whitepaper omans entry to islamic financial markets 24 february 2013

7/28/2019 Whitepaper Omans Entry to Islamic Financial Markets 24 February 2013

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ISLAMIC FINANCE GATEWAY COMMUNITYTHE PULSE OF THE ISLAMIC FINANCE INDUSTRY

SUPPORTED BY AN INITIATIVE OF

OMANS ENTRY INTO ISLAMIC FINANCIAL MARKETS

Thomson Reuters in conjunction withthe General Council of Islamic Banks and Financial Institutions(CIBAFI) and Islamic Research and Training Institute (IRTI) held a forum in Muscat on Sunday 24

th

EXECUTIVE SUMMARY

February2013 under the patronage of the Capital Market Authority (CMA). The Forum saw practitioners and marketexperts discuss Omans new Islamic banking regulations and future prospects for the industry.

The conference generated vibrant discussion between representatives of the industry and regulators, withmost of the focus being placed on the availability o f short-term money market instruments. Panelistshighlighted the challenges facing Islamic banks and Islamic windows of conventional banks as they beginoperations. They expect all of the countrys new Islamic financial institutions (IFIs) to attract deposits muchmore rapidly than they will be able to find yielding assets, based on consumer preferences indicated insurveys during the drafting stage for the Islamic Banking Regulatory Framework (IBRF).

With the restrictions on commodit y murabaha closing the only possible avenue for IFIs to place fundsdomestically with conventional banks, there is a shortage of yielding Islamic assets to generate enoughprofits to attract and retain non-current account depositors. As a result, Islamic banks may reach for yieldwith higher risk Islamic financing, or limit underwriting diligence in a way that could lead to higher non-performing loans (NPLs) in the future. In order to allow Islamic banks to grow their assets over time as theunderwriting can be performed to achieve low future NPLs, the industry panelists recommended a one totwo year waiver on placements with foreign Islamic banks provided they do not use commodity murabaha. Itwas also suggested that the Central Bank of Oman (CBO) could provide necessary oversight by cappingexposure by credit rating and/or by limiting exposure to foreign currency fluctuations by limiting currencyexposure that is not USD or fully- or partially-linked with USD. In addition, to reduce the reliance on foreignplacements, the CBO could issue short-term sukuk based on permissible structures already used in themarket by other GCC central banks. Banks could also explore short-term financing of the oil trade that wouldbe a transactional murabaha, rather than a commodity murabaha, to generate yield from short-term assets.

Panelists also recommended various methods of consumer and investor education coming from the industryitself, as well as providing training and accreditation to Islamic financial planners, whose advice may beviewed as being more unbiased. The IBRF may be improved through the development of a disputeresolution process that is able to incorporate relevant sharia issues and provide a faster form of disputeresolution.


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FORUM OUTLINE

Session 1: Capitalizing on the global Islamic financial markets interest in Oman

Session Chair: Dr. Sayd Farook, Global Head Islamic Capital Markets, Thomson ReutersPanelists:

Sohaib Umar, Executive Manager, Ernst & Young Mohammad Haris, AGM Islamic Banking, Bank Sohar Dr. J amil J aroudi, CEO, Bank Nizwa

Dr. Omar Hafiz, Secretary General, General Council for Islamic Banking & Financial Institution

Session 2: Developing a strong Islamic interbank and fixed income market: Necessary pre-requisites

Session Chair: Dr. Sayd Farook, Global Head Islamic Capital Markets, Thomson ReutersPanelists:

Azmat Rafique, Head of Islamic Banking, Oman Arab Bank

Helmi Haruna Rashi, Deputy General Manager, Markets & Investments Division, Bank Nizwa

Mohammed Nadeem Aslam, Head of Islamic Banking, Bank Muscat Dr. Salman Syed Ali, Senior Economist, Islamic Research and Training Institute

Session 3: Islamic wealth management: servicing sharia sensitive Omani investors

Session Chair: Bernardo Vizcaino, Islamic Finance Correspondent, Thomson ReutersPanelists:

Loai Batineh, Deputy General Manager, Oman Arab Bank

Tanweer Bukhari, Head of Advisory, CIMB Investment Bank

Atul Rao, Senior Executive Officer, Bank Sarasin-Alpen


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I. FORUM DISCUSSION POINTS

1. Impact of Restrict ions on Foreign Investments and Non-Domestic Bank Placements byIslamic Banks in Oman

The panelists considered the ability of Islamic banks in Oman to manage their surplus liquidi ty while the

industry develops, particularly given the limitations on Islamic banks to invest in non-Rial-denominatedplacements with foreign banks.

The Islamic Banking Regulatory Framework, citing increased country, transfer, credit, currency, reputationaland legal risks has put an outright prohibition on Rial-denominated investments or financing for any non-resident banks, including the resident banks foreign branches, affiliates or subsidiaries, as well as non-resident companies, individuals or other entities.

The liquidit y management challenge will arise from a much more rapid inflow of deposits to Islamic banksthan in asset growth due to the longer process of underwriting financing facilities, as well as typically lowerpreference by consumers for Islamic financing facilities than for deposits. A study released in December2011 by the Islamic Finance Advisory & Assurance Services (IFAAS) found that 70% of Omanis wouldconsider opening an Islamic deposit account within 12 months of them becoming available with half of those

expressing a desire to do so within 3 months of these accounts being available. On the financing sidehowever, there was still a desire to use Islamic financing, with 77% indicating a desire, but the timeline beinglonger (within 1-2 years).i

Restrict ions on commodi ty murabaha mean that Islamic banks in Oman can only resort to using it inemergency situations, where a temporary exception with limited duration is available with CBO approval.

The limits on placements held wi th foreign Islamic banks may put the new Islamic banks and windowsat a significant competitive disadvantage due to the restriction that no more than 60% of domestic net worthof the bank may be placed with non-resident banks, including overseas branches of Omani banks, theIslamic bank or windows non-resident parent bank and its affiliates.

Currently, there are no yielding investments within Oman besides providing Islamic financing tocompanies and individuals. As a result, while Islamic banks will begin providing financing, they will do soslowly to ensure proper underwriting to avoid future high rates of non-performing loans. The remainingassets (cash holdings excluding loans and the foreign placements) are likely to be held with the central bankgenerating no yield for the Islamic bank.

Some of the banks deposits will be held as amanah current account deposits, and will require no profitpayments to the depositor, and this proportion varies widely. For four large Islamic banks, Al BarakaBanking Group, Abu Dhabi Islamic Bank, Al Rajhi Bank and Dubai Islamic Bank, the average ratio of currentaccount deposits to total deposits was 55% as at the end of 2011.(ii)


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As a result, there will be a large gap between the volume of yielding assets (foreign placements plusdomestic Islamic financings, which will grow from a low base) and the total amount of non-current depositswhich will be subject to competitive pressures from conventional banks.(iii

In order to remain competitive and continue to attract and retain depositors, Islamic banks and Islamicwindows of conventional banks in Oman will face the incentive to provide higher cost financing, orweaken underwriting standards in order to grow the yielding portion of their portfolio. While rapid growth

is anticipated and will provide benefits to the economy and to the Islamic finance industry in Oman, it will notbe sustainable if it comes from a higher concentration in lower quality assets or loosening of the banksunderwriting standards. This will create a higher probability of more non-performing loans in the future,which will weaken the Islamic banking industry in Oman.

)

Also, the ability for conventional banks to open Islamic windows under signifi cantly more favorablerules with respect to paid up capital (compared with stricter rules for standalone Islamic banks) may causemore Islamic windows to be set up up as a cost effective solu tion.

2. Lack of product depth and clarity

One question still to be resolved relating to product depth is the guidance provided by the Central Bank ofOman (CBO) in the cover letter which accompanied the IBRF where the CBO cautioned:

Licensees shall note that business, authorized under IBRF, will be subjected to general/specific approvals andrestrictions. Licensees should, in particular, note that certain enabling provisions/reference to Sukuk,Securitization, subsidiary etc., in-built for possible roll-out, do not accrue to Licensees automatically and shalldepend upon future policies/authorizations/enablers.(iv

IBRF is a framework - a work in progress - which was clearly understood amongst industry players to be astarting point with a limited level of product depth. As such this will be a process by which the industryexpands the product offering in consultation with the regulators.

)

The development of new Islamic products should be aided by the ability for conventional banks to openIslamic windows under significantly more favorable rules with respect to initial paid up capital than if theywere required to establish a new Islamic bank (either independent of the bank, or as a subsidiary). Whilethe establishment of Islamic windows (seven of which are currently approved by CBO in addition to the two

standalone Islamic banks) may lead the market to be overbanked and for each bank to fail to reach aminimum efficient size, and leaving open the potential for mergers between the banks to generateeconomies of scale.

3. Lack of Investor and Consumer Education

During the product development process, and subsequently once products are approved and introduced intothe market, there will need to be a signifi cant amount of consumer and investor education regardinghow Islamic products work. In more mature markets, there is widespread consumer knowledge about how

Islamic banking products and sharia-compliant investment products work. However, there is concern amongsome consumers that it too closely resembles conventional banking because the underlying productmechanics are typically the same, which should be an area where the Islamic banking industry will need to

provide outreach.


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II. PANELISTS RECOMMENDATIONS

The panelists suggested several regulatory changes the CBO could take to provide support to the Islamicbanking industry in Oman:

1. Provide a one to two year exemption from the foreign interbank placement limits for

Islamic banks to allow them access to Islamic inter-bank money markets

The central bank could continue to specifically exclude commodity murabaha from the list of eligible inter-bank financing contracts, and the Islamic banks would still be able to use in ter-bank wakala andmudaraba, as well as having the ability to invest in sukuk issued by foreign issuers. If the CBO chose tointroduce this temporary waiver on the foreign concentration limits , it could further limit Omani Islamicbanks with concentration limits in excess of the existing ceiling based on the counterparty ratings, and couldrestrict the level of foreign-currency placements in excess of the current ceiling (where currency riskmanagement remains with individual banks) to US dollar placements, or those denominated in currencieswith exchange rates tied to the US dollar.(v

2. Issuance of a long-term (CBO and Omani Government) and/or short-term sukuk (CBO) to

provide an asset which Islamic banks could hold while they introduce Islamic financingproducts and build assets

) The waiver could be set to a maximum level which woulddecline throughout the waiver period based on projections of the demand for Islamic financing in order todemonstrate central bank credibility in not extending the waiver beyond the initially stipulated period.

Short-term sukuk might be preferable as it would provide support to the Islamic banks, but would give a lowreturn on assets at slightly lower levels than would be expected in the inter-bank Islamic money market. Ashort-term CBO sukuk would introduce fewer market dis tortions for Islamic banks in their decisionsregarding core financing activities (to consumers and businesses) as well as for the development of Islamicmoney markets (inter-bank), since both activities would likely involve higher yield than sukuk issued by theCBO. It would also allow the CBO to better control the money supply by adjusting the supply of thesukuk in response to changing economic and monetary conditions, as well as the demand for short-termCBO sukuk.

As for structure for any short-term sukuk issued by the CBO, the most viable would be sukuk al-salamand sukuk al-ijara. Both structures are issued with short tenors by the Central Bank of Bahrain (CBB), andare well accepted by the market.(vi

3. Other short-term assets

) Sukuk al-salam may be problematic because they are similar tocommodity murabaha. Sukuk al-ijara have the advantage of being tradable, but require a tangible asset forthe CBO to sell to the SPV established to issue the sukuk certificates.

A market-based alternative to a sovereign sukuk would be an approval by the CBO of an oil tradingplatform where banks provide financing for a limited duration (e.g. with maximum tenor of 30 days) of bonafide oil sales from producers to intermediaries (pipelines or shipping companies) or end users. Theexchange could be modeled on Malaysias Bursa Suq Al-Sila (based on palm oil) and would allow banks toprovide short-term financing like a commodity murabaha, but with CBO approval, would not fall under theblanket prohibition of that product since the transactions would be regular murabaha financing a real,identifiable underlying economic activity.


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4. Development of Human Capital

Investor education should focus on the pricing o f sukuk and Islamic bank products. Most Islamic banksprice products with reference to the spread over an interest rate, even though the structure is sharia-compliant and the product is not interest-based. Another alternative would be to price Islamic products at aspread above an independently calculated profit rate benchmark such as the Islamic Interbank BenchmarkRate (IIBR). (vii

There will be benefit to consumers if the consumer education is provided by the employees of banks andother financial institutions, as well as by Islamic financial planners, who will be able to provide advice that isperceived as more unbiased. If there was a certification specific to Islamic financial planning, theadvice could also be provided in a way that considers the sharia governance of the financial institution,which would lead to greater trust in the industry overall by using market pressure to encourage strongersharia governance. Islamic financial planners in particular will require a specific training and accreditationprogram.

)

However, all of this education will require Islamic financial institutions to find suitably qualified personnel,including Omani nationals to meet the Omanisation targets.(viii

An important priority will be training for local sharia scholars in Islamic finance in order to offset what is likelyto be a high degree of dependence on international sharia scholars for the first few years. Theseinternational scholars are extremely qualified, but are in high demand globally and will not have as muchunderstanding of the underlying consumer requirements regarding sharia-compliance specific to the Omanimarket.

) For a country introducing Islamic financefor the first time, it may be necessary to bring in foreign workers wi th experience in Islamic finance.However, there should also be an effort to introduce programs that can provide product-specific training that

will allow them to relatively quickly become qualified to work within Islamic finance.

In addition to investor and consumer education, the Islamic banking market will benefit from greater use ofarbitration specifically to Islamic finance where disputes can be heard and resolved with reference tosharia, which may be faster for the parties involved. Regional examples such as The International IslamicCentre for Reconciliation and Arbitration (IICRA) in Dubai can serve as models to incorporate more disputeresolution options for Islamic financial institutions.


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Panel Session at the Forum

Attendees at the Forum


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Speakers of the Forum(from left to right: Sohaib Umar, Mohammad Haris, Dr. Omar Hafiz, Dr. Sayd Farook, Khalid Yousaf, Azmat Rafique, Loai Batineh,Bernardo Vizcaino, Atul Rao, Dr. Salman Syed Ali)

Lunch at Muscat Securit ies Market (MSM)


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whitepaper omans entry to islamic financial markets 24 february 2013

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