Internationalization of Islamic Financial Institutions: Challenges and Paths to Solution

Internationalization of Islamic Financial Institutions: Challenges and Paths to Solution
by:
Samy Nathan Garas
Villa 5, Gate 789, Road 3217
Manama, Bu Ashirah 332
Kingdom of Bahrain
Telephone: +973 392 99 589
E‐Mail: samynathan@nyit.edu.bh


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ABSTRACT
The Islamic Financial Institutions (IFIs) have witnessed a significant growth recently and
become a new player in banking industry.  As IFIs move towards the international markets, they
confront several challenges on internal and external levels. Internally, IFIs still have limited
recognition by investors, marginal contribution to the macro economy and limited customer
service.  Externally, IFIs have lack of communication with other players in the financial markets.
Their products are not totally promoted to the international investors and their system is not
completely regulated and recognized by central banks.  This paper will address these challenges
and provide a conceptual framework of solutions.
INTRODUCTION
During the last three decades IFIs have been growing significantly, both domestically and
internationally.  IFIs witnessed an average annual growth rate of 23% (approximately) during
the period 1993‐2003, and 20% since 2003 (CIBAFI, 2004).
These new financial firms were established in the emerging market of the Middle East to meet
the demand of investors and borrowers who are motivated by profit maximization based on the
Islamic law (Shari’a).  IFIs offer a wide range of Islamic financial innovations starting from the
simple contract of profit‐sharing agreement (Mudaraba), which is similar to time deposit in
conventional banks, to Issuing Islamic bonds (Sukuk) and derivatives.  The growth of IFIs
attracted some of the conventional financial firms (i.e., ABN AMRO, Citibank and Dresdner
Kleinwort Benson) to add the service of Islamic windows to their clients.  Despite the
advantages that are embedded in IFIs system and management, IFIs encounter several
fundamental challenges to the prospect of being recognized internationally.  The challenges exist
in local as well as global markets.  These advantages and challenges will be discussed through
the following questions:
1.  What are the advantages that make IFIs different from conventional banks and how the
customers perceive these characteristics?
2.  What are the challenges that hinder IFIs from being recognized locally and internationally?
3.  How can IFIs articulate the proper solutions to meet these challenges?
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The paper will be divided into three parts.  First part will explain the current situation of IFIs,
explaining the factors behind their growth in local and international markets and discusses the
advantages of IFIs’ system that makes them unique and attractive to all customers.   Secondly, it
will present a model discussing the two types of challenges before IFIs internationalization:
challenges inside the Islamic countries such as the limited recognition of investors to IFIs
activities, the limited contribution of IFIs to the country’s economy and the limited customer
service.  The other set of challenges exist outside the non‐Muslim countries such as the cultural
barriers with the Western countries, the cautiousness of international customers in being
involved with IFIs transactions and the misconception of IFIs stereotype.  Thirdly, the paper will
provide some solutions that can be implemented to facilitate the process of internationalization
and provide some lessons to conventional banks on the technical and management sides.  
LITERATURE REVIEW
Internationalization has been under discussion for a long period of time, where different authors
looked at the process of internationalization from different views. For instance, Buckley and
Casson (1976) looked at the transaction costs for intangible assets and the ability to obtain and
transfer knowledge across the international markets.  This idea has been argued by Hennart (1982)
and Caves (1996).  Furthermore, Johanson and Vahlne (1977, 1990) and Carpano and Chrisman
(1994) argued the influence of internationalization on the firm’s performance.  In addition, Doz
and Prahalad (1984) focused on the organization and management of multinational firms and the
balance between international headquarters and national subsidiaries (Martinez and Jarillo, 1991;
Paterson and Brock, 2002).  Furthermore, Ghemawat (2001, 2003) noted how some types of
dimensions among the countries (i.e., cultural, administrative and geographical dimensions)
influence the internationalization process.  Therefore, they should be studied with the integrative
framework of internationalization.  These dimensions include the language, religion and social
norms (cultural dimension); political, legal and economic sides (administrative dimension); and
income, population, and education (geographical dimension).  The cultural dimension was
studied in detail by Hofstede (2001) and others (Schwartz, 1996; Bond and Chi 1997; Schwartz and
Bardi, 2001) where they built a relationship between culture, values and practices.  The cultural
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dimension has a significant influence on the internationalization process of IFIs.  On the other
hand, IFIs have high code of ethics derived from the Islamic religion which enhances their
Corporate Social Responsibility (CSR), which brought them a favorable image from the
stakeholders and enhanced their performance in their early stage.  This thought has been
developed in literature by Donaldson and Preston, 1995; McWilliams and Siegel, 2001 and Rowley
and Berman, 2000.
There is a scarcity of theoretical literature in IFIs internationalization process.  Zaher and Hassan
(2001) provide a comparative study on the salient features of Islamic banking supervisory system
in 15 countries, explaining the lack of regulatory framework in IFIs, which poses a great challenge
on IFIs to uniform their standards and policies and mandate them on all IFIs regardless their
countries.  In addition, Aggrawal and Yousef (2000) argued the economic rationales for the
superiority of Islamic financing system over its conventional counterpart.  Ebhrahim and Joo
(2001) argued that IFIs internationalization process greatly depends on the regulators who should
develop a modern financial engineering system for the advancement of IFIs.  This would reduce
their dependence on the conventional banks for drawing their expertise.  Siddiqi (2001) argued
that IFIs internationalization is challenged by developing the risk management and analysis tools
in Islamic financial theory and practice to hedge against the volatility in the international markets.
In addition, IFIs need to educate the international investors with their Islamic ethical foundation
that is embedded in their products and their mark‐up in each transaction (Hassan, 1999; Baldwin;
Humayon and John, 2000; Suseno, 2002).
This paper aims to provide a conceptual framework for the internationalization of IFIs through a
model, explaining the challenges that stand against IFIs and the possible solutions to overcome
them.
WHAT IS ISLAMIC FINANCING?
Unlike the conventional banking system, the Islamic banking system can be defined as a faith‐
based system of financial management, which derives its principles from the Islamic Shari’a.  It
promotes profit‐sharing in the conduct of banking business as well as prohibiting paying or
receiving interest on any transaction (Salleh and Hassan, 2004).  This definition asserts the main
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pillars of IFIs: guidance by Islamic Shari’a through a board of Islamic scholars called the “Shari’a
Supervisory Board” (SSB) and, most significantly in terms of a reconceptualization in finance,
the prohibition of receiving profit (interest) on borrowing and lending cash.  The Islamic
banking system has been criticized for what has been interpreted as the notion of a risk free
reward or return and the lack of recognizing the time value of money (Khan, 1994: 13).  This
argument is not totally correct because according to the modern economic theory and analysis,
Islamic banking is based on equity‐based system not on the debt‐based system which is the base
of conventional banking system (Khan, 2000: 628).  This means IFIs offer an uncertain rate of
return to the investors and in case of incurring any risk; it should be shared between the bank
and the investor.  This system allows IFIs to adjust the value of their assets and liabilities
according to any changes in the fair market value of the investment.  This means the loss is
always shared between the IFI and the investors.  On the contrary, the conventional banking
system does not reflect the changes in fair market value of the investment, instead the bank
assumes the loss alone resulting in disequilibrium between the real value of assets and liabilities
and ending by negative net worth of the bank (Haron, 2000: 631).  The prohibition of pre‐
determined interest rate on loans puts pressure on IFIs to monitor the borrowers at a reasonable
cost and get the exact information about the generated profit because the lender might provide
asymmetric information about the real profit.  Therefore, the portfolios of IFIs tend to be
concentrated in short‐term, trade‐related assets (Diamond and Dyhvig, 1983: 401).  This
emphasis on short‐term financing leads to an inimical effect on investment, growth and
economic development.  This concept reflects the social commitment between the bank and the
investors in enhancing the economy.
According to Islamic Shari’a, IFIs cannot be involved in the production or distribution of specific
activities which are forbidden by Islam such as alcohol, pork, and gambling.  In replacement,
they should invest in long‐term assets such as Profit Sharing Agreement (Mudharabah), Cost‐
Plus‐Financing (Murabaha), Equity Participation (Musharaka), and Leasing (Ijarah).  These
activities are based on real assets rather than financial assets (Bahrain Monetary Agency, 2006:
22).
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During the last three decades, IFIs have increased substantially in the Middle East and North
Africa (MENA) countries and went further to the Far East and Europe.  Among all the countries
that host IFIs, Bahrain stands as a pioneer in hosting the largest number of IFIs (37 banks) in
spite of its smallest size
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.  Bahrain hosts all the regulators of IFIs which will be presented in the
following section.  The reason behind this growth in Bahrain is the lack of natural resources in
the country, which motivated Bahrain government to nourish the Islamic banking industry and
make it as one of the main resources of income.  In addition, there is no corporate tax in Bahrain,
which supports the IFIs system.  As Parker (1993) noted that Bahraini planners are keen to
portray Bahrain’s future as equivalent to Singapore in the Far East.
Global Islamic Economy
So far, the exact size of the global Islamic economy has not been precisely identified.  However,
for the purpose of this study, we have considered the 57 member nations of Organization of
Islamic Countries (OIC) as the primary promoters of IFIs (http://www.oic‐oci.org).  Previous
studies covered part of this economy such as MENA countries, but bypassed the countries
where Muslim population is below 50%, as in the ex‐Soviet republics, U.K., France and India.
The targeted Islamic communities have in common the characteristics of a high level of poverty,
debt and high population growth (Moore, 1997: 2).  The debt accumulation is often condemned
by Islamic economists, especially in those countries who have the opportunity to improve other
industries ‐ such as tourism, manufacturing, and natural resources – that can enhance their
economy (Chapra, 1985: 84).  The second characteristic for Muslim economies is their large
defense budgets and the government subsidies to utilities (i.e., electricity, communication,
water, and transportation) instead of privatization.  The third characteristic is the low
availability of employment in the private sector.  The public sector accounts for 30‐60% of the
labor force in most of MENA countries with almost 95% in Gulf Cooperation Council (GCC)
countries.
2

1
 Bahrain is a set of 33 small islands, located at the North East of Saudi Arabia.  It has small production of oil
compared to its neighbor countries.  According to 2007 statistics, Bahrain has a small population of 708,573
approximately (http://www.infoplease.com/ipa/A0107313.html).
2
 International Monetary Fund ‐ Middle East and Central Asia Regional Economic Outlook (2005)
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Most of the Islamic economies are working towards promoting local savings, attracting foreign
investments, and reducing their capital expenditures.  The most readily available and useful tool
for achieving these ends was the creation of a banking system based on Islamic principles.
The Arabian Gulf countries constitute the foundation for IFIs because of their similarity in
religion, culture, language and arid geography.  They have four out of five largest Islamic banks
in the world and maintain the highest concentration of Islamic deposits and capital due to the
high income in the region.
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  The members of GCC countries hold 20% of the world’s crude oil
production and have a Gross Domestic Product (GDP) per capita of more than US$8,000.
Therefore, this region was found to be suitable soil for this system to grow in and move around
to the other Muslim countries.
Malaysia and South‐East Asia are additional financial regions of interest for IFIs, after GCC
countries.  Malaysia is considered the second most populous Islamic country with 54% of total
population after Indonesia which has 90% of population (Moore, 1997: 183). However, Malaysia
comes as a pioneer in Islamic banking industry for the whole Southeast Asian region.
From the perspective of conventional banking, the success of IFIs can be gauged by the rush
among the conventional banks to open their own Islamic windows, not only inside the Islamic
world but in the rest of the world such as Citibank, ABN Amro, HSBC, BNP Paribas, and Bank
of America.  
In the global market, IFIs are unique in producing Islamic bonds (Sukuk) which are different
from the traditional bonds and equity instruments.  This new tool offers a source of funding
based on the profit‐sharing concept between IFIs and investors, shifting the risks from the bank
side as in the case of traditional bonds to be on a shared basis between the bank and the
investors.  It enables the bank to exploit their comparative advantages in the loan process and
maintain a customer relationship even when loans can not profitably be held on the balance
sheet (Alkhan, 2003: 16).  
Islamic Sukuk are written documents that can be traded in the capital market and bear
ownership in tangible assets.  They are basically certificates evidencing the Sukuk holders’
3
Al‐Rajhi Banking and Investment Corp.‐Saudi Arabia; Kuwait Finance House‐Kuwait; Faisal Islamic Bank of Bahrain;
Dubai Islamic Bank‐U.A.E., and Faisal Islamic Bank of Egypt, which is part of the AlBaraka Banking Group.
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ownership in one, or more assets.
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  For instance, Partnership Financing (Musharaka Sukuk) and
Trust Financing (Mudaraba Sukuk) are good examples of Sukuk, where investors contribute
money to the Islamic bank on the basis of these two instruments, to acquire ownership and
profit in real assets.  These types of financing reflect the concept of profit‐sharing, risk‐bearing
concept between the IFIs and their investors.
The factors behind the Growth of IFIs
Several factors had contributed to the growth of IFIs, such as the economical growth of GCC
countries as a result of the oil discovery and the establishment of the Organization of Petroleum
Exporting Countries (OPEC) (Moore, 1997: 7).  This unexpected resource of income changed
completely the life style in the region and provided the foundation for IFIs.  In addition, Saudi
Arabia took the lead among the Islamic countries to promote the spirit of Islam through financial
support to the Muslim communities in the form of establishing Islamic universities, institutes,
and Islamic centers to strengthen the Arabic and Islamic identity (Halliday, 1996). During that
time, two Saudi‐funded financial firms have been founded (Dallah AlBaraka Group, 1969 and
Dar Al‐Maal Al Islami Organization, 1981) to support the international development of Islamic
banking.  After the tragedy of September 11, most of the Arab investors preferred to hold a large
portion of their investments in the Middle East in case of another similar event.  The IFIs were
the best agent to manage their investments.   In addition, the central banks in GCC countries and
especially in Bahrain, urged the Accounting and Auditing Organization for Islamic Financial
Institutions (AAOIFI) to set up the accounting and auditing standards for IFIs to protect these
investments.
CHALLENGES BEFORE IFIs INTERNATIONALIZATION
There are several challenges hindering the IFIs from being internationalized, which can be
classified into two sets of challenges.  The first set includes three challenges inside the Islamic
countries.  First, the regulators’ limited influence over IFIs activities and transactions in most of
OIC countries leads to investors’ limited recognition (Grais, 2004). Secondly, the limited role of
4
 AAOIFI – Shari’a Standards No. (18), Investment Sukuk (2004‐5), p. 4, Akbar (2003), p. 4
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IFIs in money and capital markets results in limited contributions to the country’s macro
economy (Ahmad, Pradhan and Ahmad, 2005).  Thirdly, the significant shortage of qualified
manpower and management inside IFIs leads to limited customer service (Elhiraika and Hamad,
2003).  

The second set includes three challenges outside the Islamic countries.  First the SSB influence
over the IFIs transactions and activities might be misperceived in non‐Muslim countries and
create a cultural barrier (Mirza, and Halabi, 2003, 347).  Secondly, the different characteristics of
IFIs transactions and their religious foundation lead to customers’ cautiousness and add extra
challenge before IFIs in promoting their products internationally (Iqbal and Mirakhor 1999, 381).
Thirdly, the limited capital of IFIs compared with the total capital of the financial institutions in
any country leads to marginal recognition by the central banks and enforces the IFIs to
accommodate with the existing rules which might not be compliant with Islamic Shari’a (Al‐
Omar and Abdel‐Haq, 1996).
‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐
Insert Figure 1 about here
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Challenges inside the Islamic Countries
Since the conventional banking system is widely spread inside as well as outside the Islamic
countries for decades, it gains the clients’ trust especially if it is well regulated and actively
contributed to the economy.  On the other side, IFIs are new player in the financial market;
therefore, they strive to compete with the existing system inside the Islamic countries.  IFIs are
still building up their regulatory system and trying to contribute to the country’s economy in
line with Islamic Shari’a.  IFIs are currently recruiting their employees and management from
those who work in conventional banks because of the serious shortage in their manpower.  

Investors’ limited recognition: In the financial industry, the regulators have a significant role in
organizing and controlling the transactions and implementing the fiscal policy for the whole
country.  IFIs are always compliant with the dominant regulations of any country they operate
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in; however, they have their own set of regulators that facilitate appropriate interaction with the
Islamic Shari’a.  The first element of the Islamic supervisory network is AAOIFI, which was
established in 1991 for the purpose of issuing standards in accounting, auditing, governance,
and Shari’a for IFIs in accordance with International Financial Reporting Standards (IFRS)
(Thomas, Cox and Kraty 2005, 207).  
In 2003, the Islamic Financial Services Board (IFSB) was started in Kuala Lumpur to serve as an
international‐standard setting body of regulatory and supervisory agencies
(http://www.ifsb.org).  The IFSB is focused on the structured regulatory convergence of
supervisory standards.  This international convergence is meant to achieve comparable
standards of capital measurements and capital standards.
In 2001, the International Islamic Financial Market (IIFM) was founded with the collective efforts
of the central banks and monetary agencies of six countries to facilitate secondary markets for
Islamic instruments.
5
 It has two primary roles: market education and Shari’a authentication,
which contribute to more self‐regulation and promotion of Islamic money and capital markets.  
In 2005, the Central Bank of Bahrain established The Liquidity Management Centre (LMC) for
the purpose of providing secondary market buyer for Islamic bonds (Sukuk).  The LMC plays a
key role in the creation of an active inter‐bank market which will assist Islamic financial
institutions in managing their short‐term liquidity. The establishment and depth of such inter‐
bank market will further accelerate the development process of the Islamic banking sector
(http://www.lmcbahrain.com).
During the same year of 2005, The Islamic International Rating Agency (IIRA) started operating
in Bahrain to assist in the development of the regional financial markets by providing an
assessment of the risk profile of entities and instruments which can be used as one of the bases
for investment decisions (http://www.iirating.com).  The IIRA provides different services of
rating such as sovereign ratings and credit ratings which include assessment of an entity’s
ability to repay the debt obligations in timely manner.  Also, it provides the service of Shari’a
quality rating that includes the assessment of the level of compliance with Shari’a principles.
5
 The six countries are Bahrain, Brunei, Indonesia, Malaysia, Sudan and Saudi Arabia. http://www.iifm.net
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In addition, there is the Islamic Research and Training Institute (IRTI), which was established
under the Islamic Development Bank in Bahrain to sponsor some of the most important analyses
of products, regulations, supervision, development economics and risk management (Thomas et
al., 2005: 209).
Finally in 2001, the General Council for Islamic Banks and Financial Institutions (CIBAFI) was
established in Bahrain to develop and manage a comprehensive database dedicated for IFIs
including administrative and financial information since 1998.  Currently, CIBAFI is considered
the only reliable source of information about IFIs at the global level.
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‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐
Insert Figure 2 about here
‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐
In most of the Islamic countries the central banks are not in practice of their main role in leading
the Islamic financial institutions into efficient mobilization of savings and allocation of resources
(Khan, 2000: 627).  In theory, there is nothing that makes central banks in Islamic economy differ
in a major way from the traditional concept of central banking.  In reality, the central banks in
most of the Islamic countries do not take their essential role of initiating and fostering the
development of primary, secondary, and money markets that are approved by SSB.  They still
lack new innovations which are based on profit‐sharing concept, not fixed interest rate.
Also, the central banks do not have an effective role in regulating the standards and practices for
IFIs.  As a result, their accounting practices were inconsistent and the financial statements were
not transparent due to inadequate disclosure (Thomas et al. 2005, 207).
Despite the significant growth of the above regulators, they still have some limitations which
make the investors reluctant to trust IFIs in the same way they trust the conventional financial
firms.  For instance, AAOIFI standards are mandated or used as guidelines only in six countries
(Bahrain, Sudan, Malaysia, Qatar, Saudi Arabia and Dubai) out of the 57 countries of OIC.  IFSB
lacks the authority and power to mandate their standards such as Financial Accounting
Standards Board and IFRS. IIFM has still limited access and presentation in OIC and their
conferences and seminars are not mature yet.  LMC is controlled by Bahrain central market and
6
 General Council for Islamic Banks and Financial Institutions (CIBAFI) ‐ Islamic Finance Directory (2004), p. 4
11
cannot take independent decisions.  These limitations lead to limited recognition from the
investors’ side.

Limited economic contribution: although the money and capital markets of OIC are still
considered as emerging markets, IFIs are restricted by Shari’a regulations to effectively take part
in those markets.  IFIs cannot trade in shares or bonds of any company that generates revenue
from alcohol, pork, and similar activities which are prohibited by Islam.  Therefore, IFIs have
innovated new products in replacement such as Murabaha contract, Tawarroq contract, Bei Al
Urboon and Joa’la contract
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.
However, these tools are neither available to all IFIs nor significantly contributing to the OIC
macro economy.  In addition, many Islamic nations are significantly under‐banked and this
structural fact points the need of growth inside the Islamic community.  Currently, most of the
Islamic banks are local or regional banks such as Kuwait Finance House and Bahrain Islamic
banks.  The only Islamic bank that is well established with 203 branches in 10 countries is
AlBaraka Banking Group.
‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐
Insert Table 1 about here
‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐
Finally, IFIs do not have significant contribution to incubators and entrepreneurship inside the
member countries of OIC because of their short experience.  Their investments are focused on
well‐established businesses that are approved by SSB only.

Limited customer service: IFIs are in need for accumulation of human capital as it proved to be an
important driver of endogenous growth for IFIs (Elhiraika et al., 2003; Barro 1991, 407).  According
to the Human Development Index (HDI)
 8
 for the year 2004, Brunei was ranked at 33 and Bahrain
7
 Murabaha contract means buying an asset for cash and selling it immediately on credit.  In Tawarroq contract the
Islamic bank purchases the asset on credit and sells it to another one for cash.  Bei Al Urboon includes setting up a
fixed price for a commodity to be delivered in the future.  Joa’la contract is a conditional promise by the Islamic bank to
deliver a specific quantity of a natural asset (i.e., oil, mineral, steel) upon extraction on an agreed date.  The
commodity trader would pay the pre‐determined price for it (Al‐Sheahabi 2003, 11‐13).  
8
 HDI is available with Human Development Report brought out by United Nations Development Programme
(UNDP).  It is a composite index that measures achievements of a country in different parameters.
12
at 40, despite the small population of those two countries.  Even more alarming indications of lack
include Iran, which was placed at 101, Sudan at 139 and Pakistan at 142.  The second alarming
indicator in this report is the education level, where 73% of the OIC countries occupy the lower
half in the ranks for countries listed in HDI.  These facts show that Islamic countries and
organizations have not been persuasive enough in offering non‐Muslim countries with IFIs vision
and strategy.  It indicates that IFIs success may remain at superficial levels and challenges posed to
the conventional financial system may remain feeble otherwise.
Technology, although undergoing tremendous growth, can be said to act as a backbone of the
financial sector, as well as being a main driver of market power.  It applies not only to the real‐
time clearing and settlement in money and capital markets, but also to internet‐based offerings
and Automated Teller Machines (ATMs) which are not fully implemented in IFIs due to their cost
and procedures.  Even the websites of IFIs are serving advertising purposes more than technical
support to customers.
9
  Arco Index (Archibugi and Coco, 2004) places 38 out of 57 OIC countries in
the lower half of rankings in the set of 162 countries, with 8 out 10 last places and all five last ranks
are occupied by OIC countries.
10

Challenges outside the Islamic Countries
On the global scale, OIC member countries face an economic challenge where the GDP of all
member countries together is less than 17% of the GDP of USA and does even reach 12% of the
GDP of USA and Japan (Ahmad et al., 2005).  Since the economic situation does not support the
long‐term growth prospects for IFIs, it is important to penetrate other boundaries beyond those of
the top GDP countries.  In addition, the West is reluctant to accept any approach from OIC
countries that might enhance political power in the OIC countries, such as growth in their financial
system.  The distorted stereotype of Islam in the West constitutes a significant challenge before IFIs
to penetrate these boundaries.  Also, the difference in culture, language and religion creates
another barrier before IFIs towards their internationalization.  In addition, the limited capital of
9
 De/Shakeel/Somashekar (2004) De et al. has been dealing in technological impediments in Dubai Islamic bank
(U.A.E.) which reflects the current technological situation of the Islamic world.
10
 Archibugi/ Coco (2004), ArCo Index takes into account associated variables with technological changes such as (a)
The creation of technology (b) Technological infrastructure and (c) Development of human skills
13
IFIs compared to the capital of conventional banks results in marginal recognition from the central
banks side whether inside or outside the OIC member countries.  

Cultural barrier: one of the tangible problems before IFIs is communication between Muslims and
the non‐Muslim world in general, and between Islamic and conventional banks more specifically.
This distance between the two parties have been increased due to the media and the different
attacks by some terrorists who distorted the image of Islam in the cultural consciousness of non‐
Muslims.  Therefore, IFIs face great challenge in reshaping this imbalance and bridging this gap
between the differing ways of knowing and being.  Although the problem exists, there is no
Islamic organization charged with the counterbalancing presentation between IFIs and their
conventional banking counterpart.  IFIs need to arrange for more conferences, seminars and other
channels of communications to shorten this gap and create a common ground where the two
parties meet.  In addition, the SSB should study the products of the conventional banks and
encourages the IFIs to invest in the products which are compliant with Islamic Shari’a.  This
change in attitude will encourage the conventional banking system to change their stereotype of
IFIs.
In non‐Muslim countries, IFIs have found clashes with mainstream regulations.  For instance,
treatment of Leasing (Ijara) in Islamic banking system is recognized as normal leasing instead of
mortgage which changes the concept of Ijara from purchasing the asset by the bank and leasing it
to customers to a normal lease of real estate.  Also, imposing taxes by non‐Muslim governments
on Islamic religious alms‐giving (Zakat), leads to double taxation.  Zakat is treated as a non‐
operating expense in IFIs financial statements and consequently has no influence on their net
income (Ahmed, 2002: 120).  Thus, IFIs are required to pay regulatory fees which results in double
payments to meet the dual regulations of Islamic and conventional system.

Customer cautiousness: despite the aforementioned advantages of securitization in Islamic
banking, international investors are cautious in trading in Islamic Sukuk due to their uncommon
characteristics.  Besides, the taxation system in some countries might have impact (either negative
or positive) on securitization process; therefore, issuance of Sukuk sometimes can be tax driven.
14
This lack of support from the tax collection departments hinders the issuance of Sukuk.
Furthermore, the limited tools available for liquidity management and the lack of an active
secondary market add more barriers before IFIs to contribute to the financial markets.  The last
barrier is caused by the predominance of debt‐based modes of financing, which are difficult to
transform into negotiable financial instruments.  Once Sukuk have been created, they can not be
transferred to anyone else except at par value.  This causes the whole structure of the Islamic
financial market to be highly illiquid.  Also, it leaves no opportunity in creating secondary
financial market (AlKhan, 2003: 28).
Limited recognition of central banks creates a barrier before IFIs in their internationalization
process.  So far, there is no Islamic central bank inside the OIC member countries, which makes
the IFIs dependent on the conventional banks in steering the financial industry.  In the non‐
Muslim countries such as Europe and U.S.A., Islamic banks are not recognized by their central
banks because of IFIs marginal role in their economies and the lack of definition to the Islamic
banking system.  The West still cannot fully comprehend the role of SSB, where banking‐type
decisions are made by non‐bankers, Islamic scholars (George, 1995; Patrikis, 1996).
Furthermore, the central banks in OIC member countries lack skills of commercial and
investment bankers and capabilities of credit analysis.  For example, the central banks in Iran
and Sudan use their influence to steer the country’s economy by stipulating certain capitals
towards specific industries through the reserve requirements.  Also, there is no standardization
among the SSBs in OIC countries.  For instance, if one SSB approves some transactions in one
country, it does not secure their approval by another SSB in a different country.  Thus, this type
of disagreement leads to confusion in the IFIs global strategy and makes it harder for Western
regulators to recognize, understand and work with this sector (Clode and Elliott, 1996: 18).
FRAMEWORK OF SOLUTIONS
On the Internal Level
The OIC member countries need to provide support to primary and secondary markets to
enhance the contribution of IFIs.  Primary markets should focus on promoting new issues of
stock, managing subscription operations, attracting individual and institutional savings and
15
directing them towards productive projects.  As a result, new projects will be created to enhance
the productivity base and improve the country’s economy.  The secondary market creates a
demand for marginal jobs and support securities trading for liquidation and revenue purposes
(Kamel, 2000: 641).  
IFIs must also develop more transparency in their financial reporting by eliminating the
differences in their accounting treatments; which are mainly attributed to two factors: the
differences among the interpretations of Shari’a scholars and the differences within regulatory
authorities (Karim, 1994).  This type of internal self regulations creates accounting differences and
misleads the users of financial statements.
Furthermore, IFIs need to standardize their rules of reporting.  For instance, different Islamic
banks will record the same accounts differently.  Some banks (i.e., Jordan Islamic Bank and Qatar
Islamic Bank) treat investment accounts that are based on mudaraba (profit sharing) as obligations
while others (Al Rajhi Banking and investment and Shamil Bank of Bahrain) treat the same
accounts as fiduciary investments and accordingly reported them as off‐balance sheet accounts
(Ahmed, 2001: 111).  Also, the collected income from these accounts is recorded using six different
methods which makes the income recognition process differs from one bank to another.
11
 These
types of profit‐sharing investment accounts should be recorded as limited‐term equity instrument
with residual claims.  
IFIs regulators need to be proactive in creating new innovations of investments for Islamic
banks.  For example, they should enhance the inter‐bank transactions such as overnight funds
and short‐term borrowing because Islamic banks cannot use the same tools in conventional
banking system because the interest rate is embedded.  In addition, central banks need to review
the reserve requirements on IFIs because their degree of risk is less than the conventional
counterpart (Khan, 2000: 629; Hemat, 1994).  Moreover, the regulators in OIC countries should
follow Bahrain’s model in securing a strong legal system for IFIs and establishing appropriate
licensing requirements.
11
 The six methods of income recognition are: up‐front; when installments fall due; when installments are paid; equal
distribution of income over period of transaction; end of period and constant rate of return.  (Ahmed (2001), p. 112)
16
AAOIFI has recently realized the shortage of professional manpower in IFIs; therefore, AAOIFI
started two programs (Certified Islamic Professional Accountant and Certified Shari’a Adviser
and Auditor) to enhance the level of customer service inside the IFIs.  The first program is in
accounting and auditing of IFIs and the second in Shari’a supervisory
On the External Level
Although there are differences in cultures, customs and traditions between the East and the
West, effective dialogue should take place based on the following guidelines:  First, different
civilizations complement each other and lead to integration rather than conflict.  Secondly, the
dialogue leads to recognition of the right of each party and respects it.  Effective dialogue will
identify the objectives of each party and goes about achieving them gradually and search for
common characteristics in each culture and promote them with the aim of creating more
understanding (Alghatam and Galal, 2007: 204).  IFIs should not be self‐absorbed entities;
instead, they should have an open mind to the international market, making use of human
experience and matching between Shari’a requirements and Western norms.  Despite the Shari’a
precautions against certain mechanisms and methods, IFIs can still cooperate with conventional
banking institutions in the field of new instruments.  
IFIs are still struggling to standardize their accounting requisites.  For instance, AAOIFI standards
are mandatory only in three countries (Bahrain, Sudan and Jordan) out of the 24 member countries
and form the basis for regulatory standards in Malaysia, Saudi Arabia and Qatar (AAOIFI, 2004‐5:
23).  Therefore, it is essential for IFIs to establish a unified framework to standardize practices in
order to be recognized globally such as the Generally Accepted Accounting Principles (GAAP),
which cover all the standards of auditing, accounting and financial products in a systematic way
(Moore, 1997: 248).
IFIs need to find ways to be internationally accepted by the recognized ratings agencies such
S&P 500, Moody’s, and IBCA.  If IFIs try to argue this approach by establishing their own rating
agency such as International Islamic Rating Agency (IIRA) in Bahrain, it will be self‐defeating
rather than emerging in international market.  Recently, Standard & Poor’s established a new
section for S&P Shariah Indices and Dow Jones also has established Dow Jones Islamic Fund,
17
which are positive signals towards the world recognition to IFIs.  To accelerate the process of
acceptance, Islamic scholars need to unify their ratings methodology to be introduced effectively
to the international market.
CONCLUSIONS
Globalization has significantly influenced different aspects of our life: economically, politically and
financially.  The positive side of globalization is the movement of technology and human capital
among the countries, while the negative side is lack of governments’ ability to control their
economy and determine the capital flow.  On the financial side, the increase in oil prices flourished
the investments in GCC countries and encouraged their governments to support the Islamic
financial system.  This new system prohibits interest on all transactions and fundamentally based
on Islamic laws (Shari’a).  
Currently, IFIs are existed in Muslims countries as well as some European and American
countries.  The potential growth of IFIs is quite possible; however, there are some challenges that
should be addressed to accelerate the process of their growth.  These challenges can be classified
into two sets: internal and external.  Internally, the investors still rely on the conventional banking
system because the current number of IFIs is not large enough to meet the need of OIC member
countries, the contribution of IFIs in money and capital markets is restricted by SSB and the
customer service inside the IFIs is still premature to attract new clients. Furthermore, IFIs lack a
solid regulatory system to unify their products and transactions such as the issuance and trading
of Sukuk.
Externally, the lack of communication between IFIs and the other members in the financial
markets creates a gap between them and leads to lack of awareness about IFIs products and
customer cautiousness towards the IFIs activities.  In addition, the limited contribution of IFIs to
the financial markets results in limited recognition by central banks.
IFIs need to establish effective communication with their counterparts to correct any
misunderstanding and facilitate the process of entering the global market.  As a result, the
clashes with mainstream regulators will be eliminated and the stereotype about IFIs will be
corrected in the eyes of non‐Muslim countries. Finally, IFIs should establish a comprehensive
18
training program for their employees to understand the uniqueness of Islamic financial products
and help the investors to measure the advantages of dealings with IFIs.


























19
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23
TABLE “1”
AlBaraka Banking Group Branches


Country  Subsidiary Name
Year of
establishment  Branches

Employees
Algeria  Banque AlBaraka D’Algerie  1991 11  461
Bahrain  a‐ AlBaraka Islamic Bank   1984 4  261
  b‐ Al Amin Bank  1987 1  32
Egypt  The Egyptian Saudi Finance Bank  1980 15  604
Jordan  Jordan Islamic Bank   1978 66  1,457
Lebanon  AlBaraka Bank Lebanon  1992 5  110
Pakistan  AlBaraka Islamic Bank  1991 15  595
S. Africa  AlBaraka Bank Ltd South Africa  1989 5  150
Sudan  AlBaraka Bank Sudan  1984 23  685
Tunisia  Bank El‐Tamweel Al‐Tunisi Al‐Saudi  1983 6  117
Turkey  AlBaraka Turk Participation Bank  1985 52  909
  Total  203  5,381
Source: AlBaraka Banking Group Prospectus (2006), P. 16
24
FIGURE “1”
IFIs Challenges towards Internationalization








Contribution in
money & capital
markets
Limited
Economic
Contribution
Limited Role of
Regulators
Investors
Limited
Recognition
Unqualified
Employees
Limited
Customer
Service
Localization  Internationalization
Lack of
Communication
Different
Transactions
Limited Capital of
IFIs
Cultural
Barrier
Customer
Cautiousness
Limited
Recognition of
Central Banks
Challenges inside
Islamic countries
Challenges
outside Islamic
countries
25
FIGURE “2”
IFIs Regulators and Information Centers











IRTI
Information Centers
Issue Accounting and Auditing
Standards - Bahrain
CIBAFI
Islamic Financial Institutions:
Islamic Banks, Investment Funds and Islamic
Insurance Companies (Takaful)
AAOIFI
Issue Regulatory Standards -
Malaysia
IFSB
Create environment for Islamic
secondary market - Bahrain
IIFM
Rating IFI and Islamic finance
instruments - Bahrain
IIRA
Market maker for Islamic secondary
market instruments - Bahrain
LMC
Promote Islamic
Research and
Training
Enhance market
understanding of
Islamic finance
Regulators
26
I declare that:
•  I have sincerely endeavored to produce a paper of outstanding academic quality;
•  I have produced this paper myself, without any outside assistance except from the people
and documents that I quote;
•  I have not copied and/or pasted this paper, or parts of it, from other papers or documents
available on the internet or elsewhere, except where I have explicitly stated so;
•  I have not submitted this paper or major parts of it to another seminar or class, either at the
University of St. Gallen or elsewhere, and I will not do so in the future;
•  I may use parts of this paper for my doctoral dissertation.
___________
Samy Nathan