The trillion dollar Islamic finance industry is looking beyond the troubles of Dubai developer Nakheel at possible reforms that could help draw more interest from Western players.

Dubai World rocked the global markets in November when it asked for a delay in repaying $26 billion in debt. A $4.1 billion sukuk, or Islamic bond, from its unit Nakheel staved off default thanks to a bailout from Abu Dhabi.

But Nakheel put a negative spotlight on Islamic finance as global markets began to wonder if the Islamic structure of the deal was to blame.

The Islamic finance industry hadn't been through its first crisis at that point and people didn't know what to think, said Michael McMillen, partner at law firm Fulbright & Jaworski LLP.

At the beginning people really hesitated as they saw swirling rumors of how devastating Nakheel's default would be to the Islamic finance industry.

Initial hesitation has turned to interest as opportunities have arisen for Western players specializing in distressed accounts, he said.

Those initially wary of the industry are starting to hope that Dubai World's restructuring will help the region draw up clearer bankruptcy laws and improve transparency.

Two Gulf-based bankers at major investment banks said they have seen an uptick in interest from Western clients in recent months. The market is slowly opening up as clients separate Nakheel's credit concerns from the health of the overall market.

The financial crisis as well as a lack of clarity over Dubai World's ultimate resolution, however, is keeping interest from leading to concrete action.

HOLDING OUT FOR CLARITY

Experts say Dubai isn't prepared to handle a large-scale bankruptcy in court.

Under Islamic law, the issue of bankruptcy is hazy but the underlying principle is that creditors should show forbearance if a debtor acted in good faith, said Ibrahim Warde, adjunct professor at Tufts University in Massachusetts.

Islamic finance deals in the region fall under sharia and English law, a combination that has not been tested before.

To that end, Dubai created a Special Tribunal, led by internationally renowned judges, to hear any claims by creditors. No cases have been filed yet as creditors wait for Dubai World's restructuring proposal, due any day now.

McMillen said the creation of the tribunal reassured global markets by showing that a body of legal professionals would handle the situation.

By bringing in professionals, he said, there is recognition that the current legal system is underdeveloped and needs to be addressed. That should benefit the industry in the long term.

Another long-term benefit of Nakheel's troubles is that international players that did not have a clear understanding of Islamic financing structures are now improving due diligence and educating themselves to prevent another embarrassment like Dubai World.

Warde said international interest in Islamic banking remains strong but Western bankers that would have previously rushed into buying sukuk are now opting for a healthy dose of caution.

Interest in Islamic finance hasn't changed that much but the main result of the current crisis is when prospectuses are written, they are going to be more specific in anticipating situations that could arise, he said.

That's good news from a due diligence standpoint, but it does slow down growth in the industry.

Harris Irfan, head of Islamic products at Barclays Capital, said that company is seeing interest in Islamic hedging instruments and other products, but the process of getting the deals done has slowed greatly.

In-house legal departments are taking their time on sharia representation and carefully looking at the language of the contract so no one can say it's null and void, said Irfan.

The process already takes time and we're making it even slower. It's a shame but this is going to make the industry grow at a slower pace.

(Reporting by Shaheen Pasha; Editing by Firouz Sedarat)

Dubai