Case Study: Pioneering Islamic Banking in the US

Chicago-based Devon Bank is a true pioneer when it comes to Shari’ah finance but it has had to overcome plenty of hurdles along the way, with others still to be crossed.

The bank in the US that has a solid case for claiming pioneer status in Shari’ah finance in that country is to be found in Chicago, Illinois. Perhaps, at first glance, not the obvious place to look for such innovation. However, Devon Bank resides in one of the most ethnically diverse neighbourhoods in the country. The move into Shari’ah financing basically stemmed from customer demand, explains the bank’s corporate counsel, David Loundy. There have been plenty of challenges along the way, as is always the case with pioneers in any walk of life, and there are a fair few still outstanding. But what is clear, as the story unfolds, is that Devon Bank has been pretty good at finding ways around issues or, as Loundy puts it, forcing square pegs into round holes.

This ethnic diversity is reflected in the fact that the bank’s employees are conversant in some 33 languages. The neighbourhood is often a first staging post for immigrants, many of whom ultimately move on. There are large Indian and Pakistani communities, with others from Africa, central Europe and elsewhere.

The first approach to the bank regarding Shari’ah finance came six or seven years ago. This was from a customer who wanted to buy a store front up the street but did not want to pay interest. The customer wanted to know if the bank could help. At that point, the answer was ‘no’. In fact, the only bank in the US that could help at that time was United Bank of Kuwait.

After United Bank of Kuwait was bought out, the customer came back to Devon Bank and asked the same question again. There were beginning to be other enquiries along the same lines as well, so it was felt that this was something the bank should look into. There had been early moves towards developing a solution for these customers but it wasn’t going very quickly, says Loundy.

He was a lawyer and joined the bank at about this time; the bank is family-owned and David is a family member. Given his legal background, the Shari’ah finance challenge was handed over to him. Early and subsequent assistance has come from the Shari’ah Supervisory Board of America, which is conveniently placed just two blocks up the road from the bank. One of its founders helped Devon Bank to get started and also took a keen personal interest as he has a real estate business. At that stage, the Supervisory Board was going to banks to try to attract interest. ‘We were already interested,’ says Loundy.

As the initial products began to take shape, so the enquiries started to multiply. People began asking whether the bank could provide finance for houses and cars, could help with lines of credit, could ‘help their sister in Connecticut’, says Loundy. At first, Devon Bank’s emphasis was on its own neighbourhood, with this having been its sole area of activity prior to the Islamic Finance initiative, but it was quickly pulled into other states and now provides Shari’ah products across more than 35 US states finding itself one of the top providers in the country.

So what have been the challenges? The bank was trying to ‘mesh two legal systems and two financial systems together in a way that made sense’, says Loundy. Other dimensions to the complexity involved were ensuring that the products were correct from a religious perspective while also, of course, commercially attractive. There has been a lot of education required – of the regulators, title companies, attorneys, tax authorities and other relevant parties. With obvious exasperation, he admits that practically everything about every transaction requires explanation.

The banking regulators have been very supportive,’ says Loundy. In part, this is because they see the initiative as helping to bring unbanked individuals into the banking system. ‘They see it as a valuable community service.’ Less positive has been the response at the individual state level. ‘The Secretaries of State are the bane of my existence,’ he sighs. It is hugely difficult to register to do business in each state. This is often nothing to do with Islamic banking per se but rather that the request does not ‘tick any box’, by virtue of being unfamiliar.

'The banking regulators have been very supportive, In part, this is because they see the initiative as helping to bring unbanked individuals into the banking system. ‘They see it as a valuable community service.’

Despite these issues, the bank has been able to develop a wide range of home finance products, with these including the equivalent of fixed rate, bridge financing and so on. However, tax continues to be an issue. It has been an ongoing battle to persuade the IRS (Internal Revenue Service) to respond to the questions being posed, says Loundy. ‘Essentially, they are refusing to answer.’ He says: ‘They know there is an issue, there is probably $1 billion of Islamic paper in the market’. However, for the time being at least, there is no sign of resolution. He feels there is a logical regulatory fix waiting to happen but there currently appears to be insufficient public outcry to bring about the change.

The situation is not as bad at the local tax level. There is the equivalent of the UK’s stamp duty (which needed adapting to pave the way for viable Shari’ah mortgages in the UK; see the interview with Lord Eddie George, 'NewHorizon, April–June 2007' issue) to contend with. ‘Fortunately, in many states, there are ways around it,’ says Loundy. However, where this is not the case, it just adds the basic expense of incurring the duty twice (this stems from the nature of the transaction under Shari’ah principles, which involves initial ownership by a financier).

Education is also needed on the customer side. This encompasses a broad spectrum: some customers have already had conventional mortgages but many have not. ‘A lot have never thought they would be buying a house so have never learnt about the process or about mortgage financing,’ says Loundy. The bank finds that, unlike with many mortgage applicants, the prospective customers will often come in, spend a considerable time talking to the bank, and then disappear for six months. The first point of contact comes not because they have a property in mind to buy but rather because they are exploring whether or not such a thing is feasible. Even on the commercial side, which constitutes a good part of the bank’s Shari’ah business, while the customers are typically ‘savvy business people’, Shari’ah finance still usually falls outside the reach of their expertise.

There has also been the challenge of how to reach a much wider geographical customer base. If a customer is in Chicago and wants a conventional mortgage, they may well turn to Devon Bank. If they are in Texas, they will turn to a bank there. But if they are in Texas and want a Shari’ah mortgage, then they are likely to turn to Devon Bank, explains Loundy. ‘The telephone is a wonderful device,’ he says. The bank has not made its Shari’ah products available via online banking largely because of technical reasons, particularly an inability to make the displays Shari’ah-compliant. Indeed, the bank has had an issue with technology as a whole, so there is more manual effort here than in the rest of its activities. It has developed some software itself but has struggled to find Shari’ah-compliant applications.

Of course, the competition has increased. In some ways, this is good for Devon Bank, because it builds the awareness and maturity of the market. Some areas have become highly competitive, some less so, says Loundy. Residential financing is in the former category, which is one reason for Devon Bank’s broader product set. The ‘800-pound gorilla’ is Fannie Mae, the shareholder-owned entity with a Federal remit to ensure that mortgage bankers and other lenders have enough funds to lend to home buyers at low rates in support of home ownership and rental housing. Fannie Mae has decided to make this a focus area as part of its commitment to minority home ownership and is seeking to roll out a uniform product. When this has happened and such finance is available to everyone, then Devon Bank’s differentiators will need to be breadth of product, backed up by quality of service, as the mover benefits will be no more.

One challenge that Devon Bank is particularly trying to overcome at present besets everyone in this space – lack of liquidity. The bank is trying to launch an offshore investment company but this is an uphill task, exacerbated by the subprime meltdown. Any potential investor, says Loundy, can ‘pick up a newspaper and read the headlines’. In reality though, in four and a half years, Devon Bank has had no foreclosures and no write-offs. ‘We have an exceptional portfolio performance.’ The plan is to set up an independent entity called Devon Islamic Ventures Offshore (DIVO) to try to expand the bank’s Islamic financing programme through the creation of a Shari’ah-compliant investment vehicle and the provision of an investment conduit for other Islamic financing ventures.

‘We have got pretty much everything set up and ready except the money,’ he says. DIVO has close ties with the bank but is an independent entity so will have a wider remit, beyond the reach of an Illinois bank. The vision is for a portfolio of Shari’ah-compliant businesses, provided either directly by DIVO or an affiliate, but mostly through equity investments in other providers of such services or in funds operated by such providers. There is already a Devon Real Estate Asset Management company which will eventually have DIVO as a parent and which is focused on real estate-only finance business.

There is a final interesting twist to the story: the Loundys are a prominent Jewish family. The bank itself has been operating since 1945, set up by local merchants, and owned by the Loundy family since 1953. While it might seem a huge leap from the bank’s origins to today’s faith-based banking activities, the latter are in keeping with the caring community bank envisaged by its founders. As the bank says itself within its marketing: ‘There’s no one size fits all when it comes to banking services from Devon Bank.’ Nowhere can that ethos be seen more clearly than in its pioneering Shari’ah finance activities.

Source: New Horison - Global Perspective on Islamic Banking and Insurance

Point of View: Innovations in Islamic Finance

Dr Humayon Dar, Dar Al Istithmar

The explosive growth in the Islamic banking sector over the last few years may soon be replicated in the insurance sector. NewHorizon talks to Dr Humayon Dar, CEO of Dar Al Istithmar, a subsidiary of Deutsche Bank group that provides Shari’ah consultancy services.

The huge demand for Shari’ah-compliant financial services has created innovative service offerings from the Islamic banks. Nowadays, credit cards, car loans and mortgages are all available to private individuals while investment products, many based around the sukuk and investment funds of different types, are available to wealthy individuals and corporate bodies.

The housing market, in particular, has seen tremendous growth according to Dr Dar. Until recently, banks did not offer mortgages to individuals but the liberalisation of the financial market has meant that these products are now available and Islamic mortgages are becoming very popular. Housing markets across the world have expanded but the demand for Islamic home finance has been even further fuelled by the growth in the emerging Muslim economies, particularly those of the Gulf Cooperation Council (GCC) countries.

Dr Dar thinks the positive image that the availability of Islamic financial services sends to the rest of the financial world is enhanced by Islamic scholars working closely with Western bankers in London, New York and elsewhere. There is evidence that wealthy Muslims tend to invest in Shari’ah-compliant financial products when investing locally, although they may be prepared to invest in conventional banking products when investing overseas.

There is nothing religious about Islamic banking – it is a structure that is used to differentiate between halal and haram products.

Some of the devices used to support Islamic products differ from country to country. In response to the rise in demand for credit cards, Islamic banks in different countries have created different models to replicate the economic effects of conventional credit cards. In Malaysia, for example, Islamic credit cards can be supported by the bai al-ina or buyback sale. In this the bank and the client buy and sell a piece of land between them with the difference in the buying and selling prices being used to provide the credit limit on the credit card.

This is the model used by Bank Islam Malaysia Berhard, the largest Islamic bank in that country. In the Middle East the more popular contract is the tawaruq which is similar to the bai al-ina but there are three parties involved in the buying and selling of the underlying asset: the bank, the client and a third party often found through the general marketplace.

In the UAE, credit cards are often provided as a fee-paying service with no underlying transaction. Banks provide different classes of card – gold, platinum, etc. – based on the client’s income with different fee brackets based on the type of card.

The explosive growth in demand, and the fledging nature of the Islamic financial market means that, as yet, not all business areas are fully serviced. An example of a relatively difficult area is the Treasury Operations function within a bank or large corporation. According to Dr Dar these money market operations are an ‘Achilles’ heel’ of Islamic banking and are a rather more complex area in which to achieve compliance.

In conventional banking circles a bank with excess liquidity will lend to another bank through inter-bank loans. To achieve the same function while still being Shari’ah-compliant, most Islamic banks will use a commodity murabaha. In this both banks instruct a commodity broker – bank A will instruct the broker to buy, say, $100 million of commodity and sell it to bank B on a deferred payment basis. Bank B retains the funds obtained from instructing the broker to sell the commodity for cash on the open market. Repayment occurs at a predetermined frequency agreed by both banks. The sukuk is becoming more prominent in this market, particularly those issued in Malaysia and Bahrain, and this area may present future innovations.

Islamic banking so far has not shown an explicit responsibility towards the community in which it serves so possibly this will be the next step – the emergence of banks that are genuinely socially responsible.

Dr Dar feels that the real growth area is occurring in Islamic insurance or takaful which until recently has been a relatively untapped market. Some analysts think that this sector may prove to be bigger than Islamic banking.

Part of the demand for these products is in response to directives from financial institutions. If an individual obtains financing from a bank for a car or a home, the bank makes it compulsory to obtain insurance. Some of the large Western banks are aggressively entering this market. For example, HSBC Bank Malaysia Bhd has announced that in the next two years it aims to at least double the amount of insurance products used by its existing customers. Currently, around 30 per cent of its customers use insurance products.

The reinsurance market, where insurance companies spread the risk among specialist underwriters, may also present a growth area. Although there are four or five small Islamic reinsurance companies, it is still largely dominated by conventional insurance organisations.

The emphasis in Islamic banking up until now has been on the Shari’ah compliance aspects and whether the underlying contract complies with the law. This is not necessarily ethical banking though, explains Dr Dar. There is not much similarity between Islamic finance and ethical investments or socially responsible investing.

Ethical banking has more of a Western influence. As an example, the Dow Jones screening for Shari’ah-compliant companies includes companies that are doing prohibited business, such as making or distributing alcohol, or casinos. But there are others which are strange from an Islamic point of view such as tobacco or the defence industry. ‘There is no consensus in Islam about tobacco,’ says Dr Dar ‘but Islamic funds will not invest in tobacco because it is considered unethical – an inference that has come from Western influence’.

Dr Dar feels that the next big event in Islamic banking may be what some people refer to as ‘real’ Islamic banking. The existing attempts to conduct business in a Shari’ah-compliant way could be called ‘halal’ banking rather than Islamic banking. There is nothing inherently Islamic about the operations of Islamic banks. They are simply doing business in compliance with Islamic law. Islamic banking to some people implies a social responsibility.

‘Islamic banking so far has not shown an explicit responsibility towards the community in which it serves so possibly this will be the next step – the emergence of banks that are genuinely socially responsible,’ says Dr Dar. ‘Co-operatives and mutuality have gone out of fashion in the UK but it is something that is needed in some countries.’ Dr Dar goes on to say that ‘there is nothing religious about Islamic banking – it is a structure that is used to differentiate between halal and haram products’.

After such an explosive growth period in Islamic banking, it may be time to pause for reflection while the insurance sector takes up the financial expansion.

Source: New Horison - Islamic Perspective on Banking and Insurance

Lord Eddie George - The steady hand behind Islamic finance in the UK

By Tanya Andreasyan

New Horizon met with Lord Eddie George, former Governor of the Bank of England last month. Amidst many achievements, there is no doubt that paving the way for the introduction of Islamic mortgages is something that he looks back on with pleasure and pride. Over an hour and a half, he talked to NewHorizon editor, Tanya Andreasyan, IBS’s founding editor, Martin Whybrow, and former founding CEO of HSBC Amanah and chairman of the executive committee of Jadwa Investment Bank, Iqbal Khan, about the original drivers, the hurdles and the influences for this important element of Shari’ah banking. Where the UK led, others have now followed.

A pivotal individual in terms of laying the foundations for Islamic mortgages in the UK (and beyond) is Lord Eddie George. During his time as Governor of the Bank of England, he helped pave the way for this important cornerstone of Shari’ah-compliant banking. Looking back on these efforts, he is quick to emphasise the team effort behind the development but, nevertheless, the senior backing that he provided was clearly vital to the success of the initiative. Under his steadying hand and guiding influence, all of the necessary elements to turn the dream into reality were put in place.

Having retired in June 2003 after ten years as Governor and 40 years at the Bank, Lord George is now in an ideal position to look back on the evolution of Shari’ah banking in the UK during that time, and to put this into context in terms of other major changes within the country’s banking sector over that period. The tale that Lord George recounts of his initial interest in Islamic banking goes back to before his time as Governor. He met what he describes as a delightful Muslim couple who had just bought their first house. They told him of their happiness with their new home but there was one problem which was preying on their conscience. This was the fact that they had had no option but to take out a conventional mortgage and they explained their issues and sadness. ‘I couldn’t think of any rational reason for this,’ says Lord George. The country has a terrific reputation for innovation, so surely it could find a way to meet this need, he felt.

Lord George looked into the matter at that stage and identified one issue to be the lack of standardisation. Many of the existing financial products seemed to have at least some of the characteristics consistent with the teachings of the Quran and it did not seem too difficult to fit Shari’ah-compliant products into the UK’s legal framework. However, a better and more precise understanding of Islamic banking products was needed, as well as, in the immature area of mortgages, a more consistent and standardised specification of the products required by the Islamic community.

‘There were no really standard products, so we couldn’t identify a Shari’ah mortgage. It was hard to fit this into the regulatory and legal framework because the definition of a Shari’ah mortgage differed from one place to the next.’

The next milestone came out of the Bank of England’s ‘Heart of the City’ charity which was set up in 2000. The overall aim was to encourage City companies to work with surrounding boroughs, many of which are relatively poor. In parallel, Dr Pasha, General Secretary of the Union of Muslim Organisations of the UK and Ireland, had raised the subject once more of Islamic mortgages with Lord George. Out of this came the idea to set up a working group dedicated to this subject within the Heart of the City initiative. Having discussed the subject with Gordon Brown, at that time the Chancellor of the Exchequer, Lord George invited Andrew Buxton, who had an interest in Islamic finance, to convene the group. Buxton was Chairman of the Heart of the City campaign and a former Chairman of Barclays.

The working group included representatives from the Treasury and the FSA (Financial Services Authority, the industry regulator), as well as the Council of Mortgage Lenders and a number of banks, including Ahli United Bank, HSBC and Barclays, plus lawyers and representatives from the Muslim community. There was a fairly long list of obstacles, says Lord George. Particularly thorny was the issue of stamp duty, with the need to ensure that Shari’ah mortgages did not incur this twice because of the nature of the transaction, involving initial ownership by a financier. ‘We couldn’t unhinge the stamp duty process as a whole,’ but a workable solution was ultimately hammered out with the Treasury.

There was also a need to ensure that disadvantages were removed within the ‘Right to Buy’ or ‘Right to Rent’ public home ownership schemes, so that the role of a financier did not mean that Muslim buyers were excluded from the benefits offered by such schemes. There were many ambiguities and a large part of the effort was tracking down and resolving these. ‘No one had really done this before,’ says Lord George.

There was a lot of enthusiasm which was extremely encouraging, says Lord George. It was felt that this was the right thing to do, with the UK having a tradition of being receptive and supportive of different religions and societies, and with the Shari’ah mortgage project another demonstration of this. The effort was helped by the fact that it was clear that Shari’ah banking as a whole was growing quickly. It was also felt that with mortgages, as with other Islamic products, demand might not come purely from the Muslim community.

The first working group was hosted by the Bank of England, and Lord George did not miss a single meeting... The efforts were deeply appreciated within the Muslim community... The work would allow UK Muslims to be both more Muslim and yet at the same time more British in their country.

While Lord George is quick and fulsome in his praise of other individuals involved in the work, there is no doubt that his own role was vital. Iqbal Khan points out the importance of Lord George’s patronage and involvement. The first working group was hosted by the Bank of England, and Lord George did not miss a single meeting, he recalls. The efforts were deeply appreciated within the Muslim community, he points out, with the project attracting a lot of focus. He recalls the Imam of his own local mosque making a telling point: the work would allow UK Muslims to be both more Muslim and yet at the same time more British in their country. It was a similar theme in mosques around the country, with prayers for the success of the scheme, he says.

It is also worth pointing out that the efforts were not solely of importance to the UK. Indeed, far from it. Khan cites the press coverage that the initiative generated across the Muslim world. Many countries were lagging behind and did not have the regulatory framework themselves. In fact, the UK work led to changes elsewhere, influencing regulations in Malaysia and Brunei, among other countries.

Bank of England
The Bank of England traditionally has very good relationships with other central banks, says Lord George. This is partly historical and partly through proactive means. For instance, Bank of England staff are encouraged to spend time outside the UK (Lord George himself spent a formative year in Moscow in the mid-1960s, where he saw at first hand what he describes as the Soviet ‘disconnect’ between the banks and industry). The Bank of England also introduced an annual conference for Commonwealth central banks, with this subsequently having been broadened to developing countries as a whole. And it set up the Institute of Central Banking Studies which, says Lord George, has played a very important role in Islamic finance as well.

Although Ahli United Bank, formerly United Bank of Kuwait, has been offering Islamic mortgages in the UK since the late 1990s, it was the Finance Act 2003 that really opened the door to Shari’ah-compliant mortgages providing impetus in this niche of financial markets by levelling the playing field for Islamic mortgages regarding stamp duty. As a result, other players like HSBC Amanah, Alburaq, Islamic Bank of Britain and Lloyds TSB entered the arena providing competition and increasing awareness to customers on a wider level. The work did not stop with mortgages, of course, with the ongoing evolution of areas such as Shari’ah-compliant pensions, sukuk trading and private equity, but the pioneering work in mortgages laid the foundations for further progress at home and abroad. In the UK itself, Shari’ah banking as a whole has been helped by the favourable environment, as reflected in Gordon Brown’s vision of Britain as a centre for Islamic finance.

In terms of the bigger picture, it is unlikely that the Bank of England would have taken such a lead in the past. When Lord George first joined the institution, it had a purely administrative role, implementing direct control of the economy on behalf of the government. It is easy to forget, even for those who were around at the time, that the UK’s economy was extremely cyclical, lurching from ‘boom to bust’ with interest rates that Lord George calls ‘extraordinary’ and with a trade-off between growth and inflation. Inflation was rampant and interest rates could move two per cent on one day.

The efforts were not solely of importance to the UK... In fact, the UK work led to changes elsewhere, influencing regulations in Malaysia and Brunei, among other countries.

The cycles were more pronounced than in other developed economies and, over time, the troughs were becoming deeper and the peaks higher. ‘We were looking over a precipice; there was a gradual realisation that this was not the way forward.’

The need for change opened the way to a clear shift in the role and position of the UK’s central bank, with a loosening of the political constraints that it was working under. Independence for the Bank was something that happened much faster than Lord George expected. He had discussed it with Gordon Brown and there was agreement on the matter but he expected it to take two or three years; in fact, it was set in motion four days after the new Labour government came into office. Transparency and public accountability were notable parts of the change, with Lord George pushing through the publishing of the minutes of the Bank’s meetings.

Fifteen years ago, the UK was one of the worst performers of the industrial countries; today it is one of the best. There was no one particular factor, rather a combination. The transformation was not overnight but was still relatively swift in economic terms. Now, Lord George pronounces himself ‘very optimistic’ about the UK economy. Although clearly keeping busy and ‘interested in all sorts of things’, he made a definite decision to ‘pull right back’ from the Bank of England when he retired, confident that the Bank was in excellent hands under his successor, Mervyn King (‘a first rate economist’). He laughingly says he misses the ‘molly-coddling’ of his staff at the Bank but other than that he is obviously enjoying life and still keeping a keen watching brief on the ongoing evolution of Shari’ah finance.

Source: New Horison - Islamic Perspective on Islamic Banking and Insurance