Syndicate Group 3 � The

Differentiators

- Jonas Malebye

- Dorothy Kobe

- Kugan Pillay

- Donald Singh

28 September 2007

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Table of Contents 1. Executive Summary 3 2. Introduction to Islamic Finance and Banking 4

2.1 Origin 4 2.2 Principles of Islam and Shariah 4 2.3 How does an Islamic Bank function 5 2.4 Distinct Features of Islamic Mode of Intermediation 6

3. A Global perspective 7

3.1 Introduction 7 3.2 Recent Trends 7 3.3 Growth & Business Development 8

4. Overview of the Banking Sector and Islamic Finance in the African Context 10 5. Challenges Facing Islamic Finance 13 6. Challenges Specific to Africa 16 7. Business Case for Africa 17

7.1 Possible Role for S A Banks in Islamic Wholesale Banking 20 8. Conclusion 22 9. References 23 10. Appendix 1 � Business Case Calculations 24

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1. Executive Summary There is more to Islamic Finance than the mere prohibition on interest. It also deals with other social and moral issues such as prohibition of gambling and games of chance. It discourages what is Haram and expounds profit and risk sharing. The stakeholders are wider than just the traditional stakeholders in that a significant and the most important stakeholder is Allah � God. Islamic finance has developed into a significant sector over the past couple of year, with institutions all over the world focusing on it. It is estimated that the size of this market is approximately USD 500 billion. The development is attributable the to the increase in oil prices placing a huge amount of liquidity in the hand of Islamic nations The incidence of September 11 2001 has also triggered the move from western investments and a search for alternative vehicles for the �petro-dollars�. Lastly the re-emergence of Islam as a religion warrants it followers to ensure that there is Shairah compliance. A number of countries have made their intension of being the hub for Islamic finance known. United Kingdom, Malaysia, Singapore, Qatar and Dubai are some of the countries that have registered their intention of becoming Islamic finance hub and are gearing themselves for this. Africa is home to over four hundred million Muslims accounting for over 45% of the total African population and over 27% of the global Muslim population. Our research shows that Africa is an under-serviced as regards Islamic finance and Shariah compliant banking products. The focus on this paper is on opportunities in Africa for Islamic Finance and banking. This is mooted by the increase in economic growth and improvement in social and legal standing of many African countries. Our study focussed on identifying countries with high populations and high forecasted economic Growth. We have identified two Nigeria, Egypt, Algeria and Morocco as countries with significant populations, Muslim populations and GDPs. All these countries at a high level are estimated to earn a return above the risk-adjusted cost of capital of 15% per our study. Islamic finance opportunities range from consumer banking to corporate and investment banking. Islamic consumer banking will require a material investment and need to be part of a medium to long-term strategy. On the other hand corporate and investment banking requires low investment and can be offered as part of the short to medium term strategy. The international banks have realised that corporate and investment banking is a lucrative and cost effective entry into Islamic banking. Most of these international banks do not focus on Islamic retail banking because of the amount of investment required to access this market segment. We suggest that African banks should also use the same strategy to enter the Islamic banking market and only introduce consumer banking once the corporate market has gained momentum. Islamic banking does have it challenges of banking supervision, regulation, the juristic interpretations of what is permissible and others. These we believe are only minor speed bumps, which have and will be overcome and not hamper the 15% annual growth expected from Islamic finance

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2. Islamic Banking and Finance

2.1 Origin

Islamic Finance had its origin at the inception of Islam as a religion. The most critical developments have taken place since the nineteenth century. These developments occurred in three phases. Phase one relates to the period in which Islamic societies lost touch with their old values and heritage. The highlights of this phase include:

The failed fund raising exercise for the building of the Suez Canal. The Post Office Savings in Egypt being declared non-Shariah compliant by

Islamic Jurists. The attempts in India to develop interest free Credit Societies around 1923. The development by Islamic scholars of theoretical models for financial

intermediation. The second phase stretched between 1960 and 1980 and saw the establishment of Mit Ghamr, a local savings bank in 1963. Other notable developments during this period was various research, including by the IMF, countries such as Sudan, Iran and Pakistan announced their intentions to transform their financial systems to be Shariah-compliant while Bahrain and Malaysia promote Islamic banking in parallel to conventional banking systems. In the third phase which commenced in the 1990s the amount of interest in Islamic finance increase exponentially and money poured into Islamic finance initiatives. Shariah complaint asset or advances are currently estimated between 500 billion and 1 trillion US Dollars. Sukuks are issued in Qatar, Bahrain and Pakistan. Shariah compliant Financial Indices in the Dow Jones and Financial Times are launched. Standards in accounting and auditing also evolve due to the establishment the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) and the IMF establishes a regulatory Islamic Financial Services Board. 2.2 The Principles of Islam and Shairah The Quran and the Sunnah are the primary sources of Shariah, but Ijtihad (from the same root as Jihad) plays a critical role. Ijitihad refers to the efforts of individual jurists to extract solutions to problems and is the vehicle by which the rules of behaviour not explicitly addressed to problems that arise as human societies evolve are determined. Thus, Shariah principles affect economic contracts. Any contract is valid if it fulfils the basic requirements of a valid legal contract and does not contain certain elements such as

1. Riba - the prohibition to charge and receive interest 2. Gharar - Implications of Gharar is no pure speculation and gambling, which

involve asymmetrical information, excessive uncertainty, risk and lack of

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control. Some argue that the writing of an insurance contract on the life of a person fall within the domain of Gharar.

3. Qimar - gambling 4. Myisur - games of chance involving deception 5. Haram actions - pork products, pornography, or alcoholic substances. Shariah does not preclude profit sharing. Sharing of the risks and uncertainties is an important element of Islamic financial contracts. Shariah condemns even guarantees because it removes uncertainty on the part of the lender and lender is not remunerated based on the extent of the productivity of his financial capital in the resulting profit. Muslims scholars point out that the prohibition of Riba promotes risk sharing and to consider lending a benevolent act with a view to help some one in need.

2.3 How does an Islamic Bank function? The role of the Islamic bank is a financial intermediary as in the ordinary sense, which has the function of resource mobilization and intermediation. The figure below depicts a simplified version of the basic structure of an Islamic Bank.

Funding/Resource Mobilisation Investment/Revenue Generation

Mudarabah

Investors(Depositors) Wikala

Wadia/Amanah

ISLA

MIC

BA

NK

Murabaha

Salam

Ijarah

Istisna

Mudarabah

Musharkah

Jo'ala/Rahn

The banks relationship with depositors is based on Mudurabah, Amanah, Wikala or Wadia on the liability side. However on the asset side the bank has more freedom of choice to invest depositors� investments. Formally, two theoretical models have been suggested for the structure for an Islamic Bank. The first model is based on Mudurabah and is known as the �two-tier� Mudurabah, while the second model is known as the �two windows� model The two tier Mudurabah is based on the premise that depositors entering a contract with a bank to share profits accruing to the banks investment side. The first tier is a Mudurabah between the bank and depositor, where the bank accepts the investment (deposit). The profit sharing investments are not liabilities but are like non voting equity. The deposits or investments are exempt from any reserves requirement. The

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second tier represents the Mudarabah between the bank as supplier of funds and an entrepreneur who seeks funds. The contract here entails the sharing of risks and profits. The end result the profits earned on the asset side are shared with the depositors with the benefit that the banks assets and liabilities are fully integrated. In terms of the two widows approach the balance sheet is divided into two windows, the investment accounts and demand deposits (transactions balance). The demand deposits which are in essence funds kept in safe keeping (Amana) require 100% reserve requirements, while the funds in the investment account are invested in Shariah complaint instruments and profits from these investments are shared with investment account holders. 2.4 Distinct Features of Islamic Mode of Intermediation

Profit-loss sharing � both Islamic and conventional banks are interested in the profitability a client borrower. The conventional banks are concerned with the ability of the client to service the debt and the profitability of the client does not affect the profitability of the bank. However, the Islamic bank has an interest in the profitability of the client as it has a direct impact on the profitability of the bank through profit sharing. The profits of the Islamic bank is directly impacted by the real economy

Enhanced Monitoring. Due to the interest in the clients� profitability, Islamic banks will have a higher level of monitoring of their clients.

Principal-Agency relations. Jensen and Meckling (1976) developed the principal agent problem. This problem is overcome by Mudarabah contract where managers perquisites are directly determined by their investments they choose.

Asset liability management. With conventional banks there is an asset liability mismatch that has to be managed from a spread and tenor basis. With Islamic banks the pass-through nature of profit sharing contracts ensure assets and liabilities are closely matched.

Shariah boards � These are religious scholars which exert influence compliance of the bank with Shariah principles.

.

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3. A Global Perspective

3.1 Introduction

Islamic finance (IF) is one of the fastest growing areas of banking - in terms of both the availability of new products and in geographical spread. Recent figures from the International Monetary Fund show that approximately US$400bn is invested in IF products globally, and that there are 275 IF institutions with a presence in 75 countries. These figures show that, while IF is now making a mark on the global stage.

Support for Islamic banking is also being offered by Western governments. In a speech at the Muslim Council of Britain, Gordon Brown, the Chancellor of the Exchequer, declared his ambition to make Britain "the gateway to Islamic finance and trade."

Also in a speech delivered on March 2, 2005 before the "Seminar on Legal Issues in the Islamic Financial Services Industry," Thomas C. Baxter, Jr., Executive Vice President and General Counsel of the Federal Reserve Bank of New York, offered a number of interesting remarks. As a general rule, the U.S. law is "broad enough to encompass shari'a compliant structures." Practitioners can produce products that simultaneously satisfy the demands of secular and religious law. This is so because the U.S. law is silent on matters of religion and because the common law tradition of the Anglo-Saxon legal system is flexible and adaptive. The challenges facing U.S. and Western regulators is to accommodate the free exercise of religion and still carry the secular mandate of fostering safe and sound practices in the banks that they supervise. Mr. Baxter gave a number of examples of a number of U.S. banks, which have opened special windows for shari'a-compliant banking activities as a trend for the future.

Singapore is also seeking to become a hub for Islamic banking. To that effect, the minister of finance promised to align the tax policy in the treatment of Islamic contracts with the tax treatment of conventional financing contracts to which they are economically equivalent.

3.2 Recent Trends

The recent phenomenal growth of Islamic banking underpinned the need for greater innovation and flexibility to facilitate wider acceptance of Islamic products and services. An estimate of the global Islamic industry is:

Number of Islamic financial institutions

275

Countries of presence 75

Asset holding size US$280bn

Financial investments US$400bn

Growth in last five years 15% Source: International Monetary Funds

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Islamic banking customers are not only confined to limited areas such as the Middle East but are spreading across Europe, the US and Asia Pacific.

The global Muslim population is approximately 1.6 billion and Islam is considered to be the fastest-growing religion in the world. Under these circumstances, it is hardly surprising that global financial institutions are creating a range of Islamic investment instruments.

The industry has embraced a wide range of institutions and products, including commercial Islamic banks, Islamic investment companies, Islamic investment banks, insurance companies, asset management companies, e-commerce, brokers and dealers. Products include commercial Islamic banking products, insurance products, mutual funds and unit trusts, Islamic bonds and Shari'a compliant stocks. It has been over two decades since Islamic banks first appeared as active players and today Islamic banking and finance has become a force to be reckoned with. The provision of banking services adhering to Shari'a rules has grown to such an extent that many conventional banks, both in the Middle East and in the US and Europe, have realised that it is a segment that demands their attention.

.Although the Middle East is still home to most of the world's 275-plus Islamic banks, a growing number of banks operating in the marketplace are domiciled elsewhere. Local players such as Malaysia's Bank Islam Malaysia and the UK's Islamic Bank of Britain are being joined by Citi, HSBC's Amanah and UBS's Noriba subsidiary.

Additionally, there is a spread of Islamic banking outside the Middle East and the Gulf countries. Singapore, for example, already manages around US$2bn of Shari'a compliant capital market funds and is seeking to grow rapidly over the next few years, particularly in the fields of wealth management, capital markets and reinsurance within the Islamic banking sector. Malaysia is also a strong player. Islamic banking has figured here for 23 years. Its share of the total market for Shari'a products has now reached around 12%. With strong support from its government, it is slowly creeping up year on year and is currently worth in the region of £10.7bn. And by sheer force of numbers, the Republic of Indonesia is still the most populous Muslim-majority nation in the world, with almost 86% of Indonesians declared Muslim according to the country's 2000 census. Its total population in July 2006 was more than 245 million.

3.3 Growth and Business Development

The Muslim population accounts for nearly one quarter of the world's population, and it is expected to grow at a faster rate. With demand for Islamic products rising, the availability of Shari'a-compliant banking, investment, and insurance products continues to grow.

The industry faces competition from a number of angles, not least from the conventional financial sector. Well established, western-based global financial players continue to open and expand operations in Muslim regions of the world and have built infrastructures to enter markets, particularly in the Islamic financial centres of Dubai, Bahrain, and Kuala Lumpur. They are using their

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considerable operational, marketing, and technology skills to produce and distribute Islamic financial products in direct competition with indigenous financial institutions.

Today, more than 250 Islamic banks (90 institutions of them are in the Middle East) are operating from China to the US. Western banks, through their Islamic units in the UK, Germany, Switzerland, Luxembourg, and others countries also practice Islamic banking.

The Gulf Cooperation Council (GCC) region has been a hotbed of activity as far as the Islamic banking industry is concerned, where 41 Islamic financial institutions are currently operating in the GCC countries (of which 18 are banks). Qatar and Bahrain are the leaders and hold a 70% share of the assets, while the UAE accounts for 19% of assets. The growth in assets is estimated at 15% and expected to remain so, for several reasons:

Growth in overall wealth in the Middle East.

Growing awareness about the Islamic products.

The fact that Islamic products are becoming more competitive compared to conventional products.

Wider availability and variety of Islamic financial products.

Equity/asset ratio of Islamic banks stands at 13.1% compared to 11.3% for conventional banks in the GCC region. This indicates under-utilization of capital and provides a lot of scope for taking on additional risk on the balance

The growth of Islamic finance in Asia: Countries such as Pakistan, Indonesia and, more recently, Singapore are pushing the development of their Islamic banking practices in order to replicate Malaysia's success. This trend is expected to continue.

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4. Overview of the Banking sector and Islamic finance in the African Context Africa is home to over four hundred million Muslims accounting for over 45% of the total African population and over 27% of the global Muslim population. The highest concentration of the Muslim population in Africa is in northern and western Africa. These two regions account for 45% and 33% of the African Muslim population respectively. The northern region of Africa is made up of Algeria, Sudan, Egypt, Tunisia, Libya, Western Sahara and Morocco. More than 90% of the Muslim population in northern Africa are settled in Algeria (17%), Sudan (20%), Morocco (17%) and Egypt (38%). The banking industries of these countries are at different stages of development, with Egypt currently undergoing a wave of consolidation and restructure facilitated by the Central bank with the aim of reducing the number of banks from 42 as at September 2006 to 25 by 2010. Egypt�s four biggest banks account for approximately 50% of the market. Morocco on the other side has sixteen commercial banks, which are now largely partially owned by or partnered with big European banks such as BNP Paribas, several development banks, and specialized financial institutions. The three largest banks account for over 63 percent of banking assets and deposits and cover 55 percent of credit. [Arabdatanet] Sudan Sudan has gone the full circle from a conventional banking system to a legislated Islamic banking system to a settlement which has the north of Sudan being exclusively an Islamic banking area and the south of Sudan allowing only conventional banking. The banks are prohibited from offering the alternative products through either an Islamic banking window at a conventional bank or visa versa. Given that Sudan�s population is estimated to be 75% Muslim, it is not certain whether the separation of the banking systems by region will be a permanent political solution. Algeria Algeria�s banking sector is dominated by public banks, which suffer from high levels of non-performing loans to state-owned enterprises. There were 15 private banks in 2004, but six state-owned banks accounted for over 86 percent of total bank assets in 2003. While banking sector reform and privatization has ostensibly been a goal since 1999, progress has been slow. State dominance of banking has undermined private banks and led to several bankruptcies. The government intervenes in credit markets, including subsidizing credit for loss-making public enterprises. Governance of the financial sector is weak. Egypt Egyptian banking sector is dominated by four state-owned institutions: National Bank of Egypt, Banque Misr, Banque du Caire and Bank of Alexandria. Together they represent approximately half of the Egyptian banking system�s assets. Egypt has at least 8 banks listed with the Institute of Islamic Banking and Insurance as offering Islamic finance services. Some of these banks are exclusively Islamic banks while others are non Islamic banks with an �Islamic finance window�. In a country that is 90% Muslim the largest bank in the country, National Bank of Egypt is

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not offering Islamic financial products. Only one out of the 4 largest banks in Egypt offers Islamic finance product alongside the conventional banking products. West Africa Western Africa which is home to more than 268 million people of whom134 million are Muslim, is made up of 16 countries. Of the 16 countries only Nigeria, Ghana and Cote�d Ivore have populations of more that 15 million each. Approximately 50% of the population of Nigeria, the most populous country in Africa, is Muslim. Notwithstanding this African Business new agency reported in June 2007 that Nigeria could see the launch of its first Islamic bank before the end of this year. The reform of the banking sector in Nigeria, which saw the number of banks operating in the country reduced from 89 to 25, is seen as creating an opportunity for the entry of Islamic banks into the market. The challenge that comes with the reform is the higher minimum capital requirement imposed by the Central bank in Nigeria. With only 10% of the lending in Nigeria being to individuals, the introduction of credit bureaus creates a huge opportunity for retail bankers including Islamic banks to increase their participation in the market. Southern Africa

Even though the Muslim populations in the southern parts of Africa are low or close to negligible, the region has the advantage of political stability and more sophisticated banking system. South Africa currently is home to Africa�s 4 biggest banks in Standard Bank, Nedbank, ABSA Barclays and First National Bank. The South African banking system is technologically advanced and stable. Even though South Africa has under 2 million Muslims out of a population of over 44 million 2 of the big 4 banks are pursing Islamic finance aggressively offering a full suite of retail and some commercial products. ABSA and First National Bank offer products such as Account, Islamic, Islamic Savings Account, Islamic Targetsave and Islamic Wills

In addition to ABSA and First National Bank�s participation in this Islamic finance market, AL Baraka Bank a specialist niche bank has operating in South Africa since 1989. From a net income of R406 000 in 1991 to R9.9 million in 2006, Al Baraka has experienced excellent growth although this has been from a low base. AL Baraka bank has 35 000 depositors and 5000 lending clients financing property, trade finance, vehicle or equipment. 1% of its clients are not Muslim. Its business geographic spread is 60% KZN, 30% Gauteng and only 10% Cape Town based even though Cape Town is home to the majority of South African Muslim community. First National Bank�s Islamic finance business is half the size of that of Al Baraka which has approximately R1.47 billion of assets. East Africa In East Africa Kenya�s has financial system is one of the most developed but is subject to considerable government influence and inadequate supervision. At the end of 2005, the banking sector included two mortgage financial companies, two building societies, a large number of savings and credit cooperatives, and 41 commercial banks. The six largest banks, including two majority state-owned banks and two foreign banks, control about two-thirds of banking assets. The government also owns or owns shares in several other domestic financial institutions and influences the allocation of credit. Africa business reported that Kenya opened its first shar�iah complaint bank in April of 2007 this was also said to be the first Islamic

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bank in east Africa. Gulf African Bank registered in Kenya but owned by a consortium including the Dubaian government, International Finance Corporate and Bank Muscat International (�BMI�). The partnership by the consortium members allows for skills transfer, in this case BMI will be providing recruitment, training and staff education. Kenya itself is home has approximately 4 million of the estimated 66 million Muslims in East Africa. Ethiopia and Tanzania have the largest number of Muslims in the region, accounting for more than 50% of the Muslim population of the region. Ethiopia has a small financial sector heavily influenced by the government. The central bank is not independent, and the government retains a strong influence over lending, including controlling interest rates and owning the country�s largest bank (Commercial Bank of Ethiopia), which accounts for three-quarters of total banking assets. However, the private banks have increased their share of total deposits, loans, and credit in recent years. Microfinance is well established. Foreign firms are prohibited from investing in the banking and insurance sectors. Tanzania�s financial system is relatively small and underdeveloped. The central bank lists 22 commercial banks that are licensed to operate. Credit is allocated largely at market rates. There are minimal restrictions on foreign banks, and international banks are expanding their Tanzanian operations. Privatization of remaining government-owned banks is continuing. In September 2005, the government selected a consortium led by Rabobank of the Netherlands to buy 49 percent of the National Microfinance Bank, although the government will retain 30 percent. Even though Africa�s population is 45% Muslim, the banking industry is totally dominated by conventional banking both on a continent wide basis and in individual countries of the continent. Islamic finance penetration is low and poses an opportunity for growth for most banks. The low penetration maybe due to a number of reasons, including the fact that the banking industry in the majority of the northern and western African countries are still in the developmental phase and undergoing regular restructuring, the integrity of the Islamic finance products offered by Islamic windows of conventional banks maybe questioned, lack of governmental support and not all Muslim may be subscribing to the rules that they should not pay or receive interest.

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5. Challenges facing Islamic Financing The Islamic financing industry may be growing at a rate of 15 � 20 % a year, however, it is facing several challenges some of which are discussed below: Shortage of suitable and qualified Islamic scholars Shortage of suitable and qualified Islamic scholars to pronounce on the compliance of proposed products with the Shariah law is one of the major challenges. The scholars, who take their principles from the Quran, are responsible for interpreting the rules and the definition of what is an acceptable banking product. Every new product or structure must be scrutinized and approved by competent scholars before it can be offered to clients. The Shariah experts are not only needed by the banks but also by the regulating bodies. Shariah-compliant legal framework The nature of Islamic financing instruments requires a different legal framework from the one used for conventional banking. Islamic financing requires laws that will accommodate rules and regulations which permits the profit and loss sharing modes and to ensure clear operating relationship between the Islamic banks and the country�s central banks. Corporate governance procedures around compliance with Islamic Shariah Banks with Islamic Banking windows will have to develop corporate governance procedures around compliance with Islamic Shariah in addition to meeting their country�s corporate government requirements. Taxation Some of the products offered by Islamic banks, example mortgage financing, attract double taxation. The challenge is to continue working closely with tax authorities with the aim of providing a level playing field for Shariah compliant products. Accounting and auditing standards The issue of accounting and auditing standards on Islamic products has been addressed by the establishment of the Accounting and Auditing Organisation for Islamic Financial Institutes (AAOIFI). However, Islamic banks operating in countries that do not regulate and accept Islamic banks as different from other conventional banks might not allow or recognize the application of the AAOIFI standards. Absence of Islamic insurance company It is important for any bank to have insurance in order to protect its investments against unforeseen hazards and catastrophes. Unfortunately, Islamic banks have to depend on interest-based insurance companies in the absence of Islamic insurance companies.

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Financial services regulators and central banks Financial services regulators and central banks of most countries do not distinguish between their treatment of Islamic financial service providers and conventional financial services providers. Most Islamic banks are subjected to the same controls, conditions and regulations that are applied to the conventional banks. However, there are certain factors which require that Islamic banks should be treated differently. For example, banks are required to place some of their deposits with the central banks. Central banks pay interest on these deposits which Islamic banks cannot accept as it is against Shariah principles. Alternative arrangement required to ensure that Islamic banks get a fair return on their deposits. Central banks are the lenders of last resort to commercial banks providing loans at times of liquidity crunch. Even though Islamic banks are regulated by the central banks they cannot benefit from this facility since these loans are usually provided on the basis of interest. These funds cannot be provided free of charge but alternative mechanism should be developed to suit the Islamic banks. In countries where the central banks practice open market operations, Islamic banks are not able to participate since these products sold on these markets earn or pay interest. Thus, Islamic banks are constrained when it comes to liquidity management. Need for an autonomous Shariah supervisory board The special nature of operations of Islamic banks requires different controls and supervision for the following reasons:

Most Islamic banks have their own Shariah Boards. The problem is that the Boards of different banks can issue differing views on similar practices, creating confusion in the minds of the clients.

The Board members are paid by the banks on whose committees they serve and this might make their rulings questionable.

Given the profit and loss sharing nature of Islamic banks, if not well supervised, some banks could potentially invest in riskier projects and pass substantial part of the investment losses, when they occur, onto depositors.

Failure of a bank whether conventional or Islamic could destabilise the banking system of any country.

Islamic banks can adopt the prudential and regulatory standards for the Islamic industry developed by the Islamic Financial Services Board (IFSB). Paralleling the development of the Basel II Capital Accord, the IFSB have issued two regulatory standards on capital adequacy and risk management for Islamic institutions. The challenge will be to get regulators in their countries to recognise IFSB as a legitimate body and to supervise them based on these regulations. Liquidity risk Islamic banks usually carry more liquidity than conventional banks mainly because they do not have infrastructure to match assets and liabilities. Liabilities can be long term but the general tenor of most products offered by Islamic banks is short. Adding to the problem of liquidity management is the lack of secondary markets and the underdevelopment of money market instruments.

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Lack of secondary financial markets Markets thrive on the existence of secondary financial markets. Islamic banks need to establish secondary markets in their countries. This will make their assets liquid and attractive to savers and hence make it easier for funds mobilization. Lack of inter banking transactions Adding to the problem of liquidity management is the lack of inter banking transactions. In most countries, Islamic banks exist as single entities. If the banks could use the short-term instruments they hold to transact amongst each other, they would go a long way towards developing an Islamic money market. The latest telecommunication can make it possible for large amounts to be transferred across continents. Lack of uniform standards of credit analysis There is no appropriate standard of credit analysis for Islamic banks. Similarly there is no expertise and trained manpower to perform credit analysis of projects to be financed and this will result in high liquidity and few high margin assets and hence low returns. Teaching and training Islamic banking is a new discipline. For any new discipline to succeed, high focus should be placed on education and training of staff. With the number of Islamic banks increasing, it is important to train staff and managers to equip them with the knowledge of Islamic modes of financing. Limited number of products In order for Islamic banks to have a fair chance of competing with conventional banks, they will have to come up with a substantial number of product offering.

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6. Challenges specific to Africa

Given the state of the financial sector in most African countries, there are additional challenges that will be faced by any bank wishing to introduce Islamic banking in Africa and these are listed below:

1. The economics of most of these countries are very small. 2. A high number of the population live far from the urban area and travelling

costs to and from the bank will add to banking costs. 3. Capacity in governments and central banks is generally a problem. 4. There are bigger problems of governance especially in public financial

institutions. 5. There are generally high incidences of political and economic shocks at the

macro level and at micro level; many individuals are operating below the poverty line.

6. Banking in most African countries is characterized by high interest rates intermediation spreads. The high intermediation spreads could be a reflection of high operating costs or the high risk of lending.

7. Already, across the continent there is a wide range of different types of financial service providers, namely, private sector banks, postal and rural banks, microfinance institutions and cooperatives.

8. Regulations could be inappropriate or absent. An example of an inappropriate regulation would be the requirement that clients identify themselves by means of a physical address.

9. Information infrastructure is not well developed in some countries. 10. Affordability and financial literacy.

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7. Business Case for Africa According to IMF, Africa is likely to enjoy 5.8% economic growth this year. This for Africa is higher than any rate of growth at any time in the past 25 years. The financial markets are expanding rapidly with foreign direct investment inflows and initial public offering increasing significantly. I investments in expansion projects, investments infrastructure and the increase in economically active individuals, make banking and the financial services sector, as the conduit of funding economic activity, an attractive investment opportunity. The low level of penetration of Islamic finance in the predominately Muslim regions of northern and western Africa, position Islamic finance as an opportunity of a lifetime for those pioneers willing to take the first step in a significant way. The table below highlight some of the African countries that have been identified as presenting an opportunity for Islamic finance: Description South Africa Egypt Nigeria Algeria Morocco Kenya Tanzania

GDP (USD billions) 255 107 115 114 57 23.2 12.8GDP per capita 5,425 1,489 770 3,413 1,886 681 335GDP growth 2007F 4.70% 6.70% 5.70% 4.50% 2.50% 6.20% 7.30%Main export Platinum Crude & oil Crude & oil Oil & gas Phosphate &

foodTea & Horticulture

Gold, copper & fish

Muslim population (mn) 1.4 64.8 75 32.67 29.61 6.12 13.3

Source: UBS Investment Research � EMEA Economic Perspective

The business case seeks to highlight potential opportunities which we stress does require further intensive research before any spend is committed. The premise of the business case is a Gap analysis. The countries of high growth, high Islamic populations were super imposed. This coupled with the fact that these markets are largely under-serviced in the area of Islamic banking and Finance. Our research did find - If the target market was provided an opportunity of Islamic Finance or conventional finance, they would opt for the former provided the price is correct. Thus the opportunity is obvious. The countries selected in the analysis are African countries with growth rates above 5% and with Islamic populations above 60%. South Africa is ignored, as there are initiatives in progress. A further critical assertion made is that South African banks are aggressively entering the African market. The model is built from a South African bank perspective and assumes The incremental revenue and costs will prevail over and above the normal acquisition cash flows of a an African Bank in these countries

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The details calculations and assumptions are included in appendix 1. We will briefly analyse the graph below to understand the results.

Return Analysis Islamic Finance

-1,000,000.00

-

1,000,000.002,000,000.00

3,000,000.004,000,000.00

5,000,000.006,000,000.00

7,000,000.00

8,000,000.00

Nigeria

Egypt

Algeria

Mor

roco

Tanza

nia

Kenya

Tunisa

5%

25%

45%

65%

85%

105%

125%

145%

Maximum Investment

NPV @15%

15% WACC

IRR

The above results demonstrate that all above countries provide a viable investment opportunity Save for Tanzania they all provide a return greater than 15%, which is the cost of capital on a risk-adjusted basis. The minimum investment range from $1.3m to $7m. This would be a guideline for the magnitude of the investment and return. It should be noted some countries like Nigeria are currently imposing restriction on foreign ownership of its top banks. The biggest opportunities are seen in Morocco and Algeria, Tunisia and Nigeria with IRR above 39%. Cognizance will have to be taken of the fact, that before any investment is made, extensive research needs to be conducted in the economies on the following areas Property rights Banking supervision Law of contract Infrastructure Restriction on foreign ownership. The above merely highlights opportunities that need to be explored further.

Egypt, Morocco, Algeria and Nigeria are seen as offering a great possible opportunity for Islamic consumer banking. These countries have significant Muslim populations, strong economic growths as well as banking system at the advanced developmental stage. The improving political environments and reduction in conflicts somewhat reduce the risk of doing business in the regions. A number of international organisations conduct surveys and produce indices that measure things like economic freedom, ease of doing business, resource allocation and corruption Perception. The rationalisation of the banking industry in some of these countries should create opportunities to acquire existing banking operations. Entry in the banking sector of

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the majority of the African countries would have to be through acquisitions as it may prove to be difficult to obtain banking licences. Due to the high number of banks in countries like Nigeria and Egypt the governments of these countries decided to limit the number of banking licences and encouraged consolidation in the industry. Over and above the governments started to privatise some of the banks they themselves owned. In Egypt it may be possible to acquire a specialist Islamic bank because there are a couple of those operating in the market. On the other hand in Nigeria there are only two Islamic banks, making it difficult to enter the market by acquiring a specialist Islamic banking institution. An alternative to acquiring a specialist Islamic bank is to acquire a conventional bank and attach an Islamic window to it. By Islamic window it is meant a business unit that focuses on Islamic banking. Generally the window would have its own business system while sharing some functions with the conventional bank. Its own business system would include amongst other things its own:

Executive management or a Shariah board Treasury function to ensure that funds are separated from those of the

conventional banking units Financial management and reporting procedures to enable the unit split

profits with depositors Specially trained front end staff to deal with the needs of the depositors and

borrowers Product research and development team.

International banks and some national banks in South Africa and Egypt commonly use the window operational structure. The benefit of this is that costs can be shared with the bigger bank making the Islamic operation efficient. The risk is that the credibility of the Islamic offering may be questioned if the bank does not enforce strict operational rules and communicate them to the public regularly to reassure them of the integrity of their product and services. The Islamic window operational structure is most efficient in countries where Islamic banking is at its infancy. Research has found that a happy conventional banking client is easier to convert into an Islamic banking client of the same bank, and that even people in Muslim countries do not jump at any opportunity to bank with an Islamic bank, they rather bank with a conventional bank than go to an Islamic bank without credibility, integrity and high customer service standards. Given the fact that Islamic consumer banking has penetration levels of less than 10% in markets that are considered as having embraced it, the Islamic window operational structure is the most efficient and prudent way to enter the market. The products that can be offered by a specialist Islamic bank or an Islamic window are the same and include:

Saving account Investment account Asset management Cheque account Asset and vehicle finance Property finance etc.

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Savings and investments accounts are popular as most investment type products offered by non-Islamic banks pay interest. With the growth of the middle class families in some African countries saving and investments are becoming more important. The lending side of the business is under exploited in most African countries due to the lack of effective credit bureaus. Lending products have a huge potential as the markets are under serviced in this regard. Linked to consumer banking opportunities is business banking. As a segment it is believed to be at the core of the economic future of most African countries as the growing economies encourage entrepreneurs to start small and medium sized businesses to bridge the gap between the service and products supplied by the informal sector and large corporates. The role of business banking as a funder of these entrepreneurs makes the segment as important if not more important than the corporate banking segment. An entrant into Islamic finance would need to ensure that this segment is properly serviced, as it will be the key to its growth.

7.1 What role can South African Banks play in the Islamic Wholesale financing space? The high GDP growth in Africa has resulted in a strain on the limited infrastructure that is in existence. For the current levels of economic growth to be sustained several things need to happen, which will require the innovative and new sources of funds, making corporate and investment banking an important element of future growth. The future growth needs to be underpinned by domestic processing of commodities and not just the export of raw materials. If this were to happen, companies linked to construction would experience strong growth, there will be creation of jobs and the greater population will share the growth. Middle East investors are looking for opportunities in Africa given the amount of liquidity they have resulting from the recent high prices. Who in Africa is better positioned to facilitate the flow of these funds into Africa? Who has the experience and the capacity to ensure that projects are structured in such a way that the interest of Africans will be protected? We think the answer is South African banks. South Africa could be the hub of Islamic Finance only if we act sooner than later. A number of European banks, in particular, UK banks are profiting from providing Islamic financing. The principle of risk return sharing augurs well for the different kinds of financing methods suitable for African needs. Some of these financing products, already offered by the likes of HSBC to their Muslim and non-Muslim clients and which can easily be replicated for the African market, are discussed below: Trade Finance Trade financing can be facilitated in at least two ways depending on the size of the capital required. The banks, using their finances ring fenced for Islamic financing, can provide this service on the concept of murabaha. The bank will purchase the goods needed by the clients for their business and then sell the goods to them at a predetermined higher price on a deferred payment basis. The clients can pay for the goods in a lump sum or instalments. On a bigger scale, trade finance can be

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structured such that, for example, non-oil producing countries could import oil through a profit sharing agreement with a Middle East investor. The investor pays for the petroleum and the government importing pays back the capital plus a pre agreed portion of the profit from the proceeds of the petrol sales. This is mudaraba. The banks as the structuring parties will earn a fee from this transaction. Equity Finance Banks can play a role in identifying suitable partners for equity investments in areas such as manufacturing and agriculture where the investment horizon is longer than five years. A Muslim investor can agree to pay for the import of machinery or raw material as part of his equity contribution in the business. Profits and losses will be shared as per agreed ratio over the period of the investment. In this structure called musharaka, whereas the profit is shared as per agreed ratio, the losses are shared in proportion to the capital invested by each partner. Banks can invest their money or they could earn a fee for structuring the deal. Project Finance Project financing is an area where South African banks can use their extensive experience in structuring the toll roads, telecommunication and energy deals in and outside the country to facilitate deals that will be acceptable to Muslim investors. The infrastructure backlog in Africa could be addressed by assembling the right partners to finance the development of roads, rail, telecommunication and energy generation, just to mention a few. Financier of a project, for the structure to comply with Shariah law, will share the proceeds of the project in proportion to their capital contribution. Facilitating project financing will have a spin-off on small and medium size companies that will be offered contracts to provide services to institutions involved in the big projects. Capital Markets Most countries in Africa are not rated as a result it is costly for them to raise funds in the international debt market. Banks can arrange the issue of sukuks for the Governments and given that there will be an asset on the back of the bond issue, with investors having proportionate beneficial ownership of the asset, the ultimate cost to the Government will be lower than in the case of a conventional bond. The corporate and investment solutions indicated above can be implemented with ease and without a huge capital investment in banking infrastructure. This can be a lucrative entry into Islamic Finance in the rest of Africa by South African banks. The South African banks have been using these solutions as par of their conventional banking offerings. By adapting the solutions to Shariah principles a whole new untapped market in Africa can be developed. SWOT analysis Strengths Weakness

Strong GDP growths Developing banking system

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High Muslim populations Increased macroeconomic stability

Skills shortage especially of Islamic scholars

Political tension High income disparities Corruption Developing legal system Access to capital Access to information Lack of foreign exchange liquidity

Opportunities Threats Investment in infrastructure Low penetration in Islamic finance Low competition in Islamic finance Banks are a primary source of

lending Emergence of debt capital

markets and stock exchanges Need to finance government

spending

Down turn in the commodity cycle Language and cultural differences

8. Conclusion Africa as a continent full of developing and emerging economies presents opportunities to investors wiling to take risk for a higher return on investment. The political environment may not be perfect but it is improving and with foreign direct investments creating employment and facilitating sustainable income distribution, political stability will be achieved quicker. The high Muslim populations in some of the African countries and strong GDP growth make Islamic banking in Africa a real opportunity. The consumer-banking segment is under serviced by current banking offering, leaving a gap to be filled by banking services that are congruent with the religious principles of the communities. Egypt Nigeria Algeria and Morocco have been highlighted in the document because of their size, GDP and Muslim population, but Islamic finance opportunities are not limited to them.. Partnerships with the Middle Eastern banks can help in skill development and give access to Shariah scholars. Islamic consumer banking will require a material investment and need to be part of a medium to long-term strategy. On the other hand corporate and investment banking requires low investment and can be offered as part of the short to medium term strategy. The international banks have realised that corporate and investment banking is a lucrative and cost effective entry into Islamic banking. Most of these international banks do not focus on Islamic retail banking because of the amount of investment required to access this market segment. We suggest that African banks should also use the same strategy to enter the Islamic banking market and only introduce consumer banking once the corporate market has gained momentum.

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9. References 1) 2007 Index of economic freedom 2) Websites

Al Baraka ABSA Banque Misr Zwaya (company profiles) Islamic Financial Services Board Global Islamic Financial Centre Al Watany Bank Egypt Wikipedia

3) PWC publication : Initial perspective on strategic and banking issues in key African markets

4) KPMG publications: Investing in Algeria guide

5) An introduction to Islamic Finance theory and practice: Zamir Khan and Abbas Mirakhor

6) Islamic Banking & Finance in South-East Asia: Its Development & Future By Angelo M. Venardos

7) Africa�s Financial sector � barriers to access and recommendations for donors. A paper prepared by Mark Napier 2007

8) Making Finance for Africa, Honohan and Beck, 2007 9) Introducing Islamic Banking into Conventional Banking Systems, Juan Sole´. 10) Challenges facing Islamic banks, Abdul Jabbar Karimi 11) Africa Focus, Analysis of Key Africn Economies, July 2007 A Standard

Chartered Research document. 12) UBS Investment Research � EMEA Economic Perspective

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Appendix 1- Business Case Workings

Assumptions1. SA Banks will acquire a foreign bank as part of Africa Expansion Strategy. 2. The acquistion will take place in high growth economy.3. The analysis superimposes high growth economies with countries with large Islamic populations to exploit opportunities4. Between $1m- $5n invested for Islamic window (marketing, systems, Shairah Board, staff)5. Constant growth of 3% is assumed for the next 3 years6. 50% tax rate is factored into cashflows7. Discount Rate for cost of Capital 15% adjusted for Risk ( SA Cost of capital is around 11%)8. The contribution to GDP of banking is assumed to be 1%9.The contribution to Banking GDP of Islamic Finance approximated conservatively of 0.5%10. Forecasted GDPs 2007 - source - Wordl Bank

Countries GDP 2007F GDP

growth

Contribution to GDP of Banking Revene

Islamic banking Revenue Cashflows

USD billions USD billions $ Yr 0 Yr 1 Yr 2 Yr 3Nigeria 115 5.70% 1% 1.21555 0.50% 6,077,750.00 -5,000,000.0 3,038,875.00 3,130,041.25 3,223,942.49 Egypt 107 6.70% 1% 1.14169 0.50% 5,708,450.00 -5,000,000.0 2,854,225.00 2,939,851.75 3,028,047.30 Algeria 114 4.50% 1% 1.1913 0.50% 5,956,500.00 -4,000,000.0 2,978,250.00 3,067,597.50 3,159,625.43 Morroco 57 2.50% 1% 0.58425 0.50% 2,921,250.00 -1,000,000.0 1,460,625.00 1,504,443.75 1,549,577.06 Tanzania 13 7.30% 1% 0.13949 0.50% 697,450.00 -1,000,000.0 348,725.00 359,186.75 369,962.35 Kenya 23 6.20% 1% 0.24426 0.50% 1,221,300.00 -1,000,000.0 610,650.00 628,969.50 647,838.59 Tunisa 31 6% 1% 0.3286 0.50% 1,643,000.00 -1,000,000.0 821,500.00 846,145.00 871,529.35

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Return Analysis Islamic Finance

-1,000,000.00

-

1,000,000.00

2,000,000.00

3,000,000.00

4,000,000.00

5,000,000.00

6,000,000.00

7,000,000.00

8,000,000.00

Niger

ia

Egypt

Algeria

Mor

roco

Tanza

nia

Kenya

Tunisa

5%

25%

45%

65%

85%

105%

125%

145%

Maximum Investment

NPV @15%

15% WACC

IRR

Results and Conclusion

The above results demonstrate that all above countries provide a viable investment opportunity save for Tanzania The all provide a return greater than 15% which is the cost of capital on a risk adjusted basis.The minimum investment range from $1.3m to $7m. This would be a guidline for the magnitue of the investment and return.It should be noted some countries like Nigeria are currently imposing restriction on foreign ownership of its top banksThe biggest opportunities are seen in Morroc and Algeria, Tunisia and Nigeria with IRR above 39%Conginzance will have to be taken of the fact, that before any investment is made, extensive reseach needsto be conducted in the economies on the following areas

Property rightsLaw of contractBanking supervisonInfrastructureOwnership restriction of Banks

The above merely highlights opportunities that need to be explore further.We accordingly recomment investment in these markets subject to the further research