Islamic finance

The West’s financial institutions are tapping into the lucrative Islamic finance market, with even high street banks offer sharia-compliant mortgages and credit cards.
by Nadim Khan and Mohammed Paracha


The Islamic financial industry is moving fast towards the mainstream and London is emerging as the sector’s Western centre.

The central tenet of Islamic finance is the prohibition on charging interest (or riba in Arabic). The Islamic investor cannot invest in supposedly ‘unethical’ activities such as alcohol production or gambling, as well as many of the speculative tools of conventional banking. Yet the industry is growing at a phenomenal rate, with its global worth now estimated at anywhere between $250bn (130.42bn) and $400bn (208.68bn).

The past three or four years have seen an upsurge in activity, sophistication and the ‘reach’ of the sector due to several factors. Heavyweight conventional banks have become more involved in bringing credibility to the industry, resulting in improved product development, meaning the industry has more competitive alternative products on offer. Its geographical reach is spreading as Western banks try to capture the funds of the Muslim diaspora and tap into the Middle East’s liquidity.

Political will in Muslim countries has supported this development, while Islamic financial institutions, investors and governments have looked for outlets for their wealth. Skilled bankers, lawyers and sharia scholars have widened the range of products available. Global banking giants such as HSBC, BNP Paribas, Citigroup, Deutsche Bank and Credit Suisse First Boston have joined the fray, establishing Islamic subsidiaries or units and implementing Islamic capital markets, structured finance and project finance transactions. These have complemented the efforts made by Middle Eastern and Malaysian Islamic financial institutions.

Within the Muslim world, Bahrain, Dubai and Malaysia are the main centres, along with more recently Singapore, which is intent on becoming the Islamic financial hub for the Far East. In the West, London is becoming the jurisdiction of choice, with two recent developments cementing the role. In 2004, the Court of Appeal upheld the $50m (26.1m) judgment awarded to Shamil Bank of Bahrain. This reinforced the banker’s choice in using English law for cross-border transactions. In August, the Financial Services Authority (FSA) approved a licence for the Islamic Bank of Britain, the first for a fully sharia-compliant institution. There is now talk of an Islamic investment bank. A major attraction of the FSA licence is that, after two years operating in the UK, a bank can passport in to the EU without the need for a full licence application in each EU country.

On the retail side, conventional banks in the UK are increasing Islamic offerings. Islamically structured mortgages were the key product, but offerings now include consumer finance, savings products, credit cards and insurance. While financial headlines are dominated by the big-ticket investment banking deals, institutions are realising that the retail side could have the greatest potential.

Over the past decade, investment and wholesale banking has seen the fastest growth. Short-term Murabaha (cost plus) instruments were the main tool, but recent years have seen the use of Ijara or leasing (and more recently Islamic forward lease) structures, allowing longer tenors with variable returns.

Ijara structures have been central to the development of the sukuk, an equivalent to the conventional bond. Sukuk issues have grown exponentially in the past two years, led by sovereign states and followed by an increasing number of corporates. Bahrain is on its eleventh issue and Malaysia, Qatar and Pakistan have all utilised it. In late 2004, Dubai’s Department of Civil Aviation launched the largest ever sukuk issue at $1bn (520m) and is planning to return to the market. What is notable is the volume of the paper placed with Western investors, who simply see a security from a government with a good credit rating. The 2004 e100m (68.1m) sukuk issue by the German state of Saxony-Anhalt reversed the process, tapping Middle Eastern liquidity, with around 60 per cent sold in the region.

Project finance has also boomed over the last four years, to the point where the Gulf Cooperation Council states it is rare to see a major project financing without an Islamic tranche. The most recent project to close was the upgrade of Bahrain Petroleum Company’s (Bapco) Sitra refinery. The deal illustrated the increasing comfort of conventional banks with Islamic structures, as the majority of those involved joined both tranches. There is much talk among bankers about doing one of these multibillion-dollar financings on a wholly Islamic basisIslamic structures are particularly well suited to financing big-ticket items. In 2004, Emirates used one to add to its fleet. An Islamically compliant aircraft acquisition and leasing fund was launched in 2002 and several very large crude carrier vessels have been bought by means of Ijara transactions.

With a greater volume of deals being closed on an Islamic basis, bankers are now beginning to realise the need for equivalents to conventional derivative products to hedge out risks. These types of instruments involve elements of speculation, gambling and interest (riba), and therefore (in their conventional form) are prohibited by sharia. However, a lot is being done to develop Islamic equivalents and the recent launch by Deutsche Bank of an FX Option marks an important first step in the development of such products.

As legal and banking heavyweights in the Muslim world and in the West devote increasing attention to Islamic finance and the number of shortcomings diminishes, the future for the industry is bright.

Nadim Khan is head of banking and Islamic finance in Dubai and Mohammed Paracha is a senior associate based in Bahrain, both at Norton Rose