As Oman prepares to introduce Islamic finance, a restriction on the money market instruments which banks can use may curb their ability to manage funds in the market, hurting profitability.

Authorities are expected to release Islamic banking rules by year-end, making Oman the last country in the six-nation Gulf Cooperation Council to accommodate sharia-compliant banks.

But the draft rules, seen by bankers before their publication, exclude an instrument which is widely used in some other countries: commodity murabaha or tawarruq, several banking sources in Oman told Reuters. They declined to be named because of the sensitivity of the issue.

"The central bank was careful to ensure Islamic finance is of high standards," said Mohammad Haris, head of Islamic banking at Bank Sohar.

"Certain areas, we believe, are too stringent such as liquidity management," he added without elaborating.

Omani bankers argue that in the initial stage, Oman's Islamic money market will be too shallow and undeveloped for them to access it conveniently with tools other than tawarruq.

So banks have been lobbying regulators, asking that tawarruq be made temporarily permissible until the market can develop other solutions, bankers said.

Such a provision could be similar to one given to Pakistani banks in that country's initial stage of building up Islamic banking, one Omani banker said.

Oman's central bank told Reuters the Islamic banking law was still being drafted and it would not comment on tawarruq, adding that an announcement would be made by the end of this year.

Tawarruq

In tawarruq, one party buys an asset from a vendor with payment deferred, and sells it to a third party for cash. The arrangement allows banks to manage their overnight funds.

But organised tawarruq, where transactions occur in exchange for a financial obligation, has been criticised by some Islamic scholars because of its weak link to real economic activity; Islamic finance bans pure monetary speculation.

In April 2009 the Jeddah-based International Islamic Fiqh Academy, an international body of scholars, issued a resolution criticising organised tawarruq as a "deception", hurting its acceptability in the industry.

Tawarruq, of the organised type and other types, is widely used in most countries which practice Islamic finance. There are no reliable measures of transaction volumes, but it forms the basis for many Islamic credit card transactions in the Gulf, while Malaysia's stock exchange has a trading platform based on commodity murabaha.

At least RO350 million ($909 million) will enter Oman's Islamic money market when the country's two new Islamic banks and the Islamic windows of conventional banks start operating, Haris estimated.

The figure could climb as high as RO550 million as other firms enter the market, said Shaher Abbas, Oman-based director at Islamic Finance Advisory & Assurance Services (IFAAS).

If banks lack ways to manage the funds in the market, "this money will be parked until it is deployed. Banks would be forced to place funds with the central bank at zero - this will put huge pressure on asset yields," Haris said.

In the absence of tawarruq, some banks aim to use wakala (agency) agreements under which they would entrust their money to other institutions to manage. But the small number of Islamic counterparties would limit this option's appeal, bankers said.

A ban on tawarruq could pressure the government into issuing short-term sukuk, or Islamic bonds, to fill the gap and help banks manage their money. If this happens, Oman could move ahead of some other countries which have been slow to develop issuance of short-term sukuk.

But so far Omani authorities have shown no sign of starting an extensive issuance programme. The finance ministry has no need or incentive to issue large volumes of sukuk, Abbas said.

Also, foreign exposure limits mean Oman's new Islamic banking operations will have to keep most of their money onshore. A two-year exemption from or relaxation of the limits, allowing banks to invest offshore, could alleviate the liquidity management problem, Abbas said, but authorities have not indicated they will grant such an exemption.

If there is no action to make it easier for Islamic banks to manage their money during their initial years of operation, "it will be a disaster for the banks," he said.

Competition

Even if liquidity management problems are resolved, competition may be tough for the Islamic banks from the start.

In addition to the two dedicated Islamic institutions, Bank Nizwa and Al Izz Islamic Bank, five banks plan to offer sharia-compliant products through Islamic windows: Bank Sohar, Bank Dhofar, Bank Muscat, Ahli Bank and National Bank of Oman (NBO).

Fuelling competitive pressures, the overall banking market is quite concentrated: the three largest banks accounted for 62 percent of total assets and 59 percent of total deposits as of December 2011, central bank data showed.

"Incumbent banks have a competitive advantage over new Islamic lenders, as they have expertise relating to Islamic finance products, including Bank Muscat and NBO," said Mahin Dissanayake, director of financial institutions at Fitch Ratings.

Bank Muscat has offered Islamic products in Saudi Arabia, while NBO is part-owned by Qatar's Commercial Bank of Qatar , which used to operate an Islamic window, he said.

Dissanayake said Bank Sohar, which floated on the Omani stock market in 2007, had taken three years to gain substantial market share - an indication of the time which the new Islamic banks might have to spend to become major players.

IFAAS said it had conducted a market survey suggesting 70 percent of consumers in Oman anticipated opening an Islamic savings account in the next 12 months, while 77 percent expected to take out Islamic loans in the next one or two years.

These intentions may not necessarily translate into business for the new Islamic banks, however. Studies in other countries such as Qatar have shown many consumers tend to remain loyal to their existing banks, and religious permissibility is only one factor for them; quality of service and financial returns can be equally important. – Reuters