The Bottom Line - To Survive, Islamic Banks Must Innovate.

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THE BOTTOM LINE - TO SURVIVE, ISLAMIC BANKS MUST INNOVATE.

By Mahmoud Kassem.

Of DOW JONES NEWSWIRES

MANAMA, Bahrain -(Dow Jones)-Innovation, not imitation is the key to success for Islamic banking, says Atef Abdulmalik, CEO of First Islamic Investment Bank.

Whether or not his audience at a recent Islamic banking conference saw the irony in his borrowing a Hugo Boss clothing advertisement slogan, none failed to grasp his point that the Islamic banking sector is at a critical juncture.

"For 800 year Islamic civilization was driven by invention...but doing new things is something that we in the Islamic banking industry have lagged behind in recent years," he said.

Islamic banks and banking practices - which restrict areas of investment and shun riba, or interest - took off on the back of 1970s petrodollars.

But with more capital flowing out of Middle Eastern economies than into them as investors sought higher returns in more developed U.S., European and Asian markets, it never became more than a solid niche industry with limited product offerings.

With capital invested by Arabs in the U.S. flowing back to the Middle East after the Sept. 11 attacks and increased competition from international banks that have opened Islamic banking operations, the region's banks are having to scramble to develop new products and services to attract that money and retain customers.

Arab money - anecdotally about $125 billion - is coming back to the region because many Middle Easterners have been humiliated by the way they've been treated by their banks and regulatory authorities in the search for money associated with Osama bin Laden's al-Qaida network.

Ramzi Abu Khadra, CEO of financial service company iHilal, pointed to growth in some equity markets in Arab countries as well as the rising price of land in Riyadh as evidence that money was returning from Arab investors in the U.S.

"It's said that there is about half a trillion dollars in the West that's come from the Middle East. Maybe about 25% could have come back. Maybe they're scared about someone freezing their assets because some people have had their assets frozen, and there has been a mix-up in names sometimes," he said.

Sept. 11 Sparks Soul-Searching, Product-Hunting

Sept. 11 has made Islamic banks more self-conscious, but it's not at all clear whether they'll jump in on the opportunity being offered by the inward fund flow to introduce the innovation and transparency needed to raise themselves to international standards.

"Growth (in Islamic banking) will not succeed without a better innovation push. New products need to be introduced," warned Ghiath Shabsigh, a senior economist at the International Monetary Fund.

Islamic banks also need to offer better technology and improved and efficient services if they're going to provide sustained growth, he said.

Participants at the Islamic banking conference in Manama acknowledged that First Islamic Investment Bank, the first Islamic institution to delve into leveraged private equity investment in the U.S., is among just a handful of Islamic financial institutions leading the industry forward. First Islamic Investment Bank's assets have grown grew 13.4% to $193.4 million.

But in a $200-billion-dollar industry spread over 250 institutions and 50 countries, most Islamic financial institutions are lagging behind, weighed down by thin managerial talent, weak product offerings and poor customer service.

Saudi Arabia, Kuwait and Bahrain control the largest slice of Islamic assets in the Gulf - around $9.4 billion in total.

Beyond the Arab world, Pakistan and Iran, whose banking systems are obliged by law to be Islamic, control the biggest chunks of Islamic assets at $38.5 billion and $67.6 billion.

Furthermore, the world's 1.2 billion Muslims could be holding up to $3 billion of untapped cash, as most are underserved and in countries where the banking sector is underdeveloped. Many prefer to keep their money under mattresses rather than in bank vaults.

While most Western retail banks have moved heavily into customer relationship management and targeted services... "Islamic banks don't know their customers," said Yavar Moini, an Islamic financial services consultant at Ernst & Young in Bahrain.

"It was easy for them to get money initially, but now they can't rely on religious sentiment alone," said Moini. "Their industry is becoming more sophisticated and the management of these banks will have to cater to their needs. They have to improve customer service and products."

Pressure From Western Rivals

Mortgages, pension and mutual funds and bond-like offerings are among products that have been popular with customers of Islamic banks in recent years, but the task of finding new products is made more difficult by other restrictions apart from a ban on interest that the Koran prescribes.

"Those who swallow usury cannot rise up, save as he arises whom the devil has prostrated by (his) touch. That is because they say: Trade is just like usury; whereas Allah permits trading and forbids usury," warns the Koran.

Islamic banks must also avoid investing in conventional interest-based banking and insurance services, and businesses that deal in alcohol and entertainment, such as casinos, cinema and music.

The debate on what constitutes riba is a contentious one. While most Muslims equate riba with interest and usury, some quarters like Al-Azhar, the Sunni world's top authority, permit some forms of it.

And in Pakistan for instance, banks aren't allowed to use the word "interest", but substitute them with "profit" and "loss sharing", allowing greater scope to take conventional interest-based products and seemingly disarm them of interest by calling them something else.

"Islamic banks are growing at a faster rate than conventional banks, but they are centered around a very few products. There is dissatisfaction in consumer finance, treasury operations and equity financing," said Jamil A.K. Jaroudi, general manager of investment banking group Shamil Bank of Bahrain.

"There is a market to be exploited in debt financing. Equity finance is not growing fast enough. We don't see real medium-to long-term equity investment, because there is no exit strategy," he added.

Some Islamic institutions such as First Islamic Investment have so far proved they can be successful despite the difficulty of finding long-term investors.

"There's too much liquidity going into short-term investments. There's no long-term investment, and this is because there's no money market," said Ernst & Young's Moini.

As the indigenous Islamic industry searches for ways to attract more money, international banks like Merrill Lynch, HSBC and Deutsche Bank have been creating their own Islamic banking branches, seeking to capitalize on latent demand from Muslims in the U.S. and Europe. In the U.S. alone there are up to 12 million Muslim.

If Middle East based Islamic banks want to integrate into the global financial system and tap that demand too, they must first unify regulations, increase transparency and most importantly perhaps, learn how to be more market driven.

"Islamic banks have to learn to operate at the same level as conventional banks. They have to be market-driven. They have to bridge the gap between traditional values and demand for new products," said Jeffrey Culpepper, vice chairman of Deutsche Bank in London.

-By Mahmoud Kassem, Dow Jones Newswires; +20101499853 mskassem@yahoo.com.

(Copyright © 2002, Dow Jones & Company, Inc.).

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