InternationalizationofIslamicFinancialInstitutions:ChallengesandPathstoSolution by: SamyNathanGaras Villa5,Gate789,Road3217 Manama,BuAshirah332 KingdomofBahrain Telephone:+97339299589 EMail:samynathan@nyit.edu.

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ABSTRACT TheIslamicFinancialInstitutions(IFIs)havewitnessedasignificantgrowthrecentlyand becomeanewplayerinbankingindustry.AsIFIsmovetowardstheinternationalmarkets,they confrontseveralchallengesoninternalandexternallevels.Internally,IFIsstillhavelimited recognitionbyinvestors,marginalcontributiontothemacroeconomyandlimitedcustomer service.Externally,IFIshavelackofcommunicationwithotherplayersinthefinancialmarkets. Theirproductsarenottotallypromotedtotheinternationalinvestorsandtheirsystemisnot completelyregulatedandrecognizedbycentralbanks.Thispaperwilladdressthesechallenges andprovideaconceptualframeworkofsolutions. INTRODUCTION DuringthelastthreedecadesIFIshavebeengrowingsignificantly,bothdomesticallyand internationally.IFIswitnessedanaverageannualgrowthrateof23%(approximately)during theperiod19932003,and20%since2003(CIBAFI,2004). ThesenewfinancialfirmswereestablishedintheemergingmarketoftheMiddleEasttomeet thedemandofinvestorsandborrowerswhoaremotivatedbyprofitmaximizationbasedonthe Islamiclaw(Sharia).IFIsofferawiderangeofIslamicfinancialinnovationsstartingfromthe simplecontractofprofitsharingagreement(Mudaraba),whichissimilartotimedepositin conventionalbanks,toIssuingIslamicbonds(Sukuk)andderivatives.ThegrowthofIFIs attractedsomeoftheconventionalfinancialfirms(i.e.,ABNAMRO,CitibankandDresdner KleinwortBenson)toaddtheserviceofIslamicwindowstotheirclients.Despitethe advantagesthatareembeddedinIFIssystemandmanagement,IFIsencounterseveral fundamentalchallengestotheprospectofbeingrecognizedinternationally.Thechallengesexist inlocalaswellasglobalmarkets.Theseadvantagesandchallengeswillbediscussedthrough thefollowingquestions: 1. WhataretheadvantagesthatmakeIFIsdifferentfromconventionalbanksandhowthe customersperceivethesecharacteristics? 2. WhatarethechallengesthathinderIFIsfrombeingrecognizedlocallyandinternationally? 3. HowcanIFIsarticulatethepropersolutionstomeetthesechallenges?

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Thepaperwillbedividedintothreeparts.FirstpartwillexplainthecurrentsituationofIFIs, explainingthefactorsbehindtheirgrowthinlocalandinternationalmarketsanddiscussesthe advantagesofIFIssystemthatmakesthemuniqueandattractivetoallcustomers.Secondly,it willpresentamodeldiscussingthetwotypesofchallengesbeforeIFIsinternationalization: challengesinsidetheIslamiccountriessuchasthelimitedrecognitionofinvestorstoIFIs activities,thelimitedcontributionofIFIstothecountryseconomyandthelimitedcustomer service.TheothersetofchallengesexistoutsidethenonMuslimcountriessuchasthecultural barrierswiththeWesterncountries,thecautiousnessofinternationalcustomersinbeing involvedwithIFIstransactionsandthemisconceptionofIFIsstereotype.Thirdly,thepaperwill providesomesolutionsthatcanbeimplementedtofacilitatetheprocessofinternationalization andprovidesomelessonstoconventionalbanksonthetechnicalandmanagementsides. LITERATUREREVIEW Internationalizationhasbeenunderdiscussionforalongperiodoftime,wheredifferentauthors lookedattheprocessofinternationalizationfromdifferentviews.Forinstance,Buckleyand Casson(1976)lookedatthetransactioncostsforintangibleassetsandtheabilitytoobtainand transferknowledgeacrosstheinternationalmarkets.ThisideahasbeenarguedbyHennart(1982) andCaves(1996).Furthermore,JohansonandVahlne(1977,1990)andCarpanoandChrisman (1994)arguedtheinfluenceofinternationalizationonthefirmsperformance.Inaddition,Doz andPrahalad(1984)focusedontheorganizationandmanagementofmultinationalfirmsandthe balancebetweeninternationalheadquartersandnationalsubsidiaries(MartinezandJarillo,1991; PatersonandBrock,2002).Furthermore,Ghemawat(2001,2003)notedhowsometypesof dimensionsamongthecountries(i.e.,cultural,administrativeandgeographicaldimensions) influencetheinternationalizationprocess.Therefore,theyshouldbestudiedwiththeintegrative frameworkofinternationalization.Thesedimensionsincludethelanguage,religionandsocial norms(culturaldimension);political,legalandeconomicsides(administrativedimension);and income,population,andeducation(geographicaldimension).Theculturaldimensionwas studiedindetailbyHofstede(2001)andothers(Schwartz,1996;BondandChi1997;Schwartzand Bardi,2001)wheretheybuiltarelationshipbetweenculture,valuesandpractices.Thecultural

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dimensionhasasignificantinfluenceontheinternationalizationprocessofIFIs.Ontheother hand,IFIshavehighcodeofethicsderivedfromtheIslamicreligionwhichenhancestheir CorporateSocialResponsibility(CSR),whichbroughtthemafavorableimagefromthe stakeholdersandenhancedtheirperformanceintheirearlystage.Thisthoughthasbeen developedinliteraturebyDonaldsonandPreston,1995;McWilliamsandSiegel,2001andRowley andBerman,2000. ThereisascarcityoftheoreticalliteratureinIFIsinternationalizationprocess.ZaherandHassan (2001)provideacomparativestudyonthesalientfeaturesofIslamicbankingsupervisorysystem in15countries,explainingthelackofregulatoryframeworkinIFIs,whichposesagreatchallenge onIFIstouniformtheirstandardsandpoliciesandmandatethemonallIFIsregardlesstheir countries.Inaddition,AggrawalandYousef(2000)arguedtheeconomicrationalesforthe superiorityofIslamicfinancingsystemoveritsconventionalcounterpart.EbhrahimandJoo (2001)arguedthatIFIsinternationalizationprocessgreatlydependsontheregulatorswhoshould developamodernfinancialengineeringsystemfortheadvancementofIFIs.Thiswouldreduce theirdependenceontheconventionalbanksfordrawingtheirexpertise.Siddiqi(2001)argued thatIFIsinternationalizationischallengedbydevelopingtheriskmanagementandanalysistools inIslamicfinancialtheoryandpracticetohedgeagainstthevolatilityintheinternationalmarkets. Inaddition,IFIsneedtoeducatetheinternationalinvestorswiththeirIslamicethicalfoundation thatisembeddedintheirproductsandtheirmarkupineachtransaction(Hassan,1999;Baldwin; HumayonandJohn,2000;Suseno,2002). ThispaperaimstoprovideaconceptualframeworkfortheinternationalizationofIFIsthrougha model,explainingthechallengesthatstandagainstIFIsandthepossiblesolutionstoovercome them. WHATISISLAMICFINANCING? Unliketheconventionalbankingsystem,theIslamicbankingsystemcanbedefinedasafaith basedsystemoffinancialmanagement,whichderivesitsprinciplesfromtheIslamicSharia.It promotesprofitsharingintheconductofbankingbusinessaswellasprohibitingpayingor receivinginterestonanytransaction(SallehandHassan,2004).Thisdefinitionassertsthemain

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pillarsofIFIs:guidancebyIslamicShariathroughaboardofIslamicscholarscalledtheSharia SupervisoryBoard(SSB)and,mostsignificantlyintermsofareconceptualizationinfinance, theprohibitionofreceivingprofit(interest)onborrowingandlendingcash.TheIslamic bankingsystemhasbeencriticizedforwhathasbeeninterpretedasthenotionofariskfree rewardorreturnandthelackofrecognizingthetimevalueofmoney(Khan,1994:13).This argumentisnottotallycorrectbecauseaccordingtothemoderneconomictheoryandanalysis, Islamicbankingisbasedonequitybasedsystemnotonthedebtbasedsystemwhichisthebase ofconventionalbankingsystem(Khan,2000:628).ThismeansIFIsofferanuncertainrateof returntotheinvestorsandincaseofincurringanyrisk;itshouldbesharedbetweenthebank andtheinvestor.ThissystemallowsIFIstoadjustthevalueoftheirassetsandliabilities accordingtoanychangesinthefairmarketvalueoftheinvestment.Thismeansthelossis alwayssharedbetweentheIFIandtheinvestors.Onthecontrary,theconventionalbanking systemdoesnotreflectthechangesinfairmarketvalueoftheinvestment,insteadthebank assumesthelossaloneresultingindisequilibriumbetweentherealvalueofassetsandliabilities andendingbynegativenetworthofthebank(Haron,2000:631).Theprohibitionofpre determinedinterestrateonloansputspressureonIFIstomonitortheborrowersatareasonable costandgettheexactinformationaboutthegeneratedprofitbecausethelendermightprovide asymmetricinformationabouttherealprofit.Therefore,theportfoliosofIFIstendtobe concentratedinshortterm,traderelatedassets(DiamondandDyhvig,1983:401).This emphasisonshorttermfinancingleadstoaninimicaleffectoninvestment,growthand economicdevelopment.Thisconceptreflectsthesocialcommitmentbetweenthebankandthe investorsinenhancingtheeconomy. AccordingtoIslamicSharia,IFIscannotbeinvolvedintheproductionordistributionofspecific activitieswhichareforbiddenbyIslamsuchasalcohol,pork,andgambling.Inreplacement, theyshouldinvestinlongtermassetssuchasProfitSharingAgreement(Mudharabah),Cost PlusFinancing(Murabaha),EquityParticipation(Musharaka),andLeasing(Ijarah).These activitiesarebasedonrealassetsratherthanfinancialassets(BahrainMonetaryAgency,2006: 22).

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Duringthelastthreedecades,IFIshaveincreasedsubstantiallyintheMiddleEastandNorth Africa(MENA)countriesandwentfurthertotheFarEastandEurope.Amongallthecountries thathostIFIs,BahrainstandsasapioneerinhostingthelargestnumberofIFIs(37banks)in spiteofitssmallestsize1.BahrainhostsalltheregulatorsofIFIswhichwillbepresentedinthe followingsection.ThereasonbehindthisgrowthinBahrainisthelackofnaturalresourcesin thecountry,whichmotivatedBahraingovernmenttonourishtheIslamicbankingindustryand makeitasoneofthemainresourcesofincome.Inaddition,thereisnocorporatetaxinBahrain, whichsupportstheIFIssystem.AsParker(1993)notedthatBahrainiplannersarekeento portrayBahrainsfutureasequivalenttoSingaporeintheFarEast. GlobalIslamicEconomy Sofar,theexactsizeoftheglobalIslamiceconomyhasnotbeenpreciselyidentified.However, forthepurposeofthisstudy,wehaveconsideredthe57membernationsofOrganizationof IslamicCountries(OIC)astheprimarypromotersofIFIs(http://www.oicoci.org).Previous studiescoveredpartofthiseconomysuchasMENAcountries,butbypassedthecountries whereMuslimpopulationisbelow50%,asintheexSovietrepublics,U.K.,FranceandIndia. ThetargetedIslamiccommunitieshaveincommonthecharacteristicsofahighlevelofpoverty, debtandhighpopulationgrowth(Moore,1997:2).Thedebtaccumulationisoftencondemned byIslamiceconomists,especiallyinthosecountrieswhohavetheopportunitytoimproveother industriessuchastourism,manufacturing,andnaturalresourcesthatcanenhancetheir economy(Chapra,1985:84).ThesecondcharacteristicforMuslimeconomiesistheirlarge defensebudgetsandthegovernmentsubsidiestoutilities(i.e.,electricity,communication, water,andtransportation)insteadofprivatization.Thethirdcharacteristicisthelow availabilityofemploymentintheprivatesector.Thepublicsectoraccountsfor3060%ofthe laborforceinmostofMENAcountrieswithalmost95%inGulfCooperationCouncil(GCC) countries.2

Bahrainisasetof33smallislands,locatedattheNorthEastofSaudiArabia.Ithassmallproductionofoil comparedtoitsneighborcountries.Accordingto2007statistics,Bahrainhasasmallpopulationof708,573 approximately(http://www.infoplease.com/ipa/A0107313.html). 2InternationalMonetaryFundMiddleEastandCentralAsiaRegionalEconomicOutlook(2005)

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MostoftheIslamiceconomiesareworkingtowardspromotinglocalsavings,attractingforeign investments,andreducingtheircapitalexpenditures.Themostreadilyavailableandusefultool forachievingtheseendswasthecreationofabankingsystembasedonIslamicprinciples. TheArabianGulfcountriesconstitutethefoundationforIFIsbecauseoftheirsimilarityin religion,culture,languageandaridgeography.TheyhavefouroutoffivelargestIslamicbanks intheworldandmaintainthehighestconcentrationofIslamicdepositsandcapitalduetothe highincomeintheregion.3ThemembersofGCCcountrieshold20%oftheworldscrudeoil productionandhaveaGrossDomesticProduct(GDP)percapitaofmorethanUS$8,000. Therefore,thisregionwasfoundtobesuitablesoilforthissystemtogrowinandmovearound totheotherMuslimcountries. MalaysiaandSouthEastAsiaareadditionalfinancialregionsofinterestforIFIs,afterGCC countries.MalaysiaisconsideredthesecondmostpopulousIslamiccountrywith54%oftotal populationafterIndonesiawhichhas90%ofpopulation(Moore,1997:183).However,Malaysia comesasapioneerinIslamicbankingindustryforthewholeSoutheastAsianregion. Fromtheperspectiveofconventionalbanking,thesuccessofIFIscanbegaugedbytherush amongtheconventionalbankstoopentheirownIslamicwindows,notonlyinsidetheIslamic worldbutintherestoftheworldsuchasCitibank,ABNAmro,HSBC,BNPParibas,andBank ofAmerica. Intheglobalmarket,IFIsareuniqueinproducingIslamicbonds(Sukuk)whicharedifferent fromthetraditionalbondsandequityinstruments.Thisnewtooloffersasourceoffunding basedontheprofitsharingconceptbetweenIFIsandinvestors,shiftingtherisksfromthebank sideasinthecaseoftraditionalbondstobeonasharedbasisbetweenthebankandthe investors.Itenablesthebanktoexploittheircomparativeadvantagesintheloanprocessand maintainacustomerrelationshipevenwhenloanscannotprofitablybeheldonthebalance sheet(Alkhan,2003:16). IslamicSukukarewrittendocumentsthatcanbetradedinthecapitalmarketandbear ownershipintangibleassets.TheyarebasicallycertificatesevidencingtheSukukholders

3AlRajhiBankingandInvestmentCorp.SaudiArabia;KuwaitFinanceHouseKuwait;FaisalIslamicBankofBahrain; DubaiIslamicBankU.A.E.,andFaisalIslamicBankofEgypt,whichispartoftheAlBarakaBankingGroup.

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ownershipinone,ormoreassets.4Forinstance,PartnershipFinancing(MusharakaSukuk)and TrustFinancing(MudarabaSukuk)aregoodexamplesofSukuk,whereinvestorscontribute moneytotheIslamicbankonthebasisofthesetwoinstruments,toacquireownershipand profitinrealassets.Thesetypesoffinancingreflecttheconceptofprofitsharing,riskbearing conceptbetweentheIFIsandtheirinvestors. ThefactorsbehindtheGrowthofIFIs SeveralfactorshadcontributedtothegrowthofIFIs,suchastheeconomicalgrowthofGCC countriesasaresultoftheoildiscoveryandtheestablishmentoftheOrganizationofPetroleum ExportingCountries(OPEC)(Moore,1997:7).Thisunexpectedresourceofincomechanged completelythelifestyleintheregionandprovidedthefoundationforIFIs.Inaddition,Saudi ArabiatooktheleadamongtheIslamiccountriestopromotethespiritofIslamthroughfinancial supporttotheMuslimcommunitiesintheformofestablishingIslamicuniversities,institutes, andIslamiccenterstostrengthentheArabicandIslamicidentity(Halliday,1996).Duringthat time,twoSaudifundedfinancialfirmshavebeenfounded(DallahAlBarakaGroup,1969and DarAlMaalAlIslamiOrganization,1981)tosupporttheinternationaldevelopmentofIslamic banking.AfterthetragedyofSeptember11,mostoftheArabinvestorspreferredtoholdalarge portionoftheirinvestmentsintheMiddleEastincaseofanothersimilarevent.TheIFIswere thebestagenttomanagetheirinvestments.Inaddition,thecentralbanksinGCCcountriesand especiallyinBahrain,urgedtheAccountingandAuditingOrganizationforIslamicFinancial Institutions(AAOIFI)tosetuptheaccountingandauditingstandardsforIFIstoprotectthese investments. CHALLENGESBEFOREIFIsINTERNATIONALIZATION ThereareseveralchallengeshinderingtheIFIsfrombeinginternationalized,whichcanbe classifiedintotwosetsofchallenges.ThefirstsetincludesthreechallengesinsidetheIslamic countries.First,theregulatorslimitedinfluenceoverIFIsactivitiesandtransactionsinmostof OICcountriesleadstoinvestorslimitedrecognition(Grais,2004).Secondly,thelimitedroleof

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

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IFIsinmoneyandcapitalmarketsresultsinlimitedcontributionstothecountrysmacro economy(Ahmad,PradhanandAhmad,2005).Thirdly,thesignificantshortageofqualified manpowerandmanagementinsideIFIsleadstolimitedcustomerservice(ElhiraikaandHamad, 2003). ThesecondsetincludesthreechallengesoutsidetheIslamiccountries.FirsttheSSBinfluence overtheIFIstransactionsandactivitiesmightbemisperceivedinnonMuslimcountriesand createaculturalbarrier(Mirza,andHalabi,2003,347).Secondly,thedifferentcharacteristicsof IFIstransactionsandtheirreligiousfoundationleadtocustomerscautiousnessandaddextra challengebeforeIFIsinpromotingtheirproductsinternationally(IqbalandMirakhor1999,381). Thirdly,thelimitedcapitalofIFIscomparedwiththetotalcapitalofthefinancialinstitutionsin anycountryleadstomarginalrecognitionbythecentralbanksandenforcestheIFIsto accommodatewiththeexistingruleswhichmightnotbecompliantwithIslamicSharia(Al OmarandAbdelHaq,1996). InsertFigure1abouthere ChallengesinsidetheIslamicCountries SincetheconventionalbankingsystemiswidelyspreadinsideaswellasoutsidetheIslamic countriesfordecades,itgainstheclientstrustespeciallyifitiswellregulatedandactively contributedtotheeconomy.Ontheotherside,IFIsarenewplayerinthefinancialmarket; therefore,theystrivetocompetewiththeexistingsysteminsidetheIslamiccountries.IFIsare stillbuildinguptheirregulatorysystemandtryingtocontributetothecountryseconomyin linewithIslamicSharia.IFIsarecurrentlyrecruitingtheiremployeesandmanagementfrom thosewhoworkinconventionalbanksbecauseoftheseriousshortageintheirmanpower. Investorslimitedrecognition:Inthefinancialindustry,theregulatorshaveasignificantrolein organizingandcontrollingthetransactionsandimplementingthefiscalpolicyforthewhole country.IFIsarealwayscompliantwiththedominantregulationsofanycountrytheyoperate

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in;however,theyhavetheirownsetofregulatorsthatfacilitateappropriateinteractionwiththe IslamicSharia.ThefirstelementoftheIslamicsupervisorynetworkisAAOIFI,whichwas establishedin1991forthepurposeofissuingstandardsinaccounting,auditing,governance, andShariaforIFIsinaccordancewithInternationalFinancialReportingStandards(IFRS) (Thomas,CoxandKraty2005,207). In2003,theIslamicFinancialServicesBoard(IFSB)wasstartedinKualaLumpurtoserveasan internationalstandardsettingbodyofregulatoryandsupervisoryagencies (http://www.ifsb.org).TheIFSBisfocusedonthestructuredregulatoryconvergenceof supervisorystandards.Thisinternationalconvergenceismeanttoachievecomparable standardsofcapitalmeasurementsandcapitalstandards. In2001,theInternationalIslamicFinancialMarket(IIFM)wasfoundedwiththecollectiveefforts ofthecentralbanksandmonetaryagenciesofsixcountriestofacilitatesecondarymarketsfor Islamicinstruments.5Ithastwoprimaryroles:marketeducationandShariaauthentication, whichcontributetomoreselfregulationandpromotionofIslamicmoneyandcapitalmarkets. In2005,theCentralBankofBahrainestablishedTheLiquidityManagementCentre(LMC)for thepurposeofprovidingsecondarymarketbuyerforIslamicbonds(Sukuk).TheLMCplaysa keyroleinthecreationofanactiveinterbankmarketwhichwillassistIslamicfinancial institutionsinmanagingtheirshorttermliquidity.Theestablishmentanddepthofsuchinter bankmarketwillfurtheracceleratethedevelopmentprocessoftheIslamicbankingsector (http://www.lmcbahrain.com). Duringthesameyearof2005,TheIslamicInternationalRatingAgency(IIRA)startedoperating inBahraintoassistinthedevelopmentoftheregionalfinancialmarketsbyprovidingan assessmentoftheriskprofileofentitiesandinstrumentswhichcanbeusedasoneofthebases forinvestmentdecisions(http://www.iirating.com).TheIIRAprovidesdifferentservicesof ratingsuchassovereignratingsandcreditratingswhichincludeassessmentofanentitys abilitytorepaythedebtobligationsintimelymanner.Also,itprovidestheserviceofSharia qualityratingthatincludestheassessmentofthelevelofcompliancewithShariaprinciples.

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

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Inaddition,thereistheIslamicResearchandTrainingInstitute(IRTI),whichwasestablished undertheIslamicDevelopmentBankinBahraintosponsorsomeofthemostimportantanalyses ofproducts,regulations,supervision,developmenteconomicsandriskmanagement(Thomaset al.,2005:209). Finallyin2001,theGeneralCouncilforIslamicBanksandFinancialInstitutions(CIBAFI)was establishedinBahraintodevelopandmanageacomprehensivedatabasededicatedforIFIs includingadministrativeandfinancialinformationsince1998.Currently,CIBAFIisconsidered theonlyreliablesourceofinformationaboutIFIsatthegloballevel.6 InsertFigure2abouthere InmostoftheIslamiccountriesthecentralbanksarenotinpracticeoftheirmainroleinleading theIslamicfinancialinstitutionsintoefficientmobilizationofsavingsandallocationofresources (Khan,2000:627).Intheory,thereisnothingthatmakescentralbanksinIslamiceconomydiffer inamajorwayfromthetraditionalconceptofcentralbanking.Inreality,thecentralbanksin mostoftheIslamiccountriesdonottaketheiressentialroleofinitiatingandfosteringthe developmentofprimary,secondary,andmoneymarketsthatareapprovedbySSB.Theystill lacknewinnovationswhicharebasedonprofitsharingconcept,notfixedinterestrate. Also,thecentralbanksdonothaveaneffectiveroleinregulatingthestandardsandpracticesfor IFIs.Asaresult,theiraccountingpracticeswereinconsistentandthefinancialstatementswere nottransparentduetoinadequatedisclosure(Thomasetal.2005,207). Despitethesignificantgrowthoftheaboveregulators,theystillhavesomelimitationswhich maketheinvestorsreluctanttotrustIFIsinthesamewaytheytrusttheconventionalfinancial firms.Forinstance,AAOIFIstandardsaremandatedorusedasguidelinesonlyinsixcountries (Bahrain,Sudan,Malaysia,Qatar,SaudiArabiaandDubai)outofthe57countriesofOIC.IFSB lackstheauthorityandpowertomandatetheirstandardssuchasFinancialAccounting StandardsBoardandIFRS.IIFMhasstilllimitedaccessandpresentationinOICandtheir conferencesandseminarsarenotmatureyet.LMCiscontrolledbyBahraincentralmarketand

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

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cannottakeindependentdecisions.Theselimitationsleadtolimitedrecognitionfromthe investorsside. Limitedeconomiccontribution:althoughthemoneyandcapitalmarketsofOICarestill consideredasemergingmarkets,IFIsarerestrictedbyShariaregulationstoeffectivelytakepart inthosemarkets.IFIscannottradeinsharesorbondsofanycompanythatgeneratesrevenue fromalcohol,pork,andsimilaractivitieswhichareprohibitedbyIslam.Therefore,IFIshave innovatednewproductsinreplacementsuchasMurabahacontract,Tawarroqcontract,BeiAl UrboonandJoalacontract7. However,thesetoolsareneitheravailabletoallIFIsnorsignificantlycontributingtotheOIC macroeconomy.Inaddition,manyIslamicnationsaresignificantlyunderbankedandthis structuralfactpointstheneedofgrowthinsidetheIslamiccommunity.Currently,mostofthe IslamicbanksarelocalorregionalbankssuchasKuwaitFinanceHouseandBahrainIslamic banks.TheonlyIslamicbankthatiswellestablishedwith203branchesin10countriesis AlBarakaBankingGroup. InsertTable1abouthere Finally,IFIsdonothavesignificantcontributiontoincubatorsandentrepreneurshipinsidethe membercountriesofOICbecauseoftheirshortexperience.Theirinvestmentsarefocusedon wellestablishedbusinessesthatareapprovedbySSBonly. Limitedcustomerservice:IFIsareinneedforaccumulationofhumancapitalasitprovedtobean importantdriverofendogenousgrowthforIFIs(Elhiraikaetal.,2003;Barro1991,407).According totheHumanDevelopmentIndex(HDI)8fortheyear2004,Bruneiwasrankedat33andBahrain

Murabahacontractmeansbuyinganassetforcashandsellingitimmediatelyoncredit.InTawarroqcontractthe Islamicbankpurchasestheassetoncreditandsellsittoanotheroneforcash.BeiAlUrboonincludessettingupa fixedpriceforacommoditytobedeliveredinthefuture.JoalacontractisaconditionalpromisebytheIslamicbankto deliveraspecificquantityofanaturalasset(i.e.,oil,mineral,steel)uponextractiononanagreeddate.The commoditytraderwouldpaythepredeterminedpriceforit(AlSheahabi2003,1113). 8HDIisavailablewithHumanDevelopmentReportbroughtoutbyUnitedNationsDevelopmentProgramme (UNDP).Itisacompositeindexthatmeasuresachievementsofacountryindifferentparameters.

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at40,despitethesmallpopulationofthosetwocountries.Evenmorealarmingindicationsoflack includeIran,whichwasplacedat101,Sudanat139andPakistanat142.Thesecondalarming indicatorinthisreportistheeducationlevel,where73%oftheOICcountriesoccupythelower halfintheranksforcountrieslistedinHDI.ThesefactsshowthatIslamiccountriesand organizationshavenotbeenpersuasiveenoughinofferingnonMuslimcountrieswithIFIsvision andstrategy.ItindicatesthatIFIssuccessmayremainatsuperficiallevelsandchallengesposedto theconventionalfinancialsystemmayremainfeebleotherwise. Technology,althoughundergoingtremendousgrowth,canbesaidtoactasabackboneofthe financialsector,aswellasbeingamaindriverofmarketpower.Itappliesnotonlytothereal timeclearingandsettlementinmoneyandcapitalmarkets,butalsotointernetbasedofferings andAutomatedTellerMachines(ATMs)whicharenotfullyimplementedinIFIsduetotheircost andprocedures.EventhewebsitesofIFIsareservingadvertisingpurposesmorethantechnical supporttocustomers.9ArcoIndex(ArchibugiandCoco,2004)places38outof57OICcountriesin thelowerhalfofrankingsinthesetof162countries,with8out10lastplacesandallfivelastranks areoccupiedbyOICcountries.10 ChallengesoutsidetheIslamicCountries Ontheglobalscale,OICmembercountriesfaceaneconomicchallengewheretheGDPofall membercountriestogetherislessthan17%oftheGDPofUSAanddoesevenreach12%ofthe GDPofUSAandJapan(Ahmadetal.,2005).Sincetheeconomicsituationdoesnotsupportthe longtermgrowthprospectsforIFIs,itisimportanttopenetrateotherboundariesbeyondthoseof thetopGDPcountries.Inaddition,theWestisreluctanttoacceptanyapproachfromOIC countriesthatmightenhancepoliticalpowerintheOICcountries,suchasgrowthintheirfinancial system.ThedistortedstereotypeofIslamintheWestconstitutesasignificantchallengebeforeIFIs topenetratetheseboundaries.Also,thedifferenceinculture,languageandreligioncreates anotherbarrierbeforeIFIstowardstheirinternationalization.Inaddition,thelimitedcapitalof

De/Shakeel/Somashekar(2004)Deetal.hasbeendealingintechnologicalimpedimentsinDubaiIslamicbank (U.A.E.)whichreflectsthecurrenttechnologicalsituationoftheIslamicworld. 10Archibugi/Coco(2004),ArCoIndextakesintoaccountassociatedvariableswithtechnologicalchangessuchas(a) Thecreationoftechnology(b)Technologicalinfrastructureand(c)Developmentofhumanskills

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IFIscomparedtothecapitalofconventionalbanksresultsinmarginalrecognitionfromthecentral bankssidewhetherinsideoroutsidetheOICmembercountries. Culturalbarrier:oneofthetangibleproblemsbeforeIFIsiscommunicationbetweenMuslimsand thenonMuslimworldingeneral,andbetweenIslamicandconventionalbanksmorespecifically. Thisdistancebetweenthetwopartieshavebeenincreasedduetothemediaandthedifferent attacksbysometerroristswhodistortedtheimageofIslamintheculturalconsciousnessofnon Muslims.Therefore,IFIsfacegreatchallengeinreshapingthisimbalanceandbridgingthisgap betweenthedifferingwaysofknowingandbeing.Althoughtheproblemexists,thereisno IslamicorganizationchargedwiththecounterbalancingpresentationbetweenIFIsandtheir conventionalbankingcounterpart.IFIsneedtoarrangeformoreconferences,seminarsandother channelsofcommunicationstoshortenthisgapandcreateacommongroundwherethetwo partiesmeet.Inaddition,theSSBshouldstudytheproductsoftheconventionalbanksand encouragestheIFIstoinvestintheproductswhicharecompliantwithIslamicSharia.This changeinattitudewillencouragetheconventionalbankingsystemtochangetheirstereotypeof IFIs. InnonMuslimcountries,IFIshavefoundclasheswithmainstreamregulations.Forinstance, treatmentofLeasing(Ijara)inIslamicbankingsystemisrecognizedasnormalleasinginsteadof mortgagewhichchangestheconceptofIjarafrompurchasingtheassetbythebankandleasingit tocustomerstoanormalleaseofrealestate.Also,imposingtaxesbynonMuslimgovernments onIslamicreligiousalmsgiving(Zakat),leadstodoubletaxation.Zakatistreatedasanon operatingexpenseinIFIsfinancialstatementsandconsequentlyhasnoinfluenceontheirnet income(Ahmed,2002:120).Thus,IFIsarerequiredtopayregulatoryfeeswhichresultsindouble paymentstomeetthedualregulationsofIslamicandconventionalsystem. Customercautiousness:despitetheaforementionedadvantagesofsecuritizationinIslamic banking,internationalinvestorsarecautiousintradinginIslamicSukukduetotheiruncommon characteristics.Besides,thetaxationsysteminsomecountriesmighthaveimpact(eithernegative orpositive)onsecuritizationprocess;therefore,issuanceofSukuksometimescanbetaxdriven.

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ThislackofsupportfromthetaxcollectiondepartmentshinderstheissuanceofSukuk. Furthermore,thelimitedtoolsavailableforliquiditymanagementandthelackofanactive secondarymarketaddmorebarriersbeforeIFIstocontributetothefinancialmarkets.Thelast barrieriscausedbythepredominanceofdebtbasedmodesoffinancing,whicharedifficultto transformintonegotiablefinancialinstruments.OnceSukukhavebeencreated,theycannotbe transferredtoanyoneelseexceptatparvalue.ThiscausesthewholestructureoftheIslamic financialmarkettobehighlyilliquid.Also,itleavesnoopportunityincreatingsecondary financialmarket(AlKhan,2003:28). LimitedrecognitionofcentralbankscreatesabarrierbeforeIFIsintheirinternationalization process.Sofar,thereisnoIslamiccentralbankinsidetheOICmembercountries,whichmakes theIFIsdependentontheconventionalbanksinsteeringthefinancialindustry.Inthenon MuslimcountriessuchasEuropeandU.S.A.,Islamicbanksarenotrecognizedbytheircentral banksbecauseofIFIsmarginalroleintheireconomiesandthelackofdefinitiontotheIslamic bankingsystem.TheWeststillcannotfullycomprehendtheroleofSSB,wherebankingtype decisionsaremadebynonbankers,Islamicscholars(George,1995;Patrikis,1996). Furthermore,thecentralbanksinOICmembercountrieslackskillsofcommercialand investmentbankersandcapabilitiesofcreditanalysis.Forexample,thecentralbanksinIran andSudanusetheirinfluencetosteerthecountryseconomybystipulatingcertaincapitals towardsspecificindustriesthroughthereserverequirements.Also,thereisnostandardization amongtheSSBsinOICcountries.Forinstance,ifoneSSBapprovessometransactionsinone country,itdoesnotsecuretheirapprovalbyanotherSSBinadifferentcountry.Thus,thistype ofdisagreementleadstoconfusionintheIFIsglobalstrategyandmakesitharderforWestern regulatorstorecognize,understandandworkwiththissector(ClodeandElliott,1996:18). FRAMEWORKOFSOLUTIONS OntheInternalLevel TheOICmembercountriesneedtoprovidesupporttoprimaryandsecondarymarketsto enhancethecontributionofIFIs.Primarymarketsshouldfocusonpromotingnewissuesof stock,managingsubscriptionoperations,attractingindividualandinstitutionalsavingsand

15
directingthemtowardsproductiveprojects.Asaresult,newprojectswillbecreatedtoenhance theproductivitybaseandimprovethecountryseconomy.Thesecondarymarketcreatesa demandformarginaljobsandsupportsecuritiestradingforliquidationandrevenuepurposes (Kamel,2000:641). IFIsmustalsodevelopmoretransparencyintheirfinancialreportingbyeliminatingthe differencesintheiraccountingtreatments;whicharemainlyattributedtotwofactors:the differencesamongtheinterpretationsofShariascholarsandthedifferenceswithinregulatory authorities(Karim,1994).Thistypeofinternalselfregulationscreatesaccountingdifferencesand misleadstheusersoffinancialstatements. Furthermore,IFIsneedtostandardizetheirrulesofreporting.Forinstance,differentIslamic bankswillrecordthesameaccountsdifferently.Somebanks(i.e.,JordanIslamicBankandQatar IslamicBank)treatinvestmentaccountsthatarebasedonmudaraba(profitsharing)asobligations whileothers(AlRajhiBankingandinvestmentandShamilBankofBahrain)treatthesame accountsasfiduciaryinvestmentsandaccordinglyreportedthemasoffbalancesheetaccounts (Ahmed,2001:111).Also,thecollectedincomefromtheseaccountsisrecordedusingsixdifferent methodswhichmakestheincomerecognitionprocessdiffersfromonebanktoanother.11These typesofprofitsharinginvestmentaccountsshouldberecordedaslimitedtermequityinstrument withresidualclaims. IFIsregulatorsneedtobeproactiveincreatingnewinnovationsofinvestmentsforIslamic banks.Forexample,theyshouldenhancetheinterbanktransactionssuchasovernightfunds andshorttermborrowingbecauseIslamicbankscannotusethesametoolsinconventional bankingsystembecausetheinterestrateisembedded.Inaddition,centralbanksneedtoreview thereserverequirementsonIFIsbecausetheirdegreeofriskislessthantheconventional counterpart(Khan,2000:629;Hemat,1994).Moreover,theregulatorsinOICcountriesshould followBahrainsmodelinsecuringastronglegalsystemforIFIsandestablishingappropriate licensingrequirements.

11Thesixmethodsofincomerecognitionare:upfront;wheninstallmentsfalldue;wheninstallmentsarepaid;equal distributionofincomeoverperiodoftransaction;endofperiodandconstantrateofreturn.(Ahmed(2001),p.112)

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AAOIFIhasrecentlyrealizedtheshortageofprofessionalmanpowerinIFIs;therefore,AAOIFI startedtwoprograms(CertifiedIslamicProfessionalAccountantandCertifiedShariaAdviser andAuditor)toenhancethelevelofcustomerserviceinsidetheIFIs.Thefirstprogramisin accountingandauditingofIFIsandthesecondinShariasupervisory OntheExternalLevel Althoughtherearedifferencesincultures,customsandtraditionsbetweentheEastandthe West,effectivedialogueshouldtakeplacebasedonthefollowingguidelines:First,different civilizationscomplementeachotherandleadtointegrationratherthanconflict.Secondly,the dialogueleadstorecognitionoftherightofeachpartyandrespectsit.Effectivedialoguewill identifytheobjectivesofeachpartyandgoesaboutachievingthemgraduallyandsearchfor commoncharacteristicsineachcultureandpromotethemwiththeaimofcreatingmore understanding(AlghatamandGalal,2007:204).IFIsshouldnotbeselfabsorbedentities; instead,theyshouldhaveanopenmindtotheinternationalmarket,makinguseofhuman experienceandmatchingbetweenShariarequirementsandWesternnorms.DespitetheSharia precautionsagainstcertainmechanismsandmethods,IFIscanstillcooperatewithconventional bankinginstitutionsinthefieldofnewinstruments. IFIsarestillstrugglingtostandardizetheiraccountingrequisites.Forinstance,AAOIFIstandards aremandatoryonlyinthreecountries(Bahrain,SudanandJordan)outofthe24membercountries andformthebasisforregulatorystandardsinMalaysia,SaudiArabiaandQatar(AAOIFI,20045: 23).Therefore,itisessentialforIFIstoestablishaunifiedframeworktostandardizepracticesin ordertoberecognizedgloballysuchastheGenerallyAcceptedAccountingPrinciples(GAAP), whichcoverallthestandardsofauditing,accountingandfinancialproductsinasystematicway (Moore,1997:248). IFIsneedtofindwaystobeinternationallyacceptedbytherecognizedratingsagenciessuch S&P500,Moodys,andIBCA.IfIFIstrytoarguethisapproachbyestablishingtheirownrating agencysuchasInternationalIslamicRatingAgency(IIRA)inBahrain,itwillbeselfdefeating ratherthanemergingininternationalmarket.Recently,Standard&Poorsestablishedanew sectionforS&PShariahIndicesandDowJonesalsohasestablishedDowJonesIslamicFund,

17
whicharepositivesignalstowardstheworldrecognitiontoIFIs.Toacceleratetheprocessof acceptance,Islamicscholarsneedtounifytheirratingsmethodologytobeintroducedeffectively totheinternationalmarket. CONCLUSIONS Globalizationhassignificantlyinfluenceddifferentaspectsofourlife:economically,politicallyand financially.Thepositivesideofglobalizationisthemovementoftechnologyandhumancapital amongthecountries,whilethenegativesideislackofgovernmentsabilitytocontroltheir economyanddeterminethecapitalflow.Onthefinancialside,theincreaseinoilpricesflourished theinvestmentsinGCCcountriesandencouragedtheirgovernmentstosupporttheIslamic financialsystem.Thisnewsystemprohibitsinterestonalltransactionsandfundamentallybased onIslamiclaws(Sharia). Currently,IFIsareexistedinMuslimscountriesaswellassomeEuropeanandAmerican countries.ThepotentialgrowthofIFIsisquitepossible;however,therearesomechallengesthat shouldbeaddressedtoacceleratetheprocessoftheirgrowth.Thesechallengescanbeclassified intotwosets:internalandexternal.Internally,theinvestorsstillrelyontheconventionalbanking systembecausethecurrentnumberofIFIsisnotlargeenoughtomeettheneedofOICmember countries,thecontributionofIFIsinmoneyandcapitalmarketsisrestrictedbySSBandthe customerserviceinsidetheIFIsisstillprematuretoattractnewclients.Furthermore,IFIslacka solidregulatorysystemtounifytheirproductsandtransactionssuchastheissuanceandtrading ofSukuk. Externally,thelackofcommunicationbetweenIFIsandtheothermembersinthefinancial marketscreatesagapbetweenthemandleadstolackofawarenessaboutIFIsproductsand customercautiousnesstowardstheIFIsactivities.Inaddition,thelimitedcontributionofIFIsto thefinancialmarketsresultsinlimitedrecognitionbycentralbanks. IFIsneedtoestablisheffectivecommunicationwiththeircounterpartstocorrectany misunderstandingandfacilitatetheprocessofenteringtheglobalmarket.Asaresult,the clasheswithmainstreamregulatorswillbeeliminatedandthestereotypeaboutIFIswillbe correctedintheeyesofnonMuslimcountries.Finally,IFIsshouldestablishacomprehensive

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trainingprogramfortheiremployeestounderstandtheuniquenessofIslamicfinancialproducts andhelptheinvestorstomeasuretheadvantagesofdealingswithIFIs.

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TABLE1 AlBarakaBankingGroupBranches Country Algeria Bahrain Egypt Jordan Lebanon Pakistan S.Africa Sudan Tunisia Turkey SubsidiaryName BanqueAlBarakaDAlgerie aAlBarakaIslamicBank bAlAminBank TheEgyptianSaudiFinanceBank JordanIslamicBank AlBarakaBankLebanon AlBarakaIslamicBank AlBarakaBankLtdSouthAfrica AlBarakaBankSudan BankElTamweelAlTunisiAlSaudi AlBarakaTurkParticipationBank Total Yearof establishment Branches 1991 11 1984 4 1987 1 1980 15 1978 66 1992 5 1991 15 1989 5 1984 23 1983 6 1985 52 203 Employees 461 261 32 604 1,457 110 595 150 685 117 909 5,381

Source:AlBarakaBankingGroupProspectus(2006),P.16

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FIGURE1 IFIsChallengestowardsInternationalization

Investors Limited Recognition

Limited Economic Contribution

Limited Customer Service

Limited Role of Regulators

Contribution in money & capital markets

Unqualified Employees

Challenges inside Islamic countries

Localization

Internationalization

Challenges outside Islamic countries

Lack of Communication

Different Transactions

Limited Capital of IFIs

Cultural Barrier

Customer Cautiousness

Limited Recognition of Central Banks

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FIGURE2 IFIsRegulatorsandInformationCenters
Enhance market understanding of Islamic finance Promote Islamic Research and Training

Islamic Financial Institutions: Islamic Banks, Investment Funds and Islamic Insurance Companies (Takaful) AAOIFI IRTI IFSB IIFM IIRA CIBAFI LMC Information Centers Regulators
Issue Accounting and Auditing Standards - Bahrain Issue Regulatory Standards Malaysia Create environment for Islamic secondary market - Bahrain Rating IFI and Islamic finance instruments - Bahrain Market maker for Islamic secondary market instruments - Bahrain

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Ideclarethat: Ihavesincerelyendeavoredtoproduceapaperofoutstandingacademicquality; I have produced this paper myself, without any outside assistance except from the people anddocumentsthatIquote; I have not copied and/or pasted this paper, or parts of it, from other papers or documents availableontheinternetorelsewhere,exceptwhereIhaveexplicitlystatedso; Ihavenotsubmittedthispaperormajorpartsofittoanotherseminarorclass,eitheratthe UniversityofSt.Gallenorelsewhere,andIwillnotdosointhefuture; Imayusepartsofthispaperformydoctoraldissertation.

___________ Samy Nathan