A Consumer Perspective on Islamic Banking

- Master Thesis -

Maastricht University Faculty of Economics and Business Administration Maastricht, 8 July 2009 Hilde Sijbring 217662 Thesis Supervisor: Frank Lutgens

Table of Contents
Abstract 1. 2. Introduction Theoretical Model Literature Review 2.1 Islamic Banking The Basics 2.1.1 Islamic Banking in a Historical Context 2.1.2 Islamic Banking Features 2.1.3 Islamic View on Debt and Equity 2.2 Islamic Commercial Banking 2.1.1 PLS Financing Modes 2.2.2 Non-PLS Financing Modes 2.2.3 Islamic Banking Models 2.3 Islamic Investment Banking 2.4 Risk Management at an Islamic Bank 2.4.1 Islamic Banking Risks 2.4.2 A Consumer Perspective on Islamic Banking Risks 2.4.3 A Shareholder Perspective on Islamic Banking Risks 2.5 Islamic Risk Mitigation Measures 2.6 Regulation & Supervision 2.6.1 Proponents of Adaption Basel II to Islamic Financial Framework 2.6.2 Opponents of Adaption Basel II to Islamic Financial Framework 7 7 8 10 11 12 13 14 18 20 21 24 25 25 27 28 30 3 4

3.

Data, Methodology & Findings 3.1 Islamic Commercial Banks versus Conventional Commercial banks: Where to deposit your money? 3.1.1 Data & Methodology 3.1.2 Findings & Interpretations 32 32 36

3.2 Islamic Indexes versus Conventional Indexes: Where to invest your money? 3.2.1 3.2.2 3.2.3 Introduction Islamic Indexes Data & Methodology Findings & Interpretations 45 45 46 48 55 56 58 62

4. 5.

Limitations & Recommendation Conclusion

References Appendix A: Banking in a Historical Context

Abstract
Nowadays Islamic financial institutions are present in over 75 countries, are managing more than $500 billion in assets and experience a growth rate of 15 up to 20 percent per annum. Therefore, it is time to shed more light on this banking system and to assess the risks and benefits from the viewpoint of a consumer. The main features of Islamic banking are the sharing of profit and losses, a prohibition of interest, no speculation or gambling, fair and transparent dealing, fair and just employment policies, and lastly no business should be done with unethical companies or industries. Research has been undertaken about this subject, however, no research has clearly investigated the benefits and drawbacks of Islamic banking from the consumer perspective. From a depositors point of view this thesis shows that for a risk-averse consumer it is not remunerative to switch from a conventional bank to an Islamic bank. In contrast, a risk-seeking depositor can reap extra return when opening a deposit account at an Islamic bank. Furthermore this thesis found out that a consumer can generate a greater risk-adjusted return when investing in Islamic indexes. These findings suggest that Islamic banking is, above all, interesting for the Muslim consumer who wishes to bank according to the rules of the Shariah and besides, Islamic banking is attractive for the riskseeking depositor or for the investor who wishes to earn greater risk-adjusted returns on his investments.

1. Introduction
At this moment there are over 300 Islamic financial institutions in more than 75 countries managing funds over $500 billion in assets. Furthermore, over the last decade, the Islamic banking industry experienced a growth of 15 to 20 percent per annum (Bose & McGee 2008). These institutions are not only operating in the Muslim countries but as well in other countries where Muslims are a minority, for example, in the United States, Great-Britain, Australia, China and France. Furthermore the Islamic banking products are not solely used by Muslims but as well by people with other religious backgrounds. The compliance with principles that forbid ambiguity, exploitation, deceit and fraud is appealing to many non-Muslims as well (Venardos 2006).

Islamic banking derives its principles from the Shariah, the Islamic law, which is founded on the Quran and the Sunnah of the Prophet Muhammad. According to Tamimi (2005, p. 1) the main principles of Islamic banking are: the prohibition of all sources of unjustified enrichment and the prohibition of dealing in transactions that contain excessive risk or speculation.

Investing in socially responsible funds is a phenomenon which is growing in popularity. Banking clientele want to know what happens with their money, in other words, it is demanded from banks to be transparent about their investment practices. ING undertook a research in 2003 to find out in which funds Dutch people do not want their money to be invested in. This research showed that 72 percent of the sample did not want their money to be invested in funds that are harmful for the environment, 71 percent is against investing in funds that can be related to human rights violation, 62 percent is against investing in funds related to child labor and lastly 35 percent does not want their money to be invested in the weapon industry (ING 2003). This entails that a bank should avoid investing in certain businesses and thus, the ethical and moral behavior of banks is becoming more important and investors are demanding more transparency of a banks activities. Zembla, a Dutch television program, found out in the summer of 2007 that the four Dutch banks (Rabobank, ING, ABN Amro, Fortis) could all be linked to investments in mines, child labor, the weapon industry or funds that are damaging to our climate. On July 1 2009 a new research was undertaken to investigate whether these banks changed their investment practices with respect to

investments related to the weapon industry. ABN Amro and Fortis did change their investment policies and could not be linked anymore to investments in the weapon industry, however, the investments made by ING and the Rabobank can still be associated to this harmful business1. The latter is in sharp contrast with the wishes of the consumers. A new way of meeting this demand is the socially responsible way of investing undertaken by Islamic banks. The ideology of Islamic banking is the sharing of profit and losses, a prohibition of interest, no speculation or gambling, fair and transparent dealing, fair and just employment policies, and lastly no business should be done with unethical companies or industries (Sinke 2007).

A banking system that operates differently than our conventional banking system raises some questions. Three important questions are (1) How do banks function in a system without interest?, (2) Is Islamic banking riskier than conventional banking? and (3) Can a greater return be generated by depositing your money at an Islamic bank or investing in Islamic funds?. This thesis is written from the viewpoint of a consumer of a bank. I investigate whether it is attractive and save for consumers to deposit their money at an Islamic bank and whether it is sensible to invest this money in Islamic funds.

This thesis shows that only for a risk-seeking depositor it could be attractive to open an account at an Islamic bank, since the rates of return that can be earned are in general higher than the rates paid out at a conventional bank. However, regarding the stability of the Islamic bank, as measured by the Capital Adequacy Ratio (CAR), it is doubtful whether an Islamic bank can provide enough stability to guarantee the capital value of the money deposited. On the one hand, all Islamic bank show a CAR higher than the required eight percent, however, on the other hand, the calculation of the CAR ratio leaves room for subjectivity and therefore it is important to recalculate this measure according to conventional standards in order to assess its actual stability. Furthermore, this thesis shows that depositors, who wish to invest part or all of their money in Islamic indexes, can generate higher risk-adjusted returns than when this money was invested in conventional indexes.

This thesis is organised as follows; the literature review analyses the basics of Islamic banking, Islamic commercial- and investment banking, risk management at an Islamic bank

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and the regulatory framework. Next, the following two questions are answered: (2) Is Islamic banking riskier than conventional banking? and (3) Can a greater return be generated by depositing your money at an Islamic bank or investing in Islamic funds? by means of an in-depth analysis of the balance sheets of Islamic banks and by investigating the risk-return relationship of the DJ Islamic indexes. To conclude, a recommendation will be given about whether it is attractive from a risk-return trade-off perspective to invest or deposit your money with an Islamic bank.

This proposed research will contribute to the research already undertaken by adding more clarity to questions about and issues raised around the riskiness of Islamic banking from the viewpoint of a consumer. This study should make it easier to understand what Islamic banking is all about, how it was founded, what products are mostly used and what the related risks for the bank and especially for its consumers are. This thesis will give the consumer an objective inside into the workings of Islamic banking. In practice, consumers could make use of this research to decide whether or not to deposit their money with an Islamic bank or to invest their money in Islamic funds.

2. Theoretical Model - Literature Review

2.1 Islamic Banking The Basics Islamic banking derives its principles from the Shariah, the Islamic law, which is founded on the Quran and the Sunnah of the Prophet Muhammad. According to Venardos (2006, p.28): The word Sunnahrefers to all the acts and sayings of the Prophet as well as everything he approved. The Islam knows no separation between state and religion and there is no separation between business and the Shariah. Therefore, the Shariah lays the foundation for the global economic system. This system fosters concepts of sharing, mutual support, condemnation of greed, restrictions of risk and of reasonable reward (Sinke 2007, p.5). All Muslims should be fair and honest towards each other. Hence, in a profitable, but fair way Muslims should earn their living.

Islamic banking is fully adopted in the Islamic countries of Iran and Sudan. In those countries all financial institutions are operating according to the Shariah. Other countries, such as Pakistan, Malaysia, Jordan, Bangladesh, Indonesia and Egypt, have a dual banking system where Islamic banks function next to conventional banks. This is either done through the creation of separate banks or subsidiaries or through the establishment of Islamic windows at conventional banks. Islamic banking nowadays covers investment banking, commercial banking and insurance institutions, however Chapra & Khan (2000, p. 11) define Islamic banks as: depository institutions whose core business is financial intermediation on the basis of a combination of profit-and-loss and sales-based modes of financing. In this chapter the history behind Islamic banking is explained, the basic features are investigated and the main differences with conventional banking are clarified.

2.1.1 Islamic Banking in a Historical Context One of the main differences between Islamic banking and conventional banking is the ban on interest by the former. Nowadays, paying and receiving interest is taken for granted. One does not know any different than paying back a loan with interest and receiving interest on our savings. Banks are constantly competing to provide the cheapest loans and to give the highest rate of interest on saving accounts. Most people are not aware of the fact that around 3000

years ago charging interest on a loan was forbidden by the Christians, Jews and Muslims (Venardos 2006). In the Torah can be read that usury, or excessive interest, was forbidden amongst the Jews and the same goes for the Christians as is stated in the Old Testament. Even in the Veda, the oldest scriptures of Hinduism, can be found that in Ancient India there existed laws that criticized usury and that prohibited the use of interest rates (Hassan & Lewis 2007). However, throughout history the use of interest was discovered as a very profitable tool in the banking industry and was needed to stimulate economic growth. The Jews started with charging interest in 12th and 13th century and nowadays this is still the foundation of our conventional banking system. As from the 60s, however, Muslims reintroduced the interest-free banking system. Before the 60s the Muslim-owned banks adopted similar principles as their conventional counterparts. Nevertheless, the thoughts of an important group of Muslim contemporary thinkers, the profits generated and jobs created thanks to the discovery of the large oil fields and the resentment of the Muslim population against the West after the decolonization period, stimulated the demand for Shariah compliant banking (Sinke 2007, Venardos 2007). Besides, after September 11 2001, the United States freezed the assets of Muslim investors which resulted in a withdrawal of capital which they put into accounts of local and regional Islamic banks. Migration of Muslims as immigrant labor to the United States and Europe also played a crucial role in the growth of Islamic banking in the Western world. Especially in the United Kingdom where as from 2004 three Islamic banks are operating2 (Verhoef, Azahaf & Bijkerk 2008). For the complete history on conventional banking and Islamic banking see appendix A.

2.1.2 Islamic Banking Features Islamic banking can distinguish itself from conventional banking on six main characteristics:
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All transactions should be free from interest Profits and losses from a transaction are shared between the bank and the consumer All transactions must be backed by an asset or a service Prohibition of ambiguity within transactions (gharar) Prohibition of gambling (maysir) No investments in unethical or unmoral (haram) industries

Islamic Bank of Britain (2004), European Islamic Investment Bank (2006), Bank of London and the Middle East (2007)

1. Interest-free transactions The translation for riba is increase or growth (Tamimi 2005). In the context of Islamic banking riba refers to any increase above the original amount lent and thus can be considered as interest. Among Islamic scholars there exist a difference in opinion on whether usury, which is excessive interest, and ordinary commercial interest are both prohibited or whether solely usury is forbidden. This thesis will follow the general consensus that there is no difference between charging usury and ordinary commercial interest, both is an increase on the original amount and thus is forbidden according to Shariah in all financial transactions (Jaffer 2005). According to the Quran, the rich have a large social responsibility to the poor in society. The rich can provide the weaker with financial support, however this support should not make them even worse off. Thus, exploiting the poor by charging interest on a loan is prohibited. Even when a debtor cannot pay back the principal the Quran (Quran 2:280) states: It is better if you give even the principal as charity. Furthermore money is regarded as a means of exchange. Money is not seen as an asset with an intrinsic value and therefore, no profits can be earned by exchanging money of the same currency. Money can only be generated on an investment when it corresponds to the fair risks taken, hence the profits represent a legitimate compensation (Sinke 2007).

2. Profit and loss sharing (PLS) The second key feature of Islamic banking corresponds to the sharing of profits and losses. An Islamic bank which invest in a project or company is seen as a real partner in business and therefore shares in the profits earned and losses incurred by its borrowers. In other words, the revenue of an Islamic bank is dependent upon the success of their clientele and thus there is no guaranteed return. In contrast to conventional banks who mainly rely on an in advance calculated stream of interest as their revenue source (Sinke 2007).

3. Asset or service backed transactions As stated above, money is not seen as a commodity. It is not possible to make profits by exchanging money of the same currency. The only way to make money is to sell something with intrinsic value. Thus, all transactions in Islamic banking must be backed by an asset or service (Jaffer 2005).

4. Prohibition of Gharar Also forbidden in Islam is gharar, which literally means uncertainty and hence describes a prohibition of ambiguity in transactions. When the terms of a contract are unclear, for example the price or delivery time, the contract is regarded as invalid (Sinke 2007). Therefore, selling anything that is indefinable such as the fish catch of tomorrow or selling anything without actually owning it first (for example shortselling) is not acceptable (Colborn 2005).

5. Prohibition of Maysir Maysir means gambling, in other words, contracts that include risks that are not necessary are regarded as invalid. Commercial risk, in the sense of an equity investment in a Shariah compliant company, is permissible for the reason that in this case the return on an investment is dependent upon the productive efforts made by the employees of the company and cannot be considered as a pure gamble (Sinke 2007). The productive efforts made can be regarded as a service. According to Sinke (2007, p.25): The test is whether something has been gained by chance rather than by productive effort. Often the difference between a commercial risk or gambling is quite unclear, consequently in each case it is needed to decide whether the risks taken are acceptable (Sinke 2007). The ban on maysir is often fuel for criticism on our conventional banking system, specifically on the practises of speculation, insurance and derivatives (Venardos 2006).

6. No investments in haram industries Haram can be translated as unethical or unmoral. According to the Quran it is forbidden to invest in companies that can be related to alcohol, pork, tobacco, pornography or drugs (Sol 2007).

2.1.3 Islamic View on Debt and Equity In a society capital is needed to finance businesses, projects and so on; to stimulate economic growth. Capital can be provided in the form of equity or debt. This section explains the different views of the Islamic bank and the conventional bank related to debt and equity.

As stated in Islamic Banking & Finance by Venardos (2006) Islamic banks treat debt and equity the same as conventional banks, however, for Muslims lending cannot be a profitable 10

activity. Equity investments are, just like in conventional banking, regarded as an investment in a company where you are exposed to all the risks the company is undertaking and where you share in the profits earned. Debt is seen as a contractual obligation to pay back a certain amount of money on a certain date agreed on by both parties. The value of the debt should be the same at the beginning and the end of the period thus, any discount or mark-up is considered as riba and thus is prohibited. Furthermore, partnership, instead of a creditorinvestor relationship, is highly encouraged in Islamic banking. Hence, the borrower and the bank are partners and both share in the risks and returns of the project or company. The latter is in contrast with conventional banking, where all the pressure is on the borrower and he should pay back his loan plus the interest; not considering whether his company is a success or a failure. The principle behind this feature of Islamic banking is to promote risky investments in order to stimulate economic growth and support entrepreneurs to perform at their best. That is to say, investing money is the only way to earn more money because you cannot create more money just by putting it on a bank account. Vernardos (2006, p. 57) defines the latter as follows: Money represents purchasing power whichcannot be used to make more purchasing power (money) without undergoing the intermediate step of it being used for the purchase of goods and services.

2.2 Islamic Commercial Banking A bank can be seen as an intermediary between savers and fund users. This function of a bank is of vital importance because frequently there is a mismatch between a saver and a fund user on maturity, risk- or liquidity preferences. Banks often have more and better information than a small saver to efficiently place the funds. However, their practices come at a cost namely, a certain rate of interest which according to Ayub (2007, p.29): is the cornerstone of the modern financial market. Since Islamic banks cannot charge or receive interest payments, the question arises: How do they structure their products to be profitable? This chapter will try to find an answer to the above stated question.

Islamic banks are just like conventional banks an intermediary between savers and fund users. The striking difference is the ban on interest and thus, Islamic banks use a number of different instruments to replace this. According to Jarhi and Munawar (2001) Islamic banking can be divided into two categories. The first category is related to modes of financing founded on the profit and loss sharing (PLS) principle. The second category contains the modes of financing 11

where a service or good is purchased or hired and the return is fixed, hereby called non-PLS financing. The book which was used to elaborate on these two concepts is Understanding Islamic Finance written by Ayub (2007). Unless stated otherwise, all references can be made to Ayub (2007).

2.2.1 PLS Financing Modes Originally, Islamic banking is based on the concepts which are called mudaraba and musharaka. The mudaraba financing mode existed already in the pre-Islamic Middle East together with interest-based loans to finance economic activities. With the birth of the Islam all the interest-based loans were forbidden and only the PLS financing modes were permissible. This business partnership mode remained small over centuries, only with the creation of Islamic banks it developed into a technique for large investments with money put in from a large group of savers (Hassan & Lewis 2007). Both the mudaraba and musharaka concepts are related to the risk sharing feature of Islamic banking; below both concepts are explained. Mudaraba can be translated as profit-sharing. In a mudaraba contract the bank finances a project in total and another party is responsible for the execution of the project, thus the other party brings in the expertise, labour and management for the project aiming at making profit. The bank shares in the profits generated from the project, however when the project incurs losses these are in total borne by the bank unless the losses are due to carelessness or misconduct of the other party. Hence, the rate of return is not known in advance. o Steps in a mudaraba transaction: 1. The bank and the entrepreneur reach an agreement about the project and profit sharing terms. 2. The bank gives the money to the entrepreneur. 3. The entrepreneur invests the money in the project as the two parties have agreed upon. 4. The entrepreneur and the bank share the profit from the project.

Musharaka is similar to a joint-venture contract in which two or more parties, a bank and (an)other party(ies), pool their resources and together manage a project. Thus, the difference with a mudaraba contract is that all parties involved in the contract put in 12

capital. Profits will be shared according to a predefined ratio and losses will be shared in proportion to the capital provided by each party. All partners have the right to participate in the management of the project. o Steps in a musharaka transaction: 1. The bank and the entrepreneur reach an agreement about the project, the money invested by both parties and the ratio of profit sharing. 2. The bank gives the money to the entrepreneur. 3. The entrepreneur invests the money in the project as the two parties have agreed upon. Both parties have influence on the managerial decisions that have to be made. 4. The entrepreneur and the bank share the profit from the project according to the predefined ratio.

2.2.2 Non-PLS Financing Modes Besides these two contracts, Islamic banking also works with other contracts that are not specifically based on the sharing of profits and losses. These contracts are called murabaha and ijara below these concepts will be clarified. Murabaha is the most popular Islamic financing concept. Murabaha financing is when a bank buys a good or asset for a client and resells this good to the client for the original price plus a profit margin. The clients promise to buy the good is ethically binding and thus the client needs to compensate the bank when he or she decides to refuse the purchase. o Steps in a murabaha transaction: 1. The client puts across the wish to buy an asset based on a murabaha transaction 2. The client signs a document stating the promise to buy the asset. 3. The banks buys the asset for the client 4. The client pays instalments to the bank and eventually purchases the asset. The price the client pays is the purchase price plus a profit margin for the bank.

Ijara financing is when a bank buys a good and leases this to its customer for a predetermined period at a set rental charge. The rental charge is permitted in Islamic 13

banking because it is a charge on an asset. However, the bank must retain ownership until the predetermined period has passed and thus, bears the risks which come along with owning the asset. o Steps in a ijara transaction: 1. The client expresses the need for a lease and the bank and the client agree upon the terms and conditions for this lease. 2. The bank buys the asset for the consumer 3. The consumer leases the asset and pays fixed rental fees each month to the bank 4. The client buys the asset at the end of the leasing period from the bank.

These last two contracts show close resemblance to the products offered at conventional banks. An ijara transaction, for example, can be compared to a sale and leaseback transaction in conventional financing. By a sale and leaseback transaction the lease company buys the asset of the lessee and the latter party leases it again from the lease company. The structure is the same as with ijara, only with sale and leaseback the lessee needs to be the 100 percent owner of the asset already. The transaction in conventional financing therefore mainly serves the goal of increasing liquidity3. Chong and Liu (2007, p. 9) argue: Many Islamic scholarshave warned that, although permissible, such non-profit and loss sharing modes of financing should be restricted or avoided to prevent them from being misused as a back door for interest-based financing. However, the list of the non-PLS modes is not in the slightest exhaustive. The only two constraints for an Islamic financing mode is that it may not contain interest and that the contract is clear so both parties are fully aware and informed (Khan & Mirakhor 1994).

2.2.3 Islamic Banking Models From a depositors viewpoint both a guarantee of the capital value of the deposit and growth of savings are very important. The real value of a deposit depletes over time due to inflation, so a bank needs to reward its depositors by at least offering a rate of return equal to the inflationary rate. Islamic banking can give a depositor only two choices, either security of

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capital but no growth of savings or savings growth but also running the risk of losing all or part of the capital deposited (Khan 2003). This section will explain the Islamic commercial banking models and will elaborate on the choices made available for depositors.

In Islamic banking one can distinguish three kinds of depositors, namely risk averse demand depositors and the risk seeking restricted investment depositors and unrestricted investment depositors. Demand deposits are only placed in a bank for safekeeping purposes. The capital value of a demand deposit is guaranteed by the bank, however no returns are paid on the amount outstanding. A demand deposit can be compared to a conventional current account or savings account, though on the latter a fixed and guaranteed return is paid by the bank (Chapra & Khan 2000, Sundararajan & Errico 2002). Investment deposits are used by the bank to invest in risk-bearing companies and projects. There is no guarantee in capital value for the investment depositor and furthermore the depositor does not earn a fixed rate of return. Besides, if the bank incurs any losses resulting from bad investment decisions the investment depositor can lose part or all of the deposit because the profits and losses are shared between the bank and the depositor based on a predetermined ratio. Restricted investment depositors have some influence on the banks investment strategy, whereas unrestricted investment depositors have given full authorization to the bank to manage their funds. An investment deposit account can be compared to a mutual fund account at a conventional bank. The latter also invests money in all sorts of companies and projects with the aim to generate a higher return than received on a current or savings account. Besides, the returns generated are as well passed on to the participants of the fund. This return is dependent upon the performance of the companies and projects invested in and thus it can be volatile. Therefore, the mutual fund investor is, just as the Islamic investment depositor, not sure of the rate of return earned on the deposit made. Furthermore, both types of investors can reap the benefits from professional management of their money, being the Islamic bank or a professional fund manager (Bodie, Kane & Marcus 2007). Nonetheless, there are also some vital differences, namely that a conventional bank sells the mutual fund accounts to the market, whereas an Islamic bank accepts investment deposits from the public. Second, a conventional investor owns a share of the fund invested in and thus has the right to receive information on a regular basis. The only right of an Islamic investment depositor is the right to share in profits earned and losses incurred by the bank (Chapra & Khan 2000, Sundararajan & Errico 2002). Lastly, the unrestricted investment depositor has no influence on the investment strategy of the bank and

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therefore cannot monitor or control the management of the company invested in (Nienhaus 2007). To summarize, an Islamic bank actually needs to fulfil two types of consumer demands. On the one side, the demand depositors want the bank to safeguard their deposits, and on the other side, the investment depositor demands from the bank a high return generated by making sound investment choices. Thus, an Islamic bank, actually just as conventional banks, offers consumer two distinct types of services, namely deposit safekeeping- and investment services.

As from the 1980s two different Islamic banking models have been established. The norm is the Two-Tier Mudaraba model where the asset and liabilities side of the balance sheet of the bank are fully integrated. The liabilities side is represented by depositors who go into an unrestricted mudaraba contract, which entails that the money deposited can be fully used by the bank. On the asset side the bank enters into a restricted mudaraba contract with an entrepreneur who is willing to share the profits with the bank and who is in need for funds. Besides investment deposits, a bank operating according to the two-tier mudaraba model may also accept demand deposits in exchange for a service fee for the safekeeping. Both types of depositors are fully aware that the bank can use their money for investments. An investment depositor cannot withdraw the money deposited at any time, only at maturity. However, often an Islamic bank has no objection with early withdrawal. The latter makes investment depositors like shareholders, only with a temporary time span. Thus, even when both depositors should be able to take out their money from their accounts, according to this model an Islamic bank does not need to keep any capital reserves on either kind of deposits (Khan & Mirakhor 1994, Sundararajan & Errico 2002). The second model is the Two-Windows model which is based on a separation of the investment and demand deposits. There is a window for demand deposits and one for investment deposits on the liabilities side of the balance sheet, and it is up to the preference of the depositor where the money is put in. Money deposited in demand accounts cannot be used by the bank for investment purposes, and thus the bank needs a 100 percent reserve against these deposits for the reason that these deposits can be withdrawn at par at any time. Investment depositors must be aware that their deposits are used by the bank for risk-bearing investments and thus their principal capital amount cannot be guaranteed (Khan & Mirakhor 1994, Sundararajan & Errico 2002).

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As stated in the previous section, 2.1.3, investing money is the only way to create more money because you cannot generate money just by putting it on a bank account. This illustrates why the Two-Tier Mudaraba model is the norm in Islamic banking. In the Islamic world money needs to be used to invest in trade and productivity in order to stimulate economic growth. Demand deposits as in a Two-Windows model are not encouraged.

In a conventional banking system the deposits are guaranteed. In the Netherlands all banks are covered by the Deposit Guarantee Scheme. This means that up to an amount of 100,000 euro your money deposited is guaranteed at any time (DNB 2008). Furthermore on all accounts a fixed and guaranteed rate of return is paid by the bank. The money deposited can be used by the bank for investment purposes, however, as is the case in Islamic banking, a depositor does not share in the profits earned and losses incurred of the bank. The total return to a depositor is the fixed rate of return and thus is independent of the banks performance or their profits from investments. Below, in table 1, a comparison, based on the features discussed above, of the Islamic banking system with the conventional banking system can be found.
Table 1. Characteristics Islamic banking and conventional banking Characteristic Islamic banking Islamic banking - Two-Tier - Two-Windows Mudaraba 1. Deposit guarantee - Demand deposits - Investment deposits

Conventional banking

No No

Yes No

Yes Yes

2. Rate of return on deposits - Demand deposits - Investment deposits

Demand deposits do not earn a return. Return investment deposits uncertain due to PLS principle, the final return is based on the performance of the bank

Fixed and guaranteed. Independent of the performance of the bank

3. PLS principle applies

Yes

No

Chong and Liu (2007) state in their article Islamic Banking: Interest-Free or Interest-Based where they investigated Islamic banking in Malaysia, that in practice around 70 percent of the deposits is based on the PLS mode mudaraba. These mudaraba deposit accounts should in theory be interest-free accounts since their return is based on the performance of the bank, however Chong & Liu (2007) doubt this fact. They investigated whether there is a relation between rates of return offered by conventional banks and investment rates paid out by

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Islamic banks. They found out that (1) modifications in deposit rates of conventional banks cause modifications in investment rates of Islamic banks, however not vice-versa and (2) in the long-term both rates are positively correlated. These results indicate that Islamic investment rates are closely related to conventional deposit rates. Since conventional deposit rates are closely tied to the interbank offered rates, LIBOR or EURIBOR, Islamic rates of return also use these rates as their benchmark to estimate a competitive rate of return on their investment deposits. Furthermore, they find that Islamic investment depositors do not fully share in the losses incurred by a bank. On June 30 2005, depositors of the Bank Islam Malaysia Berhad kept on receiving a positive investment return, closely tied to the market return, while their bank incurred a loss of $127 million dollars. So in theory the Islamic investment deposit rates should be linked to the profits and losses made by the bank, however, in practice these rates appear to be linked to conventional market deposit rates (Chong & Liu 2007). This illustrates that, even though, Islamic banking appears to be totally different from conventional banking, as a consumer you apparently do not need to notice very large differences in return.

2.3 Islamic Investment Banking Islamic scholars expressed the need for a stock market in the Islamic financial system; a primary and secondary market where capital instruments, like corporate stock, can be traded and as a second means, next to banks, to get access to funding (Khan & Mirakhor 1994). Investments in debt-related products, such as bonds or bank deposits, were not acceptable under Shariah law, based on the fact that these are interest-based securities and thus, the returns generated on these securities are predetermined and cannot be linked to any underlying performance (Colborn 2005). However, nowadays the issuance of sukuk, or in other words, Islamic bonds, is accepted in most Muslim regions. Sukuk (plural) are comparable to Eurobonds, however the difference is that sukuk represents ownership of a part of the underlying asset while a bond corresponds to pure debt of the issuer (Cakir & Raei 2007). There are some limitations to selling sukuk since in essence the deal should be Shariah compliant. So the sale should be asset-backed and no interest payments can be involved in the structure. Sukuk are based on an underlying contract, most often a musharaka or ijara contract. The rates of return on a sukuk contract can therefore be either variable (PLS mode musharaka) or fixed (non-PLS mode ijara), depending upon the underlying contract. Below figure 1 illustrates the structure of a sukuk al ijara. 18

Figure 1. Illustration of a sukuk al ijara

(Source: Islamic Finance Outlook 2008, Standard & Poors )

As one can see above, the transaction involves the creation of a Special Purpose Entity (SPE) issuing the sukuk al ijara. The sukuk holders become co-owners of the underlying assets and receive a fixed periodic payment based on the rental charges of the underlying asset. The proceeds of the sukuk are used by the bank to fund a specific or general purpose. At maturity the bank purchases back the co-owned assets at an amount equal to the principal of the sukuk. Equity-like investments are as well tolerable and even encouraged to undertake. As stated in the previous part, owning a share in a company is considered permissible because the returns earned on this investment can be traced back to effort put in by the underlying company and therefore, these returns can be linked to risks incurred. In general, every financial instrument with a variable rate of return which is linked to the performance of a real asset, is tolerated (Khan & Mirakhor 1994). However, Muslim investors can not invest in every company that grasps their interest. First of all, the line of business cannot include tobacco, alcoholic beverages, pork, gambling, arms, pornography, hotel and leisure industry, and conventional financial services (banking, insurance and so on) (El-Din & Hassan 2007, p.252). Second, the debt to assets ratio of the companies should be equal or smaller than 33 percent. Third, the accounts receivable by assets ratio should be equal or smaller than 45 percent. Finally, non-operating interest income should be equal or smaller than five percent. Besides, if the Muslim investor decides to buy stock he should estimate the percentage of his return that can be traced back to interest or other forbidden activities, and offer this money to charity. The latter procedure makes sure that the returns earned remain

19

pure (Colborn, 2005). In other words, Islamic investment banking can be regarded as a special case of ethical investing.

2.4 Risk Management at an Islamic Bank Islamic banks are subject to the same risks faced by conventional banks, but are also exposed to risks especially inherent to the Islamic financing modes. This section will elaborate on the main risks Islamic banks, their consumers and their shareholders are dealing with and how these risks differ from conventional banking.

The balance sheet of an Islamic bank looks different as that from a conventional bank. Figure 2 summarizes the key features on the asset and liability side of an Islamic bank. On the liability side one can find the deposits, the reserves and the capital of the shareholders, whereas the asset side represents the assets invested; either PLS based (mudaraba or musharaka), non-PLS based (e.g. murabaha or ijara) or non-banking assets (Muljawan, Dar & Hall 2004).
Figure 2. Balance sheet of an Islamic bank Assets PLS based assets (Investment assets) Non-PLS based assets (Financing assets) Non-banking assets (Property) Liabilities Shareholders equity Reserves Demand Deposits Unrestricted Investment Deposits Restricted Investment Deposits

The asset and liability sides are unique for an Islamic bank and therefore, Islamic banks have a different risk profile as conventional banks. This version of the balance sheet actually comes close to a real situation since the capital construction of an Islamic bank is quite simple. There are no complicated financial instruments present such as with a balance sheet of a conventional bank. For illustrative purposes let us assume we are dealing with a risk-averse depositor and this depositor would like to deposit 1000. In this case, a demand deposit account should suit the risk preferences. For such an account the bank needs to guarantee withdrawal at any time, the bank needs a 100 percent reserve requirement against the deposit, does not need to pay out a return on the money deposited, but does collect a fee for the

20

safekeeping services. If the depositor is more risk-seeking the money can be put on an investment account, either restricted or unrestricted. This money is used to finance PLS-based and non-PLS based assets. Since the bank does not need to guarantee the capital value of these deposits, a greater risk is run of losing the deposited money compared to a demand deposit account. As a compensation for this risk the bank shares part of the profit made on the investments between the shareholders and investment account holders based upon the proportion of each invested in the projects. However, before the money is shared, the bank holds back some money as a rainy day reserve to ensure that the money flows to investment deposit holders stay relatively constant. Besides a statutory reserve and a general reserve, a bank also holds other reserves. The first reserve is called the Profit Equalization Reserve (PER) which is created before the allocation of the profit to the shareholders and the investment account holders. The other reserve, the Investment Risk Reserve (IRR), is only taken out of the share meant for the investment account holders. Through these reserves the bank is able to smoothen the rate of return which needs to be paid out. The latter is done because of the fact that a potential depositor is more attracted to a stable rate of return instead of a very volatile rate of return (Archer & Karim 2005). Next the main risks an Islamic bank is facing due to its distinct profile are discussed.

2.4.1 Islamic Banking Risks

Credit Risk

Credit risk is the risk that a counterparty defaults on his obligations or that there is a change in the credit quality of the counterparty (Crouhy & Galai 2006). Credit risk occurs in all financial modes of Islamic banking. In the case of PLS financing, risks of non-payment of the banks share by the entrepreneur can occur. In a situation of asymmetric information the banks are not aware of the actual profit made by the entrepreneur and thus the entrepreneur can have the incentive to lower the pay-out to the bank (Ahmed & Khan 2007). In non-PLS financing the counterparty can default on paying his debt obligations in time and in full. If the cause of defaulting is because of strained circumstances then debt restructuring or even a cutback, if necessary, is allowed. However, if the delay is due to wilful default then debt restructuring is not legitimate. In the latter case there is no consensus in the Islamic financial world about what should be done with the defaulter. The conservative view is imprisonment of the defaulter or blacklisting, thus no financial compensation for the banks losses. The more liberal view is in favour of giving a financial penalty to the defaulter however, only when the 21

case is judged by a court (Chapra & Khan 2000). If the judge rules against a financial penalty and when imprisonment or blacklisting is out of the question, the risk arises that defaulting becomes a widespread trend. The lack of clear guidelines what to do with a defaulting party and the differences amongst countries, makes credit risk an important risk for a bank. Geographical or sector-specific concentration can also be risky in a credit portfolio since geographical regions or specific sectors are often influenced by the same macro economic variables. The default of one party can negatively affect the performance of other neighbouring counterparties. Since most Islamic banks are small in comparison to the large conventional banks, their diversification potential is also smaller and thus the credit risk is higher (HM Treasury 2008).

Operational Risk

Operational risk is defined as potential losses resulting from inadequate systems, management failure, faulty controls, fraud , and human error. (Crouhy & Galai 2006, p. 30). Operational risk in Islamic banking particularly arises because of the newness of the Islamic financing modes. Employing enough qualified personnel can be a problem and furthermore, conventional computer systems may not be suitable for Islamic banks. Consequently, designing Islamic banking compatible computer software might be problematic and this leads to system risks (Ahmed & Khan 2007). Besides, theoretically there are numerous Islamic modes of financing by combining PLS and non-PLS modes. Since standardization of Islamic financing means is hard to achieve, operational risks may arise here as well (Sundararajan & Errico 2002).

Market Risk

Market risk is the risk that changes in financial market prices and rates will reduce the dollar value of a security or a portfolio. (Crouhy & Galai 2006, p. 27). You can either have systematic market risk, which means that the risks are caused by macro-economic sources, or unsystematic market risk, which is instrument or asset specific market risk. Below two important market risks for an Islamic bank, one systematic and one unsystematic market risk, are discussed.

o Mark-up Risk In both PLS and non-PLS financing modes the mark-up is based on a benchmark rate; most often the LIBOR. The mark-up consist of the benchmark rate plus a risk premium. In a 22

murabaha or ijara contract the mark-up is set at the beginning of the contract and is fixed until maturity. Consequently, a change in the LIBOR rate cannot be incorporated in the markup rate and thus an Islamic bank is subject to risks stemming from changes in market interest rates.

o Commodity/Asset Price Risk Commodity or asset price risk arises when a bank buys a commodity or asset on behalf of the customer and during the holding period of the bank the commodity or asset price can change (Ahmed & Khan 2007). Ijara financing gives rise to asset price risk as the leased asset must be put on the balance sheet for the whole period of the lease, therefore asset price risks attached to the ownership cannot be transferred to the lessee (Sundararajan & Errico 2002). Theoretically the non-PLS mode murabaha should also give rise to asset price risk, since the bank buys an asset on behalf of a consumer and only after full repayment plus a mark-up the ownership of the asset is transferred to the consumer. However, as Dr. M. Saleem (2007) argues in Islamic Banking: A $300 Billion Deception, the period of a bank holding an asset is no more than a few seconds; banks are only willing to buy an asset when they have an agreement in writing stating that the consumer will and is able to purchase the asset. Therefore, asset price risk is greatest for the bank when the ijara financing mode is used.

Liquidity Risk

According to Sundararajan & Errico (2002, p. 11): Liquidity is assessed according to the volatility of the deposits, , availability of assets readily convertible into cash, access to interbank markets or other sources of cash, including lender-of-last-resort facilities at the central bank. Liquidity risk can either be funding liquidity risk or asset liquidity risk. The latter arises when there is no demand for banking transactions at the current market price. Since Islamic banks are not obliged to hedge open positions and need to hold on to their assets until maturity, they are less sensible to this risk (Crouhy & Galai 2006). However, funding liquidity risk is a risk which unquestionably should be taken into account since there is, in most countries, no inter-Islamic money market. Banks, nonetheless, can help each other out based on a mudaraba contract. A bank with excess cash can invest this in a bank which is in need for money on a mudaraba basis. The bank with the deficit uses this money as any other deposit or investment and the bank with the surplus funds receives part of the profit based on a predefined ratio (Ayub 2007). Furthermore, Islamic banks cannot make use of the

23

lender of last resort because the existing institutions only provide interest-based services (Ahmed & Khan 2007). Thus, it is difficult for an Islamic bank to quickly get access to cash to safeguard its liquidity position. The latter is a peculiar situation, since Islamic banks rely on their shareholders equity and their deposit accounts, of which the latter can be withdrawn any moment (Chapra & Khan 2000). If accepted by the bank, the issuance of sukuk can therefore be another means to get access to a great liquidity pool and thus to stabilize the liquidity position of an Islamic bank (Cakir & Raei 2007). Related to liquidity risk is the risk of a run on the bank, namely withdrawal risk. Uncertainty about the capital value of a depositors account is created because Islamic banks cannot offer depositors a predetermined rate of return. If the rate of return of the Islamic bank is lower than the rate offered by competitors, Islamic banks face a withdrawal risk (Ahmed & Khan 2007). Besides a loss of depositors, this could also have an negative effect on the banks reputation (Sundararajan & Errico 2002).

Fiduciary Risk

Fiduciary risk is the risk that a bank is held subject for negligence or misconduct and thereby violates the contract with the deposit account holders. This can lead to a loss of confidence and thus withdrawal of deposits (Chapra & Khan 2000).

All the risks described above have an influence on the performance and stability of the Islamic bank and therefore are important for the consumers and for the shareholders as well. However, there are some risks that are especially important from the perspective of the above two mentioned parties.

2.4.2 A Consumer Perspective on Islamic Banking Risks A risk which is related to the Two-Tier Mudaraba banking model is moral hazard and undue risk-taking behaviour of the management of the bank. Banks are able to invest the deposits of the investment accounts by their own good judgement, just as a professional fund manager of a mutual fund account. The direct credit risk is transferred to the investment depositors, who are exposed to the same risks as the shareholders but who do not have the same rights. Thus, in this banking model there exist an incentive for the bank to take on excessive risks and moral hazard is increased (Sundararajan & Errico 2002).

24

Furthermore, Islamic financial product are not standardized per region or even per country. One Islamic financial product can have different features at different banks, thus it is of utmost importance that banks are transparent about their business practices. The risk for the consumer lies in the understanding of the financial products that they take on from the bank, since a lack of financial understanding can lead to severe financial troubles in the future. This consumer risk should not be underestimated and should be dealt with by the bank through standardization of the Shariah rulings.

2.4.3 A Shareholder Perspective on Islamic Banking Risks One risk especially important for shareholders is displaced commercial risk. This risk can be defined as: the transfer of the risk associated with deposits to equity holders (Ahmed & Khan 2007, p. 146). In other words, an Islamic bank may forgo part of their profit, meant for the shareholders, to pay-out a competitive rate of return to satisfy its investment depositors. Even if an Islamic bank is operating in full compliance with the Shariah, it may not be able to pay a competitive rate of return to its investment depositors and thus, in order to prevent withdrawal caused by a lower return and thus to safeguard its liquidity position, it uses part of the money of the shareholders (Ahmed & Khan 2007).

2.5 Islamic Risk Mitigation Measures Another risk factor, which is not discussed above, is the prohibition of the usage of conventional risk mitigating measures under Islamic law. Because of the prohibition on interest and excessive risk-taking behaviour, Islamic banks are constrained in mitigating the risks incurred (Ahmed & Khan 2007). Conventional hedging instruments, such as swaps, options, forwards and futures, are not developed yet in a Shariah compliant way (Sundararajan & Errico 2002). This section will elaborate on the fact why these conventional hedging instruments are not tolerated and which risk mitigation measures are used in the Islamic financial world.

Options, forwards and futures are prohibited in Islamic banking because the receipt and the payment of the asset are delayed to a future date. This entails that there is uncertainty in the transaction about the real future price and this is in the Islamic financial world regarded as gharar and is forbidden. Next to the presence of gharar, there are also elements of riba within 25

these transactions which is also prohibited. Research is being undertaken how to eliminate gharar and riba within these financial contracts, however, until now there is no resolution found (Ahmed & Khan 2007).

In contrast, swaps, are allowed to some extent. An example of a swap that is allowed is the debt-asset swap which is used to mitigate liquidity risk. Assume there a two banks and a supplier, bank A, bank B and supplier C. Bank A owes 2 million of debt to bank B due in two years, and furthermore bank B is in need for liquidity to buy assets worth 2 million from supplier C. The assets are purchased on a deferred basis of 2 years and therefore, bank A can now pay the instalments to supplier C on behalf of bank B. The supplier now has two choices, he either charges a mark-up of, for example, five percent to bank B and thus receives 2 million from bank A and 0,1 million of bank B, or he supplies assets worth 1,9 million to bank B. Thus, bank B now receives 1,9 million instead of 2 million in two years and thus the debt-asset swap is a means to mitigate liquidity risk (Ahmed & Khan 2007). Parallel contracts are a way of mitigating asset price risk. Suppose a bank buys assets worth 500 based on a three-month murabaha contract, meaning the bank buys the assets now with the intentional to sell them again after three months. Thus, the bank needs to put these assets on the balance sheet for the upcoming three months and hence, these assets are subject to inflation risk or other price risk. To be protected against this risk the bank can simultaneously purchase assets worth 500 based on a salam contract for three months, meaning the bank pays 500 upfront to the supplier and receives the assets worth 500 after three months. If inflation wiped out a certain percentage of the value of the assets based on murabaha, the assets under the salam contract became more valuable and thus the bank is fully protected against this price risk (Ahmed & Khan 2007).

Besides the above described allowed methods of risk mitigation, a bank can also use other means to minimize risks. The first is the use of cash, commodities or tangible assets as collateral. In the non-PLS modes of financing collateral is often used as a means to reduce credit risk (Ahmed & Khan 2007). Within PLS modes, however, a bank cannot make use of collateral to be better protected against credit risk. A solid contract signed by both parties should reduce the risk sufficiently (Sundararajan & Errico 2002). Second, sufficient loan-loss reserves can also reduce risk. Islamic banks, just as conventional banks, need to identify their expected losses and maintain an adequate amount of capital as a reserve to cover these losses (Ahmed & Khan 2007). The reserve held by all banks is the statutory reserve, most often 26

equal to 10 percent of net profit. The latter reserve should protect a banks against negative shocks and is an effective means for a bank to be protected against risks (Archer & Karim 2005).

The theory of portfolio diversification, written by Harry Markowitz in 1952, can be useful to Islamic banks as well since portfolio selection is a Shariah-compliant way of minimizing risk. Diversification through actively selecting assets based on the contribution these make to the overall mean and variance of the portfolio is accepted, so one should not look solely to the variance of the asset but merely to the correlation of the asset with the other assets in the portfolio (Crouhy & Galai 2006). Lastly, there is also a cultural issue that automatically adds to risk minimization of credit risk. As stated above, when a client defaults on the outstanding loan purposefully, he faces either imprisonment or a court visit. Either way, he is openly punished for his sin and he could be excommunicated from society. So, the pressure from and disapproval of the social order is also an effective mode of risk mitigation.

2.6 Regulation & Supervision The job of a regulator is to monitor a banks activities and their risk management practices and enforce rules regarding a capital adequacy framework. There are two reasons why the job of a regulator is of vital importance. First, it is in the interest of national governments that a bank remains healthy. National governments most often are the guarantor for commercial banks and sometimes they act as the lender of last resort as well. Effective risk management and sufficient reserve capital is needed to minimize the costs for the governments in the case of a bank failure. Second, one failure of a bank can lead to another bank failure. In other words, a domino effect can be triggered by just one failure or run on a bank; mainly because of fear among the depositors and investors. This domino effect can affect the whole financial system and can disrupt the economy (Crouhy, Galai & Mark 2006).

The Basel Committee on Banking Supervision (Basel Committee) is the international banking regulator and introduced the Basel II capital adequacy framework. The aim of Basel II is according to Crouhy et al. (2006, p. 70): ..to ensure the adequate capitalization of banks and to encourage best-practise risk management in order to strengthen the overall stability of the

27

banking system. The framework is based upon three pillars, namely minimum capital requirements, supervisory review and market discipline. The first pillar explains to banks how to calculate the minimum capital requirements, which, in short, is eight percent times the sum of the risk weighted assets of the bank. The second pillar concerns the fact that banks need to have a strict supervisory approach to make sure that banks act in a prudent way, calculate their risks accurately and that a bank has sufficient capital to cover the risks. The third pillar intends to increase market transparency. Stricter disclosure standards have been introduced in order to make it easier for investors and depositors to estimate the banks capital adequacy (Crouhy et al. 2006). Despite the fact that Basel II is the international regulator, the question arises: Does the framework need to be adapted to account for the risks of Islamic banking? This section will elaborate on Islamic banking regulation and supervision and reflects both the views of the proponents and the views of the opponents for adaptation of Basel II to Islamic banks.

2.6.1 Proponents of Adaption Basel II to Islamic Financial Framework According to the proponents of adaptation the main differences between Islamic banking and conventional banking are, first of all, that the PLS financing modes are more risky than conventional financing modes. Second, the disclosure of information to depositors is also more important at an Islamic bank than at a conventional bank, because of the PLS principle and the unprotected investment depositors. Since the return on the investment accounts depends on the performance of the bank, investment deposit holders have a great incentive to monitor a banks investment strategy. Thus, a reduction of information asymmetry is needed which can be reached by full disclosure of a banks investment policy objectives and key data about the investments. The latter gives more freedom to the investment depositor to choose at which bank to open an investment account. Another point of difference is that Islamic banks are better able to survive external shocks since the financing losses of a bank are partially worn by its depositors as well (Sundararajan & Errico 2002). Even though, opponents might argue that adaption to Basel II is not necessary since competition and other external pressures push Islamic rates of return closer to the return on conventional financial instrument and thus, Islamic banking can be deemed similar to conventional banking, proponents go against this view by stating that Islamic finance is still very distinct from conventional finance and thus it needs an adapted version of Basel II.

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So, just as conventional banks, Islamic banks are also subject to regulation and supervisory rules. It is imperative that these institutions remain stable and healthy and that banks can be trusted by depositors. Because of the differences between Islamic banks and conventional banks, the former should, according to the proponents, be subject to a special set of rules and regulations. Therefore, in 2002, a specialised institution is established, namely the Islamic Financial Services Board (IFSB). The IFSB is an autonomous organization which sets standards regarding rules and regulations for Islamic banks to ensure the soundness and stability of Islamic banks (Chapra & Khan 2000). Up till now the work done by the IFSB is complementary to the work of the Basel Committee. The IFSB has 178 members, besides market players, the following institutions are affiliates: the International Monetary Fund (IMF), the World Bank, the Bank for International Settlements (BIS), the Asian Development Bank and the Islamic Development Bank4. Besides the IFSB, there is also the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI). The AAOIFI is an independent, international organization and is established in 1990. Both organizations are trying to adapt the universal concepts of prudent banking and accounting to the Islamic reality. This Islamic reality, however, also causes one major constraint, namely that the Islamic banking procedures are not similar across countries. What might be accepted as Shariah compliant in one country, might be rejected in another country (Chapra & Khan 2000). To be able to comply with Shariah principles on a banking level, Islamic banks need to install a Shariah board. This board is made up from scholars who are educated in the field of Islamic law, finance, economics and banking. All business activities and investments that are undertaken by the bank have to be accepted in advance by the Shariah board. This religious board needs to make sure that the operating procedures of the Islamic banks are in line with Islamic law. Consequently, this board makes sure that the company values truthfulness, brotherhood, honesty, trust, science and knowledge, sincerity, and justice and that these values form the foundation for the bank its practises (Venardos 2006).

Thus, to conclude this section, on a institutional level the Islamic financial services industry distinguishes the IFSB and the AAOIFI, and on a company level the Shariah board should ensure that the principles of the Quran are reflected in the modes of financing of Islamic banks.

www.ifsb.org

29

2.6.2 Opponents of Adaption Basel II to Islamic Financial Framework Chong and Liu (2007) argue that in theory the PLS feature of Islamic banking is very different from conventional banking and therefore they agree with the theoretical differences stated in the above section. However, according to their study undertaken in Malaysia, in practice, Islamic banking has the tendency to deviate from the profit and loss sharing feature. They find that on the asset side of the balance sheet of an Islamic bank only 0,5 percent of the assets is financed based on profit and loss sharing; the balance sheet consists primarily out of non-PLS based financial instruments and thus the financing looks not very different than from conventional banking. As stated above, they did find that the majority of deposits is based on the PLS principle. However, these depositors do not truly share in the profits and losses of the bank but rather receive a competitive rate of return. Thus, Chong and Liu (2007) state that there should be no difference in regulation and supervision between Islamic and conventional banks. To illustrate, table 2 shows the financing of the Malaysian Central bank in January 2008 and January 2009. It confirms that in Malaysia nowadays still the majority of the investments is financed by means of non-PLS financing modes.
Table 2. Financing by Concept
Financing by concept (RM million) January 2008 Mudaraba Musharaka Murabaha Ijarah 109 329 19003 35177 January 2009 325 855 35085 54835

(Source: Bank Negara Malaysia Central Bank of Malaysia, 2009)

The perspective of Chong and Liu (2007) is shared by the financial services and markets regulator of the UK, the Financial Services Authority (FSA). The FSA does not treat Islamic banks differently than conventional banks and thus does not apply the IFSB guidelines, but applies the same strict guidelines as imposed on conventional banks (N. Schoon 2008, HM Treasury 2008). One consequence of this decision is that the PLS financing modes musharaka and mudaraba are strongly penalised since holding equity positions in businesses to which the bank also lends money is considered as high risk. Depending on whether the equity holding is related to public or private equity, the risk weight is 300 or 400 percent. The latter makes the cost of capital significantly higher and thus the use of PLS financing modes more

30

expensive, which discourages the use of the truly Islamic modes. Even though the UK regulatory system is discouraging the use of Islamic financing modes, there are no future plans to change the rules applicable to Islamic banking (N. Schoon 2008). Even in the Shariah compliant country Saudi Arabia, there is no difference in the regulation between conventional and Islamic banks; no distinction is made between the different financial systems (Ariss & Sarieddine 2007).

Saleem (2005) shares the same opinion as elaborated upon above. He even claims in his book that the Quran only prohibits the charging of usury and not the charging of normal interest and furthermore, he states that the mark-up rate in non-PLS financing modes can actually be regarded as interest, only covered in Islamic terminology. Besides, as stated above, Saleem also reveals that banks only finance around 5 percent of total assets by means of the PLS financing modes musharaka or mudaraba. Meaning that over 90 percent of the banks assets are financed by non-PLS modes and are secured and backed-up with collateral and thus, there is no risk-sharing between the bank and the customer. Furthermore, as stated above, the period of a bank holding an asset is no more than a few seconds and thus the bank runs no operational risk and no risks that are related to the asset. With regards to the non-PLS financing mode ijara, the bank actually requires that the leased asset should be insured with the insurance costs paid by the customer. Thus, in practice, Islamic banks are actively trying to reduce all the risks when, according to the Quran, these risks should be shared with the client. The latter aspect shows that customers actually run the same risks as in conventional banking, so why should their regulation rules be any different. As Saleem (2005, p 27) concludes: Islamic banks have arrived at a wonderland in which through their creative use of language, there exists an Islamic equivalent to almost all the major products and modes of financing of the conventional interest based sector. Only the labels are different.

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3. Data, Methodology & Findings

3.1 Islamic Commercial Banks versus Conventional Commercial Banks: Where to deposit your money? A bank needs to offer a consumer stability, security of deposits and a competitive rate of return on the deposits made. This section will investigate whether, from a depositors point of view, it is interesting to open an account at an Islamic bank. With the banking crisis still in the back of our mind it is important to study the risk profile of an Islamic bank. The current crisis was partly triggered by abnormal leverage creation of banks and complex financial products where the financing of assets was not backed anymore by real assets from the economy. In Islamic banking an investment is always linked to a real asset or service an thus, an Islamic bank is better able to monitor a project and the obligor. Better monitoring is also easier in an Islamic bank since they are, most often, smaller in size than the conventional bank. Furthermore, an Islamic bank can only issue debt securities which are asset-backed and thus can never become dependent upon excessive leverage. One could think that an Islamic bank is, for the above mentioned reasons, more stable and thus less risky for the client or one could question whether the size does play a striking role in the sense that it is more difficult for an Islamic bank to diversify, more costly to monitor and additionally, Islamic banks have a smaller investment pool due to the fact that they may only invest in Shariah-compliant companies or funds. In this section I will do a cross-sectional analysis of the balance sheets of Islamic banks in which I focus on the theoretical implications of the main Islamic banking features that can have an impact on the consumer. Hereby I will focus on the influences of these features on pillar one of Basel II, the capital adequacy ratio (CAR).

3.1.1 Data & Methodology To examine whether banking with an Islamic bank is riskier than banking with your conventional bank, I examine the risk profile of 13 Islamic banks. This number is chosen since this was the number of available Annual Reports over 2008 written in English of Islamic banks. The Annual Reports, which include the balance sheet and income statement data of the respective bank, are found via the official websites of the banks in question. The numbers in these reports were all stated in local currency and thus, in order to compare the

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data, I converted all the numbers to U.S. dollars. Table 3 gives an overview of the sample of banks and their most interesting characteristics. Table 3 also includes the figures of three Dutch banks, primarily in order to compare the size of an Islamic bank to the size of a conventional bank. Because I mainly want to show that Islamic banks are indeed small in comparison to conventional banks, a sample of three banks seemed sufficient.

As stated in section 2.4 Risk Management at an Islamic Bank, Islamic banks face special risks due to a dissimilar asset and liability side of the balance sheet in comparison to a conventional bank. As a depositor you want to be confident that you can withdraw your money any time so, a bank is required to make sure that the risks undertaken are not excessive and that the bank holds enough capital as a reserve in case of any unpredictable losses. The amount of capital that a bank should hold is dependent upon the riskiness of the assets under management; more capital is needed to cover the risk of default of riskier assets and a smaller amount of capital should be put aside for the assets that are less risky (Chapra & Khan 2000). Capital adequacy of a bank is captured in pillar one of Basel II and is measured by means of the Capital Adequacy Ratio (CAR):
CAR = (Tier One Capital + Tier Two Capital) / Risk Weighted Assets (1)

Thus the CAR is equal to the sum of tier one and tier two capital divided by the sum of the risk-weighted assets. Tier one capital is the core capital of a bank, it comprises equity capital and reserves. Tier two capital can be described as supplementary capital of a bank, it includes undisclosed reserves and instruments that are in essence permanent and have both equity and debt characteristics (Crouhy & Galai 2006). According to the capital requirements of Basel II, the minimum CAR is equal to eight percent5. A sufficient CAR gives confidence to all the banks stakeholders that the bank is able to remain stable and that consumers can safely deposit their money at the bank. Quantifying a different CAR for Islamic banks is beyond the scope of this thesis and besides, cannot be undertaken based on solely my sample. However, I will elaborate on the effects of the different risks on the CAR for an Islamic bank.

www.bis.org

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Table 3. Descriptive Figures Islamic Banks & Dutch Banks

PLS / nonPLS ratio ($ thousand) ratio ($ thousand) (PER / IRR) 0,00 Other (0,07%) Corporate (58%) Individuals (16%) Other (2%) 0,17 Europe (4%) Domestic (96%) 1.873.805 1.836.900 0,12 440.821 112.258 (6275 / 443) AA31,05% Government (24%) Domestic (99,3%) 5.083.980 4.984.488 0,52 211.608 35.600 ( - ) A+ 11,69% by customer deposit ($ thousand) Reserves Liabilities thousand) Investment equity General Financing by region Total Total deposits ($ Demand Shareholders Statutory & Country Rating (S&P) CAR

Islamic bank

Country

Total assets

($ thousand)

CIMB Islamic

Malaysia

5.295.588

Bank Berhad

(367 branches

over Asia)

Bahrein Islamic

Bahrein

2.314.626

Bank B.S.C.

3 Government (0,4%) Private (98%) Other (1,6%) 0,11 Other (36%) Domestic (64%) 256.730 209.776

Islami Bank

Bangladesh

3.278.505

0,02

Domestic (100%)

3.078.844

2.845.297

0,11

199.661

111.938 (-)

No data

10,72%

Bangladesh

(196

Limited

branches)

Arab Islamic Bank

Palestine

304.498

0,25

47.768

3.568 (-)

No data

18,49%

P.L.C.

Bank Islam

Malaysia

6.688.159

0,00

6.316.922

5.910.931 Government (22%) Corporate (29%) Individuals (12%) Other (27%)

0,08

371.596

- 118.249 (11.780 / -)

A+

13,07%

Malaysia Berhad

BankIslami

Pakistan

235.568

0,33

Domestic (100%)

171.497

154.727 -

0,26

64.071

B-

40,03%

Pakistan Limited 0,24 Domestic (100%) 983.334

Meezan Bank

Pakistan

1.057.423

870.900 -

0,29

74.089

10.478 (-)

B-

10,08%

34

Islamic bank PLS ratio ($ thousand) ratio (PER / IRR) 0,06 GCC (13%) Europe (20%) Other (4%) Other (15%) 0,00 Middle East (3%) Other (6%) 0,33 Other (3%) 0,00 Other (3%) 0,00 0,07 Europe (35%) Middle East (42%) Other (5%) Domestic (18%) 228.624 223.707 Banks (3%) Other (97%) 0,16 26.757 - (73 / -) AAA Domestic (100%) 3.099.652 2.470.918 0,24 1.133.200 447.279 (-) AA+ Domestic (97%) 5.687.064 4.470.376 0,21 385.039 67.341 (-) AA+ Domestic (97%) 17.504.325 15.278.258 0,21 2.052.831 1.195.387 ( -) AA+ Domestic (91%) 3.800.828 3.443.365 0,18 452.670 36.688 (-) AA+ Individuals (47%) Corporate (36%) Government (7%) Domestic (63%) 7.246.704 4.554.356 0,22 1.960.679 1.018.852 (-) AA+ ($ thousand) by customer deposit ($ thousand) Reserves Liabilities ($ thousand) Investment equity General Rating (S&P)

Country

Total assets

PLS / non-

Financing by region

Total

Total deposits

Demand

Shareholders

Statutory &

Country

CAR

($ thousand)

Qatar Islamic Bank

Qatar

9.207.383

17,01%

Dubai Bank

U.A.E. (42

4.253.498

12,00%

branches)

10

Dubai Islamic Bank

U.A.E.

19.557.156

10,70%

P.J.S.C.

11

Emirates Islamic

U.A.E.

6.072.103

10,81%

Bank

12

Sharjah Islamic

U.A.E.

4.232.852

39,00%

Bank

13

Islamic Bank of

U.K.

255.381

32,10%

Britain

14 Belgium (17%) Spain (21%) U.K. (16%) Other (10%) NL (36%)

Rabobank

Netherlands

862.226.973

815.096.913 2.829.655

428.513.226 2.722.323

4.713.006 267.582

AAA AAA

13,09% 13,00%

15

Triodos

Netherlands

3.097.237

16

ASN

Netherlands

6.949.331

6.767.002

6.508.936

182.329

145.910

AAA

35

3.1.2 Findings & Interpretations This section will elaborate on credit risk and liquidity risk, especially withdrawal and displaced commercial risk, to investigate whether a CAR equal to eight percent is sufficient for an Islamic bank or not. Even though, the risk-weighted assets are normally calculated based on the related credit- , market- and operational risk, liquidity risk is very important for an Islamic bank to take into account as well. I will not elaborate further on market risk and operational risk, since these risks are already explained in 2.4. However, they are included in the evaluation of the calculation of the CAR.

Credit Risk

The ratio of PLS to non-PLS investments is very important for the risk profile of the bank. Theoretically, the PLS investment modes are the truly Islamic investment modes since the profits and losses are shared. However, in practice one can conclude from table 3, that the majority of investments is done according to non-PLS modes and so, these investments most often are collateralized and thus less risky for a bank to undertake. The PLS / non-PLS ratio ranges from 0% up to 33%, indicating that all the banks from the sample have their majority of money invested in, most often, ijara and murabaha investments. The latter is especially true for Islamic banks in Britain since: Any equity position held by a bank is penalised under Basel II by assigning a higher risk weighting for capital adequacy purposes i.e. a 300 or 400 percent risk weighting depending on whether it is public or private equity. This adds to the capital costs of mudaraba and musharaka (N. Schoon 2008, p.4). There are two approaches to measure credit risk, namely the standardized approach and the Internal Ratings-Based (IRB) approach. The former makes use of external credit ratings of, for example, Standard & Poors. The latter approach gives the bank the responsibility to assess the credit risk of the consumers themselves. This approach is the preferred way of assessing credit risk for an Islamic bank since most investments are unrated and would otherwise, under the standardized approach, receive a risk weighting of 100 percent while in practice the chance of default could be much smaller. However, Islamic banks most likely will not get the approval of the supervisor to use this credit risk assessment method since the majority of Islamic banks are relatively small and most banks lack adequate risk management skills (Chapra & Khan 2000). The IFSB also proposes the standardized

36

approach as the measure to assess credit risk6. Thus, in reality this could result in a greater amount of capital which needs to be set aside to cover the credit risk. The risk weights for using the standardized approach are shown in table 4.
Table 4. Risk weightings according to the Standardized Approach
Credit Assessment AAA to AAClaim Sovereigns Banks Option 1 Option 2
c a b

A+ to A-

BBB+ to BBB
-

BB+ to B-

Below B-

Unrated

0% 20% 20% 20%

20% 50% 50% 20%

50% 100% 50% 20%

100% 100% 100% 50%

150% 150% 150% 150%

100% 100% 50% 20%

Short-term claims Corporates

a

20%

50%

100%

100%

150%

100%

Risk weighting is based on risk weighting of sovereign in which the bank is incorporated. Banks incorporated in a given country will be

assignend a risk weight one category less favourable than that assigned to claims on the sovereign, with a cap of 100% for claims to banks in sovereigns rated BB+ to B-.
b c

Risk weighting based on the assessment of the individual bank Short-term claims in option 2 are defined as having an original maturity of three months or less

Source: Basel Committee on Banking Supervision, 2004

Besides, table 3 also shows the lack of geographical diversification of most Islamic banks. Except for the Islamic Bank of Britain and the Qatar Islamic bank, all banks from the sample have invested the majority of their monetary resources in domestic projects. This concentration of investments in one country gives rise to concentration risk. Even though the majority of the sample countries enjoys an investment grade status, it is still risky to invest in one region which is subject to the same set of macro economic variables.

The size of the bank also plays a role in estimating credit risk. A smaller bank, as stated before, enjoys less possibilities to diversify investments. The size of the Islamic banks measured by the dollar value of the assets ranges from $236 million of the BankIslami Pakistan Ltd. to $19.557 million assets of the Dubai Islamic Bank P.J.S.C.. In order to compare, the Dutch bank The Rabobank has $862.227 million assets. On average, the Islamic bank can be best compared to the Dutch niche banks ASN Bank or Triodos Bank as given in table 3. Islamic banks also operate in a niche market and for that reason, even though their growth rates are promising, these banks will probably not reach the size of the large international conventional banks and will stay focussed on their niche market. Nevertheless,
6

www.ifsb.org

37

although Islamic banks are smaller in size, they still have the possibility to diversify their portfolio in our globalised world in order to reduce credit risk.

Thus, with reference to the different financing modes, Islamic banks are not in definition riskier than conventional banks since the number of PLS financed assets is small overall and because the non-PLS financed assets are backed by collateral which can be sold on the market. However, since the majority of their financings are unrated they do need to set aside more capital than would probably be necessary based on the probability of default. Concerning concentration risk, Islamic banks do appear risky since the majority of their investments are concentrated in one specific region. However, as stated above, in our globalized world even smaller banks have ample opportunities to diversify their investment portfolio.

Liquidity Risk: Withdrawal Risk & Displaced Commercial Risk

Withdrawal and displaced commercial risk both can occur when an Islamic bank is unable to pay-out a competitive rate of return to its investment deposit account holders. Derived from my sample, the average ratio of demand depositors to investment depositors is 0,207, which entails that on average 80 percent of the depositors have deposited their money based on the PLS principle. Hence, the return of this last group is dependent upon the profit made by the Islamic bank. As discussed in previous sections, an Islamic bank needs to pay out a sensible rate of return in order to stay competitive and to reduce withdrawal risk. So, in theory, the PLS principle sounds really merciful, however in real terms such practices are not sustainable in a competitive banking environment. Table 5 will illustrate this statement by showing the composition of the pool of monetary resources available to invest in projects, companies or Islamic funds, in other words, the investment pool. The sequence of banks in table 5 is determined by the ratio of shareholders equity to total assets of each Islamic bank.

The investment pool is made up from the deposits of the investment depositors and from the shareholders equity capital. On average, 82 percent of the investment pool is derived from the investment deposit accounts. This indicates that in the event of a run on the bank, so a mass of withdrawals, the bank is left in a situation where the shareholders equity are the sole

Bank number 1 and 5 are regarded as extreme outliers and are not taken into consideration in this calculation

38

Table 5. Overview Investment Pool

Bank Total Assets ($ thousand) Investment Deposits ($ thousand) Shareholders equity (SE) ($ thousand) Total Investment Pool % Investment Deposits of Investment Pool 1 CIMB Islamic Bank Berhad 3 Islami Bank Bangladesh Limited 5 Bank Islam Malaysia Berhad 11 Emirates Islamic Bank 7 13 Meezan Bank Islamic Bank of Britain 9 10 Dubai Bank Dubai Islamic Bank P.J.S.C. 4 Arab Islamic Bank P.L.C. 2 Bahrein Islamic Bank B.S.C. 8 Qatar Islamic Bank 6 BankIslami Pakistan Limited 12 Sharjah Islamic Bank 4.232.852 1.877.898 1.133.200 3.011.098 62% 27% 39,00% 235.568 117.246 64.071 181.317 65% 27% 40,03% 9.207.383 3.552.398 1.960.679 5.513.095 64% 21% 17,01% 2.314.626 1.616.472 440.821 2.057.293 79% 19% 31,05% 304.498 157.332 47.768 205.100 77% 16% 18,49% 4.253.498 19.557.156 2.823.559 12.069.824 452.670 2.052.831 3.276.229 14.122.655 86% 85% 11% 11% 12,00% 10,07% 1.057.423 255.381 618.339 187.914 74.089 26.757 692.428 214.671 89% 88% 7% 10% 10,08% 32,10% 6.072.103 3.531.597 385.039 3.916.636 90% 6% 10,81% 6.688.159 5.438.056 371.596 5.809.652 94% 6% 13,07% 3.278.505 2.532.314 199.661 2.731.975 93% 6% 10,72% 5.295.588 2.392.554 211.608 2.604.162 92% 4% 11,69% % SE of Total Assets CAR

resource to invest in assets in order to generate profits. The shareholders capital as a percentage of total assets varies from 4 percent up to 27 percent and on average it constitutes only 13 percent. A run on a bank can therefore lead to severe liquidity risk since the majority of investments of a bank are for the longer term. Such a scenario can lead a bank to bankruptcy, especially since the market for Shariah-compliant debt instruments is yet underdeveloped, only sukuk instruments, and not all banks have access to a lender of last

39

resort. This liquidity risk can be hedged by a Shariah-compliant debt-asset swap, as discussed in 2.5, or other banks can lend the bank with liquidity problems money based on a mudaraba contract, as discussed in 2.4. Another way to mitigate this liquidity risk is to have adequate loan-loss reserves. Banks have to create reserves to counterbalance a loss and to preserve a surplus of profit in order to pay out a competitive rate of return to the investment deposit holders at all times to prevent withdrawal. In my sample most banks did keep a statutory reserve equal to at least 10 percent of the net profit. This reserve is, however, meant to absorb external shocks or unexpected defaults and not to equalize the rate of return paid to investment deposit holders. To set off the variance in the profit and losses of the bank, reserves such as the PER and the IRR are vital. However, not all banks stated in their Annual Report to have such reserves. In order to find out if the bank was able to pay the investment deposit holders a competitive rate of return, the rates paid to the latter group are compared to the rates of conventional banks founded in the same country as the respective Islamic bank. The same country is chosen in order to provide a more equal comparison. The rates of investment deposit holders are compared to the rates on savings accounts of conventional banks. Another option could be to compare them with fixed-term deposit accounts because, in theory, investment deposits cannot be withdrawn before a certain pre-agreed date. However, in practice, it has already been investigated that most banks allow their clientele to withdraw their money when it is needed, despite the fixed term-contract. Table 6 gives an overview of the rates of return for both the Islamic banks as for their conventional counterparts.

The rates of return for the conventional banks were either stated on their company website or in the respective Annual Report over 2008. The returns for Islamic banks are calculated by means of the following formula:
(Profit Paid on Deposits / Amount of PLS Deposits) x 100% (2)

As can be seen from table 6 there are differences in the rates of return of Islamic banks and conventional banks. Overall, the rates of return of Islamic banks are higher than those of conventional banks. The latter could be a compensation for the greater risk an investment depositor is running. Interesting to note is that even though the Islamic Bank of Britain experienced a net loss over the year 2008, their investment deposit holders did receive a positive rate of return on their investment deposits which signals that the bank made use of the profit equalization reserve. 40

Table 6. Overview rates of return Islamic banks and their conventional counterparts Bank
1. CIMB Islamic Bank Berhad 2. Bahrein Islamic Bank B.S.C. 3. Islami Bank Bangladesh Limited 4. Arab Islamic Bank P.L.C. 5. Bank Islam Malaysia Berhad 6. BankIslami Pakistan Limited 7. Meezan Bank 8. Qatar Islamic Bank 9. Dubai Bank 10. Dubai Islamic Bank P.J.S.C. 11. Emirates Islamic Bank 12. Sharjah Islamic Bank 13. Islamic Bank of Britain
a

Net Profit 2008

17.510 59.239 39.354

Rate of Return
4,4% 2,9% 6,8%

Bank
1. HSBC Asia-Pacific 2. BMI Bank B.S.C. (Bahrein) 3. Bank Asia Limited (Bangladesh)

Rate of Return
0,7% up to 3,0% 6,0%

5.094 93.504 - 656 7.704 394.320 52.000 397.967 92.134 52.901 - 8.259

4,6% 4,4% unknown 5,9% 3,5% 2,8% 3,6% 4,2% 3,5% 2,9%

4. Palestine Commercial Bank 5. EON Bank Group Malaysia 6. Allied Bank Limited (Pakistan) 7. Commercial bank of Qatar 8. Commercial Bank of Dubai 9. Abu Dhabi Commercial Bank

unknown 2,0% 2,5% 1,5%

average rate of 3,0%a 1,9% 1,02%

11. Barclays

2,6%

rates are dependent upon size and maturity of saving

In theory it was already stated that because of withdrawal- and displaced commercial risk a bank would target for a positive and competitive rate of return in order to avoid the two risks and apparently, in practice, this also holds. Banks are afraid to lose out on consumers and therefore they make sure that the depositors do keep on receiving a positive and competitive rate of return. Capital Adequacy Ratio

Holding an adequate amount of capital on the balance sheet in order to absorb losses is vital for the stability of a bank. Tier one capital is the most important permanent base of capital for an Islamic bank. The investment deposit accounts do not have a permanent nature and therefore, the banks equity and reserves should have a solid shock-absorbing capacity. Table 7 gives an overview of the amounts of Tier 1- and Tier 2 capital, the value of risk-weighted assets and the CAR for each Islamic bank from the sample. The numbers are taken from the Annual Reports over 2008 of the respective Islamic bank and are the CAR figures determine the order of the banks. Table 8 illustrates how the risk-weights are used to calculate the amount of credit risk, however, unfortunately this information was only available from two banks, the CIMB Islamic Bank Berhad and the Bank Islam Malaysia Berhad.

41

Table 7. Overview Constituents CAR

Tier 1 Capital ($ thousand) 72.496 2.410.229 159.614 424.710 166.499 499.835 351.770 1.499.143 No data 354.023 30.123 1.075.013 62.174 -948 61.226 146.339 1.075.013 2.756.352 228 1.220 31.343 No data 6.367 43.099 397.122 1.029.429 144.344 34.119 No data 105.397 63.105 1.562.248 6.554.971 2.303.222 324.420 59.082 410.852 2.714.190 84.009 343.033 -22.022 477.813 3.981.775 21.336 187.865 1.519.437 87.053 255.789 680.499 6.296.707 6.072.103 5.295.588 4.253.498 6.688.159 9.207.383 304.498 2.314.626 255.381 4.232.852 235.568 103.368 262.982 No data 3.278.505 -99.050 2.311.179 19.554.821 848.914 1.222.082 19.557.156 882 73.378 605.516 76.942 45.264 1.057.423 727.722 21.625.818 2.453.794 6.296.707a 1.606.490 3.981.775 3.144.232 9.182.613 No data 1.279.170 97.631 2.756.352 152.934
a

Bank Capital ($ thousand) ($ thousand) ($ thousand) ($ thousand) ($ thousand) ($ thousand) Credit Risk Market Risk Risk assets Base weighted weighted -Operational ($ thousand) Risk-weighted

Tier 2

Total Capital

Risk-

Risk-

Risk-weighted

Total assets

Total

CAR

Meezan Bank

10,08% 10,70% 10,72% 10,81% 11,69% 12,00% 13,07% 17,01% 18,49% 31,05% 32,10% 39,00% 40,03%

10

Dubai Islamic Bank P.J.S.C.

Islami Bank Bangladesh Ltd.

11

Emirates Islamic Bank

CIMB Islamic Bank Berhad

Dubai Bank

Bank Islam Malaysia Berhad

Qatar Islamic Bank

Arab Islamic Bank P.L.C.

Bahrein Islamic Bank B.S.C.

13

Islamic Bank of Britain

12

Sharjah Islamic Bank

BankIslami Pakistan Limited

Total risk-weighted assets calculated according to Basel I

Table 8. Overview Calculation Credit Risk

Total Risk-weighted 35%
175.888 201.244 259.441

Bank 50%

Risk Weighted Assets ($ thousands) Credit Risk 75%

1.358.543

CAR calculated (reported) 100%

1.259.849 986.685

Cash ($ thousand) 150%

256.440

0%

20%

assets
1.519.437 2.714.190 11,69% 13,07% 62.814 144.417

CIMB Islamic Bank Berhad

1.526.587

795.264

Bank Islam Malaysia Berhad

3.195.702

688.457

42

One can conclude from this table that all Islamic banks from the sample have an adequate capital ratio since all CAR figures are above the required eight percent. However, when looking at the last three columns, one notices that there are some differences in the ratio of total risk-weighted assets to total assets. The Dubai Islamic Bank P.J.S.C. and the Emirates Islamic Bank assign higher risk-weights to their assets than their assets are worth, in contrast, the CIMB Islamic Bank Berhad clearly weights their assets as less risky. One explanation could be that the CIMB Islamic Bank Berhad has less risky assets outstanding or another reason could be that this bank assigns less risk to their assets outstanding. Table 8, in combination with table 3 and table 4, illustrates that in this case the latter explanation is more plausible. Table 8 shows that the CIMB Islamic Bank Berhad assigned a large part of their assets a risk-weight of 0 percent. However, as can be read in table 4, only sovereigns in AAup to AAA can receive a 0 percent risk-weighting and cash (Crouhy & Galai 2006). Table 3 gives that only 0,07 percent is invested in a foreign country, which is far less than the $1.526.587 thousand dollars stated in table 8 and Malaysia itself has only an A+ rating. Besides, the cash amount outstanding, which also receives a 0 percent risk weighting, does not cover the $1.526.587 thousand dollars. In other words, one could conclude, that the CIMB Islamic Bank Berhad uses the risk-weights more arbitrarily and subjective than is stated in Basel II. This example illustrates that, even though the CAR numbers are given in the Annual Reports, it is questionable whether these numbers still hold according to Basel II. Another point of attention are the four banks present in the bottom of the list, since their CAR numbers are all above 30%. Three of these four banks are also in the bottom of table 5, which indicates that they have a larger base of shareholders capital with respect to total assets. The large CAR number thus either stems from the fact that their Tier 1 capital base is larger, from less risky outstanding assets or from a more subjective approximation of the total risk-weighted assets. Even though these numbers are far above the needed eight percent, one can doubt the soundness of such numbers as well, since very high CAR numbers also indicate inefficient use of monetary resources. In other words, a bank does not invest enough in risky assets. As stated in the Shariah, money should not just be put on an account, but should be invested in assets and services in order to stimulate the economy. A very high CAR ratio indicates that the bank is less efficient with its money allocation; it could be invested in more projects in order to generate higher returns for its investment deposit account holders and shareholders. The size of the bank is also important for capital adequacy. Since, most Islamic banks are relatively small in size, the bank cannot diversify their asset portfolios as much as larger banks can. They need a larger amount of capital relative to their assets to inspire confidence. 43

From table 7 I can derive that the two smallest banks are present in the bottom three with the largest CAR ratios, however I cannot conclude that this is due to the fact that these banks try to signal confidence to their stakeholders or that this is due to other reasons. Furthermore, the ratio of demand- and investment deposits is also an important feature in the evaluation of CAR. Islamic banks only need a 100% reserve requirement against the non-PLS demand deposits. As given in table 3, demand deposits form a minority, with the exemption of the CIMB Islamic Bank Berhad. Accordingly investment deposits form the major part of the total deposits, and for this group no reserve requirement is demanded since these depositors share in the profits of the bank and are aware of the riskiness of their account. If a bank incurs a loss, theoretically this is partly absorbed by the investment deposit holders, either through usage of the PER or IRR or through directly sharing the loss with them.

So, is an Islamic bank able to offer a consumer stability, security of deposits and a competitive rate of return on the deposits made? The CAR gives a good indication of whether an Islamic bank is stable and whether your money is safely deposited. When looking at the CAR ratio, several factors need to be taken into account in order to decide whether a CAR of eight percent is sufficient for an Islamic bank. Arguments in favor of increasing the CAR ratio for an Islamic bank are the concentration risk of investments outstanding and the relative small size of an Islamic bank. Besides, the low ratio of shareholders equity to total assets and as a percentage of the total investment pool, can lead to high liquidity risks and possibilities to hedge these risks are limited. An Islamic bank experiences high pressure to pay out a competitive rate of return, since in the event of en mass withdrawal this could lead a bank to bankruptcy. Arguments against the need of a higher CAR ratio are the fact that an Islamic bank only has a limited amount of PLS financed investments outstanding and the fact that the investment depositors absorb part of the losses a bank incurs and no capital needs to be set aside as a reserve requirement for these accounts. So, for the majority of deposit accounts no reserve is needed, since the investment deposit accounts make up, on average, 80 percent of total deposits. Above and beyond, one needs to investigate the usage of Basel II of Islamic banks to calculate the amount of risk-weighted assets in order to make it free from subjective flaws. So, at first glance, Islamic banks seem to be a stable and safe place to deposit your money as indicated by the CAR numbers, plus the rate of return earned is higher than at their conventional counterpart banks. However, the above mentioned points, need to be taken into account to decide whether this eight percent is really sufficient for an Islamic bank.

44

3.2 Islamic Indexes versus Conventional Indexes: Where to invest your money?

This section will explore whether it is sensible to deposit your money as either restricted mudaraba or unrestricted mudaraba. As shown in the above section, a higher return could be earned by becoming an investment depositor at an Islamic bank. The money deposited is used by the Islamic bank to invest in PLS projects and non-PLS assets but could as well be used to invest in Islamic funds. Given that the PLS and non-PLS projects are difficult to measure, since these are stand-alone projects, this thesis will focus on the performance of the Islamic indexes. In other words, can the higher return be explained by the performance of Islamic indexes? Hence, it is important to know the volatility and the returns on these Islamic indexes. Furthermore, from a risk mitigation perspective, diversification plays an important role. Accordingly, this section will first go into the risk-return trade-off of Islamic funds in comparison to conventional funds. Next, the diversification effect of Islamic funds is examined by calculating the correlation of these funds with conventional funds and with the market. Thirdly, regression analysis is used to examine whether abnormal returns can be earned when investing in Islamic indexes. A single factor ANOVA test is used in order to test the significance of the results.

3.2.1 Introduction Islamic Indexes Investing in indexes has grown in popularity, since investors rather follow a passive investment strategy instead of an active one (Hakim & Rashidian 2002). Muslims are only allowed as from the 90s to invest in equity. Before that time, equity investments were not considered as Shariah compliant. In the 90s these rules changed and the number of equity funds grew rapidly. Currently the amount of assets under management exceed $5 billion and the amount of Islamic equity funds worldwide is estimated at 1008.

The existing literature has covered the risk-return profile of Islamic indexes, however, the most recent investigation dates back to 2005. Hakim and Rashidian (2002) compare in their article Risk and Return of Islamic Stock Market Indexes the Dow Jones Islamic Market Index US (DJIMI-US), the Wilshire 5000 and the risk-free rate from 1999 up to 2002. The three-month Treasury bill is taken as a proxy for the risk-free rate. They found out that the
8

www.islamic-banking.com

45

DJIMI-US is less risky than the Wilshire 5000, even though the latter index is far greater and more diversified than the former. Furthermore they state that the DJIMI-US is influenced by other factors than the market or the interest rate. This finding is in contrast with the claims of Dow Jones Inc., since they propagate that the DJIMI displays high correlation with the market. Hakim and Rashidian argue that their results are probably due to the fact that the subset of Shariah compliant companies gives this index a unique risk-return profile and apparently the lack of diversification potential does not negatively affect the performance of the index. They conclude with stating that Muslim investors do not necessarily have to be worse off by investing in an Islamic index instead of in a larger conventional index. Hussein (2002, p.1) analyses the conventional assumption that: Due to increased monitoring costs, availability of a smaller investment universe, and restricted potential for diversification, it has been argued that unscreened benchmarks should outperform Islamic (ethical) investment. By examining the returns on the DJIMI and the FTSE Global Islamic Index he states that Shariah compliant investing does not lead to inferior investment performance weighted against unscreened funds, neither in the short-run nor in the long run. Hussein and Omran (2005) investigate the performance of the separate Dow Jones Indexes from January 1996 until July 2003. They divided this time period into a bull period, January 1996 March 2000 and a bear period, April 2000 July 2003. They showed that the Islamic indexes showed abnormal returns over the whole period and during the bull period; the indexes underperformed during the bear period. They compared all the returns to their counterpart indexes of the Dow Jones and concluded that the main drivers of the positive performance were the following sectors: basic materials, telecommunications, industrials and the small cap sector.

3.2.2 Data & Methodology This thesis will make use of the Dow Jones Islamic Market Index (DJIMI) and the subset of sector-specific DJIMI indexes and the Dow Jones World Index and its sector-specific sub indexes to investigate the risk-return relationship between Islamic and conventional indexes. In December 1995 the DJIMI was launched. This index is a subset of the Dow Jones World Indexes. As stated in section 2.3, the DJIMI can only select companies that meet certain requirements. Companies passing these criteria are admitted in the DJIMI. This screen on ethical investments combined with the check-up on financial ratios ensures that highly leveraged companies are not included in the DJIMI or excluded before they get into financial 46

troubles. The troubles at Enron and Worldcom were detected before their stocks plummeted and thus their stocks were taken out of the DJIMI right on time. Whether a company is included or not in the DJIMI is dependent upon the approval of the supervisory board composed out of Islamic scholars who test the companies on their Shariah compliance. Besides, the index is reviewed quarterly to reflect the latest changes and trends on the market and necessary modifications are made to the index in case of a merger, bankruptcy or takeover (El-Din & Hassan 2007). The DJIMI tracks companies in 49 countries and divided over ten different industries9. Nowadays, the Dow Jones knows 44 Islamic indexes which are distinguished by industry, region and size. All together these indexes track almost all the Shariah compliant industries globally (Hussein & Omran 2005).

I will test whether Islamic indexes outperform conventional indexes and whether there is a difference in the risk profile of these indexes. I use the monthly return data from the Dow Jones Islamic Market Index (DJIMI) and its related sector-specific indexes, the monthly return data from the Dow Jones World Index (DJWRLD) and its related sector specific indexes and as a proxy for the risk-free rate I use data about the 3-month Treasury bill in order to find the answer. The sectors covered by the Dow Jones Islamic indexes are: basic materials, consumers goods, consumer services, financials, industrials, health care, oil & gas, telecommunications, technology, and utilities. I have chosen especially for the sector specific indexes to see whether there is a difference between the performance of Shariah compliant companies and non-Shariah compliant companies in different sectors. The time span for the data covers the period of January 1996 until May 2009. I do not divide this time period into bull and bear market periods, since the Islamic investment depositors are passive long-term depositors. In theory, most often the deposit account holders cannot withdraw their money before a certain time period and besides, they have limited or no influence on the investment choices made by the Islamic bank. The data of the indexes is retrieved from Datastream on May 23 2009 and the data of the 3-month Treasury bill is taken from the website of the Board of Governors of the Federal Reserve System on July 4 2009.

www.djindexes.com

47

3.2.3 Findings & Interpretations First, an overview of the descriptive statistics can be found in Table 9. The number of observations is equal to 160.
Table 9. Descriptive Statistics Sample
Mean 0,0020 0,0014 0,0028 0,0020 0,0027 0,0013 0,0016 0,0017 0,0009 0,0007 0,0014 0,0010 0,0022 0,0021 0,0035 0,0035 0,0018 0,0014 0,0025 0,0015 0,0016 0,0021 Median 0,0043 0,0050 0,0038 0,0023 0,0038 0,0047 0,0034 0,0032 0,0027 0,0054 0,0047 0,0037 0,0033 0,0033 0,0047 0,0030 0,0034 0,0019 0,0038 0,0039 0,004 0,0039 Minimum -0,0823 -0,0940 -0,1496 -0,1350 -0,0658 -0,0793 -0,0787 -0,0757 -0,1376 -0,1325 -0,1057 -0,1048 -0,0724 -0,0739 -0,0923 -0,0951 -0,1366 -0,1339 -0,0810 -0,0785 -0,0809 -0,0674 Maximum 0,0599 0,0626 0,0885 0,0855 0,0723 0,0575 0,0791 0,0685 0,1543 0,0937 0,0776 0,0689 0,0502 0,0521 0,0675 0,0680 0,1021 0,0959 0,0849 0,0799 0,0690 0,0430 St. dev. 0,0232 0,0222 0,0298 0,0294 0,0236 0,0223 0,0187 0,0181 0,0366 0,0283 0,0273 0,0251 0,0182 0,0180 0,0269 0,0270 0,0402 0,0395 0,0263 0,0258 0,0252 0,0174 Skewness -0,6333 -0,8437 -1,0578 -0,9833 -0,1404 -0,4526 -0,6040 -0,7540 -0,3054 -1,1342 -0,5314 -0,6659 -0,5350 -0,6238 -0,5572 -0,5868 -0,3442 -0,3653 -0,1496 -0,2602 -0,8290 -1,0943 Kurtosis 1,1485 2,4942 4,5764 4,0972 0,4991 1,0873 3,5926 3,1021 3,2723 5,3226 1,7527 2,6515 1,9382 2,4663 1,1186 1,2051 0,8183 0,7170 0,3735 0,5019 1,8733 2,4338 ANOVA p-value 0,7887 Sharpe ratio 0,208 0,109 0,295 0,188 0,268 0,109 0,152 0,159 0,082 0,075 0,140 0,083 0,278 0,270 0,422 0,411 0,188 0,160 0,270 0,195 0,305 0,267

DJ Isl World DJ - World DJ Isl BsMt DJ Wrld BsMt DJ Isl ConS DJ Wrld ConS DJ Isl ConG DJ Wrld ConG DJ Isl Fin DJ Wrld Fin DJ Isl Ind DJ Wrld Ind DJ Isl HC DJ Wrld HC DJ Isl O&G DJ Wrld O&G DJ Isl Tech DJ Wrld Tech DJ Isl TeleC DJ Wrld TeleC DJ Isl Util DJ Wrld Util

0,7953

0,5592

0,9761

0,9574

0,8737

0,9624

0,9831

0,9505

0,7489

0,9497

To estimate monthly returns the logarithmic changes of the prices of both indexes are calculated by means of the following formula:
Return Pt = log(Pt) log(Pt-1) (3)

48

On a global scale, one can see that the mean return of the DJ Islamic index is higher in comparison to the mean return on the DJ World index, however not significantly higher. The high p-value of 0,7887 of the single factor ANOVA test indicates that the mean returns do not significantly differ from each other, in other words that the difference in mean returns is purely random. So even though it seems that the Islamic index invests in more profitable companies or that the greater return is a compensation for the greater risk, measured by the standard deviation, these result are not significant. Looking at the sub indexes, none of the mean return figures are significant. The differences that are stated in the mean return are therefore random differences and one cannot base any conclusions upon these numbers, except that the indexes demonstrate no difference in mean performance. Furthermore, both the world indexes as the sub indexes are negatively skewed. When the datasets were normally distributed the skewness would equal zero. However, as most often seen in financial data, the datasets are not normally distributed. The negative numbers for skewness indicate that the left tail from the mean of all datasets is longer than the right tail and thus, that the main part of the data can be grouped on the right side of the mean. Indicating that the main fraction of the data is positive in number. The fact that the data is not normally distributed can also be concluded by looking at the kurtosis. A high kurtosis indicates that more of the variance is caused by irregular deviations and again, a normal distribution has a kurtosis equal to zero. In the dataset described above all the kurtosis numbers are positive and greatest for the sub indexes basic materials and financials. Especially the kurtosis numbers of the financial sub indexes stand out because of the great difference between the DJ Islamic index and its DJ World counterpart index. Apparently the DJ World Financials index has enjoyed greater irregular extreme shocks than the DJ Islamic Financials index, while still enjoying a less risky profile. The irregular extreme shocks can be contributed to the financial crisis which started in 2007 and mainly affected, in the first place, the large international banks. The latter are players which probably do not fit the Shariah compliant criteria of Islamic banks, and thus these large international players cannot be found in an Islamic index. The less risky profile is probably due to the diversification potential of the DJ World Financials index; for the DJ Islamic Financials index it is much more difficult to find financial Shariah compliant parties to invest in.

Since there were no significant differences in mean returns, it is interesting to see whether there are differences in risk-adjusted performance as measured by the Sharpe ratio. The Sharpe ratio measures the return per unit of risk. This measure indicates whether a certain 49

return is due to good stock-picking skills or due to excessive risk-taking behavior. A superior return is only a good investment when it does not come with additional risk. A higher Sharpe ratio is a sign of better risk-adjusted performance (Sharpe 1994). The Sharpe ratio is measured as follows (Sharpe 1994):
Sharpe ratio = (R(i) Rf) / Stdev (i) R(i) = Average yearly return on index i Rf = Average risk-free rate Stdev (i) = Standard deviation of index i (4)

From table 9 one can see that the DJ Islamic indexes outperform the DJ World indexes on a risk-adjusted basis, except for the DJ Islamic Consumer Good index. . The higher Sharpe ratios of the DJ Islamic indexes show that the DJ Islamic indexes deliver a superior performance compared to the DJ World indexes. Especially in the cases of the DJ Islamic World index and the DJ Islamic subindexes of basic materials, consumer services, industrials, and telecommunications. These differences in performance could be explained by the financial and ethical screening of the DJ Islamic indexes, since this screening prevents troubled companies from being included in the index and thus it decreases the outstanding risk of the indexes.

Next, the risk and especially the correlation with market is investigated by means of calculating the beta. The beta measures the risk that cannot be diversified away. The higher the beta, the riskier the index. The beta can be calculated by means of dividing the covariance of the Islamic index and the market index by the variance of the market index, see formula 5:
= Cov(Risl, Rm) / Var(Rm) (5)

As a proxy for the market index I first took the DJ World Index to see whether the Islamic indexes are riskier than the proxy for a diversified international portfolio. Besides, I also took the subset of the DJ World indexes as a proxy for the market. The latter is done since, for example, the Dow Jones World Consumer Services index represents the market to choose from to form the Dow Jones Islamic Consumer Services index. Hence, one can see whether it is more risky to invest in an Islamic index or whether this is not the case. Besides I also calculated to beta of the subset of the DJ World indexes by taking the DJ World index as a

50

market proxy. The last is undertaken in order to compare both betas, since if both betas of the sub indexes are similar then there is still no difference in risk when investing Shariah compliant or investing in a conventional index. Table 10 gives the values for the betas calculated according to formula 5.
Table 10. Beta DJ Islamic Indexes & DJ World Indexes
Market proxy DJ-World DJ World Counterpart 1,001 0,2572 0,2015 0,8924 0,9353 0,7117 0,7326 1,2319 1,1380 1,1626 1,0875 0,5402 0,5637 0,8290 0,8431 1,4626 1,4646 0,8675 0,9105 0,7140 0,5390 0,9825 0,9975 0,9727 0,9352 1,0496 0,9861 0,9865 1,0099 0,9805 1,1556 -

DJ Isl World DJ Isl BsMt DJ Wrld BsMt DJ Isl ConS DJ Wrld ConS DJ Isl ConG DJ Wrld ConG DJ Isl Fin DJ Wrld Fin DJ Isl Ind DJ Wrld Ind DJ Isl HC DJ Wrld HC DJ Isl O&G DJ Wrld O&G DJ Isl Tech DJ Wrld Tech DJ Isl TeleC DJ Wrld TeleC DJ Isl Util DJ Wrld Util

A beta equal to 1,001 for the DJ Islamic World index illustrates that if the market index moves up by 1%, then the DJ Islamic index will move with 1,001%. The latter shows that the returns of the DJ Islamic index in general follow the market. When looking at the betas of the sub indexes, when taking the DJ World as a market proxy (column two), one can conclude that the betas of the sub indexes move in the same direction. The sub indexes are either riskier than the market or the sub indexes both have a lower beta indicating a less risky profile. 51

Column three assesses the beta of the DJ Islamic sub index by taking the corresponding DJ World sub index as a market proxy. This column shows betas that are closely pegged to 1, which is the beta for the market proxy, and which indicates that the expected returns on a DJ Islamic sub index are highly correlated to their DJ World counterpart index. For example, take the DJ Islamic Basic Materials index, one can conclude that this index shows low correlation with the market proxy as indicated by the beta of 0,2572. Thus, to check whether there exist a possibility of diversification by investing in the DJ Islamic sub index, I investigated the beta of the corresponding DJ World counterpart sub index as well. Apparently, the low correlation of the Islamic sub index can also be assigned to the DJ World counterpart index as illustrated by the beta of 0,2015. Column three shows a beta equal to 0,9825 which indicates that the returns of the DJ Islamic Basic Materials index are highly correlated to its DJ World counterpart index returns. So, one can conclude that investing in the DJ Islamic Basic Materials Index or in the DJ World Basic Materials index will generate the same returns. The latter was also indicated by table 9 by the fact that the differences in the monthly mean returns were not significant. It seems, as derived from the high correlations, that the sub indexes as the DJ Islamic World index and the DJ World index are influenced by the same set of macro economic variables.

Subsequently, I would still like to examine whether it is possible to earn abnormal returns by investing in an Islamic index by means of regressing the DJ World index against the related DJ Islamic index. Furthermore the given R2 clarifies how much of the variation in the Islamic index can be explained by movements in the related DJ World index. One would expect that no abnormal returns could be earned and that the R2 numbers are high because of the high correlation. For the regression the DJ World indexes are taken as the independent variables and the related DJ Islamic indexes as the dependent variables. Table 11 gives a summary of the regression output.

Table 11 shows that almost all the intercept coefficients are statistically insignificant, except DJ Islamic Consumer Services index which is significant at a 5 percent level. Thus, from this regression I can conclude that no abnormal returns can be earned except when investing in the DJ Islamic Consumer Services index. Furthermore, the high R2 numbers indicate that almost all the variation in the DJ Islamic indexes can be explained by the movements in the DJ World counterpart index. However, the two exceptions are the DJ Islamic Financials index

52

and the DJ Islamic Utility index. These two indexes have a more distinct risk-return profile, which is in line with their lower correlation coefficient.
Table 11. Summary Regression output
Dependent variable: Islamic Index Independent variable: DJ World counterpart Index DJ World Counterpart 0,0007 1,0073*** 0,9310 0,0009 0,9887*** 0,9513 0,0015* 1,0038*** 0,8982 0 0,9788*** 0,8909 0,0002 0,9411*** 0,5296 0,0004 1,0562*** 0,9409 0,0001 0,9923*** 0,9557 0 0,9927*** 0,9929 0,0003 1,0162*** 0,9940 0,0010 0,9867*** 0,9354 0 1,1629*** 0,6425 Test statistic 2,5714* Test statistic 2,6635** Test statistic 0,1413 Test of Significance Approach Test statistic H0 : = 1 vs. H1 : 1 0,3349

Islamic Index DJ Isl World

Statistic Intercept Coefficient R2 Intercept Coefficient R2 Intercept Coefficient R2 Intercept Coefficient R2 Intercept Coefficient R2 Intercept Coefficient R2 Intercept Coefficient R2 Intercept Coefficient

DJ Isl BsMt

Test statistic

-0,6345

DJ Isl ConS

DJ Isl ConG

Test statistic

-0,7766

DJ Isl Fin

Test statistic

-0,8343

DJ Isl Ind

DJ Isl HC

Test statistic

-0,4529

DJ Isl O&G

Test statistic

-1.0896

R2 Intercept DJ Isl Tech Coefficient R2 Intercept DJ Isl TeleC Coefficient R2 Intercept DJ Isl Util Coefficient R2 * significant at a 5% level ** significant at a 1% level *** significant at a 0,1% level

Test statistic

-0,6456

Test statistic

2,3609*

Besides, table 11 also shows that the coefficients are highly statistically significant from zero. In order to investigate whether the coefficients are also significantly different from one, a test

53

of significance is undertaken. A coefficient which is not significantly different from one indicates that the movements of the index are not significantly different as the movements from the market, since the market has a coefficient equal to 1. In order to assess the significance, a test statistic has to be calculated according to the next formula:
Test statistic = ( b*) / SE() b* = Value of under the null hypothesis SE() = Standard error retrieved from the regression analysis (6)

= Coefficient retrieved from the regression analysis

Hereby the hypothesis I test is H0 : = 1 and H1 : 1. The critical value at a five percent level of significance is equal to 1,960 and at a 1 percent level of significance the critical value equals 2,576. From this test of significance I can conclude that only the coefficients of the DJ Islamic sub indexes of Technology and Utilities differ significantly from one at a five percent level of significance; the other test statistics indicate that the coefficients do not significantly differ from one. Moreover, the null hypothesis for the DJ Islamic Industrial index can be rejected at a 1 percent level. In other words, the above three mentioned indexes do not move as the market, but have a significantly riskier profile than the market as indicated by their higher than one coefficients. Nonetheless, despite their riskier profile, according to their Sharpe ratio these indexes do generate a higher risk-adjusted return than their conventional counterparts and thus it would be a wise investments to invest in these indexes. So, can the higher returns earned by Islamic investment depositors be explained by the performance of Islamic indexes? When looking solely at the mean returns, no significant difference can be found. Besides, from the beta calculation follows that all the DJ Islamic indexes, apart from the DJ Islamic Basic Materials index, seem to follow the market as is indicated by their beta figures which are close to 1 and move in the same direction as their DJ counterpart indexes. The regression analysis indicates that all the indexes are as risky as the market, besides the DJ Islamic sub indexes of Technology, Utilities and Industry which are significantly riskier than the market. Furthermore, no abnormal returns can be earned by investing in DJ Islamic indexes, with the exemption of the DJ Islamic Consumer Services index. However, except for the DJ Islamic Consumer Goods index, the DJ Islamic indexes do outperform their DJ World counterpart indexes on a risk-adjusted basis. The latter is an important finding since this indicates that the DJ Islamic indexes are able to generate a higher return per unit of risk. 54

4. Limitations & Recommendation

Limitations I experienced when writing this thesis were in first instance the amount of academic articles covering the subject of Islamic banking or Islamic finance. A great part of the information about Islamic banking was therefore found in books. A second limitation was the availability of annual reports of Islamic banks over the year 2008 and written in English. Unfortunately Maastricht University solely has access to a European database with banking data, so I needed to search for the information on the websites of the banks themselves. The conclusions drawn from my sample consisting out of 13 banks are therefore indicative and further in-depth research is needed to be able to make a more precise comparison between Islamic deposit accounts and conventional deposit accounts and to assess the risk profile of an Islamic bank. It would be appealing to further investigate the rates of return paid out to investment deposit holders. On average, as shown in table 6, these rates are higher than the rates of their conventional counterparts, however since this is cross-sectional study, it would be nice to see the relation between these returns over a longer time-period. Besides, it would be interesting to estimate the returns made, on average, on all the investments an Islamic bank makes to highlight the profit-generating sources. Unfortunately, since most assets of Islamic banks are unrated, a recalculation of the CAR according to the Basel II guidelines was not possible. It would be of added value, however, to estimate the riskiness of these assets and to recalculate the CAR according to the conventional guidelines. The latter would give more trustworthy information about the stability of Islamic banks. Furthermore it would be interesting to assess the quality of management and assets outstanding of Islamic banks. This would answer the question whether the two smallest banks have the highest CAR ratios because they want to inspire confidence to their stakeholders or is it due to a lack of good investment opportunities or to bad cash management of the bank? Additionally, component data of the DJ indexes was not available. It would have been interesting to investigate which companies out of the DJ index were omitted for the counterpart DJ Islamic index. From my research it could be that the ethical and financial screening of the DJ Islamic index has a positive monetary impact since greater risk-adjusted returns can be earned. However, it would be interesting to shed more light on this screening to further investigate the impact.

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5. Conclusion
In ancient times, interest was prohibited by all major religions. Nowadays, solely Islamic banking has maintained this view. It is interesting to shed more light on a banking system which bans interest in all forms, since this is in contrast with our conventional interest-based financial system. The main features of Islamic banking are the sharing of profit and losses, a prohibition of interest, no speculation or gambling, fair and transparent dealing, fair and just employment policies, and lastly no business should be done with unethical companies or industries. These features form the basics for the Islamic financial products available on the market. The products can be divided in products with a profit and loss sharing feature and products where the rate of return is fixed. The return of the former is based on the profits or losses made by the project or company invested in and is therefore variable in nature. Since these Islamic products are differently structured then our conventional financial products, I looked at the different risks associated with the Islamic features. Especially the risks linked to the PLS feature, the smaller size of an Islamic bank in general, the liquidity position and the pressure of competition to pay-out an appropriate rate of return are important for Islamic banks. Even though, Islamic banks face a special set of risks, opinions vary about how different Islamic banking is from conventional banking. Proponents argue for a customized regulatory framework, while opponents dispute the differences and argue that Islamic banking should function along the same regulation as already in place for conventional banks.

Besides an explanation of the concept and functioning of Islamic banking, this thesis also answered the following two questions: (1) Is Islamic banking riskier than conventional banking? and (2) Can a greater return be generated by investing in Islamic funds?. The first question is answered by means of an evaluation of 13 annual reports of Islamic banks and focussed mainly on the first pillar from Basel II, namely whether or not a CAR higher than eight percent is necessary for Islamic banks in order to signal stability. This evaluation pointed out that the arguments in favor of a higher CAR are the concentration risk, the smaller size of an Islamic bank and the low ratio of shareholders equity to total assets and as a percentage of the total investment pool. Arguments against a higher CAR are the limited amount of PLS financed investments outstanding and the fact that investment depositors absorb part of the losses a bank incurs and no capital needs to be set aside as a reserve requirement for these accounts. However, one needs to investigate how the CAR numbers are

56

calculated in order to make a sound decision about whether or not the Islamic bank is deemed stable. Another point which came out of the evaluation of the annual reports was that when being a risk-seeking investor, one could gain a higher return when depositing your money at an Islamic bank instead of at a conventional bank. This return, however, differs greatly per bank and therefore in-depth research is necessary before any amount is deposited. Since Islamic banks can invest their monetary resources also in Islamic indexes, it is interesting to investigate the return of these indexes and the correlation of Islamic indexes with their conventional counterparts and with the market. The latter is assessed by means of a regression analysis and a calculation of the betas and showed that Islamic indexes generate comparable returns and enjoy almost the same correlation with the market as their conventional counterparts, except for the DJ Islamic Consumer Services index and the DJ Islamic Basic Materials index. Besides, all DJ Islamic indexes seem to be as risky as the market except for the DJ Islamic sub indexes of Technology, Utilities and Industry which are significantly riskier. Regarding mean returns, no significant difference could be found. However, the DJ Islamic indexes do outperform their DJ World counterpart indexes on a riskadjusted basis a pointed out by their higher Sharpe ratios, except for the DJ Islamic Consumer Goods index. This indicates that investing in Islamic indexes does pay off for an investor, since a superior return can earned per unit of risk. So investing in DJ Islamic indexes is interesting for the non-Muslim investor and for the Muslim investor who are looking for a greater risk-adjusted return as is generated by investing in conventional indexes. So, from a consumer perspective, Islamic banking is interesting for the risk-seeking nonMuslim depositor or for the Muslim depositor who wishes for a Shariah-compliant bank. Furthermore, investing in DJ Islamic indexes is interesting for every investor since higher risk-adjusted returns can be generated.

57

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(2008). The Development of Islamic Finance in the UK: The Government's Perspective, Her Majesty's Treasury, UK: 1-36.

Ahmed, H. and T. Khan (2007). Risk Management in Islamic Banking. Handbook of Islamic Banking. Cheltenham, UK, Edward Elgar Publishing Ltd.: 144-158.

Archer, S. and R. A. A. Karim (2005). "On Capital Structure, Risk Sharing and Capital Adequacy in Islamic Banks." International Journal of Theorethical and Applied Finance 9(3): 269-280.

Ariss, R. T. and Y. Sarieddine (2007). "Challenges in Implementing Capital Adequacy Guidelines to Islamic Banks." Journal of Banking Regulation 9(1): 46-59.

Ayub, M. (2007). Understanding Islamic Finance. Chichester, UK, John Wiley & Sons, Ltd.

Bodie, Z., A. Kane, et al. (2007). Essentials of Investments. Singapore, McGraw-Hill.

Bose, S. and R. W. McGee (2008). Islamic Investment Funds: An Analysis of Risks and Returns, Florida International University Chapman Graduate School of Business.

Cakir, S. and F. Raei (2007). Sukuk vs. Eurobonds: Is There a Difference in Value-at-Risk? IMF Working Paper 07/237. Washington, International Monetary Fund.

Chapra, M. U. and T. Khan (2000). Regulation and Supervision of Islamic Banks. Occasional Paper. Jeddah, Saudi Arabia, Islamic Development Bank Islamic Research and Training Institute.

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Chong, B. S. and M. Liu (2007). "Islamic Banking: Interest-Free or Interest-Based." PacificBasin Finance Journal, Forthcoming.

Cohen, E. (1992). Athenian Economy and Society: A Banking Perspective. Princeton, N.J., Princeton University Press.

Crouhy, M., D. Galai, et al. (2006). The Essentials of Risk Management. New York, USA, McGraw-Hill.

El-Din, S. E.-D. T. and M. K. Hassan (2007). Islam and Speculation in the Stock Exchange. Handbook of Islamic Banking. Cheltenham, UK, Edward Elgar Publishing Ltd.: 240-255.

El-Gamal, M. A. (2006). Islamic Finance - Law, Economics, and Practice, Cambridge University Press.

Elfakhani, S. M., M. K. Hassan, et al. (2007). Islamic Mutual Funds. Handbook of Islamic Banking. Cheltenham, UK, Edward Elgar Publishing Ltd.: 256-276.

Errico, L. and M. Farahbaksh (1998). Islamic Banking: Issues in Prudential Regulations and Supervision. IMF Working Paper 98/30. Washington, International Monetary Fund.

Hakim, S. and M. Rashidian (2002). Risk & Return of Islamic Stock Market Indexes. 9th Economic Research Forum Annual Conference Sharjah, U.A.E.

Hassan, M. K. and M. K. Lewis (2007). Islamic Banking: an Introduction and Overview. Handbook of Islamic Banking. Cheltenham, UK, Edward Elgar Publishing Ltd.: 1-20.

Hussein, K. and M. Omran (2005). "Ethical Investment Revisited: Evidence from the Dow Jones Islamic Indexes." The Journal of Investing 14(3): 105-126.

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Jaffer, S. (2005). Islamic Retail Banking and Finance - Global Challenges and Opportunities, Euromoney Books.

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Sundararajan, V. and L. Errico (2002). Islamic Financial Institutions and Products in the Global Financial System: Key Issues in Risk Management and Challenges Ahead. IMF Working Paper 02/192. Washington, International Monetary Fund.

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Information retrieved from the World Wide Web: Information retrieved from the Bank for International Settlements, 1 May 2009, www.bis.org Data retrieved from DataStream, May 23 2009 Data retrieved from the Dow Jones Indexes, May 23 2009, www.djindexes.com Information retrieved from the Islamic Financial Services Board, 5 May 2009, www.ifsb.org Information retrieved from the Institute of Islamic Banking and Insurance, 20 May 2009, www.islamic-banking.com Data retrieved from the Federal Reserve Bank St. Louis, July 4 2009, www.research.stlouisfed.org/fred2 Information retrieved from the official website of Zembla, July 6 2009, www.zembla.vara.nl

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Appendix A: Banking in a Historical Context

Conventional Banking History The origination of banking practises go back to 575 BC when carrying gold with you during travelling was not safe and thus people deposited their money in temples. A temple was a solid building where at every moment someone was present and besides, the temple was a sacred place and thus thieves could be discouraged to enter (Ayub, 2007). Shortly thereafter the Greek set up the Igibi bank of Babylon which accepted deposits and fulfilled the demand of the small farmers to buy seeds by providing them with personal loans. However, due to a bad harvest these loans most often could not be paid back which resulted in the loss of land by the farmers and eventually into slavery. In 594 Solon ended these exploiting practices and let off the outstanding debt of the farmers and gave them back their land. In spite of the cancellation of the debt, there was not an overall ban on providing loans with interest; it was only prohibited to provide loans with interest to widows and minors. The interest charged by the Greek differed from 10 percent up to 33 percent, depending on the region and the risks taken. Regardless of the acceptance of interest by the Greek, the Greek philosophers Plato (428-347 BC) and Aristotle (384-322 BC) did not agree with these practises for the reason that in their opinion charging interest could disrupt society. Even though they disapproved, only after the 2nd century AD, as money supply increased, interest rates decreased (van Straaten 2002). Cohen (2000) argues that in the 4th century the economy in Athens enjoyed the existence of regulated and unregulated banks that supported the market economy. These banks not only provided personal loans but as well exchanged currencies and took on deposits. The latter was mainly necessary to finance the maritime loans to enable merchants to trade oversees. Repayment of these loans were only needed when the ship safely arrived at its destiny, in other words, if the ship did not survive the trip the bank would lose the investment totally (van Straaten 2002). Accordingly, the principle of risk bearing was already introduced by the Greek. The Romans took over these banking practises, only their opinions about interest differed slightly with the views of the Greek. Within the Roman empire charging interest was allowed only when collateral was provided, for example, a horse or a house, or when a debtor delayed the repayment. Besides, interest on productive credits was allowed and the Romans banned interest on consumptive credits. The former was very important for the development

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of trade. However, due to the collapse of trade after the fall of the Roman Empire, around 500 AD, the need for banking services decreased rapidly and banking was made redundant in Western Europe (Van Straaten 2002). To sum up, the Greek and Romans played an important role in the development of what we nowadays know as banking. Those days, the ban on interest was not only caused by religious reasons but also because it was considered unethical and it would impoverish people.

As from around 1100 banking practises in Western Europe began to revive again, caused by a need to finance the crusades. Furthermore, during the 12th and 13th century the European trade and commerce needed to be financed. Exodus 22.25 cites: If you lend money to my people, to the poor among you, you shall not deal with them as a creditor; you shall not exact interest from them. This ban of the Roman Catholic Church offered chances to exploit this opportunity for people with a different religious background, for example the Jews. The Jews were banned from most forms of employment and were pushed in jobs such as collecting rents and taxes and lending out money. The Jews fulfilled that need of society for financial services. The Jews did ask interest on their loans, nonetheless only on loans that were provided to non-Jews because it was forbidden to ask interest on loans that were made to their own people (Van Straaten 2002). Even though the Jews were forced into this role of moneylenders, it did made them very unpopular and it even led to anti-Semitism. Laquer (p. 154, 2006) states: Following centuries of church condemnations of Jewish usury, the Jews were expelled from many countries and regions, their communities were impoverished, and very few individuals had the necessary capital to engage in money lending. One of the greatest expulsions of Jews happened in England in the years 1289-1290. Those days the King of England Edward I (1272 1307) expelled all Jews from England. The main reason for Edward I was the fact that the Jews charged usury, which he regarded as exploitation of the state (Kessler and Wenborn, 2005). Laquer (p.154, 2006) continues the above quote with: ..Money lending continued, of course, and the Lombards took 250 percent interest (this, however, did not cause a wave of anti-Lombardism). As stated in the quote, the Jews were gradually replaced by the Lombards, a group of Christian bankers.

The negative effect of the prohibition of interest was that people did not see the benefits of investing their money in a risky project without receiving compensation for the risks incurred. The consequence was that people were hoarding up their money and thus there was less 63

capital available in the market to finance trade and other commercial activities which were important for economic development. On the other side, the ban on interest did stimulate entrepreneurship and thus effectively using ones own money. However, in practice, during the 14th century, this need for efficiency most often resulted in creating innovative solutions to work around the ban on interest. Clever structures were invented to replace interest, because the severe rules of the Christian Church were not in line with the financial development and the rise of capitalism in Western Europe. The prohibition of paying or receiving interest of the Roman Catholic Church lasted till around 1838 (Van Straaten, 2007).

In medieval England there was a gradual transformation from moneylenders to private banks led by the goldsmiths families. They were the first to accept money and to issue receipts to their depositors. The latter group used these receipts to settle their debts and thus did not need to go back that often to the goldsmith to withdraw their money. An opportunity for the goldsmiths followed and the concept of money creation evolved. They could lend out more money than actually deposited, since their depositors did not need to withdraw their money at all times; the receipts had monetary value. So the deposited money was lend out at a certain interest rate, which could be kept by the families themselves. The goldsmiths always did hold on to a specific amount of money as a reserve to cover the claims for withdrawals. Only by the late 18th century the goldsmiths made banking their line of business (Ayub 2007). Throughout the last 200 years the banking practises evolved to what we call nowadays conventional banking.

Islamic Banking History As stated above, formerly charging interest was prohibited by the Christians, the Jews and the Muslims. However, as time passed the Jews started charging interest and nowadays this is still the foundation of our conventional banking system. The next paragraphs will elaborate on the evolution of Islamic banks and why they manage to hold on to the ban on usury. Usury means in this context a ban on all forms of interest, not only on charging excessive interest.

The first Muslim-owned banks were established in the 1920s and 1930s. Back then these banks adopted similar principles as their conventional counterparts. As from 1940s and 1950s several trials with small Islamic banks were undertaken in Malaysia and Pakistan. The first success in Islamic banking took place in 1963 in the city Mit Ghamr, Egypt, where the Mit 64

Ghamr Local Savings Bank was established. This bank proved that banking according to the Islamic law could be successful. Other successes followed during the 1970s; among others, the Intern-Governmental Islamic Development Bank in Jeddah and the Bahrain Islamic Bank were founded (Tamimi 2005). In 1977 the International Association of Islamic banks was set up to coordinate the different Islamic banks on Shariah rulings. In the 1980s the first Islamic bank was established in a non-Muslim country, namely the International Islamic Bank of Investment and Development in Luxembourg (Venardos 2006). Next, the two growth periods of Islamic banking are discussed; the first being the 60s & 70s and the second being the period as from the last two decades.

The growth of Islamic banks in the 1960s and 1970s was a result of several reasons. The first being the disapproval of interest by neo-revivalists. The view of the latter group of contemporary thinkers is most important in the development of Islamic banking and they made every effort for a return of the fundamentals of Islam, Quran and Sunnah. The Quran states (Quran 4:161): That they took riba, though they were forbidden; and that they devoured men's substance wrongfully;- we have prepared for those among them who reject faith a grievous punishment. According to their opinion the term riba is referring to all types of interest and thus should not be allowed in any form. Hence, this last group of people was responsible for a revival of Islamic principles (Sinke 2007). Chong and Liu (2007) confirm that the growth in Islamic banking is indeed not due to the advantages of the specific features of Islamic banking but mostly because of this revival of the Islam worldwide as from the 1960s. The second reason was the discovery of large oil fields in the Middle East and the rise of the oil price in 1973 and 1974. Both created great opportunities for development in the countries where the oil was found, and besides there were job opportunities created for the neighbouring countries. The money that was earned was an enormous stimulus for the economy and thus for the development of the banking industry. The latter has spurred the demand of Muslims for Shariah compliant financial products. The last reason is the resentment of the Muslims against the Western world. After the First World War the great Ottoman empire was sliced up and many parts became a colony of the West. Only by the mid20th century most countries regained their independence. During the colonial period the Western banking style was forced onto the inhabitants of the colonies. Thus, the imposition of the Western banking style caused a lot of resentment amongst the Muslims(Venardos 2007).

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Accordingly, the thoughts of the neo-revivalists, the discovery of oil, and the resentment of the Muslims against the West, were the main reasons to go back to the Islamic roots and to introduce interest-free Islamic banking in the 60s and 70s.

The increase in interest in Islamic finance as from the 90s is mainly due to the fact that the wealth of Islamic states is growing and the socio-political situation is changing in some states. As a consequence more Muslims are interested in investing and banking according to the rules of the Islamic law (Sinke 2007). Furthermore, according to Badawy (2005), another reason for the growth in Islamic banking of the last decade is the reaction of the United States after September 11. The United States placed severe restrictions on obtaining a visa and besides, freezed the assets of Muslim investors. Both resulted in a withdrawal of capital by many Muslim investors which they put into accounts of local and regional Islamic banks. Migration of Muslims as immigrant labor to the United States and Europe also plays a crucial role in the growth of Islamic banking in the Western world. Especially in the United Kingdom where as from 2004 three Islamic banks are operating10 (Verhoef, Azahaf & Bijkerk 2008).

Interesting to note is that at present time we live in the year 1430 according to the Islamic calendar. A fascinating comparison can be made between the medieval times according to the Christian era and the medieval times of the Islam today. Namely, the resistance against interest in Western Europe has been the strongest around 1400 AD when the religious leaders were most influential. This indicates that around the 14th century AD the Christians as well prohibited interest, however, due to upcoming capitalism the charging of commercial interest was needed to stimulate the economy and thus people invented numerous strategies to work around this ban. Eventually the practice of charging and receiving interest was legalised again. Van Straaten (2007) questions whether Islamic banking can integrate and survive in the form it has today in our capitalistic world economy or whether the banking system needs to adapt to modern times. As the history of our conventional banking system reveals, the latter happened around 1400 AD.

10

Islamic Bank of Britain (2004), European Islamic Investment Bank (2006), Bank of London and the Middle East (2007)

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