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ISLAMIC BANKING IN THE UNITED KINGDOM

01 September, 2006

By Professor Rodney Wilson

Shariah Compliant Liquidity Management

Initially the major Islamic finance activity involved wholesale operations, with banks in London providing overnight deposit facilities for the newly established Islamic banks in the Gulf. These Islamic banks could not hold liquid assets such as treasury bills, which paid interest, but the joint venture Arab banks in London, such as Saudi International Bank and the United Bank of Kuwait, accepted deposits on a murabahah (markup) basis, with the associated short term trading transaction being conducted on the London Metal Exchange!.

Although the staffs of the joint venture banks were mainly British and nonMuslims, they became increasingly well informed about shariah requirements regarding finance, and were able to respond to the demands of their Muslim clients in an imaginative manner. There was considerable interaction between British bankers involved with Gulf clients, shariah scholars and the British Pakistani community, notably through the Institute of Islamic Banking and Insurance (IIBI), that had been established in the early 1990s by Muazzam Ah, a former journalist and head of the Press Association of Pakistan:. Muazzam AM worked closely with Prince Mohammed Bin Faisal of Saudi Arabia, a leading advocate of Islamic finance, and became Vice Chairman of Dar Al Maal Al Islami in Geneva, the international Islamic finance organisation established by Prince Mohammed in 1982. The IIBI was initially located in the Kings Cross area, near to the City of London where the Arab joint venture banks operated, and in the late 1990s moved to more prestigious premises in Governor Crescent in the West End of London.

The Al Baraka International Bank

The next milestone in 1982 was when the Jeddah based Al Baraka Investment Company bought Hargrave Securities. licensed deposit taker, and converted it into an Islamic bank. This served the British Muslim community to a limited extent, but its main client base was Arab visitors of high net worth who spent the summer months in London. Its business expanded from 1987 when it opened a branch on :;•..; Whiteehapel Road in London, followed by a further branch on the Edge ware Road in 1989, and a branch in Birmingham in 1991.% as by then the bank had between 11,000 and 12.000 clicntS4. It offered current accounts to its customers, the minimum deposit being £150. but a balance of £500 had to be maintained to use cheque facilities, a much higher requirement than that of other United Kingdom banks. These conventional banks usually allow current accounts to be overdrawn, although then clients are liable for interest charges, which Al Baraka, being an Islamic institution, did not levy.

Al Baraka also offered investment deposits on a i profit sharing basis for sums exceeding £5,000. With 70 present of the annually declared rate of profit paid to deposits subject to three months notice, and 90 per cent pad for time deposits of over one year. Deposits rose from million in 1983 to £154 million by 1991. Initially much of Al Baraka's assets consisted of cash and deposits with other banks, which were placed on an Islamic basis, as the institution did not have the staff or resources to adequately monitor client funding. Some funds were used to finance commodity trading through an affiliate company, as Al Baraka was not a specialist in this area.

Al Baraka's major initiative was in housing finance, as it started to provide longterm Islamic mortgages to its clients from 1988 onwards. Al Baraka and its clients would sign a contract to purchase the house or flat jointly, the ownership share being determined by the financial contribution of each of the parties. Al Baraka would expect a fixed predetermined profit for the period of the mortgage, the client making cither monthly or quarterly repayments over a 10 to 20 year period, which covered the advance plus the profit share. There was some debate if the profit share could be calculated in relation to the market rental value of the property, but this was rejected, as frequent revaluation of the property would be expensive and administratively complicated, and given the fluctuating prices in the London property market, there would be considerable risk for the bank.

Although Al Baraka provided banking services in London, its most profitable area was investment management, and in many respects it functioned more like an investment company than a bank. It lacked the critical mass to achieve a competitive cost base in an industry dominated by large institutions, and the possibility of expanding through organic growth was limited. In these circumstances when the Bank of England tightened its regulatory requirements after the demise of BCC1 the bank decided that it was not worth continuing to hold its banking licence, as it would have meant a costly restructuring of the ownership and a greater injection of shareholder capitals. Consequently in June 1993 Al Baraka surrendered its banking licence and closed its branches, but continued operating as an investment company from Upper Brook Street in the West End of London^. Depositors received a full refund, and many simply transferred their money to the investment company. This offered greater flexibility, as it was no longer regulated under the 19S7 Banking Act but under financial services and company legislation.

The United Bank of Kuwait.

By the late 1980s there was an increasing demand from the United Bank of Kuwait's Gulf clients for Islamic trade based investment, and the decision was taken in 1991 to open a specialist Islamic Banking Unit within the bank. Employees with considerable experience of Islamic finance were recruited to manage the unit, which enjoyed considerable decisionmaking autonomy. In addition being a separate unit, accounts were segregated from the main bank, with Islamic liabilities on the deposit side matched by Islamic assets, mainly trade financing instruments. The unit had its own Shariah advisors, and functioned like an Islamic bank, but was able to draw on the resources and expertise of the United Bank of Kuwait as required.

In 1995 the renamed Islamic Investment Banking Unit (I1BU) moved to new premises in Baker Street, and introduced its own logo and brand image to stress its distinct Islamic identity?. Its staff of 16 in London included asset and leasing managers and portfolio traders and administrators, and by the late 1990s investment business was generated from throughout the Islamic World, including South East Asia, although the Gulf remained the major focus of interests. Assets under management exceed ed $750 million by the late 1990s, just prior to the merger with Al Ahli Bank, which resulted in the bank being renamed the Al Ahli United Bank9.

After Al Baraka pulled out of the Islamic housing market the United Bank of Kuwait entered the market in 1997, with its Manzil home ownership plan based on a murabahah instalment struetureio. A double stamp duty was incurred on murabahah transactions, firstly when the bank purchased the property on behalf of the client, and secondly when it resold the house to the client at a markup. This was felt by many in the Muslim community to be discriminatory, and following effective lobbying by the Muslim Council of Britain, and a report by a committee charged with investigating the issues, the double stamp duty was abolished in the 2003 budget, with the change taking effect from December of that year, The double stamp duty also applied to the ijara mortgages introduced under the Manzil plan in 1999]:.

The Islamic Bank of Britain.

The development that has attracted the greatest interest in recent years has been the establishment of the Islamic Bank of Britain It had long been felt by many in Britain's Muslim community, especially since the withdrawal of Al Baraka from the retail Islamic banking market, that the United Kingdom should have its own exclusively Islamic Bank. A group of Gulf businessmen, with its core investors based in Bahrain, but with extensive business interests in the United Kingdom, indicated that they were prepared to subscribe to the initial capital of £50 million. A business plan was formulated in 2002, and a formal application made to the Financial Services Authority (FSA) for the award of a banking licence.

The FSA was well disposed towards the application, indeed its staff charged with regulating the London operations of banks from the Muslim World were knowledgeable about Islamic banking and believed that in a multicultural and multifaith society such as that of Britain in the twenty first century, Islamic banking was highly desirable to extend the choice of financial product available to the Muslim community]?. There was no objection to the new bank being designated as Islamic, as this was not felt to be a sensitive issue in the UK, unlike in some countries where there are large Christian populations such as Nigeria, where the terms Muslim and Islamic cannot be used to designate banks. In Saudi Arabia, a wholly Muslim country, the term Islamic bank also cannot be used, as the major commercial banks and many shariah scholars object to religion being used as a marketing tool.

The major concern of the FSA was that the new Islamic bank should be financially secure by being adequately capitalised, and that the management had the capability to adhere to the same reporting requirements as any other British bank. The emphasis was on robustness of the accounting and financial reporting systems, and in proper auditing procedures being put in place. Systems of corporate governance were also scrutinised, including the responsibilities of the shariah advisory committee, and their role in relation to the management and the shareholders of the Islamic Bank of Britain. The FSA cannot of course provide assurance of shariah compliance, as that is deemed to be a matter for the Islamic Bank of Britain and its shariah committee.

However the FSA wishes to satisfy itself that the products offered are clearly explained to the clients, and that full information on their characteristics is provided in the interest of consumer protection. The Islamic Bank of Britain opened its first branch on the Edgeware Road in London in September 2004. less than one month after regulatory approval was given. Its operational headquarters are in Birmingham, where costs are lower. It has already opened two further branches in London, in Southhall and the Whitechapel Road, as well as branches in Birmingham, Leicester and Manchester, with further branches planned for later in 2006, including Leeds and Bradford in the north of England, The size of the Muslim population in the immediate locality is one factor determining the choice of branch location, the socioeconomic status of the potential clients being another factor, as middle class Muslims in professional occupations with regular monthly salaries are obviously more profitable to service than poorer groups. The bank stresses the Islamic values of faith and trust, as these are fundamental, but it also emphasises value and convenience, the aim being to have standards of service and pricing at least comparable with British conventional banks.

The opening of the first branch attracted much media attention, and therefore free publicity for the bank. The bank has a well designed website to attract business, and plans to offer online services in the future, and has produced informative and attractive leaflets and other publicity material outlining its services. All the material at present is in English rather than Urdu or Arabic, as the costs of translation and printing have to be seen in the context of promotional benefits. Some staff members are fluent in Urdu and Arabic, but at varying levels of proficiency, and foreign language ability is not a prerequisite for appointing staff, but good English is important. Many staff members have previous banking experience, and most, but not all, are Muslim,

The Islamic Bank of Britain offers current, savings and treasury accounts, all of which are shariah . interest payments or receipt with current accounts, but a . book and a multifunctional b provided, these initially bi*:r. cheque guarantee cards, accounts operate on a mudarabah 1 with £1 being the minimum Profits on savings accounts are calculated monthly and were initially at 3 percent but were subsequently reduced 2.5 percent, the current rate. No notice is required for withdrawals from has* savings accounts, which in other word> can be designated as instant access accounts. Term deposit savings accounts, which are subject to a minimum deposit of £5,000, pay higher rates.

In February 2006 deposits for one, three or six months earned 3.25 percent, 3,50 percent and 3.75 percent respectively, these having being reduced by 0.25 percent from the initial amounts offered. Unique amongst Islamic banks, the Islamic Bank of Britain offers treasury deposits, with a minimum £100,000 for 1, 3 or 6 months being invested. These operate on a murabahah basis, with funds invested on the London Metal Exchange, This type of account in other words replicates for the retail market the type of wholesale or interbank deposit facilities first operated on a shanali compliant basis in London in the early 1980s.

The Islamic Bank of Britain offer? "sonal finance, with amounts ranging from £ 1,000 to £20,000 made available for 12 to 36 months. Tlisthrough tawarruq with bank I shariah compliant commodities ti sold to client on a cost plus profit The client's agent, who is conveniently recommended by the bank, in r. the commodities and the proceed credited to the client's ... client then repays the bank deferred payments. No home financé is offered, but vehicle finance was made available in 2005,

Islamic Home Finance and Current Accounts Offered by Conventional Banks.

It is a challenge for a new entrant such as the Islamic Bank of Britain to com pete in a mature market for banking services with the major conventional banks offering Islamic products, notably HSBC through its dedicated Amanah Islamic finance divisions and Lloyds TSB. Which entered the market in a major way in 2004, with 17 branch es already having trained staff to cater for local demand for shariah compliant financial products. Being able to offer Islamic deposits and home finance through existing branches is a major advantage, with participating Lloyds TSB branches including London, Slough Birmingham Basingstoke, Southampton, as well as four in London and four in West Yorkshire including three in Bradford alone.

It was the abolition of double stamp duty, as already discussed, that encouraged new entrants into the market for Islamic home finance, notably IISBC Amanah in 2004 and Lloyds TSB from March 2005IT. At the same time the AlAhli United Bank, the successor of the United Bank of Kuwait, reached agreement with the West Bromwich Building Society for the distribution of Islamic mortgages through its extensive branch network, A similar agreement was concluded between the London based Islamic finance subsidiary of Arab Banking Corporation. Alburaq, and the Bank of Ireland, for the distribution of Islamic mortgages through its English subsidiary, the Bristol and West Building Society

There are a number of different structures for Islamic home finance in the United Kingdom, the original Al Baraka and the United Bank of Kuwait Manzil scheme being murabahah based with fixed monthly repayments to cover the cost of the house purchase that the bank undertook, plus the markup profit margin. In 1999 a second Manzil scheme was introduced based on ijara. with the United Bank of Kuwait, and its successor the Al Ahli United Bank, purchasing the property, but with the client paying a monthly rent, as well as a monthly repayments. The rent varied, but rather than being calculated on the rental value of the property, which would have implied frequent expensive revaluations, the rent was simply benchmarked to LIBOR. the London InterBank Offer Rate, As this was an interest based rate, this was potentially controversial from an Islamic perspective, but the Bank's shariah board approved its use as a benchmark, as LIBOR is often used in Islamic finance calculations because of its widespread acceptance in the banking community. The HSBC Amanah monthly home finance payments are also calculated in this way, as are those of the ABC Alburaq home financing facility marketed through the Bristol and West, although the later is designated as a diminishing musharakah scheme, as over the life of the mortgage, the client's ownership share increases as repayments are made, and the share of the bank in the equity of the house correspondingly reduces.

One factor that appears to be limiting the uptake of Islamic home finance is that the cost is higher than conventional mortgages. For Islamic financing worth £135,000 from Lloyds TSB over a period of 25 years the monthly repayments were £883 plus £21 a month for buildings insurance in March 2005. This comprised a rental payment of £693 plus a capital repayment of £190. The total monthly payment was over £100 per month more than the cost of a Lloyds TSB conventional mortgagee. With HSBC Amanah for the same loan of £135.000 over 25 years the monthly repayments were £857, only £7 per month more than the bank's conventional mortgage, but the buildings insurance of £34 per month was obligatory with the Islamic financing as the property itself is owned by the bank, unlike with a conventional mortgage where the bank simply has a charge on the property so that it can be repossessed in the case of payments default.

A survey of 503 Muslims in 10 cities throughout England undertaken by Dr [hi m ay on Dar of Loughborough University showed that many respondents had little knowledge of shariah compliant finance, but those who had enquired about Islamic home finance were deterred from proceeding by the higher costs21. These however partly reflect the limited scale of the market, and hence me higher costs per mortgage approved, as well as the costs involved in shariah compliance, not least paying the fees and expenses of members of the shariah committee. Of course the cost of a mortgage is not the only factor determining the level of business, as those Muslims who have signed contracts for Islamic finance have been prepared to pay a premium for shariah compliance. Rather the issue seems to be the size of the premium, which greater competition in the market should reduce.

A further factor inhibiting the uptake of Islamic home finance is that a significant proportion of the Muslim population in the UK are in a low socioeconomic position and cannot afford to buy property. This applied in areas such as East London where many of those in the Bangladeshi community are quite poor, but property prices are relatively high. One solution might be coownership through Islamic housing associations, with the tenant, association and bank all owning a share in the property, but at present these do not exist in the UK.

Both HSBC Amanah and Lloyds TSB offer Islamic current accounts, these being linked to the Islamic home finance being offered, as clients make their repayments through these accounts. Neither HSBC Amanah nor Lloyds TSB pay or charge interest on these accounts, but the accounts offer normal transactions facilities such as cheque books, standing orders and direct debit facilities, monthly statements and multifunctional cards that serve as cheque guarantee and debit cards. With HSBC Amanah a minimum balance of £1,000 is required to maintain the account, but with Lloyds TSB there is no minimum. At present savings and investment accounts based on mudarabah are not offered by cither bank in the UK, as the liabilities to match the Islamic mortgage assets are generated elsewhere, notably in the case of HSBC Amanah through shariah compliant deposits in the Gulf.

Regulatory Issues

In the United Kingdom the Financial Services Authority (FSA) has been responsible for the regulation of all banks and insurance companies and other financial institutions since 1997 when regulatory responsibility was taken away from the Bank of England. leaving the latter free to focus on monetary' policy. From its inception, the FSA has been positive in its approach to Islamic finance as already indicated, taking an interest in the shariah compliant products offered by conventional banks. The remit of the FSA includes maintaining market confidence in the financial system, promoting public awareness and understanding of finance, consumer protection and the reduction of financial crime, including money Iaundering23.

En the case of Islamic financial products the main concern of the FSA is that clients should understand the nature of the products being offered, and that Muslim consumers enjoy the same protection as nonMuslims. The FSA cannot have its own shariah committee, as it is a secular governmental institution, but it does expect that all institutions offering products designated as Islamic or shariah compliant, should be approved by the shariah committee of the financial institution offering the product, or where shariah compliance is outsourced, by reputable scholars such as those serving with the Dow Jones Islamic Indices Shariah Committee or Yasaar, the Dubai based company offering shariah advisory services. In other words there has lo be substance to the process of ensuring shariah compliance, as that is what the clients have the right to expect, rather than simply naming a product as Islamic.

As the United Kingdom is not, and will not become, a member of the Organisation of the Islamic Conference (O1C). it cannot qualify for membership of the Islamic Financial Services Board (IFSB). the Kuala Lumpur based inter national institution responsible for advising central banks and other agencies concerning banking and financial services regulation. Nevertheless the FSA has taken an interest in the IFSB since it was established in 2003, and has observer status. An FSA representative has attended meetings in Kuala Lumpur, and the IFSB has sponsored conferences in London. The FSA has also been involved in the International Organisation of Securities Commissions (IOSCO). and participated in the International Taskforee on Islamic Finance headed by the Securities Commission of Malaysia.

The most active FSA involvement in Islamic finance was an 18 month dialogue with the founders of the Islamic Bank of Britain before the bank was awarded its licence. Issues covered included capita) adequacy, as all banks in the United Kingdom are expected to comply with the Basel I requirements, and in due course, Basel II. This was not an issue as far as the Islamic Bank of Britain was concerned, as the initial authorised shareholder funds were £50 million, although only £2.5 million were called up by July 2004, when assets were £13.2 million, but paid up capital rose to £4.2 million by December 2004, when assets reached £51 millions. The FSA was also concerned about liquidity, although it was acceptable for this to be covered through commodity murabahah operations. and sukuk securities were also viewed as potentially acceptable??. The FSA also had to be confident that the bank management and staff involved in Islamic banking were professionally competent and that the directors were well known in financial circles. In the case of Islamic Bank of Britain, the Chief Executive Officer, Michael Hanlon. a nonMuslim, was appointed on (he strength of his previous managerial experience in banking, and as someone who was likely to be acceptable to the FSA, which proved to be a correct judgement.

In the United Kingdom deposits are guaranteed by law through a deposit protection scheme in full up to £20,000 and proportionally above that amount. With Islamic banks current accounts can be guaranteed, but not investment mudarabah accounts on which depositors earn a return based on profit sharing. Liability for losses is inherent in mudarabah contracts. To get around the legal position, investment depositors with the Islamic Bank of Britain are asked to sign a waiver foregoing their rights in the interests of shariah compliance, although they cannot be o to sign. In practice the majority have been willing to sign for this optout.

Regulatory Issues

Competition and Legal

The remit of the FSA does i competition in the financial services sector, but there are potential issues in Islamic finance when only a single provider or a small number of institutions are involved. The Arab Banking Corporation's Alburaq subsidiary launched a buy to let Islamic mortgage; scheme in October 2005, a very welcome development, but at the same time reached agreement to distribute its products through Lloyds TSB as well as through its existing distribution channels involving Bristol and West, the former building society. This rationalisation potentially offers customers more choice of shariah compliant products, but it also increases the market strength of the two largest providers of Islamic home finance, with potentially monopolistic implications for pricing.

Islamic finance has developed in the United Kingdom without the need for special Islamic banking legislation, as it has been possible to manage the industry under existing regulations, English law has proved much more suitable for Islamic finance than that of the civil lawjurisdictions of most continental European countries, and indeed has become the preferred law for cross border Islamic financial deals and product launches, including sukuk securities. International law firms based in London, such as Norton Rose, have established units specialising in Islamic finance, and this expertise can be drawn on through their worldwide offices, including those in the Gulf and South East Asia.

Where disputes arise, the English courts are solely concerned with the contractual documentation. Where both parties to a commercial transaction have signed an agreement, which has been deemed to be shariah compliant by their own shariah scholars, they cannot appeal to other potentially contradictory fatwa issued by scholars who were not parties to the agreement. In a dispute that arose between the Shamil Bank of Bahrain and Beximco Pharmaceuticals of Bangladesh over the failure of the I tiller to make a payment under a murabahah agreement, the case was taken to the High Court in London, as the agreement was signed under English law:?. Norton Rose acted on behalf of Shamil Bank, and the High Court found in its favour. Beximco subsequently appealed, but the Court of Appeal eonfirmed the judgment made by the High Court in 2004. with Beximco ordered to make the payments and cover all legal costs.

Future Prospects for Islamic Finance in the United Kingdom.

Although the UK has the most active and developed Islamic banking sector in the European Union, most activity until recently has been related to the role of the city of London as an international financial centre, rather than serving the retail banking needs of British Muslims. This is however likely to change in the years ahead, especially if other major UK based mortgage banks, notably Halifax Bank of Scotland (HBOS) and Royal Bank of Scotland (RBS, which owns NatWest) enter the market for Islamic mortgages:;;. United National Bank (UNB) launched an Islamic mortgage product in 2004 aimed at the Scottish market, with the international law firm. Norton Rose, providing advice on shariah issues, and the mortgages being based on the diminishing musharakah principle:'),

HBOS and RBS have already sent representatives to several Islamic finance conferences in London, and it seems likely that the UNB Islamic mortgage aimed at the Scottish market, even though UNB is a minor player, may encourage the larger Edinburgh based institutions such as Standard Life to bring forward their launch plans for Islamic financial products. HSBC Amanah launched an Islamic pension fund in May 2004, where the assets held in the fund are screened for shariah compliance, shares of companies involved in alcohol production and distribution, pork products and conventional banking being excluded, including ironically IISBC shares.", "['he pension fund is marketed to individuals and small Muslim family businesses. This may be a more promising way forward in the UK market than Islamic mutual funds, where there has been a history of failure, from the Kleinwort Benson Islamic unit trust of the 1980s to Flemings Oasis Fund and the Halal Mutual Fund of the 1990s, all of which failed to attract sufficient investors to ensure sustainability

The UK government is determined to create a level playing field for shariahcompliant products. In the 2005 budget statement the same treatment was extended for ijara leasing mortgages and diminishing musharakah coownership mortgages as had already been applied to murabahah mortgages in the 2003 budget, with only a single stamp duty levy applying?!. The Chancellor of the Exchequer, Gordon Brown, announced at the Muslim News Awards for Excellence in March 2005 that a consultation paper would be issued concerning equal treatment for Muslim council tenants under the "right to buy scheme", which at present is restricted to interest based mortgages.^. All this bodes well for the future, as a nondiscriminatory system of taxation and regulation will encourage more competition in the market for Islamic financial services, reduce prices and margins, and make Islamic products more affordable.

There is much that other European Union member states and aspiring entrants can learn from the quarter of century of experience in the UK, and even if some of the lessons are cautionary, many in the Muslim community now believe that British Islamic financeis really taking off.