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The A to Z of Islamic finance products

According to Armen Papazian, associate at the Judge Business School, University of Cambridge, and former MD at the Dubai International Financial Exchange, Islamic finance has a very peculiar taste to it. "It's beautiful, in fact," he says.

"Applied properly, structured honestly, and delivered with integrity, it solves some of the basic issues that conventional economies have had. It creates a stronger link between the real and nominal dimensions of an economy and entrenches ethics as a core value within the system."

While this sounds encouraging, if you decide to use Islamic finance for a business purpose, or want to incorporate Islamic financial products into your wealth management planning, the first thing you need to know is not all Islamic financial products are created equal.

Speaking at this year's Sixth International Islamic Finance Conference in Kuala Lumpur, Dr Mohd Kamal Khir, CEO of Institut Bank-Bank Malaysia, said global Islamic financial assets now total $1 trillion. Even if we accept that figure (Moody's, for example, says the figure is nearer $700 billion), it means Islamic finance is small compared to global financial assets. However, within this bijou universe there is considerable diversity.

Islamic products are based on Shariah, the body of Islamic religious law derived from the Koran and other religious texts. Shariah is not codified, but is based on interpretation by Islamic scholars who debate what Islamic actually means in terms of finance.

Islamic hedge funds have been launched with the backing of Islamic scholars, for example, but some Islamic scholars maintain the very concept of hedge funds is un-Islamic.

"To some degree it depends on the background of the individual who has been asked to opine on a particular structure," says Peter Gerard, managing director, international wealth management at BNY Mellon Wealth Management. "There is scope for interpretation, and on occasion there have been disagreements as to whether a particular structure can be considered Shariah-compliant or not."

As Islamic finance has grown in popularity in the wealthy Gulf states, there's been some bandwagon-jumping too. One Dubai-based commentator suggests many Islamic financial products are simply mainstream products with a crescent moon on the prospectus. Or, as Mahmoud El-Gamal, a professor of economics who holds a chair in Islamic finance at Rice University, has put it, "Don't take my duck, sprinkle holy water on it, and say it's a chicken."

Of course, for families who do not intend to use Islamic products for religious reasons, the precise details of the Shariah compliance may not be so vital. However, as BNY Mellon's Gerard points out, as with any other product, it's extremely important to do your due diligence before using an Islamic product.

If anything it's more important in Islamic finance than in the conventional market as there is no governing body to judge what is Shariah-compliant and what isn't. You need to dig to know what you're getting.

On the business side, if you are buying a finance vehicle constructed using Islamic principles in order to gain favour with a client in the Middle East, it is important that the vehicle is Shariah-compliant in the right way. "A structure that is deemed acceptable in Asia may not necessarily also be acceptable to scholars in Saudi Arabia," says the Islamic Finance Group at the UK law firm Allen & Overy.

The only way to make sure that the vehicle you buy is right for your target market is to work with the right partners. Most Western banks have Shariah capabilities, but, says Geert Bossuyt, head of Islamic structuring at Deutsche Bank, "some are better than others".

With financial services providers anxious to tap into the Gulf region's petrodollars, there has been a rush of Western banks into the GCC countries in recent years. Some Western banks are longer established, however. Citigroup and BNP Paribas, which was recently named Best Project Finance House in the Middle East by Euromoney, have been in the region since the 1950s, while HSBC's relationship with the Middle East dates back to 1889 and is extensive, comprising 22 offices in the region.

There is also a growing number of specifically Islamic banks in the Middle East, Malaysia, the UK, Switzerland, and, to a lesser extent, other mainland European countries and the US. The largest Islamic banks in the Middle East include Al Masraf Bank in Bahrain, Al-Rajhi Bank in Saudi Arabia and Noor Islamic Bank in Dubai.

The first UK Islamic bank, Islamic Bank of Britain, appeared in 2004, offering a range of personal finance products, while the first Swiss Islamic institution, Faisal Finance, opened in Geneva in 1982, becoming a private bank in 2006.

Additionally, many conventional banks in the Middle East have opened Islamic operations. With time, the Islamic operation often gains in importance, sometimes eclipsing the conventional bank.

For the outside investor, the main point to consider is the scholars, who are crucial to the credibility of an Islamic vehicle. They issue an opinion, or Fatwa, saying that a vehicle is Shariah-compliant. However, there is a severe shortage of scholars who are well versed both in Shariah and in international commerce – Allen & Overy estimates that there are only 12 to 13 in the world – and this has limited the growth of Islamic finance.

The main area of Islamic finance that is of interest to non-Muslims is project finance initiatives. Examples of successful Islamic deals in recent years include a $1 billion Ijara (a form of leasing) facility to expand Dubai International Airport and a $2.88 billion syndicated Islamic finance facility provided to Mobily, a Saudi Arabian mobile phone operator.

However, the most common vehicle is the Sukuk – often described as an "Islamic bond". Some scholars hotly dispute this definition, believing bonds are inherently un-Islamic because debt and interest are both haram or forbidden.

Commentators suggest that over 50% of the dollar-denominated Sukuk paper issued in the Middle East ends up with conventional investors. The appeal off Sukuk is that it reaches the parts other bonds don't. "The main driver of non-Muslims buying Sukuk is that they like the issuer," says Bossuyt.

While the full gamut of personal finance products is available in Islamic form, the attraction of these products for non-Muslims is minimal. For example, while there may be advantages to the co-operative structure of Takaful, an Islamic insurance concept whereby risks are shared, the universe isn't broad enough for Takaful use to make sense for non-Muslims.

Occasionally, there are interesting Takaful products – Salaam Insurance has just launched a competitively price Takaful car insurance product in the UK, for example – but a non-Muslim is unlikely to want to seek a Takaful solution for all their insurance needs.

For those seeking an ethical investment solution, however, Islamic investment funds, whose total assets are estimated at around $40 billion, can bring advantages. They tend to be stricter in their exclusions than conventional ethical funds – banning companies involved in gambling, pork and even conventional financial services companies because of their use of interest for example.

This puts them ahead of the curve at the moment, and Islamic funds have also made good calls in the past, such as getting out of Enron and Worldcom before their collapse – they generally don't invest in companies whose balance sheets are leveraged by more than 33%.

However, global Sukuk issuance year to date was down 59% in the third quarter of 2008 compared with 2007. The Islamic Finance Information Service blamed the decline on uncertainty over the new standards for Islamic bonds set by the Accounting and Auditing Organisation for Islamic Financial Institutions and the credit crunch.

The downside of Islamic funds is that you can miss out on performance in haram sectors, and monitoring Shariah compliance is complex and can add to a fund's total load. "Dividend cleansing", for example, a process whereby a payment is made to charity equivalent to the revenues earned by the fund from the haram activities of companies in which it invests is time-consuming and onerous.

The complexity problem has been solved to some extent by the advent of Islamic indices – Dow Jones, S&P and FTSE all provide them – which make it easier to create an Islamic universe and which have allowed for the creation of Islamic exchange-traded funds (ETFs), such as the EasyETF DJ Islamic Market range of ETFs from BNP Paribas/AXA Investment Managers.

ETFs give simple exposure to a selection of Shariah-compliant universes, but outside of ETFs on hard-to-access markets, for example North Africa, their appeal to non-Muslim investors is limited.

There's liquidity in the Middle East that doesn't exist elsewhere in the world, and that makes the region attractive to investors. In essence, the main reason for non-Muslims to consider Shariah-compliant vehicles at the moment is to tap into a population that wouldn't be available to them through a vehicle that was not Shariah-compliant.

In essence, Islamic finance products are worth investigating because you can expect to see a lot more of them as they expand throughout the world to meet demand created by both Islamic and Western businesses and investors.

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