ISLAMIC FINANCE GATEWAY COMMUNITY

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OMANS ENTRY INTO ISLAMIC FINANCIAL MARKETS

Thomson Reuters in conjunction with the General Council of Islamic Banks and Financial Institutions th (CIBAFI) and Islamic Research and Training Institute (IRTI) held a forum in Muscat on Sunday 24 February 2013 under the patronage of the Capital Market Authority (CMA). The Forum saw practitioners and market experts discuss Omans new Islamic banking regulations and future prospects for the industry.

EXECUTIVE SUMMARY
The conference generated vibrant discussion between representatives of the industry and regulators, with most of the focus being placed on the availability of short-term money market instruments. Panelists highlighted the challenges facing Islamic banks and Islamic windows of conventional banks as they begin operations. They expect all of the countrys new Islamic financial institutions (IFIs) to attract deposits much more rapidly than they will be able to find yielding assets, based on consumer preferences indicated in surveys during the drafting stage for the Islamic Banking Regulatory Framework (IBRF). With the restrictions on commodity murabaha closing the only possible avenue for IFIs to place funds domestically with conventional banks, there is a shortage of yielding Islamic assets to generate enough profits to attract and retain non-current account depositors. As a result, Islamic banks may reach for yield with higher risk Islamic financing, or limit underwriting diligence in a way that could lead to higher nonperforming loans (NPLs) in the future. In order to allow Islamic banks to grow their assets over time as the underwriting can be performed to achieve low future NPLs, the industry panelists recommended a one to two year waiver on placements with foreign Islamic banks provided they do not use commodity murabaha. It was also suggested that the Central Bank of Oman (CBO) could provide necessary oversight by capping exposure by credit rating and/or by limiting exposure to foreign currency fluctuations by limiting currency exposure that is not USD or fully- or partially-linked with USD. In addition, to reduce the reliance on foreign placements, the CBO could issue short-term sukuk based on permissible structures already used in the market by other GCC central banks. Banks could also explore short-term financing of the oil trade that would be 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 industry itself, as well as providing training and accreditation to Islamic financial planners, whose advice may be viewed as being more unbiased. The IBRF may be improved through the development of a dispute resolution process that is able to incorporate relevant sharia issues and provide a faster form of dispute resolution.

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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 Reuters Panelists: Sohaib Umar, Executive Manager, Ernst & Young Mohammad Haris, AGM Islamic Banking, Bank Sohar Dr. Jamil Jaroudi, 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 prerequisites
Session Chair: Dr. Sayd Farook, Global Head Islamic Capital Markets, Thomson Reuters Panelists: 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 Reuters Panelists: 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 Restrictions on Foreign Investments and Non-Domestic Bank Placements by Islamic Banks in Oman
The panelists considered the ability of Islamic banks in Oman to manage their surplus liquidity while the industry develops, particularly given the limitations on Islamic banks to invest in non-Rial-denominated placements with foreign banks. The Islamic Banking Regulatory Framework, citing increased country, transfer, credit, currency, reputational and legal risks has put an outright prohibition on Rial-denominated investments or financing for any nonresident banks, including the resident banks foreign branches, affiliates or subsidiaries, as well as nonresident companies, individuals or other entities. The liquidity management challenge will arise from a much more rapid inflow of deposits to Islamic banks than in asset growth due to the longer process of underwriting financing facilities, as well as typically lower preference by consumers for Islamic financing facilities than for deposits. A study released in December 2011 by the Islamic Finance Advisory & Assurance Services (IFAAS) found that 70% of Omanis would consider 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 side however, there was still a desire to use Islamic financing, with 77% indicating a desire, but the timeline being longer (within 1-2 years). i Restrictions on commodity murabaha mean that Islamic banks in Oman can only resort to using it in emergency situations, where a temporary exception with limited duration is available with CBO approval. The limits on placements held with foreign Islamic banks may put the new Islamic banks and windows at a significant competitive disadvantage due to the restriction that no more than 60% of domestic net worth of the bank may be placed with non-resident banks, including overseas branches of Omani banks, the Islamic bank or windows non-resident parent bank and its affiliates. Currently, there are no yielding investments within Oman besides providing Islamic financing to companies and individuals. As a result, while Islamic banks will begin providing financing, they will do so slowly to ensure proper underwriting to avoid future high rates of non-performing loans. The remaining assets (cash holdings excluding loans and the foreign placements) are likely to be held with the central bank generating no yield for the Islamic bank. Some of the banks deposits will be held as amanah current account deposits, and will require no profit payments to the depositor, and this proportion varies widely. For four large Islamic banks, Al Baraka Banking Group, Abu Dhabi Islamic Bank, Al Rajhi Bank and Dubai Islamic Bank, the average ratio of current account 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 plus domestic Islamic financings, which will grow from a low base) and the total amount of non-current deposits which 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 Islamic windows of conventional banks in Oman will face the incentive to provide higher cost financing, or weaken 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 not be sustainable if it comes from a higher concentration in lower quality assets or loosening of the banks underwriting 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 significantly more favorable rules with respect to paid up capital (compared with stricter rules for standalone Islamic banks) may cause more Islamic windows to be set up up as a cost effective solution.

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 of Oman (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 and restrictions. 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 shall depend upon future policies/authorizations/enablers.(iv)

IBRF is a framework - a work in progress - which was clearly understood amongst industry players to be a starting point with a limited level of product depth. As such this will be a process by which the industry expands the product offering in consultation with the regulators. The development of new Islamic products should be aided by the ability for conventional banks to open Islamic windows under significantly more favorable rules with respect to initial paid up capital than if they were required to establish a new Islamic bank (either independent of the bank, or as a subsidiary). While the 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 a minimum efficient size, and leaving open the potential for mergers between the banks to generate economies of scale.

3. Lack of Investor and Consumer Education

During the product development process, and subsequently once products are approved and introduced into the market, there will need to be a significant amount of consumer and investor education regarding how 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 among some consumers that it too closely resembles conventional banking because the underlying product mechanics 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 Islamic banking 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 interbank financing contracts, and the Islamic banks would still be able to use inter-bank wakala and mudaraba, as well as having the ability to invest in sukuk issued by foreign issuers. If the CBO chose to introduce this temporary waiver on the foreign concentration limits, it could further limit Omani Islamic banks with concentration limits in excess of the existing ceiling based on the counterparty ratings, and could restrict the level of foreign-currency placements in excess of the current ceiling (where currency risk management remains with individual banks) to US dollar placements, or those denominated in currencies with exchange rates tied to the US dollar.(v ) The waiver could be set to a maximum level which would decline throughout the waiver period based on projections of the demand for Islamic financing in order to demonstrate central bank credibility in not extending the waiver beyond the initially stipulated period.

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 financing products and build assets
Short-term sukuk might be preferable as it would provide support to the Islamic banks, but would give a low return on assets at slightly lower levels than would be expected in the inter-bank Islamic money market. A short-term CBO sukuk would introduce fewer market distortions for Islamic banks in their decisions regarding core financing activities (to consumers and businesses) as well as for the development of Islamic money markets (inter-bank), since both activities would likely involve higher yield than sukuk issued by the CBO. It would also allow the CBO to better control the money supply by adjusting the supply of the sukuk in response to changing economic and monetary conditions, as well as the demand for short-term CBO sukuk. As for structure for any short-term sukuk issued by the CBO, the most viable would be sukuk al-salam and sukuk al-ijara. Both structures are issued with short tenors by the Central Bank of Bahrain (CBB), and are well accepted by the market.(vi) Sukuk al-salam may be problematic because they are similar to commodity murabaha. Sukuk al-ijara have the advantage of being tradable, but require a tangible asset for the CBO to sell to the SPV established to issue the sukuk certificates.

3. Other short-term assets

A market-based alternative to a sovereign sukuk would be an approval by the CBO of an oil trading platform where banks provide financing for a limited duration (e.g. with maximum tenor of 30 days) of bona fide oil sales from producers to intermediaries (pipelines or shipping companies) or end users. The exchange could be modeled on Malaysias Bursa Suq Al-Sila (based on palm oil) and would allow banks to provide short-term financing like a commodity murabaha, but with CBO approval, would not fall under the blanket 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 of sukuk and Islamic bank products. Most Islamic banks price products with reference to the spread over an interest rate, even though the structure is shariacompliant and the product is not interest-based. Another alternative would be to price Islamic products at a spread above an independently calculated profit rate benchmark such as the Islamic Interbank Benchmark Rate (IIBR). (vii) There will be benefit to consumers if the consumer education is provided by the employees of banks and other financial institutions, as well as by Islamic financial planners, who will be able to provide advice that is perceived as more unbiased. If there was a certification specific to Islamic financial planning, the advice 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 stronger sharia governance. Islamic financial planners in particular will require a specific training and accreditation program. However, all of this education will require Islamic financial institutions to find suitably qualified personnel, including Omani nationals to meet the Omanisation targets.(viii) For a country introducing Islamic finance for the first time, it may be necessary to bring in foreign workers with 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. An important priority will be training for local sharia scholars in Islamic finance in order to offset what is likely to be a high degree of dependence on international sharia scholars for the first few years. These international scholars are extremely qualified, but are in high demand globally and will not have as much understanding of the underlying consumer requirements regarding sharia-compliance specific to the Omani market. In addition to investor and consumer education, the Islamic banking market will benefit from greater use of arbitration specifically to Islamic finance where disputes can be heard and resolved with reference to sharia, which may be faster for the parties involved. Regional examples such as The International Islamic Centre for Reconciliation and Arbitration (IICRA) in Dubai can serve as models to incorporate more dispute resolution 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 Securities Market (MSM)

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APPENDICES
IFAAS. 2011. IFAAS study: 85% of Omani consumers ready to take up Islamic finance products, Press release, http://www.ameinfo.com/285287.html (Accessed February 26, 2013).
ii iii i

Calculated from data in financial statements for the year ending December 31, 2011.

In theory, there may be development of an Islamic money market without central bank intervention either through rule changes or direct issuance of money market securities, but it is unlikely to occur in Oman because all of the Islamic banks and windows are likely to face a similar surplus of non-yielding cash assets. Central Bank of Oman. 2012. Circular IB-1. December 18, p. 3.

iv

v Title 6, Section 5.3.1.8 instructs: Licensees shall monitor very closely the currency risk assumed by their non-resident customers to avoid market risk triggered credit risk. The US dollar placement requirement could be limited to those denominated in USD, or those denominated in currencies of GCC countries excluding the Omani Rial, four of the five of which are fully linked with USD (KSA, Bahrain, Qatar and UAE) with the fifth being partially linked with USD (Kuwait).

Central Bank of Bahrain. 2013. CBB Sukuk Al-Salam securities oversubscribed, Press Release, February 25, 2013. http://www.ameinfo.com/cbb-sukuk-al-salam-securities-oversubscribed--331040 (Accessed February 26, 2013) Central Bank of Bahrain. 2013. CBB Sukuk Al-Ijara over subscribed, Press Release, February 13, 2013. http://www.ameinfo.com/cbb-sukuk-al-ijara-subscribed-329567 (Accessed February 26, 2013)
vii

vi

Thomson Reuters. Definition, Methodology & Criteria, http://thomsonreuters.com/products_services/financial/islamic_interbank_benchmark_rate/definition_method ology_criteria/ (Accessed February 27, 2013). According to the criteria, the IIBR is calculated as an average of profit rates submitted at the same time each day by 16 GCC-based Islamic banks for Shariah-compliant funding were it to do so by asking for and then accepting inter-bank offers in reasonable market size. The rates are requested in USD for various tenors ranging from overnight to 12 months, and a trimmed mean is calculated and reported.
viii

According to Omans Minister of Information, the Omanisation ratio for finance, insurance and real estate is set at 45% (Ministry of Information. Omanisation Policy, http://www.omanet.om/english/misc/omanise.asp (Accessed February 27, 2013)).

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