 61
2.1.1. Establishment of London as the Western centre for Islamic finance ............................................. 61
2.1.2. Muslims in the United Kingdom..................................................................................................... 63
2.1.3. Government initiatives and cooperation ....................................................................................... 65
2.1.4. The current Islamic financial market in the United Kingdom ........................................................ 66
2.1.5. Future outlook and trends for the United Kingdom ....................................................................... 76
2.2. SWITZERLAND ............................................................................................................................................. 77
2.2.1. Market players ............................................................................................................................... 77
2.2.2. Future outlook ............................................................................................................................... 80
2.3. FRANCE ..................................................................................................................................................... 80
2.3.1. Muslims in France and Islamic market potential ........................................................................... 80
2.3.2. Government initiatives .................................................................................................................. 82
2.3.3. Market players ............................................................................................................................... 82
2.3.4. Future prospects ............................................................................................................................ 84
2.4. ITALY ........................................................................................................................................................ 84
2.5. AUSTRIA .................................................................................................................................................... 86
2.6. OTHER EUROPEAN MARKETS ......................................................................................................................... 88
3. GERMAN MARKET POTENTIAL FOR ISLAMIC BANKING ACTIVITIES ........................................................ 89
3.1. MUSLIMS IN GERMANY ................................................................................................................................ 89
3.2. BANKING BEHAVIOR AND TRENDS IN DEMAND FOR CONVENTIONAL BANKING SERVICES OF MUSLIMS IN GERMANY ......... 92
3.2.1. General banking potential ............................................................................................................. 92
3.2.2. Current banking demands and trends ........................................................................................... 92
3.2.3. Particularities of German Muslim consumers (having a Turkish background) .............................. 94
3.3. POTENTIAL DEMAND FOR SHARIAH COMPLIANT FINANCIAL SERVICES ...................................................................... 95
3.4. REGULATORY FRAMEWORK AND FEASIBLE BUSINESS MODELS ............................................................................... 98
iv
3.4.1. Regulation and licensing of financial business entities in Germany .............................................. 98
3.4.2. Tax conditions ................................................................................................................................ 99
3.4.3. Feasible business models for Islamic banking operations in Germany ........................................ 100
3.5. MARKET PLAYERS IN GERMANY .................................................................................................................... 101
3.5.1. Current business activities of German Islamic financial service providers ................................... 102
3.5.2. Marketing strategies and distribution channels used ................................................................. 107
3.5.3. Obstacles and hindrances experiences ........................................................................................ 108
3.5.4. Scope of activities and future plans for Islamic financial service business .................................. 109
3.5.5. Estimations on future market development in Europe and Germany in particular ..................... 111
3.5.6. Approaches to provide Islamic financial services in the German market .................................... 112
3.6. ETHNO-MARKETING APPROACHES AND ETHICAL INVESTMENTS .......................................................................... 114
3.6.1. Ethno-Marketing approaches ...................................................................................................... 114
3.6.2. Promoting ethical investments .................................................................................................... 116
4. CONCLUSIONS .................................................................................................................................. 117
4.1. FUTURE OUTLOOK FOR THE DEVELOPMENT OF THE ISLAMIC FINANCIAL SERVICES INDUSTRY IN EUROPE ...................... 117
4.2. CHALLENGES FOR THE ISLAMIC FINANCIAL INDUSTRY IN EUROPE ......................................................................... 119
4.3. RECOMMENDATIONS FOR GERMAN FINANCIAL INSTITUTIONS ............................................................................ 120
WORKS CITED .......................................................................................................................................... 122
APPENDIX A ................................................................................................................................................ I
APPENDIX A1: THE FOUR VERSES IN THE QUR’AN DEALING WITH RIBA .................................................................................. I
APPENDIX A2: THE FIVE PILLARS OF ISLAM .................................................................................................................... II
APPENDIX B .............................................................................................................................................. III
APPENDIX B1: INSTITUTIONS AND COMPANIES CONTACTED .............................................................................................. IV
APPENDIX B2: QUESTIONNAIRE DISTRIBUTED ................................................................................................................ VI
APPENDIX B3: ANALYSIS OF ANSWERS RECEIVED ........................................................................................................... XV
v
Erklärung gemäß §31 Abs. 7 RaPO
Ich versichere, dass ich die Arbeit selbstständig angefertigt habe, nicht anderweitig für
Prüfungszwecke vorgelegt, alle benutzten Quellen und Hilfsmittel angegeben sowie
wörtliche und sinngemäße Zitate als solche gekennzeichnet habe.
_________________________________
Kati Colditz
Nürnberg, den 03. März 2009
vi
Figures
Figure 1 Definition of Riba (according to Iqbal and Mirakhor 2007, 56) 7
Figure 2 Example of a Mudaraba transaction from Gassner and Wackerbeck (2007, 64) 11
Figure 3 Permanent Musharaka transaction from Gassner and Wackerbeck (2007, 67) 12
Figure 4 Murabaha transaction (own illustration) 14
Figure 5 Salam transaction (own illustration) 14
Figure 6 Pure Ijarah transaction (own illustration) 16
Figure 7 Islamic equity fund based on Mudaraba partnership from Gassner and Wackerbeck 2007,
135 19
Figure 8 Transaction structure “Stichting Sachsen Anhalt Trust” (aligned with el-Mogaddedi 2007
and Bergmann 2008, 113) 21
Figure 9 Example for a mirrored Forex Swap transaction according to Shariah principles (own
illustration) 24
Figure 10 Takaful model based on Mudaraba transaction from Gassner and Wackerbeck 2007, 148
28
Figure 11 Commodity Murabaha Liquidity Management from Bank Negara Malaysia (2005) 39
Figure 12 Liquidity Management via Sukuk (own illustration) 40
Figure 13 Composition of the Islamic Financial Services industry (according to Islamic Development
Bank 2007) 48
Figure 14 Total Sukuk issuance (International Islamic Financial Market 2007) 52
Figure 15 Number of Islamic mutual equity funds (according to Gassner and Wackerbeck 2007,
137) 52
Figure 16 Countries of Middle East (Nationmaster 2003-2005) 54
vii
Figure 17 Development of assets held by Islamic banks (according to Islamic Development Bank
2008) 56
Figure 18 Market share of Islamic products and services in assets, deposits and financing as at end-
2005 in Malaysia (Bank Negara Malaysia 2005) 57
Figure 19 Muslim population in selected Western European countries (according to BBC 2008) 59
Figure 20 UK Muslims by ethnic group, April 2001 (Office for National Statistics 2003) 64
Figure 21 Muslims in Germany by country of origin (according to Bertelsmann Stiftung 2008) 90
Figure 22 Banks of choice of German Muslims with Turkish background (according to Gleisner 2007
and Gassner 2003) 94
Figure 23 Importance of Islamic investments for German Muslims (by religiousness and in total)
(according to survey results of Hayen, et al. 2005) 96
Figure 24 Distribution channels used by German financial institutions offering Islamic financial
services 107
Figure 25 Promotion of Islamic financial services by German financial institutions 108
Figure 26 Compliancy requirements constituting problems to German financial institutions 109
viii
Tables
Table 1 Estimated size of IFSI Segments in 2005 (according to the Islamic Development Bank 2007)
49
Table 2 Projected size of the IFSI until 2015 (according to the Islamic Development Bank 2007) 50
Table 3 Regulatory initiative in the United Kingdom (Financial Services Authority 2007) 66
Table 4 Fully-fledged Islamic banks in the United Kingdom (according to Islamic Bank of Britain
2007, European Islamic Investment Bank 2007, Bank of London and the Middle East 2007 and
Gatehouse Bank 2007) 69
Table 5 Islamic financial service offering by German institutions (according to questionnaire and
interview results) 106
Table 6 Scope of Islamic financial activities of German institutions 110
ix
Glossary of Arabic terms1
Al wadiah Principle to keep or deposit something in
custody
Amanah Describes both a relationship of trust and items
in safekeeping
Bay Salam A contract determining a pre-paid purchase
Daruah Doctrine of necessity
Fatwa (plural: fatawa) An authoritative legal opinion issued by a
Shariah Supervisory Board/ single Shariah
scholars, based on the Shariah
Fiqh Practical Islamic jurisprudence (jurists’ law)
Fiqh Mu’amalat Islamic commercial jurisprudence (rules of
transaction)
Hadithe Technical term for sources related to the
sayings and doings of the Prophet, authentic
traditions
Ijarah / Ijarah wa Iqtina A contract determining a leasing agreement/
A lease-purchase agreement
Istisnaa A contract of sale of specified goods to be
manufactured
Manfa’a The right to use an asset
Mudaraba A partnership contract in which one partner
contributes capital and the other partner
1 The explanations are aligned with the Glossaries of Hassan and Lewis 2007 and Jaffer 2005.
x
invests time and effort
Mudarib The entrepreneur or manager in a Mudaraba
contract
Murabaha The resale of goods with an agreed upon profit
mark-up on the cost
Musharaka A partnership contract in which both parties
contribute capital and may form a joint
management
Qard Hassan A benevolent (interest-free) loan
Qirad A dormant partnership (for example in a
Mudaraba contract)
Rabb al mal The partner in a Mudaraba agreement
providing the funds
Shariah Islamic religious law derived from the Holy
Qur’an and the Hadithe
Sukuk (plural of sakk) Participation securities, coupons, investment
certificate
Tabarru Donation
Takaful A Shariah compliant insurance concept (similar
to conventional mutual insurances)
Tawarruq The purchase of goods on deferred payment
and their subsequent sale (to raise cash)
Wakala An agency contract
xi
Abstract
The thesis concentrates on the potentials in the future development of the Islamic financial
service industry in Europe, in particular in Germany. In a period of continuous growth worldwide in
the recent years the United Kingdom played a major role as innovative financial centre,
establishing itself as European pioneer in Islamic finance. Domestic institutions cater foreign
customers as well as the local Muslim communities. This example, the increasing demand for
ethno-oriented banking offerings as well as financial inclusion considerations for Muslim
minorities living in Europe gave rise to the estimation that there might exist considerable domestic
market potential in other European markets too, in particular in Germany. Therefore it was
investigated on the question whether the provision of Islamic financial services for the domestic
market could constitute a worthwhile approach for German financial institutions. Furthermore the
current Shariah compliant financial product offerings in Europe were scrutinized in light of
domestic preconditions such as characteristics of the local Muslim population and governmental
initiatives. The research was built on questionnaires and interviews targeting representatives of
European financial institutions and Islamic financial industry experts. Additionally results of market
surveys and working papers issued by industry organizations and online information were included
in the analysis. It was shown that there are substantial cultural and religious differences between
Muslims living in different European countries resulting from their origins. For this reason it
cannot be concluded from the success of Islamic financial service offerings in the United Kingdom
that this approach is promising for the German market. Apparently the domestic demand among
Muslims living in Germany, predominantly of Turkish origin is not sufficient to justify the
considerable initial efforts required to enter the Islamic financial service market. This applies to
most of the other European markets analyzed, too where the supply of Islamic financial services
for local Muslim communities is currently very limited. This situation may be a result of the low-
socio economic status of many Muslim migrants in Europe on the one side, making them a rather
unattractive customer group at this point of time, as well as low market awareness for Shariah
compliant financial products on the other side, leading to only very moderate demand. For the
German market the targeting of local Turkish customers in the scope of ethno-oriented marketing
approaches as well as the limited offering of Shariah compliant financial products within a broader
concept of ethical investments were identified as interesting alternatives in contrast to the focus
on Islamic financial services, only. In an international context it was assessed that only the United
Kingdom and Switzerland might play a major role in the global Islamic financial service industry
given their establishment as international financial centers in investment and private banking.
xii
Nevertheless it appears promising for German financial institutions as well as for those from other
European countries to invest in Islamic financial product offerings targeted to Muslim majority
countries, for example the Gulf Cooperation Council, in order to attract funds for the domestic
market.
Introduction
1
Introduction
It is unusual for the Western world to make the financial system subject to religious
prescriptions. The conviction that religious and worldly affairs need to be separated especially
when it comes to economics and politics is deep-seated. People from secular states look skeptical
to Muslim majority countries like Saudi Arabia or Pakistan having a state religion. Believers there
respect increasingly the principles of Islamic law (Shariah) when handling financial matters.
Following many years of conventional banking, Muslims show more an more interest for
investment and financing possibilities that are in compliance with their faith. This development
supported by privately or state-owned financial institutions, Shariah scholars as well as
governmental and non-governmental organizations, initiated the dynamic growth of the Islamic
financial service industry that was observable in the recent decades. But not only in Muslim
majority countries has the trend gained importance. Several market players in established
European financial centers cater the rising demand for Shariah compliant services providing know
how and innovative solutions. The United Kingdom became the most important Western Islamic
financial centre and home to the first fully-fledged European Islamic banks as well as to numerous
conventional banks offering Islamic financial services (Islamic Windows). This development was
actively fostered by governmental authorities. Apart from foreign customers, industry experts
suggest European financial institutions to target the large local Muslim minorities (for example in
France or Germany) by providing respective offerings. This approach would foster the financial
inclusion as well as the overall integration of these customer groups in European societies. But not
only Muslims could be in the focus. Facing the severe financial crisis experienced in these days
fostered by highly-leveraged financial contracts and non-transparent investments, the banks’
customers call for more transparency, credibility and moral behavior. These values are inherent in
the Shariah compliant banking system in which all products and services are based on assets in
order to foster economic development and trade. Therefore it is reasonable to encourage
European financial institutions to offer financial products and services to the domestic markets
that are in compliance with the Shariah. However it remains questionable whether such
approaches bear promising potential for success. Can we conclude from the success experiences in
the United Kingdom to other European markets?
Introduction
2
The research has two major targets. Firstly, a market overview of Shariah compliant financial
products and services offerings will be developed offered for selected European markets being the
United Kingdom, Switzerland, Italy and Austria. Thereby the domestic Muslim populations as well
as governmental and regulatorary reactions and initiatives are analyzed. Secondly, the German
domestic market potential will be scrutinized. Given the large percentage of people originating
from Turkey - mostly adhering to Islamic faith, a substantial demand for Islamic financial services
could be assumed. The thesis will investigate on characteristics and banking behavior of Muslims
living in Germany in order to give recommendations for domestic financial institutions. In this
context alternative concepts are mentioned to target Turkish migrants separately without
offerings Shariah compliant financial products or to offer ethical investments without reference to
Islamic faith.
Within the course of this research major European financial institutions were approached with
the purpose to gain information about their activities in the field of Islamic banking and finance.
Answers could be retrieved from four German institutions being the Deutsche Bank, the
Commerzbank, Allianz Global Investors as well as a German federal state bank. Furthermore
representatives of the Gatehouse Bank, one of London’s newly established fully-fledged Islamic
banks, and of Credit Suisse participated in the survey. The questionnaires and interview guidelines
were designed to investigate on current and planned Shariah compliant product offerings,
obstacles observed and estimations for future trends. In the case of Germany and Italy the results
were confronted with opinions expressed by the Islamic financial industry experts Zaid el-
Mogaddedi and Alberto Brugnoni. Additionally, already conducted market surveys, working papers
and online information were used to form a comprehensive view on the subject.
The basis for the market analyses will be a literature review in the first chapter describing the
theoretical background of the Islamic financial service concept. In this respect some remarks are
made to development and status in Muslim majority countries.
1. Foundations and Basic Principles of Islamic Banking
3
1. FOUNDATIONS AND BASIC PRINCIPLES OF ISLAMIC BANKING
The Islamic economic system differs substantially from the Western conventional, capitalistic
one as it is goes beyond the pure financial and economic sphere. Its most important foundations
are the Islamic religion and the Shariah – the Islamic law- providing a religious framework as well
as social and ethical boundaries for Islamic finance and banking activities. (Gassner and
Wackerbeck 2007, 20 and 21)
1.1. ISLAMIC LEGAL AND ECONOMIC SYSTEM
The Islam is not only a religion but a “codification of general standards of behavior that reach
far beyond the contents of belief” (Gassner and Wackerbeck 2007, 21). It declares a holistic
approach to life as it regards economy, politics, social aspects and religion as closely interlinked.
(Gassner and Wackerbeck 2007, 21) “Concomitant with the statement of Islamic faith, the
individual agrees to observe the rules of Islamic law (Shariah) in private and public affairs.” (Iqbal
and Mirakhor 2007, 5) This applies also to financial matters. In this respect “believers are expected
to respond with enthusiasm to banks that offer products that respect Islamic principles of finance”
(Jaffer 2005, 31). For practical reasons, there exists a doctrine of necessity that allows Muslims to
make use of conventional banking products if adequate Shariah-compliant alternatives are not
offered (principle of Daruah). (Jaffer 2005, 31) However, after several decades of conventional
banking, people in Muslim majority countries and other parts of the world, demand increasingly
investment and financing possibilities that comply with their faith. This development gave rise to
the current dynamic growth of the Islamic financial service industry (please refer to chapter 1.5.).
1.1.1. Shariah and Fiqh
The Islamic legal system is based on Shariah and Fiqh.
Shariah can be translated as “the way to the source of life” (Algaoud and Lewis 2007, 38) and is
used to denominate a legal system which promotes a certain code of behaviour described by the
Holy Qur’an and the Hadithe (the authentic tradition). It includes a set of duties and pracitices
such as prayer, manners and morals, marriage etc. (Algaoud and Lewis 2007, 38) The Holy Qur’an
is the “Divine Books revealed to Prophet Muhammad” and is referred to as “guidance for
mankind” (Iqbal and Mirakhor 2007, 10 and 14). “As such it does not rely on the authority of any
earthly lawmaker.” (Algaoud and Lewis 2007, 38) Additionally to the Holy Qur’an, the Shariah is
1. Foundations and Basic Principles of Islamic Banking
4
based on “judgments given by the Prophet himself, reflecting the application of rules, principles
and injunctions already enunciated in the Holy Qur’an” called the Hadithe2 (Algaoud and Lewis
2007, 38). In practice there is “no universality of Islamic law [Shariah]” (Lewis and Algaoud 2001,
39) as it is applied adhering to the principles of “analogical reasoning” and “independent human
reasoning of those specialized in law”. The former is based on analogies existing between new
problems and those existing in primary sources, such as the Holy Qur’an and the Hadithe.3 (Iqbal
and Mirakhor 2007, 15). The latter refers to Shariah scholars, being experts in Islamic law, who can
interpret the Shariah themselves.4 Both principles result in a “great flexibility” (Iqbal and Mirakhor
2007, 15) in law making5.
Fiqh is the collection of all sources of law including Qur’an, Sunna2, Qiyas3 and Ijma4 and
constitutes the Islamic jurisprudence. It regulates the relationship between men and Allah
(Fiqh´Ibadah) as well as all aspects and relationships of men among each other (Fiqh Mu´amalat).
The latter comprises the regulation of commercial and financial transactions and financial
institutions. The Shariah gives important incentives according to religious beliefs whereas Fiqh
adjusts to the pressure of society as it is subject to political influences and public opinions
(Bergmann 2008, 25).
In the Western basic understanding6, individual pursuit of economic profit maximization leads
simultaneously to profit maximization for the whole society. In contrast Muslim individuals have
not only to adhere to the Shariah principles but also “to keep in mind the impact of their activities
on others and the society of a whole” (Ayub 2007, 30). In this way they should consider the pursuit
of equality and brotherhood within the society of Muslims in every economic activity. (Gassner
and Wackerbeck 2007, 22) Trade and commerce are encouraged by the Holy Qur’an as long as
2 The Hadithe are in other literature sources referred to as “Sunna” (Bergmann 2008, 28 and Iqbal and
Mirakhor 2007,13 and 14)
3 The practice of analogical reasoning is in other literature sources referred to as „Qiyas“ (Bergmann 2008,
28)
4 The principle of independent human reasoning is in other literature sources referred to as “Ijmas”
(Bergmann 2008, 28)
5 These general principles result in inconsistencies in decisions of Shariah Supervisory Boards, discussed in
chapter 1.3.5.
6 For example according to the teachings of Adam Smith, who confessed that “an individual pursuing his
own self-interest tends to simultaneously promote the good of his community as a whole” (Kaufmann,
Smith and Krüsselberg 1984, 30).
1. Foundations and Basic Principles of Islamic Banking
5
they are honest and legitimate7. People should be able to “earn their living, support their families
and give charity to those less fortunate” (Lewis and Algaoud 2001, 27).
Islamic financing is based upon four root transactions which lead finally to the very important
concepts of partnership or profit and loss sharing. Furthermore there are five essential religious
principles that have to be obeyed (Lewis and Algaoud 2001, 27 and 28). These basic elements are
explained in the following subchapters in order to build a solid ground for the understanding of
the product and compliance structures in Islamic financial institutions.
1.1.2. The four root transactions and the concept of partnership
The four root transactions according to Shariah are sales (Bay), hire (Ijâra), gift (Hiba) and loan
(Ariyah) describing respectively the transfer of ownership, the transfer of the right to use, the
gratuitous transfer of ownership and the gratuitous transfer of the right to use. These basic forms
are applied to specific transactions such as pledge, deposit and guarantee and build the basis for
all transaction structures in Islamic finance. (Lewis and Algaoud 2001, 27)
The traditionally most accepted and most correct forms of Islamic financing are the profit-and-
loss sharing contracts: Mudaraba and Musharaka. According to Algaoud and Lewis (2007, 28) this
form of equity based financing is considered as the “backbone of Islamic banking practice” as it
represents the idea of the Holy Qur’an, namely that every investment should foster economic
development by providing capital to companies and infrastructure projects (Gassner and
Wackerbeck 2007, 67). As can be derived from the name, profits and losses are shared between
the creditor and the borrower on a predetermined basis. Consequently it is considered as a
“return-bearing” contract in contrast to an “interest-bearing” contract in conventional banking
(Mirakhor and Zaidi 2007, 49). The two basic concepts Mudaraba and Musharaka and will be
explained in section chapter 1.2.1.
1.1.3. Religious principles guiding investment behavior
As already mentioned before there are certain key assumptions that distinguish Islamic Finance
essentially from conventional financing activities. The four most important principles are described
below.
7 The Islam prescribes further ethic an moral standards to be obeyed, such as “justice and fair dealing,
gentleness, fulfilling of covenants and paying liabilities, mutual cooperation and removal of hardship, free
marketing and free pricing, freedom of Dharar (detriment)” (Ayub 2007, 64-70).
1. Foundations and Basic Principles of Islamic Banking
6
1.1.1.1. Riba – the prohibition of interest
The issue of Riba is the most controversial and, at the same time, the most far reaching aspect
in the Islamic financial system. Its interpretation is subject to many debates around the world8. It
can be translated into English as “increase”, “access”, “growth”, “addition”, “usury” (Algaoud and
Lewis 2007, 42) or simply “prohibited gain” (Ayub 2007, 47). A common consensus about the
actual sense has not been reached yet. Most Islamic scholars agree that the Holy Qur’an prohibits
the payment and taking of any interest (for the detailed Qur’an content please refer to Appendix
A1). Some more liberal experts argue that only “usury” in the sense of exorbitant, excessive
interest should be banned (Algaoud and Lewis 2007, 42f.). The latter opinion was followed by
believers of Hinduism, Judaism and Christianity, too. (Lewis and Algaoud 2001, 64). Over the years
the prohibition lost its importance in the other world religions. In the Muslim world there is a
substantial difference between profits resulting from entrepreneurial activities and profits
generated by granting loans. The latter is defined as “receiving a monetary advantage without
giving a counter value” (Algaoud and Lewis 2007, 42) and is therefore forbidden according to the
Holy Qur’an. It declares that those who take Riba are at war with God and his Prophet Muhammad
because Riba deprives the wealth of God’s blessing and encourages the wrongful appropriation of
property belonging to others and harms Muslims’ welfare. In transactions only the principal should
be paid and in case the counterparty is unable to pay it should be forgone. (Lewis and Algaoud
2001, 28 and 29)
There are several subcategories of Riba to be considered. The most high-level distinction can be
drawn between Riba Nasiah and Riba Al-Fadl. In conventional banking the borrower is charged for
the time it takes to redeem the loan. Therefore an increase on the original principal is paid.
Shariah scholars do not regard this time period generating the interest as an asset constituting
value (Gassner and Wackerbeck 2007, 27). Riba Al-Nasiah relates to all forms of money-to-money
exchange “provided the exchange is delayed or deferred and additional charge is associated with
such deferment” (Iqbal and Mirakhor 2007, 55). All profits, fixed in advance, resulting from
granting a time delay in the redemption of loans are not-admissible as no “counter value” is given
(Algaoud and Lewis 2007, 42). The second form Riba Al-Fadl is involved in barter exchanges (or
hand-to-hand exchanges). It is required that “commodities are exchanged for cash instead of
8 Some popular revisionists’ views are outlined in Algaoud and Lewis 2007, 44ff.
1. Foundations and Basic Principles of Islamic Banking
7
barter since there may be differences in the quality of the goods” (Iqbal and Mirakhor 2007, 56) so
that an “unjust increase, being Riba” (Iqbal and Mirakhor 2007, 55) could emerge.
In Figure 1 the main characteristics of the prohibited Riba are summarized. Interest should not
be equalized with the rate of return which is the profit or loss generated by a business activity.
(Algaoud and Lewis 2007, 46) The most important difference between interest and rate of return
is that the latter is neither guaranteed nor predetermined and can turn negative if the business
activity generates losses. It is the classical outcome of a partnership contract (as described in
chapter 1.2.1). (Algaoud and Lewis 2007, 46)
Figure 1 Definition of Riba (according to Iqbal and Mirakhor 2007, 56)
As in most Muslim countries both conventional and Islamic financial institutions operate in a
so-called “mixed system” (please refer to 1.5.2), the respective Muslim governments “have
legislated for, or tacitly approve, role of interest within their economies” (Lewis and Algaoud 2001,
39).
1.1.1.2. Maysir and Gharar – The prohibition of gambling and
transactions involving speculation
The “unjustified enrichment through games of pure chance” (Algaoud and Lewis 2007, 40) in
order to “amass wealth without effort” (Lewis and Algaoud 2001, 30) is called Maysir or Qimar
(the Arabic terms are used identically) and forbidden according to the Holy Qur’an. Maysir is
involved in contracts where the ownership of a good depends on the occurrence of a
predetermined, uncertain event in the future. In other words there will be a definitive gain for one
o Riba defines an interest rate.
o Riba is always positive and fixed ex-ante.
o Riba is tied to the time period and the amount of the loan.
o The payment of Riba is guaranteed regardless of the outcome
or the purposes for which the principal was borrowed.
o The collection of Riba is enforced by the state apparatus.
1. Foundations and Basic Principles of Islamic Banking
8
party and a definitive loss for the other party, but when the contract is signed it is not sure who
will be the winner or the looser. (Gassner and Wackerbeck 2007, 31) The Qur’an tells about this
principle among others in verse 219 which states:
“They ask thee concerning wine and gambling. Say: ‘In them is great sin and some benefit
for people; but the sin is greater than the benefit’.” (4:219) (Ayub 2007, 62)
According to Lewis and Algaoud (2001, 39) Gharar means “to undertake a venture blindly
without sufficient knowledge or to undertake an excessively risky transaction”. Consequently
every contract that is built on speculative assumptions is void. Transactions containing excessive
risk are supposed to foster uncertainty and fraudulent behavior. However minor uncertainties and
a certain degree of risk are permitted as it is involved in every economic activity. A clear definition
to which extent risk taking is Halal9 does not exist. (Ayub 2007, 58)
In an economic context the ban of Maysir and Gharar has particular relevance for financial
markets notably the derivatives market and the insurance business. As a derivative financial
instrument speculates in general on the development of its underlying value (for example in future
contracts or short-selling transactions) the concept of Gharar applies (Algaoud and Lewis 2007,
40). Therefore the trade of all conventional derivate instruments is impossible in Islamic finance.
The current lack of Shariah compliant derivatives is critical (please refer to 1.2.4.3 for Islamic
derivatives and to 1.4 for Risk and Liquidity Management of Islamic banks). Consequently market
participants invest considerable efforts in developing Shariah compliant derivative instruments. In
the same way Maysir and Gharar influence to a large extent the Islamic insurance business.
According to Shariah scholars, the Western style insurance products comprise Gharar and Maysir
(for explanations please refer to 1.1.4.).Therefore Islamic insurance companies have to change
their business model accordingly and offer Takaful, a mutual insurance product.
1.1.1.3. Halal and Haram – Code of “ethical investment”
As already mentioned in the beginning of chapter 1.1, there exist several ethical and social
criteria for exclusion regarding the investment targets and financial products allowed for Muslims.
The forbidden and not admissible actions and businesses are called Haram whereas legal and
permitted activities are referred to as Halal. Neither private investors nor companies or banks are
9 The concept of Halal is defined later in this chapter. It describes permitted transactions or goods in
contrast to Haram, meaning prohibited or wrong transactions or goods.
1. Foundations and Basic Principles of Islamic Banking
9
allowed to invest in Haram businesses dealing with, for instance, “alcohol, tobacco, pork-related
products, […], gambling, cinema, pornography, music and suchlike” (Khan and Bhatti 2008, 59).
This “ethical investment” code has to be strictly obeyed and even firms that conduct only small
parts of their business in the pre-mentioned Haram domains are excluded10 (Khan and Bhatti
2008, 59). Another industry that is affected by the code and cannot be target of investment is the
financial service industry. As already described before, Riba is condemned by Muslim scholars
(please refer to 1.1.1.1). Thus, securities issued by banks and insurance companies that operate in
the conventional, interest-based financial system are not admissible for Muslim investors.
Furthermore it is forbidden to invest in companies that are debt-ridden. (Bergmann, 2008, 37 and
38) These Shariah requirements are of special importance in stock investment and Islamic mutual
funds. In order to separate Halal investments from Haram stocks, a sophisticated screen process
has to be executed (please refer to chapter 1.2.4.1.).
1.1.1.4. Zakat –The social duty to benef it society
In Islam, wealth is regarded as a trust from God and should therefore take over a social duty in
order to benefit society. It is an obligation for the Islamic state to guarantee a fair standard of
living (called Nisab) to its people and to balance social imbalances. The most important
mechanism in this context is Zakat (Lewis & Algaoud, 2001, 29). It is one out of the five pillars of
Islam11 and constitutes a religious levy or almsgiving required in the Holy Qur’an (Algaoud and
Lewis 2007, 40). In consequence approximately “2.5 percent assessment on assets held for a full
year (after a small initial exclusion, the Nisab)” has to be dispensed (Lewis & Algaoud, 2001, 29). In
particular, Islamic financial institutions have to establish a Zakat fund to collect and redistribute
Zakat to the deserving poor, either directly or via religious institutions. The concerned assets
include initial capital, reserves and profits. (Lewis & Algaoud, 2001, 29 and 30) The calculation and
payment of the Zakat is overseen by the Shariah Supervisory Board (please refer to chapter 1.3).
(Iqbal and Mirakhor 2007, 289)
1.2. ISLAMIC FINANCING TECHNIQUES AND PRODUCTS
Islamic banking and finance was developed in the first place to finance trade and commerce (in
compliance with the Shariah) and consequently to foster the economic development in the
10
According to the common opinion in the literature reviewed a business activity up to 5 percent in Haram
businesses is allowed. 11
The Five Pillars of Islam can be found in the Appendix.
1. Foundations and Basic Principles of Islamic Banking
10
respective countries (please refer to chapter 1.5.1). Nowadays the financing of private
investments is also a huge market (for instance home financing), however originally it was
forbidden to take loans for private persons as it would encourage them to “live beyond their
means” (Altundag & Nadia, 2005, 48).
Each Islamic financing technique is based upon either of two basic principles. These are “profit
and loss sharing” and “mark-up” (also referred to as “cost-plus financing”). The profit and loss
sharing technique is used for equity-based financing modes as the bank invests directly in business
ventures and participates in generated profits or losses. In contrast the mark-up technique is
applied in debt-financing techniques as the customer appears as debtor to the bank, paying the
original purchase price of a commodity plus a predetermined mark-up.
In the following the structures of both financing techniques are described and examples for
implementation are given. It has to be mentioned that the nomenclature of Shariah compliant
products is not uniform. For this reason it is possible that some of the products presented below
are named differently depending on the literature. The list is not exhaustive and points out only
some of the most popular examples of Islamic financial products.
1.2.1. Equity-based financing techniques
Equity-based financing modes in Islamic banking constitute the ideal form of financing for
Shariah scholars as the bank participated directly in the business venture and forms together with
the entrepreneur a partnership. Therefore the two forms presented below are known as “twin
pillars of Islamic banking” (Lewis and Algaoud 2001, 45). It is referred to as “variable return
financing” because the return cannot be determined in advance but only the ratio of participation
in profit or loss generated (Dar 2007, 85). However for the banks the following techniques are the
most risky ones and they “show strong preference for other less risky modes” (Lewis & Algaoud,
2001, 48) (please refer to chapter 1.4.2).
1.2.1.1. Mudaraba
The Mudaraba contract is a two tiered transaction for an Islamic bank. On the asset side it
provides money, for example for an entrepreneur called “Mudarib”, and finances its project as so-
called “Rabb al-mal”. As such it possesses all assets but does not have any active part in the
enterprise. At the end of the contract the investment is redeemed by the entrepreneur and the
1. Foundations and Basic Principles of Islamic Banking
11
bank participates in the generated profit on a predetermined basis. However if the project fails it
participates simultaneously in the losses and can, in the worst case, lose all its investment (but not
more). The entrepreneur manages the project and provides his economic and technical knowhow.
He is liable to the bank in case of gross negligence and might lose his income. As he has not
invested capital, his financial damage will be very limited (Mirakhor and Zaidi 2007, 49 to 52 and
Gassner, and Wackerbeck 2007, 63). The funds used by the bank are usually held in trusteeship
from savings or investment account holders, i.e. depositors (liability side). The depositors share in
turn the profits and losses experienced by the bank and thus participate in the earnings of the
projects or companies the bank has invested in. To come to full circle their rate of return depends
from the real sector and cannot be considered as interest (please refer to chapter 1.1.1.1)
(Mirakhor and Zaidi 2007, 51 and 52). As the bank only provides capital but no management
expertise this form of financing is also called “Qirad”, to be translated as “dormant partnership”
(Lewis and Algaoud 2001, 27 and 28). The mechanism of a Mudaraba contract between a bank and
a company (i.e. the asset side) is shown in Figure 2.
Figure 2 Example of a Mudaraba transaction from Gassner and Wackerbeck (2007, 64)
1.2.1.2. Musharaka
The Musharaka partnerships are very similar to the Mudaraba form however in contrast to the
former both, entrepreneur and bank, provide capital for the project and form de facto a kind of
Joint Venture. Both partners have the rights (but not the obligation) to participate in the
management and share profits according to a predetermined ratio and losses in proportion to
their respective capital invested. Consequently both have the incentive to invest wisely and should
1. Foundations and Basic Principles of Islamic Banking
12
have an active interest in the investment (Mirakhor and Zaidi 2007, 51). In order to illustrate the
structure of a Musharaka partnership, please refer to Figure 3.
Figure 3 Permanent Musharaka transaction from Gassner and Wackerbeck (2007, 67)
Subcategories of the Musharaka contract can be differentiated according to the duration the
bank’s engagement in the venture:
Permanent Musharaka
The duration of the contract is unlimited until one party resigns the contract or the project is
liquidated. This form of financing is designed for long-term financial investment of the bank.
(Altundag and Nadia 2005, 54)
Diminishing Musharaka
In contrast to the permanent Musharaka, the bank’s engagement is reduced over time and
another party (usually the entrepreneur) buys the bank’s shares to a higher price than the original
value. Hence the bank commits to a short or medium term investments and receives a profit out
of the difference between original share value and received price (Altundag and Nadia 2005, 54).
The diminishing Musharaka structure is used for example in house financing. (Gassner and
Wackerbeck 2007, 89)
For both Mudaraba and Musharaka contracts, the profitability of Islamic banks is directly linked
to their physical investments. This is the main difference to conventional banks who earn interest
on the loans they provide irrespective of the profitability. Therefore Islamic banks are more likely
1. Foundations and Basic Principles of Islamic Banking
13
to demand a continuous, complete flow of information from their counterparty which might lead
to higher transparency and stability. They tend to be more interested in stable long-term
relationships with their clients. (Mirakhor and Zaidi 2007, 49) According to Bergmann (2008, 38)
these forms of equity financing fosters the better understanding and monitoring of the business
and involved risks from the bank’s side. However Gassner and Wackerbeck (2007, 67) argue that
the current use of equity-based forms in Islamic finance is very low (approximately 5 percent on
the asset side in Islamic banks). This is mainly due to the high risk involvement of the banks, an
obvious principal-agent problem12 and the increasing innovation in the Islamic finance industry
evolving debt-based instruments, leasing forms and efficient capital market instruments (please
refer to the chapters 1.2.2, 1.2.3 and 1.2.4).
1.2.2. Debt-based financing techniques
In contrast to the techniques described above, debt-based financing is referred to as “fixed
return financing” (Dar 2007, 85) based on the “mark-up” or “cost-plus” concept.
In order to visualize the structure and its implication the most popular financing instrument,
Murabaha, is outlined below. It is used as basis in 70 to 80 percent of all Islamic financing
transaction according to Altundag und Nadia (2005, 51) and Bergmann (2008, 50).
1.2.2.1. Murabaha
In Islamic banking business, loans to private and business clients have to be granted for a
specific purpose (for example to buy a specific commodity). In this way the Islamic bank purchases
the commodity from a third party on behalf of its client. Before reselling it to him it adds a
predetermined mark-up on the spot price constituting the return for its services. The client
redeems the amount either immediately or on a deferred payment basis-called “Murabaha-bi-
muajjal”. (Mirakhor and Zaidi 2007, 52 and Lewis and Algaoud 2001, 52) The mark-up is fixed in a
contract before hand and can not be changed during the duration of the contract. Therefore it is
to be clearly differentiated from interest at it is not linked to the duration but “computed on
transaction basis for services rendered” (Lewis and Algaoud 2001, 52 and 53). The bank bears an
associated risk as it owns the assets between purchase and resale. (Mirakhor and Zaidi 2007, 52)
12
If managers are agents of the financiers, called the principals, moral hazard might be involved as “the
managers […] may act in their own interest rather than in the interest of the principals” (Mishkin 2003, 193).
1. Foundations and Basic Principles of Islamic Banking
14
Figure 4 Murabaha transaction (own illustration)
In order to adapt the Murabaha concept to different customer needs, several variations exist.
Two of them are Salam and Istisnaa.
1.2.2.2. Bay Salam
According to the Shariah, goods cannot be sold if they are not yet in existence, at the time
when the contract is closed. The Salam contract constitutes an exception, provided strict rules are
adhered. It is mostly used in agricultural context and recently as Islamic alternative to
conventional derivatives (please refer to 1.2.4.3).
Following this transaction, the bank purchases the goods (for example the yield of a farmer) in
advance before they are produced. It pays the full purchase price immediately to the farmer as
soon as the contract is closed (please refer to Figure 5). Therefore both parties have an advantage.
The farmer receives capital from the bank, immediately and the bank buys the crop at a good price
and can resell it for a profit on the market. (Bergmann 2008, 56)
Figure 5 Salam transaction (own illustration)
The quality and quantities of the goods to be sold, the date and place of delivery and the
purchase price have to be exactly determined in the contract. The deal can not be closed if the
provision of the goods is uncertain. (Altundag und Nadia 2005, 59 and 60) Furthermore it has to be
about “homogenous goods” (Gassner and Wackerbeck 2007, 57) which are not characterized by
1. Foundations and Basic Principles of Islamic Banking
15
special features that could make it difficult to find a substitute. The contract is binding. In this way
that the seller (farmer) has to buy the goods on the market if he is not able to provide them at the
agreed date. (Gassner and Wackerbeck 2007, 57) Usually the Islamic financial insitutions tries to
resell the goods immediately as it does not want to be in the physical possession of it.
Consequently they might enter a parallel contract. Either the goods are resold to the original seller
or to a third party for a higher price than the purchase price, so that the Islamic financial
institutions makes a profit. (Bacha 1999)
1.2.2.3. Istisnaa
The Istisnaa contract can be seen as subcategory of Salam, designed for a special purpose, such
as the financing of manufacturing on contract or for project financing. (Bergmann 2008, 59)
The structure becomes obvious using an example from Gassner and Wackerbeck (2007,59): A
customer approaches the Islamic bank because he needs a specific good (for example a machine),
which is not yet produced and which he cannot pay immediately. After the Istisnaa contract is
closed, the bank assigns a respective supplier with the production of the machine according to the
specifications of its customer. The manufacturer receives a first installment from the bank at the
start and further payments as the production advances until the machine is finished. Subsequently
the machine is handed over to the bank and later on to the customer who pays the purchase price
plus a predetermined margin to the bank in regular installments after he has received the good.
Additionally to Salam and Istisnaa there exist further forms of contracts that are based on the
Murabaha concept (for example Arbun) which will not be explained in the context of this paper.13
1.2.3. Leasing
In chapter 1.1.2 “the transfer of the right to use” (Ijarah) was mentioned as one out of four root
transactions in Islamic banking. Ijarah contracts are quite similar to the conventional concept of
leasing, however some aspects are different in order to avoid Riba and Gharar (please refer to
chapters 1.1.1.1 and 1.1.1.2). They are very popular with Islamic financial institutions and can be
found in the structures of the most innovative structures (please refer, for example, to Ijarah
Sukuk in chapter 1.2.4.2) owing their great flexibility. In one of the largest Islamic financial centres,
Malaysia, 31.6 percent of the total Islamic financing activities in 2005 was based on the Ijarah
13
Further information can be retrieved from for example from Gassner and Wackerbeck (2007, 53 to 63) or
Lewis and Algaoud (2001, 55 to 59).
1. Foundations and Basic Principles of Islamic Banking
16
concept14. (Bank Negara Malaysia 2005) As described below the bank owns the assets until the
end of the lease term at least. Even if the lessee fails to pay the rental payments, the bank still can
sell the asset on the market easily. Additional to the pure Ijarah contract, the further development
Ijarah wa Iqtina exist.
Pure I jarah
Core of the Ijarah contract is the sale of the “Manfa’a”, the right to use an asset, for a specific
period. The goods are bought by the Islamic bank from a third party. Afterwards they are leased
out to the clients who pay rental fees for their use (please refer to Figure 6). The bank, as lessor,
bears the risk as it is the owner of the assets. Consequently it is responsible for maintenance and
insurance.
Figure 6 Pure Ijarah transaction (own illustration)
The leased asset must have a productive usage (for example building, aircraft, car) and the rent
is pre-agreed for the whole period, in order to avoid speculation. (Mirakhor and Zaidi 2007, 52)
However the terms of the lease payment can be renegotiated at agreed time intervals so that the
bank can react to major market developments. (Bergmann 2008, 64) The pure Ijarah transaction
can be compared with the conventional operating lease contract. (Lewis and Algaoud 2001, 56)
I jarah wa Iqtina
In the pure Ijarah contract (refer to the chapter above) the lessee has not option to buy the
asset at the end of the lease term. In the Ijarah wa Iqtina, to be translated as “hire and purchase”,
he has. (Mirakhor and Zaidi 2007), 52) Consequently the ownership is transferred to the lessee
after the term of the contract when all rental payments have been made. Up to this point of time,
14
The Annual Report states further that only 0.3 percent was based on Mudaraba and Musharaka contracts
and the Mudaraba principle was applied in 6.9 percent of the cases. (Bank Negara Malaysia 2005)
1. Foundations and Basic Principles of Islamic Banking
17
the lessor bears all risks for possible losses or damages regarding the lease asset, except they are
caused by gross negligence of the lessee. (Gassner and Wackerbeck 2007, 69) The Ijarah wa iqtina
contract is similar to a financing lease arrangement in the conventional system. (Lewis and
Algaoud 2001, 56)
1.2.4. Capital market instruments
Due to the infancy of the Islamic financial industry the number of Shariah-compliant capital
market instruments is very small compared to the conventional market. However numerous
product innovations have been developed in the last decades in order to create competitive
products for private and business customers as well as for the Islamic financial institutions
themselves. To give some examples, this chapter will focus on Islamic stocks, mutual equity funds,
Sukuk and Islamic derivatives.
1.2.4.1. Islamic stocks and equity funds
Investment in shares is very interesting for Muslim investor as no element of Riba (please refer
to 1.1.1.1) is involved in contrast to other capital market instruments, like bonds for example.
From the point of view of Shariah scholars, equity shares are preferred instruments because the
capital is provided for productive purposes and the shareholder participates directly in the
entrepreneurial success. However investment targets have to be filtered following two processes:
the “industry screen” and the “financial-ratio screen”. (Dow Jones Indexes 2008)
Industry screen
Firstly there exist restrictions regarding the industry in which the target company operates.
According to the code of ethical investment that distinguishes between Haram and Halal
investments (please refer to 1.1.1.3), Muslims are only allowed to invest in shares of Halal
businesses. The Dow Jones Islamic Market Index (presented later in this chapter) that constitutes a
major benchmark in the Islamic financial service industry summarizes on its homepage Haram
businesses that are excluded for stock investments (Dow Jones Indexes[2] 2008):
“Excluded from the indexes are producers of alcohol and pork-related products, providers
of conventional financial services (banking, insurance, etc.) and providers of
entertainment services (hotels, casinos/gambling, cinema, pornography, music, etc.).
1. Foundations and Basic Principles of Islamic Banking
18
Tobacco manufacturers and defence and weapons companies, although not strictly
forbidden for investment under Islamic Law, are excluded from the indexes as well.
Financial -ratio screen
As soon as a stock passed the industry screen its financial parameters are scrutinized.
Firstly the debt to equity ratio15 has to be lower than 33 percent. Secondly the percentage of
cash and interest bearing securities has to be lower than 33 percent in reference to market
capitalization. The same is true for the relation between accounts receivables and market
capitalization. (Dow Jones Indexes 2008)
Due to complexity of modern companies, in cannot be avoided that firms are to a very limited
extend active in Haram businesses. Therefore more liberal Shariah scholars argue that the ratio of
Haram business in relation to total revenues must not exceed 5%. However this ratio is
controversial and not applied by all Shariah Supervisory Boards. (Gassner and Wackerbeck 2007,
128)
As can been seen from both the industry and financial-ratio screen it is rather complicated for a
private investor to find a Shariah-compliant investment. Therefore Islamic equity indices are very
popular as the screening processes are executed by professional firms and supervised by a Shariah
supervisory board. The major Islamic equity indices are the Dow Jones Islamic Market Index series,
the Standard and Poor’s Shariah Indices and the FTSE Global Islamic Index Series. Many Islamic
funds as well as private and business investors align their portfolio with these indices.
Is lamic equity funds
Islamic equity funds can be structured in two ways- either as a Mudaraba partnership (please
refer to 1.2.1.1) or according to the Wakala model16. In both cases a Shariah Supervisory Board has
to supervise the Shariah-conformity of the investment decisions and the investment companies
operations.
15
The debt to equity ratio is calculated by dividing the total debt by the 12-months average of equity capital
or the firm’s market capitalization. (Dow Jones Indexes 2008) 16
Literally Wakala means “looking after, taking custody” (Ayub 2007, 347) and describes an agency contract
in Islamic finance.
1. Foundations and Basic Principles of Islamic Banking
19
In the first case the investment company is the Mudarib and the shareholders assume the role
of the Raab-al-mal. The remuneration for the investment company is taken from the generated
profits and variable depending on the result. If the fund generates a loss, it is passed on to the
shareholders and the investment company receives nothing. (Gassner and Wackerbeck 2007, 134
and 135 and Ayub 2007, 201)
Figure 7 Islamic equity fund based on Mudaraba partnership from Gassner and Wackerbeck 2007, 135
In the second case the investment company operates as an agent for the shareholders and
agrees on fix remuneration in advance (absolute or percentage of the fund volume). This has to be
approved by the Shariah Supervisory Board and disclosed in the fund prospectus. Furthermore this
concept is consistent with the conventional equity fund. (Gassner and Wackerbeck 2007, 136)
There are several other categories of Shariah compliant funds in existence for example Ijarah
funds, commodity funds, Murabaha funds or mixed funds. (Ayub 2007, 201) At present
approximately 350 islamic funds are issued, the majority of them being equity funds. (Gassner and
Wackerbeck 2007, 136) Detailed numbers can be retrieved from chapter 1.5.3.
1.2.4.2. Sukuk
“Islamic finance is diversifying as banks develop a new range of products in compliance with
Shariah law.” (Middle East Economic Digest 2007) In this development Sukuk17 evolved and gained
increasingly importance as innovative Shariah compliant financing instruments. In principle they
are participation certificates based on an approved underlying asset (for example a building, hire
17
The term Sukuk is the plural form of the Arabic word “Sakk” translated as certificate or bond.
1. Foundations and Basic Principles of Islamic Banking
20
cars, oil or gas pipelines) for specified financial consideration. For this reason they can be regarded
as asset backed securities. (Middle East Economic Digest 2007) However it is to be clearly
differentiated from conventional bonds as the latter present an debt to the issuer only, whereas
Sukuk represent “additionally an ownership stake in an asset or project” (Mirakhor and Zaidi 2007,
57)
Sukuk can be based on several Islamic commercial contracts. The categories that are most
common are Sukuk al-Murabaha (debt based), Sukuk al-Mudaraba (equity based), Sukuk al-
Musharaka (equity based), Sukuk al-Ijarah (debt based), Sukuk al-Salam (debt based), Sukuk al-
Istisnaa (debt based) and hybrid Sukuk forms. (el-Mogaddedi 2007)
As the Sukuk al-Ijara are among the most popular forms of Sukuk they will be taken as an
example in the following. The structure comprises the use of a specified asset through the lessee
whilst the ownership remains with the lessor. Mostly the former is the original owner of the asset
and enters a sale-and-lease back arrangement with a so-called Special Purpose Vehicle (SPV). The
leasing project could be a real estate investment, for example. In 2004 the German federal state
Saxony Anhalt carried out the first sovereign Sukuk issuance in Germany. This prominent example
of the “Stichting Saxony Anhalt Trust” which will be used to present the basic structure of a Sukuk
al-Ijara transaction.
Firstly Saxony Anhalt found a Special Purpose Vehicle, in this case the “Stichting Saxony Anhalt
Trust” which was established in the Netherlands for tax reasons. Subsequently Saxony Anhalt sold
some of its real estate property, mostly used by fiscal authorites, to this trust and entered
simoultanuously a leasing contract for a time period of five years in order to obtain the rights to
use back. The “Stichting Saxony Anhalt Trust” issued Sukuk amounting to € 100 million in 2004 on
the basis of the acquired real estate property. The Sukuk investors (60 percent originating from
the Gulf states and 40 percent from Europe according to Bergmann (2008, 113)) paid the € 100
million to the trust that forwarded the capital to the federal state. The latter payed predetermined
leasing rates based on the six months EURIBOR plus 1 percent. These payments were distributed
to the Sukuk investors according to the contracts signed. In most cases Sukuk can be traded on a
secondary market, provided there is sufficient liquidity. The transaction can be better
comprehended looking at Figure 8. After the period of five years, Saxony Anhalt may buy the real
1. Foundations and Basic Principles of Islamic Banking
21
estate property back (at a price fixed at the beginning of the lease term) and obtain the ownership
of the assets. In this case the Sukuk are redeemed at nominal value.
Figure 8 Transaction structure “Stichting Saxony Anhalt Trust” (aligned with el-Mogaddedi 2007 and
Bergmann 2008, 113)
In chapter 1.5.3 the rapid development of Sukuk issuances is described.
1.2.4.3. Islamic Derivat ives
Financial derivatives are financial instruments whose payoffs are linked to “previously issued
securities” (underlying) (Mishkin 2003, 337). These are for example forwards, futures, options and
swaps. (Brealey, Myers and Allen 2006, 727). In the conventional banking sector, derivative
instruments are extensively used for two reasons: hedging18 and speculation19. Whereas the
purpose of hedging is to reduce the bank’s and customers’ exposure to certain risks, speculators
“generate risk so that they can benefit from the increased return that risk brings.” (Institute of
Islamic Banking and Insurance[2] 2007) Due to the obvious involvement of Gharar and Maysir
(please refer to 1.1.1.2) all forms of speculation are regarded Haram (please refer to 1.1.1.3) in
Islamic finance and banking. Consequently the use of derivatives for speculation is not permissible.
18
Hedging is a mechanism for financial institutions and investors to protect themselves against different
kind of risks, such as currency or interest rate risk, by using financial derivatives. (Mishkin 2003, 337-339) 19
Speculation describes the activity of forecasting changes in process, for example in stocks, land,
commodities or currencies, with the purpose to make a profit or avoiding a loss. (Mishkin 2003, 340)
1. Foundations and Basic Principles of Islamic Banking
22
Hedging, however, is basically allowed for Islamic financial institutions as soon as the derivative
instruments and the underlying assets are structured and chosen in conformity with Shariah
requirements. (Gassner and Wackerbeck 2007, 153)
As already mentioned in chapter 1.4, adequate alternatives to conventional derivatives are very
rare in the young Islamic financial industry but substantial efforts are taken to fill the void.
(Institute of Islamic Banking and Insurance[1] 2007) In the context of derivatives the need for
innovation arises out of the unconformity of conventional derivatives with the Shariah in various
aspects. According to Gassner and Wackerbeck (2007, 154) the following features of conventional
derivatives contradict with Shariah requirements. Firstly the underlying asset is never delivered
and just a price difference, for example between spot and future market, is balanced. In this way
the contract is about a“fictious good” which contradicts the philosophy of Islamic banking,
namingly the promotion of commerce and trade. Secondly for many conventional derivatives both
payment and (fictional) delivery take place in the future. This is generally non-permissible for
Islamic finance contract as well as the trade of liabilities. Finally the evaluation of conventation
derivatives, like options for example, is often based on the interest-based models, such as the
Black-Scholes-formula (please refer to 1.1.1.1). Hence conventional derivatives cannot be used for
risk mitigation by Islamic financial institutions or Muslim investors.
However there are two general approaches to find a solution. On the one hand “a number of
instruments/ contracts exist in Islamic finance that could be considered a basis for derivative
contracts within an Islamic framework.” (Bacha 1999, 18). These are especially Bay Salam (please
refer to chapter 1.2.2.1) structures. On the other hand new Islamic products are developed, which
are not applied in practice so far, for example Khiyar and Istijrar. For both approaches the
admissibility is disputed by Shariah scholars. The Islamic Financial Services Board (please refer to
chapter 1.3.6.2) holds the following:
“For risk mitigation instruments (in particular, derivatives) such as the Islamic profit rate
swap, foreign exchange swap, forward (using the Salam principle), forward foreign
exchange (using the Wa`d principle), options (using the `urbun principle), futures contract
and Bay` al-Istijrar contracts, only half of the jurisdictions surveyed accepted these
contracts as Shari`ah permissible. The different Shari`ah interpretations among
jurisdictions – and among Shari`ah boards of IIFS – have also resulted in non-uniformity in
1. Foundations and Basic Principles of Islamic Banking
23
the acceptance and design of Shari`ah-compliant alternatives.” (Islamic Financial Services
Board[1] 2008)
In order to give an example for the application of traditional Islamic contracts as hedging
instruments, the use of the Bay Salam contract will be explained. For the basic understanding of
Bay Salam contract please refer back to chapter 1.2.2.1. In principle the structure can “closely
resemble forwards20” (Bacha 1999, 19) with the difference that the buyer of the commodity in the
first place, pays the full purchase price as soon as the contract is closed and not at the end of the
contract term. Another difference is that the “predetermined price is normally lower than the
prevailing spot price” (Bacha 1999, 18) because the buyer is compensated for the full payment in
advance so that he can resell the asset with profit. Whereas in a conventional forward contract the
forward price is usually higher than the spot price “by the amount of the carrying cost” (Bacha
1999, 18) In any case, for the purpose of hedging, parallel contracts are used as neither of the
parties want to be in the actual possession of the goods.
Conventional forex swaps21, for instance, can also be mirrored in Islamic finance by using a
synthetic Murabaha contract (please refer to 1.2.2.1). However it has to be mentioned that trade
with currencies is only allowed in the spot market according to the AAOIFI (please refer to 1.3.6.1)
in order to avoid Riba (please refer to1.1.1.1). Consequently only a one-side obligation to buy a
currency in the future are allowed to hedge currency risk. Such a transaction could be structured
as follows (example according to Gassner and Wackerbeck 2007, 157 and 158; please refer to
Figure 9): Party A sells platinum to its counterparty B which is worth $1000 today. The payment
has to be made in one year whereas A adds a 5 percent profit margin on the price, resulting in
$1050 due in one year. The counterparty B sells in turn aluminium to A, worth €750 today. As in
the previous transaction the purchase price is due in one year and a profit margin of 4 percents
charged, resulting in €780. At the currency spot market €1 costs $1,33. The metals are exchanged
immediately to fulfill the criteria of delivery today (however mostly they are directly sold to third
parties). After one year time the two amounts, $1050 and €780 are due as amounts receivables on
20
“A forward contract is an advance order to buy or sell an asset. The forward price is fixed today but
payment is not made until the delivery date at the end of the contract.” (Brealey, Myers and Allen 2006,
746) 21
“Forex swaps involve two transactions, an exchange of currencies on a given date and a reversal at a later
at a later date. They are typically of a short term nature.” (Jorion 2007, 221)
1. Foundations and Basic Principles of Islamic Banking
24
both sides and have to be exchanged. Thus they imply a certain forward exchange rate. In this
example around 1,35 $/ €.
Figure 9 Example for a mirrored Forex Swap transaction according to Shariah principles (own
illustration)
In this way market participants in the Islamic financial services industry try “to provide the
characteristics of conventional derivatives while still maintaining Shariah compliance “(Edwardes
2007). Solutions are often “proprietary and […] not generally openly available” leading to high
transaction costs and product development efforts for all market participants. (Edwardes 2007).
1.2.5. Funding operations and Accounts
Islamic retail banking is a very recent phenomenon and fostered by certain newly established
Islamic financial institutions, for example the Islamic Bank of Britain (please refer to 2.1.4.3). In the
following chapters, typical retail banking products like Islamic current, savings and investment
accounts are briefly described.
1.2.5.1. Current Accounts
Deposits in current accounts are guaranteed loans to the Islamic bank. These funds are held in
trust by the bank and can be used for its operations, as long as they are in conformity with the
Shariah. However these deposits cannot be invested in profit and loss sharing ventures by the
bank (in contrast to deposits of other accounts, please read below) as this might endanger the
customers’ deposits. As taking of interest is prohibited (please refer to chapter 1.1.1.1), the
depositor receives no remuneration. The money is hold according to either of the following
1. Foundations and Basic Principles of Islamic Banking
25
principles: “Al wadiah” to be translated as trust and safekeeping (Lewis and Algaoud 2001, 47),
“Qard hassan”, to be translated as good, interest free loan (Gassner and Wackerbeck 2007, 61) or
as a benevolent loan (Lewis and Algaoud 2001, 47).
Basically Islamic banks provide the same services in conjunction with current accounts like
conventional banks. These are, for example, the execution of bank transfers, the use of automated
teller machines (ATMs) with the help of debit cards or the provision of online banking facilities and
credit cards. Obviously Islamic banks are not entitled to charge interest on overdraft. In order to
compensate this problem, banks might charge a “penalty charge” which is a lump sum,
independent from the amount and duration of the overdraft. (Gassner and Wackerbeck 2007, 77
and 78)
1.2.5.2. Savings and Investment Accounts
Islamic savings and investment accounts are similar in their nature to their conventional
counterparts. In a savings account the customer makes a deposit at the bank and is guaranteed
the full repayment plus a small return. In investment accounts, however, the full repayment is not
secured but the return is usually higher. The major difference between conventional and Islamic
accounts is that the return (if paid) is not fixed in advance, as this would constitute interest.
For the savings accounts the already mentioned principle of “Al wadiah” can be extended by a
permission, granted by the depositor, that the funds can be employed at own risk. This guarantees
him full return and voluntary profit sharing in the return generated with the help of his funds. A
second possibility to realize a savings account is to treat the deposits as “Qard hassan” deposits
(please refer to chapter above) while the bank grants “pecuniary or non pecuniary benefits”.
(Lewis and Algaoud 2001, 47)
Investment accounts are realized on the basis of Mudaraba contracts. In this way the
depositors participates in the entrepreneurial risk resulting from the use of his funds in equity
participations. Thereby the bank acts as Mudarib and the depositor takes the role of the capital
provider Raab al mal (please refer to chapter 1.2.1.1). The returns generated are shared, according
to an agreement made in advance, between the bank and the depositor. However in case of a loss,
the depositor risks parts or all of his deposits. (Lewis and Algaoud 2001, 48 and Gassner and
Wackerbeck 2007, 80 and 81)
1. Foundations and Basic Principles of Islamic Banking
26
1.1.4. Takaful
“Analogue to the development of Islamic banks, Muslim economists have tried to find a
Shariah-compliant alternative to conventional insurance. In this way the so-called Takaful
insurance evolved.” (Gassner and Wackerbeck 2007, 144)
Given the increasing popularity and the high market growth rates in this segment (10 to 25
percent per annum according to Bergmann (2008, 102) and Ayub (2007, 428)), the Islamic
alternative to conventional (non-mutual) insurance products will be briefly explained in the
following focusing on the basic concept. In principle Takaful products are distributed by Islamic
banks which either promote their own takaful products or establish a separate takaful company.
Conventional insurance products are not Shariah-compliant due to the involvement of Riba,
Maysir, Gharar and an “invalid transfer of risk from the insured to the insurer” (Ayub 2007,419).
Firstly Riba (please refer to 1.1.1.1) is involved as the insurance companies usually invest the
capital in interest-bearing capital market instruments and secondly as soon as the amount insured
is exchanged against the amount of premiums, there emerges an excess of money on one side,
constituting Riba, too. (Ayub 2007, 419) Furthermore the insurer-insured relationship contradicts
with Shariah principles as “commercial benefit is involved on both sides for an uncertain event”
(Ayub 2007, 419), hence Gharar (please refer to 1.1.1.2). Assuming a life insurance one could also
detect elements of Maysir (please refer to 1.1.1.2) as the insured person “bets” on the fact that he
is still alive when the insurance contract term ends, so that he can enjoy the redemption. (Gassner
and Wackerbeck 2007,144 and 145 and Bergmann 2008, 100) In other words “the profit of one
party is dependent on the loss of the other” (Ayub 2007, 419).
The Islamic alternative to conventional insurance, called Takaful is based on the concept of
mutuality and a contributory agreement among the insured parties, similar to conventional
mutual insurance models. The International Monetary Fund (Solé 2007) explains:
“Several individuals agree to pool resources with the understanding that in case of
need, each of them is entitled to draw resources from the pool.”
In this way the Takaful concept is based on “shared responsibility, common benefit and mutual
solidarity” (Ayub 2007, 421). The pool mentioned above is a Takaful fund which might be
complemented by savings funds. The Takaful operator (either an Islamic bank or a Takaful
1. Foundations and Basic Principles of Islamic Banking
27
company) manages these funds and receives remuneration from the premium payers. The mode
of operation of the Takaful insurance depends on the underlying basic transaction (for example
Mudaraba or Wakalah) and the type of insurance (for example property insurance or life
insurance). (Ayub 2007, 422 and 423 and Gassner and Wackerbeck 2007, 145 and 146)
To take an example out of Gassner and Wackerbeck (2007, 147 to 149), a Takaful insurance
based on a Mudaraba transaction is assumed (please refer to Figure 10). In the first step the
insured persons pay their premiums in the Takaful funds in form of a donation (called Tabarru
concept). The Takaful operator administers these funds and withdraws resources needed for
potential damages of the insured, for Retakaful premiums for Islamic reinsurer and for distribution
costs. The fund and the operator close a Mudaraba agreement (please refer to 1.2.1.1), in which
the operator takes the role of a Mudarib, who is agent of the Takaful funds (Raab-al-mal),
responsible for the Shariah-compliant investment of the premiums. Consequently the annual
surplus is shared on a predetermined basis between the two parties whereas the operator
distributes parts of the results to the shareholders. In this way the operator has an incentive to
generate positive results and minimize risks. However the operator has the responsibility to
provide for the risk of a loss. Firstly reserves are accumulated in profitable years and secondly the
operator commits to provide interest-free loans (Qard hassan principle) to the funds to be used
for payment in cases of damage. According to Bergmann (2008, 100) a main difference to
conventional insurance products is that the insured person in a Mudaraba Takaful insurance
participates in the profits or losses generated by his/ her funds.
1. Foundations and Basic Principles of Islamic Banking
28
Figure 10 Takaful model based on Mudaraba transaction from Gassner and Wackerbeck 2007,
148
1.1.5. Use of Islamic financing techniques and products and profitability
In chapter 1.2.3 the utilization of different Shariah complaint contracts in the Malaysia Islamic
financial services industry was already indicated. On a global base Iqbal and Mirakhor (2007, 150)
note that “Murabaha (41 percent) has been the first choice of Islamic banks, followed by
Musharakah (11 percent), Mudaraba (12 percent), Ijarah (10 percent) and others (26 percent)”.
Being subject to several religious restrictions Islamic finance and banking products bear generally
higher risks. At the same time they should render the same return as conventional products in
order to stay competitive. Given the requirement that every contract must be based on assets,
transaction costs are significantly higher as well as monitoring costs, especially in equity contracts
(Iqbal and Mirakhor 2007, 150). Consequently it could be assumed that Islamic products and
services are more expensive, which might be partially accepted by Muslims who appreciate the
Shariah conformity. According to Gassner and Wackerbeck (2007,41) empirical researches have
shown that lower competitiveness of this product cannot be proven and Muslims and non-
Muslims alike are increasingly attracted by those offers. For example a high percentage of Chinese
(non-Muslims) in Malaysia buy Islamic financial products. However other sources indicate that it is
very difficult in practice to measure the performance of Shariah compliant products and the
efficiency of Islamic banks as adequate and transparent benchmarks are missing so far. At present
the LIBOR (London Inter Bank Offer Rate) is used generally, however it belongs to the interest-
based system. (Iqbal and Mirakhor 2007, 167)
Furthermore it has to be kept in mind that the industry is driven by high growth rates and rising
demand whilst institutions face few market pressure and competition. This situation might lead to
unrealistic assessments. In this way “some levels of inefficiency is compensated by the abnormal
initial profit margin” that might erode fast as more banks become active in this Islamic financing.
(Iqbal and Mirakhor 2007, 154)
Additionally to the special requirements for products and services offered by Islamic financial
institutions, the latter are challenged by further specifications resulting from Islam. In this way
they have, for example, to establish a second layer of governance and compensate the lacking
1. Foundations and Basic Principles of Islamic Banking
29
Islamic inter-bank market to manage their liquidity and risks. These aspects will be discussed in the
next chapters.
1.3. GOVERNANCE AND COMPLIANCE STRUCTURE OF ISLAMIC BANKS
The governance issues in Islamic banking differ substantially from those of the conventional
system. The main difference lies in additional key stakeholders that have to be considered in
everyday operation.
One out of two new stakeholder groups is, according to Algaoud and Lewis (2001, 163), the
Islamic Community. The Islamic bank has an “overriding obligation” (Lewis and Algaoud 2001, 163)
to obey Islamic law, being the Shariah. That implies that all products and services offered have to
be strictly Shariah compliant. The ideas of “Amanah” (trust) and stewardship play important roles
in this respect and should guide the operational practice of every Islamic financial institution. In
order to safeguard the compliance with the strict religious standards, each Islamic financial
institution is supposed to have a Shariah Supervisory Board as defined in chapter 1.3.
The second stakeholder group which is not present in conventional financial institutions
consists of Musharaka and Mudaraba partners (please refer to chapter 1.2.1.). The Islamic bank
captures the role of a management or dormant partner in a selected business venture and has
therefore different obligations and risks to bear.
These two stakeholder groups provide “strong justification for an additional layer in the
corporate governance of an Islamic bank” according to Voker Nienhaus (2007, 129), being the
Shariah Supervisory Board.
The Shariah Supervisory Board takes a “unique position in the governance structure of an
Islamic Bank” (Nienhaus 2007, 141). It acts as a religious supervisory board ensuring that the
bank’s practices and activities do not contradict Islamic ethics.
1.3.1. Shariah Supervisory Board standards
Until recently there was a lack of unique requirements and standards regarding the
composition, characteristics and functions of Shariah Supervisory Boards. However as the industry
grows, they are increasingly important in order to create a level playing field for all Islamic
financial institutions. By today, approaches to harmonize essential standards are taken by the
1. Foundations and Basic Principles of Islamic Banking
30
“Accounting and Auditing Organization for Islamic Financial Institutions” (abbreviated AAOIFI,
please refer to chapter 1.3.6.1). An increasing number of financial insitutions committs to the
“Accounting and Auditing General Standards for Islamic Financial Institutions ” (AAGSIF) issued by
the AAOIFI. (Gassner and Wackerbeck 2007, 48). The content of chapters 1.3.2 and 1.3.3 is aligned
with these standards in order to give a representative example of how the religious supervision in
Islamic banks is organized.
1.3.2. Characteristics of a Shariah Supervisory Board
For every fully-fledged Islamic bank it is obligatory to have a permanent Shariah Supervisory
Board. (Iqbal and Mirakhor 2007, 289) This religious committee is characterized in three features,
being the qualification of its members, their independence from the financial institution and the
binding nature of its decisions for the respective financial institutions (Gassner and Wackerbeck
2007, 33).
Qual i f ication
According to the AAOIFI (please refer to 1.3.6.1) a Shariah Supervisory Board should consist of
at least three Shariah scholars, who must have a comprehensive education in legal questions (Fiqh
Mu’amalat, please refer to 1.1) (Gassner and Wackerbeck 2007, 33). Traditionally the scholars’
reputation in public, achieved by excellent education and a high position in society, was most
decisive for their appointment (Altundag und Nadia 2005, 46). Today the financial expertise of the
Sharia Supervisory Boards members becomes increasingly important as they have to assess
financial instruments, products and processes that are becoming more and more complex
(Gassner and Wackerbeck 2007, 33). According to Gassner and Wackerbeck (2007, 33) there are
currently not more than fifty scholars worldwide who fulfill both of the prementioned
requirements. Often, one Sharia scholar holds several mandates in various Sharia Supervisory
Boards of different financial institutions and additionally in standard setting organizations like the
AAOIFI (Nienhaus 2007, 137 and 139). The shortage of adequate Scharia Scholars hinders the
development of this industry as religious supervision is one of the most important features in
Islamic banking. Consequently Islamic financial insitutions, non-governemental organizations and
governements of certain countries invest heavily in the education of new Sharia scholars. It is
common practice that the Sharia scholars are appointed by shareholders upon recommendation
1. Foundations and Basic Principles of Islamic Banking
31
of the board of directors. There are no specifications regarding the duration of a scholar
appointment. (Nienhaus 2007, 136 and 137)
Independence
It is essential for the credibility and reputation of the financial institution within the Muslim
community that the Sharia Supervisory Board is absolutely independent . Therefore its members
should neither have management positions nor important financial interest in the company (for
instance as a shareholder) in order to avoid conflicts of interest. (Algaoud und Lewis 2007, 41). The
Sharia Supervisory Board must not be “subject to instruction by management, board of directors
and shareholders” (Nienhaus 2007, 136). However the scholars are mostly employed by the bank
and “their remuneration is proposed by the management and approved by the board” (Iqbal and
Mirakhor 2007, 290). This employment status may affect the required unbiased opinion.
Binding nature of fatawa
As described later in this chapter the main function of a Shariah Supervisory Board is to certify
that the bank’s products and processes are compliant with Shariah precepts in order to give
believers the certainty to invest or deposit in accordance with their faith (Jaffer 2005, 216).The
scholars, being experts in Islamic jurisprudence (Fiqh Mu’amalat) are capable to issue their own
interpretation of Islamic law (Shariah) as described in chapter 1.1.1. This “authoritative legal
opinion” (Jaffer 2005, 216) of a Shariah Supervisory Board or single scholars is called “fatwa”
(plural form is “fatawa”) and absolutely binding for the financial institution. (Algaoud und Lewis
2007,39) Looking at Islamic banking practice in Europe, it is appearent that the fatawa are only
binding inside the financial instituion, (i.e. between the Sharia Supervisory Board and the
management) as the legal system in non-Muslim countries does not rule on Islamic law. (Gassner
and Wackerbeck 2007,34)
1.3.3. Functions of a Shariah Supervisory Board
According to Volker Nienhaus (2007, 136) the Sharia Supervisory Board is “entrusted with
directing, reviewing and supervising the activities of the Islamic financial institution, in order to
ensure compliance with Islamic Shari’a rules and principles”. These activities are referred to as
“Shariah Audit and Certification” and comprise the issuance of fatawa. The Sharia Supervisory
1. Foundations and Basic Principles of Islamic Banking
32
Board functions can be differentiated between a constitutive and an alternating or operative
function (Gassner and Wackerbeck 2007, 34).
The constituitve funct ion
Before a new Islamic bank can start operations, its Sharia Supervisory Board has to certify the
Sharia conformity of all products and internal processes. Afterwards the scholars should prepare a
report of compliance. (Gassner and Wackerbeck 2007, 34 and Nienhaus 2007, 136) This process
has to be run only once and is described by Iqbal and Mirakhor (2007, 289) as “ex-ante Shariah
audit”.
The al ternating or operative function
Subsequently the running operations of the institution are monitored and the Sharia
Supervisory Board has to “vet all new contracts, audit new contracts, approve new product
developments and overseas the collection and distribution of Zakat” (please refer to chapter
1.1.1.4) (Algaoud und Lewis 2007, 41). Furthermore it is concerned with the “disposal of non-
Shariah compliant earnings and [the] advise on the distribution of income or expenses among the
bank’s shareholders and investment account holders” (Iqbal and Mirakhor 2007, 289). The
management has to inform the Sharia Supervisory Board regularly on activites and should consult
it whenever a new product or process is under development. For daily business, internal
employees with respective knowledge are asked to control the processes and provide their results
to the Sharia scholars. (Gassner and Wackerbeck 2007,34). In the annual report of the Islamic
financial institution, the report of the Shariah Supervisory Board should be integral part. (Iqbal and
Mirakhor 2007, 289) The product innovation process will be described seperately due to its high
complexity and importance for competitveness and development of Islamic financial service
institutions.
1.3.4. Product innovation process
The certification of new products and processes belongs to the most important processes in an
Islamic bank. Gassner and Wackerbeck describe in their publication “Islamic Finance” (2007, 34-
36) how the Shariah Supervisory Board can be integrated in the product innovation process.
In the first step the management or the respective operative entity develops a rough outline of
the new financial product or internal process. The drafted structure is then presented to the
1. Foundations and Basic Principles of Islamic Banking
33
Shariah Supervisory Board which examines and fundamentally approves the basic structure. After
this first hurdle is taken, business experts can refine the concept and a jurist is contracted to
prepare necessary papers. Subsequently the final product or process description is handed over to
the Shariah Supervisory Board which proceeds with the detailed analysis. If applicable it gives
recommendations for improvement which should be incorporated before the fatwa – constituting
the final certification- is issued. If the Shariah Supervisory Board is not content with the business
experts’ proposals the process is repeated several times.
Consequently the period for product development is considerably longer for Islamic banks
compared to their conventional competitors. This fact is amplified by the small number and high
work load of available Shariah scholars. Both constitute a bottleneck factor for the growth of
Islamic financial institutions and leads to a disadvantage in competition with conventional banks.
However the vetting and auditing of new products and processes is essential for credibility and
marketing. (Gassner and Wackerbeck 2007, 35)
In search of measures for improvement, Islamic banks hire special Sharia consultants or
advisers who are involved in product and process development. They identify critical issues
beforehand and shorten the process considerably. (Gassner and Wackerbeck 2007, 35) Notably
many London law firms advise on Islamic financing techniques and new market entrants rely on
their expertise, experience and well-established contacts to financial institutions in Muslim
countries. (Baba 2007, 397)
1.3.5. Inconsistency of fatawa
In absence of global standardization and of a superior national or supranational Shariah
Supervisory Board it is possible that fatawa of different Shariah Supervisory Boards on the same
financial product are inconsistent. This leads to the scenario that for example the same transaction
is prohibited by the Shariah Supervisory Board of the Islamic bank A but certified – and therefore
declared admissible – by the Shariah Supervisory Board of Islamic bank B. (see example in Gassner
and Wackerbeck 2007, 36). In consequence decision-making within the industry is inefficient as
efforts are duplicated and standards are missing. (Iqbal and Mirakhor 2007, 289) Thanks to
improved transparency of issued fatawa (for example in the internet) and active exchange
between Sharia scholars, it becomes more common to consider old fatawa in decision processes.
(Gassner and Wackerbeck 2007, 36) However a extensive harmonization of fatawa can not be
1. Foundations and Basic Principles of Islamic Banking
34
expected. This would contradict the Islamic idea that every men has to interprete the Holy Qur’an
and the Shariah in his own (imperfect) way as no common interpretation exists (explained in
chapter 1.1.1). (Iqbal 2001, 56)
REGULATORY FRAMEWORK
Even though the Islamic banking and finance sector expanded rapidly over recent decades it is
still in its infancy. In Western and Islamic countries Islamic banks are still a minority compared to
conventional banks, expect Iran, Sudan and Pakistan where the whole financial sector is Islamized
(please refer to chapter 1.5.3). (Brown, Hassan und Skully 2007, 96) Consequently Islamic banks’
efficiency is constrained, among others, by lacking industry-wide standards and regulations as well
as by disadvantages in the tax treatment of their products in Western legislations (for example the
double stamp duty22). It is one of the most important tasks ahead to create adequate legal,
regulatory and tax frameworks to contribute to the further development of this industry. In
addition to national legislators, non-governmental agencies like the AAOIFI and the IFSB (please
refer to the chapter below) invest considerable efforts in order to foster standardization and
harmonization. These approaches are important in order to enhance the comparability between
Islamic banks and their competitive position regarding conventional banks. (Gassner and
Wackerbeck 2007, 48 and Iqbal and Mirakhor 2007, 289)
1.3.6. Standardization and Harmonization
The two most important standard setting organizations in Islamic finance and banking sector
are the “Accounting and Auditing Organization for Islamic Financial Institutions” (AAOIFI) and the
“Islamic Financial Services Board” (IFSB). Islamic financial institutions are not forced to adapt the
standards, guidelines and concepts issued by both organizations. However regulatory and
supervisory agencies in many Muslim countries have aligned their laws and standards according to
their publications (Gassner and Wackerbeck 2007, 50). Furthermore they are used on a voluntary
basis by Western fully-fledged Islamic Banks like the European Islamic Investment Bank (please
refer to 2.1.4.3) and Islamic Windows in conventional Western banks like the HSBC Amanah
(please refer to 2.1.4.4). In the following both agencies will be presented briefly focusing on their
main objectives.
22
Please refer to chapter 1.3.7 for explanation.
1. Foundations and Basic Principles of Islamic Banking
35
1.3.6.1. AAOIFI
The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) is an
international Islamic non-profit body that was found in 1991 in Bahrain based on an agreement
signed in 1989 by large financial institutions from Middle East23. AAOIFI’s objectives are to
“develop, disseminate (through training, seminars, publication of periodical newsletters),
interpret, review and amend accounting and auditing standards for Islamic financial institutions”.
In this way the confidence from consumer side should be improved.
So far the organization has issued about fifty-six standards in accounting, auditing, governance,
ethics and Shariah compliance for Islamic financial institutions. Furthermore the AAOIFI carries out
professional qualification programs (for example the Sharia Adviser and Auditor “CSAA”) to
“enhance the industry’s human resource base” (AAOIFI[1] 2006-2007)
AAOIFI’s members comprise currently about 150 financial institutions in thirty countries
(Gassner and Wackerbeck 2007, 49 and AAOIFI[4] 2006-2007) as well as regulatory and
supervisory authorities (for example central banks or monetary agencies), organizations and
associations responsible for regulating the accouting and auditing profession and “supporting
members” who “already have or intend to have relations with Islamic financial institutions’
products” (AAOIFI[3] 2006-2007).
1.3.6.2. IFSB
Another international organization dedicated to standardization in the Islamic financial industry
is the “Islamic Financial Services Board” (IFSB) found in 2002 in Kuala Lumpur. (IFSB[1] 2008) The
IFSB works in close cooperation with international associations of bank and capital market
supervisors, for example the Basel Committee on Banking Supervision. In principle it adapts the
existing standards and guidelines of these international associations and adjusts them according to
the particularities of Islamic financial institutions. So far the institution has issued seven standards,
guidelines and technical notes for instance on the areas of risk management, capital adequacy,
corporate governance, transparency and market discipline and recognition of ratings. (IFSB[2]
2008) In particular the IFSB strives towards the determination of uniform criteria to identify
23
The institutions involved were the Islamic Development Bank (Saudi Arabia) , the Al Baraka Banking Group
(Bahrain), Dar Al Mal Al Islami (Switzerland) , the Al Rajhi Banking and Investment Corporation (Saudi
Arabia), the Kuwait Finance House (Kuwait) and Bukhari Capital (Malaysia). (AAOIFI[3] 2006-2007)
1. Foundations and Basic Principles of Islamic Banking
36
measure, manage and publish risks of financial institutions. (Gassner and Wackerbeck 2007, 50) By
the end of Januar 2008, the IFSB counted 150 members including the International Monetary
Fund, the World Bank, the Bank for International Settlement as well as several market players in
twenty-nine countries. (IFSB[2] 2008)
1.3.7. Regulation
Islamic financial institutions compete in all countries with conventional banks (except Iran,
Sudan and Pakistan24). As already pointed out in chapter 0, the conventional competitors
outnumber the Islamic financial institutions and regulations are “generally aligned to the
conventional system” (Brown, Hassan und Skully 2007, 108). This leads to disadvantages for
Islamic financial institutions and Shariah compliant products, for instance to unfavorable in tax
treatment of their products or to difficulties in refinancing. “Several studies indicated that these
regulations influence the operational performance of Islamic banks significantly” (Gassner and
Wackerbeck 2007,161). Consequently it is questionable whether both conventional and Islamic
institutions should be subject to the same regulatory frameworks as their business models differ
substantially.
Some countries like Malaysia, Bahrain and notably the United Kingdom actively support the
improvement of regulatory conditions for Islamic financial institutions from a national quarter.
(Gassner and Wackerbeck 2007, 162)
1.3.8. Accounting, Reporting and Zakat
Referring to chapter 1.3.6 it can be stated that generally accepted accounting and reporting
standards are missing. Despite the fact that many Islamic financial institutions align their systems
by now with the standards issued by AAOIFI, the majority of them reports additionally according
to conventional standards, for example IFRS. This leads to confusion and problems, due to
operational differences in Islamic banking business.
In this way the calculation of key figures such as the results generated with certain Islamic
financing activities is very difficult. The treatment depends very much on the basic Islamic concept
applied in the respective financing technique and “the same products can affect the balance sheet
and profit and loss statement of an institution in completely different ways.” (Gassner and
24
Iran, Sudan and Pakistan have fully Islamized their financial sectors. For further information please refer to
chapter 1.5.2.
1. Foundations and Basic Principles of Islamic Banking
37
Wackerbeck 2007, 162) Another problem constitutes the reporting of additional risks comprised in
active Islamic financing techniques.
Furthermore the Islamic finance and banking concept requires additional duties of disclosure,
such as the reporting on the Shariah conformity of its products (please refer to chapter 1.3) and
the information necessary to calculate and pay Zakat (please refer to 1.1.1.4). Uniform Zakat
regulations are not in place, yet leading to a distortion of competition. (Gassner and Wackerbeck
2007, 163).
1.4. RISK AND LIQUIDITY MANAGEMENT OF ISLAMIC BANKS
1.4.1. Liquidity Management
“The lack of efficient secondary markets and liquidity in the Islamic financial markets has
indirectly limited the range of maturity structures available to investors. Due to the
absence of liquidity, Islamic financial institutions cannot easily expand portfolios across
capital markets and are restricted in opportunities for portfolio diversification.” (Iqbal
and Mirakhor 2007, 204)
The preceded statement indicates among others the lack of interest-free capital market
instruments. Islamic banks cannot participate in the conventional intra-bank market neither they
have access to lender of last resort facilities provided by Central Banks as they are based on
interest, too. They are forced to hold higher, non-productive liquidity reserves leading to an
overall lower profitability (Gassner and Wackerbeck 2007, 164).
In certain Muslim countries like Bahrain, Malaysia and Saudi Arabia, approaches for an Islamic
inter-bank money market are visible. (Iqbal and Mirakhor 2007, 241) However due to the small
number of Islamic banks and their relatively small size, they do not achieve sufficient liquidity.
(Gassner and Wackerbeck 2007, 164)
In order to find a remedy the IFSB (please refer to 1.3.6.2) issued the “IFSB 2: Capital Adequacy
Standard for Institutions (other than Insurance Institutions) offering only Islamic Financial Services
(IIFS)” (IFSB[3] 2008) in 2005 and formed a task force in 2006 in order to align money market
operations of Central Banks with liquidity management requirements of Islamic banks. The
standard IFSB 2 proposes principles for minimum capital adequacy requirements regarding several
1. Foundations and Basic Principles of Islamic Banking
38
risk categories (please refer to chapter 1.4.2 ) and different Islamic financing assets (for example
Murabaha, Bay Salam etc). (Gassner and Wackerbeck 2007, 165)
In the following two approaches for Sharia compliant liquidity management in Islamic banks are
presented. The first concept is definitely prevalent whereas the second alternative was recently
presented by the Islamic Development Bank25 and is now subject to a pilot project in Bahrain.
Example of Commodity Murabaha Liquidity management (Gassner and
Wackerbeck 2007, 166 and Ayub 2007, 375)
This type of transaction involves the trade of commodities, originally metals from the London
Metal Exchange. Nowadays it is possible to use other commodities as well such as crude palm oil
in this example. The commodity Murabaha transaction explained in the following is offered by
Malaysia’s Central Bank: Bank Negara Malaysia and the Islamic Development Bank for liquidity
management purposes of Islamic financial institutions (Bank Negara Malaysia 2005 and Islamic
Development Bank 2007-2008). However its admissibility is disputed and Muhammad Ayub (2007,
375) emphasizes that “it is considered a grey area […] and it should be ensured that the
transaction does not become a mere exchange of papers”.
Figure 11 sketches the structure of the transaction. In the first step, the Islamic bank buys the
commodity from an agent A at stock price ‘x’ (1) and resells it immediately to the Central Bank (2).
The Central Bank agrees to pay the spot price plus a predetermined mark-up ‘m’ as deferred
payment (3) and commissions the bank to resell the commodity to agent B. The bank follows this
demand (4) and receives the spot price for the commodity from agent B (5). It forwards the
payment to the Central Bank (6). In the last step the bank receives the spot price (its original
outlay) plus ‘m’ as return on its investment from the Central Bank. In this way institutions can
easily invest their excess liquidity for the short term in the Islamic money market while earning a
return. However due to the commodity transaction involved the transaction costs are higher
compared to transactions in the conventional money market. (Gassner and Wackerbeck 2007,
167)
25
For more information on the Islamic Development Bank please refer to chapter 1.5.7.
1. Foundations and Basic Principles of Islamic Banking
39
Figure 11 Commodity Murabaha Liquidity Management from Bank Negara Malaysia (2005)
Likewise Islamic financial institutions can raise short term capital from the market. The
corresponding basic concept calls “Tawarruq” and constitutes the revised Murabaha transaction.
In this transaction the Central bank sells commodities at forward price to the Islamic bank which
resells it immediately at the spot market. Therefore the institution receives liquidity immediately.
Afterwards it has to pay its debt to the Central bank. The forward price includes the spot price plus
a mark-up (Gassner and Wackerbeck 2007, 167).
L iquidity Management via Sukuk (Gassner and Wackerbeck 2007, 165 and
(Ayub 2007, 374 amd 375)
Sukuk belong to the most innovative and most famous capital market instruments in Islamic
finance (please refer to chapter 1.2.4.2) and many market participants try to improve their
liquidity situation using these flexible instruments. The Islamic Development Bank issued a
respective approach recently (Gassner and Wackerbeck 2007, 165). The basic structure is
visualized in Figure 12. The financial institution securitizes a pool of Shariah conform income-
generating assets (for example stocks, real estate, Sukuk and other liabilities) and sells them to a
Special Purpose Vehicle (SPV) (Ayub 2007, 374). The latter issues several short-term participation
certificates (Sukuk) with a large spectrum of maturities (for example 1 week, 1 months, 3 months).
It is important to ensure that the Sukuk are transferable to other investors and market makers,
thus tradeable on a secondary market. The market maker determine the ask and bid price for
1. Foundations and Basic Principles of Islamic Banking
40
these securties referring to a benchmark (for example the LIBOR). At maturity the Sukuk are
redeemed and simoultanously a new tranche is issued.
Figure 12 Liquidity Management via Sukuk (own illustration)
According to Gassner and Wackerbeck (2007, 164) this structure would be very convenient for
insitutions holding excess liquidity but quite complicated for those who want to raise money for
the short term. However the Liquidity Centre in Bahrain26 for example offers a similar model in a
pilot project currently.
1.4.2. Risk Management
Islamic banking is a relatively new concept and its instruments are generally not well
comprehended, neither are their risks. In this respect the Islamic financial institution is asked to
“educate its consumers “(Bank Negara Malaysia 2005), which means to provide them with the
necessary information and comprehensive advice.
On the other side, Islamic banks bear considerable risks in providing their products and
conducting their business. These risks include firstly those faced by conventional banks likewise
(for example the credit risk). However additionally they are affected by additional risks unique to
Islamic banks “owing their compliance with the Shariah” (Ahmed and Khan 2007, 145).
26
Liquidity Centre of Bahrain was found by Bahrain Islamic Bank, Dubai Islamic Bank, Kuwait Finance House
and Islamic Development Bank in order to facilitate the investment of surplus funds of Islamic financial
institutions in accordance with Shariah principles by offering short and medium term liquid investment
structures. (Liquidity Management Centre B.S.C. 2008)
1. Foundations and Basic Principles of Islamic Banking
41
Based on the list in Ahmed and Khan (2007, 145 to 147) and in comparison with several other
literature sources27, the most important risk classes for Islamic banks are outlined below.
1.4.2.1. Credit Risk
The Credit Risk can be defined as “the potential that the counterparty fails to meet its
obligations in accordance with agreed terms” (IFSB 2005). The claim for interest paid on overdraft
is forbidden, like every form of interest, and cannot be used to compensate the banks shortfall in
payment. Credit risk can arise, for instance, out of a Murabaha contract (please refer to 1.2.2.1)
when the counterparty fails to fulfill the debt. The IFSB defines in its principle guideline 1 (please
refer to 1.3.6.2) a subcategory of credit risk, being the “Equity Investment Risk”. This relates in
particular to the risk exposure in equity participations in Mudaraba and Musharaka contracts
(please refer to 1.2.1). (Islamic Financial Services Board[2] 2005) The bank is exposed to the risk
that the counterparty does not redeem the shares if due or provides false information about
generated profits. In these cases the bank has little opportunity to counteract. (Ahmed and Khan
2007, 145)
1.4.2.2. Market Risk
Market risk refers “to the potential impact of adverse price movements on the economic value
of an asset” resulting in a “loss in on- and off-balance sheet positions” (Islamic Financial Services
Board[2] 2005). The systematic market risk arises out of macro sources. In Islamic Finance and
Banking a typical example is the “mark-up risk” comprised in Murabaha contracts. As explained in
chapter 1.2.2.1, banks usually use a benchmark to price their product, for example the LIBOR.
However an important prerequisite for the product’s Shariah compliance is that the mark-up is
fixed in advance. Assuming a Murabaha contract over a longer duration, the benchmark, in this
example the LIBOR, may change significantly whereas the mark-up has to stay the same. (Ahmed
and Khan 2007, 145) In this way the bank might be charged higher mark-ups in short-term liquidity
transactions with other banks than it receives.
The unsystematic market risk is asset or instrument specific. All Mudaraba, Musharaka, Bay
Salam and Ijarah (please refer to chapters 1.2.1, 1.2.2.1 and 1.2.3) contracts comprise the
commodity/ asset price risk. It emerges out of the fact that the bank buys a durable asset on
27
Please refer also to the Risk Management Standard of the Islamic Financial Services Board[2] 2005,
Gassner and Wackerbeck, 2007, 167 to 169, Solé 2007 and Bergmann 2008, 103 to 108.
1. Foundations and Basic Principles of Islamic Banking
42
behalf of its customers and might, in case the customer does not fulfill his obligation, be forced to
resell the commodity for the lower price.
1.4.2.3. Liquidity Risk
In general it is problematic for Islamic banks to “obtain cash at reasonable cost”, also called
“funding liquidity risk”, and to sell assets at a profitable price, also called “asset liquidity risk”. This
is due to three obstacles. Firstly there are strict Fiqh restrictions (please refer to 1.1) on the
securitization of debt instruments leading to the fact that banks have problems to sell its
receivables. Secondly the inter-bank money market for Islamic banks develops very slowly. The
main reason for this dilemma is that conventional money market instruments “cannot or hardly be
converted to a Shariah-compliant form” (Gassner and Wackerbeck 2007, 168) (please refer to
chapter 1.2.4.3). Therefore Islamic banks cannot raise funds quickly from the market. Finally the
lender of last resort facililties provided by central banks are not accessible for Islamic banks as
they are all based on interest28. (Ahmed and Khan 2007, 145) For further explanation of liquidity
management please refer back to chapter 1.4.1.
1.4.2.4. Operational Risk
The Basel Committee on Banking Supervision (2001) defines operational risk as follows: “the
risk of direct or indirect loss resulting from inadequate or failed internal processes, people and
technology or from external events”. In Islamic banking the personal risk is especially high due to
the infancy of the industry, for example lacking qualified professionally or appropriate IT
infrastructure.
1.4.2.5. Legal Risk
As already pointed out in chapter 0 most legal systems (except Sudan, Pakistan and Iran) do not
provide for or even hinder the activities of Islamic financial institutions. Regulations aligned with
the conventional system might constrain Islamic bank’s efficiency or make certain transactions
impossible. Transactions and contracts are only standardized to a small extent and banks have to
invest considerable time and money in the negotiation of complex transactions. Finally Islamic law
is not enforceable in front of courts in Non-Muslim countries so that Islamic banks might have
problems to sue counterparties who failed to fulfill their obligations. (Ahmed and Khan 2007, 146)
28
There exist some exceptions, for example in Malaysia. There the Bank Negara offers interest-free lending
facilities to Islamic financial institutions. (Bank Negara Malaysia 2005)
1. Foundations and Basic Principles of Islamic Banking
43
1.4.2.6. Displaced Commercial Risk
The displaced commercial risk can also be referred to as “rate of return risk” according to IFSB
1 and “derives from competitive pressures on IIFS to attract and retain investors (fund providers)”
(IFSB 2005). Ahmed and Khan (2007, 147) give an example: In case the Islamic bank is not able to
“offer competitive rates of return” compared to its peer group (including conventional banks) due
to the restrictions of Shariah, it may be forced to “apportion part of [its] own share in profits to
investment depositors” in order to avoid that depositors withdraw their funds. (Ahmed and Khan
2007, 147)
1.4.2.7. Shariah Risk
Shariah risk describes “the risk that the terms agreed in the contract do not effectively comply
with Islamic jurisprudence and thus are not valid under Islamic law” (Solé 2007). It can be
minimized by constant monitoring of a Shariah Supervisory Board or Shariah adviser (please refer
to 1.3.), however it might still be rejected by other Shariah scholars or customers, as the
interpretation of Islamic law is not uniform. Consequently the product has to be withdrawn from
the market and restructured and the Islamic bank might lose in reputation within the Muslim
community. Furthermore it is possible that standard setting organizations change the
requirements and likewise the competitive basis for the financial institutions. The Frankfurter
Allgemeine Zeitung (2008) reported the following example. In March 2008 the AAOIFI (please refer
to 1.3.6.1) tightened the regulations for the emission of Sukuk (please refer to 1.2.4.2). Its scholars
declared that most products available on the market are not compliant with Islamic faith because
issuers are guaranteed to receive the original face value at maturity on the buy back of the
respective commodity, no matter whether it generated profit or loss. Such transactions are now
forbidden according to the AAOFIF as the investor and issuer have to participate both in profits
and losses equally generated by the commodity. Fortunately already issued Sukuk did not have to
be restructured but only new ones. However Sukuk issued before the change might be rejected by
some investors and banks have to invest in the product development of the new Sukuk.
1.4.2.8. Risk management techniques and regulations
Regarding the product descriptions in chapter 1.2 and the various types of risk mentioned in
this chapter, it becomes obvious that “Islamic banking goes beyond the pure financing activities of
conventional banking” (Lewis and Algaoud 2001, 60). Therefore risk management and
1. Foundations and Basic Principles of Islamic Banking
44
diversification of risk is of utmost importance. In the following several approaches to deal with the
high risk exposure are presented.
Firstly most Islamic banks have a strong preference for particular contracts. For example, they
prefer a debt financing mode (like Murabaha) over an equity participation (like Musharaka) in
order to limit the potential loss. In this way the original “twin pillars” (Lewis and Algaoud 2001, 45)
of Islamic banking, being Musharaka and Mudaraba contracts (please refer to 1.2.1), lose
importance compared to more innovative and more secure modes of financing, for example Ijarah
(please refer to 1.2.3) and Sukuk issuance (please refer to 1.2.4.2).
Secondly banks establish extensive “reserve funds out of past profits” (Lewis and Algaoud 2001,
60) to compensate major losses resulting, for example, from counterparty default in a partnership
contract (Musharaka or Mudaraba). Consequently they hold a higher, more conservative, level of
equity in relation to debt compared to conventional banks that usually operate with higher
leverage ratios (Lewis and Algaoud 2001, 99). Due to large conceptional difference compared with
the conventional system, regulatory frameworks like Basel II29 can only be adopted in Islamic
banking to a small extent. However the standard setting organization IFSB mentioned in chapter
1.3.6.2 issued own guiding principles for risk management and capital adequacy that “serve to
complement BCBS’s guidelines in order to cater for the specifities of IIFS [Institutions offering only
Islamic Financial Services]” (Islamic Financial Services Board[2] 2005). These are in particular the
standards “IFSB 1: Guiding Principles of Risk Management for Institutions (other than Insurance
Institutions) offering only Islamic Financial Services (IIFS)” and “IFSB 2: Capital Adequacy Standard
for Institutions (other than Insurance Institutions) offering only Islamic Financial Services (IIFS)”
(for the latter please refer to chapter 1.4.1) (IFSB 2005).
As already mentioned in chapter 1.2.4.3 it is quite problematic to structure derivatives in
compliance with Shariah. (Gassner and Wackerbeck 2007, 170). Eventhough the demand is
increasing such instruments are very rare in the Islamic banking system, so far. This leads to major
difficulties in efficient risk management.
29
The Basel Committee of Banking Supervision (BSCB) is a standard-setting body on all aspects of banking
supervision in the conventional (interest-based) banking system. The framework “Basel II” provides a
measure and a minimum standard for capital adequacy that is implemented by various national authorities.
(Bank for International Settlement 2008)
1. Foundations and Basic Principles of Islamic Banking
45
1.5. HISTORY AND CURRENT DEVELOPMENT OF ISLAMIC FINANCE
Being the third and last “great monotheistic religion” (Lewis and Algaoud 2001, 16) the Islam
counts over 1.2 billion followers worldwide and is the second largest religion in terms of numbers
after Christianity. It was “promulgated by the Prophet Muhammad in Arabia early in the 17th
century” (Lewis and Algaoud 2001, 16) and spread around the world since then. Today Muslims
constitute the majority of population in more than 40 countries (for example Malaysia, Indonesia,
Saudi Arabia, Bahrain). Further 6 to 8 million live in Western Europe and the USA, respectively.
(Lewis and Algaoud 2001, 16 and 17) It is important to mention that the Muslims population is
growing faster with 1.8 percent per annum than the rest of the population (about 1.12 percent
p.a.). (Walker, et al. 2007)
Whereas the conventional financial service industry looks back at a history of about 700 years
(Dawood 2008), the Islamic financial services industry (abbreviated hereafter IFSI) is a very young
phenomenon being in operation for about three decades (Islamic Development Bank 2007). The
following chapter will outline the milestones in Islamic banking’s history and gives a short
description on the current, dynamic development . Furthermore the basic business models that
have evolved in the IFSI lately, will be defined.
1.5.1. Historical milestones
The idea of an interest free banking system in accordance with the principles of Shariah
evolved long time before the first Islamic bank came into existence. When Western commercial
banks established the first banks in the Muslim world (1890s, the Barclay Bank in Cairo) Islamic
scholars already criticized “that interest in all its forms constitutes the prohibited Riba”. (Islamic
Development Bank 2007) However due to the pressure of colonial powers in most Islamic
countries, the conventional financial system was introduced because a sophisticated banking
system was absolutely necessary for import and export transactions and economic growth.
(Altundag und Nadia 2005, 31) Furthermore the doctrine of necessity (Daruah, please refer to 1.1)
allows believing Muslims to handle their financial matters in the interest-bearing system if there is
no adequate Shariah-compliant alternative available. (Jaffer 2005, 31) Nevertheless theoretical
models for alternatives to the interest-bearing system were developed by Islamic scholars and
economists since 1930s and in the 1960s first comprehensive concepts appreared. An interest-free
1. Foundations and Basic Principles of Islamic Banking
46
banking system should give Muslims the possibility to invest and deposit money while respecting
their religious and ethical prinicples.
In 1961 the these concepts were firstly applied in practice by the “Mit Ghamr Savings
Associations” in Egypt. The concept was based on interest-free, rural, cooperative banking aligned
to the system of German savings banks and modified according to Shariah requirements (Billah
2007, 401). Within this scope, the financial institutions invested directly in trade and industry to
foster economic development and shared their profits with the depositors. However these banks
were formed under cover because the founders “feared [the banks] to be seen as manifestation of
Islamic fundamentalism” (Lewis and Algaoud 2001, 5) Their worries turned out right as they were
forced to close down three years later, in 1964, for political reasons. According to Lewis and
Algaoud (2001, 6), “similar political antagonism occured [at various times] to Islamic banks in other
Muslim countries”, for example in Syria, Oman and Saudi Arabia. Eventhough the first experiment
failed it was a starting point for further efforts. In Malaysia the bank “Tabung Haji” found in 1962,
corresponded to Shariah principles as well and, most importantly, survived until today. It “has
become the oldest Islamic financial institution in modern times” (Islamic Development Bank 2007).
When the Arab world started to benefit from the oil wealth in 1973 and 1974, banking was heavily
supported and political climate changed. (Lewis and Algaoud 2001, 7) Both the conventional and
the Islam financial industry grew dynamically and in respect of the latter, two key insitutions were
established , being the Islamic Development Bank and the Dubai Islamic Bank. The former is an
intergovernmental bank “aimed at providing funds for development projects” in its fifty-six
member countries30. It gave “momentum to the Islamic banking movement followed by private
and governmental institutions” and have been fostering the development of Shariah compliant
financial instruments (Lewis and Algaoud 2001, 11). The Dubai Islamic Bank became known as “the
world’s first fully-fledged [private] Islamic bank” (Altundag und Nadia 2005, 33 and Dubai Islamic
Bank 2005). Both institutions play a major role in today’s Islamic financial market.
During the 1980s several other Islamic financial institutions and academic institutions emerged
as well the first Islamic mutual funds. Additionally international organizations invested research
30
Information according to (Islamic Development Bank[2] 2008), the five countries holding the highest
shareholdings currently, are the Kingdom of Saudi Arabia (23.10%), the State of Kuwait (11.50%), the Great
Socialist People's Libyan Arab Jamahiriyah (9.26%), the Islamic Republic of Iran (8.11%) and the Arab
Republic of Egypt (8.01%).
1. Foundations and Basic Principles of Islamic Banking
47
efforts into the new domain, for instance the International Monetary Fund. (Islamic Development
Bank 2007)
In the following decade the public interest grew and central banks and monetary authorities called
for regulation and supervision of the Islamic financial services industry. Consequently first
standards were issued by the newly found standards setting organization AAOIFI (please refer to
1.3.6.1). Between 2002 and 2006 further organs established next to the AAOIFI, for example the
Islamic Financial Services Board (please refer to 1.3.6.2), the International Islamic Rating Agency
and the Liquidity Management Centre in Bahrain. In this way the insitutional infrastructure for the
Islamic financial services industry built up step by step (please refer to 1.5.2). Simoultanoulsy the
Islamic capital market took shape, markably by the launch of the first Islamic indices, the Dow
Jones Islamic Market Indices in 1999 and FTSE Shariah Global Equity Index Series in 2003 (Dow
Jones Indexes 2008 and Islamic Development Bank 2007) and the growth of the mutual funds
market (please refer to Figure 15). Furthermore “the pace of product innovation has increased and
major cross border providers emerged” (Jaffer 2005, 3). The attraction of new market participants
worldwide led the Islamic financial services industry grow by double digit growth rates since 2000
(please refer to 1.5.3) and it expanded from “regional business to global scale” (Jaffer 2005, 3).
The Islamic Development Bank (2007) summarized in its initiative:
“The various segments of the industry and the related intellectual capital, institutions and
policy initiatives have developed rapidly and attained a degree of maturity and
international recognition.”
In order to visualize the current composition of the Islamic financial services industry, please refer
to Figure 13 below.
1. Foundations and Basic Principles of Islamic Banking
48
Figure 13 Composition of the Islamic Financial Services industry (according to Islamic Development
Bank 2007)
1.5.2. Approaches to expansion and development
In principle there are several ways for expansion in the IFSI. Firstly governments can decide to
“completely transform the country’s financial sector into a fully Islamic system” (Solé 2007). This
step was taken by Pakistan, Iran and Sudan in the early 1980s, whereas in Sudan and Pakistan the
process is not yet finalized. (Lewis and Algaoud 2001, 13 and 14 and Islamic Development Bank
2007). Obviously this decision is taken on strong religious and political grounds however due to
the infancy of the Islamic banking and finance industry the Islamization of the whole system
“could act as a severe brake on financial (and economic) activity” (Solé 2007). The second
possibility is “to establish Islamic financial institutions side by side with traditional banks” in a so-
called “mixed system” (Lewis and Algaoud 2001, 13 and 14). This model is applied by most Muslim
countries and latterly also by some Western states (for example the United Kingdom).
As already indicated in Figure 13 there are three basic business models for market participant
to operate in the in the Islamic financial service industry. On the one hand fully-fledged Islamic
banks are found that offer nothing but Shariah-compliant products and services. The majority of
them was etablished in Middle-East, however many of those operate worldwide (please refer to
0.). On the other hand conventional banks open up “Islamic Windows”. These are banking units or
1. Foundations and Basic Principles of Islamic Banking
49
subsidiaries that are “charged with the task of creating, promoting and operating Shariah
compliant financial products and related services“ (Jaffer 2005, 32). In the beginning these services
are often offered in line with conventional products and later on provided using a dedicated
branch. As will be presented later in chapters 2 and 3, international Western financial institutions
like HSBC, Deutsche Bank or Allianz Global Investors are already operating such Islamic Windows
or are in progress to enlarge their activites in this sector. Finally there are Islamic investment and
holding companies active in the market that are mostly etablished in non-Muslim countries. They
were either not granted a banking license in the respective country (for example India) or are
dedicated to insurance and funds products. (Lewis and Algaoud 2001,13 and 14)
1.5.3. Estimated size of the industry and growth trends
The size of the Islamic financial service industry as a whole is very difficult to estimate owing
“the limited availability of systematic and reliable statistical information” (Islamic Development
Bank 2007). However it is possible to gather information from various sources in order to
assess the volume of assets in the different segments and subsequently evaluate the size of the
whole. In Table 1 the estimated size of assets in different IFSI segments worldwide is shown.
Table 1 Estimated size of IFSI Segments in 2005 (according to the Islamic Development Bank 2007)
The information indicates that by the end of 2005 more than 300 institutions in over 65
jurisdictions managed Shariah compliant assets worth between $700billion to $1 trillion31 (Islamic
31
The market volume of around 700 billion US$ in assets can also be found in various other literature
source. Please refer also to Bergmann (2008, 130) and Gassner and Wackerbeck (2007, 15).
1. Foundations and Basic Principles of Islamic Banking
50
Development Bank 2007). The same source suggests that the average annual growth rate of the
Islamic financial services industry assets between 1995 and 2004 was 10 to 15 percent- “a trend
which is expected to continue” (Solé 2007). Based on these facts the Islamic Development bank
projected the size of the industry for the upcoming years until 2015 (please refer to Table 2).
Consequently the IFSI could grow to $1.4 trillion by 2010 and to impressive $2.8 trillion by 2015.
Furthermore it is estimated that at this time “more than half of financial services provided are
expected to become Shariah compliant in the Gulf Cooperation Council (GCC) region” and about
15 to 25 percent in several South Asian countries (please refer to 1.5.7). (Islamic Development
Bank 2007) According to Gassner and Wackerbeck (2007, 16) there are several factors cauzing the
rising interest of financial services provider for Islamic financial services worldwide. Firstly, the
demand for Islamic financial services rises massively as Muslims become increasingly aware of
possibilites to handle financial matters in compliance to their faith. Secondly, it becomes
appearant that prosperity is growing in many Muslim countries32 which results in “significant
liquidity avaiable in Middle-East” (Jaffer 2005, 3) that could be attracted by private companies.
Finally the current offering of Shariah-compliant products and services is insufficient and leaves
considerable space for further growth.
Table 2 Projected size of the IFSI until 2015 (according to the Islamic Development Bank 2007)
32
For instance the gross domestic product per capita in the Emirate Qatar in 2007 amounted to 63,100 US$
compared to estimated 41,370 US$ in Switzerland. (Gassner and Wackerbeck 2007, 16)
1. Foundations and Basic Principles of Islamic Banking
51
Despite of the promising growth figures it has to be mentioned that the current market share
of the Islamic financial service institutions is not higher than 1 percent in relation to the global
conventional financial service industry and constitutes therefore merely a niche market. (Gassner
and Wackerbeck 2007, 15) The further growth of this industry will depend largely on several
aspects, like the integration in the existing financial system, the industry consolidation, the
understanding and awareness of Islamic finance in the public and the advancements in the
standardization and harmonization process. (Islamic Development Bank 2007) Furthermore
political influences on the growth of this industry are not to be underestimated. For example the
terrorist attacks on September 11, 2001 influenced the development in different ways. On the one
hand side they raised questions of terrorist financing in the Western world which is wrongly linked
to Shariah compliant financial services. Thus several jursidictions became skeptical about the IFSI.
However other governments, for instance in the United Kingdom, initiated programmes to
promote tolerance and integration of Muslims, including the facilitation of Shariah compliant
product offerings (please refer to 2.1.3). (Jaffer 2005, 31) Furthermore investors from Middle-East
withdrew their money from Western legislations and tried to find adequate investments in their
home countries which impeded the establishment of Western markets in this industry. However
emirical research material for such development are rare and the prevailing effects cannot be
definitely determined. (Gassner and Wackerbeck 2007, 42 and 43 and Bergmann 2008, 129)
In order to give examples for recent trends in the industry, the development of Sukuk issuances
and the number Islamic mutual equity funds will be visualized in the subsequent figures.
Sukuk belong to the most innovative and successful products in the Islamic financial services
industry currently (please refer to 1.2.4.2). After the instrument emerged in 2000 the volumes of
Sukuk issued grew dynamically. As can be seen from Figure 14 the number rose from 2003 to 2007
by calculated 54 percent per year (CAGR33). It is estimated that the volume could increase to
approximately 180 million US$ in 2010 (International Islamic Financial Market 2007).
33
The Compound Annual Growth Rate (CAGR) is calculated by the following formula:
1. Foundations and Basic Principles of Islamic Banking
52
Figure 14 Total Sukuk issuance34
(International Islamic Financial Market 2007)
Islamic mutual equity funds (as described in chapter 1.2.4.1) firstly launched in 1980s in order
to collect money for building Mosques in the USA, grew dynamically in the following years, expect
for a short decline in 2002 resulting from the events on September 11, 2001 and the burst of the
new economy bubble. (Gassner and Wackerbeck 2007, 137) The calculated annual growth for the
last 10 years is around 17 percent and shows further growth potential.
Figure 15 Number of Islamic mutual equity funds (according to Gassner and Wackerbeck 2007, 137)
34
Best estimation including both corporate and sovereign issues of domestic and internal Sukuk.
CAGR +54%
CAGR +17%
1. Foundations and Basic Principles of Islamic Banking
53
1.5.4. Islamic financial centers
Several Islamic financial centers have established constituting global hubs for product
development, distribution and coordination. Prerequisites for the cities or states to establish as
financial centers are in principle the existing market potential, an adequate financial infrastructure
and regulatory framework designed to foster industry development. In order to increase their
significance for Islamic financial service industry, new financial metropolises like Dubai, Manama
(Bahrain) and Kuala Lumpur compete with established ones, like London or Singapore. According
to Ricardo Baba (2007, 384) Manama in Bahrain and London are the two major centers at the
moment while Kuala Lumpur is very much growing as well. Gassner and Wackerbeck (2007, 42 to
47) mentions furthermore, Dubai and Abu Dhabi as potential new financial hubs for Shariah-
compliant financial services.
LATEST DEVELOPMENTS IN MIDDLE EAST AND SOUTHEAST ASIA
Certain Islamic economies, especially in Asia and the Middle East, experienced a strong
economic situation in the recent years which gave considerable momentum to the development of
Islamic finance and the banking sector as a whole. (Bergmann 2008, 128) The Economist
Intelligence Unit (2007) summarized in its study:
“Strong liquidity resulting from high oil and gas prices, a growing maturity among
investors, the repatriation of assets following 9/11 and the development of Islamic
finance have all contributed to creating a thriving environment for both local and
international banks.
1.5.5. Geographical classification
The term “Middle East” does not determine a clear cut geographic boundary. It is rather a
historically grown term used to describe the countries and regions in Southwest Asia and North
Africa whereas the definition of G8 includes more countries than the original one. In Figure 16
both the traditional and the G8 definitions are visualized in a map.
1. Foundations and Basic Principles of Islamic Banking
54
Figure 16 Countries of Middle East (Nationmaster 2003-2005)
The ”Gulf Cooperation Council for the Arab States of the Gulf” (abbreviated GCC) is an
economic agreement among the following countries situated in the Middle East: United Arab
Emirates, the Kingdom of Bahrain, the Kingdom of Saudi Arabia, the Sultanate of Oman, Qatar and
Kuwait. (Gulf Cooperation Council[1] 2007) aiming at establishing a common market and customs
unions as well fostering the economic cooperation and harmonization of standards. (Gulf
Cooperation Council[2] 2007)
Southeast Asia is like the Middle East not a precisely defined term but both are widespread in
literature about Islamic finance and banking. It comprises in general countries that are south of
China, east of India and north of Australia. In the respect of IFSI are the countries Malaysia,
Indonesia and Singapore of special importance.
1.5.6. Financial markets in Middle East and Southeast Asia
“The capability of a financial market depends largely on the trust of private and institutional
investors in integrity, stability and transparency of this market.” (Gassner and Wackerbeck 2007,
42) In the past insufficient financial infrastructures in the countries of Middle East and Southeast
Asia were one of the main reasons for major outflows of capital to established financial centers in
Europe and the USA. A high proportion of asset management activities for investors from the Gulf
were centered in Switzerland and London or investors bought considerable shares of Western
companies. (Gassner and Wackerbeck 2007, 42) Recently political, economic and financial reforms
1. Foundations and Basic Principles of Islamic Banking
55
have changed the picture and market participants can operate now in signifiantly different
environments eventhough the “pace of these reforms varies from country to country” (Economist
Intelligence Unit 2007). Domestic investors are increasinly interested in local opportunities for
investments. However according to Gassner and Wackerbeck (2007, 43) still only 11 percent of
surpluses generated in the GCC countries are invested in the local markets. Due to this trend and
the growing prosperity in the regions, international banks increase their local presence
significantly and work in cooperation with new established local institutions as the latter face a
lack of adequately trained experts. (Economist Intelligence Unit 2007)
1.5.7. Development of the Islamic banking sector in GCC countries and Malaysia
The IFIS has its “maximum concentration in the GCC, South and Southeast Asia regions” (Islamic
Development Bank 2007). Today, the banking and Takaful operations are mostly concentrated in
Bahrain, Malaysia and Sudan whereas the majority of mutual funds is concentrated in Saudi
Arabian and Malaysian markets and the international capital markets. (Islamic Development Bank
2007)
The “assets held by Islamic banks [in these regions] are steadily growing“ (Islamic Development
Bank 2008). For some examples of this development please refer to Figure 17. In single cases the
asset concentration on single institutions is significant. The two biggest conglomerates who
“pioneered” Islamic banking, according to the Insitute of Islamic Banking and Insurance (IIBI) in
London (2008), are Dar Al-Maal Al-Islami (DMI) and Al-Baraka. The “Dallah Albaraka Group”,
headquartered in Jeddah, Saudi Arabia, accounts for 26 percent of all assets and 23 percent of all
deposits held by private Islamic banks. It operates fifteen banks, some of them in Western markets
like the United Kingdom35. The second player to mention is the Dar al-Maal Al-Islami Trust36
headquartered in Geneva, Switzerland but owned by an Arabian family and sponsor of many
international Islamic banking organizations. It operates ten banks, seven investment companies
and three takaful companies in fifteen countries. (Lewis and Algaoud 2001, 12 and 13)
In Malaysia, which is one of the fastest growing Islamic banking markets, the market share of
Islamic products and services in selected banking sectors was apportioned in 2005 as illustrated in
Figure 18. Net income of the Malaysian Islamic banking sector rose from 2,485 million Malaysian
35
These are the “Al Baraka Investment Company” and the “Dallah Al Baraka Investment Company”. Please
refer to chapter 2.1.1. 36
Refer also to http://www.dmitrust.com/ , 02.12.2008; 17:00
1. Foundations and Basic Principles of Islamic Banking
56
Ringgit (€536 million37) in 2004 to 3,197 million Malaysian Ringgit (€688 million) in 2005, which is
an increase of 28.7 percent. The central bank states that “insitutional capacity and capability of
the Islamic banking players as well as the financial infrastructure and regulatory framework was
further strengthened” in 2005. (Bank Negara Malaysia 2005) The Malaysian governement as well
as legislators in the GCC countries (for example in Bahrain) actively supports the development of
the Islamic banking sector by initiating dedicated education programs and designing new
regulatory frameworks in order to create a level playing field for conventional and Islamic banks.
(Gassner and Wackerbeck 2007, 42 and 43 and Bank Negara Malaysia 2005) These measures seem
to prove successful as according to a study conducted by Booz & Company, more than 20 fully-
fledged Islamic banks were found in the GCC region and Malaysia only between 2006 and 2008.
(Vayanos and Wackerbeck 2008)
Figure 17 Development of assets held by Islamic banks (according to Islamic Development Bank 2008)
37
Exchange rate 02.12.2008, 16:00: 4,63834 MYR/ EUR according to http://www.xe.com/ucc/convert.cgi
1. Foundations and Basic Principles of Islamic Banking
57
Figure 18 Market share of Islamic products and services in assets, deposits and financing as at end-
2005 in Malaysia (Bank Negara Malaysia 2005)
Among market participants is “a widespread agreement that more Shariah compliant products
will come to the market – whether retail, institutional or even exotics.” (Economist Intelligence
Unit 2007) As already mentioned in 1.5.3, the Islamic Development Bank (2007) estimates the
market share of Islamic banking products and service by 2015 to be around 50 percent in the GCC
region and 15 to 25 percent in Southeast Asia. Similarly Western institutions established in the
GCC region will increase their Shariah-compliant product offerings to around 40 percent of their
portfolio in the next three years. (Economist Intelligence Unit 2007)
1.6. PROSPECTS FOR ISLAMIC FINANCIAL INDUSTRY
As pointed out in the section above, the Islamic financial services industry shows promising
growth prospects for several reasons. Firstly Muslims become increasingly aware of the
possibilities to invest in conformity with their faith which leads to rising demand. On the supply
side a growing number of financial institutions worldwide are interested to establish themselves in
the niche market of Islamic finance, either as fully-fledged Islamic bank or Islamic Window. They
either settle down directly in Middle East and Southeast Asia where the proximity to local clients
(especially high net worth individuals) and the liberalization and reformation of markets bring
their influence to bear or try to approach the Muslim communities in Western markets. The
second path should be subject of the following chapters.
In the United Kingdom, that has established as European Islamic financial center, the market
depth is already significant. Fully-fledged Islamic banks, in retail and investment banking, can be
1. Foundations and Basic Principles of Islamic Banking
58
found as well as professional Islamic Windows of well-known conventional banks and specialized
Shariah advisors and lawyers. The government issues regulations to smooth the way for these
developments. Initiatives in other European countries, like Italy and France to build up fully-
fledged Islamic banks show that they do not want to lack behind the United Kingdom in this
respect. The 6 to 8 million Muslim living in Europe might show great unexploited market potential
and could be addressed, for example via ethno- and minority marketing approaches backed by a
Shariah compliant product and service offering. The following section 2 gives a market overview of
the existing Shariah compliant product and service market in Europe complemented by experts’
opinions on further potential and challenges ahead. Finally in section 3 the results of interviews
with several key financial institutions in Germany are presented leading to recommendations on
how German banks could become active in Islamic finance.
2. Evolution of Islamic Banking in Western Europe
59
2. Evolution of Islamic Banking in Western Europe
In Figure 19 estimations about the Muslim populations in some Western European countries
are visualized. However it has to be kept in mind that these figures do not include temporary
residents and illegal migrants. Neither they indicate the dynamic growth rates of Muslim
population in some these countries that could lead to substantial higher numbers in 2008.
Figure 19 Muslim population in selected Western European countries38
(according to BBC 2008)
The countries colored blue will be analyzed in this section whereas Germany (marked red) will
be subject of section 3. Grey shaded countries are not in the focus of this research. For further
information to this markets please refer to 2.6.
38
The BBC gathered the information about the Muslim population from the respective national statistics
offices (Austria 2001, Italy, Netherlands 2004, Switzerland 2000, and United Kingdom 2001) governmental
estimates (France and Germany) and the US State Department (Belgium, Denmark, Spain and Sweden).
2. Evolution of Islamic Banking in Western Europe
60
“Although most Muslims in the West are aware of the Islamic prohibition of Riba, they are not
necessarily willing to investigate Islamic savings and financing possibilities, especially if the services
seem expensive compared to the conventional equivalents.” (Wilson 2007, 430) Consequently
Islamic banking and finance products are only offered to a limited extent in non-Muslim countries,
such as Western Europe. However, “its development [there] is already having a major impact on
the Islamic finance industry worldwide” (Wilson 2007, 431). This is caused by the more favorable
“climate for innovation” and legislative features, such as the protection of intellectual property
rights. The reasons for the advancements of Islamic banking business in Europe are diverse. Firstly
most initiatives of Islamic banking in Europe are “supply rather than demand driven” (Wilson
2007, 430). The momentum originates in the Muslim countries (such as the GCC countries or
Malaysia) and not in the European Muslim communities. Therefore all fully-fledged Islamic banks
in Europe, mainly established in the United Kingdom, were initiated and sponsored by institutions
and investors from Muslim majority countries in Middle East or Asia. Secondly European
companies, suffering from the current credit crunch, have to investigate on new possibilities to
raise funds. Given the excess liquidity, especially in the oil-exporting countries, it becomes
reasonable to offer Shariah compliant investment facilities to approach the foreign investors.
Another aspect is the targeting of Muslims living in Europe with retail products, done by the
Islamic Bank of Britain for example. However these approaches are of less significance so far.
Finally the rising interest for “ethical investments” facing the current financial crisis in the
conventional system might give momentum to the development of Shariah compliant financial
products. People in Europe, Muslims and non-Muslims alike, might look for new investment and
banking facilities that are based on assets, providing sustainability and credibility.
In the following the markets for Islamic financial services in the United Kingdom, Switzerland,
France, Italy and Austria are presented, and Shariah compliant offerings of local financial
institutions introduced. The market analyses are partially based on questionnaires and interviews
conducted within the scope of this research, others base on data available in dedicated market
surveys and in the internet. Initially, the developments in the United Kingdom, the pioneer of
Islamic finance in Europe, will be scrutinized.
2. Evolution of Islamic Banking in Western Europe
61
2.1. UNITED KINGDOM
2.1.1. Establishment of London as the Western centre for Islamic finance
“London has earned itself a status as the major Islamic financial centre in the West.” (Baba
2007, 397) In the 1980s when the first Islamic banks in the Gulf were found (please refer to 1.5.1),
banks in London provided them with Shariah-compliant overnight deposit facilities. These short-
term trading transaction were based on the Murabaha concept (please refer to 1.2.2.1) and
handled with commodities from the London Metal Exchange. They laid the cornerstones for
London’s expertise in Islamic banking because the people involved gained valuable knowledge in
responding to special demands of Muslim clients. In the following years, the interactions between
“British bankers involved with Gulf clients, shari’a scholars and the British Pakistani community,
notably through the Institute of Islamic Banking and Insurance (IIBI)39” (Wilson 2007, 419)
improved and became increasingly important. In 1982, the first fully-fledged Islamic bank was
established in London when the Al Baraka Investment Company (please refer to 1.5.7) acquired
“Hargrave Securities”, a licenced deposit taker in the UK and converted it into an Islamic bank.
(Wilson 2007, 420) Until 1993 it operated as a retail bank offering current accounts, chequeing
facilities, investment deposits and most importantly house financing. However products and
services were predominantely targeted at Arab visitors to London and high net worth individuals
from the Gulf. Later in 1990s British Muslims were approached as well. Due to lacking critical mass
and a change in British banking law, the Al Baraka Bank re-incorporated in 1993 as investment
company, gave up it banking license and closed its three branches. It is now operating two
subsidiaries, being the “Al Baraka Investment Company” dealing with short term financing and the
“Dallah Al Baraka Investment Company” concerned with long term financing. The company
generated profits of $12.2 million in 1996, having total assets of over $385 million and investment
deposits amount to $161 milllion. Therefore its profit to asset ratio was 3.12 ,well above the Al
Baraka company in Bahrain with 2.64. (Wilson 2000)
In the 1990s London Islamic banking market grew moderately. New advances in retail banking
were made however the remained at very limited scale. Regulatory and tax disadvantages lead to
39
The Institute of Islamic Banking and Insurance, abbreviated IIBB, was found in 1991 in London as “centre
of excellence for professional education, training, research and related activities to build a wider knowledge
base and deeper understanding of the world of finance promoting the Islamic principles”. (Institute of
Islamic Banking and Insurance[3] 2008)
2. Evolution of Islamic Banking in Western Europe
62
low consumer protection and high prices making the products unfavorable. (Financial Services
Authority 2007) In those days the Islamic financial services focused predominantely on investment
banking, private banking, mortgages and health care finance. They were provided by conventional
banks within the scope of Islamic Windows. Consequently further knowlegde was built up and
staff was challenged to use skills in financial engineering to adopt existing services in a Shariah-
compliant way. The British Muslim community did rarely benefit from this development. (Wilson
2000) After first approaches in 1995, the British government eventually committed in 2001 to
combate the financial exclusion of this minority (Institute of Islamic Banking and Insurance[2]
2007). It initiated several legislative changes and intensified the dialogue with Muslim
communities40. (Financial Services Authority 2007) Thereafter the measures showed immediate
effect. In 2004 the first fully-fledged Islamic retail bank was licensed by the Financial Services
Authority (FSA) followed by the first European Islamic investment bank licensed in 2006.
Subsequently different players established in London either as fully-fledged Islamic bank or Islamic
Windows. The Financial Services Authority (2007) summarized
“Most of the growth of Islamic finance in the UK has taken place in the last five years.[…]
Both on the retail and the wholesale side, the quality of products has improved; a wider
range of products has become avaiable; and more players entered the market.”
There might exist several reasons why London could finally establish as “global ‘hub’” (Financial
Services Authority 2007) or “ancillary centre” (Baba 2007, 397) for Islamic finance. First of all the
Islamic finance industry is a very recent phenomenon and tries to expand from Middle East and
South East Asia around the globe. In doing so knowledge and skills of international financial
centers are indispensable and London proved as traditional financial centre that it is willing to
innovate and respond flexibly to new ideas. Market players find there a “large pool of legal,
accounting and financial engineering skills on which they draw” (Financial Services Authority
2007). One of the innovations made is the Murabaha treasury deposit account invented by the
Islamic Bank of Britain (please refer to 2.1.4.3). Major international banks represented or based in
London did already operate a presence in the Middle East for several years and gained experience.
Most of them established themselves as Islamic Windows in the market and rely on their
experiences in product development and a solid pool of resources from conventional banking
40
Selected regulatory changes to provide a level playing field for Islamic banks will be discussed in chapter
2.1.3.
2. Evolution of Islamic Banking in Western Europe
63
activities. Another aspect is the excess liquidity in Middle East. For example Gulf investors look for
foreign investment targets as their domestic markets could not keep up with the rapid
accumulation of wealth in the region caused by the rising oil prices. In this respect London is closer
to the Middle East than New York and in a favorable time zone. (Wilson 2000) Finally the British
Muslim community is very well organized and fosters advancements in Islamic retail banking. In
response regulatory authorities and the governments in the United Kingdom removed obstacles
for Islamic financial service providers that are still present in most other Western legislations.
In the following, the market potential for Islamic banks will be closer examined by looking at
the Muslim community living in the United Kingdom.
2.1.2. Muslims in the United Kingdom
A census executed in the United Kingdom in 2001 showed that “after Christianity, Islam was
the most common faith with nearly 3 per cent describing their religion as Muslim (1.6 million)”
(Office for National Statistics 2003). The contact to Muslims has grown historically since the
Middle Ages and from 1960s onwards when many people arrived from former colonies,
predominantely from East Asia and East Africa Asia. Nowadays at least 50 percent of the Muslim
population was born in the UK and well-established and well-organized permanent communities
exist. (BBC 2008) In 2001, around “one third of the Muslim population was under 16 – the highest
proportion for any group” (Office for National Statistics 2003) As can be derived from Figure 20,
the UK Muslim population is quite heterogenous. (Wilson 2000) The Pakistani and Bangladeshi
ethnic groups consitute the largest ones, counting around 658,000 and 260,000 people,
respectively. (Office for National Statistics 2003) Additional to the permanent residents comprised
in the 2001 census, there live approximately 500,000 temporary Muslim residents in the UK. These
are for example students or summer visitors from the Gulf. (Wilson 2000) In total it is estimated
that over two million Muslims live in the UK, being 350,000 households that have in average twice
the size of a typical British family. (Wilson 2000)
2. Evolution of Islamic Banking in Western Europe
64
Figure 20 UK Muslims by ethnic group, April 2001 (Office for National Statistics 2003)
The largest Muslim communities live in the urban areas of the cities London, Birmingham,
Manchester, Leicester, Bradford and Glasgow and face “high level of unemployment, low level of
qualification and low home ownership” (BBC 2008). However according to Rodney Wilson (2000)
this is about to change as an increasing number of those people are becoming professionals
holding a university degrees who belong to the middle class. Others own small or medium sized
local enterprises.
It can be stated that both the younger and the older generation of Muslims in the UK are
strongly devoted to religion and have excellent knowledge of it. Therefore the majority is aware of
the concerns about Riba and other Islamic restrictions in financial matters (please refer to 1.1.3).
Rodney Wilson (2000) explains that some of those who have conventional bank accounts, devote
received interest to charity organizations for purification purposes.
Regarding the data shown above, it can be summarized that there is a significant domestic
market potential in the United Kingdom for Islamic banking, given the high religiousness.
Eventhough the percentage of Muslims to the total population is not as high as in other countries
(for example in France, please refer to 2.3). This assessment was confirmed by the British bank
Lloyds TSB which conducted a research that showed: "Over three-quarters of British Muslims want
banking services that fit with their faith” (BBC 2005).
2. Evolution of Islamic Banking in Western Europe
65
2.1.3. Government initiatives and cooperation
In the course of researches and investigations initiated after the terrorist attacks on September
11, 2001 it was found that many Muslims in Western countries face social exclusion and live
concentrated in urban areas of large cities. (Plews 2005, 31 and Wilson 2000) The United Kingdom
government promoted thereupon more tolerance in British society and issued several programs.
(Plews 2005, 31) Some of those facilitated the provision of Shariah compliant financial services, by
abolishing regulatory hurdles and tax disadvantages, in order to give local Muslims the possibility
to handle their financial matters in accordance with their faith.
Lord Edward George (Governor of the Bank of England) emphasized already in 1995 the
growing importance on Islamic banking on an international level and suggested to “put Islamic
banking in the context of London’s tradition of ‘competitive innovation’” (Financial Services
Authority 2007). It became appearant that the United Kingdom has a “clear eceonomic interest”
(Financial Services Authority 2007) in establishing as the European Islamic financial centre. In 2001
a high level working group was initiated chaired by Lord George with the target to “examine the
barrieres to Islamic finance in the UK” (Financial Services Authority 2007). Its members included
represantatives from the City of London, the government, the Muslim community and the FSA
who identified, for example, the problem of double stamp duty paid on Islamic mortgages41. All
resolutions passed became a matter of public policy and were translated into respective
government legislations (please refer to Table 3). The overriding principle is “no obstacles, but no
special favours” for Islamic banks with the purpose to create a level playing field facing
competition of conventional banks.
In the subsequent years the interaction with the Muslim community has been reinforced, for
example, by maintaining working level contacts with Islamic institutions (such as the IIBI), other
regulatory agencies, the Islamic financial service industry and international organizations (such as
the AAOIFI). (Financial Services Authority 2007) Since 2004, at least four fully-fledged Islamic banks
have be granted a banking license by the FSA, namely the Islamic Bank of Britain (2004), the
European Islamic Investment Bank (2006), the Bank of London and Middle East (2007) and the
Gatehouse Bank (2008). Together with the numerous Islamic Windows operated by London’s
41
Before the stamp duty had to be paid in Islamic mortgage contracts twice as it was first paid on the
purchase of the property by the bank and secondly it emerged on the transfer of the property by the bank
to the customer at the end of the mortgage term. Similar tax disadvantages for Islamic financial products
exist in several legislations due to the asset transactions involved.
2. Evolution of Islamic Banking in Western Europe
66
conventional banks (who are not subject to special authorisation by the FSA), this results in the
highest concentration of Islamic financial insitutions in a non-Muslim country.
Table 3 Regulatory initiative in the United Kingdom (Financial Services Authority 2007)
2.1.4. The current Islamic financial market in the United Kingdom
Rodney Wilson (2007, 425) states that “there is much that other European Union member
states can learn from the quarter of a century experience in the UK and, even if some lessons are
cautionary, many in the Muslim community now believe that British Islamic finance is really taking
off.” The following chapters should give a rough overview over Shariah-compliant products and
services offered by British market players that are presented subsequently.
2.1.4.1. Retai l Market
Although the retail market was assigned considerable growth potential in the UK by experts at
the beginning of the 2000s (see Wilson 2000), it proved only partially true. So far only the
mortgage market achieved a considerable asset volume of £500 million which is still very few in
comparison to £1.1 trillion assets in the conventional UK mortgage market. Most of these products
are based on Ijarah and diminishing Musharaka concepts as described in chapters 1.2.1.2 and
1.2.3. (Financial Services Authority 2007) The Takaful business is only present to very limited
extent as not more than two British providers operate in this business. The demand for current
and savings account was obviously overestimated.42 The FSA (2007) commented that financial
42
In 2006 the Islamic Bank of Britain only maintained 50,000 retail accounts for 42,000 people. This covers
roughly 2 percent of the Muslim community in the United Kingdom. (Financial Services Authority 2007)
2. Evolution of Islamic Banking in Western Europe
67
decisions in the Muslim community are influenced by “a variety of factors” and it is therefore
misleading to regard needs and demands of Muslim consumers as uniform.
However according to Sohail Jaffer (2005), Islamic retail products are a very young
phenomenon and in the beginning major resources were invested in the research of wholesale
and wealth management products as they target the most affluent customer groups. The Western
Muslim minority markets were lately used as “testing ground” for innovative Islamic retail
products which are often adapted versions of already existing wholesale products. It is important
to mention that Islamic retail banking was first brought forward in Western markets because the
demand was assessed higher than in Muslim majority countries. This is mainly cauzed by the
relatively high proportion of Muslims belonging to the middle class ,in contrast to countries in the
Middle East where the middle class is very small and the gap between poor and wealthy
customers is considerably larger.
Hence it might be too early to judge whether the advance of the Islamic retail banking market
will turn out successful. In this sense the FSA (2007) points out that recent reforms might result to
an increasing market share of those products in the next years.
2.1.4.2. Wholesale market
In contrast to the Islamic retail market, financial services targeted to corporate and institutional
clients as well as to high net worth individuals gained further importance in the recent years. Over
twenty-five new firms, including three fully-fledged Islamic banks, established in this domain.
Especially major international banks, having their headquarters in London, cater this market
successfully. (Financial Services Authority 2007) The products and services offered range “from
project and trade financing to structured products, asset management and private banking”
(Financial Services Authority 2007). The most considerable growth can be observed in the Sukuk
market (please refer to 1.2.4.2). London established the first secondary Sukuk market in the world
in 2006 which handled already $2 billion in the beginning of 2007. (Financial Services Authority
2007) In the same year the first Sukuk was listed on the London Stock Exchange and currently the
government supports the idea of issuing sovereign Sukuk. The wholesale products and services at
offer are mostly targeted at international customers and only in second place to the local Muslim
community. (Wilson 2000)
2. Evolution of Islamic Banking in Western Europe
68
In London the European Islamic banking activities are concentrated. That becomes apparent in
the number of Islamic banking providers, both fully-fledged Islamic banks and Islamic Windows,
situated in the City.
2.1.4.3. Fully-fledged Islamic banks
The Is lamic Bank of Br itain
In 2004 when the Islamic Bank of Britain (IBB) received authorization by the FSA, it attracted
major media attention being the first fully-fledged Islamic bank in the United Kingdom, after the Al
Baraka company gave up its banking license in 1993 (please refer to 2.1.1), and the pioneer in
Islamic retail banking business. (Wilson 2007, 421) The company formerly known as “Islamic House
of Britain” was found in 2002 with £14 million start-up capital raised by a private placement in the
Gulf, major contributors being the Qatar International Islamic Bank with 49 percent share in initial
capital and the Abu Dhabi Islamic Bank which provided resources and personnel. (Middle East
Economic Digest 2004 and Islamic Bank of Britain 2008) In October 2004 the bank became listed
on the Alternative Investment Market of the London Stock Exchange43 in order to broaden the
shareholder base and especially to include more UK investors (Middle East Economic Digest 2004).
IBB’s board and management are staffed with Gulf and UK business men who all have gained
extensive working experiences in Bahrain and Qatar before. Key numbers and financial data can be
derived from Table 4. The customer deposits in 2007 amounted to £135,000,000 (compared to
£84,000,000 in 2006) and customer financing increased to £15,800,000 (compared to £10,500,000
in 2006). Although key financials and customer data could be improved recently, the growth is still
quite modest and the bank is not as successful as previoulsy anticipated by the media. Initially the
company intended to expand to Europe, especially Germany and France, after holding the UK
banking license for two years. However this did not happen so far. The Islamic Bank of Britain
focuses on retail banking services for the Muslim community in the UK and offers only some
selected wholesale services, such as a treasury account. (Islamic Bank of Britain 2008) The bank’s
product and service offering includes Shariah compliant current and saving accounts for private
persons and businesses, treasury accounts for high net worth individuals and financial institutions,
43
The market capitalization amounted to £25.14 million on December 19, 2008. On June 30, 2008 there
were 419,000,000 ordinary shares (ISIN: GB00B02KNV97) in issue whereby 57.33 percent of the ordinary
shares are not in public hands. (London Stock Exchange 2008 and Islamic Bank of Britain[2] 2008)
2. Evolution of Islamic Banking in Western Europe
69
personal and business finance, commercial property finance, banking for Mosques and charity
organizations and transfer services to send money abroad.
Table 4 Fully-fledged Islamic banks in the United Kingdom (according to Islamic Bank of Britain 2007,
European Islamic Investment Bank 2007, Bank of London and the Middle East 2007 and Gatehouse
Bank 2007)
All products and services are certified and audited by a permanent Shariah Supervisory Board
chaired by Dr. Abdul Sattar Abu Ghuddah44. (Islamic Bank of Britain[4] 2008) The operation’s
headquarter is located in Birmingham where a major part of United Kingdom’s Muslim community
is situated. Further six branches are operated in other cities of the United Kingdom, for example in
London and Leicester. According to Rodney Wilson (2007, 422) the IBB chooses branch locations
ain response to the “socio-economic status of potential clients”. It targets “middle-class Muslims
in professional occupation with regular monthly salaries”. Additionally to the branch network, the
IBB distributes its products and services via postal, telephone and online banking facilities. (Islamic
Bank of Britain[3] 2008) The marketing philosophy comprises the attempt to make everything
simple and understandable for customers whilst being transparent and requiring no minimum
deposit amount. (Jaffer 2005, 26). In doing so, the bank promotes its products and services on a
“well-designed website” as well as on “informative and attractive leaflets in English, not Arabic”
(Wilson 2007, 423). In its marketing initiatives, products are also targeted to non-Muslim
customers adhering to ethical principles similar to those promoted by the Shariah. (Islamic Bank of
Britain 2008) In average 175 employees were employeed during 2007 (Islamic Bank of Britain
2007) from which most are Muslims but only some speak Arabic fluently (Wilson 2007, 422).
44
Further members are Sheikh Nizam Muhammad Saleh Yaqoobi and Mufti Abdul Kadir Barkatullah.
2. Evolution of Islamic Banking in Western Europe
70
The European Is lamic Investment Bank
The first independent Shariah compliant investment bank was authorized by the FSA in 2006
(European Islamic Investment Bank 2008). It’s founders include individuals and institutions
(including Islamic banks) based in GCC countries and in Europe. It is chaired by Adnan Ahmed
Yousif who is at the same time CEO and Board Member of the Al Baraka Banking Group (please
refer to 2.1.1). Since April 2006 the EIIB is listed on the Alternative Investment Market (AIM) of the
London Stock Exchange45 and in November 2006 it opened a representative office in Bahrain
(European Islamic Investment Bank[2] 2008). It has established a strategic alliance with the Bank
Islam Malaysia Berhard in Malaysia to have access to the Malaysian market and operates to large
scale in Middle Eastern markets (European Islamic Investment Bank 2007).
EIIB’s core business is investment banking, operated in three business lines being Islamic
treasury and capital markets (for example interbank commodity transactions, term financing,
Sukuk and structured trade transactions), asset management including private banking in Europe,
Middle East and Asia and corporate finance, advisory and real estate. Customer deposits
amounted to £275,000,000 in 2007 (compared to £49,000,000 in 2006). (European Islamic
Investment Bank 2007) All products are Shariah compliant, monitored by a permanent Shariah
Supervisory Board consisting of four members46. At the end of the year 2007 the EIIB employed
thirty-nine employees . (European Islamic Investment Bank 2007) It is regarded as a young “niche
operator” which has to experience disadvantages facing highly competitive investment banking
services of leading European investment banks. (Wilson 2007) For key figures and financial
information please refer to Table 4.
The Bank of London and the Middle East
A second fully-fledged Islamic wholesale bank was established in London in August 2006 and
authorized by the FSA in July 2007. (Bank of London and the Middle East 2007) Additionally it was
granted the permission to passport its operations in the European Economic Area47 as first Islamic
financial institution in the UK. (Financial Services Authority 2007) The Bank of London and Middle
45
The market capitalization of the EIIB amounted to £75,4 millions on December 19, 2008. It is listed under
ISIN GB00B126GW60. (London Stock Exchange[2] 2008) 46
The Shariah Supervisory Board is staffed by Justice (rtd.) Muhammad Taqi Usmani, Dr Abdul Sattar Abu
Ghuddah, Dr Abdul Latif Mahmood Al Mahmood, Sheikh Nizam Muhammad Seleh Yacouby. 47
This cross-country passport enables BLME to „offer its products and services across all EU member states,
without a physical presence in the host country“. (Financial Services Authority 2007)
2. Evolution of Islamic Banking in Western Europe
71
East London (BLME) started with a paid-up capital base of £175 million raised by a private
placement which has been increased by a second private placement recently, leading to a capital
base of over £250 million. This is the best capital base for any Islamic bank in the UK. (Bank of
London and the Middle East 2008) According to the Annual Report 2007, the Board intends to list
the bank on the Alternative Investment Market (AIM) of the London Stock Exchange “in the near
future”. The BLME provides similar products and services like the EIIB. It operates a Markets
division and Corporate Banking division. The former is concerned with Islamic treasury and
financial institutions whereas the latter handles Shariah compliant trade finance, real estate
finance, project finance and structured finance. (Bank of London and the Middle East[2] 2008) The
bank held customer deposits amounting to £5,601,432 in 2007 and had liabilities to financial
institutions worth £108,649,281. (Bank of London and the Middle East 2007) Further key figures
and financial information can be derived from Table 4.
Shariah certification is under responsibility of a permanent Shariah Supervisory Board48. (Bank
of London and the Middle East 2007) Regarding its performance in 2007 and the outlook in 2008
the CEO Humphrey Percey stated in the Annual Report (2007):
“In the UK and EU region we are confident that the demand for Islamic Finance and
particularly Sharia’a based products will continue to grow, prompted by increased trade
and capital flows emanating from the Gulf region, and the latent demand for assets that
can provide improved yields and diversification to Islamic investors.”
The distribution of products and services is targeted towards Europe, Middle East and North
Africa. Similarly assets are dispersed to GCC countries (79 percent), Europe –especially Germany
and France (16 percent) and Turkey and Algeria (5 percent). At the end of the year 2007 thirty-four
employs served BMLE. (Bank of London and the Middle East 2007)
The Gatehouse Bank
In May 2007 the Gatehouse Bank was found as a subsidiary of the Securities House Kuwait49
and provided with a paid-up capital of £10,000,000 by its parent company (Gatehouse Bank 2007).
48
The Shariah Scholars employed are Sheikh Dr. Abdulaziz Al-Qassar (Chairman), Sheikh Dr. Esam Khalaf Al-
Enezi, Sheikh Dr. Mohammed Daud Bakar and Sheikh Dr. Mohammad Imran Usmani. 49
According to own website information (please refer to http://www.sh.com.kw/, accessed: 20.12.2008;
12:30), the Securities House was established in Kuwait in 1982 and constitutes one of the leading and “most
2. Evolution of Islamic Banking in Western Europe
72
It was authorized by the FSA in April 2008. (Gatehouse Bank[1] 2008) Focusing on business clients
and other financial institutions in Western Europe and GCC countries, it offers business financing,
capital market instruments, institutional wealth management and treasury accounts. The business
is supported by a strategic partnership with a European open ended fund managers. The product
portfolio will be enlarged following the investor demand. Furthermore the bank operates a
“unique Shariah Advisory and Shariah Compliance Department” (Gatehouse Bank[2] 2008) in
addition to the inhouse auditing and certification processes ensured by its permanent Shariah
Supervisory Board50. The marketing strategy includes the adressing of ethical investors and
depositors (Muslims and non-Muslims alike) as well as the promotion of fund-raising in Middle
East for Western business clients. Advertisments are places in respective print media
(advertisment in English and Arabic). Additionally personal networks are used. The Gatehouse
Bank plans to approach potential client areas in Asia, the United States and Latin America in 2009.
The liquidity and risk management is handeled by holding high liquidity reserves and by making
use of Islamic treasury accounts (provided by other Islamic financial institutions). For example in
the year 2007, “free cash has been deposited with the Islamic Bank of Britain [please see above],
with whom we have entered into several Shariah compliant deposit transactions” (Gatehouse
Bank 2007) As 2007 was “the start-up period” and the bank had not yet received its authorization
by the FSA, key financials are not to be regarded as comparable (please refer to Table 4).
Challenges are especially the lack of managers having adequate knowledge and experience in
Islamic banking and finance, the high time and cost efforts involved in the product development
process as well as the lack of suitable banking software, because the vast majority is designed for
the interest-based system. Regarding religious compliance there exists a two-sided problem. On
the one hand side the inconsistency in fatawa of different Shariah Supervisory Boards (especially
those of the Gulf region versus those from Malaysia) hampers efficiency, complicated by the the
shortage of Shariah scholars. In a dedicated questionnaire, a represenentative of the Gatehouse
Bank claimed that Islamic financial institutions should “take the Shariah principles more seriously
and stop believing that anything conventional can be replicated islamically”
successful investment companies in the GCC and Middle East region”. Since 1996 it is listed on the Kuwait
Stock Exchange. 50
Members of Gatehouse’s Shariah Supervisory Board are Sheikh Nizam Yaquby (Chairman), Dr. Abdul Aziz
Al-Qassar, Shaykh Haytham Tamim, Mufti Muhammad Nurullah Skider. (Gatehouse Bank[3] 2008)
2. Evolution of Islamic Banking in Western Europe
73
It was estimated that the “exponential growth” already forecasted for Islamic banking and
finance in Europe “may even be faster given the crisis of conventional markets”. Especially the
activites in capital markets and syndicated financing are supposed to grow considerably next five
years. Thereby the use of modern distribution channels and cross selling potentials is very
important however difficult for a start up operation. 51
Subsidiaries of Middle Eastern inst itutions
In Addition to newly established Islamic banks in the United Kingdom, financial institutions
stemming from the Middle East have opened subsidiaries dedicated to Islamic financial services in
the City of London. For example the Al Baraka Group (please refer to 2.1.1) owns the Dallah Al
Baraka Investment Company as well as the Al Baraka Investment Company, as already described
before. Furthermore the Arab Banking Corporation International Bank (please refer to the next
chapter) and the Al Rajhi Investment Corporation established asset management firms. These
subsidiaries have not obtained a banking license and are thus not authorized by the FSA.
2.1.4.4. Islamic Windows
“It is a challenge for new entrants such as the Islamic Bank of Britain to compete in a
mature market for banking services with major conventional banks offering Islamic
products, notably HSBC, though its dedicated Amanah Islamic finance division and Lloyds
TSB. (Wilson, 2007, 423)
Well before the first fully-fledged Islamic banks have been established in the United Kingdom,
several conventional banks based in London have opened an Islamic Window in order to cater the
needs of predominantly international Muslim customers.
HSBC Amanah52
The HSBC Group53 is headquartered in London and constitutes one of the largest banking and
financial service provider worldwide. In 1998 it established the global banking division “HSBC
Amanah” which is a separate branch operating in Saudi Arabia, the United Arab Emirates,
51
Information on the Gatehouse Bank was retrieved from online sources as mentioned in the text and from
a questionnaire answered by the Head of Distribution. For further information please refer to the Appendix
B . 52
The Arabic term “amanah” can be translated as “trust”: 53
The name was given according to its founding member, the “Hongkong and Shanghai Banking
Corporation”. (HSBC 2008)
2. Evolution of Islamic Banking in Western Europe
74
Malaysia, UK, USA, Indonesia, Bangladesh, Brunei and Singapore. Its business is fully differentiated
from conventional banking activites. The Amanah brand was found to make “HSBC the leading
provider of Islamic banking worldwide” and has now “the largest Islamic banking team of any
international bank” comprising more than hundred professionals. (HSBC Amanah 2008) In 2006
HSBC Amanah was already the largest foreign provider of Islamic banking in Malaysia and earned
10 percent of its net income with its Islamic banking division. (Walker, et al. 2007) The bank offers
Islamic retail and wholesale products and services. On the one hand it offers personal financial
services, comprising several Shariah compliant accounts, credit cards, home, vehicle and personal
financing solutions, Takaful products, investment solutions and private wealth management.
(HSBC Amanah[2] 2008) The availablity of single products and services depends on the market. For
most offerings a minimum deposits is required. On the other side HSBC Amanah caters business
and institutional customers. This includes trade, project and structured finance, capital markets
services and corporate adivsory as well as treasury and risk management and transaction banking
offers. Furthermore working capital and asset finance solutions as well as investment banking
services (for example Islamic mutual funds and Sukuk) are provided. (HSBC Amanah[3] 2008) In
order to obey “the highest Shariah standards in the Islamic banking industry” (HSBC Amanah[4]
2008) HSBC Amanah has three layers of Shariah supervision integrated into its operations. Firstly a
Global Shariah Advisory Board (GSAB) advises on“research activites inteded for further
development of Islamic financial service industry” (HSBC Amanah[4] 2008). It is formed by
representative scholars54 of the four Regional Shariah Committees (RSC), which supervise HSBC
Amanah businesses and operations in Saudi Arabia, Indonesia, Singapore and Malaysia. (HSBC
Amanah[4] 2008) The Regional Shariah Committees (RSC) are supervised by a Central Shariah
Committee (CSC) which is responsible for Shariah-compliancy in the United Arab Emirates, Qatar,
UK, USA and Bangladesh. Regarding distribution, HSBC Amanah is well backed by a large network
of 835,000 ATM machines and 9,500 offices worldwide as well as internet and telephone banking
facilities of the HSBC Group. (HSBC Amanah[2] 2008) The Annual Reports do not include
operational or financial data separately displayed for HSBC Amanah.
L loyds TSB
54
The GSAB is staffed by Sheikh Abdallah Bin Sulaiman al-Manea, Sheikh Dr. Abdallah Bin Muhammad al-
Mutlaq, Sheikh Dr. Mohamed Ali Elgari, Sheikh Nizam Yaquby, Sheikh Dr. Muhammad Imran Usmani, Sheikh
Dr. Mohammed Daud Bakar, Sheikh Dr. Mohammad Akram Laldin, Sheikh Adiwarman Anwar Karim. (HSBC
Amanah[4] 2008)
2. Evolution of Islamic Banking in Western Europe
75
The Shariah compliant product and services offering of Lloyds TSB and most other conventional
banks in London is much smaller compared to HSBC Amanah and mostly enabled by targeted
partnerships with Islamic financial service providers. Rodney Wilson (2007, 423) states that Lloyds
TSB acquired the company “Cheltenham & Gloucester” in 1995 (formerly the Building Society) and
formed a focused mortgage and retail savings subsidiary which was its gateway to the Islamic
banking business in 2005. Nowadays Lloyds TSB offers Islamic home finance products in
cooperation with the Arab Banking Corporation International Bank (ABC)55 . Likewise a “Shariah
Baby Bond Child Trust Fund” is offered in cooperation with “The Children’s Mutual56” for Muslim
parents who want to invest for their children in compliance with Islamic law. Furthermore British
Muslims can hold free Islamic current accounts and special Islamic student accounts for which
internet and telephone facilities are available. (Lloyds TSB 2008) The bank operates two branches
in London. (BBC[2] 2005) In a BBC (2005) interview, Gordon Ranking from Lloyds TSB explained
that: "our research shows that over three-quarters of British Muslims want banking services that
fit with their faith” which ultimately led the bank expand its product and service offering in this
domain, eventough it is still very limited. The same article indicates that British high street banks
might fear to loose their Muslim customers to newly established Islamic financial institutions (like
the Islamic Bank of Britain). That is why a lot of them might amend their conventional products
with Shariah compliant offerings in the near future.
Standard Chartered-Saadiq Is lamic Banking
In 2007, Standard Chartered rolled out an Islamic business brand, called Saadiq57. Within this
framework the company provides Shariah compliant personal services (such as accounts, credit
cards, personal and auto finance) and wholesale services (such as corporate banking and capital
markets solutions) in Bangladesh, Pakistan the United Arab Emirates and Malaysia. However the
website does not indicate that these services are actively marketed in the United Kingdom.
(Standard Chartered 2008)
55
The Arab Banking Corporation International Bank (ABC) is headquartered in Manama, Bahrain while
operating a London-based subsidiary. It is a conventional wholesale bank offering a large number of Islamic
financial services. (for further information please consider http://www.arabbanking.com/index/index.asp,
25.12.2008; 12:20) 56
The Children’s Mutual is a company specialized in savings and investment for children. It is a trading name
of the Tunbridge Wells Equitable Group. (for further information please refer to:
http://www.thechildrensmutual.co.uk/about-the-childrens-mutual/corporate-information.aspx, 25.12.2008;
12:15) 57
The Arabic term can be translated as “truthful”.
2. Evolution of Islamic Banking in Western Europe
76
Other Is lamic Windows of conventional banks
In course of the research conducted for this paper, some indications were found that other
banks, incorporated in the United Kingdom, offer Shariah compliant services-either in line with
their conventional products or through a separate Islamic brand. One of those is the Barclays
Bank. However it became obvious that these institutions target Islamic products and services to
Middle East and South East Asian markets and not to the United Kingdom or Europe. That is why
their activities are not of primary importance for this analysis.
2.1.4.4.1. Shariah Advisories
As already mentioned earlier in chapter 1.3.4, many law firms in London have specialized in
advising on and developing Islamic financing techniques for Islamic financial institutions. (Baba
2007, 397) One of the most popular advisories is BMB Islamic. Being part of the the BMB
Investment Group, BMB Islamic provides “Shariah advisory service as well as capital, placement
and distribution services of its parent company” (BMB Islamic 2008) In this way BMB Islamic assists
companies in structuring Islamic financial products, advises on underlying Islamic contracts and
issues fatawa to certify Shariah compliancy (please refer to 1.3). (BMB Islamic[2] 2008).
2.1.5. Future outlook and trends for the United Kingdom
According to the Financial Services Authority (2007) the cornerstones for the future
development of Islamic banking in the United Kingdom are laid, regarding institutional and
regulatory requirements as well as the necessary expertise. The government supports the growth
of the Islamic financial industry and initiates “Islamic Finance Expert Groups” that foster the
communication and exchange between different public institutions and the Muslim community.
Non-governmental organizations, for instance International Islamic Financial Market (IIFM) are led
from the City of London. The latter launched lately, amongst others, an initiative for the
development of derivatives that abolish hurdles regarding liquidity and risk management.
Additionally the use of EU pass porting (described in chapter 2.1.4.3) by Islamic financial
institutions will enhance the possibilities for the UK to establish as European Islamic financial
center. The FSA (2007) assumes that the demand for retail products will increase, especially
concerning personal finance and solutions for small and medium sized enterprises. On side of the
wholesale market, the Sukuk market is already well established and will further expand given, for
example, the issuance of sovereign Sukuk by the British government. The authority suggests
2. Evolution of Islamic Banking in Western Europe
77
targeting the Shariah compliant products offerings to non-Muslim, too. This could be done by
approaching ethical investors who emphasize sustainability and fairness. In case the target group
can be expanded, Islamic banking would emerge from a niche product to mainstream leading to
substantially cost reductions for the institutions resulting from economies of scale. Rodney Wilson
(2000) underlines, that the United Kingdom will maintain its place as major Islamic financial centre
if, especially, the human capacities are strengthened. This included the “real appreciation of
diverse Muslim cultures and respect for Islam” (Wilson 2000) as well as understanding the
technicalities and legal concepts. He expects a growing demand coming from the British Muslim
community as this is a much more attractive customer group than, for example, German or French
Muslim residents owing differences in religiousness58. This opinion is shared by important market
players introduced above (both fully-fledged Islamic banks and Islamic Windows).
2.2. SWITZERLAND
According to a census conducted in 2000, over 300,000 Muslims lived in Switzerland
representing around 4.2 percent of the population. (Altundag und Nadia 2005) However “official
figures suggest that the Muslim population has doubled in recent years” (BBC 2008) caused by
signficant immigration inflows from Bosnia, Serbia and the Kosovo. It is estimated that about
150,000 Muslims stay illegially in the country. Formerly most Muslims arrived as workers from
Turkey, Albania and former Yugoslavia. In subsequent years they were followed by their families
and later by asylum seekers. Only few hold Swiss citizenship. (BBC 2008)
2.2.1. Market players
Switzerland being an internationally established financial centre for private wealth
management is home to several Swiss and international financial institutions that are active in the
field of Islamic banking as well as to one fully-fledged Islamic bank. Most important is the interest
of wealthy customers from the Middle East for Switzerland regarding financial matters, owing the
favorable tax conditions and the reputation promising confidentiality. Therefore a lot of Arabic
financial institutions follow their customers and establish branches in Switzerland. These are for
example the Blom Bank, the Arab Bank, the Bankmed and the Banque Audi. However, only few of
them offer Shariah compliant financial services. (Soukup 2008) In contrast the Dar Al Maal Islamic
investment trust (abbreviated DMI, please refer also to 1.5.7) headquartered in Geneva does. It
58
This aspect will be further deepened in chapter 3.
2. Evolution of Islamic Banking in Western Europe
78
describes itself as “the world’s most powerful Arab banking institutions” (Faisal Private Bank[1]
2009) and holds considerable ownership shares (around 79 percent) in the Faisal Private Bank, the
Swiss fully-fledged Islamic bank. DMI provides Shariah compliant products mainly for Arab clients
based in the Middle East and some wealthy Arab temporary residents of Geneva. Switzerland’s
small Muslim community, most of them stemming from Turkey and North Africa and employed in
low-wage jobs does not belong to DMI’s target group. (Wilson 2007, 431)
Faisal Private Bank
The same holds for the Faisal Private Bank that received authorization of the Swiss Federal
Banking Commission (SFBC) in 2006 and is the first Islamic private bank as such. It promotes “an
attractive ethical alternative to traditional investments” (Faisal Private Bank[2] 2009) in order to
target Muslims and non-Muslims alike whereby the ethical principles are derived from the
Shariah. (Faisal Private Bank[2] 2009) The bank offers real estate planning, wealth management
and investments for institutional clients. At the end of 200659 the bank employed thirty-eight
employees and held assets amounting to CHF 103,204,000 (equal to €70,179,661.1160). It earned
CHF 1,744,000 (€1,185,348.58) of profit, constituting a decrease of 41 percent compared to the
2005 profit of CHF 4,248,000 (€2,887,248.14). However these figures are not representative as the
institution was not authorized as bank before 2006. (Faisal Private Bank (Switzerland) SA 2006)
Bank Sarasin & Cie AG
The Bank Sarasin & Cie AG focuses exclusively on “sustainable private banking” as corporate
philosophy. It caters private and institutional investors. Among others its offering seems to include
an Islamic investment fund and other Shariah compliant financial products61. (Bank Sarasin & Cie
AG 2009 and el-Mogaddedi 2008)
UBS I slamic Finance
In 2002 the UBS founded “Noriba” a 100 percent private wealth management subsidiary
specialized on Shariah compliant investment possibilites. It was headquartered in the Kingdom of
59
The homepage only provides an Annual Report for 2006. Further information was not available on
request. 60
Exchange rate 1 CHF = 0.680009 according to http://www.xe.com/ucc/convert.cgi, accessed: 14.01.09;
17:00. 61
Detailed information could not be obtained.
2. Evolution of Islamic Banking in Western Europe
79
Bahrain. In 2006 the business unit was fully re-integrated into the firm. The UBS declared it aims at
providing its full product range (global wealth and business banking, global asset management and
investment bank) as an integrated business model offering Shariah compliant products in line with
conventional products. “Clients have sought to receive these products from UBS itself rather than
from the separately branded unit.” (UBS 2006) Consequently the brand, called UBS Islamic
Finance, caters high net work individuals worldwide but predominantly in the Middle East with
Shariah compliant investment products and wealth planning services. It operates five
representative offices in Abu Dhabi, Bahrain, Dubai, Cairo and Beirut, describing itself as
“commited to the Middle East” (UBS 2009). Three Shariah compliant products are introduced on
the companies website. Firstly the bank offers a fixed-term deposit based on a commodity
Murabaha (please refer to 1.2.2.1). Secondly a structured Islamic investment is provided based on
two simoultanous transactions involving the foreign exchange markets. In this case profit should
be generated based on developments of the investment currency against an alternative curreny
(please refer to 1.2.5.2). Finally the clients are catered with a “Shariah compliant succession
planning solution” including wealth transfer, the establishment of a trust and asset consilidation.
(UBS 2009) Shariah compliancy is ensured by a permanent Shariah Advisory Council62 that certifies
all products before their launch and ensures their compatibiltiy with Islamic law through regular
audits and periodic reviews. (UBS 2009)
Credi t Suisse
The Credit Suisse offers Islamic private banking services in line with conventional products, too.
However it has established a dedicated global Islamic distribution team consisting of private
bankers. Its efforts are merely concentrated on the high net worth individuals and business clients
in Middle East. Thereby it offers capital market instruments, asset management and private
wealth management solutions based on the Islamic concepts Murabaha, Ijarah and Sukuk. A
permanent Shariah Supervisory Board63 ensures Shariah compliance of the products and services
offered. Answering to a dedicated questionnaire, a representative from the Credit Suisse Dubai
branch mentioned that the product development process requires substantially higher time and
cost efforts compared to conventional banking products and the inconsistency of Shariah scholars’
62
The Shariah Supervisory Board consists of Sheikh Nizam Yaquby, Dr. Abdul Sattar Abu Ghuddah and Dr.
Mohammed Elgari. 63
The Shariah Supervisory Board is staffed by Sheikh Dr. Muhammed Elgari, Sheikh Nizam Yaquby and Dr.
Muhammad Imran Ashraf Usmani.
2. Evolution of Islamic Banking in Western Europe
80
decisions complicates the situation additionally. At present the bank caters less than 5,000
customers with Islamic financial services holding Islamic assets between €500 million and €1
billion. Around 70 percent of revenues are apportioned to equity portfolios whereas the remaining
30 percent concentrate on Sukuk, notes and private equity products. The overall result of Islamic
financial service activities amounted to less than €5 million in 2007. The Credit Suisse approaches
clients in English and Arabic by promoting Shariah compliancy and ethical investments. Within this
scope small and medium enterprises are targeted, too. Major distribution channels are personal
networks and word-to-mouth advertisement. Prospectively it is planned to offer Shariah compliant
products via the existing branch network in order to expand to other markets and to enlarge the
client base. Furthermore the product portfolio will be complemented by structured products and
Shariah compliant investment funds. However it seems problematic to find adequate experts for
product development. It was assessed that there will open up new markets for Islamic banking
products and demand for new and innovative products and services will rise. Operationally the
lacking software based on an interest-free system poses problems to further development. 64
2.2.2. Future outlook
Given the good international reputation of Swiss financial institutions, especially in private
banking, wealthy individuals from Muslim majority countries might become increasingly interested
in their Shariah compliant product offerings as this trend proceeds. Therefore it seems likely that
Switzerland establishes itself as centre for Shariah compliant private wealth management in
Europe. The Swiss financial institutions will thereby cater their international clients in Switzerland
and, via respective subsidiaries, in Middle East. However, due to the fact that neither initiatives
from the Swiss government are known nor Swiss banks have made advances in this respect, it can
estimated that the local Muslim community might not be targeted due to the low socio-economic
status.
2.3. FRANCE
2.3.1. Muslims in France and Islamic market potential
France constitutes the “largest potential market for Islamic finance in the West” (Moody's
Investors Service 2008) given the fact that it is home to five to six million Muslims, amounting to 8
64
A representative from the Credit Suisse Dubai branch answered a questionnaire dedicated to Islamic
Windows, compiled by the author. For further information please refer to Appendix B.
2. Evolution of Islamic Banking in Western Europe
81
to 9.6 percent of the total population. This is the largest Muslim population in Europe. The
majority (around 70 percent) originates from former North African colonies: Algeria, Morocco and
Tunesia. (BBC 2008) Regarding the integration of immigrants the French state strictly follows the
principle of secularity and opposes communitarism. (Moody's Investors Service 2008) For this
reason most Muslims living in France hold the French citizenship. At the same time there exist
major integration problems regarding Muslim immigrants given their contradictory attitude
towards the French strict seperation of religion and public life. For instance the abolition of
religious symbols (especially the Islamic headscarf) from public schools was answered with “a
major national row” (BBC 2008). In 2005 France experienced a wave of rioting among mainly
immigrants, potentially caused by the high unemployment and the unsatisfying living situations in
poor suburbs. (BBC 2005)
Despite their low socio-economic status Zoubeir Ben Terdeyet65 (2008) ascribes significant
market potential to the French Muslims. He mentions that a new middle and upper class
representated by senior executives and professionals in banking, IT and legal fields emerges
currently. Furthermore he adds that “French nationals of Northern African origin outnumber other
ethnic groups in starting new businesses in France” (Terdeyet 2008) and are increasingly
interested in home financing. Compared to the British Muslims, who come from the Middle East
and Asia where Islamic banking industry is already well established, French Muslims are not yet
aware of the possibilitites to invest and safe according to their faith as Shariah compliant products
were only launched recently in their home countries. Mr. Terdeyet (2008) estimates that an
increasing number of Muslims in France adheres to Islamic prinicples in their daily life and
business practices. This fact might be confirmed by the growing halal food industry66 in France
amounting to €8 billion in 2008. Furthermore Moody’s Investor services (2008) emphazise that
“France shares a long, shared history with the Muslim and Arab world” and Islamic investors and
financiers could be especially interested to invest in French Shariah compliant products. At the
moment already 5 to 10 percent of real estate investments in France come from Middle Eastern
funds (even though they are not all Shariah compliant). (Terdeyet 2008)
65
Zoubeir Ben Terdeyet is founder and executive manager of “Isla Invest Consulting”, a French consulting
company specialized on Shariah compliant investments. 66
The concept of Halal and Haram was already explained in chapter 1.1.1.3 regarding investments. In can
also be applied to food regarding for example the prohibition of pork meat and alcohol.
2. Evolution of Islamic Banking in Western Europe
82
2.3.2. Government initiatives
Given the possible market potential, Paris “aims at competing with London as European hub for
Islamic finance” (Moody’s Investors service 2008) by establishing an Islamic financial services
sector. For the time being the political and governmental authorites have already launched several
initiatives to support this development. Initially the French Financial Markets Authority (FMA)
issued a note in 2007, comprising among others the authorization of Shariah compliant collective
investment schemes and specific criteria charactizing Islamic funds (according to the screen
process of the two major index suppliers, please refer to 1.2.4.1). Moreover the Paris Europlace
Committee, a French financial think tank, carried out a study on necessary technical adjustments
for a level playing field of conventional and Islamic financial products in the French legal and tax
framework. It has to be mentioned that only Islamic wholesale business was subject to this
research. In the result the French economy minister Christine Lagarde concluded that “French law
already offers the best flexibility and adaptibility to welcome Islamic financial operations”.
(Terdeyet 2008) Nevertheless there are still new measures and tax incentives for Islamic financial
services in preparation. The support of the French state is regarded as indispensable for the
development of the financial service industry, according to Moody’s Investors Service.
Currently the governmental efforts concentrate on investment and corporate banking, in
particular on the issuance of Sukuk (please refer to 1.2.4.2) by private sector companies in order to
raise funds in Middle East. The process for the development of Islamic retail banking is in a much
earlier stage and the establishement of a French fully-fledged Islamic retail bank is not foreseeable
in the near future. (Moody’s Investors Service 2008)
2.3.3. Market players
The information on Islamic banking activities of well-established French financial instiutions is
very rare. It can be assumed that the BNP Paribas operates an Islamic banking unit in Bahrain since
2003 for its Islamic investment banking activities in Middle East. Thereby it concentrates especially
on the launch of Sukuk, structured project financing solutions and deposits. It is supposed to
ensure Shariah compliancy by employing a permanent Shariah Supervisory Board, according to an
article in the Middle East Economic Digest 2003. Furthermore the bank launched the first Islamic
fund under French law in 2007, called “Easy ETF DJ Islamic Market Titans 100” that was capitalized
with $20 million in July 2008. (Terdeyet 2008)
2. Evolution of Islamic Banking in Western Europe
83
Similarly the Alternative Investment Team of the Société Générale Asset Management (SGAM),
has launched a Murabaha fund (please refer to 1.2.2.1) called “SGAM AI Shariah Liquidité” early in
2008 and a series of Shariah compliant index funds linked to the Standard & Poor’s Shariah indices.
The former was created in collaboration with the Banque Française Commerciale de l’Océan
Indien for the Réunion (capitalized at $15 million in June 2008). Both products are certified and
audited regarding their Shariah compliance by Ratings Intelligence Partners (please refer also to
3.4.1) who provide the bank with Shariah scholars on demand. (Société Générale Asset
Management 2007) The company’s national websites for Jordan and Lebanon67 suggest
furthermore that Société Générale caters the local customers with Islamic compliant wealth
management. Mr. Terdeyet (2008) mentioned additionally that the Gulf Finance House68 made
two major acqusitions in France recently using Islamically structured financial products, amounting
to €70 million and €80 million respectively. The Société Générale provided the funding for one of
those transactions.
The French consultancy FS International Partners chaired by Fehmy Saddy planned to establish
the first fully-fledged Islamic bank in France, the “Bank Tayssir”. It submitted the formal
application to the French banking authorities in 2006. Information on the website indicate that the
planned financial institution was supposed to cater the Muslim communities in France in order to
“fill a void in the financial market”. (FS International Partners 2006) In doing so the company
clearly committed to the principle of secularity, resulting in the statement to offer Shariah
compliant services “to individuals and institutions, irrespective of their nationality, ethnic origin,
creed or religious preference” (FS International Partners 2006) The capital was supposed to be
raised with the help of a private placement, offering participation shares to foreign institutional
investors intitally and later on to domestic individuals and institutional investors in France.
Information published by Bloomberg in 2007 indicate that the application process is still ongoing.
Moody’s Investors Service (2008) assess in their article that a fully-fledged Islamic retail bank
could possibly be found using a Joint Venture between an established French financial institution,
providing the market knowhow and distribution network, and a Middle Eastern institution,
67
For further information please refer to
http://www.sgbj.com/sgbj/english/templates/common.asp?folder=17§ion=17 for Jordan and
http://www.sgbl.com.lb/sgbl/english/templates/common.asp?folder=17§ion=17 for Lebanon,
respectively. (Websites accessed 16.01.2009; 13:00) 68
The GFH is an Islamic investment company based in Bahrain.
2. Evolution of Islamic Banking in Western Europe
84
providing technical expertise and religious legitimacy. However as the process is going very slowly
relying on unsufficient research data available this point of time, it is very doubtful that such a
venture could emerge in the near future.
2.3.4. Future prospects
A critical aspect linked to the advance of Islamic banking in France is the lacking acceptance of
this concept in the French (domestic) population. Moody’s Investors Service (2008) underline that
“Islam and Shariah are words that do not immediately have positive connotations in France
today”. The developments since September 11, 2001 and the riots in French suburbs in 2005 and
2006 (as already mentioned above) have made French people afraid of a strong Muslim
intransparent community that could endanger the religious neutrality lived in France. Therefore it
would be advisable to promote Shariah compliant products for the whole population as “ethical”
alternatives (please refer also to 3.5.2) to conventional financial products (Moody’s Investors
Service 2008). In the end the provision of Islamic financial retail services in the French market
could constitute a helpful mean for the integration of the Muslim community and a real business
opportunity for French financial institutions. (Terdeyet 2008)
Regarding the Islamic wholesale business in France, that is presumably in a better position to
develop at the moment, the first Islamic fully-fledged financial institution could emerge around
2010, according to the estimations of Moody’s Investor Service (2008). The company expects new
initiatives from French banks’ side, involving for example the launch of further Islamic funds and
Sukuk in order to raise funds in Middle East. This becomes increasingly important facing the
current liquidity crisis in the conventional financial system. In addition to the firms’ interest,
French academic institutions invest heavily in research and publications as well as education
programs and courses are created in order to increase the acceptance for Islamic financial services
as ethical alternative. (Moody’s Investors Service 2008)
2.4. ITALY
In order to investigate on the Islamic financial market in Italy, Alberto Brugnoni was
interviewed. He is president and founding member of the organization ASSAIF69 being a think tank
that creates Islamic financial structures for Middle Eastern investors and the Muslim community in
69
ASSAIF abbreviates “Associazione per lo Sviluppo di Strumenti Alternativi e di Innovazione Finanziaria”. It
was found in the 1980s. (ASSAIF 2008)
2. Evolution of Islamic Banking in Western Europe
85
Italy. The organization targets, among others, the establishment of a Mediterranean Islamic micro-
finance network. (ASSAIF 2008 and Brugnoni[1] 2008) Eventhough Mediobanca70 is the only Italian
bank working on Islamic financial products currently, Mr. Brugnoni ([3] 2008) assigned
considerable growth potential to the Islamic financial service industry in Italy. He gave several
reasons. Firstly the ASSAIF receives numerous requests from the Italian Muslim community for
Halal investments (please refer back to chapter 1.1.1.3). Italy is home to around 1 million Muslims
(being 1.5 to 2 percent of the total population) that account for 32 percent of all foreigners.
(Brugnoni[2] 2008) He noted that this is almost the size of the Muslim community in the United
Kingdom bearing in mind that the latter live there in the third generation wheras Italians Muslims
face language and integration problems being the first generation of immigrants. Secondly the
ethical banking market is, according to his assessment, already quite big in Europe and well
developed in Italy in particular. It could constitute an adequate gateway to introduce Islamic
financial products by applying “migrant marketing” approaches. The values embodied in Islamic
financial instruments are not only appreciated by Muslims. Thirdly Mr. Brugnoni emphasized
Italy’s location at the Mediterranean Sea and its proximity to the Arab world resulting in an
already exisiting “mutli-billion dollar trade balance with the GCC” (Brugnoni[2] 2008). Appearently
Italy is the first trading partner of GCC countries in various sectors. He mentioned that “a
tremendous flow of money goes back and forth which has to be financed” (Brugnoni[3] 2008).
Thus Italy could position itself as important player in Islamic investment banking and merchant
banking. In contrast Islamic retail banking is not feasible in Italy and most countries of continental
Europe owing major regulatory and fiscal hurdles. However respective initiatives are in discussion
in the Italian Ministry of Finance and might become effective in the near future. Additionally a
change in attitude is fostered on European level by financial inclusion considerations of the
European Commission.71 Mr. Brugnoni ([3] 2008) stated that “the countries in continental Europe
have to do what the UK did three years ago” in order to create a level playing field for
conventional and Islamic banks. The president of ASSAIF forecasted 2009 to become an interesting
year for Islamic financial institutions. They are well positioned in times of credit crunch in the
70
Mediobanca is a leading investment bank in Italy. Information about Islamic financial products and
services could not be retrieved from the bank’s website. (please refer to
http://www.mediobanca.it/about_us/our_mission.php, 31.12.2008, 14:00) 71
The European Commission aims at including “non-bankable people”. This defines in the first place people
who are in the need of a loan but cannot provide guarantees. However in the second place this term holds
also for people who cannot make use of the conventional banking system due to restrictions resulting from
their faith. (Brugnoni[3] 2008)
2. Evolution of Islamic Banking in Western Europe
86
conventional system. Banks might face further liquidity problems as the conventional interbank
market is still dried up to a large extent. Therefore conventional financial institutions might
increasingly try to attract money from the GCC by offering Shariah compliant investments.
Mr.Brugnoni ([3] 2008) assessed particular high potential for growth in investment banking. The
Sukuk business will gain importance as especially Takaful providers look for secure tangible asset
in Europe that can be securitized. Furthermore he mentioned that large conventional funds in the
GCC countries might be converted to Islamic funds which need to be invested – preferably
offshore. Finally private equity might be in the focus as it is very close to the Islamic idea of
partnership and profit and loss sharing.
To sum up Europe, and Italy in particular, could benefit from a rising demand originating in the
Middle East and South East Asia for Shariah compliant investment possibilities as the latter is
channeled to Europe in search of adequate investment products and services. The Muslim
community in Italy plays, for the time being, a subordinated role but might gain in importance
after several regulatory changes have been made that make Islamic retail banking more attractive.
In April 2008 news were spread that Italy might get a fully-fledgded Islamic bank (IFIBAF 2008).
However this information was not right. Actually, Mr. Brugnoni ([3] 2008) explained that the
Italian Banking Association (ABI) organized two conference (in 2007 and 2008 respectively) that
resulted, amongst others, in the signing of a Memorandum of Understanding by the ABI and the
Union of Arab Banks aiming at an enhanced cooperation between Italian and Arabic banks. This
was mistaken by the press. It referred predominantly to the conventional banking sector and not
to Islamic banking in particular. However there is another approach initiated by Al Baraka (please
refer to 2.1.4) that discusses to open up a subsidiary or at least a representative office in Italy
offering Shariah compliant investment banking services. So far this has not happened.
2.5. AUSTRIA
Among 8.2 million people in Austria, 339,000 to 400,000 belong to the Muslim faith in 2001,
constituting 4.1 percent. In the early 20th century, when Bosnia-Herzegovina was annexed by
Austria-Hungary, a significant number of Muslims was ruled by the Austrian government. Later on
large immigrations flows from Turkey and the Balkans arrived during the world wars. Islam is
recognized as official religion in Austria, meaning that it is taught in schools, for example. (BBC
2008) Walker, et al. (2007) state that the Muslim population in Austria will grow by 10 to 15
2. Evolution of Islamic Banking in Western Europe
87
percent per annum in the next years and Philipp Wackerbeck (2008) assigns around €230 million
market potential to this target group. Alexander von Pock (2007) estimates that 20 to 30 percent
of Austrian Muslims would prefer a Shariah compliant financial product to a conventional one,
even to worse conditions. Around one third would prefer it for the same conditions (compared to
a conventional product) and for additional 33 percent the religious orientation is not relevant.
There might emerge new market oppourtinities for Austrian financial institutions, as Muslims in
Austria are in general younger and save more (savings rate aroung 18 percent). Of special interest
are mortgage financing solutions, insurance products and mutual funds, according to Mr.
Wackerbeck (2008). The regulatory and fiscal framework conditions have to be adapted in
advance in order to provide a suitable market environment. For instance, the double stamp duty
for Islamic mortgage financing has to be abolished, like in other European markets. In establishing
itself in the Islamic financial market, Austrian institutions should base on cooperations with Middle
Eastern partners for example in the United Arab Emirates, Saudi Arabia, Indonesia or Pakistan in
order to obtain knowledge in product development, operations, IT and sales. At the same time the
local banks can provide market knowledge and a distribution network. (Wackerbeck 2008 and
Walker et al. 2007) Looking at suitable distribution strategies,Walker, et al. (2007) suggest to have
employees from the same ethnical and religious background to advise customers in their mother
tongue. Furthermore a sensitive marketing strategy is of utmost importance in order to approach
the target group effectively.
There are already some banks in Austria that offer tailor-made products and services for ethnic
minorities. (Walker, et al. 2007) In this way several Turkish and Slovenian banks cater their
customers with export financing solutions and other services destinated towards their home
country. However it is not appearant whether those banks offer Shariah compliant services. The
only Austrian financial instiution that offers Shariah compliant services to a small extent, is the
Raiffaisen Zentralbank 72. According to the institution’s website (RZB 2009), it provides an interest-
free Euro clearing account for Islamic financial institutions satisfying the requirements of the
Shariah. Furthermore Islamic financing solutions and structured products are appearently offered
on demand, according to an interview of “diewirtschaft” with Tarek Mourad (2007) from RZB. He
stated that the current demand for their offerings concentrates on the GCC countries, only.
Austrian companies show interest only in case their business partners are provided by an Islamic
72
The Raiffeisen Zentralbank Österreich AG (RZB) is headquartered in Vienna and belongs to the leading
commercial and investment banks in Austria. It is the third largest national institution.
2. Evolution of Islamic Banking in Western Europe
88
bank. RZB’s customers for Shariah compliant products are majorly institutions. Shariah compliancy
is ensured by the Shariah Supervisory Boards of the respective Islamic partner bank on customer
side and only in case of project financing solutions RZB refers to external Shariah scholars. Mr.
Mourad (2007) admitted that it would not be recommendable to concentrate on the Austrian
market, only (for example by offering an Islamic fund exclusively equiped with Austrian securities).
The demand for such a product would not be sufficient (Mourad 2007).
2.6. OTHER EUROPEAN MARKETS
Not within the scope of this analysis are other European markets with significant Muslim
population such as Belgium (4 percent of the total population), the Netherlands (5.8 percent of the
total population), Denmark (5 percent of the total population), Sweden (3 percent of the total
population), or Spain (2.3 percent of the total population). Referring to initial research efforts and
several studies on the Islamic banking industry in Europe (for example Wilson 2007), some of
these countries show first approaches in targeting Muslim migrants using ethno-oriented
marketing approaches or in providing Shariah compliant services. For instance the Spanish
newspaper La Clava (2006) announced in July 2006, that the “Spanish banking giants Caixa and
Santander prepare to launch Islamic financial services”. However detailed information could not
be obtained. It can be assumed that, following the United Kingdom example, several large
European financial institutions will investigate on possibilities to participate in the growing Islamic
financial market. But, similarly to the markets presented above, the concentration on Muslim
majority countries in Middle East and Asia might be prevailing as the demand from the local
Muslim communities is not regarded as sufficient. Furthermore certain Islamic products and
services can only be offered to less favorable conditions owing the disadvantages in the national
regulatory and tax regimes apart from inefficiencies in product development and operations.
3. German market potential for Islamic Banking activities
89
3. German market potential for Islamic Banking activities
The main target set for this paper is to analyze the market potential for the provision of Islamic
financial services in Germany. Experts, like Zaid el-Mogaddedi (2008)73 who was interviewed in the
course of this research, stated that Germany lacks behind the United Kingdom as domestic
financial institutions do not follow the trend seriously enough. In the following it will be
investigated on the question whether Germany is an attractive market to offer Shariah compliant
banking services looking at different aspects. These are the target customers, German Muslims,
and the existing legal and tax frameworks. Additionally current Islamic banking activities of
German financial institutions will be presented even though they do not cater the local Muslim
community so far. The current demand and supply situation in the German market is shown and
possible reasons for the hesitant development as well as feasible market entry approaches will be
discussed. The latter could comprise a solution to “start slow” by first implementing an ethical
marketing approach to target Muslim banking customers separately whilst offering conventional
products.
MUSLIMS IN GERMANY
Even though traces of Islam in Germany date back to the 17th century and the first Mosque was
already built in 1920 in Berlin-Witmersdorf, major immigration flows did not start before the
1960s. In those days a significant number of people from Muslim majority countries like Turkey,
Yugoslavia, Tunisia and Morocco entered West Germany74. A significant number of Turkish people
arrived in response to a bilateral recruitment agreement between West Germany and Turkey.
They were needed in particular for manual work in order to support the local work force and were
merely seen as “guest workers” who will not permanently reside in Germany. As such they were
approached neutrally. (Bertelsmann Stiftung 2008) After time elapsed many Turkish immigrants,
who came as “guest workers”, settled down permanently in Germany and it became obvious that
they will not return to their home countries. However German domestic population and politicians
refused to realize this development for a long time. The result was a merely unplanned and
uncontrolled immigration for some decades, numbers can hardly be traced. Nowaday Muslims
73
Zaid el-Mogaddedi is president of the Institute for Islamic Banking and Finance in Frankfurt providing
consulting services for institutes offering Shariah compliant services. Furthermore he promotes the Islamic
finance concept in the scope of industry conferences and publications. 74
Non-Turkish immigrants came majorly as political or war refugees and asylum seekers.
3. German market potential for Islamic Banking activities
90
(predominantely of Turkish origin) live in the 3rd or 4th generation in Germany – most of them were
born here. (Schirrmacher 2007) Starting in 1970s with the outbreak of the Islamic Revolution in
Iran and later in 2001 with the terrorist attacks on September 11, the religion Islam was
increasingly seen very skeptical in Germany and the fear of terrorism led to mistrust against
Muslims, especially in the media. The variety and differentiations of Muslim religiousness are
mostly ignored. (Bertelsmann Stiftung 2008) Nevertheless Muslims living in Germany are in
general quite well integrated compared to other European countries. (Halm 2006)
According to the Bertelsmann Stiftung (2008) 3.2. to 3.5 million Muslims live in Germany,
constituting around 4 percent of the total population, whereas about 1 million hold the German
citizenship. The vast majority (approximately 2.4 million people) originates from Turkey (please
refer to Figure 21).
Figure 21 Muslims in Germany by country of origin (according to Bertelsmann Stiftung 2008)
3. German market potential for Islamic Banking activities
91
Even though the majority of Muslims in Germany has the same national background, “a low
level and disjointed organization of the Muslim community” (Bertelsmann Stiftung 2008) can be
observed. Only 10 to 15 percent of German Muslims are members of Mosque associations and
organizations75 and the community can be described as both culturally and religious divers. This
constitutes an important difference to the very well organized British Muslim community having
joint influence on governmental issues (please refer to 2.1.2). Dedicated surveys (refer to
Schirrmacher 2007 and Bertelsmann Stiftung 2008) showed an outstanding high importance of
religion throughout Muslims in Germany. In detail 90 percent of them are religious, thereof 41
percent highly religious.76 However often the handling of Islamic rites and rituals in daily live is
rather pragmatic and some rules are stricter obeyed than others. In general it can be stated that
Islam religion has high influence on areas of life such as child education, personal crises, family
events, but low importance for issues of partnership, work and leisure time and political attitudes.
In contrast to other Muslim majority countries, Turkey follows the central political principle of
secularity, the strict seperation of religion and state. This approach is supported by 75 percent of
Muslims with Turkish background in Germany. (Sen and Sauer 2006) Referring to chapter 2.1.2,
this constitutes a further major difference to Muslims in the United Kingdom or France, who
originate from countries where religion is also a matter of politics. Among Muslims living in
Germany a pluralistic and tolerant approach to religion and everyday life is practiced, in general. It
was found out that German domestic society has only little knowledge about the variety of Muslim
life and often regards Muslims as homogenous group. (Bertelsmann Stiftung 2008) However it is
important to realize major differences in needs and behavior, for example, among the different
generations of Turkish Muslims in Germany.
Most media attention is attracted by German Muslims following a radical attitude. They
account for around 10 to 12 percent of the Muslims in Germany, in numbers 320,000 to 420,000
people. (Schirrmacher 2007)
75
The local mosques constitute the smallest unit where people of the same nationality and faith come
together. Often mosques are registered associations and organized in Mosque associations and (umbrella)
organization that operate on a national level, such as the Turkish Islamic Union for Religious Affairs (DITIB)
or the Central Council for Muslims in Germany (ZMD). (Bertelsmann Stiftung 2008) 76
According to Bertelsmann Stiftung 2008, 70 percent of German domestic population are religious, thereof
18 percent highly religious.
3. German market potential for Islamic Banking activities
92
3.1. BANKING BEHAVIOR AND TRENDS IN DEMAND FOR CONVENTIONAL BANKING
SERVICES OF MUSLIMS IN GERMANY
3.1.1. General banking potential
Most surveys and studies on banking behavior and special demands of Muslims in Germany
concentrate on people with Turkish background; constituting the largest group (please see above).
Although Muslims of different national origin should not be ignored, as they still constitute around
750,000 people, the following analysis will refer to Muslims having a Turkish background only.
According to Gassner (2003 and 2004) there are more than 600,000 Muslim households in
Germany, comprising around 553,000 employees who are subject to social insurance contribution
and 55,000 self-employed. All households have €15 to 25 billion assets deposited with German
banks. Their average household income amounts to €1,769, being significantly lower than the
German average household income of €2,733. However Gassner (2003 and 2004) arguments that
Muslim households have double the savings rate of German households which assigns them
promising banking potential that is underexploited at the moment. This is mainly due to the fact
that the variety of banking services is not yet used by German Muslims. Currently a Turkish
household spends €371 per month in average for financial services, compared to €459 in German
households. Given the annual household income of €13 billion, an annual demand of €2.7 billion
for financial services in Muslim households can be derived.
In the following two chapters banking demands and trends as well as particularities in
consumer behavior of Muslims in Germany are scrutinized, without special regard to Islamic
financial services.
3.1.2. Current banking demands and trends
As already mentioned above, the group of Muslim consumers cannot be regarded as
homogenous. There exist major differences, especially regarding the various generations living in
Germany. In this context the first immigrants, known as “guest workers”, arriving in Germany in
the 1960s, constitute the first generation whereas their children, grandchildren and great-
grandchildren form the 2nd to 4th generation of Turkish Muslims in Germany. Obviously, Muslims in
3. German market potential for Islamic Banking activities
93
the later generations (often born in Germany77 and holding the German citizenship) approach in
their demands and preferences more to the German domestic population than their parents or
grandparents. The following statements are merely general in nature and have to be investigated
in detail for every generation.
Turkish immigrants are especially interested in acquiring real estate (either in Turkey or
Germany) financing start-up businesses and investing in gold and jewelry (Hayen, et al. 2005).
Furthermore they demand consumer loans and provision products for their families and children.
The most common target for saving is to provide for the future of children and family. Mutual
funds and securities are hardly asked for owing the increased security requirements and, often,
little knowledge about this asset classes within the Turkish community. In the past Muslims in
Germany transferred money to Turkey regularly and invested heavily in Turkish real estate. Hayen,
et al. (2005) see, prospectively, an increased focus on Germany. This estimation is underlined by
Gassner (2004), stating that in 2001 only 27.1 percent of Turkish immigrants transferred money to
Turkey, compared to 34.4 percent in 1995. Furthermore the percentage of Turkish Muslims
possessing real estate in Germany has risen from 1.6 percent in 1980 to 7.6 percent in 2001.
Therefore it could be derived that there will be an increased mortgage financing demand in the
upcoming years. Other aspects gaining importance are the investment in private pension
provisions and direct investments, for example in business ventures. Nevertheless it has to be
born in mind that Muslims in Germany face an above average unemployment rate and have often
a lower socio-economic status. Therefore they might not belong to the most attractive banking
customers groups in Germany, so far. However according to several experts, for example Mr.
Terdeyet (2008), the group of European Muslims belonging to the middle class grows and it seems
reasonable to anticipate that this trend will have effects on the German market, too.
Gleisner (2007) asked 1,000 people in Muslims Germany, having a Turkish background, about
their financial institutions of choice. The results showed that the vast majority refers to German
banks for their banking and financing needs (76 percent) and only some are customers of Turkish
banks having subsidiaries in Germany (20 percent). The rest (4 percent) relied on “third nation
banks”, such as big international banks like Citigroup or HSBC. However co-operations of German
banks with Turkish banks, for example to facilitate remittance services or the provision of banking
77
According to the Berlin-Institut für Bevölkerung und Entwicklung (2009), half of the persons living in
Germany, having a Turkish background were born in Germany.
3. German market potential for Islamic Banking activities
94
services in Turkish language were highly appreciated among the respondents. In 200078 Turkish
customers had conventional banking accounts preferably with savings banks (Sparkassen; 53
percent), followed by major private banks (24 percent) and cooperative financial institutions
(Genossenschaftsbanken; 17 percent). (Gassner 2003) These results are shown in Figure 22. Mr.
Zaid el-Mogaddedi (2008) added in an interview for this research that German financial
institutions enjoy great confidence in the Muslim community given their size and reputation. Apart
from the clear preference of German financial institutions in both surveys, the favored institutions
are consumer banks promising easy access to money and competent advice. (Hayen, et al. 2005)
Figure 22 Banks of choice of German Muslims with Turkish background (according to Gleisner 2007 and
Gassner 2003)
3.1.3. Particularities of German Muslim consumers (having a Turkish
background)
In targeting Muslim consumers (especially those having a Turkish background), German
financial institutions should consider certain particularities - independent from the products and
services they distribute. At first informal and familial links are of highest importance as people of
this target group focus on confidentiality. Traditionally they count on relatives or friends in order
78
The survey results are taken from Gassner (2003) based on a survey conducted by TNS Emnid (2000):
“Deutsche Banken und Versicherungen aus türkischer Sicht“.
3. German market potential for Islamic Banking activities
95
to gain information about products and services and finally to make decisions. In doing so,
considerations about price-performance ratio may be subordinated. Often Turkish people are
encouraged by fellow countrymen who work in the financial institution. In any case the financial
institution can gain confidence through intensive and competent advisory services in order to find
the best product solution. Normally Turkish migrants of the first generations are more loyal than
Germans as soon as they have found a suitable financial institution. (Hayen, et al. 2005) Another
aspect which plays an important role when approaching the Turkish target group is the language
problem. Hayen, et al. (2005) constituted that most Turkish Muslims in Germany are either
insufficiently provided with financial services or the financial services they make use of do not fit
their needs. This is mostly due to a deficit in information caused by misunderstandings and
language barriers. Around 43 percent of respondents in the respective survey79 stated, that they
would appreciate to be advised in Turkish language. This point of view is shared by Gleisner (2007)
who noticed a product differentiation based on the service language. Consequently he states that
most Turkish migrants would prefer a financial institution due to service offerings in their native
language. In order to approach the target group successfully it seems appropriate to promote
banking products and services in Muslim communities, associations and media, preferably in the
respective language. (el-Mogaddedi 2008) An example for the implementation of such an ethno
marketing approach is shown in chapter 3.5. Even though there seems to be a significant potential
unexploited in the German Muslim community there is little knowledge on the consumer behavior
available.
3.2. POTENTIAL DEMAND FOR SHARIAH COMPLIANT FINANCIAL SERVICES
Given the unexploited banking potential analyzed in chapter 3.1, it might be promising to offer
Shariah compliant financing and banking services in Germany in order to respond to financial
services needs resulting from religious prescriptions. However the results stemming from a survey
conducted by Evers and Jung (Hayen et al. 2005) do not support this assumption. For the majority
of Muslims in Germany it is “rather not important” or “not important” (for detailed information
please refer to Figure 23) to invest in compliance with the Shariah, even though more than two
thirds of them characterize themselves as “religious” or “highly religious” (please refer to 0). The
result is based on survey conducted among 1,000 Turkish Muslim migrants in Germany in all
79
Hayen et. al. (2005) conducted a survey among 1,000 Turkish adults in Germany with the target to gain an
empirical overview over consumer behavior and access of migrants with Turkish background to financial
services in Germany and their degree of integration into the German financial services sector.
3. German market potential for Islamic Banking activities
96
generations. It showed furthermore that less than 1 percent of the respondents hold Shariah
compliant investments at the moment and also less than 1 percent plan to invest in those
products in the future.
Figure 23 Importance of Islamic investments for German Muslims (by religiousness and in total)
(according to survey results of Hayen, et al. 2005)
The reasons for this result can be found in different aspects. Firstly Turkish Muslim migrants in
Germany often discredit Islamic investments and banking services due to scandals and bad
experiences with the “Turkish Holdings” in the time period between 1995 and 2001. In those days
Turkish people promoted the investment in Turkish Holdings within their communities in
Germany. Those were supposed to invest the received capital in Shariah compliant and ethically
correct business ventures in Turkey which should earn above-average returns for the investors.
Owing their reference to Islamic faith, these holdings gained trust among the Turkish migrants in
Germany. In this way they collected between €5 billion and €25 billion (accurate numbers could
not be traced). However the Holdings operated a pyramid investment scam and embezzled the
money. In this way the Turkish migrants in Germany lost their money. (Chahboune and el-
Mogaddedi 2008) This experience created great mistrust among the Muslim community in
Germany and works against new approaches to establish a domestic Islamic banking market.
(Hayen, et al. 2005) Nevertheless the success of these holdings showed that the demand was
basically in existence and might still be today. In the survey mentioned above, about 25 percent of
the respondents admitted that they were already offered Islamic investment products whereas 40
3. German market potential for Islamic Banking activities
97
percent of the offerings seemed to be suspect. Consequently there are still untrustworthy
providers of Islamic banking services in the German market that hamper further developments.
That is why Mr. el-Mogaddedi (2008) mentioned within the scope of the interview that Turkish
Muslims would rather trust German established institutions that offer Shariah-compliant products
owing its standing and reputation.
Secondly the general desire to invest in compliance with the Shariah is obviously a matter of
religiousness. As indicated in Figure 23, around one quarter of the persons who characterized
themselves as “highly religious” would invest in Shariah compliant products and services. However
those products do not play a role for those who are less religious. In comparison, the Muslim
community in the United Kingdom (especially Pakistanis) is well established, organized and strictly
religious so that the demand is higher and the informal promotion within the community leads to
greater market awareness and level of information.
In addition to the reasons mentioned above, experts, like Michael Saleh Gassner (2004) and
Zaid el-Mogaddedi (2008), blame that the market awareness for Shariah-compliant products in
Germany has not yet been created. They argue that the demand would rise as soon as appropriate
products and services are offered by German financial institutions. From their point of view it is of
utmost importance to market the products and services actively within the Muslim communities
and to ensure proper regulation and supervision in order to create credibility.
However Hayen et. al (2005) argue that Muslims in Germany are already well integrated into
the conventional banking system. For example 90 percent of the Turkish migrants hold a
conventional bank account. This constitutes a major difference to the United Kingdom were
migrants have problems to access to the conventional system, owing their low socio-economic
status, and often live without a bank account. In this situation a new Islamic retail bank is more
demanded than in Germany.
To sum up it can be hold that there was a huge demand in the earlier Turkish migrant
generations for Islamic financial services. Owing the embezzlement through the Turkish Holdings,
the niche market is now flawed by a bad reputation. In the new generations it cannot be definitely
stated whether there would be a sufficient demand potential for serious Shariah compliant
product offerings. However it seems unlikely given the well integration of Muslims in the
conventional system and a more pragmatic handling of religious rules in daily life given the
3. German market potential for Islamic Banking activities
98
separation of religion and public life. This assessment is shared by most of the German financial
institutions’ experts interviewed within the scope of this research.
3.3. REGULATORY FRAMEWORK AND FEASIBLE BUSINESS MODELS
The following short analysis of the regulatory framework and tax situation for the Islamic
banking business should only highlight some of the most important aspects that have to be
considered by institutions that plan to offer Shariah compliant financial services in Germany. It
does not make a claim to be complete. Subsequently feasible business models are introduced that
would allow a market entry in accordance with the current regulatory framework. In this respect a
recommendation for promising core businesses are given.
3.3.1. Regulation and licensing of financial business entities in Germany
In general there are three types of financial business entities defined in the German Credit
Act80. Firstly, only credit institutions are permitted to use the name “bank” in their name. Their
activities include for example, deposit business, credit business, financial commission business,
depot business, guarantee business, money transfer, issuance and administration of electronic
money. Credit institutions need to apply for an unrestricted banking license and have to comply
with several equity and liquidity rules. In this respect it is important to mention that the licensing
of a fully-fledged Islamic bank is improbable in Germany, however deposit and credit business
could theoretically be offered without taking or granting interest. Obviously the latter
precondition is vital for the provision of Islamic banking services. There may arise problems for the
deposit business regarding the investor protection. As described in chapter 1.2.5.1, there is a
certain amount of risk involved, for example, in holding Islamic savings accounts. The holders
might lose parts of their deposits when the bank invests their money in unprofitable business
ventures. This situation is not compatible with the requirement for investor protection in German
law81. However these problems could be avoided by making special contractual agreements with
Islamic account holders that point at these risks in particular. The same holds for the right to
charge interest on arrears, provided for in §288 BGB. Both parties, financial institution and
customer, could sign an adequate agreement that they both resign from their claims and arrange,
80
The German Credit Act (Kreditwesengesetz) came into effect in 2002 and determines among others the
supervision and regulation of the German banking sector through one single institution, being the
Bundesaufsichtsamt für Finanzdienstleistungen (Bafin), in cooperation with the German Central Bank. 81
The investor protection is laid down in the “Anlegerschutzverbesserungsgesetz”.
3. German market potential for Islamic Banking activities
99
for instance, a penalty payment to a charity organization in case of delay. (Gassner 2004 and Bälz
1995)
The second type of financial business entities are the financial service institutions. They are
either agents for financial services (for example in private wealth management, financial transfers
or in dealing with foreign cash currencies) or active in the credit card business. They have to be
licensed as well, but for example initial capital requirements are significantly lower. Institutions
belonging to the third category that is the least regulated are financial companies. These
businesses can, for example, acquire company shares, collect due money debts, offer leasing
products, deal with capital market instruments on their own account or structure merger and
acquisition transactions. The fact that the leasing business is not regulated in particular benefits
Islamic banking activities as they are often based on the Ijarah concept (please refer to 1.2.3).
Similarly Murabaha structures can be offered by such companies (please refer to 1.2.2.1).
Consequently, Michael Saleh Gassner (2004) states that “discussing the regulatory framework in
Germany with regard to Islamic financial products we could state that key services could be easily
structured by using a leasing entity.” However several banking needs, for instance deposit
business, money transfers and guarantee, can only be provided by a universal banking holding an
unrestricted banking license. It is further constituted that financial institution offering Islamic
banking services in Germany would lack suitable (interest-free) refinancing facilities (please refer
also to 1.4). This defect might be solved by external partnerships with other Islamic financial
service providers. (Gassner 2004 and Bälz 1995)
3.3.2. Tax conditions
Regarding the tax treatment of Islamic financial services, it has to be mentioned that certain
products can only be offered to less attractive conditions. An example is the double taxation of
Islamic mortgage financing products according to the Murabaha principle (please refer to
2.1.31.2.2.1). As described in the respective chapter, the bank has to pay conveyance duty
(Grunderwerbsteuer) when it acquires the real estate on behalf of the customer. Later on when
the customer buys the real estate from the bank in regular installments, the conveyance duty has
to be paid again. Consequently the conditions for the Islamic mortgage financing product are not
favorable as the bank includes the expenses for the conveyance duty in its calculations. In the
United Kingdom the unfavorable treatment of Islamic mortgage products are abolished by a
special regulation that waives the second payment of the conveyance duty (please refer also to
3. German market potential for Islamic Banking activities
100
2.1.3). Initiatives to improve the regulatory and tax conditions for Islamic banking activities in
Germany are not planned so far. (Gassner 2004)
3.3.3. Feasible business models for Islamic banking operations in Germany
Given the analysis in the preceding chapters 3.3.1 and 3.3.2, it can be summarized that it is
possible for German financial institutions to offer Islamic financial services in compliance to
German law provided some special agreements with the customers are made. However there
arise inefficiencies in refinancing and disadvantages in tax treatment that lead to higher costs for
the provision of such products and consequently to higher prices. These defects could be solved by
government initiative (for example a dedicated working group) similar to those observed in the
United Kingdom. Furthermore the Islamic banking industry and the financial institutions
themselves are asked to enhance cooperation and provide industry solutions that improve the
situation.
In principle, Islamic financial services could be provided in Germany using several business
models. Firstly established German financial institutions can offer Shariah-compliant products in
line with their conventional products. This approach is currently followed by all of the German
institutions interviewed (please refer to the next chapter) as well as by most of the other
European market players (please refer to back to chapter 2). However in this case, the credibility
among Muslims might suffer as conventional funds, generated in the interest-based system, may
be used to finance the Shariah compliant products. On the other hand the solution appears
convenient in order to test the feedback and the demand without taking too much risk. Using this
approach it is recommendable to apply a different marketing approach to target the Muslim
customers as described in chapter 3.1.3.
Secondly a German financial institution might open a separate subsidiary dedicated to Islamic
finance – an Islamic Window in its strict sense (please refer to 1.5.2). In this case the bank
establishes a separate brand for its Islamic activities and separates the funds used for Shariah
compliant products from the conventional capital. The initial capital could be generated, for
example, in Middle East. (Gassner 2003) Currently, none of the German banks operates an Islamic
Window. However as discussed in chapter 2.1.4.4, several financial institutions in the United
Kingdom follow this approach quite successfully. An advantage is that the Islamic branch is backed
3. German market potential for Islamic Banking activities
101
by the large pool of resources and knowledge provided by the parent company. Furthermore it
prospers from the good reputation and the popularity of the latter.
The most consequent implementation of the Islamic finance philosophy in Germany would be
the foundation of a fully-fledged Islamic bank (please refer to 1.5.2). For this purpose a formerly
Islamic Window (as described above) can apply for a banking license and separate itself from its
parent institution. (Gassner 2004) Another approach is to establish an Islamic institution from
scratch, as happened in the case of the Islamic Bank of Britain (please refer to 2.1.4.3). However
for such ventures foreign capital (for example from investors in the GCC) is almost indispensable.
As already mentioned before it appears questionable whether a fully-fledged Islamic bank would
be granted a banking license in Germany at the moment.
There are several core businesses possible for all three business models. The venture can either
concentrate on retail business only. This is the most risky alternative as it is based on the local
Muslim community only and cannot build additionally on foreign demand. Furthermore the
regulatory requirements in this domain are most restrictive. Therefore a focus on high net worth
individuals, institutional and business clients seems to be more promising. However as the vast
majority of Muslims in Germany has a low socio-economic standard and most enterprises owned
by Muslims do not achieve sufficient scale, these offerings would certainly target foreign Muslim
customers only (for example in the GCC). The demand in this domain is more reliable and all of the
German institutions interviewed cater this business line (please refer to the next chapter).
3.4. MARKET PLAYERS IN GERMANY
Within the scope of this paper it was investigated on the activities of German financial
institutions in the field of Islamic finance. The online research conducted in advance showed that
only few institutions offer Shariah compliant products and services whereby they concentrate,
without exception, on markets abroad targeting business and institutional clients as well as high
net worth individuals. Furthermore there is only very few information available on the institutions’
websites. In order to scrutinize the Islamic banking activities of four major German financial
institutions more thoroughly, business models, product offerings, distribution and marketing
concepts and the scope of Islamic banking activities were analyzed as well as their approaches to
safeguard the Shariah compliance of their products and the obstacles and hindrances they
experience when providing Islamic financing solutions. The institutions were provided with an
3. German market potential for Islamic Banking activities
102
identical questionnaire (please see Appendix B). In two cases the answers to the questionnaire
were accomplished by a personal interview. All information and conclusions mentioned in the
following are based on these questionnaires or interviews and online information available.
In addition to the offerings from German financial institution scrutinized below, the German
federal state Saxony Anhalt was a pioneer in issuing “the first quasi-sovereign Sukuk” (Parker
2008) in 2006. Within the framework of “Stichting Saxony Anhalt Trust” (please refer also to
chapter 1.2.4.2) it seized the opportunity to raise substantial capital from Middle Eastern and
European investors who adhere to the Islamic faith. However the Trust was incorporated in the
Netherlands to avoid German tax legislation. Furthermore it did not create momentum for further
issuances by German corporates or other federal states. (Parker 2008)
3.4.1. Current business activities of German Islamic financial service providers
In Table 5 the major findings of the questioning mentioned above are shown82. In the following
the Islamic financial service offerings of all four institutions are presented very briefly in order to
gain a quick overview. None of the institutions asked operates a separate subsidiary dedicated to
Islamic financial service but offer the Shariah compliant products and services in line with
conventional products and services.
The first bank to mention here (thereafter called “G1”) was one of the German pioneers in the
field of Islamic banking by launching the actively managed Shariah compliant mutual fund “Al-
Sukoor European Equity Fund” in 2000. In doing so it cooperated with the Saudi-Arabian Dallah-Al-
Baraka Bank (please refer to 1.5.7). However the fund was closed in 2005 as only € 4 million of
assets could have been collected in five years. Regarding the reasons for this failure Jalalle
Chahboune and Zaid el-Mogaddedi (2008) determine an improper marketing in the German target
customer group as well as the significant course corrections following September 11, 2001.
Furthermore the markets in GCC countries, where the product was actively promoted, showed a
clear preference for real estate investments and not for equity investments in those days.
Following this experience, the institution “focuses its Islamic product offering [now] exclusively on
Islamic banks and other financial institutions in Muslim majority markets” (G1). It operates
subsidiaries in Dubai and Singapore as well as representative offices in Cairo, Addis Ababa, Beirut,
Jakarta and prospectively in Libya. It was explained that the bank cannot forecast significant
82
A complete overview of all results generated in the questionnaires can be retrieved from the Appendix B.
3. German market potential for Islamic Banking activities
103
market potential for Shariah compliant products in the German market at the moment as most
Muslims living in Germany access conventional financial services. Current Islamic financial
offerings provided by this institution are merchant banking services as well as capital market
instruments and treasury products (please refer to Table 5). Interestingly, the certification of
products regarding Shariah compliancy is left to the clients’ Shariah scholars on a case by case
basis. Reasons for this approach might be lower permanent costs and higher acceptance of the
products by the respective client. Liquidity and risks are managed using the conventional inter-
bank market and conventional, interest-based hedging instruments. It appears questionable
whether this handling is accepted by Shariah scholars who examine the funding basis of the
Shariah compliant products.
The second market player (thereafter “G2a”) is already well established in the GCC with a
comprehensive network of subsidiaries and branches. In order to respond to the local demand for
Shariah compliant investment possibilities, its investment company launched five Shariah funds in
2006 concentrating on equities from Asia/ Pacific, China and Japan as well as precious metal
securities. Marketing efforts for these products are exclusively targeted to the GCC countries,
Malaysia and Japan. They are theoretically distributable within the scope of German retail
business, however customers do not ask for it in general. (G2b83) In July 2008, the bank launched
four further Islamic funds, being exchange traded funds (hereafter ETFs). Three are based on the
Standard & Poor’s 500 and 350 Shariah index whereas another one traces the development of the
Dow Jones Islamic Market index (mentioned in chapter 1.2.4.1). These products were subject to
the questionnaire (please refer to Appendix B). Findings are shown in the summary (please refer to
Table 5). In contrast to the mutual funds offered by its investment company, the Shariah
compliant ETFs are only authorized for distribution in Austria, the Netherlands, Finland,
Luxembourg, Spain and Germany. They are also available for retail clients as no minimum deposit
is required. Product management efforts remain low as it concerns passive index investments and
securities are selected in alignment to the respective index. This fact facilitates the ensurance of
Shariah compliancy considerably, as the securities are scrutinized by the indices’ Shariah
Supervisory Boards before they are included in the portfolio. Therefore the bank does not employ
a permanent Shariah Supervisory Board but has a service agreement with Ratings Intelligence
83
A second interview with a representative of this institution is summarized in chapter 3.5.1.
3. German market potential for Islamic Banking activities
104
Partners84 providing Shariah scholar services when necessary. In 2008 the Shariah compliant ETFs
generated more than € 10 million revenues85, having less than € 50 million assets under
management. Thereby the ETF focusing on Shariah compliant securites in Europe (based on the
S&P Europe 350 Sharia Index) is most profitable by earning the highest revenues and requiring
least efforts. The institution plans to add new Shariah compliant products to its portfolio in the
future. Additionally the current offerings will be distributed in further markets via the exisiting
branch network and by making use of cross-selling potential.
The third bank interviewed within the scope of this research (thereafter “G3”) has situated its
department dedicated to Islamic financial services in London and caters predominantly markets in
Middle East. Originally, the Islamic banking activities were initiated in the Dubai branch in the
years 2002 and 2003 when Shariah compliant products were increasingly demanded. Today, the
institution works closely together with the fully-fledged Islamic banks headquartered in London
(please refer to 2.1.4.3), exploiting for example cross-selling potentials. It was stated that there
appears only insignificant demand for Shariah compliant products and services from European
customers. Only in cases of project financing solutions for European business clients, when Middle
Eastern investors participate on the equity side, the bank is asked to provide Shariah compliant
solutions on the debt side of the transaction. Apart from project and trade financing solutions and
other merchant banking products, the institution concentrates on the provision of capital markets
instruments, hedging and treasury products. The latter are predominantly based on Murabaha
contracts (please refer to 1.2.2.1) and experience increasing demand. That is why institution plans
to expand and update its Shariah compliant treasury products offering. However hedging and
treasury products are least profitable requiring highest efforts. Considerably better profitability
show syndicated financing solutions and Sukuk products. Currently it is planned to reduce the
existing client base in line with credit reviews. Shariah compliancy of products is ensured in two
ways. Firstly, in bilateral agreements, bank G3 negotiates and aligns its products directly with the
requirements of the client’s Shariah Supervisory Board. In case of multilateral agreements it has
arrangements with “highly reputable Shariah advisors” (G3) that certify the products. However the
admissibility can never be ensured to 100 percent but is “in general absolutely necessary as sales
argument”. (G3)
84
Ratings Intelligence Partners is a London-based Shariah advisory catering private and insitutional investors
as well as fund managers. 85
This figure is not comprised in Table 5 as the comparison focuses on results in 2007.
3. German market potential for Islamic Banking activities
105
Another German bank, with a similar business model, was approached within the scope of this
research because its representatives participated in the Islamic Finance and Real Estate Forum in
Frankfurt/ Main in November 2008. However the person contacted declared that the institution
has only gained very few experiences in the Islamic financial service business and was therefore
not willing to participate in the survey.
The interview partner of an asset management company interviewed (thereafter “G4”) stated
that the company had no experience with Islamic funds before the product launch of two Shariah
compliant funds in May 2008. In the beginning considerable research and knowledge building
efforts were invested in order to gain sufficient expertise. In this case the development of Shariah
compliant products was fostered by the parent company that showed commitment by starting a
Seed-financing for the funds and invested largely in the product launch. Today it acts as sponsor in
order to achieve profitable scale. This commitment is also important to satisfy Shariah scholars. It
is planned to move the Islamic funds together in an operative entity with the already offered
Takaful products (please refer to 1.1.4). However so far this is not foreseeable. The parent
company predicts high potential to gain significant market share in the Islamic financial market,
given its well-known brand name. The two mutual funds of G4 focus on global equities in general
and those of emerging markets, respectively whereas stocks are preselected according to the Dow
Jones Islamic Market index (please refer to 1.2.4.1). Subsequently the fund portfolio is further
defined through amendments (so-called ex-index investments) made by the fund managers. This
process is supervised by a permanent Shariah Supervisory Board that meets for quarterly reviews
of the portfolio. Additional operational advice is received from “BMB Islamic” (Shariah advisory,
please refer to 2.1.4.4.1) having twenty-four hours access to an online portfolio management tool
in order to ensure Shariah compliancy. It was emphasized that “every stock dividend received has
to be purified”. That means 5 percent of each dividend is booked in a separate account
(administered by the custodian bank State Street) and donated to a charity organization at the end
of the year, as form of Zakat (please refer to 1.1.1.4). Authorization for distribution of the funds is
also planned in France, Portugal, Germany and Austria, especially because there is potential
demand among the Muslim population in La Reunion, belonging to France. However the funds
could be also sold in Germany via a private bank that was part of the group until recently.
Regarding this possibility the interview partner stated that the bank “is currently not interested,
3. German market potential for Islamic Banking activities
106
even though it has many Turkish customers. Its customer advisers in the German branches do not
see any demand from customers’ side.”
Table 5 Islamic financial service offering by German institutions (according to questionnaire and
interview results86
)
86
Please refer to Appendix B.
3. German market potential for Islamic Banking activities
107
3.4.2. Marketing strategies and distribution channels used
The institutions mentioned distribute their Islamic financial services offerings predominantly in
Muslim majority countries using the distribution channels shown in Figure 24.
Figure 24 Distribution channels used by German financial institutions offering Islamic financial services
Apart from local presence and cross selling agreements, the interview partners mentioned the
companies’ websites, specialist industry conferences87 and German-based sales manager as “other
distribution channels” (please refer to Figure 24). Whereas two institutions concentrate in their
marketing strategies on Muslim believers only, the others consider ethical investors, as well. In
this context the product offerings are promoted using the means listed in Figure 25. It becomes
apparent that word-of-mouth advertisement is most important, corresponding to the analysis in
chapter 3.1. Additionally to the means shown in the graph, direct approach was mentioned by one
of the institution in order to effectively promote its services (“others” in Figure 25). All interview
partners affirmed that they use English in their advertisement whereas two translate product
descriptions in German, too. Arab, Urdu or another language prevailing in Muslim majority
countries is not applied.
87
Specialist industry conferences start taking in place in Germany, too. An example was the “Islamic Finance
and Real Estate Forum” held in Frankfurt/ Main on November 4 to 5, 2008.
3. German market potential for Islamic Banking activities
108
Figure 25 Promotion of Islamic financial services by German financial institutions
3.4.3. Obstacles and hindrances experienced
Looking at operational problems three institutions asked denied a lack of adequate human
resources. Only G3 admitted “Arab language speakers with Islamic Finance experience prepared to
work outside the GCC and which still fit in an European organization are rare”. Other operational
problems could not be traced apart from G4 mentioning the new product features causing
additional efforts in product handling and administration. More problems occurred regarding
Shariah compliancy requirements. All interview partners stated that several aspects hinder
efficiency and cause substantial time and cost efforts. One respondent stated that “investors want
comparability - if each transaction has different structural features, investors cannot focus on
credit analysis alone and comparability of investments is not available.” Therefore industry-wide
standards would be highly appreciated. Only in one case, it was declared that passive index
investments are easier to handle as the securities are chosen by the index’ Shariah Supervisory
Board. However this was not confirmed by the other fund provider that bases its products on
indices, too. In launching Islamic funds the asset management company faced extremely high one-
off external costs arising out of the hiring of Shariah Supervisory Board and Shariah advisers as
well as out of the opening of special, interest-free, accounts with the custodian bank. Additionally
higher internal costs in daily operation for Islamic funds are required. They are caused by research
costs for ex-index investments (screen processes for securities according to the Dow Jones Islamic
Market Index methodology) and additional administration expenses. To sum up, it becomes
evident for the interview partner that Shariah compliant funds are more expensive than their
3. German market potential for Islamic Banking activities
109
conventional counter parts. None of the institutions asked saw difficulties arising out of the
regulatory or legal framework in the respective core markets regarding the provision of Islamic
financial services. However this may be caused by the fact that all respondents are hardly active in
European markets. Finally two interview partners claimed that most banking software is designed
for the interest-based system. This situation leads to difficulties in mapping the banking processes
in an IT infrastructure.
Figure 26 Compliancy requirements constituting problems to German financial institutions
3.4.4. Scope of activities and future plans for Islamic financial service business
In consequence it becomes obvious that Islamic banking is a quite new working field for all
institutions, except one that is active in this field since 2002. The product offering is targeted
exclusively to business clients, institutions clients and wealthy individuals and many solutions are
tailor-made to the customers’ need, as product standards are lacking so far. Shares of the Islamic
mutual or ETFs could be accessed by retail customers earning a low or average income (that
constitute the majority of Muslims in Germany). However as described in chapter 3.1.2, especially
Turkish Muslims in Germany are hesitant in buying capital market products but focus on
conservative banking products (such as Islamic bank accounts, mortgage financing and consumer
loans). The latter are not offered in Germany by any of the institutions asked. The products
3. German market potential for Islamic Banking activities
110
provided are merely focused on the rising demand in Middle East and South East Asia where
private and business clients look for offshore investments and financing possibilities (please refer
to 1.5.6).
Regarding the scope of activities, the institutions asked were either not willing to give
particulars or not able to do so due to the recent launch of products (please refer to Table 6). Only
one respondent institution has already gained experience for six years in this domain. It has to be
mentioned that the asset management company (G4) is supported by the parent company
providing significant start-up capital included in the assets under management. Given the rare
data it is not reasonable to draw conclusions on the success of Islamic financial service activities
provided by German financial institutions.
Table 6 Scope of Islamic financial activities of German institutions
None of the respondents forecasted the establishment of a separate subsidiary dedicated to
Islamic financial services, only. However two institutions plan to expand to other markets by
distributing their Shariah compliant products and services via their existing branch network.
Within this scope two interview partners stated the client base should be enlarged whereas one
bank plans to reduce its client base in line with credit reviews. Furthermore new products and
services will be added by three institutions and existing products may be complemented by new
features in the case of two respondents. The disinvestment in current activities as well as a change
in marketing strategy is not considered by the institutions asked.
3. German market potential for Islamic Banking activities
111
3.4.5. Estimations on future market development in Europe and Germany in
particular
In the following the estimations expressed by the interview partners introduced above
regarding the future Islamic financial market development in Europe and in Germany in particular
will be summarized.
Looking at Europe two respondents admitted that an increasing number of people show
interest in Islamic financial services. However the vast majority of them seem to be discouraged by
higher costs resulting from lacking industry-wide standards and high structuring and development
efforts Therefore the actual demand from European customers will not rise except their investors
(for example from Middle Easter) specifically ask for it. One respondent added that the Islamic
finance markets in the United Kingdom and Switzerland might slowly due to the fact that they are
well-established international financial centers in investment banking and private wealth
management. However was estimated that other financial market places like Frankfurt are not
popular and established enough to attract sufficient demand from abroad. Furthermore the same
interview partner had doubts that the global Islamic financial service industry will maintain the
growth rates experienced in the last decades. It was mentioned that Islamic banks in Muslim
majority countries are affected by the liquidity crisis, too. However all other respondents
predicted rising demand and further growth in these markets.
All interview partners assessed the future market share of Islamic financial products in
Germany to be very low. This estimation was backed by four major reasons that were supported
by two respondents respectively. Firstly it was stated that most Muslims in Germany are already
well integrated in the conventional financial system and make extensive use of certain
conventional banking products (as described in chapter 3.1.2). Another aspect mentioned was the
principle of secularity as prevailing attitude among Muslims in Germany having Turkish
background. This argument was backed by the fact that even in Turkey, being a Muslim majority
country, the market share of Shariah compliant assets amounts only to 3 percent, even though
numerous Islamic banks are active in the market. The separation of religion and private life might
therefore lead to differences in religiousness compared to for example Muslims in the United
Kingdom. It was concluded that many Muslims in Germany might not feel the necessity to invest
and safe in compliance to their faith. Finally the respondents estimated that increased costs for
Shariah compliant products would discourage potential customers.
3. German market potential for Islamic Banking activities
112
In consequence the interviews showed that a potential for the distribution of Shariah
compliant banking services might appear reasonable, given the high number of Muslim people in
Germany (almost twice as much as in the United Kingdom). However the experiences made with
Muslim consumers in the institutions’ branches as well as respective surveys proved that the
majority does not show any interest in such offerings.
3.4.6. Approaches to provide Islamic financial services in the German market
In contrast to the opinions described above, Zaid el-Mogaddedi experiences high demand from
the side of Muslims in Germany and determines a deficit in marketing and the insufficient contact
to the target group as main reasons for the lacking interest experienced by German financial
institutions. He assessed that 20 to 30 percent of Muslims in Germany are highly interested in
Shariah compliant banking products and 50 percent would be receptive for such offerings in
principle. (Wittrock and Salvenmoser 2007) As already analyzed in chapter 3.1.1, he pointed out
that this customer segments might be attractive given the fact that in addition to the € 2.7 billion
invested in conventional financial services (savings and insurance products) each year, the Turkish
Holdings could generate another €5 billion (minimum) of investments applying the Islamic finance
concept. (el-Mogaddedi 2008) The expert suggested promoting Shariah compliant products and
services through well-established German institutions, given the bad experiences of Muslims in
Germany with the Turkish Holdings (as described in chapter 3.1).
Mr. el-Mogaddedi (2008) described the following market approach. Currently, a fully-fledged
Islamic bank in Germany is not feasible due to the regulatory framework that does not provide for
such an institution. However to establish an Islamic Window could constitute a reasonable
alternative given the high importance of reputable brand names in the Muslim community. In this
case the institution does not have to employee a permanent Shariah Supervisory Board but can
rely on external service providers to safe costs
Mr. el-Mogaddedi (2008) assessed high market potential for Islamic retail products, in
particular the offering of various Islamic banking accounts as well as retirement provisions, Takaful
products and mortgage financing solutions. It appears important to choose a comprehensive
concept, comprising short- and long-term oriented products in services, in order to achieve a
sustainable market entry and to avoid negative effects due to volatile demand for single products.
Another topic that might be interesting, however not as relevant, is Islamic merchant banking
3. German market potential for Islamic Banking activities
113
especially the catering of financial needs arising in small and medium sized enterprises. Islamic
investment banking would “overburden” (el-Mogaddedi 2008) the German financial market as it is
not established enough, compared to London.
For the distribution of Islamic products in the German market, Mr. el-Mogaddedi (2008) did
not see any necessity to agree on partnerships with Middle Easter institutions. He explained
that German financial service providers enjoy very good reputation and credibility within the
Muslim community whereas those from Middle East are hardly known in Germany. It is
important to approach the target group directly as Islamic banking is “people’s business” (el-
Mogaddedi 2008). Major places for product promotion should be Mosques, Turkish
associations and media. Furthermore, events designed to prove expertise in Islamic finance
could be organized for interested customers. The distribution and advisory has to show a high
level of quality, even though Mr. el-Mogaddedi (2008) did not see a necessity to have Muslims
or Turkish speaking employees in contact to customers. He assessed more relevance in having
an Islamic finance expert in the background to respond to religious questions.
Given the assessment in chapter 3.1.2, Muslims in Germany prefer consumer banks. In
correspondence Mr. el-Mogaddedi (2008) predicted that especially German savings banks
(Sparkassen) and cooperative financial institutions (Volksbanken) as well as private banks
concentrating on retail banking majorly, such as the Postbank, would constitute promising
candidates to establish a dedicated Islamic banking subsidiary. This estimation is backed by the
fact that these institutions cater already a large percentage of Turkish customers in several regions
and could build on the position of trust they earned already. (el-Mogaddedi 2008)
Despite the promising arguments above, the president of the Institute for Islamic Banking and
Finance admitted as well, that German institution might fear political arguments in case they
would offer banking services that respond to requirements of the Islam. In the United Kingdom
the topic is appraised in a more non-judgmental way emphasizing “business is business” (el-
Mogaddedi 2008). The governmental agencies, such as the Financial Services Authority, do not
show reservations towards this topic and dedicate, for example, a website and a working group to
the topic in line with the financial inclusion efforts of the government. In Germany, it is sometimes
argued that the development of an Islamic financial market would foster the establishment of a
parallel society and not the integration of Muslims in Germany. (el-Mogaddedi 2008)
3. German market potential for Islamic Banking activities
114
Consequently government initiatives in Germany to foster the development of Islamic finance
could not be observed, so far.
3.5. ETHNO-MARKETING APPROACHES AND ETHICAL INVESTMENTS
Even though Islamic financial services are not offered in Germany so far, people having a
Turkish background have already been discovered as attractive customer group by several
financial institutions. In order to target these clients differently, they follow an ethno-marketing
approach. Other institutions promote ethical investments in order to respond to the rising needs
for transparency and sustainability. These concepts might be based on the realization that “the
marketing focus is developing away from product towards customer orientation” (el-Mogaddedi
2008). In the following two concepts will be introduced.
3.5.1. Ethno-Marketing approaches
One of the institutions introduced above as well as one of the German savings banks target
Turkish customers by providing advisory services in Turkish language. For this purpose the former
has established a separate brand whereas the latter the offering as intercultural service. However
neither of the institutions provides Shariah compliant products. In the following the first approach
(thereafter “G2b”) will be discussed in detail based on an interview.
The different brand describes merely a marketing concept, fully integrated into the institution’s
conventional retail segment. The interview partner explained that the services are targeted to
Turkish people living in Germany and other immigrants, whereas predominantly private individuals
earning a low and average income are in the focus. In particular the bank aims at responding to
the special needs and banking habits of this target group, for example, by providing advisory
services and product descriptions in Turkish language. Therefore fifty-four Turkish branches were
integrated into conventional retail branches and cater the customers with the same products (for
example current, savings and investment accounts, personal and home financings solutions). The
locations are chosen according to researches detecting streets of houses with major Turkish
population. The customers can make use of all distribution channels, including automated teller
machines, telephone and online banking. Additionally cross-selling potential is used as co-
operations with large Turkish companies in Germany were agreed. The products and services are
promoted actively in the Turkish community, as thereby the target group is covered by 100
percent. Advertisements are launched in Turkish newspapers, Turkish radio and TV channels. The
3. German market potential for Islamic Banking activities
115
respondent stated “Turkish people are more willing to give recommendations and the Turkish
bank advisers establish personal relationships with the clients.” Therefore word-to-mouth
advertisement plays a significant role in targeting these customers. Similarly the structure of
advisory talks is significantly different in case of Turkish customers. They focus more on small talk
in order to build trust. In 2008, the brand catered 65,000 customers and plans to enlarge this
number to 100,000 by 2009. The institution’s conventional retail business in Germany counts
additional 230,000 Turkish customers. The interview partner explained that Turkish customers
should be targeted differently than German domestic clients as they feel closely connected to
Turkey, even though they live in Germany the 3rd or 4th generation. Many households still use
Turkish language at home and their values are considerably oriented towards the home country.
In their banking needs and habits, Turkish clients show a high preference for established brands,
which is an advantage for brand belonging to one of the biggest German financial institution.
Furthermore the aspect of trust and an increased safety need are of utmost importance. It was
emphasized that Turkish customers are very skeptical given the bad experiences made with the
Turkish Holdings some years ago. Therefore they count considerably on recommendations given
within the Turkish community and show risk-averse banking behavior. Especially savings products
earning fixed interest rate, financial provision products for the family and home purchase savings
are demanded whereas investments in securities play a much more subordinated role. Looking for
adequate bank advisers, value is set on sensitivity in handling three different generations of
Turkish migrants, as their needs differ substantially. Furthermore profound finance know how,
bilingualism (Turkish and German) and an inner connection to the Turkish community, preferably
by having a Turkish cultural background, are important. Currently 120 employees are working for
brand, the majority of them belonging to the 3rd generation. It is well established within the
Turkish community in Germany and has thus good connection to this target group.
The concept should underline institution’s image of an innovative bank approaching customers
differently according to their needs. Worrying about negative reactions from the side of German
domestic customers in advance, the financial integration of migrants implied in this idea turned
out to be seen very positively. In this way the brand could extend its lead in the following years
facing competitors who follow similar concepts88. It might be considered to expand the brand’s
88
The approach to target Turkish customers in Germany separately is applied by four further financial
institutions including one savings bank and two non-German private banks.
3. German market potential for Islamic Banking activities
116
branches to Turkey, possibly in co-operation with local partner banks. However this is not
foreseeable for the next years.
3.5.2. Promoting ethical investments
In the analyses comprised in chapter 3.4.1, it was already indicated that several German
financial institutions see promising potential in promoting “ethical investments” that do not target
Muslim banking clients in particular, but all investors interested in a sustainable and moral
investment. The demand for ethical behavior is a worldwide consumer trend that might be
strengthened due to current crisis in the conventional financial markets. In the recent months it
became apparent that banking customers lose trust and confidence in the investment practices of
conventional financial institutions and look for transparent and sustainable investments that
comply with ethical values. (Capellmann and Peverelli 2008) A German cooperative financial
institution offers a concept that might correspond to this trend. The institution established a
different brand that distributes ethical and ecological banking products investing only “in favor of
men and nature” and excluding investments in businesses concerned for example with weapons,
nuclear power stations and children work. It tries to achieve credibility by promoting strict
investment criteria and offering advance programs. Additionally it introduces itself as Germany’s
“transparent” bank allowing insight, for example, in the bank’s own investments.
The criteria for products that claim to be Shariah compliant are very similar to those used by
ethical investment providers. Therefore Islamic banking could be regarded as sub-category of
ethical banking and products could be promoted within this framework. This approach might have
the advantage that the potential client base is enlarged, as the faith is not the prevailing sales
argument.
4. Conclusions
117
4. Conclusions
4.1. FUTURE OUTLOOK FOR THE DEVELOPMENT OF THE ISLAMIC FINANCIAL
SERVICES INDUSTRY IN EUROPE
The first chapter indicated that the Islamic financial service industry has experienced a fast
development in the recent decades, facing rising demand and increasing popularity around the
world. The product innovations fostered by Islamic financial institutions and international non-
governmental organizations aim at enlarging the product and service offerings to customers and
making them more competitive facing conventional products and services. A significant number of
important advances was initiated or supported by Western financial institutions having valuable
experience and knowledge in traditional financial markets. That is why an increasing number of
investors and institutions from Muslim-majority countries turn to Europe, especially to the United
Kingdom. Consequently single financial service providers in Europe participated in the dynamic
growth of the Islamic financial industry by offering Islamic financial services in line with
conventional products or by establishing an Islamic Window. The most important developments
occurred in the United Kingdom where the government actively supported these activities and
launched initiatives to foster the financial inclusion of local Muslim minorities. In this environment
the first European fully-fledged Islamic banks were founded, even though they were initiated and
sponsored by Middle Eastern investors. Some Swiss financial institutions have gained
acknowledgement by providing Islamic financial services based on their experience in private
banking. However, as analyzed in section 2, these two markets, that have the status of
international financial centers in the domains of investment banking and private banking, are well
in advance compared to other European countries. This might appear surprising, given the fact
that the United Kingdom and Switzerland have considerably less Muslim population than, for
example, Germany or France. It could have been assumed that these countries bear important
domestic market potential for Islamic financial products. But it has to be kept in mind that “Islam
is religion and a culture, lived differently in various areas of the world” and “efforts to target these
customers are necessarily contingent on geographic location and context” (Walker, et al. 2007)
Therefore it is not reasonable to conclude from the success in the United Kingdom that the same
approach turns out successful in all other European countries with Muslim population. Refering to
the United Kingdom example the necessary prerequists seem to be a highly religious Muslim
4. Conclusions
118
community that is well established and well organized. Muslims originating from countries
adhering to the principle of secularity seem to be less interested in Shariah compliant products
than those of countries where religion and politics are connected. Furthermore a low coverage
with conventional banking products in the target group appears to be fostering the development
of an Islamic banking sector. Finally the government plays an important role by launching
respective initiatives to support the process. Apart from the demand of Muslim communities,
foreign customers lead to efficient scale of Islamic banking business. The later are majorly
attracted by the reputation of the financial institution and the market place as such .
The government in France recognized the domestic potential for Islamic financial services,
given the large Muslim population and their characteristic. Several initiatives were launched in
order to foster further development. However the advances are very much in infancy and at this
point in time it is difficult to assess whether Paris can establish itself as second European Islamic
financial centre (after London) given the low acceptance of Islam faith in the French society and
the domestic conflicts with Muslim migrants. Similarly Italy and Austria show some promising
features, such as their proximity and historical trade relations to Muslim majority countries and a
considerable percentage of Muslim population. At this point of time the respective offerings are
very rare. This might be due to the fact that neither of the markets is a well-established financial
centre. Furthermore most Muslim migrants in Italy live there in the first generation and the
Muslim community in Austria constitutes a very heterogeneous group, comprising people from
various origins. Consequently the developments of an Islamic financial market are not fostered by
an organized Muslim community. The governments do not show sufficient interest in the
development of the Islamic banking sector in order to abolish existing regulatory and fiscal
obstacles. In consequence an outlook for these markets is difficult and only limited potential might
be assessed for the near future.
The analyses of the German market will be summarized below. In short it can be stated that
there is no institutions offering Shariah compliant services for the domestic market but all market
players interviewed focus on markets abroad. The regulatory framework would allow for the
provision of Islamic financial services in principal if some separate agreements are made. However
a fully-fledged Islamic bank could not be authorized at the moment. It seems questionable
whether the domestic demand for Shariah complaint services would be sufficient for various
reasons (please see below). Regarding the popular comparison between domestic market
4. Conclusions
119
potential in United Kingdom on the one side and Germany and France on the other side Rodney
Wilson (2007, 431) pointed out:
“Banks in France and Germany have been uninterested in Islamic product development
for their local Muslim communities, largely because of their lower socioeconomic position
in relation to British Muslims, with many of the Arabs in France and Turks in Germany
unemployed, or in casual and sometimes illegal jobs, paying low wages. This is correctly,
although unfortunately, not perceived to be a profitable customer base for the banks.”
(Wilson 2007, 431)
Therefore it can be stated that the local Muslim communities in European markets, except in
the United Kingdom, are currently regarded as not attractive enough to offer Shariah compliant
retail products. If possible business opportunities abroad should be leveraged in order to achieve
sufficient scale.
Looking at core segment, market players in all countries, except the United Kingdom,
concentrate on Islamic corporate, investment and private banking business only. Thereby several
European financial institutions use their good reputation and prove profound knowhow and
experience to establish themselves in this market, serving predominantly customers originating or
living in Middle East and South East Asia successfully.
4.2. CHALLENGES FOR THE ISLAMIC FINANCIAL INDUSTRY IN EUROPE
European financial institutions that offer Islamic financial services face, similar to their
counterparts in other parts of the world, several industry-wide challenges that hamper further
development and innovations. As analyzed in detail for the German financial institutions, market
players face problems in liquidity and risk management that complicate operations as the
institution have to use interest-free accounts, for example, that lead to money loosing value over
time and higher costs in administration. Shariah compliant hedging instruments are very rare and
expensive whereby they are not accepted by all Shariah scholars. Furthermore especially
institutions situated in London had problems to find adequate personnel that have sufficient
knowledge in Islamic finance. Regarding the Shariah compliance, interview partners complained
several times about the shortage of Shariah scholars, inconsistencies in fatawa as well as the high
efforts involved in product development. Finally lacking IT infrastructure, providing for an interest-
free banking system constitutes a major challenge to the majority of institutions asked.
4. Conclusions
120
Additionally national regulations and tax regimes would make Islamic product offerings less
favorable to customers in European markets (please refer to the market analyses in sections 2 and
3).
4.3. RECOMMENDATIONS FOR GERMAN FINANCIAL INSTITUTIONS
The assessment of the market potential for Islamic financial services showed two opinions. On
the one hand side, relevant market surveys, for example conducted by Every and Jung and the
“Zentrum für Türkeistudien” in Germany as well as all interview partners from German financial
institutions asked, concluded that Muslims in Germany, especially those having a Turkish
background (constituting the majority), are not interested in Shariah compliant financial services.
In the course of this research the possible reasons were identified, being the good integration of
Muslims in Germany in the conventional banking system, the separation of religion and public life
as prevailing attitude among people having a Turkish background, differences in religiousness and
higher costs for Shariah compliant products and services.
On the other hand side, Islamic finance experts who have gained a lot of experience within the
scope of a Shariah consultancy and respective research work, stated that there is demand for
Shariah compliant products that became obvious in the response to the offerings made by the
Turkish Holdings some years ago. Nowadays the Muslim customers are just not aware of serious
possibilities to invest and handle their banking operations in compliance with their faith. It is up to
the German financial institutions to market the products actively by establishing a relationship of
trust with the Muslim community and to create market awareness.
Consequently it cannot be finally stated whether the demand would arise in response to
adequate offerings. However the potential for Islamic retail services in Germany seems not to be
promising enough to compensate the high investments necessary. These are in particular the
resource intensive knowledge building, the setting up of an adequate compliance structure and
the product development process as well as finding solutions for Shariah compliant risk and
liquidity management. Furthermore it is not foreseeable that governmental and regulatory
authorities in Germany plan to launch initiatives in this respect that could improve the competitive
basis of such products (for example by abolishing tax disadvantages).
In order to exploit market potential present in the Turkish community in Germany, banks could
follow an ethno marketing approach. By offering targeted banking product and services,
4. Conclusions
121
responding to consumer behavior and special demands. German institutions could build on their
good reputation and enhance customer loyalty. This approach costs considerably less effort and
could constitute a first step towards a more customer oriented banking industry. Furthermore the
market of ethical investments seems to become more important, given the current developments
in the conventional market. Consequently German institutions could enlarge their offerings in this
respect gradually, comprising some Shariah compliant products to test the consumer reactions.
However it is not recommendable at this point in time to focus on the provision of Islamic financial
services for the local Muslim community, only.
Looking at market in GCC countries and Southeast Asia (that were not subject to this paper)
German institutions should keep pace with other European institutions to invest in local presences
and Shariah compliant product offerings. In these markets demand is definitely about to rise,
according to estimations made in literature and by most market participants.
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122
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Appendix
I
Appendix A
APPENDIX A1: THE FOUR VERSES IN THE QUR’AN DEALING WITH RIBA
Surah al-Rum (verse 39)
“That which you give as Riba to increase the people’s wealth increases not with God; but that
which you give in charity, seeking the goodwill of God, multiplies manifold.” (30:39)
Surah al-Nisa’ (verse 161)
“And for their taking Riba although it was forbidden for them, and their wrongful appropriation
of other people’s poverty. We have prepared for those among them who reject faith a grievous
punishment.” (4:161)
Surah Al-e-Imran ( verse 130)
“O believers, take not doubled and redoubled Riba, and fear Allah so that you may prosper.
Fear the fire which has been prepared for these who reject faith, and obey Allah and the
Prophet so that you may get mercy.” (3:130)
Surah al-Baqarah (verses 275-281)
“Those who take Riba shall be raised like those who have been driven to madness by the touch
of the Devil; this is because they say: ‘Trade is just like interest’ which God has permitted trade
and forbidden interest. Hence those who have received the admonition from their Lord and
desist, may keep their previous gains, their case being entrusted to God; but those who revert,
shall be the inhabitants of the fire and abide therein forever” (275)
“Allah deprives Riba of all blessing but blesses charity; He loves not the ungrateful sinner.”
(276)
“O, believers, fear Allah, and give up what is still due to you from Riba if you are true believers.”
(278)
Appendix
II
“If you do not do so, then take notice of war from Allah and His Messenger. But if you repent,
you can have your principal. Neither should you commit injustice nor should be subjected to
it.” (279)
“And if the debtor is misery, let him have respite until it is easier, but if you forgo it as charity, it
is better for you if you realize.” (280)
“And be fearful of the Day when you shall be returned to the Allah, then everybody shall be
paid in full what he has earned and they shall not be wronged.” (281)
(according to Ayub 2007, 44)
APPENDIX A2: THE FIVE PILLARS OF ISLAM
1. Acceptance of the shahahda or witness of faith and reciting the sentence ‘la ilaha illa LLah,
Muhammadu rasulu llah’ (in its alternative translation, ‘There is no God but the God and
Muhammad is his Prophet’). Anyone who utters the shahada in full faith must be regarded
as a Muslim.
2. Prayer, or salat, is prescribed to perfrom five times per day […], receded by self-
purification through ritual washing, performed facing in the direction of the Holy Mosque
in Mecca, demonstrating ‘submission to God’s will’ by word of mouth and physical
gesture.
3. Alms or zakat [...]. The Holy Qur’an stresses that the giving of alms is one of the chief
virtues of the true believers; the generally accepted amount being one-fortieth of
Muslim’s accumulated personal or business wealth. […]
4. Fasting or sawm. All believers are required to observe the ninth lunar month of the
Muslim year, Ramadan, as period of fasting in which they abstain from eating, drinking,
smoking and sexual relations from sunrise to sunset (Holy Qur’an 2:185-6). The purpose is
to subjugate the body to the spirit and to fortify the will through mental discipline, thus
helping the believer to come nearer to God.
5. Pilgrimage. The hajj, or pilgrimage to Mecca must be performed at least once a life of
every Muslim, health and means permitted (Holy Qur’an 3.97).
(according to Lewis and Algaoud 2001, 19 and 20)
Appendix
III
Appendix B
In the course of this research several financial institutions in Europe as well as experts in Islamic
finance were approached. Thereby German financial institutions were focused in particular in
order to gather valuable information for a market analysis. However no importance was assigned
to aspects like the location within Germany, size of the institution or core business. European
targets were predominantly chosen in the United Kingdom and Switzerland.
In the first step a comprehensive online research was conducted in order to select potential
banks, consultancies and experts. Subsequently Zaid el-Mogaddedi, founder and managing
director of the Institute of Islamic Banking and Finance (IFIBAF) was interviewed and several
contact persons indentified. Further useful contacts were established during the “Islamic Finance
and Real Estate Forum” (November 4th to 5th, 2008 in Frankfurt/ Main) attended by Dr. Robert
Bosch (BearingPoint Management and Technology Consultants). The respective persons were
approached via email and provided with a dedicated questionnaire (please see below).
Additionally they were asked to participate in a personal interview in order to analyze some
aspects in detail. Finally twenty institutions were contacted thereof nine are incorporated in
Germany. In the further proceeding eleven persons approached were willing to participate in this
research and answered the questionnaire and/ or participated in an interview. However three of
those could not provide information as they do not provide Islamic financial services. The detailed
lists of institutions and companies contacted are shown below.
Appendix
V
2. thereupon no answer was received:
The master file of the questionnaires distributed is attached below. Thereafter the answers
to the questions will be analyzed numerically.
Appendix
VI
Appendix B2: Questionnaire distributed
I. Current Business Activities
I.a Business Concept and OrganizationPlease note that all questions (if not stated otherwise) refer only to your activities in Islamic finance and banking!
1. How is the Islamic Window integrated into your organization?
as seperate subsidiary comments
as division comments
Islamic products/ services are offered together
with conventional products/ services comments
other (please specify) comments
2. How do you ensure that conventional capital (interest-based) is not used for Islamic financing?
separation of funds for Islamic window activities comments
supervision by Shari'a supervisory board comments
conventional capital is used for Islamic financing
(shari'a compliance?) comments
others (please specify) comments
3. What is your core business?
Retail banking comments
Merchant banking comments
Private banking (Private Wealth Management) comments
Investment banking comments
others (please specify) comments
4. What is/are your core market/s?
Europe (please specify countries) comments
Middle-East (please specify countries) comments
Asia (please specify countries) comments
Americas (please specify countries) comments
Africa (please specify countries) comments
5. Do you have any shareholders or sponsors who foster your advances in Islamic banking and finance?
Gulf-based financial institutions (please specify) comments
Gulf-based individuals comments
Financial institutions based in Europe (please
specify) comments
Individuals based in Europe comments
others (please specify) comments
none comments
Islamic Banking a worthwhile challenge for German banks
Analysis: Islamic Windows in European conventional banks
Please answer the following questions by choosing one or more of the answers provided and insert an "x" in the
respective box at the left. If possible, please give further explanations/ specifications to your answer in the box
provided on the right (overwrite "comments").
Appendix
VII
6. Who are your target customers?
Private Individuals (low income) comments
Private individuals (average income) comments
Private individuals (high income) comments
Business Clients comments
other Financial Institutions (B2B) comments
People originating from certain countries/ regions
(e.g. Turkey) comments
Immigrants comments
Naturalized people comments
others (please specify) comments
Appendix
VIII
I.b Product/ Service PortfolioPlease note that all questions (if not stated otherwise) refer only to your activities in Islamic finance and banking!
1. Which products/ services do you offer to your clients?
Current accounts comments
Savings and investment accounts comments
Personal financing (e.g. Car financing) comments
Home financing comments
Business financing comments
Trade/ project financing comments
Capital market instruments comments
Asset Management comments
Private Wealth Management comments
Treasury Accounts (B2B business) comments
Takaful comments
others (please specify) comments
2. What are the products/ services based on (tradtional Islamic finance contract)?
Murabaha (mark-up principle) comments
Mudaraba/ Musharaka (equity participation) comments
Ijara/ Ijara wa iqtina (leasing/ hire and purchase) comments
Bai'salam/ Istisnaa (pre-paid purchase) comments
Tawarruq (purchase on deferred payment and
subsequent sale) comments
Sukuk (Islamic participation certificate) comments
others (please specify) comments
3. Do you require a minimum deposit?
yes, for the following products/ services (please
specify products and minimum deposit amount) comments
no comments
4. Did you enter strategic partnerships to offer certain products/ services?
yes (please choose one of the options/ examples
below and specify in comments box) comments
e.g. with takaful company to provide takaful
products on commission comments
e.g. with commodity providers (e.g. car sellers) to
offer commodity (car) financing comments
e.g. with other financial institutions to offer
structured business financing products comments
other strategic partnership (please specify) comments
no, we did not enter any strategy partnership comments
Appendix
IX
I.c Distribution and MarketingPlease note that all questions (if not stated otherwise) refer only to your activities in Islamic finance and banking!
1. Which distribution channels do you actively use?
Branches/ Points of Sale (please add number and
locations) comments
Automated teller machines (ATMs) comments
Telephone Banking comments
Online Banking comments
Mobile customer advisers comments
Cross Selling via other institutions (please specify) comments
others (please specify) comments
2. What is your marketing strategy?
Focus on Believers (promoting Shari' a compliance,
"trust and piety") comments
Addressing ethical investors/ depositors (also Non-
Muslims) comments
Promote fund-raising in Middle-East (e.g. for
business clients) comments
Approach Small and Medium enterprises comments
others (please specify) comments
3. How do you promote your products/ services?
Print Media (e.g. leaflets, advertisement in
magazines, poster) comments
Online Media (e.g. own website, google, Islamic
Banking associations' websites) comments
Personal networks/ word-of-mouth advertisement comments
Local presence (e.g. close to mosques) comments
others (please specify) comments
4. Which language/s do you use in your advertisement?
English comments
German comments
Arabic/ Urdu comments
Turkish comments
others (please specify) comments
I.d Shari' a Compliance
6. How do you integrate the Shari' a supervision in your compliance structure?
Operating own Shari' a supervisory board (please
specify on members, tasks and processes) comments
Sharing Shari' a supervisory board (please specify
on partner institute, members, tasks and
processes) comments
others (please specify) comments
Appendix
X
I.e Scale and success of activities Please note that all questions (if not stated otherwise) refer only to your activities in Islamic finance and banking!
1. How many customers do you have in average?
< 5.000 comments
5.000 - 10.000 comments
10.000 - 50.000 comments
50.000 - 100.000 comments
> 100.000 comments
2.
< 50.000.000 EUR comments
50.000.000 EUR - 100.000.000 EUR comments
100.000.000 - 500.000.000 EUR comments
500.000.000 EUR - 1.000.000.000 EUR comments
> 1.000.000.000 EUR comments
3.
< 1.000.000 EUR comments
1.000.000 - 5.000.000 EUR comments
5.000.000 - 10.000.000 EUR comments
10.000.000 EUR - 50.000.000 EUR comments
50.000.000 EUR - 100.000.000 EUR comments
> 100.000.000 EUR comments
4.
< 0 % comments
0 % - 20% comments
20% - 40% comments
40 % - 60% comments
> 60% comments
5.
e.g. Home finance 15%
Product group 1 comments
Products group 2 comments
Product group 3 comments
Product group 4 comments
Product group 5 comments
Product group 6 comments
Products group 7 comments
Product group 8 comments
Product group 9 comments
Product group 10 comments
How are your revenues apportioned to product groups (please insert the product group on the left
and the percentage number in the comment box on the right, as shown in the example below)
How many assets do you have under management in average? (please specify what is included in
AuM in the comments box e.g. deposits and institutional money)
How many revenues were generated in 2007?
What was the annual growth rate of revenues from 2006 to 2007?
Appendix
XI
6.
e.g. Home finance 2
Product group 1 comments
Products group 2 comments
Product group 3 comments
Product group 4 comments
Product group 5 comments
Product group 6 comments
Products group 7 comments
Product group 8 comments
Product group 9 comments
Product group 10 comments
7.
e.g. Home finance 4
Product group 1 comments
Products group 2 comments
Product group 3 comments
Product group 4 comments
Product group 5 comments
Product group 6 comments
Products group 7 comments
Product group 8 comments
Product group 9 comments
Product group 10 comments
8.
< 0 EUR comments
0 EUR - 5.000.000 EUR comments
5.000.000 EUR - 10.000.000 EUR comments
10.000.000 EUR - 15.000.000 EUR comments
> 15.000.000 EUR comments
Please bring your Product groups in an order according to their profitability (1=highest profitability,
5=lowest profitability)! (please write the respective number (1-5) in the comment box on the right,
your product groups will appear as inserted in question 6)
Please bring your Product groups in an order according to the efforts/costs involved (1=highest
efforts needed, 5=lowest efforts needed)! (please write the respective number (1-5) in the
comment box on the right, your product groups will appear as inserted in question 6)
What was the overall result in 2007 (profit /(loss))?
Appendix
XII
II. Planned Business Activities and Estimated Market Potential
IIa. Planned Business ActivitiesPlease note that all questions (if not stated otherwise) refer only to your activities in Islamic finance and banking!
1.
yes, to bundle our activities in this field comments
yes, to improve our credibility comments
others (please specify) comments
no comments
2.
yes, it is planned to offer Islamic finance and
banking services via the exisiting branch network in
other markets/ regions
(please specify in comment box) comments
yes, it is planned to open up new branches (please
specify in comment box) comments
no, we will not expand comments
others (please specify) comments
3.
yes, we will add new products/ services (please
specify in comment box) comments
yes, we will add new features to the existing
products/ services (please specify in comment box)
comments
yes, we will enter new strategic partnerships to
enlarge our portfolio (please specify in comment
box) comments
no, we will operate with the existing portfolio comments
no, we plan to reduce our portfolio (please specify
in the comment box) comments
no, we plan to terminate an existing strategic
partnership (please specify in the comment box) comments
others (please specify) comments
4.
yes, we will offer our products to a broader client
base (please specify in the comment box) comments
yes, we will reduce our client base (please specify
in the comment box) comments
no, we will continue targeting our products/
services to the current client base comments
others (please specify) comments
Do you plan to enlarge your product/ service portfolio in the future?
Do you plan to change your customer group in the future (for all or single products/ services)?
Do you plan to open a subsidiary dedicated to Islamic finance and banking?
Do you plan to expand to other markets in Europe/ in your home market?
Appendix
XIII
5.
yes, we will offer online-banking services in the
future comments
yes, we will offer telephone-banking services in the
future comments
yes, we will hire mobile customer advisers comments
yes, we will establish ATMs comments
yes, we will make use of cross-selling potential
(please specify in the comment box) comments
others (please specify in the comment box) comments
no comments
6.
yes (please specify in the comments box) comments
no comments
7.
Customers comments
Revenues comments
Assets under Management comments
8.
yes (please specify activities in comments box) comments
no comments
IIb. Estimated Market PotentialPlease note that all questions (if not stated otherwise) refer only to your activities in Islamic finance and banking!
1.
a) regarding new markets (countries/ regions) comments
b) regarding products/ services demanded comments
c) regarding attractive customer groups comments
d) regarding new distribution channels/ cross-selling
potentials? comments
e) regarding overall growth prospects for this
industry? comments
f) others (please specify) comments
How would you assess the future market potential of Islamic Banking and Finance in Europe?
(Please write your answer in the Comments box on the right.)
Do you plan to add new distribution channels?
Do you plan to change your marketing strategy?
What are your operative targets for the upcoming year (2008)? (please insert percentage changes
in the comments box)
Do you plan to disinvest in certain activities?
Appendix
XIV
III. Observed Obstacles and Problems
IIIa. Operational hindrancesPlease note that all questions (if not stated otherwise) refer only to your activities in Islamic finance and banking!
1.
make use of Islamic derivate instruments (please
specify in the comments box) comments
make use of Islamic treasury accounts provided by
other Islamic financial institutions (please specify in
the comments box) comments
holding high liquidity reserves comments
use of conventional inter-bank market comments
others (please specify in the comments box) comments
2.
use of Islamic derivate instruments (please specify
in the comments box) comments
holding high liquidity reserves (to provide for
counterparty failure etc) comments
others (please specify in the comments box) comments
3.
yes, especially managers comments
yes, especially sales staff comments
yes, especially experts for product development comments
yes, others (please specify in comments box) comments
no comments
4.
yes (please specify in the comments box) comments
no comments
IIIb. Hindrances regarding Shari' a compliance and regulatory issues
1.
The product development process for Islamic
finance and banking products requires substantially
higher time and costs efforts than in a conventional
bank. comments
There is a shortage of Schari' a scholars. comments
The inconsistency in decisions made by Schari' a
boards on the admissibility of products/ processes
(fatwas) leads to disadvantages for certain financial
institutions.
comments
Industry-wide standards (e.g. Accounting rules) are
missing. comments
Western Islamic financial institutions face
credibility problems in the Muslim community. comments
others (please specify in the comments box) comments
2.
yes, as an Islamic bank it is problematic to fulfill
certain regulatory requirement (please specify in
the comments box) comments
yes, Islamic financial institutions face higher tax
burdens on their products which make them less
competitive in the market comments
others (please specify in the comments box) comments
no comments
IIIc. Technical problems
1.
yes, most banking software is designed for the
interest-based system comments
yes, there are no adequate banking software
offerings for Islamic banks available comments
yes, others (please specify in comments box) comments
no comments
Do you face higher regulatory/ legal hindrances in your core markets than conventional banks?
Do you experience problems in managing and mapping your processes and activities due to lack of
adequate IT infrastructure?
How do you handle your liquidity management?
How do you handle your risk management?
Do you experience problems in finding adequate human resources (having knowledge in Islamic
Finance and Banking)?
Do you experience any other operational problems?
Islamic Banks face additional compliance requirements imposed by the Shari' a Supervisory Board.
Please mark the statements you would approve and specify your answer in the comments box!