Inter Nationalization of Islamic Financial Institutions

8/14/2019 Inter Nationalization of Islamic Financial Institutions

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InternationalizationofIslamicFinancialInstitutions:ChallengesandPathstoSolutionby:

SamyNathanGaras

Villa

5,

Gate

789,

Road

3217

Manama,BuAshirah332

KingdomofBahrain

Telephone:+97339299589

EMail:[email protected]


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ABSTRACTTheIslamicFinancialInstitutions(IFIs)havewitnessedasignificantgrowthrecentlyand

becomeanewplayerinbankingindustry. AsIFIsmovetowardstheinternationalmarkets,they

confrontseveralchallengesoninternalandexternallevels.Internally,IFIsstillhavelimited

recognitionbyinvestors,marginalcontributiontothemacroeconomyandlimitedcustomer

service. Externally,IFIshavelackofcommunicationwithotherplayersinthefinancialmarkets.

Theirproductsarenottotallypromotedtotheinternationalinvestorsandtheirsystemisnot

completelyregulatedandrecognizedbycentralbanks. Thispaperwilladdressthesechallenges

andprovideaconceptualframeworkofsolutions.

INTRODUCTIONDuringthelastthreedecadesIFIshavebeengrowingsignificantly,bothdomesticallyand

internationally. IFIswitnessedanaverageannualgrowthrateof23%(approximately)during

theperiod19932003,and20%since2003(CIBAFI,2004).

ThesenewfinancialfirmswereestablishedintheemergingmarketoftheMiddleEasttomeet

thedemandofinvestorsandborrowerswhoaremotivatedbyprofitmaximizationbasedonthe

Islamiclaw(Sharia). IFIsofferawiderangeofIslamicfinancialinnovationsstartingfromthe

simplecontractofprofitsharingagreement(Mudaraba),whichissimilartotimedepositin

conventionalbanks,toIssuingIslamicbonds(Sukuk)andderivatives. ThegrowthofIFIs

attractedsomeoftheconventionalfinancialfirms(i.e.,ABNAMRO,CitibankandDresdner

KleinwortBenson)toaddtheserviceofIslamicwindowstotheirclients. Despitethe

advantagesthatareembeddedinIFIssystemandmanagement,IFIsencounterseveral

fundamentalchallengestotheprospectofbeingrecognizedinternationally. Thechallengesexist

inlocalaswellasglobalmarkets. Theseadvantagesandchallengeswillbediscussedthrough

thefollowingquestions:

1. WhataretheadvantagesthatmakeIFIsdifferentfromconventionalbanksandhowthe

customersperceivethesecharacteristics?

2. WhatarethechallengesthathinderIFIsfrombeingrecognizedlocallyandinternationally?

3. HowcanIFIsarticulatethepropersolutionstomeetthesechallenges?


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Thepaperwillbedividedintothreeparts. FirstpartwillexplainthecurrentsituationofIFIs,

explainingthefactorsbehindtheirgrowthinlocalandinternationalmarketsanddiscussesthe

advantagesofIFIssystemthatmakesthemuniqueandattractivetoallcustomers. Secondly,it

willpresentamodeldiscussingthetwotypesofchallengesbeforeIFIsinternationalization:

challengesinsidetheIslamiccountriessuchasthelimitedrecognitionofinvestorstoIFIs

activities,thelimitedcontributionofIFIstothecountryseconomyandthelimitedcustomer

service. TheothersetofchallengesexistoutsidethenonMuslimcountriessuchasthecultural

barrierswiththeWesterncountries,thecautiousnessofinternationalcustomersinbeing

involvedwithIFIstransactionsandthemisconceptionofIFIsstereotype. Thirdly,thepaperwill

providesomesolutionsthatcanbeimplementedtofacilitatetheprocessofinternationalization

and

provide

some

lessons

to

conventional

banks

on

the

technical

and

management

sides.

LITERATUREREVIEWInternationalizationhasbeenunderdiscussionforalongperiodoftime,wheredifferentauthors

lookedattheprocessofinternationalizationfromdifferentviews.Forinstance,Buckleyand

Casson(1976)lookedatthetransactioncostsforintangibleassetsandtheabilitytoobtainand

transferknowledgeacrosstheinternationalmarkets. ThisideahasbeenarguedbyHennart(1982)

andCaves(1996). Furthermore,JohansonandVahlne(1977,1990)andCarpanoandChrisman

(1994)arguedtheinfluenceofinternationalizationonthefirmsperformance. Inaddition,Doz

andPrahalad(1984)focusedontheorganizationandmanagementofmultinationalfirmsandthe

balancebetweeninternationalheadquartersandnationalsubsidiaries(MartinezandJarillo,1991;

PatersonandBrock,2002). Furthermore,Ghemawat(2001,2003)notedhowsometypesof

dimensionsamongthecountries(i.e.,cultural,administrativeandgeographicaldimensions)

influencetheinternationalizationprocess. Therefore,theyshouldbestudiedwiththeintegrative

framework

of

internationalization.

These

dimensions

include

the

language,

religion

and

social

norms(culturaldimension);political,legalandeconomicsides(administrativedimension);and

income,population,andeducation(geographicaldimension). Theculturaldimensionwas

studiedindetailbyHofstede(2001)andothers(Schwartz,1996;BondandChi1997;Schwartzand

Bardi,2001)wheretheybuiltarelationshipbetweenculture,valuesandpractices. Thecultural


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dimensionhasasignificantinfluenceontheinternationalizationprocessofIFIs. Ontheother

hand,IFIshavehighcodeofethicsderivedfromtheIslamicreligionwhichenhancestheir

CorporateSocialResponsibility(CSR),whichbroughtthemafavorableimagefromthe

stakeholdersandenhancedtheirperformanceintheirearlystage. Thisthoughthasbeen

developedinliteraturebyDonaldsonandPreston,1995;McWilliamsandSiegel,2001andRowley

andBerman,2000.

ThereisascarcityoftheoreticalliteratureinIFIsinternationalizationprocess. ZaherandHassan

(2001)provideacomparativestudyonthesalientfeaturesofIslamicbankingsupervisorysystem

in15countries,explainingthelackofregulatoryframeworkinIFIs,whichposesagreatchallenge

onIFIstouniformtheirstandardsandpoliciesandmandatethemonallIFIsregardlesstheir

countries.

In

addition,

Aggrawal

and

Yousef

(2000)

argued

the

economic

rationales

for

the

superiorityofIslamicfinancingsystemoveritsconventionalcounterpart. EbhrahimandJoo

(2001)arguedthatIFIsinternationalizationprocessgreatlydependsontheregulatorswhoshould

developamodernfinancialengineeringsystemfortheadvancementofIFIs. Thiswouldreduce

theirdependenceontheconventionalbanksfordrawingtheirexpertise. Siddiqi(2001)argued

thatIFIsinternationalizationischallengedbydevelopingtheriskmanagementandanalysistools

inIslamicfinancialtheoryandpracticetohedgeagainstthevolatilityintheinternationalmarkets.

Inaddition,

IFIs

need

to

educate

the

international

investors

with

their

Islamic

ethical

foundation

thatisembeddedintheirproductsandtheirmarkupineachtransaction(Hassan,1999;Baldwin;

HumayonandJohn,2000;Suseno,2002).

ThispaperaimstoprovideaconceptualframeworkfortheinternationalizationofIFIsthrougha

model,explainingthechallengesthatstandagainstIFIsandthepossiblesolutionstoovercome

them.

WHATISISLAMICFINANCING?Unliketheconventionalbankingsystem,theIslamicbankingsystemcanbedefinedasafaith

basedsystemoffinancialmanagement,whichderivesitsprinciplesfromtheIslamicSharia. It

promotesprofitsharingintheconductofbankingbusinessaswellasprohibitingpayingor

receivinginterestonanytransaction(SallehandHassan,2004). Thisdefinitionassertsthemain


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pillarsofIFIs:guidancebyIslamicShariathroughaboardofIslamicscholarscalledtheSharia

SupervisoryBoard(SSB)and,mostsignificantlyintermsofareconceptualizationinfinance,

theprohibitionofreceivingprofit(interest)onborrowingandlendingcash. TheIslamic

bankingsystemhasbeencriticizedforwhathasbeeninterpretedasthenotionofariskfree

rewardorreturnandthelackofrecognizingthetimevalueofmoney(Khan,1994:13). This

argumentisnottotallycorrectbecauseaccordingtothemoderneconomictheoryandanalysis,

Islamicbankingisbasedonequitybasedsystemnotonthedebtbasedsystemwhichisthebase

ofconventionalbankingsystem(Khan,2000:628). ThismeansIFIsofferanuncertainrateof

returntotheinvestorsandincaseofincurringanyrisk;itshouldbesharedbetweenthebank

andtheinvestor. ThissystemallowsIFIstoadjustthevalueoftheirassetsandliabilities

according

to

any

changes

in

the

fair

market

value

of

the

investment.

This

means

the

loss

is

alwayssharedbetweentheIFIandtheinvestors. Onthecontrary,theconventionalbanking

systemdoesnotreflectthechangesinfairmarketvalueoftheinvestment,insteadthebank

assumesthelossaloneresultingindisequilibriumbetweentherealvalueofassetsandliabilities

andendingbynegativenetworthofthebank(Haron,2000:631). Theprohibitionofpre

determinedinterestrateonloansputspressureonIFIstomonitortheborrowersatareasonable

costandgettheexactinformationaboutthegeneratedprofitbecausethelendermightprovide

asymmetricinformation

about

the

real

profit.

Therefore,

the

portfolios

of

IFIs

tend

to

be

concentratedinshortterm,traderelatedassets(DiamondandDyhvig,1983:401). This

emphasisonshorttermfinancingleadstoaninimicaleffectoninvestment,growthand

economicdevelopment. Thisconceptreflectsthesocialcommitmentbetweenthebankandthe

investorsinenhancingtheeconomy.

AccordingtoIslamicSharia,IFIscannotbeinvolvedintheproductionordistributionofspecific

activitieswhichareforbiddenbyIslamsuchasalcohol,pork,andgambling. Inreplacement,

theyshould

invest

in

long

term

assets

such

as

Profit

Sharing

Agreement

(Mudharabah),

Cost

PlusFinancing(Murabaha),EquityParticipation(Musharaka),andLeasing(Ijarah). These

activitiesarebasedonrealassetsratherthanfinancialassets(BahrainMonetaryAgency,2006:

22).


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Duringthelastthreedecades,IFIshaveincreasedsubstantiallyintheMiddleEastandNorth

Africa(MENA)countriesandwentfurthertotheFarEastandEurope. Amongallthecountries

thathostIFIs,BahrainstandsasapioneerinhostingthelargestnumberofIFIs(37banks)in

spiteofitssmallestsize1. BahrainhostsalltheregulatorsofIFIswhichwillbepresentedinthe

followingsection. ThereasonbehindthisgrowthinBahrainisthelackofnaturalresourcesin

thecountry,whichmotivatedBahraingovernmenttonourishtheIslamicbankingindustryand

makeitasoneofthemainresourcesofincome. Inaddition,thereisnocorporatetaxinBahrain,

whichsupportstheIFIssystem. AsParker(1993)notedthatBahrainiplannersarekeento

portrayBahrainsfutureasequivalenttoSingaporeintheFarEast.

GlobalIslamicEconomySofar,theexactsizeoftheglobalIslamiceconomyhasnotbeenpreciselyidentified. However,

forthepurposeofthisstudy,wehaveconsideredthe57membernationsofOrganizationof

IslamicCountries(OIC)astheprimarypromotersofIFIs(http://www.oicoci.org). Previous

studiescoveredpartofthiseconomysuchasMENAcountries,butbypassedthecountries

whereMuslimpopulationisbelow50%,asintheexSovietrepublics,U.K.,FranceandIndia.

ThetargetedIslamiccommunitieshaveincommonthecharacteristicsofahighlevelofpoverty,

debtandhighpopulationgrowth(Moore,1997:2). Thedebtaccumulationisoftencondemned

byIslamiceconomists,especiallyinthosecountrieswhohavetheopportunitytoimproveother

industries suchastourism,manufacturing,andnaturalresourcesthatcanenhancetheir

economy(Chapra,1985:84). ThesecondcharacteristicforMuslimeconomiesistheirlarge

defensebudgetsandthegovernmentsubsidiestoutilities(i.e.,electricity,communication,

water,andtransportation)insteadofprivatization. Thethirdcharacteristicisthelow

availabilityofemploymentintheprivatesector. Thepublicsectoraccountsfor3060%ofthe

labor

force

in

most

of

MENA

countries

with

almost

95%

in

Gulf

Cooperation

Council

(GCC)

countries.2

1Bahrainisasetof33smallislands,locatedattheNorthEastofSaudiArabia. Ithassmallproductionofoil

comparedtoitsneighborcountries. Accordingto2007statistics,Bahrainhasasmallpopulationof708,573

approximately(http://www.infoplease.com/ipa/A0107313.html). 2InternationalMonetaryFund MiddleEastandCentralAsiaRegionalEconomicOutlook(2005)


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MostoftheIslamiceconomiesareworkingtowardspromotinglocalsavings,attractingforeign

investments,andreducingtheircapitalexpenditures. Themostreadilyavailableandusefultool

forachievingtheseendswasthecreationofabankingsystembasedonIslamicprinciples.

TheArabianGulfcountriesconstitutethefoundationforIFIsbecauseoftheirsimilarityin

religion,culture,languageandaridgeography. TheyhavefouroutoffivelargestIslamicbanks

intheworldandmaintainthehighestconcentrationofIslamicdepositsandcapitalduetothe

highincomeintheregion.3 ThemembersofGCCcountrieshold20%oftheworldscrudeoil

productionandhaveaGrossDomesticProduct(GDP)percapitaofmorethanUS$8,000.

Therefore,thisregionwasfoundtobesuitablesoilforthissystemtogrowinandmovearound

totheotherMuslimcountries.

Malaysia

and

South

East

Asia

are

additional

financial

regions

of

interest

for

IFIs,

after

GCC

countries. MalaysiaisconsideredthesecondmostpopulousIslamiccountrywith54%oftotal

populationafterIndonesiawhichhas90%ofpopulation(Moore,1997:183).However,Malaysia

comesasapioneerinIslamicbankingindustryforthewholeSoutheastAsianregion.

Fromtheperspectiveofconventionalbanking,thesuccessofIFIscanbegaugedbytherush

amongtheconventionalbankstoopentheirownIslamicwindows,notonlyinsidetheIslamic

worldbutintherestoftheworldsuchasCitibank,ABNAmro,HSBC,BNPParibas,andBank

ofAmerica.

Intheglobalmarket,IFIsareuniqueinproducingIslamicbonds(Sukuk)whicharedifferent

fromthetraditionalbondsandequityinstruments. Thisnewtooloffersasourceoffunding

basedontheprofitsharingconceptbetweenIFIsandinvestors,shiftingtherisksfromthebank

sideasinthecaseoftraditionalbondstobeonasharedbasisbetweenthebankandthe

investors. Itenablesthebanktoexploittheircomparativeadvantagesintheloanprocessand

maintainacustomerrelationshipevenwhenloanscannotprofitablybeheldonthebalance

sheet(Alkhan,

2003:

16).

IslamicSukukarewrittendocumentsthatcanbetradedinthecapitalmarketandbear

ownershipintangibleassets. TheyarebasicallycertificatesevidencingtheSukukholders

3AlRajhiBankingandInvestmentCorp.SaudiArabia;KuwaitFinanceHouseKuwait;FaisalIslamicBankofBahrain;

DubaiIslamicBankU.A.E.,andFaisalIslamicBankofEgypt,whichispartoftheAlBarakaBankingGroup.


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ownershipinone,ormoreassets.4 Forinstance,PartnershipFinancing(MusharakaSukuk)and

TrustFinancing(MudarabaSukuk)aregoodexamplesofSukuk,whereinvestorscontribute

moneytotheIslamicbankonthebasisofthesetwoinstruments,toacquireownershipand

profitinrealassets. Thesetypesoffinancingreflecttheconceptofprofitsharing,riskbearing

conceptbetweentheIFIsandtheirinvestors.

ThefactorsbehindtheGrowthofIFIsSeveralfactorshadcontributedtothegrowthofIFIs,suchastheeconomicalgrowthofGCC

countriesasaresultoftheoildiscoveryandtheestablishmentoftheOrganizationofPetroleum

ExportingCountries(OPEC)(Moore,1997:7). Thisunexpectedresourceofincomechanged

completelythelifestyleintheregionandprovidedthefoundationforIFIs. Inaddition,Saudi

ArabiatooktheleadamongtheIslamiccountriestopromotethespiritofIslamthroughfinancial

supporttotheMuslimcommunitiesintheformofestablishingIslamicuniversities,institutes,

andIslamiccenterstostrengthentheArabicandIslamicidentity(Halliday,1996).Duringthat

time,twoSaudifundedfinancialfirmshavebeenfounded(DallahAlBarakaGroup,1969and

DarAlMaalAlIslamiOrganization,1981)tosupporttheinternationaldevelopmentofIslamic

banking. AfterthetragedyofSeptember11,mostoftheArabinvestorspreferredtoholdalarge

portionoftheirinvestmentsintheMiddleEastincaseofanothersimilarevent. TheIFIswere

thebestagenttomanagetheirinvestments. Inaddition,thecentralbanksinGCCcountriesand

especiallyinBahrain,urgedtheAccountingandAuditingOrganizationforIslamicFinancial

Institutions(AAOIFI)tosetuptheaccountingandauditingstandardsforIFIstoprotectthese

investments.

CHALLENGESBEFOREIFIsINTERNATIONALIZATIONThereareseveralchallengeshinderingtheIFIsfrombeinginternationalized,whichcanbe

classifiedintotwosetsofchallenges. ThefirstsetincludesthreechallengesinsidetheIslamic

countries. First,theregulatorslimitedinfluenceoverIFIsactivitiesandtransactionsinmostof

OICcountriesleadstoinvestorslimitedrecognition(Grais,2004).Secondly,thelimitedroleof

4AAOIFIShariaStandardsNo.(18),InvestmentSukuk(20045),p.4,Akbar(2003),p.4


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IFIsinmoneyandcapitalmarketsresultsinlimitedcontributionstothecountrysmacro

economy(Ahmad,PradhanandAhmad,2005). Thirdly,thesignificantshortageofqualified

manpowerandmanagementinsideIFIsleadstolimitedcustomerservice(ElhiraikaandHamad,

2003).

ThesecondsetincludesthreechallengesoutsidetheIslamiccountries. FirsttheSSBinfluence

overtheIFIstransactionsandactivitiesmightbemisperceivedinnonMuslimcountriesand

createaculturalbarrier(Mirza,andHalabi,2003,347). Secondly,thedifferentcharacteristicsof

IFIstransactionsandtheirreligiousfoundationleadtocustomerscautiousnessandaddextra

challengebeforeIFIsinpromotingtheirproductsinternationally(IqbalandMirakhor1999,381).

Thirdly,

the

limited

capital

of

IFIs

compared

with

the

total

capital

of

the

financial

institutions

in

anycountryleadstomarginalrecognitionbythecentralbanksandenforcestheIFIsto

accommodatewiththeexistingruleswhichmightnotbecompliantwithIslamicSharia(Al

OmarandAbdelHaq,1996).

InsertFigure1abouthere

ChallengesinsidetheIslamicCountriesSincetheconventionalbankingsystemiswidelyspreadinsideaswellasoutsidetheIslamic

countriesfordecades,itgainstheclientstrustespeciallyifitiswellregulatedandactively

contributedtotheeconomy. Ontheotherside,IFIsarenewplayerinthefinancialmarket;

therefore,theystrivetocompetewiththeexistingsysteminsidetheIslamiccountries. IFIsare

stillbuildinguptheirregulatorysystemandtryingtocontributetothecountryseconomyin

linewithIslamicSharia. IFIsarecurrentlyrecruitingtheiremployeesandmanagementfrom

those

who

work

in

conventional

banks

because

of

the

serious

shortage

in

their

manpower.

Investorslimitedrecognition:Inthefinancialindustry,theregulatorshaveasignificantrolein

organizingandcontrollingthetransactionsandimplementingthefiscalpolicyforthewhole

country. IFIsarealwayscompliantwiththedominantregulationsofanycountrytheyoperate


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in;however,theyhavetheirownsetofregulatorsthatfacilitateappropriateinteractionwiththe

IslamicSharia. ThefirstelementoftheIslamicsupervisorynetworkisAAOIFI,whichwas

establishedin1991forthepurposeofissuingstandardsinaccounting,auditing,governance,

andShariaforIFIsinaccordancewithInternationalFinancialReportingStandards(IFRS)

(Thomas,CoxandKraty2005,207).

In2003,theIslamicFinancialServicesBoard(IFSB)wasstartedinKualaLumpurtoserveasan

internationalstandardsettingbodyofregulatoryandsupervisoryagencies

(http://www.ifsb.org). TheIFSBisfocusedonthestructuredregulatoryconvergenceof

supervisorystandards. Thisinternationalconvergenceismeanttoachievecomparable

standardsofcapitalmeasurementsandcapitalstandards.

In

2001,

the

International

Islamic

Financial

Market

(IIFM)

was

founded

with

the

collective

efforts

ofthecentralbanksandmonetaryagenciesofsixcountriestofacilitatesecondarymarketsfor

Islamicinstruments.5Ithastwoprimaryroles:marketeducationandShariaauthentication,

whichcontributetomoreselfregulationandpromotionofIslamicmoneyandcapitalmarkets.

In2005,theCentralBankofBahrainestablishedTheLiquidityManagementCentre(LMC)for

thepurposeofprovidingsecondarymarketbuyerforIslamicbonds(Sukuk). TheLMCplaysa

keyroleinthecreationofanactiveinterbankmarketwhichwillassistIslamicfinancial

institutionsin

managing

their

short

term

liquidity.

The

establishment

and

depth

of

such

inter

bankmarketwillfurtheracceleratethedevelopmentprocessoftheIslamicbankingsector

(http://www.lmcbahrain.com).

Duringthesameyearof2005,TheIslamicInternationalRatingAgency(IIRA)startedoperating

inBahraintoassistinthedevelopmentoftheregionalfinancialmarketsbyprovidingan

assessmentoftheriskprofileofentitiesandinstrumentswhichcanbeusedasoneofthebases

forinvestmentdecisions(http://www.iirating.com). TheIIRAprovidesdifferentservicesof

ratingsuch

as

sovereign

ratings

and

credit

ratings

which

include

assessment

of

an

entitys

abilitytorepaythedebtobligationsintimelymanner. Also,itprovidestheserviceofSharia

qualityratingthatincludestheassessmentofthelevelofcompliancewithShariaprinciples.

5ThesixcountriesareBahrain,Brunei,Indonesia,Malaysia,SudanandSaudiArabia.http://www.iifm.net


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Inaddition,thereistheIslamicResearchandTrainingInstitute(IRTI),whichwasestablished

undertheIslamicDevelopmentBankinBahraintosponsorsomeofthemostimportantanalyses

ofproducts,regulations,supervision,developmenteconomicsandriskmanagement(Thomaset

al.,2005:209).

Finallyin2001,theGeneralCouncilforIslamicBanksandFinancialInstitutions(CIBAFI)was

establishedinBahraintodevelopandmanageacomprehensivedatabasededicatedforIFIs

includingadministrativeandfinancialinformationsince1998. Currently,CIBAFIisconsidered

theonlyreliablesourceofinformationaboutIFIsatthegloballevel.6

InsertFigure2abouthere

In

most

of

the

Islamic

countries

the

central

banks

are

not

in

practice

of

their

main

role

in

leading

theIslamicfinancialinstitutionsintoefficientmobilizationofsavingsandallocationofresources

(Khan,2000:627). Intheory,thereisnothingthatmakescentralbanksinIslamiceconomydiffer

inamajorwayfromthetraditionalconceptofcentralbanking. Inreality,thecentralbanksin

mostoftheIslamiccountriesdonottaketheiressentialroleofinitiatingandfosteringthe

developmentofprimary,secondary,andmoneymarketsthatareapprovedbySSB. Theystill

lacknewinnovationswhicharebasedonprofitsharingconcept,notfixedinterestrate.

Also,the

central

banks

do

not

have

an

effective

role

in

regulating

the

standards

and

practices

for

IFIs. Asaresult,theiraccountingpracticeswereinconsistentandthefinancialstatementswere

nottransparentduetoinadequatedisclosure(Thomasetal.2005,207).

Despitethesignificantgrowthoftheaboveregulators,theystillhavesomelimitationswhich

maketheinvestorsreluctanttotrustIFIsinthesamewaytheytrusttheconventionalfinancial

firms. Forinstance,AAOIFIstandardsaremandatedorusedasguidelinesonlyinsixcountries

(Bahrain,Sudan,Malaysia,Qatar,SaudiArabiaandDubai)outofthe57countriesofOIC. IFSB

lacksthe

authority

and

power

to

mandate

their

standards

such

as

Financial

Accounting

StandardsBoardandIFRS.IIFMhasstilllimitedaccessandpresentationinOICandtheir

conferencesandseminarsarenotmatureyet. LMCiscontrolledbyBahraincentralmarketand

6GeneralCouncilforIslamicBanksandFinancialInstitutions(CIBAFI) IslamicFinanceDirectory(2004),p.4


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cannottakeindependentdecisions. Theselimitationsleadtolimitedrecognitionfromthe

investorsside.

Limitedeconomiccontribution:althoughthemoneyandcapitalmarketsofOICarestill

consideredasemergingmarkets,IFIsarerestrictedbyShariaregulationstoeffectivelytakepart

inthosemarkets. IFIscannottradeinsharesorbondsofanycompanythatgeneratesrevenue

fromalcohol,pork,andsimilaractivitieswhichareprohibitedbyIslam. Therefore,IFIshave

innovatednewproductsinreplacementsuchasMurabahacontract,Tawarroqcontract,BeiAl

UrboonandJoalacontract7.

However,thesetoolsareneitheravailabletoallIFIsnorsignificantlycontributingtotheOIC

macro

economy.

In

addition,

many

Islamic

nations

are

significantly

under

banked

and

this

structuralfactpointstheneedofgrowthinsidetheIslamiccommunity. Currently,mostofthe

IslamicbanksarelocalorregionalbankssuchasKuwaitFinanceHouseandBahrainIslamic

banks. TheonlyIslamicbankthatiswellestablishedwith203branchesin10countriesis

AlBarakaBankingGroup.

InsertTable1abouthere

Finally,IFIsdonothavesignificantcontributiontoincubatorsandentrepreneurshipinsidethe

membercountriesofOICbecauseoftheirshortexperience. Theirinvestmentsarefocusedon

wellestablishedbusinessesthatareapprovedbySSBonly.

Limitedcustomerservice:IFIsareinneedforaccumulationofhumancapitalasitprovedtobean

importantdriverofendogenousgrowthforIFIs(Elhiraikaetal.,2003;Barro1991,407). According

totheHumanDevelopmentIndex(HDI)8fortheyear2004,Bruneiwasrankedat33andBahrain

7Murabahacontractmeansbuyinganassetforcashandsellingitimmediatelyoncredit. InTawarroqcontractthe

Islamicbankpurchasestheassetoncreditandsellsittoanotheroneforcash. BeiAlUrboonincludessettingupa

fixedpriceforacommoditytobedeliveredinthefuture. JoalacontractisaconditionalpromisebytheIslamicbankto

deliveraspecificquantityofanaturalasset(i.e.,oil,mineral,steel)uponextractiononanagreeddate. The

commoditytraderwouldpaythepredeterminedpriceforit(AlSheahabi2003,1113).8HDIisavailablewithHumanDevelopmentReportbroughtoutbyUnitedNationsDevelopmentProgramme

(UNDP). Itisacompositeindexthatmeasuresachievementsofacountryindifferentparameters.


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at40,despitethesmallpopulationofthosetwocountries. Evenmorealarmingindicationsoflack

includeIran,whichwasplacedat101,Sudanat139andPakistanat142. Thesecondalarming

indicatorinthisreportistheeducationlevel,where73%oftheOICcountriesoccupythelower

halfintheranksforcountrieslistedinHDI. ThesefactsshowthatIslamiccountriesand

organizationshavenotbeenpersuasiveenoughinofferingnonMuslimcountrieswithIFIsvision

andstrategy. ItindicatesthatIFIssuccessmayremainatsuperficiallevelsandchallengesposedto

theconventionalfinancialsystemmayremainfeebleotherwise.

Technology,althoughundergoingtremendousgrowth,canbesaidtoactasabackboneofthe

financialsector,aswellasbeingamaindriverofmarketpower. Itappliesnotonlytothereal

timeclearingandsettlementinmoneyandcapitalmarkets,butalsotointernetbasedofferings

andAutomated

Teller

Machines

(ATMs)

which

are

not

fully

implemented

in

IFIs

due

to

their

cost

andprocedures. EventhewebsitesofIFIsareservingadvertisingpurposesmorethantechnical

supporttocustomers.9 ArcoIndex(ArchibugiandCoco,2004)places38outof57OICcountriesin

thelowerhalfofrankingsinthesetof162countries,with8out10lastplacesandallfivelastranks

areoccupiedbyOICcountries.10

ChallengesoutsidetheIslamicCountriesOn

the

global

scale,

OIC

member

countries

face

an

economic

challenge

where

the

GDP

of

all

membercountriestogetherislessthan17%oftheGDPofUSAanddoesevenreach12%ofthe

GDPofUSAandJapan(Ahmadetal.,2005). Sincetheeconomicsituationdoesnotsupportthe

longtermgrowthprospectsforIFIs,itisimportanttopenetrateotherboundariesbeyondthoseof

thetopGDPcountries. Inaddition,theWestisreluctanttoacceptanyapproachfromOIC

countriesthatmightenhancepoliticalpowerintheOICcountries,suchasgrowthintheirfinancial

system. ThedistortedstereotypeofIslamintheWestconstitutesasignificantchallengebeforeIFIs

topenetrate

these

boundaries.

Also,

the

difference

in

culture,

language

and

religion

creates

anotherbarrierbeforeIFIstowardstheirinternationalization. Inaddition,thelimitedcapitalof

9De/Shakeel/Somashekar(2004)Deetal.hasbeendealingintechnologicalimpedimentsinDubaiIslamicbank

(U.A.E.)whichreflectsthecurrenttechnological situationoftheIslamicworld.10

Archibugi/Coco(2004),ArCoIndextakesintoaccountassociatedvariableswithtechnologicalchangessuchas(a)

Thecreationoftechnology(b)Technological infrastructureand(c)Developmentofhumanskills


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13

IFIscomparedtothecapitalofconventionalbanksresultsinmarginalrecognitionfromthecentral

bankssidewhetherinsideoroutsidetheOICmembercountries.

Culturalbarrier:oneofthetangibleproblemsbeforeIFIsiscommunicationbetweenMuslimsand

thenonMuslimworldingeneral,andbetweenIslamicandconventionalbanksmorespecifically.

Thisdistancebetweenthetwopartieshavebeenincreasedduetothemediaandthedifferent

attacksbysometerroristswhodistortedtheimageofIslamintheculturalconsciousnessofnon

Muslims. Therefore,IFIsfacegreatchallengeinreshapingthisimbalanceandbridgingthisgap

betweenthedifferingwaysofknowingandbeing. Althoughtheproblemexists,thereisno

IslamicorganizationchargedwiththecounterbalancingpresentationbetweenIFIsandtheir

conventional

banking

counterpart.

IFIs

need

to

arrange

for

more

conferences,

seminars

and

other

channelsofcommunicationstoshortenthisgapandcreateacommongroundwherethetwo

partiesmeet. Inaddition,theSSBshouldstudytheproductsoftheconventionalbanksand

encouragestheIFIstoinvestintheproductswhicharecompliantwithIslamicSharia. This

changeinattitudewillencouragetheconventionalbankingsystemtochangetheirstereotypeof

IFIs.

InnonMuslimcountries,IFIshavefoundclasheswithmainstreamregulations. Forinstance,

treatmentof

Leasing

(Ijara)

in

Islamic

banking

system

is

recognized

as

normal

leasing

instead

of

mortgagewhichchangestheconceptofIjarafrompurchasingtheassetbythebankandleasingit

tocustomerstoanormalleaseofrealestate. Also,imposingtaxesbynonMuslimgovernments

onIslamicreligiousalmsgiving(Zakat),leadstodoubletaxation. Zakatistreatedasanon

operatingexpenseinIFIsfinancialstatementsandconsequentlyhasnoinfluenceontheirnet

income(Ahmed,2002:120). Thus,IFIsarerequiredtopayregulatoryfeeswhichresultsindouble

paymentstomeetthedualregulationsofIslamicandconventionalsystem.

Customercautiousness:despitetheaforementionedadvantagesofsecuritizationinIslamic

banking,internationalinvestorsarecautiousintradinginIslamicSukukduetotheiruncommon

characteristics. Besides,thetaxationsysteminsomecountriesmighthaveimpact(eithernegative

orpositive)onsecuritizationprocess;therefore,issuanceofSukuksometimescanbetaxdriven.


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14

ThislackofsupportfromthetaxcollectiondepartmentshinderstheissuanceofSukuk.

Furthermore,thelimitedtoolsavailableforliquiditymanagementandthelackofanactive

secondarymarketaddmorebarriersbeforeIFIstocontributetothefinancialmarkets. Thelast

barrieriscausedbythepredominanceofdebtbasedmodesoffinancing,whicharedifficultto

transformintonegotiablefinancialinstruments. OnceSukukhavebeencreated,theycannotbe

transferredtoanyoneelseexceptatparvalue. ThiscausesthewholestructureoftheIslamic

financialmarkettobehighlyilliquid. Also,itleavesnoopportunityincreatingsecondary

financialmarket(AlKhan,2003:28).

LimitedrecognitionofcentralbankscreatesabarrierbeforeIFIsintheirinternationalization

process. Sofar,thereisnoIslamiccentralbankinsidetheOICmembercountries,whichmakes

theIFIs

dependent

on

the

conventional

banks

in

steering

the

financial

industry.

In

the

non

MuslimcountriessuchasEuropeandU.S.A.,Islamicbanksarenotrecognizedbytheircentral

banksbecauseofIFIsmarginalroleintheireconomiesandthelackofdefinitiontotheIslamic

bankingsystem. TheWeststillcannotfullycomprehendtheroleofSSB,wherebankingtype

decisionsaremadebynonbankers,Islamicscholars(George,1995;Patrikis,1996).

Furthermore,thecentralbanksinOICmembercountrieslackskillsofcommercialand

investmentbankersandcapabilitiesofcreditanalysis. Forexample,thecentralbanksinIran

andSudan

use

their

influence

to

steer

the

countrys

economy

by

stipulating

certain

capitals

towardsspecificindustriesthroughthereserverequirements. Also,thereisnostandardization

amongtheSSBsinOICcountries. Forinstance,ifoneSSBapprovessometransactionsinone

country,itdoesnotsecuretheirapprovalbyanotherSSBinadifferentcountry. Thus,thistype

ofdisagreementleadstoconfusionintheIFIsglobalstrategyandmakesitharderforWestern

regulatorstorecognize,understandandworkwiththissector(ClodeandElliott,1996:18).

FRAMEWORKOF

SOLUTIONS

OntheInternalLevelTheOICmembercountriesneedtoprovidesupporttoprimaryandsecondarymarketsto

enhancethecontributionofIFIs. Primarymarketsshouldfocusonpromotingnewissuesof

stock,managingsubscriptionoperations,attractingindividualandinstitutionalsavingsand


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15

directingthemtowardsproductiveprojects. Asaresult,newprojectswillbecreatedtoenhance

theproductivitybaseandimprovethecountryseconomy. Thesecondarymarketcreatesa

demandformarginaljobsandsupportsecuritiestradingforliquidationandrevenuepurposes

(Kamel,2000:641).

IFIsmustalsodevelopmoretransparencyintheirfinancialreportingbyeliminatingthe

differencesintheiraccountingtreatments;whicharemainlyattributedtotwofactors:the

differencesamongtheinterpretationsofShariascholarsandthedifferenceswithinregulatory

authorities(Karim,1994). Thistypeofinternalselfregulationscreatesaccountingdifferencesand

misleadstheusersoffinancialstatements.

Furthermore,IFIsneedtostandardizetheirrulesofreporting. Forinstance,differentIslamic

banks

will

record

the

same

accounts

differently.

Some

banks

(i.e.,

Jordan

Islamic

Bank

and

Qatar

IslamicBank)treatinvestmentaccountsthatarebasedonmudaraba(profitsharing)asobligations

whileothers(AlRajhiBankingandinvestmentandShamilBankofBahrain)treatthesame

accountsasfiduciaryinvestmentsandaccordinglyreportedthemasoffbalancesheetaccounts

(Ahmed,2001:111). Also,thecollectedincomefromtheseaccountsisrecordedusingsixdifferent

methodswhichmakestheincomerecognitionprocessdiffersfromonebanktoanother.11These

typesofprofitsharinginvestmentaccountsshouldberecordedaslimitedtermequityinstrument

withresidual

claims.

IFIsregulatorsneedtobeproactiveincreatingnewinnovationsofinvestmentsforIslamic

banks. Forexample,theyshouldenhancetheinterbanktransactionssuchasovernightfunds

andshorttermborrowingbecauseIslamicbankscannotusethesametoolsinconventional

bankingsystembecausetheinterestrateisembedded. Inaddition,centralbanksneedtoreview

thereserverequirementsonIFIsbecausetheirdegreeofriskislessthantheconventional

counterpart(Khan,2000:629;Hemat,1994). Moreover,theregulatorsinOICcountriesshould

followBahrains

model

in

securing

astrong

legal

system

for

IFIs

and

establishing

appropriate

licensingrequirements.

11Thesixmethodsofincomerecognitionare:upfront;wheninstallmentsfalldue;wheninstallmentsarepaid;equal

distributionofincomeoverperiodoftransaction;endofperiodandconstantrateofreturn. (Ahmed(2001),p.112)


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16

AAOIFIhasrecentlyrealizedtheshortageofprofessionalmanpowerinIFIs;therefore,AAOIFI

startedtwoprograms(CertifiedIslamicProfessionalAccountantandCertifiedShariaAdviser

andAuditor)toenhancethelevelofcustomerserviceinsidetheIFIs. Thefirstprogramisin

accountingandauditingofIFIsandthesecondinShariasupervisory

OntheExternalLevelAlthoughtherearedifferencesincultures,customsandtraditionsbetweentheEastandthe

West,effectivedialogueshouldtakeplacebasedonthefollowingguidelines: First,different

civilizationscomplementeachotherandleadtointegrationratherthanconflict. Secondly,the

dialogueleadstorecognitionoftherightofeachpartyandrespectsit. Effectivedialoguewill

identifytheobjectivesofeachpartyandgoesaboutachievingthemgraduallyandsearchfor

commoncharacteristicsineachcultureandpromotethemwiththeaimofcreatingmore

understanding(AlghatamandGalal,2007:204). IFIsshouldnotbeselfabsorbedentities;

instead,theyshouldhaveanopenmindtotheinternationalmarket,makinguseofhuman

experienceandmatchingbetweenShariarequirementsandWesternnorms. DespitetheSharia

precautionsagainstcertainmechanismsandmethods,IFIscanstillcooperatewithconventional

bankinginstitutionsinthefieldofnewinstruments.

IFIsarestillstrugglingtostandardizetheiraccountingrequisites. Forinstance,AAOIFIstandards

aremandatoryonlyinthreecountries(Bahrain,SudanandJordan)outofthe24membercountries

andformthebasisforregulatorystandardsinMalaysia,SaudiArabiaandQatar(AAOIFI,20045:

23). Therefore,itisessentialforIFIstoestablishaunifiedframeworktostandardizepracticesin

ordertoberecognizedgloballysuchastheGenerallyAcceptedAccountingPrinciples(GAAP),

whichcoverallthestandardsofauditing,accountingandfinancialproductsinasystematicway

(Moore,1997:248).

IFIs

need

to

find

ways

to

be

internationally

accepted

by

the

recognized

ratings

agencies

such

S&P500,Moodys,andIBCA. IfIFIstrytoarguethisapproachbyestablishingtheirownrating

agencysuchasInternationalIslamicRatingAgency(IIRA)inBahrain,itwillbeselfdefeating

ratherthanemergingininternationalmarket. Recently,Standard&Poorsestablishedanew

sectionforS&PShariahIndicesandDowJonesalsohasestablishedDowJonesIslamicFund,


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17

whicharepositivesignalstowardstheworldrecognitiontoIFIs. Toacceleratetheprocessof

acceptance,Islamicscholarsneedtounifytheirratingsmethodologytobeintroducedeffectively

totheinternationalmarket.

CONCLUSIONSGlobalizationhassignificantlyinfluenceddifferentaspectsofourlife:economically,politicallyand

financially. Thepositivesideofglobalizationisthemovementoftechnologyandhumancapital

amongthecountries,whilethenegativesideislackofgovernmentsabilitytocontroltheir

economyanddeterminethecapitalflow. Onthefinancialside,theincreaseinoilpricesflourished

theinvestmentsinGCCcountriesandencouragedtheirgovernmentstosupporttheIslamic

financialsystem. Thisnewsystemprohibitsinterestonalltransactionsandfundamentallybased

onIslamiclaws(Sharia).

Currently,IFIsareexistedinMuslimscountriesaswellassomeEuropeanandAmerican

countries. ThepotentialgrowthofIFIsisquitepossible;however,therearesomechallengesthat

shouldbeaddressedtoacceleratetheprocessoftheirgrowth. Thesechallengescanbeclassified

intotwosets:internalandexternal. Internally,theinvestorsstillrelyontheconventionalbanking

systembecausethecurrentnumberofIFIsisnotlargeenoughtomeettheneedofOICmember

countries,thecontributionofIFIsinmoneyandcapitalmarketsisrestrictedbySSBandthe

customerserviceinsidetheIFIsisstillprematuretoattractnewclients.Furthermore,IFIslacka

solidregulatorysystemtounifytheirproductsandtransactionssuchastheissuanceandtrading

ofSukuk.

Externally,thelackofcommunicationbetweenIFIsandtheothermembersinthefinancial

marketscreatesagapbetweenthemandleadstolackofawarenessaboutIFIsproductsand

customercautiousnesstowardstheIFIsactivities. Inaddition,thelimitedcontributionofIFIsto

the

financial

markets

results

in

limited

recognition

by

central

banks.

IFIsneedtoestablisheffectivecommunicationwiththeircounterpartstocorrectany

misunderstandingandfacilitatetheprocessofenteringtheglobalmarket. Asaresult,the

clasheswithmainstreamregulatorswillbeeliminatedandthestereotypeaboutIFIswillbe

correctedintheeyesofnonMuslimcountries.Finally,IFIsshouldestablishacomprehensive


19/27

18

trainingprogramfortheiremployeestounderstandtheuniquenessofIslamicfinancialproducts

andhelptheinvestorstomeasuretheadvantagesofdealingswithIFIs.


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19

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FIGURE1IFIsChallengestowardsInternationalization

Contribution in

money & capital

markets

Limited

Economic

Contribution

Limited Role of

Regulators

Investors

Limited

Recognition

Unqualified

Employees

Limited

Customer

Service

Localization International-

ization

Lack of

Communication

Different

TransactionsLimited Capital of

IFIs

Cultural

Barrier

Customer

Cautiousness

Limited

Recognition of

Central Banks

Challenges inside

Islamic countries

Challenges

outside Islamic

countries


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25

FIGURE2IFIsRegulatorsandInformationCenters

IRTI

Information Centers

Issue Accounting and Auditing

Standards - Bahrain

CIBAFI

Islamic Financial Institutions:

Islamic Banks, Investment Funds and Islamic

Insurance Companies (Takaful)

AAOIFI

Issue Regulatory Standards -

MalaysiaIFSB

Create environment for Islamic

secondary market - BahrainIIFM

Rating IFI and Islamic finance

instruments - BahrainIIRA

Market maker for Islamic secondary

market instruments - BahrainLMC

Promote Islamic

Research and

Training

Enhance marketunderstanding of

Islamic finance

Regulators


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Ideclarethat:

Ihavesincerelyendeavoredtoproduceapaperofoutstandingacademicquality; Ihaveproducedthispapermyself,withoutanyoutsideassistanceexceptfromthepeople

anddocumentsthatIquote;

Ihavenotcopiedand/orpastedthispaper,orpartsofit,fromotherpapersordocumentsavailableontheinternetorelsewhere,exceptwhereIhaveexplicitlystatedso;

Ihavenotsubmittedthispaperormajorpartsofittoanotherseminarorclass,eitherattheUniversityofSt.Gallenorelsewhere,andIwillnotdosointhefuture;

Imayusepartsofthispaperformydoctoraldissertation.

___________

Samy Nathan

Inter Nationalization of Islamic Financial Institutions

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