11/10/2013: BlackRock Institute survey: N. America & W. Europe: October 2013

BlackRock Investment Institute Economic Cycle survey for North America and Western Europe is out and here are core results (emphasis is mine):

"This month’s North America and Western Europe Economic Cycle Survey presented a positive outlook on global growth, with a net of 65% of 113 economists expecting the global economy will get stronger over the next year. (6% lower than within the September report).

At the 12 month horizon, the positive theme continued with the consensus expecting all economies spanned by the survey to strengthen or remain the same except Sweden. 

The consensus outlook for the Eurozone was also strong, with 87% of economists expecting the currency-bloc to move to an expansionary phase over next six months. The picture within the bloc was not uniform however, with most respondents expecting only Greece to remain in a recessionary phase and an even mix of economists expecting Portugal and Belgium to be in an expansionary or recessionary phase at the 6 month horizon (and similarly so for Sweden, outside of the currency-bloc). 

With regards to North America, the consensus view was firmly that the USA and Canada are in mid-cycle expansion and are expected to remain so through H2 2013."

Note that this correlates well with my own outlook: http://www.fergco.co/2013/10/9102014-businessinsider-most-important.html

Also note: the above views do not reflect BlackRock own views or advice. 

Two charts as usual:

Note that in the chart above, Ireland now firmly converged with the Euro area. This is a very strong move compared to September survey: http://www.fergco.co/2013/09/1292013-blackrock-institute-survey-n.html And the above is confirmed by the overall comparative expectations forward:

So on the net - good result for Ireland and positive outlook for Euro area as a whole.

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12/9/2013: BlackRock Institute survey: N. America & W. Europe: September 2013

BlackRock Investment Institute released its latest Economic Cycle Survey for North America and Western Europe region for September 2013.

Per summary: "This month’s North America and Western Europe Economic Cycle Survey presented a positive outlook on global growth, with a net of 71% of 119 economists expecting the global economy will get stronger over the next year. (1% higher than within the August report). 

At the 12 month horizon, the positive theme continued with the consensus expecting all economies spanned by the survey to strengthen or remain the same. 

The consensus outlook for the Eurozone continued to improve, where the 6 month forward outlook shifted from 75% to 86% expecting the currency-bloc to move to an expansionary phase. The picture within the bloc was not uniform however, with most respondents expecting Portugal, Greece, Belgium and the Netherlands to remain in a recessionary phase over the next 2 quarters. 

With regards to the US, the consensus view firmly that North America as a whole is in mid-cycle expansion and remaining so through H2 2013."

September improvement for the global outlook was much shallower than a 10 point jump in August. Ditto for Eurozone outlook: this rose from 57% in July to 75% in August to 87% in September. Italy outlook seemed to have improved quite markedly, however.

Note: these views reflect opinions of survey respondents, not that of the BlackRock Investment Institute. Also note: cover of countries is relatively uneven, with some countries being assessed by a relatively small number of experts.

Two charts as usual:

Ireland continues to lead expectations, just as it did in previous 3 months.

In global expectations there were some notable movements in analysts' replies. 6% of analysts expected global economy to get a lot stronger over the next 12 months back in August, and this declined to 2% in the current survey. 69% expected it to get a little stronger in August and this proportion rose to 76% in September. 5% expected the global economy to get a little weaker in the next 12 months back in August, which in September rose to 6%. 

In Ireland's case, in August zero percent of analysts expected the economy to get a lot stronger over the next 12 months and this remained unchanged in September survey. All analysts (100%) expected the Irish economy to get a little stronger over the next 12 months in September survey - same as in August. 57% of analysts expected the economy to be in an early-cycle recovery over the next 6 months back in August, and this fell to 50% for September survey. There was significant rise (from 0% to 17% between August and September surveys) in the proportion of analysts expecting Irish economy to be in mid-cycle expansion over the next 6 months period. The number of analysts expecting the economy to be in a late-recession over the next 6 months dropped from 43% in August to 33% in September.

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6/9/2013: BlackRock Institute survey: North America & Western Europe: August 2013

BlackRock Investment Institute released its latest Economic Cycle Survey for North America and Western Europe region.

Per summary: "This month’s North America and Western Europe Economic Cycle Survey presented an improvement in the outlook for global growth over the next 12 months – the net proportion of respondents with a positive outlook increased to 70% from 60% last month. 

The consensus outlook for the Eurozone was particularly positive, where the 6 month forward outlook shifted from 57% to 75% expecting the currency-bloc to move to an expansionary phase. 

The picture within the bloc was not uniform however, with most respondents expecting Portugal, Greece, Belgium and the Netherlands to remain in a recessionary phase, while the consensus has shifted to expect expansion for France, Spain, Finland and Ireland over the next 2 quarters. An even mix of economists expect Italy to be expansionary or recessionary at the 6 month horizon (and similarly so for Norway, outside of the currency-block). 

With regards to the US, the proportion of respondents expecting recession over the next 6 months remain low, with the consensus view firmly that North America as a whole is in mid-cycle expansion and remaining so through H2 2013."

Note: these views reflect opinions of survey respondents, not that of the BlackRock Investment Institute. Also note: cover of countries is relatively uneven, with some countries being assessed by a relatively small number of experts.

Here are two summary charts:

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ISLAMIC FINANCE 2010
by IFSL RESEARCH

OVERVIEW

The global market for Islamic financial services, as measured by shariacompliant assets, is estimated by IFSL to have reached $951bn at end-2008,25% up from $758bn in 2007 and three quarters up on the 2006 total(Chart 1). However, 2009 may have seen a pause following strong growth ofprevious years. Commercial banks account for the bulk of the assets withinvestment banks, sukuk issues, funds and takaful making up the balance.

Key centres are concentrated in Malaysia and the Middle East including Iran,SaudiArabia, Malaysia, Kuwait, UAE and Bahrain (Chart 2). Islamic financeis also developing in Asian countries such as Bangladesh, Pakistan andIndonesia, as well as North African countries such as Sudan and Egypt. TheUK, in 8th place, is the leadingWestern country and Europe’s premier centrewith $19bn of reported assets, largely based on HSBC Amanah. Assets inother Western countries are currently small but a number of countries,particularly France, are looking to develop a presence in Islamic finance.

While the Islamic finance industry initially has been less affected by thefinancial crisis and global economic downturn, there are ongoing challenges,particularly for the sukuk market and for some Islamic banks. The sukukmarket fell back in 2008, but despite recovery in issuance to $20bn during2009, is being tested by its ability to deal with several defaults. A $10bn loanby Abu Dhabi staved off the threat of a potential default by Dubai World onits repayment on the Nakheel $4bn sukuk in December 2009. Quality issuersof sukuk continue to attract demand from investors.

Islamic banks have not been immune to the effects of the financial crisis anddownturn: some have suffered a higher rate of non-performing loans thanconventional banks, mainly due to their exposure to falling real estatemarkets. Revenue and profitability has suffered in both 2008 and 2009 andliquidity is a significant restraint for some banks.

Islamic banks have not been immune to the effects of the financial crisis anddownturn: some have suffered a higher rate of non-performing loans thanconventional banks, mainly due to their exposure to falling real estatemarkets. Revenue and profitability has suffered in both 2008 and 2009 andliquidity is a significant restraint for some banks.

- 22 banks including five that are fully sharia compliant, more than in anyotherWestern country. Two Islamic banks were granted licences in 2008.
- 20 Sukuk issues raising $11bn listed on London Stock Exchange,exceeded only by Dubai Nasdaq.
- Seven sharia compliant exchange-traded funds (ETFs).
- 20 law firms supplying services in Islamic finance.-
- Advisory services provided by Big Four professional service firms.
-Institutions offering educational and training products in Islamic finance.
- Off-exchange trading in commodity-based agreements linked to LMEcontracts.

GLOBALMARKET FOR ISLAMIC FINANCE

As mentioned in the overview, IFSL estimates that the global market forIslamic financial services, as measured by sharia compliant assets, isestimated to have reached $951bn at end-2008, 25% up from $758bn in 2007(Chart 1). Assets have grown from about $150bn in the mid-1990s. Islamiccommercial banks accounted for 74% of the assets, investment banks 10%,sukuk issues also 10%, funds 5% and takaful 1%.

Assets that can be allocated to individual countries from The Banker’ssurvey of 500 organisations reveal that the leading countries for shariacompliant assets are Iran with $293bn, Saudi Arabia $128bn and Malaysia$87bn (Table 1). These are followed by other Gulf states including UAE,Kuwait, Bahrain and Qatar. The UK, in 8th place, is the leading Westerncountry with $19bn of reported assets, largely based on HSBC Amanah.Countries with most of the 302 firms reporting to The Banker’s surveyinclude Malaysia with 37, Bahrain 34 and Kuwait 30. Iran, Sudan, SaudiArabia and Indonesia each have between 20 and 23 firms supplying Islamicfinance (Table 1).

Broadening geographical customer base for Islamic services The market iscurrently most developed in Malaysia, Iran and the majority of countries thatform the Gulf Co-operation Council (GCC). However, Islamic finance ismoving beyond its historic boundaries in these countries into new territories.Markets where Islamic finance is developing include:

- Other countries in the Middle East and North Africa such as Turkey,Sudan, Egypt, Jordan and Syria.
- Other Asian countries such as Indonesia, which has the largestindigenous Muslim population in the world, as well as Hong Kong,Singapore, Bangladesh, Pakistan and China.
- Western countries in Europe and North America. Countries such as theUS, France, Germany and the UK each have indigenous Muslimpopulations of between one and five million, although Russia has muchthe largest in Europe with 30m. The customer base in Western countriesis not necessarily restricted to Moslems: other customers may beattracted by the ethical and environmental basis of Islamic finance.

Following the lead set by the UK, otherWestern countries, such as Japan andFrance, are looking to make the appropriate regulatory and legal reforms thatwould facilitate provision of Islamic financial products. London is seeking toconsolidate its position as the gateway to Islamic finance in Western Europe.Providers in London are likely to focus on services that complement thoseavailable in other centres. Government strategy for the development ofIslamic finance in the UK is set out on page 7.

Sharia compliant financial services

Banking and sukuk - the issue of Islamic notes - represent the forms ofIslamic finance that are most well established, although takaful (insurance)and funds are also evolving. Products that may be the subject of innovationinclude private equity and private wealth management.

Banking Islamic banks have been perceived favourably since the onset of thefinancial crisis in 2008 as they have been less exposed to losses frominvestment in toxic assets. However, they have not been immune from theeffects of the crisis and the subsequent economic downturn. Some Islamicbanks have suffered a higher rate of non-performing loans than conventionalbanks, mainly due to their exposure to falling real estate markets. Revenueand profitability has suffered in both 2008 and 2009 and liquidity is asignificant restraint for some banks.

In its World Islamic Banking Competitiveness Report 2009/10 McKinsey &Company recommended that many Islamic banks need to take action in anumber of core areas in order to:

- Enhance and diversify their business mix, by tapping into new businesslines such as personal finance asset management and various areas ofinvestment banking.
- Upgrade risk management in order to address credit and liquidityconstraints. This would also include avoiding excessive exposure to realestate.
- Reduce operational costs and improve service quality to maintaincompetitiveness.
- Explore growth opportunities in the international markets, especiallywhere any excess capital can be better deployed in underdevelopedmarkets.

Islamic banks compete not only with each other but also with all other banksoffering conventional finance, particularly those that have establishedIslamic ‘windows’. In the Banker’s survey, balance sheet assets of shariacompliant banks rose 29% from $622bn in 2007 to $800bn in 2008, of which$701bn were in commercial banks and $99bn in investment banks.

In the UK, five fully sharia compliant banks have been established putting itin the lead in Western Europe (Table 2). The Islamic Bank of Britain (IBB)became the first stand-alone retail Islamic bank in the country in 2004 andwas followed between 2006 and 2008 by The European Islamic InvestmentBank (EIIB), The Bank of London and The Middle East (BLME), EuropeanFinance House and Gatehouse Bank. IBB is the only bank with a high streetpresence having eight branches and around 50,000 customers. EIIB providesinvestment banking services including trade finance, private equity and assetmanagement. BLME offers Sharia compliant investment, corporate andprivate banking to businesses and high net worth individuals globally.European Finance House offers a range of investment products and servicesto clients that include companies and wealthy investors. Gatehouse Bank is awholesale investment bank operating in capital markets,institutional wealth management, Treasury business andadvisory services.

In addition to the five sharia compliant banks, there are anestimated 17 conventional banks that have set up windows inthe UK to provide Islamic financial services (Table 2). HSBCAmanah is the only conventional bank with an Islamicwindow to report to the Banker’s survey: its assets of $16.5bnaccount for 85% of the UK’s identified assets, with a further6% from BLME and 4% from the HSBC parent bank.

The 22 Islamic banks in the UK substantially exceeds that in anyother western country or offshore centre (Table 4). The UK market forIslamic mortgages has grown to about £500m, some 0.3% of the total UKmortgage market.

Sukuk are issues of Islamic notes that represent an alternative toconventional bonds. Issuance of sukuk increased rapidly from $1bn a yearin 2002 to $34bn in 2007 (Chart 3). In common with the broad-basedslowdown in global capital market activity, sukuk issuance fell awayduring 2008 to $15bn, as a result of a decline in asset valuation, a lack ofliquidity and a lack of market confidence. The ruling from the Accountingand Auditing Organisation for Islamic Financial Institutions (AAOFI) thatquestioned the sharia compliance of some sukuk structures also acted as abreak on issuance in 2008.

Sukuk issuance rose from the low point of Q4 2008 to reach $6bn in eachof Q3 & Q4 2009, resulting in an annual total of $20bn, up by 30% on 2008.Most issuers in 2009 have been government or quasi governmentorganisations. Uncertainty has arisen from the financing problems at DubaiWorld, resolved for the time being by a $10bn loan fromAbu Dhabi. This hasbrought concerns about settlement of sukuk defaults into focus with keyissues set out in the side panel. In the meantime, quality issuers of sukuk arecontinuing to attract demand from both Islamic and non-traditional investors.

Malaysia is the main country in the global market, but Indonesia andSingapore have come into the market more strongly in 2009. According toIslamic Financial Information Service (IFIS), the main factors hinderingrevival of the sukuk market in the GCC are troubled Kuwaiti investmentcompanies, the real estate market in the UAE and the availability of credit inSaudi Arabia.. There was one sukuk listing in Nasdaq Dubai and two on theLondon Stock Exchange in 2009. This has brought the Dubai total atend-2009 to 21 listings totalling $18bn and to 20 listings in London worth$11bn.

Long term prospects for sukuk are positive, with three factors having a rolein fostering growth in demand when market conditions improve:

- There is a commitment to a substantial programme of infrastructureinvestment in the GCC totalling up to $1,000bn over the next ten years,some of which will be financed through Sukuk.
- Recent years have shown that there is an appetite and demand forinvestment in Sukuk that goes well beyond Islamic investors amongstthose investors that wish to gain exposure to diverse but high qualityassets.
- Governments and regulators in a variety of countries have recognised theimportant role that Sukuk can play in capital markets and have beengiving priority to developing their countries as Sukuk centres. Inaddition to Dubai and the UK, these include Bahrain, Hong Kong,Malaysia, Japan, Pakistan, Singapore and South Korea.

Islamic funds The market for Islamic funds has been expanding steadily.Eurekahedge estimates that the total number of sharia compliant fundsreached 680 funds by end-2008 having risen more than threefold from around200 in 2003. Ernst & Young estimates that the total value of these funds has grown from $20bn in 2003 to $44bn in 2008 (Chart 4). Equity funds accountfor the largest segment: 40% of funds, with fixed income 16% and real estate& private equity 13% (Chart 5). Cash, commodities and other funds make upthe balance. Over half of funds, 58%, are invested in a portfolio covering theMiddle East and Africa. A further 20% are in a global portfolio, 15% in Asia,6% in America and the residual 1% elsewhere.

The bulk of Islamic funds are small scale with two thirds being less than$100m and many of these having attracted only $10m to $15m. The domicileof funds is heavily concentrated with nearly two thirds of the total number offunds being in five jurisdictions: Malaysia 23%. Saudi Arabia 19%, Kuwait9%, Luxembourg 7% and Bahrain 6%. Cayman, Ireland and Indonesia eachaccount for a further 3-4% each, but the remaining 25% is divided between afurther 23 countries, including 1% in the UK.

Eurekahedge estimates that the average return on Islamic equity funds was22% in 2009, recovering from an average drop of 28% in 2008. This wasclose to the return on the global equity index, up 25% in 2009 following a fallof 37% in 2008. The largest Islamic equity funds, according to Failaka, arethe US-based Amana Funds, which it estimates account for 95% of Islamicfunds in the US totalling $2.3bn in 2009.

There has been a substantial decline globally in the number of new fundlaunches since the 2007 peak. In the UK new offerings in 2009 haveincluded:

- BLME launching a sharia compliant money market fund, the first of itstype to be launched in Europe.- Qatar Islamic Bank
- European Finance House launching its GlobalSukuk Plus Fund.G
- atehouse Bank and DDCAP announced the launch of a fund in early2010 to invest capital in structured trade finance transactions. DDCAP isa wholesale Islamic market intermediary company.

This followed a more active year in 2008 when four exchange traded funds(ETFs) were listed on the London Stock Exchange. Other offerings in 2008included a fund of equity funds, the first of its type globally by SEI; the firstsharia compliant retail capital-protected equity fund in the UK by Alburaq;and the launch by FTSE Group of the FTSE Bursa Malaysia Hijrah ShariaIndex, in association with Bursa Malaysia.

Takaful, similar to mutual insurance, is a risk sharing entity that allows forthe transparent sharing of risk by pooling individual contributions for thebenefit of all subscribers. The global market remains at an early stage ofdevelopment and is estimated at $8.3bn in 2008, up from $6.6bn in 2007(Chart 6). Iran, where takaful is the compulsory form of insurance, is thelargest market, with assets totalling $2.6bn (Table 1). It is followed byMalaysia, with premiums of $2.1bn, UAE $1.0bn and Saudi Arabia $0.8bn.Together, these four countries account for over three quarters of the globalmarket. Smaller markets for takaful with annual premiums of over $100mhave developed in Kuwait, Bahrain, Qatar, Sudan and Indonesia. Penetrationof takaful is nevertheless low in these and other countries with Islamicmajorities. Takaful represents a strong growth opportunity, particularly withregard to life insurance, as sharia compliant products are developed.

The takaful market in the UK remains at an early stage of development.Principle Insurance, authorised by the FSA in 2008, was the first shariacompliant independent takaful company in the UK, but it stopped taking newbusiness in 2009. The remaining takaful available in the UK is restricted toHSBC Amanah’s home insurance offering. Prudential was given approval in2006 to launch a takaful business in Malaysia in partnership with BankNegara Malaysia.

Other financial products The range of products generated by Islamic financehas broadened steadily. In the UK in 2007 Merrill Lynch structured the firstsharia compliant credit default swap for a UK power company involvingGCC investors. In 2008, Barclays Capital and Sharia Capital Inc. of the USlaunched the first Islamic fund of hedge funds. Sharia compliant publicprivate partnerships (PPP) are also under consideration.

The UK has a successful record as a trading centre for Islamic products ascommodity-based LME contracts are traded off exchange. This has been akey mechanism for Islamic financial institutions to manage their assets andliabilities. In 2008 ETF Securities launched a sharia compliant precious metalexchange trade commodity platform, based on platinum, palladiumsilver, gold and a basket of other metals.

Law firms The UK is a major global provider of the specialist legalexpertise required for Islamic finance, with 20 major law firms providinglegal services in Islamic finance (Table 5).

Professional service firms The Big Four professional services firms -PricewaterhouseCoopers, KPMG, Ernst & Young and Deloitte - have eachestablished an Islamic finance team in London providing specialist servicesincluding advice on tax, listings, transactions, regulatory compliance,management, operations and IT systems.

Education and training There is a growing demand for skills as Islamicfinance expands and UK institutions are at the forefront of providingqualifications for the global industry.

Courses in Islamic finance are offered by the Chartered Institute forSecurities and Investment (CISI), Chartered Institute of ManagementAccountants, Association of International Accountants, Cass BusinessSchool and the Institute of Islamic Banking and Insurance. These courseshave been key to the development of Islamic finance qualifications in theUK. One new development in January 2010 has been the launch by AstonBusiness School of an Islamic Finance and Business Centre.

In a separate initiative, the Islamic Finance Council UK has developed apioneering ‘Scholar Professional Development Programme’ in conjunctionwith the CISI. The objective of the course is to teach conventional finance toShariah scholars worldwide. Partners for this programme include the CentralBank of Bahrain and the International Shariah ResearchAcademy for IslamicFinance (ISRA) that is backed by Malaysia’s Central Bank.

Beyond Islamic finance, the UK education offering that majors in Islamspans the full range of qualifications starting from 16 year-old school levelthrough vocational and career-based qualifications as well as undergraduateand postgraduate degrees.
GOVERNMENT STRATEGY FOR DEVELOPMENT OF ISLAMIC FINANCE IN THE UK

London has been providing Islamic financial services for 30 years, althoughit is only in recent years that this service has begun to receive greater profile.An important feature of the development of London and the UK as the keyWestern centre for Islamic finance has been supportive government policiesintended to broaden the market for Islamic products for both shariacompliant institutions and firms with ‘Islamic windows’ (see side panel).

A key aspect of supportive government policy has been the establishmentsince 2003 of an enabling fiscal and regulatory framework in the UK forIslamic finance. There have been a number of initiatives which are intendedto form part of a continuing process:

The removal in 2003 of double tax on Islamic mortgages and theextension of tax relief on Islamic mortgages to companies, as well asindividuals.- Reform of arrangements for issues of bonds so that returns and incomepayments can be treated ‘as if’ interest. This makes London a moreattractive location for issuing and trading Sukuk.- Initiatives by the Financial Service Authority to ensure that regulatorytreatment of Islamic finance is consistent with its statutory objectivesand principles.

Following a review into the case for issuing sharia compliant governmentbonds, the UK Government announced in November 2008 that this would notoffer value for money at the present time. The situation has since been keptunder review by the Government. Investors would welcome a UKGovernment sukuk as it would provide more liquidity in the secondarymarket and act as a benchmark for UK companies that might considerissuing sukuk.

During 2009 the UK Government has been following through on otherinitiatives designed to support the UK as a centre for global finance and toensure conventional and alternative finance are treated on the same basis.Specifically, it has been undertaking a consultation on the legislativeframework for those alternative finance investment bonds (AFIBs) or sukukthat are structured to have similar economic characteristics to conventionaldebt instruments. Following this consultation, the Government announced on21 January 2010 that it intends to introduce measures to provide ‘clarity onthe regulatory treatment of corporate sukuk, reducing the legal costs for thesetypes of investments and removing unnecessary obstacles to their issuance’.

BARRIERS TO DEVELOPMENT OF ISLAMIC FINANCE

The global development of Islamic finance requires that further progress ismade in addressing a number of barriers. These may be broadly groupedwithin the following headings including: taxation and regulation;standardisation; awareness; and skills. More details on these barriers aredetailed in the The December 2008 UK Government paper on ‘Thedevelopment of Islamic finance in the UK: the Government’s perspective’.

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The new UK tax law on sukuk

Mohammed Amin MA FCA AMCT CTA (Fellow), tax partner at PricewaterhouseCoopers LLP and head of the firm's Islamic finance practice in the UK, explores the new UK tax law on sukuk. This article is based on the presentation given by the author at IIBI's monthly lecture in London, July 2007.

Diagram 1 illustrates an ijara sukuk. The owner has a building and decides to raise money using that building. It sets up a special purpose vehicle (SPV) and sells the building to that SPV, and then rents it back. The SPV pays for that building by issuing sukuk. Those sukuk are not a debt owed by the SPV; instead they are a direct legal claim on a proportionate share of the building and of the rent it generates.

Diagram 2 illustrates a mudarabah sukuk, based upon an actual example. XYZ trading company has a collection of business assets and wants to raise $500 million to use in its business. It sets up an SPV, here XYZ Sukuk Ltd, which raises $500 million to buy the assets. That $500 million comes from the investors as payment for sukuk certificates. Next the assets, which are now owned by XYZ Sukuk Ltd on trust for the investors, are contributed to a mudarabah whereby 99 per cent of the profits of the mudarabah will go to the trust for payments to investors subject to a maximum limit, in this case of six per cent, i.e. six per cent of $500 million = $30 million p.a. Again, the investors are not receiving interest but a share
of the business profits.

Before this year's tax law, what happened if a sukuk was issued? The basic problem was that tax costs arose in the issuing SPV company. The SPV is receiving something that is clearly taxable income. However the payments that the SPV makes to the investors do not give rise to any tax relief. Those payments to the investors are not interest; they are simply paying on to the investor the fractional entitlement to the rent or the fractional entitlement to the income of the mudarabah. There is no reason why the SPV should get tax relief for those payments under basic UK tax law. So tax arises in the SPV.

Even if the sukuk-issuing SPV tried to argue that this payment to the investors should really be treated like interest, it still wouldn't get tax relief. There is a very specific provision in our tax code, in the Income and Corporation Taxes Act (ICTA) 1988 section 209(2) (e) (iii). If you issue securities, in other words debt instruments, under which the interest payable on those securities is dependent upon the results of the company's business, then that interest doesn't get tax relief. Instead it is treated as a distribution, like a dividend. It is not a tax-deductible expense.

We now have some new legislation in the Finance Act (FA) 2007. However, if you search FA 2007 for the word 'sukuk', you will not find it. The rules for sukuk introduced in 2007 follow the same overall approach as the 2005 rules for murabaha transactions or mudarabah transactions. HM Treasury simply created a definition, a new concept in UK tax law; something called an 'alternative finance investment bond' (AFIB). If the definition is met, certain tax consequences follow.

The definition of an AFIB

The legislation requires one or more persons to pay money to a bond issuer. The bond issuer is going to acquire some assets which will generate income or gains.

There has to be a fixed period of time when the arrangements will end. A sukuk that is perpetual won't qualify. As part of the legal agreements, the issuer has to undertake that at the end of the sukuk it will dispose of any bond assets that are left.

The issuer will also make other payments to the investors, which are called additional payments. In diagram 1, the additional payments come from the rent and in diagram 2 from the business profits.

The additional payment must not exceed a reasonable commercial return on a loan equal to the amount of the capital. One of the things that the UK Government was most concerned about was ensuring that it did not give a tax deduction for payments on sukuk instruments which had equity characteristics, i.e. which were equivalent to ordinary shares. The law does not stipulate what is a reasonable commercial return; that would depend upon the facts and circumstances.

The bond issuer is going to manage the bond assets. In other words, the bond assets are not managed by the investors. Of course, the bond issuer can delegate management. In diagram 2, once the bond assets have been contributed to the mudarabah, XYZ Trading Company as the mudarib is going to manage that mudarabah.

The sukuk, the bond, has to be transferable. This doesn't mean it has to be physically transferred. The sukuk could be issued and the same people may hold it for its entire five- or ten-year life, which is actually very common with sukuk. There is relatively little secondary trading in practice, but the critical thing is that they have to be transferable.

The AFIB has to be listed on a recognised stock exchange. There is a provision in the Income Tax Act 2007 section 1005 which details what a recognised stock exchange is and there is a provision in the legislation to recognise a stock exchange purely for the purpose of the AFIB rules. As well as a long list of fully recognised stock exchanges, HM Revenue & Customs (HMRC) lists seven exchanges which are recognised only for the purposes of the AFIB rules. (See www.hmrc.gov.uk/fid/rse.htm)

Diagram 1 Ijara sukuk

If issuing a sukuk from the UK, it is important to make sure that it is listed on a fully recognised stock exchange within the Income Tax Act 2007 definition to avoid paying withholding tax. If a sukuk is listed on a fully recognised stock exchange, then the consequence of the 2007 rules is that it is treated for tax purposes as if it were a debt instrument and the exemption for listed eurobonds should apply. Interest on listed eurobonds can be paid without withholding tax.

If a UK-based sukuk is created and listed on a stock exchange which is only recognised for the purpose of the AFIB rules and not recognised for any other purposes, then the eurobond exemption would not apply. The eurobond exemption looks specifically at stock exchange designations under Income Tax 2007, not at the extension for sukuk. Finally, there is an accounting test. If the issuer were to prepare accounts under International Financial Reporting Standards (IFRS), the sukuk would be treated as a financial liability.

After all the strict definitions there are a few relaxations:

• The issuing entity can acquire the bond assets either before or after the sukuk itself is issued.


• Bond assets can be any kind of property and can be secondary rights in property. For example, it could be that instead of owning a building the asset could be a lease over a building.


• A declaration of trust is permitted but not mandatory.


• Bond holders may be given the right to terminate early.


• The additional payment, the economic return to the bond holder, can be either fixed or variable. However, if the payments are not fixed then the test of whether they represent only an amount equivalent to a normal commercial return on the capital is made by looking at the maximum amount of the additional payments. To ensure that the additional payments cannot exceed a reasonable commercial return, it may be worth including a numerical cap in the documentation, as in diagram 2.


• Finally, the redemption payment can be satisfied by the issue or transfer of shares. This caters for convertible or exchangeable sukuk, corresponding to convertible or exchangeable bonds.

Tax consequences of qualifying as an AFIB

From the issuing company's perspective, the AFIB is treated as a loan relationship. In other words, it is treated as if it were debt and all the tax rules for corporate debt apply to the AFIB. The Government is not saying that this is a debt instrument or that the issuer is paying interest, it is merely saying that it is going to apply the same tax law that would have applied if there had been a debt instrument.

Diagram 1 Mudarabah sukuk

The additional payments are treated as if they were interest for tax purposes. This potentially makes them tax-deductible, and there is an express override of section 209 (2) (e) (iii). The issuer is taxed as if it beneficially owned the assets, which means that it is entitled to any capital allowances (tax depreciation) the assets qualify for.

To a limited extent the issuer is treated as a financial institution. The existing tax law for Islamic finance in FA 2005 and FA 2006 applies only if one party to the transaction is a financial institution, broadly speaking a bank, a building society, a wholly owned subsidiary of a bank or building society, or an overseas recognised deposit taker. The issuer of an alternative finance investment bond is treated as a financial institution but only for two specific categories of asset. These are purchase and resale assets, in other words assets which are used in a murabaha transaction, and diminishing shared ownership assets.

The reason for these two choices is that when drafting this legislation HM Treasury primarily saw sukuk as an equivalent to conventional securitisation. Conventional banks lend conventional mortgages and often securitise them. Islamic banks typically provide mortgages by purchase and resale of property or proportional ownership of property. Accordingly, the AFIB rules enable Islamic banks to securitise their Islamic mortgages.

Taxation of buyers and sellers of AFIBs

Buyers and sellers of sukuk are legally buying and selling a fractional ownership interest in assets. Before FA 2007, this gave rise to many technical questions. Was the purchase and sale of the assets subject to stamp duty; was it subject to capital gains tax or income tax; and was it subject to VAT or stamp duty land tax? If a sukuk paid rental income, was that rental income taxed in the UK if you were non-resident? Most of these questions are actually unresolved because sukuk were quite unfamiliar in a UK tax context.

The situation now is that for both corporate and individual investors, sukuk are treated exactly as equivalent conventional debt would be treated for tax purposes, both for the taxation of income payments and for the taxation of gains or losses from buying and selling sukuk.

Areas where further change is needed

In diagram 1, the first thing the owner does is to sell the buildings to the SPV. That sale is a taxable sale. If the building has gone up in value, the company will pay tax on the gain. If the company had issued a conventional eurobond it would not have sold the building or transferred the building anywhere and therefore it would not have paid tax.

There needs to be some mechanism designed to stop tax arising on the gain when the building is sold, perhaps by deferring it as long as the building eventually reverts to the entity which sold it to the SPV.

Similarly, that sale of the building will give rise to stamp duty land tax. Again, that is an extra cost which does not arise if a conventional debt instrument is issued. The sale may also give rise to value added tax consequences. These are areas where the law needs to go further to put sukuk issuers into an equivalent position to conventional bond issuers.

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Shariah Tax Planning in the UK

By Riyazi Farook, Islamic Finance New, 26th January 2007 (Vol. 4, Issue 4)

In the UK, a 40% inheritance tax (IHT) is imposed on certain assets in excess of £285,000 (US$564,860) of a deceased person’s estate for the tax year 2006/2007. This individual allowance, which is revised annually, is known as the nil rate band (NRB). There are ways to substantially reduce or even eliminate any IHT liability, if arranged prior to death. ReliefsWhilst there are many exemptions and reliefs available, the following provides a summary of the most relevant principles.

Gifts

Gifts of any value made by the deceased to the surviving spouse, before or on death, are exempt from IHT. However, these gifts may be liable to IHT on the death of the surviving spouse. English law does not recognize the Islamic Nikkah (solemnization) ceremony if undertaken in the UK, with the exception that the ceremony is used to obtain a civil marriage certificate. If the surviving spouse is not UK domiciled, the inter-spouse exemption is limited to £55,000 (US$109,023). A popular use of this exemption is to ensure that on death all assets in excess of the NRB are passed to the surviving spouse. Gifts of any value made to a registered UK charity are exempt from inheritance tax (IHT).

Lifetime transfers

Gifts of any value are deemed to be exempt from IHT if made seven or more years prior to death. Otherwise, IHT is payable in full on gifts made less than three years prior to death, and on a sliding scale if made between three and seven years prior to death. Gifts in which the donor retains some beneficial interest, such as a house in which the donor continues to reside rent-free, are considered to be “gifts with reservation” and are liable to full IHT.

Business property relief

The transfer of shares owned for two or more years by the deceased in an ongoing business concern is exempt from IHT. This is crucial for business owners, as the vast majority of trading companies and partnerships qualify for this relief. Investment companies or properties – both commercial and residential – generating rental income normally do not qualify for business property relief.

Annual exemption

A single gift of £3,000 (US$5,947) per annum can be made which is exempt from IHT. Any unused annual exemption can be carried forward one tax year, enabling a maximum of £6,000 (US$11,894) to be gifted.

Deeds of variation

The beneficiaries of an estate are able to retrospectively revise a will after death, usually for religious, family or tax reasons. In order for a deed of variation to be accepted by the Inland Revenue, all beneficiaries must be over 18 and sane, and give their written consent within two years of death. Deeds of variations are typically very costly and time-consuming.

Advanced inheritance tax planning

Where a client’s assets are considerable, the above rules will need to be augmented to ensure tax is mitigated. Listed below are some of the more popular advanced techniques which typically apply to those whose assets are valued in excess of £1 million (US$1.966 million). Quite often these methods involve some form of capital gains tax (CGT) planning. The following are merely simplified solutions – more complex solutions need to be discussed with professional tax planners.

DT and IIP

Assets can be transferred into a discretionary trust (DT) on death. A DT also allows assets up to the NRB (£285,000 (US$564,860)) to be exempt from paying inheritance tax. Anything over this amount owned by the deceased is placed into another type of trust called an interest in possession (IIP) trust, which also allows for tax mitigation. Technically the assets in the IIP trust are held for the benefit of the spouse, although the trustees will only give the spouse what is due to her under Shariah rules. Consequently, once the trustees distribute the assets from the IIP, a potentially exempt transfer lasting for seven years is created on the spouse. The DT can also be used to reduce the assets of someone who pro-actively wishes to reduce the value of their estate during their lifetime. Typically, in this scenario one is discouraged from making gifts, as gifts made to any person apart from the spouse will automatically trigger a CGT charge. The value of a DT is that the CGT charge can be deferred by placing assets into the trust.

Declaration of trust

Ownership of an asset to be deemed as shared by a group of individuals, rather than just the legal owner (or indeed just one individual other than the legal owner) is allowed under declaration of trust. This is crucial for married couples, as it allows both NRBs to be applied to the value of the family home if it was initially purchased in a single name. For example if the husband initially purchased a house now valued at £500,000 (US$991,082), this would exceed his NRB by some £215,000 (US$426,171). By completing a deed of trust (DoT) on this property, and allowing half the property to be owned by his wife, the two sets of NRB can be offset against the value of the property. These would be worth £570,000 (US$1.12 million), which is greater than the value of the property at £500,000 (US$991,082), thereby eliminating any tax charge.

Offshore planning

Principally, offshore planning is the ability to hold assets in an environment where they are exempt from both inheritance and CGT, and relies on one obtaining a non-domicile status. This strategy is for the very wealthy whose assets exceed the £5 million (US$9.91 million) mark.

Conversion to tenants in common

Couples who own their family home as joint tenants would have the house automatically passed to the surviving spouse in the event of one partner’s death, regardless of any provisions made in the will. This situation does not conform to Shariah law and would likely lead to a tax charge when the surviving partner eventually dies. A couple owning a £500,000 (US$991,082) home as joint tenants would have the house passed to the wife upon the husband’s death, making her the sole owner. A tax charge would arise on her death. Owning a home jointly as tenants in common allows for the half owned by one partner to be included as an asset in their will on death, instead of passing to the surviving spouse. This arrangement not only allows Shariah law to be applied to the half owned by the deceased, but also avoids a tax charge on the death of the surviving partner, as their share is now worth £250,000 (US$495,509), which is less than the NRB.

The Importance of Inheritance in Islam

Many can speculate as to why Islam has placed such an emphasis on the laws of inheritance and making a will. One could argue that it prevents family conflict on death, or that it represents a means via which needy relatives can benefit from a wealthy family member. The Muslim law of inheritance has been praised all over the world, including from western quarters, for its refined and elaborate set of rules on the transference of property.

The Hadith states: “A man may do good deeds for seventy years but if he acts unjustly when he leaves his last testament, the wickedness of his deed will be sealed upon him, and he will enter the Fire. If [on the other hand], a man acts wickedly for seventy years but is just in his last will and testament, the goodness of his deed will be sealed upon him, and he will enter the Garden.” (Ahmad and Ibn Majah).

With such compelling instructions in the Shariah, one would expect every adult Muslim to give priority to making a will. Unfortunately this priority has to a large extent been neglected. Muslims who reside in the UK are hit by a double whammy because of their apathy. UK tax authorities have imposed a whopping 40% tax on assets over a certain threshold held upon death. For the tax year 2006/2007, this amounts to £285,000 (US$564,860). In addition, English law dictates the “law of intestacy” on a person who passes away without a valid will in place. This effectively distributes their assets in a pre-determined, un-Islamic fashion, to the heirs. Invariably this predetermined distribution will not be tax-efficient and often will be contrary to both the wishes of the family of the deceased and contrary to Shariah. (There are also practical considerations concerning the Islamic rites of burial such as janazah (funeral prayer), ghusl (ritual washing), kafn (burial shroud), dafn (burial not cremation) along with any wasiyyah (bequests) such as avoiding post mortem, and also fidya (compensation for missed fasts/prayers, etc) to consider.) The preparation of a valid will is not just an obligation for Muslims, but is also vital to mitigate tax, protect one’s assets, to ensure one’s wishes are followed after death and to ensure potential family disputes are minimized.

Shariah law is very clear on debt settlement and the subsequent distribution of wealth. Only after fully settling the deceased’s debts and burial costs can his wealth be distributed. Shariah allows the deceased to bequeath up to a third of his estate to anyone other than a recipient entitled to a share from the remaining two-thirds.

Heirs to the estate

After the distribution of up to a third of one’s assets, heirs to a Muslim’s estate as defined in Shariah are the fixed share inheritors (wife or husband) and the residuary inheritors (usually sons and daughters), whose exact percentage of inheritance is not fixed.

Shariah inheritance law is not recognized by UK law and so Muslims should prepare their wills, incorporating trusts into which all their assets are placed automatically on death.

Legal and tax concerns

The laws of intestacy apply when a person dies without leaving a will. Essentially, the first £125,000 (US$247,750) plus chattels are given to the wife, and half of the remainder of the estate is placed in a trust giving the wife a right to income for life. On the wife’s death, the assets pass to any children above 18 years of age. Otherwise, the remaining half is held in a trust until they come of age. Evidently, this approach does not conform to the Shariah, as the assets would be trapped under the trust for an uncertain amount of time, often involving the Court of Protection’s consent when administering the child’s assets. This rule also applies in the event of a dispute between inheritors, possibly leading to a court battle. Mutual agreement between all heirs to share the assets could avoid such a distressing situation. However, there is no certainty of this, particularly in cases involving a considerable amount of assets.

Once death occurs, all authorities (such as banks and investment companies) will freeze the deceased’s assets until a probate certificate is received by them. Accounts held jointly escape this freeze and the surviving partner can continue using the account after the other partner passes away.

The presence of a will enables the named executors to obtain a probate certificate. Without a will, the spouse and children would need to get letters of administration. With the certificate of probate, the executors are authorized to manage the assets of the deceased with a view to transferring them to the ownership of the rightful heirs.

The process of probate can be completed within a few months if the assets of the deceased are less than £150,000 (US$297,270) and if there are no inheritance tax concerns. Otherwise, it can take years to conclude. A probate certificate will only be issued once the inheritance tax liability is paid. There are ways to resolve this situation and manage the probate process efficiently from an Islamic as well as a legal perspective.

Conclusion

It is clearly very important for a Muslim to plan his financial affairs adequately prior to death. The Shariah strongly supports this view. For Muslims owning substantial wealth, the Islamic philosophy, however, must be accompanied by sophisticated trust-based tax planning in line with UK taxation laws. Failure to achieve this may render the entire Islamic planning void, and result in a 40% tax charge. It is recommended that Muslims utilize trust-based will solutions. These are legally valid, thereby avoiding the laws of intestacy. Furthermore, by placing assets on death into trust, the trustees are able to ensure an Islamic distribution occurs. Finally, certain types of trust are effective at mitigating inheritance tax as well as providing asset protection. Careful drafting of one’s will, including the right type of Shariah compliant tax effective trusts, along with choosing honest trustees, will allow the preparation of a legally valid, tax efficient and Shariah compliant will.

Case study

What follows is a clear illustration of the case, based on a real life case study, where the estate value exceeds £575,000 (US$1.13 million) but not £1.5 million (US$2.97 million).

Sufiyan is married to Ameena and they have a son and two daughters. Sufiyan has an estate worth £950,000 (US$1.88 million), excluding business property worth £1 million (US$1.98 million), from his IT firm which he founded and still owns. In addition, Ameena owns assets worth £285,000 (US$564,860). Sufiyan’s personal pension fund totals £200,000 (US$396,478). The question then arises on the potential IHT liability: how it can be reduced and how should these estates be distributed in an Islamic way through their wills?

The potential liability amounts to £266,000 (US$527,275) (40% tax applied to the difference between Sufiyan’s estate less the NRB). To reduce the tax liability, a will in accordance with the Shariah and inserted with two key trusts needs to be created. The trusts are the DT, as defined earlier, into which assets equivalent to the NRB will pass on death (referred to as a NRB discretionary trust). In addition, an interest in possession trust (IIP), which has a life tenancy for the living spouse, is set up. A life tenancy is simply the right to income for life. As the wife holds a life tenancy in the IIP, all transfers to the IIP are free of IHT on death. A transfer to an IIP is essentially the same as an inter-spouse exemption for taxation purposes. Naturally then, the balance above the NRB on the first death will be passed into the IIP to avoid any taxation.

Conclusion

Adequate planning of one’s financial affairs is crucial for Muslims, as laid out in Shariah law. Those who own substantial wealth not only need to properly follow through with rules set out under the Shariah (see below), but must also acknowledge the importance of trust-based tax planning, in line with UK taxation laws. Failure to observe these laws would cause a hefty tax charge of 40% to the heirs. Islamic tax planning utilizing trust-based will solutions is legally binding and avoids the laws of intestacy. Placing assets into a trust also ensures that the trustee can distribute the wealth according to Shariah principles. Moreover, certain types of trust are also effective at mitigating IHT and providing asset protection.

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First UK Islamic business banking account- Riyazi Farook
http://www.youtube.com/riyazi


Lloyds TSB is to offer the UK's first business account by a High Street bank that complies with Islamic law.

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Islamic finance and the FSA-UK (Financial Services Authority)

Howard Davies Chairman, Financial Services Authority

Thank you for the invitation here today, and for giving me the opportunity of setting out the FSA’s approach to financial regulation, in general, and to Islamic finance and Islamic banking, in particular.

It is a good moment to devote some thought and discussion to the way in which Islamic finance fits into the global financial system, and to the way in which it should be regulated, in all its manifestations. One particularly good reason for doing so is that, in recent years, there has been a significant revival of the historic tradition of Islamic banking. Some countries, notably Iran, Pakistan and Sudan, have moved to structure their systems on a purely Islamic footing. In rather more countries, Islamic banks have been established alongside conventional banks on the Western model.

There are no solidly reliable statistics on the size of Islamic finance, but it is clearly of growing importance globally and is attracting increasing attention and visibility. Some commentators estimate that the Islamic banking and finance market has grown at between 10% and 15% annually over the past decade and that it is currently worth between $200 and $500 billion. As President Reagan once memorably remarked, "a billion here, a billion there and pretty soon you are talking real money".

Bahrain and Malaysia are regarded as perhaps the market leaders in the development of international Islamic finance. And indeed both the Bahrain Monetary Agency and Bank Negara Malaysia, the Malaysian central bank, have been among the authorities who have come together to establish the Islamic Financial Services Board. They have been helped by the Islamic Development Bank and the IMF to set up the Board, which aims to promote, disseminate and harmonise best practice in the regulation and supervision of the industry. It will be launched in new premises in Kuala Lumpur on 3 November of this year, in the presence of Prime Minister Mahathir. The FSA has been invited to attend.

We hope it will play an important role in guiding authorities, including our own, which so far have limited experience of regulating Islamic financial institutions. One of the expressed aims of the Board will be to set standards and principles for supervision and regulation, consistent with the Sharia law and principles, and to liaise and co-operate with other standard setters around the world.

In the UK, of course, we do not yet have a large well-developed Islamic financial structure. But there is already a reasonably significant amount of business of various kinds. There are no purely Islamic banks in the UK today, but London is an important centre for Islamic banking products. Some UK banks have Islamic windows. HSBC is one notable example. They, of course, have considerable expertise elsewhere in the world of operating within financial systems in which Islamic banks are their competitors and collaborators. And some banks here use the London Metal Exchange for Murabaha. The customer buys and sells forward a metal on the London Metal Exchange and earns a profit.

But it is fair to say that most Islamic banking in the UK at present is transacted by relatively wealthy individuals or large institutions. Since there is no focused Islamic bank, and some retail sector Islamic products are rather difficult to construct here at present, I would acknowledge that there is a market gap.

There are approximately 1.8 million Muslims permanently resident in the UK. They make up around 340,000 households. A rough estimate suggests that they have, collectively, savings of approximately £1 billion. And in addition to the permanently resident population there are many Muslims who visit the UK. Last year over half a million Muslims came here from the Middle East and Pakistan, spending nearly £600 million during their visits. So the potential market, whether for savings products, borrowing, or simply transaction-related finance is very large.

Against that background, it is perhaps surprising that, in spite of many initial expressions of interest, and much energy expended by knowledgeable enthusiasts, there have so far been no dedicated Islamic banks established in this country. That certainly does not reflect any lack of dialogue between the FSA and the Islamic community. Those links go well back into the time when banking supervision was the province of the Bank of England, and the current Governor has throughout his time of office taken a particular interest in Islamic financial issues. In September 1999, early in my term of office at the FSA, I hosted a meeting with the Citizens Organising Foundation and Representatives from the Islamic community, at which I tried to set out the FSA’s likely new approach to banking regulation and supervision, when we became fully responsible for it, which we did in December last year.

But time has moved on since then. The FSA is now well established as a single regulator for the whole of the UK’s financial system, so it is a good moment to take stock of the way we now operate, of the objectives given to us by Parliament, and the way in which those objectives, and the regulations which flow from them, can be transposed to handle the particular needs and demands of Islamic financial institutions.

You will be pleased to know that I do not plan to take you through all 500 clauses of the Financial Services and Markets Act, passed in the year 2000, and which provides the legal basis for our work. Indeed, I will restrict myself to a few words only about clause 1, which sets out the objectives of financial regulation. We are given four main tasks.

First, we are required to work to maintain confidence in the UK’s financial markets. That has been something of a challenge in recent months, as we have been blown by forces from across the Atlantic.

Our second principal objective is to promote public understanding of the financial system. That is a new role for a regulator. It has taken us into areas of consumer education which previous regulators have not touched. We have developed materials for use in schools to educate children in the principles of finance. That applies from primary schools right up to the 16 –18 age group. We hope that, over time, all that work will have the effect of enhancing financial literacy which is distressingly low in the UK.

Our third objective is to protect consumers of financial services, but bearing in mind their own responsibilities. In other words we are not meant to protect people from any mistaken saving or investment decision they may make. The principle ‘buyer beware" certainly still applies. Under that heading we try to ensure that financial institutions in our care are reasonably sound in financial terms, that they offer fair contracts which can be reasonably well understood by consumers, and that there is an ombudsman scheme, and a compensation scheme, to underpin the market when things go seriously wrong, as they sometimes do in even the best ordered markets.

Our fourth objective is to work to reduce financial crime. That objective has gained particular prominence in the last twelve months as international concerns about money laundering, in particular, have come to the top of the political agenda. It is our responsibility to try to ensure that financial institutions have systems in place which protect them against abuse by those who wish to launder the proceeds of organised crime, or who wish to finance terrorism.

I mention these four objectives, because they underpin everything we do, and we must ensure that however we regulate financial businesses we are contributing to those aims set for us by Parliament.

When we translate that to the arrangements for supervising banks, we require new applicants to meet five - what we call - threshold conditions for authorisation as an institution entitled to take deposits in the UK. Some of those conditions, such as the legal status of a bank, its location etc, are entirely straightforward. And the two key conditions are that a bank must have adequate resources and must have reasonable systems and controls to manage the type of business it wishes to undertake in a reasonably sound and prudent way.

How do these principles apply, or how would they in principle apply to an Islamic bank? I should emphasise that we have not yet received a formal Islamic bank application, though we are aware of some interest in doing so, and as I have said we have held preliminary discussions already about how our conditions might be met.

Perhaps the first important thing to say is that we welcome diversity and innovative developments in the world of finance, such as the growing Islamic finance market. London has prospered over the centuries by providing a congenial home for international financial institutions, and innovation has been its life blood. So we have a clear economic interest, as a nation, in trying to ensure that the conditions for a flourishing Islamic financial market are in place in London. The business opportunity is large and potentially very attractive. We recognise that there are no banks catering specifically to the large and growing UK Muslim population, and I can tell you that in principle we have absolutely no objection to the idea of an Islamic bank on our patch.

But, that said, we will treat applications from Islamic institutions no differently from any other. Of course there has to be a level playing field and it would not be appropriate, or even legally possible for us, to lower our standards for one particular type of institution. Indeed I would strongly argue that since, if it was to be successful, an Islamic bank would need a reputation for capital soundness and proven management, it would in any but the very shortest term be entirely counterproductive to authorise a bank on a different basis from that which we apply to conventional institutions.

But we recognise that, to fit the bill, our requirements would need to be shaped to suit the particular demands of an Islamic bank. Islamic banks differ from conventional banks in four main ways. They offer a rather different range of types of Islamic finance, from Murabaha through Ijarah and Salam to Istisna. I know that there are other – to me – exotic products like sukuks. I am not going to stand here today and tell you that I am expert in these different types of transaction. But, ‘I know a man who is’. And we have a small team in the FSA who have made a study of Islamic banking, and its regulation.

We recognise that the risk sharing characteristics of these Islamic contracts are rather different from those in place in a conventional bank. We recognise that there is a mix of contracts on the liability side. In particular, unrestricted Islamic investment account holders share in the risks of the bank, since their deposits have some of the characteristics of equity stakes. It is entirely reasonable to take some of these defined features into account when looking at the capital structure of the bank. If customers genuinely share risks, and understand that they are doing so, that may reduce the amount of capital required.

We also think it is important for Islamic banks themselves to be clear about the type of products they wish to offer. If we were to authorise an Islamic bank we would look carefully at its business plan, just as we do with any other institution. We want to know that it has understood the nature of its market, the profit opportunities open to it in that market, the nature and intensity of the competition, and the types of products it wishes to offer. For example, will the bank offer capital-certain deposit products or not? In some, but not all, Islamic deposits the client’s capital is generally at risk if the bank loses money, even if it doesn’t fail. If that is so, then it is important potential customers understand that they do not benefit from the deposit protection arrangements in quite the same way as depositors in Western style institutions.

Relevant to this point is the question of whether Islamic banks are truly banks, or are essentially more like fund managers, even though they may offer traditional banking services such as money transmission. I know that this question is one which is often discussed in the Islamic financial community. But I have to say that, now that we are a single regulator, we think it is of rather secondary importance. At least, that is, from a regulatory perspective. Since we have one regulator we have one basic set of conditions for authorisation, which needs to be met by any firm transacting financial business, albeit the details will differ in the case of a fund manager, on the one hand, or a bank on the other.

These differences are, I believe, less important than the similarities. What we are really looking for when we authorise a bank is an organisation which abides by sound principles of corporate governance, which has adequate capital for the risks it plans to take on, and which has a capacity for managing those risks which we believe to be robust. In the case of an Islamic institution, we would include in that advice and assessment of legal and documentation risks, though I think it would not be appropriate, or even possible, for us to check compliance with Sharia law, which is perhaps an additional risk factor which needs to be taken in to consideration. That in our view, is a matter for the institution itself.

Before I finish, I wonder if I might say a word about one particular issue which has been of some concern in the Islamic community, the question of Islamic mortgages and how they might be treated. A working party led by the Governor of the Bank of England, and of which one of my staff is a member, has been looking specially in recent months at the barriers to Islamic mortgages. The main problem we see is that they unwittingly attract stamp duty twice: once when a lender buys a property and a second time when its transferred to the mortgagor. That is a matter for the Treasury and the Inland Revenue to resolve. It seems to me to be the crucial issue to get right, and one on which I cannot offer you a certain answer today.

There is another potential difficulty, though one which I believe to be of somewhat less importance than the stamp duty point.

As far as we can see, the current Basel Capital Accord which governs the principle and practice of banking supervision around the globe today, does not appear to give us discretion for anything other than 100% capital treatment for Ijarah mortgages. For those who find this a baffling statement, perhaps it will clarify things if I simply state that this means a bank would have to carry twice as much capital in respect of an Ijarah mortgage as it would for a conventional mortgage, where the weighting is 50%. While that it is not necessarily a complete block on the development of the market, it certainly would make Islamic mortgages a little more expensive than conventional ones. This is something we are looking at very carefully at present, in conjunction with the Bank and the Treasury. It is a particularly difficult issue because the Basel rules are incorporated into European Union law. We are trying to look in a sympathetic way at the possibility of a different treatment under the existing rules, and we have asked Islamic financial institutions for more information which might conceivably allow us to propose a case for different treatment.

Even if that were to prove impossible, there is help on the horizon. On the 1st of next month the Basel committee will publish a new version of its capital accord, for consultation. And that would allow a more flexible treatment of Islamic mortgages if it goes through on current plans, which would probably remove this competitive disadvantage. I have to say, however, that we do not expect it to be finally approved for use until around 2006, which undoubtedly is a problem for institutions wishing to get into this market at present.

So let me end where I began. We see no objection of principle to the establishment of an Islamic bank in the UK. Indeed, we would welcome a soundly financed and prudently managed Islamic financial institution in this country, which would be good for Muslim consumers, good for innovation and diversity in our markets, and good for London as an international financial centre. But we have to treat applications from Islamic institutions in the way we do those from other, conventional firms, to ensure that they can compete effectively, and in the long term, on a level playing field with conventional finance providers.

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