Mustapha Abdul Jalil, chairman of Libya’s National Transitional Council (NTC) and caretaker head of state, caused a stir on 24 October when, during a speech declaring the North African state “liberated” from his predecessor Colonel Muammar Gaddafi, he announced that the country would adopt sharia as the basis of all future laws, including those related to finance.

Stripping away the rhetoric imposed on his words by many Western commentators, this statement has at least one important consequence for Libya: all banking done in the country in the future will have to be sharia compliant. As such, it will not be possible for Libyan banks to charge interest.

This is likely to create several problems for council members in Tripoli, and oil and finance minister Ali Tarhouni in particular, as they seek to rebuild the Libyan state. The move could also create opportunities for Middle East financial institutions with experience in Islamic banking, but there are likely to be more difficulties in the near future than opportunities.

Banking system

Bankers, analysts and consultants describe three clear issues for the National Transitional Council to overcome in the coming months. The first is making sure there is a functioning banking system in place and that international markets are reassured as to the value of the Libyan Dinar. The second is ensuring there are proper checks and balances in place to stop “capital leakages”. The third, and in many ways most difficult, will be coping with an influx of foreign currency that could leave the system “awash” with money, says one regional banker.

Meanwhile, in the longer term, the NTC and the national governments that succeed it will have to build a banking system that matches their chosen economic model - something that is by no means decided.

“Libya was not sharia-compliant. If they now want to operate a wholly Islamic system, there will be problems”

Dennis Cox, Risk Reward

Under Gaddafi, the Libyan financial industry was small, underdeveloped, and widely seen as being in need of reform. Following a restructuring of the banking sector in 2005, the country was left with around 16 banks, while the Central Bank of Libya, and hence the Gaddafi regime, was at the epicentre of the sector. It was, says Dennis Cox, chief executive officer of London-based financial consultancy Risk Reward, “perfectly adequate” for the centrally managed way the economy was run until 2011.

Sharia compliance

“But that doesn’t mean they have the people or the skills to just move to an open, free-market economy,” he says. In particular, shifting to sharia compliance could be a major headache for the banking sector.

“Libya was not sharia-compliant. If they now want to operate a wholly Islamic system, there will be problems. There is a lot of thinking to be done.”

First and foremost, Cox says, echoing other finance profesionals with experience of Islamic banking, Libya has few technocrats or banking executives who have training in sharia-compliant finance. Further, the country lacks Islamic scholars with knowledge of the issues surrounding Islamic banking.

Full sharia compliance would mean Libyan institutions would not be able to hedge either currency or commodities, a big problem for major oil producers and food importers. It could also mean cancelling existing contracts and finance arrangements, as well as cause issues for the few foreign investors in the domestic banking system, which include France’s BNP Paribas and Arab Bank of Jordan.

In common with regional bankers, Cox believes Libya would do best to introduce a “blended” system similar to the Gulf states. Saudi Arabia in particular has a mix of sharia-compliant and traditional international banking.

Meanwhile, as the NTC makes these decisions, it will also face the issue of reintegrating the Central Bank of Benghazi and other state-run financial institutions, with the existing Tripoli-based Central Bank of Libya. The former was set up in March alongside the Libyan Oil Company to allow rebel forces to sell oil produced in eastern Libya on to international markets. In August and September, the UN handed over about $6bn of funds held abroad by the Libyan regime to the NTC, allowing the council to fund both the war and the creation of government institutions.

Foreign holdings

Now, the NTC is in effective control not just of the Central Bank of Libya, but also the country’s sovereign wealth funds, the Libyan Investment Authority and its subsidiaries: the Libyan African Investment Portfolio; the Libyan Foreign Investment Company; and the Libyan Foreign Bank. The Institute of International Finance, a Washington-headquartered association of international banks, estimates the total foreign holdings of the Libyan state to be about $110bn.

“If [the NTC floods] the market with cash it could have terrible consequences”

Dennis Cox, Risk Reward

With Tarhouni claiming that Libyan oil output could be 500,000 barrels a day (b/d) by the end of 2011, and oil prices in Europe above $100 a barrel, overall oil revenues could hit $1bn-plus a month after accounting for domestic consumption and foreign companies’ shares of output, says one experienced regional oil analyst. This will further bolster the state coffers, although it is likely to be the only major form of revenue for the foreseeable future given the poor state of the country’s tax system under Gaddafi.

It will be extremely important for the NTC to make sure rigorous checks and balances are in place before it starts processing and distributing cash, says one expert on finance in post-conflict states. Otherwise, there will be huge potential for embezzlement and infighting over alleged corruption.

“If they flood the market with cash it could have terrible consequences,” says Cox. “They don’t want to do things too fast.”

On the plus side, says John Trench, head of Mena banking and treasury at Risk Reward and former head of risk management ad British Arab Commercial Bank, there is plenty of talent in the Libyan banking sector, and there are a number of skilled executives who will be integral to helping the finance industry get back on its feet.

In the meantime, for consultants who specialise in training and advisory - particularly in Islamic banking - the lack of capacity in Libya could provide a lucrative market for years to come.