Sunday, December 31, 2006

THE PERFORMANCE OF MALAYSIAN ISLAMIC BANK DURING 1984-1997: AN EXPLORATORY STUDY
Abdus Samad & M. Kabir Hassan

The study evaluates intertemporal and interbank performance of Islamic bank (Bank Islam Malaysia Berhad (BIMB) in profitability, liquidity, risk and solvency; and community involvement for the period 1984-1997. Financial ratios are applied in measuring these performances. T-test and F-test are used in determining their significance. The study found that BIMB is relatively more liquid and less risky compared to a group of 8 conventional banks. Our analysis of the primary data identified reasons why the supply of loans under profit sharing and joint venture profit sharing is not popular in Malaysia. 40% to 70% bankers surveyed indicated that lack of knowledgeable bankers in selecting, evaluating and managing profitable project is a significant cause.


I. Introduction

Evaluation of bank performance is important for all parties: depositors, bank managers and regulators. In a competitive financial market bank performance provides signal to depositor-investors whether to invest or withdraw funds from the bank. Similarly, it flashes direction to bank managers whether to improve its deposit service or loan service or both to improve its finance. Regulator is also interested to know for its regulation purposes.
Bank Islam Malaysia Bhd (BIMB) is a single full-fledged Islamic bank in Malaysia. The important underlying force that led to the establishment of this Islamic bank in Malaysia was the elimination of riba that is used for interest. Tabung Haji took the initiative to do business without using interest considered as being predetermined rate of return to a deposit. Tabung Haji is an organization for the Muslim for taking care of pilgrims to Mecca. It is basically act as a privately to facilitate the Muslims to perform their Hajj with the feeling of minimum financial burden. Its objective is to implement Muslim code of life (shariah) in Hajj and all business transactions. All transactions in the conventional banks are based on interest or "riba" which is prohibited by Islam. Tabung Hajj wanted to get rid of "riba" (interest). Islamic bank is sought as a solution to it. With the increase in Muslim populations and awareness of Islamic values, there was a greater demand for Islamic bank and interest-free finance by Muslim consumers, traders, investors, and businessmen.
Bank Islam Malaysia was established in July 1983 to meet these demands and challenges. Since then BIMB introduced and marketed various interest free products such as Wadiah ad Dhamana account, Mudarabah, Musharakah and others. Bank's business has expanded over the years. Its assets and deposits have increased from RM 325 mil to RM 4,440 mil in 1997. The financing of loans and services increased to RM 991 mil in 1997. The number of branches increased to 75 in 1998.
However, 15 years have passed since BIMB was established. There has been no study as to how the bank performed in liquidity, profitability, risk and solvency, as well as its commitment to economy and Muslim community during 1984-1997. The previous studies on profitability and other measures, Samad (1998), Ariff (1989), Dirrar (1996), Mohiuddin (1991) Sum (1995) and Hassan (1999) are far from satisfactory. These studies used neither statistical technique nor made inter-temporal and inter-bank comparisons with three sets of conventional banks. However, such issues of profitability, liquidity, risk and solvency; and community involvement of the bank during 1984-1997 are very important to depositors and investors. So, the present study intends to evaluate the perfor-mance of Islamic banks using the above mentioned criteria. This study is different from the earlier studies with respect to contents, coverage of years and methodology. In evaluating BIMB's performances, this study also wants to test two hypotheses. The first hypothesis states that the liquidity ratios of Islamic banks are expected to be higher in earlier years of operation than later years due to a learning curve. The second hypothesis states that as

Islamic banking makes its inroad in the society, the volume of two truly islamic financial modes of lending (Mudharabah and Musharakah) are expected to grow larger in later years of its operation.
Hassan (1999) examines the Islamic banking principles in theory and its application with a case study of Bangladesh. The abundance of short-term funds compared to long-term funds available for lending is a rational response on behalf of banks to solve informational asymmetries prevalent in credit market. In traditional finance literature, it is shown that debt contract (murabaha) is superior to equity contract. However, equity contract can be superior to debt contract in an economy where informational asymmetries resulting from adverse selection and moral hazard are smaller. In Islam, business is an Ibadah (worship) and is recommended whereas riba (interest) is prohibited. From business point of view Islamic bank is not only a firm but also a moral trustee of the depositors where deposits are trust given to banking firm. It is naturally expected that as a custodian of trust for the depositors' deposits, Islamic bank is likely to be more liquid and become more solvent compared to its counterpart conventional banks. Islamic bank management, according to Islamic ethics, is accountable to the depositors in this world and the world hereafter for their failure to keep the trust entrusted upon them. It is, therefore, expected that the liquidity and solvency ratio of the Islamic bank will be higher than conventional banks.
However, it is also expected that the liquidity ratio of the Islamic bank may decline during the later periods compared to its early eras. As the bank grows, it acquires more skill and the art of banking business, it will keep less liquidity and thus the liquidity ratio may decline. This paper wants to test the hypothesis that the liquidity ratio and solvency for Islamic banks in the early periods are higher than those of later periods are.
Instead of interest based contract, Islamic bank is founded on different philosophy; and it delivers a set of distin-guished products in the financial market. Unlike conventional banks where interest is an integral part of bank business, Islamic bank was established to avoid interest in all bank transactions. It does not deal with interest. Interest is avoided because "riba" is prohibited in Islam. As a business firm BIMB delivers special financial prod-ucts that are different from the conventional banks. It delivers interest-free products. For example, trust profit sharing (called Mudarabah) and joint venture profit sharing (called Musharakah) are two distinguished and unique products of an Islamic bank. The important feature of this loan (Mudarabah and Musharakh) is that they are interest-free. There are no elements of interest involved in this transaction. For the Muslims there is a great demand for them. BIMB was established to meet these demands. With the increase in Muslim population, business firms and entrepreneurs in Malaysia, the supply of Mudarabah and Musharakah loan was a long waited product. In these transaction Muslims can serve religious obligation and at the same time can earn profits. With the economic development of Malaysia and the increase in Muslim population, Islamic values, Muslim business and firms, it is expected that demand for these products (Mudarabah and Musharakah) are likely to increase gradually over the years. It is also expected that the information gap between bank and the bank borrowers to be minimum because both party jointly working to maximize profit and minimize losses. Projects undertaken under the Mudarabah and Musharaka are constantly supervised and monitored by the Islamic bank. So the chances of failures are minimized. Based on the expectation of minimum failure it is expected that the supply of these loans will increase over the years. This paper will test the hypothesis that the supply for this loan (Mudarabah and Musherakah) of the Islamic bank increases over years.
The paper is organized as follows. Following introduction and rational of this study in section I, Section II describes methodology, data and the tools for measuring bank performance. Section III provides empirical evidence and analysis. Summary and Conclusion are provided in Section IV.

II. Methodology and data:

Financial management theories provide various indexes for measuring a bank's performance. One of them is accounting ratios. The uses of the financial ratios are quite common in the literature. Bank regulators, for example, use financial ratios to help evaluate a bank's performance. Booker (1983Z), Korobow (1983), Patnam (1983), Sabi (1996), Samad (1999), Akkas (1994), Meister and Elyasiani (1988) and Spindler (1991) gave employed financial ratios for evaluating a bank's performance. In order to see how Islamic Bank (BIMB) performed over 14 years, this study approaches an analysis of inter-temporal performance of Islamic bank. In other words, the paper makes

comparison of performance of BIMB between two periods 1984-1989 and 1990-1997. Year by year comparison of performance and explanation is difficult specially for a study of extended years. Secondly, it is easy to see and explain the differences between two periods. In the context of present study, bank performance of the yearly periods 1984-1989 is compared to that of later period 1990-1997. This is not a new method (Elyasiani, 1994). In addition to inter temporal comparison, the study makes comparison of Islamic bank (BIMB) and conventional banks performances. First, BIMB is compared with a conventional bank (Bank Pertanian) which is a smaller (in terms of asset) bank than BIMB. Second comparison is made with another conventional bank (Perwira Affin) which is larger than BIMB. Third, comparison of BIMB and the 8 conventional bank is made here. This type of inter-bank analysis is common in bank performance study (Sabi (1996). In the competitive financial market, performance of a bank can be better understood by an analysis of inter-bank comparison. The study uses fourteen financial ratios for bank's performance. These ratios are grouped under four broad categories. The analysis of bank performance concentrates on the following on four financial ratios: a. profitability; b. liquidity; c. risk and solvency; d. commitment to domestic and Muslim community.

a. Profitability Ratios:

The profitability can be judged by the following criteria.
1 Return on asset (ROA) = Profit after tax/ total asset
2 Return of equity (ROE) = Profit after tax/ equity capital
3 Profit expense ratio (PER) = profit/total expense. A high PER indicates that a bank is cost efficient and
makes higher profit with a given expense.
ROA and ROE are the indicators of measuring managerial efficiency [Ross (1994), Sabi (1996), Hassan (1999) and Samad (1998)]. ROA is net earning per unit of a given asset. It shows how a bank can convert its asset into net earnings. The higher ratio indicates higher ability and therefore is an indicator of better performance. Similarly, ROE is net earnings per dollar equity capital. The higher ratio is an indicator of higher managerial performance. However, profitability is only part of bank performance story.

b. Liquidity Ratios

Bank and other depository institutions share liquidity risk because transaction deposits and saving accounts can be withdrawn at any time. Thus when withdrawal exceeds new deposit significantly over a short period, banks get into liquidity trouble. There are several measures for liquidity.
1 Cash deposit ratio (CDR) = cash/deposit. Cash in a bank vault is the most liquid asset of a bank. Therefore, a higher CDR indicates that a bank is relatively more liquid than a bank which has lower CDR. Depositors' trust to bank is enhanced when a bank maintains a higher cash deposit ratio.
2 Loan deposit ratio (LDR) = Loan/deposit. A higher loan deposit ratio indicates that a bank takes more financial stress by making excessive loan. Therefore, lower loan deposit ratio is always favorable to higher loan deposit ratio.
3 Current ratio = Current asset (CA) / current liability (CL) (1) It indicates how the bank management has been able to meet current liability i.e. demand deposit with the current asset. A high ratio is an index that shows bank has more liquid asset to pay back the trust (deposit) of the depositors. When withdrawals significantly exceed the new deposits banks usually recourse to replace this shortage of funds by selling securities. Government securities are easily sold and are considered liquid. As such the current ratio as measured above is expected to be more preferable to lower current ratio.
4 Current asset ratio (CAR) = current asset/total asset. A high CAR indicates that a bank has more liquid asset. A lower ratio is a sign for illiquidity as more of the assets are long term in nature.

b. Risk and Solvency Ratios

A bank is solvent when the total value of its asset is greater than its liability. A bank becomes risky if it is insolvent. The following are the commonly used measures for a risk and insolvency.
1 Debt equity ratio(2) (DER) = Debt/equity capital. Bank capital can absorb financial shock. In case asset values decrease or loans are not repaid bank capital provides protection against those loan losses. A lower DER ratio is a good sign for a bank.
2 Debt to total asset ratio(3) (DTAR) = Debt/total asset indicates the financial strength of a bank to pay its debtor. A high DTAR indicates that a bank involves in more risky business.
3 Equity multiplier (4) (EM) = total assets/share capital. It is the amount of assets per dollar of equity capital. A higher EM indicates that the bank has borrowed more funds to convert into asset with the share capital. The higher value of EM indicates greater risk for a bank.
4 Loan to deposit ratio (LDR) = loans/deposit measures liquidity as well as credit risk for a bank. A high
value indicates a potential source of illiquidity and insolvency.

b. Commitment to Economy and Muslim Community

1 Long term loan ratio (LTA) = long term loan/total loans. A high LTA indicates a bank commitment for
supporting long term development project.
2 Government Bond Investment (GBD)=Deposit invested in government bond/Total Deposit. A higher GBD
indicates high liquidity and less risk.
3 Mudaraba-Musharaka Ratio (MM/L)=Mudaraba-Musharaka/Total Loans. A higher percentage of MM/
L indicates a greater commitment to community developments.
The performance of Islamic bank BIMB is measured in three stages. First, the performance of initial 5 years is compared with the performance of the subsequent 6 years by using the performance measures as delineated above. Second, Islamic bank is compared with two selected banks. Of the two banks, one (Bank Pertanian) is a smaller and the other (Perwira Affin) is larger than BIMB. Third, BIMB is compared with banking industry represented by a group of 8 banks.(5)
In all three stages of comparison, ANOVA is used to test the null hypothesis of the equality of means in order for our comparison more reliable and meaningful. Since MSB/MSW is the estimated F-value, so if the estimated Fvalue is higher than the critical value, there is sufficient evidence to reject Ho that the means of performance of the two banks are equal. In other words, ANOVA supports the conclusion that the population means of the variable for the two banks are not identical. On the other hand, if the F-statistics is less than its critical, ANOVA supports that the performances are not statistically different from each other.

III. Analysis of Empirical Results

Table 1 shows means and standard deviation of various performance measures of the Islamic bank (BIMB) between 1984-1989 and 1990-1997. All profitability measures PER, ROA and ROE (6) in Table 1 indicate that BIMB makes significant progress in profitability during 1984-1997. This improved performance is statistically significant as the means of ROA and ROE ratios are different between the two periods. The higher returns might have been due to higher risky investments by the bank. This is supported by the increased debt equity and equity multiplier ratio. These two measures of risk and insolvency, that is DER and EM are statistically significant at 5% level.

This improved profitability (PER) performance when compared with a conventional bank/banks show that (Table 2, Table 3, and Table 4) BIMB is lagging behind the conventional bank. An average profit of BIMB is 21% whereas the average profit of the conventional bank for the same periods was 36%. This difference in profitability performance is statistically significant at 5% level. These results are consistent with those of Samad (1999) and Hassan (1999). There are various reasons for lower profitability performance of BIMB. First, BIMB does not have wide scope for investment in any stock or security because of religious constraints. It can only invest in Shariah approved projects. It can not invest beyond the Shariah Board approved investments even if it can earn higher rate of returns. Shariah Board supervises bank investment. Secondly, investment in government bond is a major source of earnings. The rate of return of government bond is lower than other types investments. (7) Thirdly, in order to provide the guarantee of depositors' deposits and trust (amanah), BIMB maintains more liquidity than the conventional banks. This is evident from inter-bank comparison of liquidity ratio. Inter-bank comparison in Table 1 shows that liquidity position of BIMB has not changed over 13 years. All four measures of liquidity do not show statistically any significant difference. The means of the two periods for CDR, LDR, CR are not statistically different. This indicates that bank's maintenance of liquidity position remains unchanged between 1984-1989 and 1990-1997. This unchanged liquidity position rejects our hypothesis that BIMB will hold less liquidity in the subse-quent years of operation when bank becomes matured. However, inter-bank comparison of liquidity measures of performance among the group of eight bank and two individual banks provides no evidence in either way. In terms of most liquid asset i.e. cash, cash-deposit ratio, BIMB shows better performance than Perwira Affin and it is significant at 5% level. Despite better performance, BIMB is behind the group of eight banks.
Bank performance of risk and solvency between 1984-1989 and 1990-1997 (Table 1) reveals that BIMB's involve-ment in risky business measured in DER, DTAR, EM increased over years. The means of debt-equity ratio (DER) and equity multiplier (EM) increased from 9.14 to 19.59 and from 10.38 to 19.49 respectively, and are statistically significant at 0.5% level. Other measures, like DTAR and LDR show deterioration of risk but are not statistically significant. However, when BIMB is compared with conventional banks in table 2, table 3 and table 4 it is found that BIMB is relatively less risky and more solvent than two other individual conventional banks (Pertanian and Perwira Affin) and the group of eight banks. The average debt-equity and the equity multiplier for Islamic bank are
14.78 and 14.95 as compared to 43.33 and 47.34 for the Partanian Bank and 41.78 and 43.60 for the Perwira Affin bank respectively. The difference in means in DER and EM for two individual banks (Pertanian and Perwira Affin) versus BIMB is statistically significant. The comparison of means for risk measure in DTAR for BIMB and the group of eight conventional banks in Table 4 indicates that the average debt-asset ratio for Islamic bank is 0.80 as compared to 0.92 of the conventional banks and this difference in means is statistically different. ANOVA suggests that the null hypothesis (Ho) of the equality of two means for BIMB and the group of eight banks be rejected at 1% level of significance. This implies that these two performance measures are not equal.
First, the reason for low risk of the Islamic bank (BIMB) is that its investments in government securities are much larger than the conventional banks. This difference in investments is statistically significant. Secondly, it has more equity capital compared to assets shown by its equity multiplier (EM). Larger equity capital indicates a higher shock absorbing capacity for the Islamic bank. It can withstand more assets or loan losses compared to bank (banks) which has (have) less capital. . However, lack of data on loan losses and non-performing loans in Islamic and conventional banks prevents us from making a conclusive judgment.
Banks' involvement in delivering special products (Mudarabah and Musharakah) shows that between 1984-1989 and 1990-1997, the average supply of loans under this category has increased from .0002 to .002 and the difference in means of the two periods is not statistically significant. Therefore, we cannot conclude decisively that the supply of Mudarabah and Musharakah loans has increased over this time period (Table 1).
Our primary data provides several reasons why Mudarabah and Musharakah are not popular in Malaysia. The analysis of the primary data in Table 5a indicates that 40% of the respondents consider that (B)(8) as a major cause. 32% of the respondents support that (A) is a cause, i.e. Mudarabah and Musharakah are not popular because the alternative modes of financing are more profitable and less risky than Mudharabah and Musharakah. 20% of the respondents indicates that they do not feel comfortable with the idea of sharing joint management (C). Only 8% support that hypothesis that the monitoring cost of the Mudaraba and Musharaka is very high for the bank.


The distribution of responses is based on raking made in the alternative answer. Table 5b shows that only 70% respondents put "B" in the first rank, 62.5% people have ranked "A" in the first rank, 18.7% people rank it 2nd and 3rd. "D" has been ranked 2nd and 3rd by 50% of the respondents.
It appears from the replies of the respondents that the problem of moral hazard and adverse selection still exists in Islamic banking system. The Islamic bank cannot altogether eliminate the problem of asymmetric information and that is why the supply of loan under this category has not increased, contrary to our expectation.
With regard to BIMB's community commitment measured by the investment in government securities and loans as a percentage of total assets, LTA, it is found that there has been no difference in performance over the two periods. The low t-ratio for the period suggests that the means for the two measures are not statically significant (Table 1)
Interestingly, the Malaysian experience in Islamic Banking is very similar to those found in Bangladesh. The data on Islamic Bank Bangladesh Limited (IBBL) shows that majority of financing operation is in short-term trade financing and long-term financing is rarely given to entrepreneurs. Musharaka financing has hovered around in the vicinity of 2% during the bank's 16 years existence. Financing to the agriculture has been minimal. (Hassan, 1999)

IV. Summary and Conclusion

The examination of various performance measure and the inter-temporal comparison of BIMB's performance reveal that Islamic bank made (statistically) significant progress on return on assets (ROA) and return on equity (ROE) during 1984-1997. The average ROA, PER and ROE during this period were 0.43, 21.5 and 8.07 respectively. The comparison of BIMB with a group of conventional bank on ROA and ROE does not show (statistically) any difference in performance. The liquidity performance between 1984-89 and 1990-97 in various measures such, as cash-deposit ratio (DER), loan-deposit ratio (LDR), and current ratio (CR) show neither deterioration nor improvement. However, inter bank comparison of liquidity performance suggests that Islamic bank appears to be statistically more liquid compared to a group of 8 conventional banks at least in cash-deposit measure. The average cash-deposit ratio of BIMB is 0.021 compared to 0.012 of the conventional bank.
Risk and insolvency measures between 1984-89 and 1990-97 found that BIMB risk increased and it is statistically significant in debt-equity (DER) and equity multiplier (EM). DER and EM increased from 9.16 to 19.59 and 10.38 to 19.49 respectively. However, the comparison of Islamic bank and a group of conventional bank indicate that Islamic bank is still less risky and more solvent measured in DER, DTAR, EM and LDR. The difference in risk measured in debt-equity is statistically significant. Although the means of other measures such as DTAR, EM and LDR of the Islamic Bank are lower compared to a group of conventional banks, they are not statistically signifi-cant.
Islamic bank's performance in community financing and participating in government project measured in GBD, LTA and MM/L does not show any statically difference between 1984-1989 and 1990-1997. The comparison of Islamic bank and the group of eight conventional banks reveal that there is no difference in economic participation (measured by LTA) between them. ANOVA also supports this finding, as the F-value is statistically insignificant.
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Thursday, December 28, 2006

MANAGING FINANCIAL RISKS OF SUKUK STRUCTURES
Ali Arsalan Tariq (M.Sc. International Banking)


TABLE OF CONTENTS

I. Introduction
II. Islamic Financial Assets: Overview of Theoretical Aspects
2.1 Prohibitions
2.1.1. Prohibition of Riba (Interest)
` 2.1.2. Prohibitions of Gharar (Excessive Uncertainty)
2.1.3. Avoidance of Unethical Investments and Services
2.2 Alternative Basis of Financial Instruments
2.2.1 Partnership Contracts
2.2.2. Exchange Contracts
2.2.3. Financial Assets
III. Evolution and Profile of Sukuk Structures and Markets
3.1 Types of Sukuk
3.1.1 Pure Ijarah Sukuk
3.1.2. Hybrid/Pooled Sukuk
3.1.3. Variable Rate Redeemable Sukuk
3.1.4. Zero-coupon non-tradable Sukuk
3.1.5. Embedded Sukuk
3.1.6. Expanded List of Sukuk
3.2 Recent Developments in Sukuk Markets
3.3 Cases: Ijarah: Sovereign Sukuks
3.3.1 Qatar
3.3.2 Malaysia
3.3.3 Ijarah Corporate Sukuks: Gutherie
3.3.4. Hybrid Corporate Sukuks: IDB
3.4 Assessment of Sukuk Structures
IV. Risks underlying Sukuk Structures
4.1 Market Risks
4.1.1. Interest Rate Risk
4.1.2. Foreign Exchange Rate Risks
4.2. Credit and Counterparty Risk
4.3 Shariah Compliance Risk
4.4 Operational Risks
4.5 Institutional Rigidity
V. Managing Financial Risks of Sukuk Structures
5.1 Sukuk and the Challenge of Institutional Reform
5.1.1 Public Debt Management
5.1.2. Derivative Markets
5.1.3. Securitisation
5.1.4. Liquidity and Secondary Markets
5.2 Sukuk and the Challenge of Derivatives
5.2.1. Embedded Options and Gharar
5.2.2. Embedded Options as a Risk Management Tool
5.2.3. Islamic Embedded Option
5.2.4 Floating to Fixed Rate Swaps of Sukuk
5.2.5. Pricing of Sukuks with Embedded Options
VI Conclusion
Bibliography

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U.K. the Global Center for Islamic Finance?
Gordon Brown supports development of 'Shari'a-compliant finance'

Gordon Brown, England's chancellor of the exchequer, has stated that he wants to make Britain the global center for Islamic finance. The chancellor said the Labour government will continue to implement the "tax and regulatory reform to support the development of Shari'a-compliant finance."

Addressing business leader at a conference organised by the Muslim Council of Britain on Tuesday, Brown said, "Entrepreneurial vibrancy and dynamism of Britain's Muslims, combined with Britain's openness to the world and the historic ties with Muslim countries, that makes the ambition to make Britain the gateway to Islamic finance and trade a realistic and realisable ambition."

Ahmed Mohammed Ali, president of the Islamic Development Bank, also present in London, welcomed the chancellor's openness to Islamic finance.

"London has traditionally been a major center for structuring and arranging Islamic finance since the 1980s," said Mohammed Ali. The president of the IDB underlined the important support of the Financial Service Authority, Britain's banking watchdog, which authorized in 2004 the complete inclusiveness of the Islamic Bank of Britain in the UK banking system.

Analysts in the city of London appreciated Brown's move to grab a slice of the Islamic financial market, which is estimated to be around $400-$500 billion.

"Brown's position and reform implementation is good news for the banking sector," said Amy Waldron, spokesperson for Lloyds TSB, a British bank that will launch on Wednesday a range of Islamic financial services in all its UK branches.

Muslims and non-Muslims living in Britain will have the possibility of opening
current accounts and get mortgages for their house in compliance with their religious faith. According to Shari'a law "interest" or "usury," known as riba, is banned.

"As a matter of faith, a Muslim cannot lend money to, or receive money from
someone and expect to benefit," states the Islamic Bank of Britain on its website. "To make money from money is forbidden - - wealth can only be generated through legitimate trade and investment in assets."

A bank which offers Islamic current accounts cannot charge interest and savings will
not be invested in industries and stock markets. For Islamic mortgage, banks pay up to 90 percent of the house cost and then charge the customer a monthly rent to repay the money borrowed.

"Instead of lending money the bank buys the property for the customer," said Paul Sherrin, head of Islamic Financial Services at Lloyds TSB. The interest rate is embedded in the "rent payback system" said Waldron, but in this way the client of Muslim faith is not going against the financial laws set by his religion.

The total Muslim population in Britain is over 1.6 million according to the Office for
National Statistics and recent research led by Lloyds TSB show that over 75 percent of British Muslims would prefer a banking system that conforms with Islamic laws rather than adopting Western financial services.

Sherrin said, "Having spoken to Muslims across the country we know that more than three -quarters want current accounts and mortgages that fit with their faith. By making these products available nationwide we're bringing Islamic banking into the mainstream and we're giving the Muslim community access to financial services that meet their needs without compromising their religion."

However, to satisfy the growing demand for Islamic finance in Britain, banks have started a talent battle to hire internationally renowned and financially literate Muslim scholars as advisors to the emerging Islamic banking business.

Humayon Dar, managing director of the London-based shari'a consultancy Dar Al
Istithmar insitute, told the Financial Times that there is a real shortage of qualified
Imams and scholars who can issue fatwas (religious edicts) that are trusted by Muslim citizens. "There are perhaps 150 [such scholars] worldwide who are involved with Islamic finance but only 20 are internationally recognized," says Dar.

In the UK several prominent banks, including HSBC, Citigroup, Barclays Capital, Lloyds TSB, Deutsche bank, BNP Paribas and Standard Chartered, have hired Imams and Muslim scholars as consultants for their Islamic financing branches.

Ekmeleddin Ihsanoglu, secretary general of the Organisation of the Islamic conference, which represents over 1.2 million in the world, commented positively the effort of Western banks in addressing financial concerns of Muslim devotees. "The OIC would be more than happy if Islamic finance products became available outside the borders of the [57] member states," he said.

The secretary general of OIC added that the increased economic and trade commitments between the West and OIC member states "will open a whole new avenue for the cooperation and engagement of the West with the Muslim world to promote peace and dialogue at the time when misunderstandings, misrepresentation and defamation of Islam is on the rise."

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Wednesday, December 27, 2006

BVI FSC Statistical Bulletin for Q2 2006

Soon after the new site launch BVI Financial Services Comission has published the Statistical Bulletin for the second quarter of 2006. Although it is stated on the bulletin that publication month is July 2006, actually it became available on 20th December 2006.

Legal/Enforcement and International Co-operation Division stats shows 1 Advisory warning, 8 enforcement matters, international co-operation matters with 8 formal requests requiring disclosure of non-public information and 6 informal requests requiring disclosure of public information. Division also provided advice to internal Division of the Comission in over 115 cases.

The Insolvency Services Division activities resulted in no change in the total number of BVI insolvency practitioners in the first quarter of 2006, however the Division licensed one new insolvency practitioner and revoked one licence.

BVI FSC statistics confirms that BVI is conservative banking jurisdiction having only 9 banking licences for banking operations in and from within the BVI. One new general banking licence was issued in the first quarter of 2006 and in total there were 6 General Banking licences and 3 Restricted Class 1 Banking licences on the 31st March 2006.

As regards Fiduciary services – at the end of the first quarter 2006 there were licenced 98 General Trust (3 new) and 103 Restricted Trust (2 new) services providers, 4 Authorised Custodians (1 new) and 107 Registered Agents. Also 1 new Company Management licence was issued totalling to 20 Company Management licences.

Investment Business stats confirms that the most popular type of funds constituted in the BVI is professional funds, and their number in the jurisdiction is still increasing. The 46% increase in the number of professional funds was fixed in the first quarter of 2006, if compared to the same quarter of 2005, and a 54% increase, compared to the previous quarter.

The first private fund was re-registered as a Segregated Portfolio Company in the reported period. It was soon after the Segregated Portfolio Companies Regulations were officially published on 22 December 2005. Totally there were 189 Segregated Portfolio Companies at the end of the first quarter 2006.

Insurance sector stats shows that 6 new Captive Insurers were licenced in Q1 2006.

The largest statistical figures reflect the activities at the Registry of Corporate affairs. Looking at stats we should take into consideration that starting from 1 January 2006 only BVI Business Companies were registered. Previously the most popular BVI company type was BVI IBC (International Business Company), but after new legislation passed the new companies are named BVI BC's (Business Companies). 17,892 new BVI Business Companies were incorporated in the first quarter of 2006. It is more than for the same period in 2005 when 15,772 BVI IBC's were registered. Number of dissolutions for Q1 2006 is 1,141.

The total number of BVI International Business Companies was 689,555, but the number of BVI Business Companies was 19,421 at the 31 March 2006. In total it is 708,976 world’s most popular business entities incorporated for international business.
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THE EFFECTS OF CONVENTIONAL INTEREST RATES AND RATE OF PROFIT ON FUNDS DEPOSITED WITH ISLAMIC BANKING SYSTEM IN MALAYSIA
Dr Sudin Haron & Norafifah Ahmad


Interest rate has long been recognized not only by classical and neo-classical economists but also by contemporary economists as one of the factors that determine the level of savings in the economy. Although there are cases of inconsistent findings, it is a generally accepted opinion that interest rate has a positive relationship with savings. In other words, customers are guided by the profit maximization theory. Since there is no pre-determined rate of return involved in Islamic banking system, it is unknown whether Islamic bank customers are subjected to the normal conventional theory of economic behavior. If this assumption is true, a conclusion can be made that both interest rate of deposit accounts of conventional banks and rate of profit declared by Islamic banks have strong relationship with the amount of deposits of Islamic banks. Therefore, the management of Islamic banks is bound to follow the market rate when declaring the rate of profit to their customers, vice versa. Using Adaptive Expectation Model, this paper examines the effect of interest rates of deposit account facilities of conventional banks and past dividend rates on funds deposited by customers on the Islamic deposit facilities of Malaysian banks.

Introduction

After nearly four decades of their establishment, Islamic banks have managed to positioned themselves as financial institutions not only playing important role in resource mobilization, resource allocation and utilization but are actively involved in the process of implementing government monetary policy. Apart from offering almost all traditional banking facilities, Islamic banks also facilitate domestic and international trades. The first Islamic bank, pioneered by Mit Ghamr Local Saving Bank, was established in 1963 in a provincial rural centre in the Nile Delta (Egypt). At present, there are more than 200 interest-free institutions operating in 40 nations worldwide and providing services that are compatible to those services offered by conventional banks. In 1985 this system mobilized an estimated US $5 billion funds which currently has increased to US $ 80 billion. Western conventional based financial institutions such as Citibank, JP Morgan, Deutsche Bank, ABN Amro and American Express have started introducing interest-free products to customers. Similarly, multinational corporations such as General Motors, IBM and Dewoo Corporation have began to use interest-free services.
Like conventional banks, Islamic banks also depend on depositors’ money as a major source of funds. Bank Islam Malaysia Berhad (one of the Islamic banks in Malaysia) for example, had total deposits amounting to 83% of total liabilities and shareholders’ equity as at the end of December 1998. Since depositors’ money is a major source of funds, it is important for the management of Islamic banks to know the factors that influence customers’ decision making in depositing their money with Islamic banks. With the exception of a study conducted by Metawa and Almossawi (1997) which shows religion as a factor of customers’ choice of Islamic bank in Bahrain, other studies proved otherwise. The evidence from studies conducted in Sudan and Turkey, for example, shows that religion is not the main reason for customers selecting Islamic banks (Erol and El-Bdour, 1989). Similarly, studies conducted in Malaysia and Singapore find both religion and profit as the reason for people maintaining their relationship with Islamic banks (Haron et. al., 1994; Gerrad and Cunningham, 1997).
Since depositors are motivated by returns, it is important for Islamic banks management to understand the extent that rates of return on deposits influence their customers’ decision to deposit. The purpose of this study is to highlight the strength of the relationship between the deposits of Islamic banks, and its ‘rate of profit’ of both savings and investment deposit facilities. This study will also measure whether the rates of interest available at conventional banks have a direct influence on the level of deposits of Islamic banks.


Theoretical Considerations

Rate of interest has always been featured as one of the important considerations in explaining the saving behavior of individual. Saving, according to Classical economists, is a function of the rate of interest. The higher the rate of interest, the more money will be saved, since at higher interest rates people will be more willing to forgo present consumption. Based on utility maximization, the rate of interest is also at the center of modern theories of consumer behavior, given the present value of lifetime resources. For a net saver an increase in the rate of interest will have an overall effect composed of two partial effects: an income effect leading to an increase in current consumption and a substitution effect leading to a reduction in current consumption (Hadjimatheou, 1987).
Keynes (1936) despite arguing the quantitative importance of the interest rate effect believes that in the long run substantial changes in the rate of interest could modify social habits considerably, including the subjective propensity to save. Friedman (1957) in his neoclassical analysis of the consumption function suggested that the main variables determining the average propensity to consume are ‘the rate of interest, the relative dispersion of transitory components of income and of consumption, the ratio of wealth to income, and the age and composition of consumer units’. In view of the importance of the rate of interest on consumption, many researchers using various methodologies try to establish the strength of relationship between these two elements. Wright (1967), Taylor (1971), Darby (1972), Heien (1972), Juster and Watchel (1972), Blinder (1975), and Juster and Taylor (1975) in their studies found an inverse relationship between interest rate and consumption. Modigliani (1977) based on his works and after seeing evidence on the effect of interest rate on consumption concludes that the rate of interest effects on demand, including the consumption component, are pervasive and substantial.
Each of the different types of deposits available at the conventional banks carries a different rate of interest or yield to the depositor. In general, the longer the maturity of a deposit, the greater the yield that must be offered to depositors, in part because of time value of money and the frequent upward slope of the yield curve. For example, notice of withdrawal (NOW) deposits and money market deposits (MMDAs) are subject to immediate withdrawal by the customer and, accordingly, interest rate offered to depositors is among the lowest of all deposits. In contrast, negotiable CDs and time deposits of a year or longer to maturity often carry higher rates. Similarly, savings or thrift deposits are designed to attract funds from customers who wish to set aside monies in anticipation of future expenditures or financial emergencies. These deposits generally pay significantly higher interest rates to customers than transaction deposits do, particularly for those deposits the customer agrees to hold with the bank for several months or years.
Conventional bankers have learned that deposit pricing can be used to shape the kind of customer base each bank can best serve. Changing deposit prices affect not only spread between bank loan rates and deposit interest rates but also customer balances and deposit mix decisions, which in turn, influence both bank growth and profit margins (Edmister, 1982). As Rose (1991) points out, deposit pricing is best used to protect and increase bank profitability, rather than to simply add more customers and to take market share away from competitors. Indeed, when new deposit plans are introduced, its biggest appeal and greatest chance for success lies with those customers who already hold deposits with the bank. And even those customers the bank already has will not automatically pay higher prices for deposit services. They will pay no more for a deposit than the sum total of its benefits to them and will go elsewhere when the value of those benefits falls below the deposit’s price or if a competitor offers a significantly better package of services.
In summary, two important elements emerge from this overview. First, the acknowledgement by conventional banks that those who are willing to part with their monies must be rewarded. Second the recognition that different types of deposits carry different amount of returns or rewards. Therefore, if the management of Islamic banks believe that the attitude of depositors of Islamic banks are indifferent to those of conventional banks, the same rates of return will be rewarded with rates of conventional banks. There are several serious repercussions if the management of Islamic banks believe that depositors at Islamic banks possess similar attitudes to those at the conventional banks. The interest rate will continue to have an influence on the operations of Islamic banks as long as this thought remains in the mind of their management. Findings of Metwally (1997), for example, confirmed that conventional and Islamic banks offer their depositors similar returns.
International Journal of Islamic Financial Services Vol. 1 No.4
Although some empirical research have found that people who patronise Islamic banks look for monetary rewards, this is not necessarily true for all cases. In 1984, Kuwait Finance House did not distribute any profit to their depositors, but there was no evidence of massive withdrawal of deposits. Similarly, Islamic banks in Sudan never reward their current account holders, but a bulk of their funds is supplied through these facilities. As institutions whose foundations are based on religious doctrines, it is paramount for Islamic banks management to believe there are other factors that dominate the economic behaviour of Muslims. These principles comprise the belief in the day of Judgement and the life in the hereafter, the Islamic concept of riches, and the Islamic concept of success. All of these principles are expected not only to have a significant impact on the decision-making process of Muslims, but also to have an influence on their perceptions of Islamic banks.
The first principle has an effect on the depositors’ behaviour and their decision-making process. The choice of action is based not only on the immediate financial returns but also on those returns in the hereafter. Therefore, the decision to place deposits with Islamic banks is not because of a profit motive but rather to gain the blessing of Allah. One of the ways to gain this blessing is to support any program that will improve Muslim communities. Since Islamic banks operate on an interest-free basis and their establishment is designed to improve Muslim communities, Muslims who support these banks are therefore considered people who achieve salvation as indicated by Verse 20 of Al Tawbah.
In the case of the second principle that involves wealth, Islam has given a clear guideline to be followed by Muslims. In Islam, wealth is a bounty from Allah and is a tool that may be used for good and evil. Poverty is, in some instances, associated with disbelief and riches are considered a gift from Allah. Wealth itself is considered as an important means by which man can pave the way for the attainment of his ultimate objective. All persons are exhorted to work to earn a living and to accumulate wealth. Accumulating wealth is considered among the highest blessings bestowed on man and everyone is encourage to strive for wealth (Verse 10 of Al Jumu’ah).
The methods of earning, possessing, and disposing of wealth, however, must be in line with the Shariah. The best method of accumulating wealth as defined by Shariah is by striving to succeed on one’s own and not from the income generated from other peoples’ efforts. This is in line with many hadiths in which the Prophet (pbuh) had given his advice to Muslims to work for their own food. Therefore, in line with these hadiths Muslims should not regard rewards from Islamic banks as a source of income.
The Islamic concept of riches also serves as an important factor that influences Muslim attitudes towards the existence of Islamic banks. Islam defines success as the level of obedience to Allah and not the accumulation of wealth. Service and obedience may be rendered by the positive use of capabilities and resources given by Allah. According to Islamic teachings, if a man really wants to serve Allah, the utilisation of the natural and human resources made available to him is not only a privilege but also a duty and obligation prescribed by Allah. This is in line with Verse 27 of Al Anfal which commands Muslims not to betray the trust given by Allah and His Apostle. Applying this principle to the banker-customer relationship would mean that the customer should not be discouraged by the low profits or limited success of Islamic banks.
In light of these three principles, Islamic bank customers are expected not to be guided by the profit motive. Instead, the reason for placing their monies with the Islamic banks is directed towards receiving a blessing from Allah and this action is considered the best way of managing the resources given by Allah. Since it is a belief of every Muslim that all properties belong to Allah, returns on their deposits are also considered a gift from Allah irrespective of amount. Similarly, in the case of loss, it is all from Allah.
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ISLAMIC INSTRUMENTS FOR MANAGING LIQUIDITY
Yahia Abdul-Rahman

This paper provides a practitioners perspective on the overwhelming need for prudent management of liquidity and development of Islamic money market instruments.

Islamic banking and financing is gaining momentum world-wide. Many of the international RIBA banks are now focusing on LARIBA banking and financing to gain a significant market share of the funds and the deals which insist on LARIBA dealings. Many estimate the LARIBA funds looking for halal investing and banking to be from $ 50 billion to $80 billion. Most of these funds are now handled in Europe; mainly in the London financial markets. In 1996, Citibank has started "Citibank Islamic" in Bahrain and is now providing limited Islamic financing windows out of its international operations in New York & San Francisco.

Islamic banks world-wide have not yet come up with the competitive financial instruments and products which allow them to provide valid avenues to the LARIBA owner of funds and which compete in quality and security with instruments offered by other RIBA banks and investment companies in the world. Yahia Abdul-Rahman

1. The Problem of Liquidity Management

Liquidity is the ease by which an asset can be exchanged for another with little or no loss of value; usually cash. Liquid assets are those held in cash or are invested in instruments which can be converted rapidly into cash like deposits in cash with a bank as a current demand deposit, deposits in other banks and investments in short term liquid government securities.

The bank manager tries to maximize his/her bank's return on total assets by investing as much of the cash available. However, the management is also challenged by the need to have enough liquidity to meet any mismatch of the term structure (maturity dates) of assets and liabilities.

Islamic (LARIBA) banks and financial institutions world-wide are running their retail banking (demand deposit) operations at a self imposed reserve requirement of 100% ( or close to it). This is mainly due to central bank's unwillingness to extend borrowing privileges to them in the case of a "run" on the bank (except in Malaysia). This problem is further complicated by the inability of the Islamic LARIBA financial institutions to hold high liquid and government-guaranteed securities (e.g. treasury bills). The opportunity cost of the cash held by Islamic LARIBA banks as insurance against a devastating "run" is the interest rate born on government debt ( otherwise known as the "seignorage" accrued by the government issuing the currency being held by the bank). In their quest to achieve maximum returns for their clients, the Islamic LARIBA bank therefore suffers from two major handicaps when compared to RIBA banks: (i) lack of access to the safety net provided by the Central Banks (except in Malaysia and a few other Islamic countries), thus

having to provide its own very costly self-insurance due to the inability to diversify the risk of a "run"; and (ii) lack of access to government guarantees of all securities, they can only hold cash, thus paying significantly more seignorage to the issuing government than the RIBA banks holding treasury bills.

The problem faced by the Islamic (LARIBA) bank manager is that he/she has to make a choice between investing the bank's idle cash in available RIBA short term money market instruments and earn RIBA returns or forgo the interest/RIBA returns, In order to circumvent this dilemma the manager resorts to one or more of the following options depending on the institution's Shariah board :
• Refuse to take interest.
• Accept interest and use it for charitable purposes based on a fatwa (Islamic legal opinion) issued by some
scholars.
• Invest in gold and/or precious metals "cash & carry" forward contracts. These are based on LIBOR/ LlBID
rates.
• Keep track of the lost money market interest opportunity and get rewarded by the RIBA bank involved in terms of services and interest free facilities to balance out the lost interest.
The above is a list of "emergency" measures taken by many Islamic LARIBA banks to minimize their losses in comparison to their RIBA counterparts. While some of these measures may not legally be permitted from a shariah point of view, they should be viewed as temporary measures paving the way for genuine Islamic LARIBA products which will allow the LARIBA bankers in the future to follow the spirit as well as the letter of Islamic law (shariah), without sacrificing competitiveness in the financial markets. It is the duty of Islamic (LARIBA) bankers to develop and/or find such profitable Islamic LARIBA financial products.

2. Shariah Guidelines Related to Liquidity Management

Money does not reproduce. It grows when it is invested in a tangible economic activity. Money is a measuring tool. The success or failure of the economic activity is measured by the return on the investment. This return can be estimated but not determined in advance. (1)

Shares in companies, partnerships, Mudarabah activities, Musharakah partnerships can be bought or sold for investment activities and not for speculation and paper trading purposes.

Deposits in Islamic LARIBA banks for specific purposes cannot be mingled with other purposes without the approval of the account owner. For example an Amana/Wadeeaa demand deposit cannot be used in a Mudaraba (money management) pool without the approval of the account owner.

The ultimate purpose of the Islamic LARIBA bank is to accumulate the savings of the community and to reinvest such savings back in the community in order to generate productive economic activities, job opportunities and community affluence. In the USA banking regulators require banks to satisfy this objective by enforcing the Community Redevelopment Act "CRA". The Islamic LARIBA bank, through its ability to create credit, can be an important tool in the development and the economic growth of the community.

Contracts: The following conditions have to be fulfilled for a contract to be lawful from an Islamic jurisprudence point of view. (2) The offering of the article and the acceptance of the receiver in a written format. The contract should specify details of price, specifications, delivery terms, default penalties to be applied, breach of contract ramifications,. .. .etc. The contract should be registered (notarized -registered with the authorities). Both parties to the contract should be qualified and capable. The transaction involving the contract should be for halal business. Buying and selling should be genuine, not artificial or simulated. Titles should change hands and registered, unless in a non-Muslim society where situations of capital gains taxes and unnecessary additional expenses need to be avoided.

Islamic LARIBA financial instruments, like shares in a venture or a company, can be negotiated (bought/sold) since it represents a common share in the total assets of the business. There are some restrictions regarding the buying and selling of such shares. These are :

Money cannot be sold for money. Exchange should be for exact value in cash.

The value per share in the business should be determined on the basis of appraisal of the business (fundamental analysis) and the free (efficient) fair market forces of supply and demand.

Cash transactions should be settled .immediately as per the contract. Titles and cash should transfer immediately after mutual agreement taking in consideration the settlement period (usually 3 day to 7 day settlement).

It is permissible to buy shares in businesses which have debt in their balance sheets. However that debt should not be dominant (ranges between 0% to a maximum of 35% depending on the Shariah advisory board in charge).

A share in a business can be transferred from one investor to another without being really held by both, if both delegate someone to act on their behalf. It is exactly like Merrill Lynch or Rashid Hussain Securities holding shares in "street name" for clients.
Liquidation and/or Conversion of Shares: Liquidation of shares is the ability to sell such shares or to margin it for cash. All schools of thought agree that the owner of capital has the right to terminate the contract when he/she wishes unless otherwise detailed in the contract. However, if a Mudarib starts his/her work, the schools have different opinions. For example, the Shafii, Hanafi and Hanbali schools all give the right to the owner of capital to terminate any time after the start of the business unless otherwise indicated in the contract. Maliki school of thought does not allow. The Mudarabah contract can be time limited. Based on the above, all financial instruments can be liquid.

3. Designing Islamic Short Term Liquidity Instruments

RIBA banking instruments were developed to meet the growing market needs over more than 150 years. These instruments refer' to "debt" securities which are short term. Such short term liquidity instruments mature in a few hours, over night, a day or longer. In general, liquidity instruments mature in periods ranging from 3 months or less to one year. Some of the most common RIBA "debt" securities are : Commercial Papers: These are corporate bonds representing short term secured and unsecured loans to corporation.

Commercial Paper consists of short-term notes issued by large and highly rated firms. Typically these notes are of short-term maturity, ranging up to 270 days (beyond that limit the firm is required to file a registration statement with the Securities and Exchange Commission; SEC). Because the firm issues these directly, the interest rate the firm obtains can be significantly below the rate a bank would charge for a direct loan. These papers are not acceptable Islamically as they are based on the charging of interest.
Certificate of Deposit (CDs) : These are issued by banks with maturity ranging between one month to several years. These are not acceptable LARIBA instruments as CDs are based on paying interest and in RIBA banking they use interest bearing instruments to back them.

Bankers' Acceptance (BA) : These are short term loans granted to importers and exporters by their banks. One way to get a credit commitment from a customer before the goods are delivered is to arrange a Commercial Draft. Typically the firm draws up a Commercial Draft calling for the customer to pay a specific amount by a specified date. The draft is then sent to the customer's bank with the shipping invoice. If immediate payment of the draft is required it is called Sight Draft. If immediate payment is not required it is called Time Draft. When the Draft is presented and accepted by the customer, then it is called a Trade Acceptance and is sent back to the selling firm. The seller can keep the Acceptance or can sell it at a discount to a bank or another institution. If a bank accepts the draft, meaning that the bank is guaranteeing

payment, then the draft becomes Bankers' Acceptance BA. Discounting may not be acceptable by Islamic LARIBA Banking laws.

Municipal & Government Loans' These are short term loans to finance municipalities' and government agencies' short term capital needs.

Treasury Bills : These are short term "debt securities" issued by the government and in the USA they mature between 30 and 90 days.

It is important for the Islamic LARIBA banker to understand that the currently used RIBA liquidity instrument were developed over the years to meet specific needs in a RIBA financial setting. It is the challenge and the responsibility of the LARIBA Islamic banker to.

- First understand the needs for which such instruments were developed,
- Then offer solutions and creative ideas to meet the needs of the market in a LARIBA setting,
- Then "manufacture" and market competitive and/or new products (instruments) which meet the market needs, test the product, and solicit the legal and jurisprudence opinion about its Islamic viability from both the scholars and the LARIBA practitioners,
- And finally try to compare the product to its RIBA corresponding product substitute in order to identify niches which can be useful in marketing it or deficiencies to be corrected.

Unfortunately, this is not done most of the time. Many Islamic LARIBA bankers go to the currently available RIBA instruments, render them "halal" or "haram" and in some cases try to force an Islamic "dressing" onto them to make them look acceptable. Such "dressings" are labeled by Islamic jurist as heyal (or circumvention), and it has been severally criticized by most scholars ; with an entire section of Imam Ibn Taymiyah's fatwa (Islamic legal conclusion) being dedicated to the condemnation of a veriety of those heyal. This does not mean that the use of any RIBA financial instruments automatically falls under heyal. Many financial instruments used by RIBA bankers can be easily modified (as opposed to disguised) to become in accordance with shariah.

To illustrate our approach, let us consider the CDs. In a RIBA bank one way of manufacturing a CD is by looking at a portfolio of loans arranged by the bank and match it with a portfolio of CDs. The interest rate paid to the CD investor is made lower than the average return of the portfolio (interest rate spread). The bank gets the liquidity needed to expand its portfolio and makes a profit in the process, and the CD investor gets a guaranteed interest and capital preservation.

Any ideas in a LARIBA banking setting?

At American Finance House LARIBA in the USA, we devised what we acrynamed SPIN CDs (Specific Investors CDs). We show the investor a specific portfolio of say automobile leases (Ijara) and discuss the expected rate of return. This way the small investor feels comfortable of the asset backing the CD and the expected return. Using this approach, we can plan our liquidity because we get to know the maturity and in the same time create more liquidity to finance more projects the LARIBA way.

Needless to say, creative LARIBA banking instruments manufacturing is badly needed for the growth and prosperity of LARIBA banking.

3.1. Riba-Based Short-Term Instruments That Can Be Readily Adapted

Bankers' Acceptances can be issued by the LARIBA Bank for a service charge and/or a commission for arranging the deal.
LARIBA Islamic Bonds with short-term maturity, are also available mainly in Malaysia and the Islamic Republic of Iran.

The most important factor is the creation of a market for such instruments with market makers, brokers, sales force and support from the major LARIBA banks and financial institutions in order to reach a critical mass to achieve the momentum and volume needed to reach our goal.

3.2 Developing a LARIBA Money Market Fund

A RIBA Money Market Account is simply a mutual fund which invests only in the short term Money Market Instruments. Money Market can be a confusing term since all Investment markets involve money. Markets that trade only in very short-term debt securities, however, are usually referred to in RIBA banking as the Money Market because they are most quickly turned into cash. In other words, the money one invests in a RIBA Money Market account is being used for short-term loans to various companies and government bodies.

RIBA Money Market Mutual Funds invest in RIBA short-term debt securities such as commercial paper, CDs, BAs, short term loans and treasury bills.

Shares in a money market mutual fund are always worth US $1. Investors earn income by receiving RIBA interest on the money which the fund lends to corporations and governments. The rate of RIBA interest fluctuates every day because the loans are so short-term in nature that every day at least one loan is completed and a new one begins at a new rate. Although one cannot predict how much interest will be earned in Money Market Mutual Fund investment, which itself depends on the trends of the interest rates, Money Market Funds offer tremendous safety. An Islamic LARIBA alternative which provides similar liquidity and safety is badly needed.

The downsides for Money Market Mutual Funds investing are :

The possibility of earning a better return by investing in another instrument. However, this is usually done with a higher risk,

The insufficient diversification of the fund and the policy of a high risk investment by the portfolio manager. Both concerns are not allowed by most if not all prospectuses and government regulatory agencies.

RIBA Money Market Funds in the USA have become diversified and extremely sophisticated. There are funds that invest only in government and government agencies short-term securities. Others invest in international government securities. Some Money Market Funds use futures, options and derivatives to enhance the yield. However, remember that the share value stays always at US $1 ; that is the principal is safe in most of the cases.
Money Market Funds are also characterized by the investment banking company that manages them, the portfolio manager and the prospectus which defines in minute details the fund objectives, investment policy and restrictions.

In today's economy, the amount of money flowing in and out of Money Market Mutual Funds provides economists with valuable information and insight about the savings trends and investment behavior of the public and institutions.
THE QUESTION IS: do we have creative LARIBA Islamic bankers who can develop a LARIBA Money Market Mutual Fund? THE ANSWER IS A DEFINITE YES. There are plenty of short term LARIBA instruments which can be "manufactured" to serve the needs of the huge trading volumes in oil & gas, food items like rice, wheat, sugar and meats and other consumer and capital goods.

It is the author's firm belief that the development of a LARIBA Money Market Mutual Fund is a must and an urgent top priority for those LARIBA bankers as well as investors who aspire to earn "halal" returns with minimum risk to the principal. These are mainly the masses (al-naas) as well as larger financial and commercial institutions which suffer from occasional and periodic excess or shortage of liquidity and who are committed to "halal" LARIBA investing.

4. The Need for Specialization in LARIBA Islamic Banking Services

LARIBA Banking and Financing institutions need to start specializing in specific banking services in the 2Ist century. In the past, LARIBA Islamic banks have served their customers in many of the following combined capacities :

a. Direct Investment & Deal Makers Investment Companies :
This has created a lot of volatility and instability in the LARIBA system in the 20th century. We need to improve upon that. The sad and painful experiences of what happened in Egypt and BCCI should never be allowed to happen again. The damage which was sustained by the Islamic banking system has propagated into the following three generations in many countries.

b. Retail LARIBA Banks :
These institutions should focus on providing regular banking services needed by the community with an eye on community redevelopment using the LARIBA models. Examples are: financing small businesses in the community, single family residences, construction financing, automobile leasing and short term trade financing. In addition, such retail banks should serve the investment/savings needs of the community with products tailored to fit the low risk needs of the small saver/investor.
The instruments produced by such banks can be packaged in portfolios that can be used as the foundation of the short-term instruments discussed above as well as the LARIBA capital markets.

c. Wholesale LARIBA Banks :
These would be designed to serve the medium and large size institutions and corporations as well as the high net worth savers/investors. They should be designed to help provide the liquidity for the smaller retail LARIBA banking units.

d. "Mega" LARIBA Regional Banks :
These would serve the regions and provide liquidity for the Wholesale banks above.

e. LARIBA Investment Banking Institutions :
These should focus on investment banking activities using the LARIBA way, Examples are like taking Musharakah deals public, arranging for Islamic bond issues and organizing direct investment deals which are structured the LARIBA way.
This entity is the most important in developing the Money Market Mutual Fund through its knowledge of the capital market instruments available as well as the availability of various short-term instruments in the market.

f. LARIBA Brokerage Institutions :
These would be involved in the identification, sorting out, and assembly of available short-term instruments (like BBA -Bai Bi Thamanin Aaajil -Murabaha deals or Mudarabah deals). In addition, it would market such instruments and products produced by the investment bankers mentioned above.

Such institutions can act simultaneously to manufacture, package, and market portfolios of LARIBA financial instruments to meet the risk/return needs of the majority of investors looking for an alternative to RIBA banking instruments. Notice ihat the market niche for which such institutions will cater is characterized , by the risk/return profiles it offers through its securitized portfolios. In this respect, they can generate volume and liquidity by attracting nonMuslim as well as Muslim clients. Without such marketability to a large number of investors, the dream of LARIBA money market mutual funds cannot be fully realized.

5. Recommendations

A dedicated effort to humbly engage in a mutually educational dialogue with Central Banks around the world (especially the Federal Reserve Board in the USA, the Bundes Bank in Germany and the Bank of

Japan), as well as international institutions such as the IMF is required. The goal of this dialogue is to learn of possible apprehensions held by those institutions about the interaction of LARIBA banking with the rest of the international financial and monetary system as a complement and an alternative in the global financial, banking and monetary system. It is important to reach a common understanding that LARIBA banking complements the existing financial institutions, and that it will provide additional stability to the financial system, despite false accusations by some.

We should believe deep in our heart that Islamic banking is not trying to destroy the existing RIBA system. We are simply trying to provide a small alternative for the public to choose from.
In our dialogues with the IMF and Central Banks around the world, we need to develop an effective formula for supervision of Islamic Banks and Finance Companies' operations by those institutions. Today's Islamic LARIBA bankers are the first to admit the necessity of building a system of checks and balances which prevents previous financial disasters from recurring. BCCI -type episodes and the Egyptian Islamic finance companies' meltdown should never be allowed to happen again. Earlier experiences have taught us that good intentions are not enough. We need to learn from the regulatory and examination and development experiences of such institutions as the Federal Reserve Board in the USA, the Bundes Bank in Germany and the IMF. Just as non-banking financial institutions are engaged in dialogues with Central Banks regarding regulation of derivatives trading, uncovered options and other risky instruments; the Islamic LARIBA bankers need to engage in dialogues which qualify the riskiness of various financial instruments, and the regulations to reduce bankruptcy and systemic risks. We need to reduce our use of the word "Islamic". At this stage of our history, the word unfortunately acts as a polarizing factor which develops barriers to getting to bankers and others in the RIBA system as well as the public.

We need to let the public judge us by our deeds and our operating behavior, sincerity and results.

We need to stop calling the LARIBA system "Interest Free Banking". IT IS WRONG. This term gives the consumer the wrong meaning of LARIBA banking. As profits are made and are translated into a percentage, people will say: "So, What is the Difference? It is like Interest." We do not want to give the slightest doubt about our system or our sincerity.

And Allah knows best, and we ask Him his support and guidance,
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Saturday, December 23, 2006

Interest and Islamic Banking - Dr. Bilal Philips


Dr. Bilal Philips (Profile)

By: Riyazi FarookAny source

Money for everyone

In Alaska all citizens receive a cash handout every year from a fund which is continually topped up by royalties that the state receives from the oil extracted. Everyone who has been a citizen for a year is entitled to an equal handout – all children are included. The amount paid for 2006 was $1106.96 (USD) which was a rise of 30% on the previous year. A family of four people received $4428, with no questions asked about their current wealth status. Rich and poor alike have the same.

The fund is invested in equities, bonds and real estate. It is kept inflation-proofed by retaining some income before payouts to citizens. Payments have been running since 1982 and the fund has grown a real 10% p.a. return since the start.

Citizens of the UK must wonder why such an imaginative thing was not done for them when North Sea oil was discovered at about the same time as the reserves in Alaska. Sam Brittan with Barry Riley did suggest this in 1978 but nothing was done. Instead the wealth went into the state machine for redistribution according to the normal bureaucratic socialistic methods. A basic income like Alaska’s could have addressed the needs of the poorest far better than the alternative attempts so far.

Read The Free Lunch – Fairness with Freedom for ideas that would empower people directly like the Alaskan example, see: www.the-free-lunch.com

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Seasonal greetings to our readers


This picture of a somewhat post modernist Christmas tree that I took in Vilnius, Lithuania recently is suitably bleak for a CAP blog

It's been a pretty mixed year for those of us who would like to see a reformed Common Rural Policy delivering real economic benefits to deprived areas in the countryside and promoting environmental goals. The Pillar 2 budget is much smaller than we would have hoped for.

The Doha Round is suspended and it is uncertain whether an agreement can be reached. The EU may then pull back from its commitment to phase out export subsidies which would deliver real benefits to farmers in the Global South. It would also remove what has been the most powerful pressure for CAP reform. In the States, it looks as if we are going to get another Farm Bill that will ensure that most of the benefits go to corporate farmers growing particular commodities.

Some hope that the new transparency about who gets what from the CAP will exert pressure for reform as the public becomes aware that most of the money goes to large-scale commercial farmers. However, Britain and Germany are likely to resist any cap on subsidies. Public pressure on these matters tend to not to be maintained and is confused by the complexity of the CAP and misleading public messages.

In this respect it was alarming to see the BBC's respected environmental correspondent, Sarah Mukherjee, for whom I have a great deal of time, making a broadcast on Radio 5 recently which contained a number of basic errors about the dairy sector and appeared to be an unquestioning acceptance of a NFU press release. The dairy sector in the UK does have real problems, but the broadcast gave a soft treatment to the retailers and their market power.

Our friends at the farmsubsidy.org network are organising a conference on transparency in the CAP in Budapest at the end of January which unfortunately conflicts with other commitments that I have. However, it looks very interesting and further information can be found here:
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Friday, December 22, 2006

BVI FDI in the Hong Kong: New Statistics, Facts and Figures

On December 18, the Census and Statistics Department has released the statistics on Hong Kong's Gross National Product (GNP) and External Factor Income Flows (EFIF) for the third quarter of 2006. The figures in general confirm the previous Foreign Direct Investment ratings and tendencies for Hong Kong published some days ago, and analysed in the previous blogposts.

According to the new preliminary statistics for the 3rd quarter 2006, the total factor income inflow into Hong Kong made $158.2 billion in the 3rd quarter of 2006, and increased markedly by 29.5% if compared to this period of 2005. Within total factor income inflow, the Direct Investment Income increased very little – just by 26.7% over the year 2005; the reason for this rise were generally increased earnings of some prominent local enterprises from foreign investments.

Analysing by country or territory, the largest source of Hong Kong's external factor income inflow in the third quarter 2006 is still China Mainland, its stock accounts for 27.9% of the total amount. The second position is again occupied by the British Virgin Islands, with a share of 18.7%. The other major direct investors were the US, with 11.0%, and the UK, with 7.2%.

The British Virgin Islands, along with the Mainland, were also the most important places for Hong Kong's external factor income outflow. In the third quarter of 2006, the stock of the British Virgin Islands made 15.4% of the total amount, while the stock of China Mainland was just some 6% higher and made 21.7%. Other major investors from this list are the Netherlands, at 11.3%, and the US, at 10.8%.

I have compiled the information on dynamics of BVI and China Mainland foreign direct investments to Hong Kong in the table below:

Period (Qtr)Total ($M)BVI ($M)(%)China ($M)(%)
2004 4th111,42922,86620.52%29,52926.50%
2005 1st113,84624,24721.30%28,59325.12%
2005 2nd132,00834,81126.37%36,12927.37%
2005 3rd122,16627,29222.34%30,65225.09%
2005 4th135,94426,86019.76%39,40028.98%
2006 1st*149,20928,16518.88%42,41928.43%
2006 2nd*163,84029,49218.00%51,44431.40%
2006 3rd*158,24329,62018.72%44,19627.93%


$=Hong Kong Dollar

* Preliminary data

As we can see from the table in the last 2 years the level of BVI foreign direct investments to Hong Kong was increasing from quarter to quarter (except one extreme peak at the 2nd quarter of 2005). The fact that in percentage terms the part of BVI direct investments in 2006 is lower than in 2005 can be generally explained with the increase of direct foreign investments from Mainland China. Other countries have substantially lower % of FDI in Hong Kong.
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Sri Lanka and the Scope for Islamic banking
By Faizal Salieh (Click "Sri Lanka" label on bottom of the article for more)

Introduction

Sri Lanka is one of the few non-Islamic countries to have legislated for Islamic banking. The revised Banking Act No 30 of 1988, as amended in 2005,allows both commercial banks and specialized banks to operate on a Shariah compliant basis, including: “the acceptance of a sum of money in any manner or form from any person for a fixed period of time for investment in a business venture of the bank on the basis that profits or losses ofthe venture will be shared with the person fromwhom such money is accepted in a manner deter-mined at the time the money is accepted.” Thislandmark legislation came in after years of inten-sive discussions and lobbying by Amana Invest-ments, the pioneer Islamic services provider in the country, with the Central Bank of Sri Lanka.

Political environment

Sri Lanka is a democratic socialist republic which gained inde-pendence in 1948 from colonial powers. The President is thehead of state, wielding executive powers based on the Frenchmodel, and is elected for a term of six years. The national legis-lature is the parliament, with 225 members elected for five years. Local government is devolved to nine provincial councils elected once every four years. The newly elected President, Mahinda Rajapakse, is keen toresolve the country’s ethnic Tamil problem which has pre-vented the economy from reaching its full potential. The CeaseFire Agreement with the Liberation Tigers of Tamil Elam (LTTE) is still operational. The present regime’s “pro-business and pro-poor” approach, which was strongly emphasized in its budgetfor 2006, is comparable to that of India. In his inaugural policystatement Mr Rajapakse indicated the need for an active pri-vate–public partnership process to rebuild a new Sri Lanka.

Demography

The majority of the country’s 19.5 million population is Bud-dhist (77%), while Muslims constitute about 8.5%. Populationgrowth in 2004 was around 1.1%. The workforce is estimated to be about 8 million with labour participation (working population) of around 48% and unem-ployment at 8.5% as at the end of 2004. The service sector accounts for 45% of total employment.

Economy

Although relatively small, the economy has been quite resilient to the shocks and impacts of the longstanding ethnic conflict and the tsunami of 2004. The implementation of the ceasefire agreement with the Tamil rebels in 2001 and the pursuit of a negotiated peace settlement have helped the economy to record positive growth rates.The economy grew by 5.1% during the first half of 2005 despite the setbacks caused by the tsunami disaster. It is expected to record a growth of 5.3% for 2005. The country’s per capita GDP at market prices for the first time crossed the US$1,000 mark in 2004, recording US$1,031.

Sri Lanka is one of the few non-Islamic countries to have legislated for Islamic banking

The services sector is the largest sector in the economy, representing 54% of GDP. Agriculture contributes about 20% and manufacturing 26%. Expatriate worker remittances are a major source of funding the trade deficit. The capital account is closed but the current account is partly liberalized. The local currency is determined by market forces. Since May 2004 a rising trend in inflation has been observed with substantial demand pressure still prevailing. The year-end inflation is projected to be 10%–11% based on improved supply side factors and monetary policy measures, though thepublished figures indicate 13%–14% in September 2005. Interest rates showed an increasing trend in 2005 with the Average Weighted Deposit Rate (AWDR) moving from 5.3% in January to 6.2% in December. Weighted Average Prime Lending rates moved from 9.8% to 12.2% during the correspondingperiod. The yield on 12-month Treasury Bills increased from7.65% to 10.4% during the first eight months of 2005. Based on the expected budget deficit in 2006, higher oil prices and the pressure on the local currency, the upward trend in interestrates is likely to continue. International trade improved significantly with a 12.7% growth in exports, and an 11.3% growth in imports, while services and remittance increased substantially during the first eight months of 2005. Aided by the high growth in remittances and other inflows, the overall balance of payments has turned to a surplus of around US$190 million by the end of the first eight months of 2005. Gross official reserves increased to US$2.2 billion or 3.2 months’ of imports in that period. The budget deficit was 5% of GDP (5.4% in 2004). Prospects for 2006 are promising according to the Central Bank of Sri Lanka, with a projected 6% economic growth. Key structural reforms in the power and telecommunication sectors and the labour markets are being facilitated by the government. The banking, insurance and equity markets embody the major part of Sri Lanka’s financial sector.

Financial sector

The commercial banking sector constitutes about 65% of the total assets in the financial system. There are 22 commercial banks operating in Sri Lanka, comprising two large state-owned banks, nine private banks and 11 foreign banks. Their total assets as at the end of July 2005 was about US$11.76 billion. The two state banks account for about 48% of the total assets whilst the foreign banks account for 14%. The average growthrate of deposits in the banking system has been around 15% over the last five years. The two state-owned banks – Bank of Ceylon and Peoples Bank – along with Commercial Bank of Ceylon and Hatton National Bank, account for a large chunk of the current market both in terms of deposits and advances. The performance of the banking sector improved during the first half of 2005, as reflected by the growth in capital funds and increased profits of banks. Customer deposits are the main source of funds for banks and constitute about 75% of their liabilities.

The country’s financial system is largely a bank-based one, and not really market based. The capital markets are underdeveloped and have not posed real competition to the banking sector. The low level of financial disintermediation has resulted in high interest spreads for the banks. Public confidence in the banking system is high as there has been only one bank failure since the country’s independence in 1945 – that of Pramuka Bank, a small savings bank, which collapsed in 2002. The new Government has since announced its commitment to resurrect this bank. Consolidation is gathering momentum in the banking system as the regulators have begun directing banks towards higher capitalization, better risk management practices, higher operational efficiencies and strict internal controls. The banking system is preparing itself to comply with Basel II. There are 13 licensed insurance companies in Sri Lanka including one Takaful operator (Am├úna Takaful). The total premium collected in 2004 amounted to US$239.11 million, while the total assets of the insurance companies amounted to US$705.57 million. The insurance penetration level measured in terms of total gross premium as a percentage of GDP is around 1.5% and the insurance density or per capita premium amounts to US$14.80. This offers a promising growth opportunity for strong insurance companies and banks who can offer bancassurance products. The Takaful concept in insurance is seeing increasing market acceptance, and two of the largest insurance operators have announced their intention to offer Takaful products to the market in 2006. The equity market has remained relatively small despite a long period of existence. Market capitalization is about US$6 billion, or 15% of GDP. The largest securities market is government securities. The Colombo Stock Exchange (CSE) has gained over 27% in2005 in terms of All Share Price Index. The daily average turnover on the CSE was around US$4.63 million in 2005, with shares of more than 200 companies being traded. The Securities and Exchange Commission of Sri Lanka is the capital market regulator in the country and monitors the CSE.

Scope for Islamic banking

Islamic banking has been a long-cherished need among SriLanka’s Muslims since the creation of market awareness in 1997, when Amana entered the market as the pioneering Islamic financial institution offering Shariah compliant deposit and financing products. There have been other attempts at village and provincial levels to create Islamic fund-type operations, but their success has been limited due to, among other reasons, their being unregistered entities with little professionalism and the absence of aprofit motive. Of late, the Ceylinco Group has formed a company that offers PLS-based products to the market. Amana has led the market both in terms of creating awareness and providing Shariah compliant financial solutions. Whilst the group was able to obtain early regulatory approval to operate its Takaful insurance business, the regulatory approval for a banking licence has taken well over seven years, as it involved fundamental changes to the Banking Act. Amana is now at the head of the queue for a licence to operate as a fully fledged Islamic commercial bank following the new legislation; some of the existing conventional banks are expected to open Islamic banking windows with a view to preventing their Muslim customers from migrating to Islamic banks. It is also possible that the market might see a few new entrants to Islamic banking, although the Central Bank has upped the minimum capital requirements for licensing substantially. The size of the Islamic market is estimated at around US$500 million – US$600 million. The regulators are becoming alive to the growing Islamic market segment, both local and global, and the global developments and trends in Islamic banking. Some of the key challenges they face in this regard include developing appropriate mechanisms to regulate Islamic banks, facilitating inter-bank transactions and developing relevant inter-bank and treasury instruments for the investment of surplus funds by Islamic banks. Further relevant changes to the fiscal and legislative environments will soon be necessary to facilitate Islamic banking transactions. Yet another challenge facing the industry is the competency gap in human resources, both at the regulatory and market levels. Islamic bankers and Shariah scholars are scarce resources and are critical success factors to the industry’s future growth and development. All in all, Sri Lanka is an emerging market and the scope for Islamic banking looks both positive and exciting.
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