In February 2008, when France’s economy minister, Christine Lagarde, announced that making her country more open to Islamic finance was to become a top priority, she threw down the gauntlet to her neighbors across the English Channel — the United Kingdom is the largest Islamic finance market in Europe, holding roughly US$19 billion in Islamic financial assets, according to Bloomberg. Since Lagarde’s declaration, economic policy has been changing in France to help Islamic finance find a foothold in the country. The Ministry of the Economy appointed an Islamic finance specialist, Thierry Dissaux, last year to create a legal route allowing financial instruments based on Islamic law, known as shariah.

With the largest Muslim population in Europe — accounting for an estimated 10% of the country’s population of 65 million — officials and bankers in France think that Islamic finance could find a very profitable home inside its borders. However, France’s main goal is to attract liquidity from the Gulf and Asia. After a number of changes to tax laws over the summer, Islamic transactions are now given the same treatment in the country as conventional transactions. The change was done discreetly, to ensure French secular principles are respected and so as not to inflame anti-Islamic public opinion.

Does all this portend well for the overall regional expansion of Islamic finance? "Europe could be a channel for Islamic finance, in proportion to the size of its economy," says N. Bulent Gultekin, Wharton finance professor and former governor of Turkey’s central bank. "The Gulf countries … have good contact with Europe, especially the U.K. Europe must just manage its Islamic fear."

London Calling First

European interest in Islamic finance accelerated in the 1990s, although regulators at the Financial Services Authority (FSA) in the U.K. note that the first truly Shariah-compliant transactions in London were undertaken in the 1980s. The U.K. was the first European Union member to adapt its fiscal legislation to place conventional and Islamic finance on a level playing field. From the regulatory perspective, the FSA’s motto when it comes to Islamic finance has been: "No obstacles, but no special favors."

"The first significant change came with the Finance Act of 2003 [in the U.K.], which prevented multiple payment of stamp duty land tax on Islamic mortgages," notes Mohammed Amin, an Islamic finance consultant and former U.K. head of Islamic finance at PricewaterhouseCoopers. "Following the Finance Act, Islamic products were on the same tax footing as conventional products."

In 2004, the first 100% Shariah-compliant retail bank in a non-Muslim country opened its doors in the U.K. Islamic Bank of Britain (IBB) was soon followed by European Islamic Investment Bank, Bank of London & The Middle East, European Finance House and Gatehouse. In addition, more than 20 traditional U.K.-based banks opened Islamic divisions often called an "Islamic window." HSBC Amanah is the leading Islamic services provider. London also has a takaful — an Islamic insurance company — and sukuk, Islamic bonds listed on the trading exchanges. "But the retail and takaful market are small in the U.K.," Amin points out. According to an International Financial Services report released this year, the Islamic mortgage market in the U.K. is worth only £500 million (US$797 million), or about 0.3% of the country’s total home loans.

Still, the U.K. is currently eighth among Islamic financial markets in the world (Iran ranks first, followed by Saudi Arabia and Malaysia). London has benefitted from the enormous revenues of the oil-rich Gulf region, as Arab investors have sought alternative markets to the U.S. after 9/11. In addition, by having offices in London, Islamic finance institutions, under EU agreements, offer products in other EU countries without the need for separate government authorization.

In terms of Islamic banking, London has had an appreciable competitive advantage for years over other EU countries. Not only does it offer a variety of banks to choose from, but also law and accounting firms as well as consultancies specializing in Islamic finance. What’s more, British common law may be also easier to adapt to Islamic finance products and investors are familiar with it since most Gulf countries were former English colonies, says Dissaux of France’s Ministry of the Economy. "Civil law in France could be more rigid," he concedes.

Islamic Transactions Penalized

Between 2003 and 2008, roughly 40 Islamic finance-based transactions worth three billion euros (US$4.2 billion) were completed in France’s real estate market — one-third that of the U.K., according to DTZ Asset Management, a European real estate asset management firm. In July, DTZ and law firm Norton Rose published a "white book" on Islamic finance and real estate in France, emphasizing how Islamic finance was penalized by double taxation on the buying and re-selling of property in France.

The white book noted how Islamic finance transactions were more expensive and less protected in France than in conventional finance. Consider real estate transactions: Under Islamic finance, a creditor bank buys a property and sells it to a debtor. The deal could be considered financial speculation, when in fact it is not because Islamic finance requires a transaction to be based on a real asset. What’s more, under traditional French regulation, this is treated as two transactions, which requires paying two separate taxes.

Until this summer, France had no solution for avoiding multiple taxes on Islamic transactions. "In France, an Islamic structure was more expensive than a conventional one," "Before the financial crisis, the additional cost was 7% but the return was 15%, so Islamic investors didn’t care," says Kader Merbouh, coordinator of the Islamic finance program at Paris Dauphine University. "Now the return is much lower. The price could even be up to 1.5 times the cost of a traditional framework."

In August, France modified its fiscal regulations, allowing for an alternative system of banking based on the absence of interest payments, in accordance with Islamic financial law. Since then, new rules related to Islamic finance were published in the official French tax bulletin, facilitating the development of sukuk bonds, murabaha (financing by re-sale, often via installment payments), ijara (financing by leasing or rental) and istisna (financing of construction and then sharing profits). The changes address company tax, value-added tax and registration fees.

The new rules should help France develop Shariah-compliant investment banking, and possibly lead to rules on retail banking, including home credit products and working capital. By the end of the year, regulations will allow musharaka (shared ownership), wakala (deposits), mudaraba (profit-sharing entrepreneurship) and salam (financing for agriculture or manufacturing). The rules governing sukuk will be reviewed.

"There was no obstacle to Islamic finance, but the framework was unclear," Dissaux notes. "First, we needed to clarify that an Islamic product must be offered within the regulated banking sector. Second, we had to exempt … the margins that appear in Islamic finance transactions [from value-added tax], based on a purchase and a sale, without making any reference to Shariah principles because France is a secular state."

Only Money Welcome?

Islamic finance does collide with a sensitive issue in France: The principle of "laicism," or the non-religious nature of French law. "The recent regulation hasn’t changed the law, but only the fiscal application, which respects the philosophy of both France and Islamic finance," Merbouh says. It also helped in terms of public relations that "the rules were published during the summer holiday, which has helped integrate the news politically and financially," he adds.

In addition, "we have used French legal concepts to establish a framework for each product," Dissaux notes. "The frameworks encompass and go beyond the definition of Shariah-compliant products, without referring to Shariah within the legal and secular frameworks. The exact definition and approval of Islamic products remain at the entire discretion of Shariah boards," the advisory groups of Islamic financial institutions that oversee products and services.

Such discretion is necessary; with popular political opinion calling for a public ban of the Muslim face veil, the niqab, some French have begun associating anything Islamic as a threat to their national heritage. Some Muslims point out that while they do not feel welcome in France, Muslim money from the Gulf is. Many public and private organizations have stepped up PR and education efforts about Islamic finance to help defuse tensions.

There’s also more to be done in terms of elevating the profile of Islamic finance at Europe’s universities, according to DTZ’s report. Currently, only two master’s degrees in Islamic finance are available in France — at Strasbourg and Paris Dauphine. Module are also offered at the business schools ESC Reims or ESC Lille. In contrast, the U.K. has a much larger range of ways to earn certification and more university programs.

Although France has the largest Islamic community in Europe, Islamic retail banking won’t be available in the near future in the country. It’s a different matter overseas, where French banks have jumped into Islamic finance. BNP Paribas opened an Islamic division in 2003 in Bahrain, and Societé Générale and Calyon (Crédit Agricole) followed suit. Their experiences could be helpful in developing Islamic retail banking in France, experts say. However, no bank wishes to launch a retail business in France yet, even though a survey by French pollsters Ifop in 2008 reported that 55% of French Muslims were ready to borrow according to Shariah principles, even if it meant paying a bit more for it.

"The return on investment is not enough," says Jean-Paul Laramée, general secretary of the French Institute for Islamic Finance (FIIF). "Of the five or six million Muslims in France, the extra market would be around six billion euros. This is too small — the equivalent of a day in the main market — to justify opening a new branch." In March, French bank BPCE and Qatar Islamic Bank signed a memorandum to establish a partnership in France, but discussions are ongoing.

"Muslims say they are ready to change from a traditional to Islamic banking market," Laramée notes. "But they also believe that Islamic finance is cheaper, because it doesn’t require interest. This is wrong, at the very least. It could be effectively at the same cost."

Islamic Bond Focus

After a few years in operation, Europe’s Islamic finance market has not reached expectations. IBB in the U.K. says it has struggled to attract a large number of the country’s two million Muslims. In July, it announced it was raising an additional £20 million by issuing shares to Qatar International Islamic Bank at 1p per share. If the share issue did not proceed, IBB said in a press release that it would be unable to continue operating as a going concern.

Overall, the Islamic retail market in the U.K. hasn’t been as robust as predicted. Its Muslim community is small (about 3% of the population, according to some estimates) and "not all Muslims want to use Islamic finance," consultant Amin points out. "Most of them have already used traditional finance and banking, and not all of them have money to invest."

That’s important for French bankers to bear in mind, as French officials forecast that the country will attract US$120 billion of Islamic assets through lending and investments in French businesses, property and financial markets by 2020. "France can rise to the U.K.’s level. They are not so far ahead in my view," Dissaux says.

Meanwhile, other European countries are tailoring their markets for Islamic investment. Germany has numerous sukuk issuances and Italy and Belgium have considered issuances also. Luxembourg may be the most advanced country in courting Islamic finance besides France and the U.K., observers say. The Grand Duchy has 15 sukuk issuances worth 5.5 billion euros, the equivalent to London’s volume. Luxembourg changed its fiscal policies a few months before France did.

Sukuk is the main focus in France because it can assist companies or institutions in raising funds or attract large amounts of money via investment banking. "Currently, [oil firms] Total and Saudi Aramco are preparing a sukuk issuance to finance the Jubail refinery in Saudi Arabia," FIIF’s Laramée says. "But there is also important potential in the Mediterranean Union, launched by President Nicolas Sarkozy. There will be billions of euros of investment in infrastructure, port engineering, sustainable development and environmental cleanup. I also see an opportunity for local entities like Paris to finance development after being hurt by derivatives and other toxic products from traditional finance."