NEWHORIZON January to June 2014
IBB Completes its First Deal in Scotland
and Announces a Cash ISA
Islamic Bank of Britain plc, the UK’s only wholly Shari’ah-compliant retail bank, has completed its first finance deal in Scotland for Al-Meezan, a non-profit, non-political organisation based in Glasgow. The deal for commercial property finance, valued at £400,000, has enabled Al-Meezan to complete renovation and extension work at its premises. It also includes refinancing of the credit for the initial building works, making Al Meezan’s finances fully Shari’ah compliant. As a result, Al-Meezan now has 10 purpose-built classrooms, a refurbished lecture theatre, a large foyer area, a multi-purpose room, a prayer hall, toilet facilities on both the ground and first floor, a lift and new kitchen facilities.
Al-Meezan provides Islamic education to over 600 women, children and teenagers in Glasgow and its surrounding areas. With growing demand for its services, the renovated premises will allow Al-Meezan to offer more classes in improved facilities.
Sultan Choudhury, managing director, IBB commented on the deal, ‘As a result of working with Al-Meezan, IBB has pioneered the development of Islamic commercial property finance in Scotland. With organisations struggling to access business finance we expect continued interest in our offering, particularly in Scotland where there is a growing interest in Islamic and ethical finance.’
Salma Shaikh, chairperson of Al-Meezan added, ‘The completion of the Al Meezan building works represents a tremendous achievement for the centre and the local community in Glasgow. It is also significant for the centre that we were able to complete the works with finance from IBB. For organisations like ours it is important that we do not compromise the values that are important to us in the path towards growth. We feel it’s a win-win situation to have IBB as our finance partner with which we share our Islamic and ethical values.’
As a Shari’ah-compliant product, IBB’s commercial property finance is tailored to the needs of the customer, and is in line with Scottish law. In this case, the product uses the Islamic finance principles of shared beneficial ownership (musharakah) with a lease element (ijara), where IBB and the customer buy the property as partners. The property is owned by both parties beneficially and the customer makes an occupancy payment to IBB in return for having the sole use of the property. At the end of the term, when all acquisition payments have been made and the finance has been settled, IBB’s beneficial share of the property transfers fully to the customer.
In a second announcement IBB launched a Notice Cash Individual Savings Account (ISA). The account is the UK’s first Shari’ah-compliant cash ISA and offers consumers an ethical, tax-free way to save. It means that Muslim consumers who prefer to receive a Shari’ah-compliant return on their savings no longer need to miss out on the tax efficient benefits of an ISA or compromise on their beliefs by placing their deposits in interest-based products.
The IBB Notice Cash ISA is offering an expected profit rate of 1.8%, free of tax. The minimum deposit for the IBB Notice Cash ISA is £250 and requires savers to give 120 days’ notice in order to make a withdrawal. Savers can make regular deposits and profit is calculated and accrued to the account monthly.
Meezan Bank Launches Alternative to Bancassurance
Bank Negara Malaysia has announced a Memorandum of Understanding (MoU) with the Central Bank of the United Arab Emirates. It provides the framework to further strengthen bilateral cooperation with the Central Bank of the United Arab Emirates for the development of enhanced financial services linkages between the two countries, including in the area of Islamic finance, to support and facilitate greater financial and economic ties between Malaysia and the United Arab Emirates.
Commenting on the signing, Governor Zeti said, ‘This Memorandum of Understanding provides further avenues for our central banks to work together in areas that will facilitate closer financial and economic linkages. I look forward to the cooperation and collaboration with the Central Bank of the United Arab Emirates in deepening our financial sector linkages.’
IFSB Revise Guidelines on Capital Adequacy
IFSB (Islamic Finance Services Board) has issued revised guidelines on capital adequacy to bring their advice into line with the requirements of Basel III. This standard aims to assist the implementation of a capital adequacy framework that will ensure effective coverage of risk exposures and allocation of appropriate capital to cover these risks, based predominantly on the Standardised Approach. In order to achieve these objectives, IFSB-15 provides guidance on the features and criteria for high-quality regulatory capital components, including Additional Tier and Tier 2, which comply with Shari’ah rules and principles. Similarly, IFSB-15 provides new guidance on macroprudential tools, such as capital buffers, leverage ratio and domestic systemically important banks, which will facilitate supervisory authorities in achieving the goal of protecting the banking system and the real economy from system-wide shocks
IFSB-15 also provides more elaborate guidance on the capital adequacy treatment of various risk exposures related to Shari’ah-compliant products and services, including sukuk, securitisation and real estate. The new Standard has revised and consolidated earlier guidance on the treatment of profit-sharing modes of financing, as well as expanded guidance on credit risk mitigation techniques as well as calculation of capital charge for various approaches to market and operational risks. These revisions endeavour to enhance the loss absorption capacity of the Islamic financial institutions and provide a more comprehensive framework for the application of risk weights aligned closely to the underlying risk exposures.
IFSB also revised guidelines for takaful firms. The aim is to provide guidance to the industry in understanding the types of risks to which the takaful industry is exposed. Taking into consideration the particular requirements of Islamic finance, the guidelines highlight the key risks which are specific to takaful undertakings, i.e. Shari’ah-non-compliance risk, risks arising from segregation of funds and risks relating to the use of Re-Takaful. The document further illustrates the responsibilities and functions of key management functions in ascertaining the effectiveness of the risk management framework.
Oman to Launch Short-Term Business Finance Product
For the first time businesses within the Sultanate of Oman are to be offered a Shari’ah-compliant working capital finance product from Maisarah Islamic Banking Services of BankDhofar. The Bank has worked with Shari’ah advisory firm, IFAAS, (Islamic Finance Advisory & Assurance Services) to develop an innovative new financing product based on the Islamic finance principle of mudarabah, which is in accordance with Shari’ah standards issued by industry body, AAOIFI.
Following the launch of the product, business clients of Maisarah will be able to manage their day-to-day cash flow and working capital needs in a Shari’ah compliant way. The facility will be available to established large and medium-size corporates and will enable them to avoid using short-term, interest-based financing products.
NEWHORIZON January to June 2014 News
Al Salam Bank Launch Shari’ah Compliant Asian REIT Fund
Al Salam Bank – Bahrain (ASBB) has launched what it claims is the world’s first Asian REIT fund, the Al Salam Asia REIT Fund, that invests according to Shari’ah principles. ASBB will be the sponsor and seed investor for the Fund. The Shari’ah-compliant fund will be managed by B&I Capital AG, a pioneer in Asian REIT investments.
The fund’s portfolio will consist of 15 to 35 positions, diversified through active country and sub-sector allocation within the Asian REIT asset class. Each position will be equally-weighted, rebalanced and reviewed as part of the risk management process.
Deputy CEO of ASBB, Dr Anwar Khalifa Al Sada said that the goal of the Fund is to give investors a long-term, superior risk-adjusted total return through a combination of high, stable and growing dividends as well as a significant opportunity for capital appreciation.
‘The Fund aims to deliver benefits of diversified real estate ownership in Asia while avoiding many of the pitfalls of holding physical property and real estate developer equities’, Dr Al Sada said.
‘Historically, REITs have lower volatility, superior returns and low correlation compared to equities and can provide some hedge against inflation’, Mr Talal Abdul Aziz Al Mulla, Head of Investment at ASBB said. ‘The strong demographics and growth potential in Asia have resulted in Asian REITs providing a return of 12% higher than developed country REITs, over the last 10 years. We believe that Al Salam Asia REIT Fund will provide an optimum investment solution for accessing the growing Asian real estate market in a diversified and Shari’ah-compliant approach.’
The fund manager for Al Salam Asia REIT Fund, B&I Capital, has over 50 years of combined experience covering Asian markets, and can draw on several market cycles of experience. B&I are headquartered in Zurich, with a presence in Singapore to support research, fund management and growth.
Pakistan Introduces a Shari’ah Governance
The State Bank of Pakistan (SBP) has issued a comprehensive Shari’ah Governance Framework (SGF) to further strengthen the overall Shari’ah compliance environment in Islamic banking institutions (IBIs). The framework aims at institutionalising the Shari’ah compliance function in IBIs. It is believed this framework will give Shari’ah scholars greater independence from bank management.
It explicitly defines the roles and responsibilities of all organs of IBIs including boards of directors, executive management, Shari’ah boards, Shari’ah compliance department and internal and external auditors with the aim of achieving Shari’ah compliance. The framework requires IBIs to constitute Shari’ah boards comprising at least three Shari’ah scholars meeting SBP fit-and-proper criteria. One of these scholars is to be a resident Shari’ah board member providing day-to-day advice. It also prescribes an effective mechanism for the oversight by boards of directors over the Shari’ah compliance environment and introduces external Shari’ah audit requirement for IBIs.
On the other hand, it also imposes limitations on scholars, who may not serve on more than three Shari’ah boards at any one time. In the case of the resident Shari’ah scholar, that person may only work with a single bank in Pakistan. Their decisions, however, will be binding on managements, with any disputes being referred up to the Shari’ah board of the SBP.
Malaysia Move Towards a Life Insurance and
In early 2014 Bank Negara Malaysia completed its initial public consultation on the proposed concept paper on the life insurance and family takaful framework. The concept paper outlines the proposal to support the long-term development of the life insurance and family takaful industry in Malaysia which encompass areas including the provision of operational flexibility, diversification in delivery channels and strengthening market conduct. During the two-month consultation period, a total of 254 respondents submitted feedback online and through letters to Bank Negara Malaysia. Respondents included members of the public, individual intermediaries, consumer associations and industry associations of life insurers, takaful operators and financial advisers.
Feedback was received in most key areas namely flexibility in the operational structure of life insurers and family takaful business including intermediaries’ remuneration, and improvements in the effectiveness of multifaceted delivery channels. In the area of strengthening market conduct, feedback was received on the proposed balanced scorecard framework to improve the professionalism of intermediaries, the establishment of an online product aggregator to facilitate comparison of pure protection products as well as enhanced disclosure requirements to assist consumers in making informed decisions.
All feedback is being taken into consideration and further engagements with stakeholders will be undertaken in the course of finalising the overall framework to ensure that the life insurance and takaful industry continues to enhance its value proposition and remain relevant to prevailing market environment.
Malaysia Published New Rules for Bai Al-Inah
Bai al-inah is a somewhat controversial Islamic finance instrument. It has been fairly widely used in Malaysia, while in the more conservative GCC scholars have tended to view bai al-inah as impermissible in Shari’ah, because it has no connection to real economic activity.
Bai al-inah is effectively a way for a financial institution to make a loan without charging interest, but at the same time making some money on the transaction. The glossary in this publication defines the term as follows:
‘This refers to the selling of an asset by the bank to the customer on a deferred payment basis, then buying back the asset at a lower price and paying the customer in cash terms.’
The new rules published by Malaysia’s Securities and Exchange Commission underline the need for a bai al-inah transaction to have two distinct legs, with the ownership of the asset actually being transferred. Furthermore it will not be enough to say that this is what has happened; it must be demonstrated in all the documentation.
NEWHORIZON Rabi Al-Awwal – Sha’ban 1435 News
The Potential of Islamic Social Funds to Alleviate Poverty
Thomson Reuters in collaboration with the Islamic Research and Training Institute (IRTI), a part of the Islamic Development Bank Group have released what they claim is the first study to cover Islamic social finance across countries in South and Southeast Asia with sizeable Muslim populations including Indonesia, India, Pakistan, Bangladesh, Malaysia, Singapore and Brunei Darussalam. It is titled the Islamic Social Finance Report 2014 and it studies the historical trends, legal and regulatory environment, supporting infrastructure, success stories, good practices and potential of Islamic social finance by key players in zakat and awqaf.
According to the report, Islamic social funds could potentially meet resource shortfalls to alleviate widespread poverty in South and Southeast Asia. The potential of Islamic social funds remains unrealised as actual zakat (compulsory annual contributions) and returns of Awqaf (endowments) are not fully utilised in most countries. Additionally, most countries in South and Southeast Asia do not have an Islamic microfinance industry, which further diminishes the optimal potential of Islamic social finance.
Both, South and Southeast Asia, account for about 720 million (45%) of the world’s Muslim population which totals around 1.6 billion. Poverty is widespread in four of the seven countries studied. Around 76.5% of Bangladesh’s population lives on less than US$2 a day, while in India it is 69%; in Pakistan it is 60% and in Indonesia it is 46%.
Professor Dr. Mohamad Azmi Omar, Director General of IRTI, said, ‘A sustained flow of social funds demands high degrees of social acceptance and credibility, which in turn, are influenced by levels of integrity, transparency and professionalism in the management of these funds.’
Dr. Sayd Farook, Head of Islamic Capital Markets, Thomson Reuters, said, ‘Despite overarching goals of social justice and equity, Islamic banking, takaful and the Islamic capital markets are for-profit sectors of the Islamic economy that have been criticised for not doing enough to help the poor. Islamic social finance has a significant role to play in alleviating poverty.’
He added, ‘The report confirms that transparency and good governance are the fundamental requirements for the success of Islamic social finance institutions. With the increasing calls for corporatisation and an increased level of professionalism, the use of a large network of private institutional zakat collectors is far more efficient compared to a large number of unconnected private individual collectors.’
According to the report, zakat collection reached US$1.4 billion in Bangladesh which has the highest poverty level in the South and Southeast Asia region. The report suggests that zakat collection in Pakistan and Indonesia could fill the resource gap to alleviate hardcore poverty across this region.
With the absence of data on awqaf data in most of these countries, the study focuses on Indonesia and India as they constitute the largest Muslim populations. Registered awqaf have an estimated market value of US$24 billion in India and US$60 billion in Indonesia. At a minimum return of 10%, awqaf assets could earn the equivalent of 0.3% of India’s GDP and 0.8% of Indonesia’s GDP, which is more than the resources required to push Muslims out of hardcore poverty.
The report also identifies an overwhelming use of murabahah among Islamic Microfinance Institutions (MFI) due to the contract’s simplicity and familiarity. These Shari’ah-compliant modes, however, offer no in-built protection against exploitation and abuse. The report adds that Islamic MFIs should use profit and risk-sharing modes as opposed to debt-creating modes to safeguard beneficiaries against a debt spiral.
The report concludes that a professionally managed zakat-financed microfinance programme could potentially serve a much larger population of the poor. Furthermore, the report illustrates with examples from Singapore and Malaysia that state control may not necessarily hamper creativity and innovation in awqaf development. The report suggests that waqf development must be a mandatory obligation of the waqf management and new forms of waqf should be explicitly covered in the regulatory framework for awqaf.
Ernst & Young Identify Growth and Challenges for the Islamic Banking Industry
The Ernst & Young World Islamic Banking Competiveness Report 2013/14 suggests that world Islamic banking assets exceeded $1.7 trillion in 2013, an average annual growth of 17.6% over the last four years, but that growth may be affected in future by the challenging economic and political issues in some of the emerging markets and by the large scale operational transformation begun by leading Islamic banks 18 months ago.
The report identifies Qatar, Indonesia, Saudi Arabia, Malaysia, the UAE and Turkey (QISMUT) as key to the future internationalisation of the Islamic banking industry. The report says, ‘They hold a large pool of financial and intellectual capital of the industry that will drive the next wave of development across existing and new markets.’ In 2012 QISMUT accounted for 78% of international Islamic banking assets and is expected to grow at an annual rate of 19.7% over the next five years, significantly faster than the rest if the Islamic world.
On the downside the report says that some leading Islamic banks have been doubling in size every four years and this is likely to prove a capability challenge. While ongoing transformation programmes have the potential to allow Islamic banks to close the profitability gap with conventional banks, the success of these programmes will depend on exceptional leadership and management capability. The need for regulatory clarity is another issue identified by the report as a possible obstacle to growth.
Shaikh Usmani and Dr Rodney Wilson Share IDB Prize in Islamic Banking and Finance
The Islamic Development Bank has announced Shaikh Muhammad Taqi Usmani from Pakistan and Professor Dr. Rodney Wilson from the United Kingdom as the joint winners of the 2014 IDB Prize in Islamic Banking and Finance in recognition of the professional and academic role they have played in advancing Islamic finance and banking regionally and globally.
The selection committee conferred the prize upon Shaikh Muhammad Taqi Usmani ‘in recognition of the significant work he has carried out to crystallise the roles for the implementation of Islamic finance and to encourage innovations, his participation in the important ruling on riba during his distinguished career as a judge on the Shari’ah Appellate Tribunal of Pakistan, his global leadership role as a Shari’ah scholar advising and supervising Shari’ah Boards of Islamic financial institutions in the Islamic world, Europe, USA and as Chairman of the Shari’ah Standard Council of AAOIF. The statement also took note of “the impact of Shaikh Usmani’s writings in encouraging many to understand how to implement riba free lives and his instrumental role in introducing the teaching of Islamic finance within the curriculum of traditional religious institution.”
The selection committee also recognised ‘the role Professor Dr. Rodney Wilson has played in the promotion of teaching Islamic finance and in introducing modern management teaching techniques to Islamic finance that provided a neutral and objective perspective adding to the credibility of teaching Islamic finance in the world, his sustained and continuous teaching, research, supervision and consultancy works on Islamic finance including with IFSB (Islamic Financial Services Board) with respect to its Shari’ah Governance Guidelines.’ He was also recognised for ‘his immense role in mainstreaming Islamic finance and ensuring that Islamic economics, banking and finance courses and programmes are taught at western universities, which has resulted in offering of such programmes and courses at a number of universities in the UK and other parts of Europe.’
The UK Government Support Muslim Home Buyers
In the wake of the UK Government’s announcement that they intended to issue a UK sovereign sukuk in late 2013, they announced in February 2013 that their Help-to-Buy mortgage guarantee scheme can now also be used by providers of Home Purchase Plans (HPPs), which are Shari’ah-compliant alternative to conventional mortgages.
The rules of Help-to-Buy have been amended to enable banks that sell HPPs to purchase a government guarantee for them. The Islamic Bank of Britain have has stated its intention to participate by offering Home Purchase Plans under the scheme. It is believed that this will be particularly supportive to some Muslim homebuyers who have been unwilling to use a traditional Help-to-Buy mortgage because of their religious beliefs. The inclusion of HPPs in the Help to-Buy scheme, however, introduces more choice for all consumers and prospective homebuyers.
Under an HPP, a property’s ownership is split between the customer and the bank. After buying a portion of the property with their initial deposit, the purchaser of the property pays regular installments to the bank, covering rent for the portion they do not own and an acquisition payment. In this way, a customer gradually buys the property from the bank and eventually becomes the sole owner.
In order to purchase the government guarantee, banks will have to satisfy the same stringent criteria for an HPP as for a normal mortgage. HPPs sold in the UK are also subject to regulation by the Financial Conduct Authority (FCA), in much the same way as mortgages.
NEWHORIZON January to June 2014
Morocco approved a draft Islamic finance bill in early January. The bill expected to be approved by mid 2014 regulates Islamic banks and allows for sukuk sales.
Bahrain-based Islamic banks Elaf Bank, Capivest and Capital Management House, which merged in January 2013 have been rebranded and will now operate as Idbar Bank, The new bank has $300 million in paid-up capital, $329 million in equity and an asset base of $360 million.
In a strategic move aimed at underlining its local and international growth ambitions and broadening the appeal of its Islamic finance products and services to all communities in the UAE, Noor Islamic Bank has been renamed Noor Bank. The bank claims that its simplified name underlines that the bank is a values driven and principles based financial institution with Shari’ah compliance at the heart of its business decisions. ‘Adherence to Shari’ah values and principles is in our DNA and they will continue to be the bedrock of our business decisions,’ said Hussain AlQemzi, CEO of Noor Bank.
Following the suspension of operations in early 2013, the Insurance Commission of Jordan (IC) has decided to liquidate one of the country’s three takaful providers, Al Baraka Takaful as of 8 January 2014. The decision was made after Al Baraka Takaful was unable to adhere to an agreed restructuring plan designed to solve the company’s problems. An attorney has been appointed to carry out the liquidation and preserve the company’s assets and funds.
In early January, the Dhaka Stock Exchange (DSE) announced the launch of its Islamic index, DSEX Shari’ah Index (DSES). The DSES was designed in conjunction with S&P Dow Jones Indices. It will serve as a Shari’ah-compliant broad market benchmark which measures the performance of the Bangladesh equity market.
Tunisia’s third takaful company, Assurances At-Takafulia, began trading in early January 2014. Currently, the takaful business accounts for just 1% of the total insurance market in Tunisia. The company has a capital of US$6.1 million. Its shareholders comprise several conventional insurers and reinsurers and a bank.
Bahrain Issue New Regulatory Framework
Bahrain’s central bank is to issue a new regulatory framework for takaful. The new framework is the result of a two-year consultation with the industry on operations and solvency. The new framework is expected to increase a takaful company’s ability to distribute surpluses to policyholders and dividends to shareholders.
It will also introduce a solvency element, which is designed to ensure that takaful companies match the risks on their books to likely obligations to policyholders. It will in addition replace the controversial use of qard hassan to meet shortfalls in policyholder funds with capital injections from shareholders.
Takaful companies will be required to report every year rather than every three years as at present. The use of performance fees will be limited and replaced by the concept of earmarked assets, top-rated assets set aside to strengthen policyholders’ funds.
Bahrain’s intention is to attract a greater share of the global takaful business. Takaful has been growing steadily in Bahrain and at the end of the third quarter of 2013 accounted for 23% of all insurance premiums. Takaful growth in 2013 was expected to be 10% over 2012.
Pakistan Forms Islamic Banking Committee to Boost Growth
Despite having the second largest Muslim population in the world, Islamic banking assets in the country account for just 9% of total banking assets. In an attempt to turbo-charge growth Pakistan’s Financial Ministry have formed an Islamic Banking Committee. The aim is to increase Islamic banking’s share of total assets to 15% by 2017.
Part of their remit will be to look at converting conventional banks into Shari’ah-compliant institutions. They will particularly look at the legal impediments to such conversions and the ways in which these can be removed.
The committee comprises scholars, regulators and bankers. It is due to report by December 2014, which means the timescale to reach the target of 15% Islamic banking assets by 2017 is very tight. In the meantime Pakistan is launching initiatives such as a media awareness campaign to try to boost Islamic banking growth.
NEWHORIZON Rabi Al-Awwal – Sha’ban 1435SUKUK UPDATE
According to a survey by Islamic Finance News Malaysia remained the largest sukuk market in 2013, but the United Arab Emirates bounced back to reclaim its position as one of the leaders in the market. There were also signs that new markets were beginning to develop with offerings from countries such as Singapore, Turkey, Nigeria and Oman. The survey also identified a trend towards cross-border issuance, with Malaysia leading the charge.
Bahrain Revamps Sukuk Rules
Bahrain’s central bank merged its rules for issuing and listing financial securities including sukuk in effort to make the process more efficient and to increase Bahrain’s appeal to issuers across the GCC. Bahrain is, in fact, the first Gulf state to implement the unified standards adopted by the GCC states. Under these rules there will be a 48-hour window for the incorporation of an issuing agent or SPV (Special Purpose Vehicle) following the approval of the offer documents. This ruling applies to both local and international sukuk.
Hong Kong to Enable Sukuk Issuance
In early January 2014 he Hong Kong government issued a notice that it will table a Loans (Amendment) Bill 2014, to accommodate the issuance of Islamic bonds (sukuk) under the Government Bond Programme. Davide Barzilai, partner and Asia Pacific Head of Islamic Finance in the Hong Kong office of global legal practice Norton Rose Fulbright commented:
‘This is good news for the Hong Kong financial centre as it means the government have moved much closer to their goal of issuing a sukuk and should result in an issuance within a matter of months. This should peak interest amongst the banks and bond investors both in Hong Kong, the wider Asia Pacific region and the Middle East. It boosts the credibility of Islamic finance in the wider markets and shows that Hong Kong is able to react quickly to assist its financial services sector.’
The Government amended its tax laws in July 2013 to enhance Hong Kong’s competitiveness through developing a sukuk market, by providing a taxation framework for the bonds comparable to that for conventional bonds. The Hong Kong Monetary Authority (HKMA) is examining practical issues to formulating a sukuk issuance plan. Bonds issued under such a programme could encourage other potential issuers to raise funds in Hong Kong.
Luxembourg Play Catch Up
A draft bill has gone before the parliament of the Grand Duchy of Luxembourg to pave the way for the issue of a sovereign sukuk. The proposed sukuk will be slightly smaller than the UK sukuk announced in late 2013, €200 million compared to £200 million.
Luxembourg is apparently ahead of the UK in one respect. They have already identified the assets to back the sukuk. It is believed the UK has not yet reached this stage.
This so far two-horse race is all about establishing the respective financial centres in Luxembourg and London as the leading centre for Islamic finance outside the Islamic world. France and South Africa have both threatened to join the race, but so far neither has reached the stage of an announcement.
IILM Expands Sukuk Programme
In early January the International Islamic Liquidity Management Corporation (IILM) conducted an auction of $860 million US 3 months A-1 rated sukuk at a yield of 0.55635. The new issuance is part of the IILM Programme
rated A-1 by Standard and Poor’s Rating Services. This issuance brings the total amount of the IILM’s outstanding sukuk to $1.350 billion US. The auction was fully subscribed by the following primary dealers Abu Dhabi Islamic Bank, Al Baraka Turk, CIMB Islamic Bank Berhad, KBL Private Bankers, Kuwait Finance House, Maybank Islamic Berhad, National Bank of Abu Dhabi, Qatar National Bank and Standard Chartered.
This is the third sukuk issuance from IILM, following an initial offering in August 2013 and a second in November 2013. The two issuances totalled $490 million US. They have also expanded the number of primary dealers from seven to nine with the two latest to be appointed being Abu Dhabi Islamic Bank and CIMB Islamic Bank Berhad.
UK Government Appoints Advisors
for Sukuk Issue
HM Treasury has appointed HSBC and Linklaters LLP as external advisors to assist it in its work to develop a government sukuk. HSBC will provide expert financial advice on structuring the sukuk to ensure that it conforms to the principles of Islamic finance. It will also assist HM Treasury and the UK Debt Management Office in making the necessary preparations for issuance.
Linklaters LLP will provide commercial legal advice in relation to the capital markets, tax, regulatory and real estate implications of issuing a sovereign sukuk for the first time. The Linklaters team will be led by Elaine Keats, a capital markets partner based in the City of London and supported by the firm’s global head of Islamic finance, Neil Miller and Richard O’Callaghan, a capital markets partner, both based in Dubai.
It is anticipated that issuance will take place during 2014-15 by way of a syndicated offering. The government anticipates recruiting additional syndicate members closer to the time.
The appointment of advisors follows an open competition launched in December 2013. The firms appointed are market leaders in the area of Islamic finance and have significant expertise in sukuk issuance. The government believes that their appointment represents value for money for the taxpayer. In line with the government’s transparency agenda the Treasury will publish the contracts.
NEWHORIZON January to June 2014SUKUK UPDATE
Hong Kong Look to Kick Start Sukuk Issuance
The first steps in Hong Kong’s ambitions to become a major centre for sukuk issuance in the Far East were amendments to tax laws, which were enacted in July 2013 and a Loans (Amendment) Bill is currently on the table. Hong Kong have apparently recognised, however, that they need more than a sukuk-friendly legislative environment and so in April 2014 the Hong Kong Monetary Authority (HKMA) and Bank Negara Malaysia (Central Bank of Malaysia) jointly organised an Islamic finance conference in Hong Kong to raise the level of interest and appreciation on sukuk as a viable financing and investment instrument amongst the business and financial communities from Hong Kong and China.
The half-day conference saw regulators and market leaders in the Islamic finance field from Hong Kong and Malaysia discuss and deliberate on a wide range of issues related to sukuk, from the latest trends in the global sukuk market to the business opportunity for Islamic finance in Hong Kong, the practical issues in structuring sukuk and its investment appetite.
In his opening remarks, Mr. Peter Pang, Deputy Chief Executive of the HKMA, said, ‘With the tax framework for sukuk in place, Hong Kong’s financial platform is ready for sukuk issuance. We highly welcome local and overseas entities to make use of Hong Kong’s platform to issue sukuk. To play a lead-off role for this market, we are working closely with the HKSAR Government to prepare for the inaugural issuance of Government sukuk under the Government Bond Programme to promote the further development of the sukuk market in Hong Kong.’ Mr Pang added, ‘We very much appreciate the close partnership we have established with Malaysia in developing Islamic finance and look forward to more co-operation opportunities in the future.’
He also emphasised the important role that Hong Kong could play in the development of Islamic finance in China and other countries of the Far East, saying, ‘As an international financial centre and given our unique role as a gateway to China, Hong Kong is well-positioned to provide an effective platform to channel the surplus funds from the Islamic world to this part of the world where there is a huge financing need to sustain the high growth of the Asian economies. Our platform will enable Islamic investors to access investment opportunities in Asia, particularly China, while at the same time allowing fund raisers to tap into the liquidity pool in the Islamic world.’
Mr. Muhammad Ibrahim, Deputy Governor of Bank Negara Malaysia, said, ‘This inaugural conference is set to mark a significant step to enhance collaboration and deepen financial linkages in Islamic finance between Malaysia and Hong Kong. We look forward to sharing our Islamic finance marketplace with Hong Kong in terms of expertise in structuring, managing and distributing sukuk as well as providing advice on legal and Shari’ah matters.’
Mr. Muhammad emphasised the importance of adopting international standards and best practices by new markets, with a proper governance framework to facilitate execution of Islamic finance transactions and instil investor confidence in the industry. Potential areas of collaboration will also include dual listing of sukuk; leveraging on Malaysia’s Shari’ah governance framework and arbitration platform and developing human capital in Islamic finance.
The conference was attended by around 200 representatives from policy-makers, regulatory authorities, corporates, financial institutions, fund management firms, law firms and other stakeholders from Hong Kong, Malaysia and other economies.
Al Baraka Consider Raising Sukuk in Pakistan and South Africa
According to The Express Tribune, Bahrain-based Al Baraka is considering the issue of subordinated sukuk through its South African and Pakistani subsidiaries to boost their regulatory capital. Al Baraka conducted a similar exercise in its Turkish subsidiary last year.
Subordinated sukuk are a response to the tighter capital adequacy requirements enshrined in Basel III. Analysts and commentators expect the issuance of subordinated sukuk to increase, as Islamic banks seek to comply with Basel III, although regulatory issues and Shari’ah concerns are likely to hamper issuance in some markets.
Other recent announcements of subordinated sukuk have come from three Malaysian banks Maybank Islamic, Public Bank and RHB Islamic and also the Saudi Investment Bank.
Dubai Issue New Sukuk Regulations
Dubai’s Securities and Commodities Authority (SCA) has approved new regulations for sukuk On applications for issuance and principal listing of sukuk, the regulation demands the following conditions to be met;
1. Sukuk must be approved by the Shari’ah committee of the applicant, but if the latter has no Shari’ah committee then it must be approved by a Shari’ah committee approved and accredited by the issuance regulator.
2. Unless the SCA decide otherwise, the nominal value of the sukuk issuance to be listed must be not be less than 10 million dirhams. (The previous minimum was 50 million dirhams. This is seen as an attempt to encourage small and medium-sized enterprises to issue sukuk.)
Regarding sukuk trading, clearance and settlement, the regulation provides that:
1. Listed sukuk may be traded, cleared and settled inside or outside the market but must be done according to the market procedures.
2. Any trading in principally listed sukuk conducted outside the market must be recorded in a special record provided solely for that purpose by the market and this must be done within the period stipulated by the market.
3. Any trading in principally listed sukuk conducted outside the market shall be null and void if not recorded according to Clause (2) of this Article.
Regarding the rules for issuance and listing (concerning applicant) the regulation demands that applicants must meet the following conditions:
The applicant’s article of incorporation should not contain any restriction that prevents the applicant from acting in his capacity in matters related to issuance and listing of sukuk according to the rules of this regulation.
Regarding the principal listing of retail sukuk, the applicant must have been established in the UAE outside a financial free zone. The regulation also demands the listing of sukuk on the markets to avoid doing business outside the official framework.
The regulation makes it mandatory for officers of applicant organisations to ensure all information given to the SCA and the markets are fully correct and complete and for the applicant to ensure that no proceeds made from the issuance of sukuk is used for any purpose that is not Shari’ah compliant.
..... And Issue a Long-Term Sukuk
At the end of April the Government of Dubai raised $760 million through a 15-year sukuk. The order book was more than three times oversubscribed. The profit rate was 5%. Subscribers came primarily from fund managers (27%) and banks (63%) and from a wide range of geographies including Asia (9%), UK (17%), continental Europe (11%) and the Middle East (61%). The 15-year maturity is unusually long for a sukuk, but seems to be aimed at paving the way for state-owned organisations to raise long-term finance to repay the debts incurred during Dubai’s 2009 financial crisis.
NEWHORIZON Rabi Al-Awwal – Sha’ban 1435SUKUK UPDATE
Saudi Telecom Seek to Reduce Reliance on Bank Finance
Saudi Telecom will issue a $1.3 million sukuk, which will take the form of a local private placement. The issue will be managed by J P Morgan Chase, Standard Chartered and the investment division of Saudi Arabia’s National Commercial Bank. This is the first time Saudi Telecom have raised finance from the debt markets rather than the banks. Although the issuance has been approved by the board and shareholders, there are as yet no further details on timing, duration or level of returns.
IILM to Develop Standard Documentation for Ijara Sukuk
The IILM has said that it aims to develop standard documentation for ijara sukuk, hopefully, by the end of 2014. The organisation believes that the lack of standard documentation is affecting the universal acceptability of ijara sukuk and is, therefore, slowing growth. A working group will be set up to study the issue and will include representatives from the Islamic Development Bank and the International Monetary Fund.
London Under Attack?
To date the London Stock Exchange (LSE) has been the number one choice for international issuers of sukuk. According to the LSE’s website they have issued 53 sukuk raising $38 billion, but now there are new guys on the block looking for a share of the action.
According to the website, Sukuk, the Irish Stock Exchange (ISE) outperformed London in 2013 with 15 sukuk listed and five in the early months of 2014. (London had one listing in the early months of 2014.) It is suggested that their success is at least in part due to the fact that it is relatively inexpensive to list on the ISE. Listings on the ISE are technical listings so there is no secondary trading on the exchange, but since there is relatively little secondary trading at the moment, this may not be a serious disadvantage.
First Japanese Commercial Bank to Issue Sukuk
The Bank of Tokyo-Mitsubishi UFJ, Ltd. (BTMU) has announced that its subsidiary, Bank of Tokyo-Mitsubishi UFJ (Malaysia) Berhad (BTMU Malaysia), has set up a $500 million (or equivalent) multi-currency sukuk programme. This is the first by a Japanese commercial bank.
Through this programme, BTMU Malaysia has obtained the mandate to raise funds in multi-currencies including US Dollars, Malaysian Ringgit and Japanese Yen over 10 years. BTMU Malaysia envisages issuing its first tranche of the sukuk at an appropriate timing in anticipation of strong global demand for sukuk instruments. The monies raised through this sukuk programme will serve as funding sources for BTMU Malaysia to keep pace with increasing demand and its growing exposures to multi-currency Shari’ah-compliant financing.
BTMU Malaysia’s Islamic banking business has progressed steadily over the past few years. It has taken on a proactive role in providing Islamic financial services through its International Currency Business Unit, since it obtained a license from the central bank of Malaysia in 2008. BTMU Malaysia is the only Japanese bank to have its own in-house Shari’ah committee. This sukuk programme further underpins BTMU and BTMU Malaysia’s commitment to contribute to the development of Islamic finance and provide stronger support to customers’ demands for Islamic financial services not only in Malaysia, but also in other Asian and Middle East countries.
UK Government Makes Good on Promise to Issue Soveriegn Sukuk
On 25 June 2014 the UK government claimed it had cemented Britain’s position as the western hub for Islamic finance by becoming the first country outside the Islamic world to issue sovereign sukuk. The government confirmed that £200 million of sukuk, maturing on 22 July 2019, have been sold to investors based in the UK and in the major hubs for Islamic finance around the world.
The UK’s first sovereign sukuk received very strong demand, with orders totalling around £2.3 billion, more than 10 times oversubscribed and allocations have been made to a wide range of investors including sovereign wealth funds, central banks and domestic and international financial institutions. Investors from the major centres for Islamic finance in the Middle East, Asia and Britain were all represented in the final allocation. The profit rate on the sukuk has been set at 2.036% in line with the yield on gilts of similar maturity. The issue will be listed on the London Stock Exchange.
HSBC structured the sukuk deal and acted as a book runner alongside Qatar’s Barwa Bank, Malaysia’s CIMB, National Bank of Abu Dhabi and Standard Chartered. Law firm Linklaters provided legal advice.
The Chancellor of the Exchequer George Osborne said:
‘Today’s issuance of Britain’s first sovereign sukuk delivers on the government’s commitment to become the western hub of Islamic finance and is part of our long-term economic plan to make Britain the undisputed centre of the global financial system.
‘We have seen very strong demand for the sukuk, resulting in a price that delivers good value for money for the taxpayer. I hope that the success of this government issuance will encourage further private sector issuances of sukuk in the UK.
‘By issuing sovereign sukuk, the government has demonstrated that it is possible to create a successful British base for Islamic finance.
‘Britain’s sovereign sukuk uses an ijara structure, the most common structure for sovereign sukuk, with rental payments on property providing the income for investors. The sukuk is underpinned by three central government properties.’
Some commentators and analysts have questioned whether the issue is large enough to have any significant impact on the UK’s Islamic finance industry. It is a drop in the ocean in a market which is expected to reach global issuance of $60¬65 billion in 2014.
There are, however, positives to be drawn from the issuance. First, it has underscored the UK government’s commitment to supporting the growth of Islamic banking in the UK. Until this issuance UK-based Islamic financial institutions had no UK AAA-rated liquidity instrument available to them, forcing them to retain higher levels of cash than they would have ideally wished to have. This levels the playing field for these Islamic financial institutions in the UK. Secondly at a global level, the issuance emphasises the UK government’s determination to support the City of London in its bid to retain its position as the leading Western hub for Islamic finance.
Logically, the success of this sukuk issuance should encourage the UK government to further issues in the future, but the UK Debt Management Office told Reuters that ‘it had been hard to find suitable assets to structure the issue, which does not pay interest in the same way as a conventional bond. It has not proven easy to find sufficient assets either for bigger size or for a programme of issuance.’ (The current issuance is underwritten by rents from three government building.)
The next question is whether the issuance will encourage other Western governments to issue sovereign sukuk and several have flirted with the idea. If other Western governments do follow suit and this in any way threatens London’s position as the leading centre of Islamic finance in the West, then the UK government may look harder at the question of further issuance.
A second question is whether this sovereign sukuk will kick-start the issuance of corporate sukuk in the UK to finance major infrastructure projects. UK government is obviously not averse to foreign investment in such projects. Recently they have apparently talked to China about investment in the proposed high-speed rail link, HS2 and in nuclear power plants. With a suitable investment vehicle such as sukuk, it is possible that Middle Eastern states looking to diversify their investment base could be interested in these and similar projects.
For the moment, everyone seems very happy with the result of the June 25 issuance. It has been very successful and the UK government have made good on a promise that many in the UK Islamic finance community feel was made to them, making a new liquidity instrument available to them. This is, however, a beginning and it will be interesting to see what happens next, both in the UK and more broadly in other Western countries.
NEWHORIZON January to June 2014
FOOD FOR THOUGHT
Looking Ahead: Islamic Finance Outlook 2014
The world financial markets continue to test the interconnectedness of global and domestic banks to international economic and political agendas. Islamic financial institutions (IFIs), on the contrary, are demonstrating resilience as world events continue to reshape the landscape of global financial services. The test, however, will be the way through which the Islamic finance (IF) industry prepares itself for the opportunities and challenges thrown up by the inevitable rapidly changing global economy.
The Islamic Finance Industry
The Banker, in its recent special issue (published in November 2013) on ‘Top Islamic Financial Institutions’ reported that the IF industry has witnessed its assets rising for the seventh consecutive year since it began collecting data in 2006, climbing up from USD 1.2 trillion in 2012 to USD 1.3 trillion in 2013, which is an annual growth of 8.7%. Such data is based on disclosed assets by all Islamic finance institutions (fully Shari’ah-compliant institutions as well as those with Shari’ah ‘windows’) covering commercial banking, funds, sukuk, takaful and other segments. The breakdown by category is as shown above:
It is also revealed that while the growth of the industry in 2013 has seen a slowdown from 20.7% in 2012 to 8.7%, the compound annual growth rate since 2006 is still a considerably healthy 16%. In addition, an estimated $628 million of Islamic microfinance assets is also a growing segment, although only representing about 0.8% of the estimated total global microfinance market of $78 billion (Thomson Reuters, ‘Global Islamic Economy 2013’).
Such staggering growth and development prospects, one way or the other, have accelerated the eastward shift in the world’s economic centre of gravity. The economies of the Middle East and Asia – including key Muslim member countries – are seen as increasingly central. The Group of 20 (G20) – a summit that plays a key role in international economic policy – now includes three IDB (Islamic Development Bank) and OIC (Organisation of the Islamic Conference) member countries (Indonesia, Saudi Arabia, and Turkey).
The eastward shift creates numerous opportunities for the IF industry, including:
• managing the savings and wealth being created
• supporting ongoing economic growth by providing financing
• exercising increased influence in global forums and decision-making bodies.
These global forums include forums that have traditionally been dominated by Western economies (such as the G20, the International Monetary Fund (IMF) and the World Bank) and new forums that provide greater focus on emerging economies in Asia, the Middle East and Africa.
The Role of Economic Crises
Since 2008, the world has also witnessed waves of successive financial crises, ranging from institutional crises (e.g. the failure of Lehman Brothers) through systemic crises (e.g. the virtual collapse of European debt markets) to sovereign debt and currency crises (e.g. fundamental challenges to the eurozone), with the result that the very pillars of the global financial system have been shaken up.
The ongoing financial crises have certainly prompted a high level of questioning about the conventional financial system. This creates an unprecedented opportunity for the Islamic financial sector, in particular, to contribute to a global dialogue on the very nature of the Islamic financial system.
This opportunity has been further bolstered by:
• the increased clout of member countries (three of which are members of the influential G20)
• the active attention the industry has already received in international commentaries on the financial system.
Some observers believe the Islamic finance industry has not played an active enough role in the dialogue – further underscoring the present opportunity. Important international organisations such as the IDB and IFSB (Islamic Financial Services Board) can consider a targeted strategy to work with the three G20 members – Turkey, Indonesia, and Saudi Arabia – to help bring Islamic finance more strongly to this forum.
Contributing to the global dialogue can not only help the Islamic finance industry itself, but it can also have a genuine impact on the broader financial system by transferring novel principles and good practices.
Where Does the Industry Currently Stand?
Many are of the view that the IF industry commenced with the introduction of Islamic banks in the mid-1970s. In the very beginning stage, the operations of Islamic banks were underpinned by the principle of two-tier mudarabah, i.e. on the liabilities side of the balance sheet, the depositor would be the financier and the bank the entrepreneur and on the assets side, the bank would be the financier and the person seeking funding the entrepreneur. After having gone through what Warde (2010) described as ‘a three-stage evolution1, however, the operations of Islamic banks, which dominate the IF industry, has essentially moved from ‘two-tier mudarabah’ to ‘two-tier murabaha’, whereby the bulk of the assets and liabilities elements of Islamic banks are dominated by murabaha modes of finance.
1The three stages comprise three distinct phases: the early years (1975-1991); the era of globalisation (1991-2001); and the post-September 11, 2001 period. However, it can be argued that there is a fourth stage; namely an era after the 2008 global financial crisis.
After more than four decades since its initiation; an important question which begs for a timely investigation is ‘Where does the IF industry currently stand?’ In spite of an impressive growth of the industry for the last few years as stated earlier; the IF industry consisting of four main sectors, namely Islamic banking, Islamic capital markets, takaful and retakaful and non-bank financial institutions (such as investment banks, asset management companies, securities firms, leasing companies, etc.) and microfinance institutions; are currently characterised by the following:
Considerably higher cost of transactions
The higher cost of transactions is indeed one of the major unresolved issues in the IF industry. Some would say that this happens due to the economics of scale that the industry has not yet attained. Others might contend that the problem arises because of lack of legal and regulatory harmonisation, which have contributed to an uneven playing field leading to the higher cost of transactions for Islamic financial products. Notwithstanding such arguments, this requires a solid solution, particularly in the area of home financing, which is ubiquitous in many Muslim countries and also for the Muslim communities living in non-Muslim countries.
Limited options of risk management instruments, mitigation techniques and quantitative measurement models
Despite the prominent initiatives by the Islamic Financial Services Board (IFSB) in issuing guidelines relating to risk management, stress testing and capital adequacy standards, a more detailed technical guidance, which features the techniques and methodologies of risk assessment taking into account the unique risks for IFIs, is still required.
Furthermore, it was also commonly understood that whilst the definition of risks in IFIs is not substantially different from the ones in their conventional counterparts, a modification in the identification, measurement and mitigation of risks may be required due to some Shari’ah principles. More importantly, there is a dire need to develop a proper legal environment and suitable regulatory framework, which is needed for the sound practice of risk management in IFIs.
In addition, limited liquidity instruments for Islamic capital markets are another challenge. In response to this challenge, the International Islamic Liquidity Management (IILM) has recently and successfully launched ‘Golden Triangle Sukuk’ featuring a connection between financial stability, economic development, and debt management.
Financial inclusion gap
Financial inclusion is a concept that has gained importance since the early 2000s. It initially referred to the delivery of financial services to low-income segments of society at affordable cost. Two distinct features which characterise the concept of financial inclusion from an Islamic perspective are two-fold the notions of risk-sharing, and redistribution of wealth (Mohieldin et al, 2012). Although there is a strong demand for Islamic microfinance services in OIC countries, it is, nevertheless not met by the supply. A study by Mohieldin et al. (2010) shows that although OIC countries have more microfinance deposits and accounts per thousand adults as compared to non-OIC countries, the values of MFI deposits and loans as percentage of GDP are still much lower in OIC countries (0.61% and 0.79%) compared with developing countries (0.78% and 0.97%) and low income countries (0.92% and 1.19%). The microfinance gap in OIC is not only demonstrated by its limited scope, but also by the lack of regulation in OIC countries compared to other developing countries. In the MENA region for example, only Egypt, Morocco, Syria, Tunisia, and Yemen have specific legislation for microfinance institutions.
Restricted legal and regulatory framework
A daunting task for IF industry stakeholders is not only to establish regulatory harmonisation between different jurisdictions, but also to conform with the standards and guidance set out by international standard setting bodies such as the BCBS (Basel Committee on Banking Standards), IOSCO (International Organisation of Securities Commissions) and IFRS (International Finance
Reporting Standards). Surely, the idea of ‘one size fits all’ is not viable due to the fact that different countries have different institutional and regulatory frameworks.
Lack of Islamic monetary policies
At the macro level, the availability of Islamic monetary instruments is indispensable to support the macroeconomic objectives of the Islamic financial system. Another important element of such an instrument is for the purpose of liquidity management. Some countries have initiated the
creation of such instruments, such as in Indonesia2 and Malaysia3. More efforts, however, need to be undertaken to also allow inter-jurisdictional transactions and liquidity management between the countries implementing an interest-free financial system.
2Bank of Indonesia (BI) has issued SBSI (Sertifikat Bank Indonesia Syariah) or Bank Indonesia Islamic Certificate.
3An Islamic monetary instrument based on collateralized murabaha was issued by Bank Negara Malaysia (BNM) that would enable collateralised interbank transactions in the Islamic Money Market in the country
Lack of human capital enhancement
The continuing growth and intensified competition among market players in the IF industry has certainly posed quantitative and qualitative human resource problems for the industry. It does not come as a surprise, therefore, that the IF industry needs more and better-qualified personnel, which, unfortunately is in rather short supply. An establishment of visionary polices and initiatives to respond to this matter will definitely be useful. Furthermore, such policies and initiatives are in line with recommendation no. 5 of the ‘10-Year Framework and Strategies for Islamic Financial Services Industry Development’, which states ‘develop the required pool of specialised, competent and high-calibre human capital.
Perceptions about Islamic finance
Many still think that Islamic finance is basically an industry designed by Muslims and offered to solely to the Muslim market. Although it appears to be partially the case, nonetheless, the key spirit of Islamic finance is a great deal more profound than what has been stated. Take, for example, interest (riba) prohibition. It is shared with Judaism and Christianity. It is also interesting to note that charging interest is also prohibited in Buddhism, Hinduism and many other faiths and philosophies (Abdul Rahman, 2010).
What Are the Future Trends?
Despite the existing and foreseeable challenges, the prognosis for Islamic finance seems to be positive validating the assertion that Islamic finance is merging into the mainstream and is here to stay and grow.
Renewed interest is being witnessed from the West, as can be seen from the recent announcement by the UK of a sovereign sukuk and a reiteration of the desire by multiple cities to position themselves as the ‘global hub’ of Islamic finance. Within the Middle East, capitals such as Dubai, Doha and Manama remain keen to retain their identity as centres of Islamic finance. In fact, Dubai has gone one step ahead and declared its intention to become the capital of the Islamic economy. Further afield, Kuala Lumpur remains committed as the trailblazer for Islamic finance and the halal economy.
This shift from mere banking and finance to the broader Islamic economy is interesting in that it has not only expands the size of opportunity many times, it also proposes to create a link between Islamic finance and the real economy including sectors as diverse as hospitality, media, clothing, food and lifestyle.
In addition to the heightened interest from these somewhat more traditional centres of Islamic finance, the most encouraging signs of the proliferation of Islamic finance are coming from Turkey, Africa and Central Asia, where emerging and transition economies are embracing Islamic finance not only as a means of raising capital for infrastructure projects, but also as mainstream retail banking, finance and insurance. The fact that the World Bank has chosen Istanbul as the location for its centre of excellence in Islamic finance is indicative of the shift to new markets and frontiers for Islamic finance.
While Islamic finance remains set for growth and expansion, a trend that can be expected to endure in the short to medium term is the variation of performance across sectors. Banking and sukuk will continue to dominate the industry in terms of size. Islamic funds and takaful, on the other hand, while growing steadily, will remain modest in terms of the overall share. Although some see this as a challenge, this also presents a great opportunity. As the link between the real and nominal economy becomes more pronounced these sectors are bound to become more prominent.
Another very positive development in the Islamic finance industry is the reorientation towards social objectives and financial inclusion. This is being driven by both push-and-pull factors. Where on one side, a need is being felt to respond to the criticism that Islamic finance has failed to deliver on its promises of fairness, equity and inclusion, there is also a genuine demand and opportunity in the wake of the Arab Spring and the ongoing global recession to redirect innovation towards services and products that create more economic opportunities, jobs and financial inclusion for those who hitherto have been on the sidelines of the Islamic finance revolution. Islamic microfinance, crowd-funding, SME finance, etc. are the buzzwords at Islamic conferences and symposia. Academicians, researchers and practitioners are now increasingly focusing on developing new and innovative Islamic financial products and solutions that can make a real difference to the common man. Competitions, grants and awards are being established to incentivise the brightest minds to take up the challenge. This trend bodes well for the realignment of Islamic finance with the Maqasid Al Shari’ah, a critical link that many deem was broken as Islamic finance pursued an agenda of emulating a permissible version of conventional finance with little attention to the broader purpose and objectives of an Islamic economy.
With the above trends poised to continue over the short to mid-term, two associated factors will be critical. First, product innovation there is a dire need for new solutions and products to satisfy existing and emerging needs. Product innovation will, therefore, need to go beyond tweaking and juxtaposing existing contracts and look at newer and more imaginative ways of delivering what is being demanded by the market.
Second, as Islamic finance expands to new territories and jurisdictions and gets more connected to the global Islamic economy, harmonisation of Shari’ah, legal and regulatory rules will become even more critical. This is to ensure that cross border transactions costs are low and the industry is able to be efficient and competitive. This in turn means that governments and regulators need to think less in terms of competition and more on the lines of collaboration and cooperation. While regional, national and local variations will exist, these should add to the richness of Islamic finance and not become a hindrance to its proliferation. This therefore is not only the biggest challenge but also the greatest opportunity.
The Tasks Ahead
The growing presence of the Islamic finance industry cannot be understated. Various regulatory and supervisory units have been established to ensure efficiency and prudence in the operations of Islamic financial institutions. An issue which remains topical is the convergence of financial stability and economic development. The fact that Islamic finance has been a thriving phenomenon requires further examination in strategising the policies and initiatives and, more importantly, to ensure that values are preserved and resonated across all components of Islamic financial system. It is, therefore, proposed that the areas which necessitate particular consideration in the years to come are as follows:
Promoting equity based finance and strengthening the linkage between real and financial sector
Islamic finance may have made significant progress from the early days but so far it has constrained itself mostly to debt-like instruments derived mainly from trade-based contracts such as murabaha, ijara, istisna and salam. With the maturity of the market, institutions and players, the need now is to embrace the true spirit of sharing risk and rewards and move to more equity-based finance. This will not only help differentiate and distance Islamic finance from the allegation of ‘conventional finance in a
different guise’, but also enable it to serve and expand in areas where it is currently falling short. Greater sharing of risk would inevitably require greater involvement, oversight and participation in the real economy and further development of risk management techniques, but this is exactly what Islamic finance needs to do now.
Legal, Regulatory Framework and Monetary Policies
At the macro and governmental level, there is now more than ever the need to create an enabling environment to support the growth of Islamic finance. We previously highlighted the need for greater harmonisation and coordination across legal and regulatory jurisdictions. Equally important are measures by governments that are keen to promote Islamic finance to ensure that the playing field remains level and conducive in terms of fiscal and monetary policies, tax rules, supervision and reporting, so that Islamic finance can compete from a position of strength.
Enhancing Financial Inclusion through Promoting an Institutionalisation of Zakat and Waqf
Finally, one cannot overstate the importance of the other tools in the arsenal of Islamic finance. These are not only unique but have historically been vital bastions of the Islamic economy and a critical means for the achievement of its goals and objectives.
Unfortunately, in recent times, zakat and awqaf are seen as primitive, inefficient and even, in places, as corrupt institutions that have outlived their utility and failed to deliver to their beneficiaries. It is true that there are significant challenges, with legal and regulatory not the least, to the rehabilitation of these institutions, but the potential that these institutions possess in terms of reach, diversity and inclusion outweighs any efforts that may be required to bring these back to the mainstream.
In this regard, visionary policies and solid initiatives need to be set out to foster a stronger collaboration among countries and international strategic stakeholders to promote an institutionalisation of these redistributive instruments so that the modernisation and rehabilitation of zakat and awqaf as formidable institutions of Islamic finance can be attained. Furthermore, such a transformation is needed to ensure that real change is brought about through financial inclusion.
Periodic Assessment of the IF Industry and its Impact on the Society at Large
The IF industry which started at a modest scale in the 1970s has indeed demonstrated a tremendous growth over the last four decades; it is even dubbed as one of the fastest growing industries, having attained double-digit growth in the last few years. As such, this has prompted questions about the actual magnitude of the industry, interconnection and interdependence between sectors within the industry and, more importantly, the impact of the industry on society at large. It is believed that various jurisdictions might have different levels of development. Therefore, through comprehensive and methodical assessments, a set of appropriate policies and initiatives can be formulated to drive further development and transformation of the IF industry. What is equally important to support such efforts is the development of comprehensive and reliable data on the industry, which could then be utilised as a global main reference for any quantitative assessments.
Rebranding Islamic finance
The fundamental essence of Islam is its universality and the fact that it transcends time, place and people. The prophet Muhammad (PBUH) was sent as a mercy to the world. Islamic finance in its true form is a financial ideology that is grounded in the principles of justice, fairness, compassion, honesty, equity, sharing and inclusion. These divine principles also transcend time, place and people and as such have been emphasised not only in all Abrahamic monotheistic religions, but are also cherished across all civilizations and humans. The need therefore is to highlight not the exclusivity of Islamic finance but the universality of its appeal as an ethical,
socially responsible and fair system of finance not just for Muslims but for the whole world.
Prior to joining IRTI IDB, Hylmun Izhar was a lecturer at the Markfield Institute of Higher Education (MIHE) in the UK where he taught Islamic Financial Instruments, Economic Development and Finance and Cross Culture Management. He was also a Research Associate in Islamic Finance at Oxford Islamic Finance in the UK. He has a master’s degree from Loughborough University and a PhD in Islamic Finance from Durham University. He has also presented numerous papers in various international conferences and has conducted professional training courses for regulators, bankers and university professors in the area of Islamic economics and Islamic finance.
Yahaya Rehman joined IRTI IDB following a 15-year career including periods spent with Ernst & Young, KMPG and Accenture and most recently as Vice President of the Capitas Group International. He was educated at the International Islamic University, Oxford University and the London School of Economics.
NEWHORIZON Rabi Al-Awwal – Sha’ban 1435ANALYSIS
Islamic Financial Engineering:
Prospects and Challenges
The establishment of the Islamic financial system was a distant-dream in the colonial era and was restricted to a vague theoretical idea in some scholars’ imaginations until the early phase of the de-colonised Muslim world. That it could become such a dominant phenomenon in the first decade of 21st century had hardly crossed anyone’s mind. Arguably, a handful of scarcely known Pakistani landlords, who were the first to initiate small-scale Shari’ah-compliant micro financial services for agricultural purposes in Pakistan in 1950s, might never have thought that they could actually be pioneering such an impregnable industry.
Although the hypothesis and vision of a Shari-ah-compliant banking and financial system existed somewhere in the scattered pages of classical fiqh for centuries, putting those ideas into practice on such a tremendous scale was never going to be an easy task. Nevertheless, with the repeatedly diligent efforts and interaction of Shari’ah scholars and finance practitioners coupled with the general rise in prices of oil in the 1970s, the industry began to gain momentum and it has never looked back; it has enjoyed uninterrupted growth.
Notably, in last two decades the Islamic financial sector has progressed by leaps and bounds. According to some estimates the industry has already expanded to comprise more than 550 institutions in more than 75 countries. Interestingly, while the industry is currently thought to be worth $1 trillion, Islamic finance is making continuous progress and is on target to hit its prospective target of $4 trillion in the near future.
Apart from these facts and figures, the most striking aspect of the industry is its claim to be premised on Shari’ah. This is the distinctive feature that draws a clear line between this industry’s services and that of its counterparts. Compliance with Shari’ah in all of its contracts and dealings is the focal point of the industry. Due, however, to being pitched to compete with its already well-established conventional counterpart, the industry is required time and again to develop innovative and competitive financial products and all of these products need to be compliant with Shari’ah guidelines. The proposition of innovation in Islamic financial products gives rise not only to the question of whether Shari’ah provides enough flexibility for the purpose, but it also seeks clarification on the rules and regulations of the Shari’ah that govern the modification of contracts.
This article attempts to underline the key Shari’ah conditions or restrictions that, if they are violated, may potentially render the contract either defective, null and void or make it unlawful.
An Overview of the Islamic Law of Transactions:
Shari’ah provides a comprehensive system of life and offers a number of well-disciplined guidelines to resolve issues related to different aspects and dimensions of life. Broadly, Shari’ah commandments are divided into three major sections namely - aqÉyed (beliefs) ÑibÉdÉt (prayers) and muÑÉmlÉt (mutual contracts/ dealings). While the first two disciplines find explicit directives and explanations in the primary sources of Shari’ah and leave no scope for any amendment or alteration, the basics of the muÑÉmlÉt have been introduced with the conditional permission of adaptation and modifications in it, as and when needed.
Since business and financial contracts fall under the remit of muÑÉmlÉt, there is a general permissibility for innovation in their contractual forms and structures. This notion is based on the widely accepted concept among the Shari’ah scholars that asserts that in muÑÉmlÉt everything is permissible until proved otherwise.
Conventionally, a financial product represents the underlying mutual contract between the involved parties that validates the transaction. Contrary to this, however, Islamic financial contracts have of necessity to abide by certain prescriptions and restrictions of Shari’ah in its entirety.
Arguably, the starkest difference between Islamic and conventional modes of contracts lies in the fact that the latter can be formulated and structured merely on the basis of the mutual consent of the involved parties without bothering about their subjective implications on the collective health of the society. Compared to this, the Islamic modes of contracts are subject to certain guidelines and restrictions of Shari’ah to maintain equity, justice and the integrity of society as a whole.
With the objective of identifying the Shari’ah boundaries in the sphere of trade and finance, it is important to pinpoint the Shari’ah-repugnant elements of conventional banking contracts that render their transaction impermissible. In this regard the Qur’anic verse,
‘O you who believe, devour not your property among yourselves by unlawful means except that it be trading by your mutual consent’ (al-Qur’an 4: 29),
may be deemed as a fundamental axis around which the whole mechanism of Shari’ah-based economic activities, financial contracts and transactions revolve. According to Iqbal ‘this verse is perhaps the most important verse in the Qur’an on economic matters. It tells us both the dos and the don’ts in wealth creation.’
Furthermore, a comprehensive study of the words ‘unlawful means’, in the above verse, would serve the purpose of identifying the prohibited forms and elements of a contract. In the interpretation of the verse, Ibn-e Khatheer explains that ‘all kinds of tools and methods of trade and contracts premised on the basis of Shari’ah-prohibited elements, such as riba (interest, usury) and maysir (gambling) do constitute unlawful means. In addition, according to Maulana Mawdudi, the expression unlawful ‘covers all transactions which are opposed to righteousness and are reproachable either legally or morally.’
Essentially, Shari’ah aims at eliminating all possible sources and means of exploitation in business dealings. To this end, it is possible to identify a common ethical theme running through all Shari’ah prescriptions and axioms. These prescriptions in general seek to bring ease, peace and benefit to all. It is this notion and proposition of Shari’ah that lays great emphasis on implementing the substance of Shari’ah-rulings instead of only maintaining their form in products. It is, however, repeatedly argued that in the rush to bring innovation in financial products, Islamic financial institutions, in some instances, tend to compromise on the theme and substance of Shari’ah by employing ruses and subterfuges. Technically, there is almost a consensus among the scholars that in order to circumvent a prohibited contract, an artificial device, technique or mechanism does not change the status of the contract. Hence, it is argued that artificial Islamic financial products such as ÑÊnah and tawarruq run contrary to the essence and substance of Shari’ah guidelines.
Notwithstanding all these, it is essential to note that in the debt-based conventional financial system, the involvement of riba, gharar, maysir and unethical elements constitute a substantial part of underlying contracts. It, therefore, seems imperative to discuss them in detail here.
Riba is derived from the Arabic root of ‘raba, yarbu’. Literally it means an increase, addition or growth. Technically, riba implies any stipulated premium over a lent amount, or in an exchange of specific (ribawi) commodities, deferment from one side, or in a barter exchange, to exchange any fungible commodity that is usually sold by measure or weight with the similar kind while either side’s weight or measure is in excess of the other’s.
Importantly, contrary to common belief that riba happens only in contracts of pecuniary transactions, it may take many shapes and forms. Prof. Habib Ahmad rightly observes ‘Although it is common to associate riba with interest, it has much wider implications and takes different forms.’ Based on primary sources’ instructions pertaining to probable forms of riba, Shari’ah jurist have classified riba into two basic categories; riba al-duyËn and riba al-buyÑË. Whereas, riba al-duyËn implies interest/usury in lending and borrowing, riba al-buyÑË refers to the excess of one counter-value or a time lag in delivery of one party’s goods in a barter exchange of the same genus of commodity. Furthermore, both kinds of riba are subdivided into two types of each. Riba al-duyËn could be either (a) riba al-qard, in which interest is stipulated from the beginning of a loan contract, or (b) riba al-Jahiliyyah in which compound interest is imposed after a default. Similarly, riba al-buyÑË could be either (a) riba al-nasiya, which encompasses two possibilities (1) selling something on deferred
payment and increasing the amount for any delay in repayment of the consideration price or (2) in a barter exchange, transacting with commodities that have the same characteristics and deferring either side’s delivery on the spot. Riba al-fadl also arises out of the barter exchange of commodities provided that on the both sides the commodities have the same characteristics and any one of the trading parties is claiming an excess over the other. The probable and possible forms of riba could be understood through the following illustrative
The term gharar is translated in various ways as fraud, deceit, misleading, tricking, ambiguity, uncertainty, etc. In accordance with its semantic root, gh-r-r, it encompasses meanings of peril, risk, jeopardy, hazard, etc. Technically, in trade or exchange contracts, the term commonly implies excessive uncertainty or ambiguity in the terms and conditions of a contract, subject matter, its composition, delivery, consideration or any sort of vagueness in relation to the transaction from either party. Though, the term has not been used in the Qur’an in this particular sense, a number of Shari’ah jurists from authentic prophetic traditions have inferred the meaning and implications of the term. Basically, the corner-stone in this regard is the hadith that ‘the prophet has forbidden the sale in which uncertainty (gharar) exists’ (Tirmizi). Though, the interpretation of gharar varies as per the associated methodology and criteria of various schools of fiqh, almost all of them agree that if elements of ignorance (jahalah) are excessive in relation to the contract or the subject matter itself is non-existent at the time of dealing, the contract would be invalid due to the involvement of gharar in it.
Maysir may be termed as a pure game of chance. Its English equivalent is gambling, which is largely defined as a zero sum game. From the Shari’ah perspective, Shaikh al-Qardawi holds that ‘any contract that is made of only two possibilities, either gains or loss’ is tantamount to maysir. Moreover, in maysir the gain is always acquired on the expenses of the other party’s loss. Interestingly, it is noteworthy that in all sorts of maysir, there is the necessary involvement of excessive gharar, as the same is an inseparable element of maysir, however, this is not always necessary in a vice versa case. According to Shari’ah jurists, the contracts of conventional general or life insurance and futures (the contract in which the delivery of the subject matter is not intended; instead, it aims to offset the price differential) fall under this category. Shari’ah has rhetorically prohibited maysir and has deemed it as a disdainful and unscrupulous activity.
The Scope for Islamic Financial Engineering:
In the last few decades, the structure and scope of conventional financial products have been significantly transformed. At the time being, most of the existing forms of financial contracts are remarkably different from those discussed in classical Islamic literature. The terms of trades, contracts, dealings, transactions and financing have also witnessed substantial changes and innovations. Consequently, there has emerged a vital need for an entirely new and innovative approach towards Islamic business and trade models.
The modern Islamic financial structure, that is a comparatively new and niche discipline, is faced with the challenge of competing with its well-matured conventional counterpart in terms of developing innovative financial products. In fact, the dynamic nature of conventional financial instruments has necessitated a high demand for their new Shari’ah-compliant alternatives. In this regard, the first question that strikes the mind is, whether it is possible for Shari’ah-based financial system to go hand in hand with the conventional system in terms of innovation in contracts and products. To this end, it is of paramount significance to note that regarding mutual dealings (muamlat), the general principle of Shari’ah is permissibility. This signifies that all is permitted until explicit prohibition is proved. Imam al-Siyuti has discussed this principle in detail, arguing that, initially the original verdict about any contract is permissibility and nothing is illegal except what Shari’ah clearly prohibits, although there is a small section of conservative jurists that subscribes to a reverse formula, which holds, all is defective/unlawful unless permissibility is found. Ibn-e- Quyyim, however, has negated the later theory and has categorically reproached the proponents of the same. He points out that ‘claims of those who subscribe to the notion that all mutual dealings or contracts of Muslims are unlawful until they prove their permissibility in Shari’ah’ is premised on irrelevant and baseless grounds. Hence, bearing in mind the jurisprudential maxim of general permissibility (al asl fil-ashya al-ibahah), the task of ascertaining what is explicitly prohibited in Shari’ah would automatically result in crystallising what remains permissible.
In this regard, fundamentally two of the prophetic traditions are of paramount importance and worthy of discussion. Noman Bin Bashir narrates that the prophet (pbuh) says ‘what is permissible is obvious and what is prohibited is obvious and in between lies doubtful that most people do not know whether the same is lawful or unlawful. Whosoever abstains from doubtful is saved from ÍarÉm’ (Tirmizi).
While interpreting the hadith, Abdul Rahman Mubarakpuri writes ‘whatsoever is prohibited is expressively elaborated either in Qur’an or in hadith and there are things that constitute doubtful.’ He asserts, however, that these doubtful are doubtful for a layman due to his lack of expertise in jurisprudence. As far as expert jurists are concerned, it is possible for them to distinguish between halal and haram through the application of reasoning, rationality and discretion.
In another hadith, the prophet (pbuh) says, ‘All conditions agreed upon by Muslims are upheld, except a condition which permits a prohibited or prohibits a permitted thing’ (Tirmizi). Essentially, these two prophetic traditions could be taken as fundamental in providing a vital clue about the standpoint of Shari’ah in order to underline the scope of the Islamic financial engineering and product development process.
The Status of Subterfuges (Íila) in Islamic Financial Engineering
At the time being, with the increasing expansion of Islamic financial institutions, the demand for their innovative and client-friendly products has grown from all quarters. Islamic financial institutions that are ideally ‘Islamic’ first and ‘financial institutions’ second are faced with two challenges in this regard. Firstly, they have to operate within the realm of Shari’ah boundaries in all of their dealings and contracts and secondly, they are required to be efficiently competitive with their conventional counterparts in terms of developing attractive and consumer-friendly products. To meet both the demands is something that requires rigorous cooperation and interaction between Shari’ah scholars and Islamic finance experts.
Notably, the constantly growing demand for new and competitive Islamic financial products puts immense pressure on concerned stakeholders. Ironically, in the rush to bridge the gap between demand and supply for innovative products, some institutions resorted to legal stratagems and came up with pseudo-Islamic instruments, which has given rise to deep doubt over the objectives of these institutions and attracted widespread criticism of the whole industry. Although the industry has already rejected some highly questionable products, they have left the scars of scepticism in some minds. Similarly, in the process, it was noticed that due to the concentrated focus on meeting the demand of new products, sometimes the essence of maqasid al-Shari’ah was/is severely compromised in some instances. As a result, this raises the question of whether the circumvention of the prohibitions is all that Shari’ah requires from its followers or whether something else is meant from the introduction of certain Shari’ah maxims and guidelines. Often the legality-seeking approach of Shari’ah scholars seems to ignore the fact that according to the legal maxim the main focus in a contract should be given to the consequences and not to the words and forms only.
Here, it is important to note that employment of a legal stratagem (hilah) to circumvent the prohibition superficially does not work and is severely condemned in the literature of Shari’ah. The Qur’an has vividly criticised the acts of Jews who used to apply a stratagem in order to justify their violations of prohibitions in certain deeds. In this regard, Ibn-e Qayyim has categorically stated that ‘had the prohibition of certain dealings or deeds been linked only with their names or forms, instead of their essence, Allah would have never cursed Jews for their circumventive strategies.’ He further goes on to say ‘in certain mutual contracts, people seek stratagems to legalize riba and change their names as sale’. As an example of stratagem, he says ‘if one wishes to sell his hundred dirhams by hundred and twenty, he normally sells a commodity to the buyer (borrower, in the real sense) on deferred payments of hundred and twenty and then buys back the same by hundred on the spot; in this contract neither of the two has any intention to get the commodity except lending and borrowing on interest.’ According to him, in the eyes of Shari’ah there is no difference between this contract and the contract explicitly based on interest. Additionally, he considers the contract based on stratagem to be greater in corruption.
Thus it is almost clear that, in general, Shari’ah allows modification to a contract so far as it does not involve a prohibited element. Also, the boundaries and limits of Shari’ah in the context of modification of contracts require to be honoured in letter and spirit without resorting to the circumvention of the related Shari’ah guidelines.
Though still being termed as a nascent and niche industry, the Islamic financial sector has already established a firm footing across the Muslim world in general. While the industry has been successful in providing an alternative financial mechanism, its objectives are allegedly compromised in many cases. In a rush to develop some alternative products, the industry has ended up offering a number of pseudo-Islamic products, which by and large has dented the confidence of the community in the services of the industry.
In this regard, it is essential for the industry to evaluate the overall Shari’ah-compliance level of the available products and services, as well as redefining the nature of its product development criteria in the light of maqasid al Shari’ah. To this end, calls for the involvement of high calibre Shari’ah scholars in the product development process are increasing. There is also, a need for committed efforts from Shari’ah scholars to help in the designing of new viable
Shari’ah-based products under the guidance of maqasid is greater than ever.
Mohammad Abdullah Nadwi is a Shari’ah scholar and a doctoral candidate (Islamic Economics) at the Markfield Institute (University of Gloucestershire, UK). He has worked with Islamic Relief, Birmingham, as a research assistant in its Islamic microfinance and waqf department. He completed his first degree at the Islamic University Nadwatul Ulama Lucknow, India, followed by an MA in the UK.
Ms Sameen Zafar is a doctoral candidate (Economics) at the University of Nottingham. Prior to this, she completed her BSc (Economics Honour) from Lahore University of Management Sciences (LUMS) Pakistan, followed by an MSc (Development Economics) from the University of Nottingham. Sameen has taught economics and Islamic economics both at the undergraduate and master levels in Pakistan and in the United Kingdom (University of Nottingham). She has also presented papers in Durham University Islamic Finance conferences.
NEWHORIZON January to June 2014
FOCUS ON MICROFINANCE
Islamic Microfinance and Poverty Alleviation
The following article is drawn from the proceedings of the 5th WIEF (World Islamic Economic Forum) Roundtable 2012 held in Dhaka, Bangladesh and reproduced with their permission. The subject matter continues to be of importance in the context of the Maqasid al Shari’ah.
Islamic microfinance is becoming an increasingly popular mechanism for alleviating poverty, especially in developing countries around the world. The Islamic microfinance industry as a whole is expected to reach more than $2 billion dollars in 2012 and is a continually growing sector due to its ethical principles and prohibition of riba (interest). This amount of assets is, however, only 1% of the total microfinance of the world.
The concept of Islamic microfinance adheres to the principles of Islam and is a form of socially responsible investing. Investors who use their wealth for Islamic microfinance projects only involve themselves in halal projects, which benefit the community at large. Such projects include zakat, which is charity based or trade and industry projects to develop a country’s economy.
The mechanism of lending in Islamic microfinance differs from conventional microfinance due to the prohibition of riba. Unlike conventional microfinance, Islamic microfinance offers an interest-free way to give small loans to people who are poor and in need. At a time when poverty is still prevalent around the world, there is no better solution than opting for funding that can provide benefits to a poverty-stricken community and help to rebuild economies.
Islamic microfinance gives the investor a chance to get involved in worthwhile projects, which could essentially play a significant role in targeting poverty and alleviating it in many countries around the world. Islamic microfinance primarily relies upon the provision of financial services to poor or developing regions, which are subject to certain conditions laid down by Islamic jurisprudence. It represents the merging of two growing sectors: microfinance and the Islamic finance industry. It has the potential not only to be the solution to an increased demand to help the poor, but also to combine the Islamic, socially responsible principles of caring for the less fortunate with microfinance’s ability to provide financial access to the poor. Utilising Islamic financial instruments such as murabaha and musharakah to help in facilitating Islamic microfinance can not only act as a spur to the Islamic microfinance sector, but can also increase the options of Islamic finance and make it more accessible to poverty-stricken countries.
Hundreds of Islamic microfinance institutes have been developed across the world. As in many countries of the world, the Islami Bank Bangladesh Limited (IBBL) has launched an Islamic microfinance scheme to deal with poverty. In this paper we will see how it works and if it can indeed contribute to the alleviation of poverty.
Poverty: Concepts and Views Conventional vis á vis Islamic
In the conventional approach poverty is defined as any individual having an income of less than US$ 1 per day, while in nutritional terms the definition of poverty is a person’s inability to achieve nutrition levels of 2112 kilo calories per day.
By comparison, the Islamic approach uses the concept of nisab (the point at which people become liable to pay zakat), i.e. people having less than the amount of nisab are poor. This is a universal definition, which is applicable at any time and in any place in the world, while the definition of poverty in the conventional approach is not universal, i.e. it needs to be revised over time and it is not applicable in the developed countries of the world.
Approaches to Poverty Alleviation
Anti-poverty programmes can be broadly classified into two strategies. First are the indirect strategies that formulate a macro-economic policy framework to ensure sustainable growth, higher employment and higher per capita income to eventually reduce poverty. Second are the direct strategies that target the underprivileged population and provide them the necessary assistance to ensure credit access, improve health conditions, increase literacy rates and ultimately eradicate poverty.
Indonesia, Malaysia and Thailand are good examples of countries that have alleviated poverty through indirect strategies. These countries have pursued consistent macro-economic policies that have ensured growth rates of 6% or more and increased public spending on education, health, family planning, etc. for decades.
By contrast, Bangladesh is an example of a direct policy application where government and non-governmental organisations provide a set of services such as ensuring access to credit, healthcare and educational services to targeted underprivileged individuals.
NEWHORIZON January to June 2014
FOCUS ON MICROFINANCE
Differences between Conventional and Islamic MFI
Islamic microfinance has some fundamental differences from conventional micro-finance, which are presented in Table 1.
Islamic Microfinance around the World
There are a great many Islamic microfinance initiatives. There are more than 300 Islamic financial institutions in more than 65 countries managing assets of approximately US$ 1.0 trillion in a Shari’ah compatible manner and the annual growth is more than 15%. Some of the important microfinance programmes are presented in Table 2.
The Evolution of Islamic Microfinance in Bangladesh
The unwillingness of commercial banks to provide financial services to the poor is the major rationale for market intervention in financial services at the micro level. Keeping this idea in mind, in 1976 Prof. Dr. Yunus began a pilot project in Jobra village in the Chittagong district of Bangladesh to provide credit to landless and very poor people. Later, this project turned into a specialised bank named Grameen Bank. Presently, this credit system is recognised as micro-credit, which provides collateral-free credit to the poor through an institutionalised mechanism.
After that, thousands of organisations became involved in providing microcredit facilities to the poor. The prime goal of all those organisations was to provide credit facilities to poor people, especially rural women, without any collateral requirements. This microcredit is, however interest based and also does not care about Shari’ah compliance. Consequently, NGO-based MFls came forward with microfinance programmes as a poverty alleviation initiative to meet the financial requirements of the rural poor. Islamic NGOs in Bangladesh are a response to the need to safeguard the Islamic way of life and encourage the rural poor to practise interest-free transactions through financial intermediation.
Formal poverty alleviation initiatives under the Islamic framework were undertaken in Bangladesh during the 1990s, but those programmes, started after the independence of Bangladesh, can hardly be termed as rural development initiatives. Rabitat-al Alam AI-Islami is perhaps the only organisation that started its relief activities in 1977 among the Rohingya refugees and then extended its operation among the Biharis in Dhaka and tribal people in the Chittagong Hill Tracts and Rangpur. The origin of organisations like the Islam Procher Samity, World Assembly of Muslim Youth and Islamic Education Society can be traced back to the 1970s, but they did not have any credit component in their programmes.
At present, dozens of Islamic NGOs and cooperatives are working with micro-investment as one of their programme components. Poverty alleviation initiatives under the Islamic framework by the Islami Bank Bangladesh Limited (IBBL) are noteworthy. IBBL launched its Rural Development Scheme (RDS) in 1995 as a pilot scheme in the rural areas of particular districts under the direct supervision of the nearby bank branches.
Strength of Islamic Microfinance in Bangladesh
• Shari’ah based microfinance
• Collateral free
• Farming and off-farming activities
• Job creation
• Welfare and ethical services
• Qard facilitates for sanitation
• Select suitable villages within a 10 kilometre radius from a branch location;
• Conduct a base line survey to identify target groups of people and also to establish the base line situation;
• Organise the target people in groups of five people in a centre with a minimum of two and a maximum eight groups under the direct supervision of a Field Officer (FO);
• One Field Officer, who is a regular employee of the Bank, shall organise a target group of 400 from 400 selected families within the target group through the centres;
• The centre has to conduct regular weekly meeting on a fixed date and time in the presence of the FO to collect compulsory savings and weekly instalments;
• Each member is to make compulsory savings of Tk.10/ (US$0.15) each week;
• The investment amount along with the profit has to be paid back by the client members in 44 equal weekly instalments.
The Achievement of Islamic Microfinance
The Rural Development Scheme (RDS) is to alleviate rural poverty by providing small and micro investment to the agricultural and rural sector for generating employment and raising the income of the rural poor. The scheme also provides welfare, moral and ethical services to the rural people of the country. Brief information on this scheme is given below.
Potential of Islamic Microfinance in Poverty Alleviation
Financial transactions cover a significant part of the daily activities of human life. Applying and following Islamic laws in daily life activities, it is assumed that it will be easier to get rid of any illegal activities, harmful for mankind, if one works under an Islamic microfinance programme (IMP).
Firstly, most of the poor in Bangladesh have a strong belief and confidence that whatever happens in the world is pre-destined by Allah. Their poverty is not an exception. They strongly believe that properties, wealth, amenities and valuables come from Allah. In addition to that, they also believe that they cannot be freed from the curse of poverty until Allah wills. In case of any injury, mental depression or sickness, they consult religious persons, e.g., a local Imam from the Mosque to get their advice. Generally people maintain a strong belief that religious and pious people do nothing harmful for mankind. Following their advice and suggestions, poor people may give up their bad habits, such as gambling, stealing, drug addiction, etc., which are sometimes considered as causes of their poverty. As a result, poor borrowers will be motivated and attracted to IMPs for the alleviation of their poverty.
Secondly, unlike conventional NGOs and MFls, Islamic lending institutions provide loan money in kind and ownership of the commodity strictly lies with them until the borrower has fully repaid the financier. Moreover, regular repayment capacity depends largely on the productive use of credit. Thus, IMPs primarily ensure the productive use of investments and thereby enhance the repayment capacity of the borrowers.
NEWHORIZON Rabi Al-Awwal – Sha’ban 1435 FOCUS ON MICROFINANCE
Thirdly, IMPs are operated by personnel having an adequate knowledge of Islamic laws. So, qualified Madrasha students can be appointed as field officers. IMPs can create plenty of suitable job opportunities for them and thus their poverty can be alleviated.
Fourth, Islamic microfinance institutions, unlike any other conventional NGO-MFls, will not strive to maximise profit under any or all circumstances. As a result, microfinance products can be delivered at comparatively lower costs.
Finally, most rural women fear that joining conventional NGO-MFls may exclude them from practising pardah (the seclusion of women from the sight of men or strangers as practiced by Muslims). For this reason, many credit-needy women in rural areas do not participate in the conventional NGO-based microfinance programmes. Islamic microfinance can, therefore, be an alternative solution to overcome such fears because Islamic NGO-MFls promote and support the pardah or hijab system for the welfare of the Muslim
Challenges of Islamic Microfinance
From the beginning, Islamic microfinance programmes (IMP) in Bangladesh have encountered numerous challenges. The major challenges so far encountered by the Islamic NGOs, cooperatives and MFls can be described under the following headings:
Lack of funds for targeting the ultra poor
Funding IMPs is the major challenge for Islamic NGOs and MFls. In order to cover the poor living below the poverty line, a huge volume of funding is required. Due to lack of sufficient funds, many Islamic NGOs, MFls and cooperatives have failed to reach the poorest of the poor. As a result of misconceptions about Islamic views on the promotion of modernisation and the empowerment of women, donors and development agencies very often show little or no interest in funding Islamic NGOs/MFls, but conventional NGOs/MFls are heavily supported and funded by national and international donors and development agencies. Consequently, Islamic microfinance is yet to expand its country-wide outreach effectively.
National and international Islamic donors and development agencies should come forward to fulfil the funding requirements of the Islamic NGOs/MFls. Alternatively, like IBBL, other Islamic commercial banks and NGOs may initiate microfinance programmes.
Lack of entrepreneurial and managerial skills
Conventional NGOs/MFls have sufficient trained, skilled and experienced manpower. They are very familiar with rural poverty and have gained a lot of experience in poverty alleviation strategies since the independence of Bangladesh. They have a good relationship with national and international donors and development agencies. On the other hand, Islamic NGOs/MFls are working in limited areas with a limited number of religiously motivated, skilled, but less experienced manpower. As a result, despite their willingness, they are unable to expand their activities all over the country.
Lack of Islamic knowledge among the members
Due to lack of knowledge in Islamic rules and regulation, not all clients are aware of the Islamic modes of transaction that cause Shari’ah violations. If enough Shari’ah knowledge can be imparted to the clients then Shari’ah violations could be reduced, but if they have little or no interest in examining the nature and methods of Shari’ah compliance, the main goal of introducing Islamic microfinance may never be achieved.
Islamic microfinance is a model that could reach so many poor people on a sustainable basis that it would have a serious impact on their lives. We can do the best work ever, but if we do not reach scale, the impact will be limited. Similarly, we can reach very many people, but if the programme is not sustainable and it is relying on an external source of subsidy, the whole thing will collapse. It is also important that the programme is not just sustainable, but also that it makes a positive change in people’s lives. If we agree on this definition of success, then we can begin talking about the challenges facing Islamic microfinance in building such a model.
Recognising that there is a problem
The first challenge for those who are interested in building such a model is to recognise that there is a problem and to admit that we have failed so far in applying the definition of success defined above. Some MFls that have been in the market for a decade serving only 4,000 5,000 active borrowers thought they were doing a great job; that there was no problem and if they had more money they could serve more people. If we do not know that we are sick we will not go to the doctor and if we do not recognise that we did not succeed so far, we will not do anything to change the course of our actions.
We need to think about the sustainability of the model from the beginning. The MFI will have to cover all of its cost with a margin of profit from its own operations and not from donations or sadaqat or zakat. Those donations should be used to sustain the organisation and we should not channel them to the clients, because only sustainable MFls/banks can reach many poor people. If we can encourage rich people to invest in poor people’s projects and both have profits, we might reach a point where there are no poor any more except those who do not have any human capital and need relief.
Defining the target group
In conventional microfinance, there was a huge debate about whether microcredit is something that can serve all the poor including the poorest of the poor or not. Though there are still differences, the majority agree that the destitute poor will always need charity. The goal is to help ultra poor families to rely on themselves; to stop needing the stipends and to link them later with MFls from where they can borrow to expand their enterprises. Until this is clear and well defined, people will continue to be confused and the proposed solutions will continue to be confusing.
One of the challenges we need to overcome while trying to build an Islamic microfinance business model is to change some of the terminology we have been using, such as investment instead of loan and investor not creditor.
Lack of product diversification
Islamic microfinance in spite of the richness of fiqh literature remains highly murabaha centric; even ‘ijarah has not seen many takers unlike in mainstream Islamic finance. Profit/loss sharing, though highly acclaimed as an ‘ideal’, is hardly used. The ‘actual’ number of institutions based on zakah, awqaf and qard al-hasan is nowhere near the vast potential these institutions and ‘instruments offer. Agency problems with PLS in mainstream Islamic finance have already been highlighted as a matter of grave concern that pushes Islamic Fls to opt for debt-based products. They become particularly acute in rural settings.
Integrated Model of Islamic Microfinance – Zakat and Awaqf
The diversion of micro-credit for consumption purposes by the borrowers is one of the important sources of credit default in conventional microfinance. In addition the charging of a generalised, higher rate of interest has also hindered poverty alleviation through credit rationing and adverse selection problems. These basic challenges of conventional microfinance can be resolved if an Islamic microfinance institution is designed in an integrated manner by incorporating the two basic, traditional institutions of Islamic finance – awaqf and zakah, into a single framework.
Although the creation of such a singular institution may be premature given the present context, in this paper we attempt to outline the basic concept of such a singular institution. Such an integrated model may effectively resolve the fund inadequacy of Islamic MFls by using funds from zakah and awqaf. The IMFls may use the zakah fund in disbursing funds to fulfil basic consumption needs for the hard-core-poor target group in the first place, based on the principle that no return can be realised from zakah funds, which should be disbursed within one financial year. Zakah funds may also be used to provide capital investment or business initiation funds and for that no return should be charged. Awqaf funds, however, may be used as investable funds to provide capital investment and working capital financing for micro businesses.
Such an integrated model may reduce the chances of loan default because the basic inherent tendency of the poor to use the loan fund for consumption purposes will be met. As their basic consumption needs are covered, the poor micro-entrepreneurs may be in a better position to focus on their business alone. Moreover, the IMFI may initiate financing through different Islamic Shari’ah-compliant modes. Since Islamic financing modes are based on principles of social justice and equity and riba is prohibited, Islamic MFls are likely to yield better benefit if they are properly designed.
In conventional microfinance, there was a huge debate about whether microcredit is something which can serve all the poor including the poorest of the poor or not. Though there are still differences, the majority agree that the destitute poor will always need charity. The goal is to help ultra poor families to rely on themselves; to stop needing the stipends and to link them later with MFls from where they can borrow to expand their enterprises.
Micro-finance involves providing credit without collateral to the marginally poor. The weaknesses of conventional microfinance such as charging high fixed interest rates, credit diversion, credit rationing and nonconformity with the Islamic faith of the majority population necessitates the creation of Islamic microfinance. There is an opportunity for Islamic microfinance to grow by catering to the needs of underprivileged people.
Islamic microfinance integrated with two traditional Islamic tools of poverty alleviation such as zakat and awqaf in an institutional set-up will be able to touch the ultra poor. This model will be financially viable and sustainable in the long run, resulting from lower default rates and the proper use of zakah funds, which do not require any return. This will create a win-win situation for all stakeholders. All these factors will lead to lower default rates and the graduation from poverty will be higher.
To sum up, the integrated Islamic microfinance model will yield more benefit for overall social welfare. Finally, if a number of NGOs apply the integrated model, the aggregate benefit of alleviating poverty will be greater.
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Mr. Mohammad Abdul Mannan is currently the Managing Director of Islami Bank Bangladesh Limited – the largest private sector bank in Bangladesh. Before assuming the position of Managing Director in May 2010, he had spent 20 years working for the Bank in a variety of capacities. He is also leads the Task Committee of Islamic Banks Consultative Forum, the key body for Shari’ah based financial institutions.
NEWHORIZON Rabi Al-Awwal – Sha’ban 1435DEVELOPMENT FINANCE
The Role of Profit Rate
in Islamic Development Financing
The following article is drawn from the proceedings of the 5th WIEF (World Islamic Economic Forum) Roundtable 2012 held in Dhaka, Bangladesh and reproduced with their permission. The subject matter continues to be of importance in the context of the Maqasid al Shari’ah.
The objective of this article is to bring out the central role played by the rate of profit and its components, the profit-sharing ratios, as microeconomic and macroeconomic variables in the Islamic approach to development planning. The objective criterion of Islamic development cooperation is recognised as the knowledge-induced simulation of an underlying integrated shura-based social welfare function derived from social consensus formation. This social welfare model is implicitly invoked here, not explicitly formalised.
The shuras that will be invoked in this analysis are of the most embryonic type at the micro level. They thereafter integrate with the higher levels of shuras through the process of interactions and interrelationships on the development issues at point.
The grand shuratic social welfare criterion at the embryonic levels is the integration through discursion of the representatives on the critical socio-economic variables (state variables) and the policy variables. The critical state variables are taken here as consumption, production, income and entitlement, with their disaggregation by urban and rural sectors (or a suitable indication of income groups). The policy variables relate to equity participation, profit sharing, co-financing, foreign trade financing and secondary capital market instruments.
The policy variables are induced by the principal set of Islamic instruments and institutions that guide all other policy orientations. These central premises are the elimination of financial interest, the institution of mudarabah, zakat and the elimination of israf.
Simulation of the interactive-integrative social welfare criterion signifies a discursive approach to consensual (or agreement-based) decision making on the issues at point. Such social consensus of agreement is brought about on the basis of Shari’ah knowledge on the issues governed by the characterising set of state and policy variables. Thereby, each of the above sets of variables is characterised by knowledge-induced assigned weights by the sharees that vary both with time as well as with different groups of ‘decision makers.
Formalising Interrelationships between State Variables and Policy Variables
The multitudes of interrelationships and changes that are found to exist between state variables and policy variables and which affect the consequent decision making by the sharees make the consensus development process a difficult one. The independence problem is explained by formalising some interrelationships among the state variables and the subsequent expected effects of the policy variables on these state variables. The central role played by the profit rate and its component, the profit-sharing ratios as micro-macro interfaced variables for policy coordination will thereby be brought out.
Let xi denote the general symbol for the variables, consumption (i=1). investment (i=2), output (i=3), trade flow (i=4) and money supply (i=5); xi denotes the state variables for 1=1,2.....5.
Let r denote the rate of profit,
z denote the zakat disbursement,
R= N/L denote the ratio of necessaries (N) to luxuries (L),
(N/L) is proxy for the reduction in the israf variable.
Q denotes the shuratic simulative parameter indicating weights/ordinals attached to a particular stage of the group preference on the choice of policy variables. These ordinals represent the level of knowledge formation in the continuous iterations, interactions and integrations that go on the shuratic process referred to above.
Each of the above variables is a function of time and Q variables.
The critical interrelationships among a diversity of changes among the state variables and their functional dependence on the rate of profit are brought out in Figure 1. As shown here, all the state variables are positive functions of the rate of profit, r, and of the zakat variable, z. The shapes of these curves, however, would be such that multiple intersecting points will arise among any two. The relationships are explained in the following.
An increasing amount of consumption expenditure is shown to be followed by investment expenditure increasing at a decreasing rate. This is the consequence of the nature of the consumption-investment menus of an economy during the process of its transformation to an Islamic state. We also note, however, that the Islamic economy, although investment-prone through its institution of profit-sharing, would also be subject to temporary marginal efficiency limitations on capital productivity, which can thereafter be pushed forward by new induction of knowledge formation. Likewise, increases in consumption follow an evolutionary (graduated) regime of the basic needs menu of development. In order to sustain both investment and consumption in their recommended patterns of evolution toward an Islamic economic transformation, the need for product, economic and risk diversification will be central. These conditions are the cause and effect of knowledge-induced change in an Islamic economy. The role of technological change as an appropriate product of knowledge formation to establish the conditions of Islamic economic transformation thus becomes a central one inducing the consumption and investment curves.
Consequently, the rate of profit would increase, drawing away capital from consumption activity into investment activity and vice-versa. Subsequently, the output curve, as the locus of the intersections of the consumption and investment curves, will denote multiple equilibrium values for resource allocation.
Such multiple intersections (equilibrium values along the output curve) among these curves would occur over time and over different levels of x’s. These points are shown by a, b, c, b’, b” in Figure 1, corresponding to the consumption curve, S1 the investment curve, S2, and the output curve, S3.
A similar formalisation can be argued out for the relationship among the trade-flow curve (S4), the money supply curve (S5) and the other curves mentioned above. For instance, the money supply curve, S5, could lie above and below a given long-term rate of profit. In addition, in the process of approximation of the rate of profit to the long run near-normal rate of profit in a transforming Islamic economy, there will appear multiple intersections (equilibria) with all the other curves.
The movement of the trade flow curve, S4 would depend upon the relative magnitude of the output-investment gap and the output consumption gap, while these menus interchange as mentioned above. For instance, when the value of output exceeds the aggregate demand for goods and services (consumer goods and investment goods); then export value will increase. This would result in the S4 curve rising upwards. Contrarily, when the output value is less than the aggregate demand for goods and services, the import value will increase. This would cause the S4 curve to move downwards. Multiple intersections (equilibria) are thus established again between any two curves and all of them.
Relationships between Critical Variables in the Islamic Economic Giving Rise to Multiple Equilibria
Higher zakat disbursement is expected to increase both the consumption and investment expenditure. In the first case, the effect is more pronounced with an ageing population under the incidence of zakat need. The second case applies to the productive effect of zakat at the grassroots levels. This latter effect is particularly enhanced in a regime of stable population change, wherein the structure of population remains young. Thus, in either case, an increase in zakat disbursement is formalised to have a positive effect on output through the aggregate demand stimulation, and vice versa.
To bring about the influence of trade invoked in the formalisation of Figure 1, it is expected that export-oriented industries will be positively affected by the productive enhancement of grassroots entitlement. This is also enhanced by the mudarabah-type inter-linkages among different sectors of the economy.
Contrarily, during a period of excess current consumption, an increase in zakat disbursement would only marginally increase import demand, because only basic needs are affected by such an increase in demand in respect Islamic policy orientations. Consequently, even in a consumption-prone structure of the economy caused by factors such as, ageing and unmet consumer demand, a net increase in the export value of goods would be expected by the increase in zakat disbursement. The only other factor that tampers with the S4 curve in these circumstances is the temporary limitation on the marginal efficiency of investment. This would decline with an increase in investment, causing multiple switches between consumption and investment expenditures to occur. The relationship between zakat and the trade flow curve in respect to the consumption expenditure and the output, are then, once again, seen to be controlled the rate of profit.
Next, the relationship between the money supply and zakat needs be formalised in relation to the growth of national income and thereby in relation to national economic profitability. Zakat collection and hence disbursement, is a positive function of national income and wealth formation. The latter remains independent of money supply and depends mainly on productive transformation and ownership; thus there is no direct relationship between money supply and the zakat level.
The effect of the relationship between zakat disbursement, output, and money supply, brings out the directly endogenous relationship of money supply with productive change. Money supply curve, S5 is, therefore, controlled totally by the rate of profit. The increase in zakat disbursement being a positive function of the output function, i.e. national income, the excess demand for money to undertake grassroots investment ventures, is also annulled by the supply of zakat funds. The total money demand function in the Islamic economy not having a speculative demand component and debt instruments, because of the absence of financial interest, is thereby determined by the endogenous clearance of the goods market. This means that there exists a one-to-one correspondence between the monetary sector and the products/services market in the Islamic economy in its evolutionary stages. Consequently, an excess demand and supply of money is progressively reduced and is so coordinated by policy and institutional presence as long as the products/services market is found to adapt towards its equilibrium.
The relationship between the rate of profit and zakat disbursement is thus expected to be positive when the simultaneity principle (negative trade-off in the ethical sense) between distributive equity and productive entitlement formation at the grassroots levels remains in place. Multiple equilibrium and disequilibrium conditions can exist, however, if coordination among policy and state variables is not attained. Consequently, such situations may turn out perverse results for zakat. An. example is when zakat collection is simply disbursed as current consumption spending. A negative relationship between zakat and the rate of profit can then be found to exist. This will cause the money supply curve to swing below the long-run rate of profit.
All such changes and interrelationships in the general equilibrium context of simulation among policy and state variables, reflected by the shuratic process in the social welfare criterion, reflect the absence and thus the need for effective policy coordination emanating from the embryonic shuras and integrating with the entirety of economic relations. Otherwise, the indeterminate nature of a compounding of factors will make any specification of the interrelationships an impossible task. The multiple intersecting points that will exist among the different relationships will provide perverse results for the Islamic economy.
The relationships between the state variables and policy variables are now specified by the following system:
(N/L) denotes the symbol indicating a given phase of the basic needs regime. These relationships provide constraint for simulating the underlying grand shuratic social welfare function.
The points of intersection between any two of the curves, S1 to S6, are important to note. They signify choices of the state variables in pairs that are consistent with an optimal choice of the knowledge parameter, 0. As these points shift over time due to policy shifts, they also correspond with different values of 0s. Finally, if it is possible to link together all the pairs of values of the state variables with optimal choices of 0-values, we- have a desired inter-temporal path of the state and policy variables. These are shown in Figure 1.
In Figure 1 again, r denotes profit rate, x denotes the vector of state variables, 0 denotes ethically induced policy parameters, 0s. These parameters project over time onto the (policy variables, state variables) plane of (x, r), but now there are multiple equilibrium points shown by the intersection of the curves S1, S2, S3, S4, S5, S6. These points are b, b’, b”, etc. The locus of these points is shown by abb’ b”.
The indeterminate nature of the multiple intersecting points among any two of the curves is complicated further by the time path of shifts in these curves. Both the basic needs’ regime as well as the 0-values change. The 0-values are revised by the sharees in respect to their comprehension of specific issues in the shuratic process and the assigning of weights to the use of different development financing instruments. Thus, if the 0-curve shifts with changes in the knowledge parameters, there are altogether new points for the state variables. In this way, the multiple choice policy variables are shown again. This implies, that the shuratic social welfare function will be able to be optimised locally but not globally, with respect to a given set of knowledge parameters inducing decision making. This is the same thing as to optimise the underlying social welfare function locally with respect to corresponding state and policy variables, but not globally along a unique path of the 0-values. Thus, multiple values in the relationships among the state variables resulting from the 0-values will be reflected in social consensus formation. This will then result in multiple values for the social welfare function.
Extension of the Shuratic Social Welfare Formalisation to the Development Co-operation Problem of the Islamic Ummah~
It is to be noted that so far the formalisation of the social choice formation under social consensus has been with respect to a given nation state. To generalise it to the case of Islamic economic cooperation in the context of the regionally-linked economic cooperation model, it is necessary to expand the policy set by a further incorporation of Islamic development financing instruments. Among the most important ones are equity participation and foreign trade financing, particularly of capital and intermediate goods that would promote the linkages between the primary and secondary sectors. There are, then, the secondary capital market instruments that would help mobilise the resources of Islamic countries.
These additional policy instruments must reinforce the key ones, namely mudarabah, elimination of interest, the institution of zakat and the avoidance of israt. It is implied, that the goals of Islamic development cooperation is structural transformation, most importantly keeping in view the objectives of self-reliance through grassroots entitlement formation and distributive equity in a simultaneous framework and not in the conflicting policy trade-offs reflected in neoclassical models of resource allocation and development.
Equity Participation as a Key Islamic Development Financing Instrument
Let us look first at equity participation in this context. In an inter-country context within a given region, an equity project would mean a multi-national joint venture in which the benefits are jointly enjoyed by the investors in the project. Pooled goods are sold without the countries having to compete for the markets. The revenues are then shared equitably between the investors in respect to their proportion of equity in the project. Benefits are also enjoyed in respect of employment and utilisation of their common natural resources necessary for the production of the portfolio of primary and secondary goods with good linkages between themselves. The countries also benefit from adopting the appropriate technology of production in the equity project by orientating it to the progressively evolving basic needs approach to development and capital-labour-augmenting technical change. The equity projects also benefit the countries by opening up service sector diversification, wherein must lie the basis for complementary development for both urban and rural populations and on-the-job training programmes. These can be exemplified by the establishment of socio-technical schools at the grassroots levels.
Yet, despite all these, care must be taken that such joint-ventures do not turn out to be free-rider projects. That is to say, the measurement of benefits and costs must be so well monitored that each of the participants in the project receives their due share of the benefits. This objective can be achieved by having the social goods being produced by the project, to be cleared in a market setting, with minimal government interference except by guiding the shuratic directions of structural change and in jointly participating in market-viable projects.
When viewed in this above light, the profitability rate, r, of the whole economy in the region, becomes a function of the rates of profits earned by each country with and without the project. In the general case with equity participating joint-venture projects, the profit function can be written down as,
P = P (p1 p2 ..., Pm, P11, P12, ... P1m, , Pm1, Pm2, ... Pmn),
where Pj, i = 1, 2, ... m are the m number of profit levels for the m countries, respectively, without the n projects, j=1, 2 ... , n.
pij, i=1, 2, ..., m, j = 1, 2, ... , n; are the profit levels obtained in the presence of the n number of projects by the m number of countries, respectively.
Clearly then, the rate of profit for the region as a whole becomes an extension of the rate of profit for one country. It also denotes the profit rate as arising from the sharing of benefits of the joint-venture project in the region as a whole. It is not always necessary for each country in the region to participate in a given project to get the benefits of the project. Project benefits can be disbursed to others through the provision of social goods, like trade in basic needs, export of factors of production, supply of fresh water, trading facilities and industrial and marketing developments. Thus, there are service-related values generated by the regional profit-sharing venue of multi-national projects.
The effectiveness of shuratic policies and their monitoring to ensure policy compliance will be reflected in the magnitude of the various profit rates and in the diversification of risk, products and economics achieved by the projects. The shuras will be supported by their enforcing organisations belonging to the interlinked regional development framework. These organisations will look into the matter of enforcing the policies and directives of the shuras with the aim of realising Islamic structural transformation.
Profit Rate and Profit Sharing as Macro Policy Variables in Islamic Political Economy
It is to be noted too, that the surveillance by shuras along with their supportive agencies encompasses an entire domain of both macroeconomic and microeconomic matters. While the total rate of profit can be treated as a macroeconomic policy variable, its components, particularly the project-related rates of profit, are of a microeconomic nature. This brings up the important nature of Islamic policy instruments. That is, there cannot be a distinct category of these policy instruments between macroeconomic and microeconomic types. Macroeconomic matters must be determined by recourse to ethical policies, but which can only be possibly formed in microeconomic institutions. Microeconomic projects, thus, provide the aggregation levels for macroeconomic policy coordination.
Very briefly, the Islamic perspective on macroeconomic policies can be summarised as follows. Islamic fiscal policy depends importantly upon the zakat expenditure together with other expenditures by the government, private sector and households. These expenditures essentially channel themselves through mudarabah enterprises in the financial and goods sectors. In the case of consumption expenditures, they are determined by market forces and not by excess demand created and funded by governments. The zakat expenditure, treated either as consumption or investment expenditures by the recipients, is again a decision undertaken by households and enterprises. In each case of fiscal expenditure in the Islamic economy, therefore, there is a directly identifiable agent at work, one that is motivated by ethical considerations and by an institution of the mudarabah type. The profit rate here is, therefore, an average reflection of the price of capital good that is invested in or takes the form of resource allocation between consumption and investment activities at the level of the household.
In the case of monetary policy in the Islamic economy, the demand for money is determined by the demand for goods and services including investment. This is again a determinant of the enterprises that undertake investments and of households that demand goods and services. In addition the demand for goods and services and the appropriations of investments must be determined-by Islamic prescriptions. The most important one is investment in and production of graduated basic needs.
On the side of money supply, banks in the Islamic economy overwhelmingly act as investment banks, trying to match potential mudarabah’ investors with an appropriate investment portfolio. In this the banks themselves become shareholders or mudaribs. The supply of money being linked to the products/services market is actually a demand for investment. Only marginally do banks in an Islamic economy create or destroy monetary aggregates. Such a thing would happen only in the case of a need to pay off unwanted external debts. While, therefore, there is no debt financing for domestic economic needs, marginal debt financing may exist for paying off external debts.
The profit rate being the price of alternative investments in an Islamic economy, it stimulates the demand and supply of money in mudarabah enterprises economy-wide. The ethical questions on the side of investment and the goods market interrelate with the monetary considerations. There is, therefore, again the direct presence of micro-enterprises that activate the ethical-economic considerations in the Islamic economy. Monetary policy controlled by the rate of profit, thus becomes an economy-wide (macroeconomic) reflection of the ethical microeconomic policy variable.
The Goal of Maximising Profitability and Risk Diversification in Equity Projects
Finally, the important conditions for mudarabah enterprises as joint multi-national ventures in equity participation, namely, profitability, risk and product and economic diversification, must be kept in view by the shuras as embryonic polity and their supporting organisations. It is well known in development cooperation that in general international development organisations finance public projects. This can raise problems of free ridership in the sharing of costs and benefits from them. This can lead to a loss of efficiency and cause inequitable distribution of costs and benefits among the participants. In the field of economic cooperation such free ridership causes conflicts among the participants or welfare losses through market inefficiencies. An example here is the conflicts generated in the Common Fund sponsored by a group of developing countries of the UNCTAD (United Nations Conference and Development).
Through the action of shuras and their supported policy-enforcing organisations in minimising free ridership in multinational joint-ventures, economic efficiency would be promoted. A fair distribution of costs and benefits linked with such projects would be realised. Consequently, prospects for social consensus formation among the participants would be enhanced. It is necessary, that such conditions be optimally realised through a market system. In all of these relationships, the shuratic model of development cooperation, which is a policy-theoretic model based on ijtehadi (consensual) perspectives of development matters, becomes a social welfare simulation model in the sense of social consensus formation through knowledge-based discussion.
Such a model can be compared more successfully with the heuristic satisfying model of organisational behaviour rather than with the public choice model or with the new and old institutionalist economic models. The shuratic model differs from the neoclassical optimisation models because of its intrinsic departure from the utilitarian basis of the other models. It differs also because of its essentially theoretical foundation and worldview perspective which, for example, the old institutionalist school did not have.
NEWHORIZON January to June 2014
When equity participation takes the form of co-financing, there are more complicated capital market issues that must also be addressed in conjunction with the two important aspects of such joint-ventures, namely, the goals of profitability and risk and product and economic diversification in a regionally-interlinked framework of development cooperation.
In order to look at both the economic efficiency as well as the distributive equity sides of project financing simultaneously, co-financing in Islam would not mean a simple grant or concessional funding of projects by Islamic development organisations. In the spirit of minimising the free-ridership problem in such projects, the co-financier must be a participant himself, be it through direct equity participation or via a middle institution facilitating the joint-venture. The Islamic development organisation in this sense thus becomes a mudarib in the venture, just as a financial intermediary would act as a mudarib along with other enterprises and individual investors in the domestic Islamic economy.
Co-financing would, therefore, be determined by the capitalisation of the project with suitable expected rates of return. This would have to be followed by continuous monitoring of the project in order to realise at least that targeted expected rate of return. The shuras as embryonic polity along with their supporting policy-enforcing organisations play an important role in this. They must see to it that the participants of the regionally-interlinked cooperating countries, development organisations, community-based organisations and enterprises, all coordinate their efforts toward realising the Islamic development principles and instruments while realising the profitability, product, economic and risk diversification goals.
Co-financing, being motivated by the simultaneous goals of economic efficiency and distributive equity in the Islamic regionally-interlinked development context, must be supported by proper capital market instruments. Here, development organisations can think of floating short and long-term participatory certificates. The Islamic Development Bank (IDB) has proposed several of these items in the form of trade portfolio certificates, long-term trade financing certificates of deposits revolving around its foreign trade financing as a short-term one or around its leasing and equity participation. There are also the certificates of deposits on the IDB Unit of Deposit and in the Islamic Banks portfolio. The important task now is to see how these outlets of capital market investments can be efficaciously run in freely operating market economies of Islamic countries.
Debt-Equity Swapping In Comparative Islamic Frameworks
Linked to co-financing is the idea of debt-equity swapping. This assumes the following financing method first, the investing company acquires existing debt in the secondary market or in the case of commercial banks utilises its own holdings. It then exchanges this debt with the debtor government for local currency so that the debt is retired. Finally, it uses the domestic currency to purchase local equity or finance approved domestic projects. As far as the debtor country is concerned, some of its foreign-currency-denominated debt has been retired early. Equity financing along with co-financing has thus the benefit of converting the inefficiencies of the debt burden of developing countries into productive investments. The returns from these investments would consequently pay off the company or firm that buys the debt. That is, it swaps debt for equity.
In the Islamic approach to development financing, however, the debt-equity swap would have effects on the debt burden different from those assumed under interest bearing transactions. This difference is explained with the help of Figure 2.
In figure 2, let,
D denote the volume of external debt outstanding,
V denote the value of the debt repayment,
E denotes the level of equity that may be invested to swap debt.
V (E,i) shows that the value of debt is a function of the volume of equity swap, E, and the rate of interest, i. Since the volume of debt outstanding increases with i, V(E, i) is an inverse function of the rate of interest, but as debt/equity swap increases, the foreign-currency-denominated debt of the debtor country is retired early. Thus V(E, i) is a positive function of the level of equity, E, but the level of equity in turn is a positive function of the rate of profit. Hence, V(E, i) is a positive function of the rate of profit, r, and inverse function of the rate of interest, i.
E (r) shows that equity is a positive function of the rate of profit, r.
The 45 degree line OC shows, that any point on it represents a full payment of debt, thus, the value of debt equals liquidation of an equivalent amount of debt. The curve OCLR is the Laffer debt relief curve, showing low levels of debt liquidated by the value of debt, i.e. up to the point C on the 45 degree line through the origin, but at the point L, the debt burden increases and with it default also increases. This becomes pronounced at the point R, where debt increases but repayment declines.
The Laffer debt relief curve essentially values debt outstanding in terms of the interest related discounted rate in a securitised market. The horizontal axis is taken to be a sum of debt and equity swap, [D (i)+E (r)]. This means, that by assuming debt as equity by the co-financing company, the debt of the country is not removed, but is really converted into another way of repaying it productively out of the yields on foreign equity in the debtor country.
It is, however, important to note that while in the Laffer curve with the interest related discount factor on the securitisation of debt, the curve OCLR applies; in the Islamic equity participation case the following holds instead.
With every increased rate of profit, the part of the Laffer curve applicable is the truncated portion OCL, OC’L’, etc, as the curves shift with increased debt-equity swaps. The locus, OCLL’ denotes a temporary equity driven debt repayment, but actually, with adjustment in the equity market, higher levels of debt are
amortised at points like C, C’, etc. The temporary locus OCLL’ .... tends to approximate to the 45 degree line. This proves the superior effectiveness of debt-equity swap in a securitised
market with the rate of return on equity replacing the rate of
This feature of debt-equity swapping in the presence of a profit-sharing equity market is essentially the arrangement for debt financing in the Islamic capital market. It shows that there can be good prospects for foreign investment in Islamic countries under the Islamic regionally-interlinked integration programme. The driving force in this catalytic capital movement is the rate of profit, or more correctly, the profit-sharing ratios among the participants. This brings us back to the mudarabah-type joint ventures in an Islamic economy revolving around several of the development financing instruments of Islamic economic cooperation.
One can now raise the question as to why equity participation has not proven to be successful in Islamic countries, while it remains an essential area of Islamic development financing. The answer may be found in the lack of favourable economic conditions for profitability, risk and the absence of product and economic diversification for joint ventures and for co-financing, a climate conducive to foreign investment, and above all, the availability of an Islamic capital market. So far, Islamic countries have only seen the inception of some prime development organisations and many development-related• agreements have been ratified between member countries under the banner of OIC (Organisation of the Islamic Conference) and IDB, but Islamic countries have yet to cover a sure mileage in the above directions with all their political and socio-economic resources. Political change would be a pre-requisite.
The Islamic Treatment of Foreign Trade Financing as a Development Instrument for the Ummah
The approach taken here is that any Islamic development ventures must be market-oriented. Consequently, they must be motivated by prospects of profitability and risk diversification and must satisfy the Principles of Social Justice (including Distributive Equity) and Entitlement Formation. This has been shown to be the case for the Islamic approach to the equity financing, co-financing and development of secondary capital market instruments in the regionally-interlinked model of Islamic development cooperation. The same can very well be extended to foreign trade financing. Foreign trade financing cannot be looked upon as simply a means of placing the unused funds of development organisations for facilitating trade flows. It must be directly linked to contributing toward the productive transformation of Islamic economies in terms of increasing value added in targeted sectors.
NEWHORIZON Rabi Al-Awwal – Sha’ban 1435DEVELOPMENT FINANCE
Figure 3 shows how foreign trade financing instruments can be treated as a development financing institution and not simply as a trade facilitator.
Two countries, A and B, reach their respective production and consumption points, (PA, CA) for country A and (PB, CB) for country B, by inter-bloc (inter-country) trade. Thus, the value of exports in one country equals a proportion of the value of imports in the other country, the proportion being aA, aB, for the two countries, respectively. The assumption of economic complementarity is made in this inter-bloc (inter-country) trading. If it turns out that more than one country in an economic region in the Islamic economic cooperation scheme is specialising in the same industries, then the symbols A and B would stand for two complementary regions, and so on. Thus, competition for markets between countries in the same region is replaced by the pooling of similar commodities for trading with complementary regions in the Islamic world.
The output expansion paths, OA, OB, thus represent aggregate outputs in the countries or regions, as the cases may be. It is also to be noted from Figure 3, that the given countries or regions are shown to be producing both types of goods, but of these only one is a tradable; the other is domestically consumed. The consequence of such a production menu is complementarity between the primary and secondary goods sectors in each country or region. This two-country or two-region case may be generalised to multiple countries and regions in the framework of the regionally-interlinked model of Islamic economic integration.
The value of exports for country A (region A) = PEA. EA, where, pEA, denotes the export price of traded good, QIA, in the amount EA, with QIA being the value of the labour-intensive goods in country A.
The value of import of part of these goods to country B (region B), after a mark-up of m in foreign trade financing is added to the export price, equals (PEA + m). IB = a. PEA EA, where, a denotes the proportion of the exports, EA of A, that becomes an import to B. Now,
EA = a. (1 + m/PEA). IB.
This shows, that the export of A increased for every unit of the import of B with an increase of m relative to the price, PEA (the real mark-up in A’s prices), for given value of a.
Likewise, EB=b. (1 + m/PEB). IA, means that the export of B increases for every unit of the import of A with an increase of m relative to the price PEB (the real mark-up in B’s prices), for a given value of b.
Thus, in both cases, foreign trade financing brings about gains in the export potential of countries A and B with the help of the mark-up in real terms. The above expressions for the mark-up relations can be modified by considering fob (free on board). prices and cif (cost insurance freight) prices, but this does not alter the result as stated.
Welfare Effects of Foreign Trade Financing to Islamic Integration
The positive foreign trade effect of the mark-up on the flows of goods translates into increased production and consumption effects. Note that with the real value of m increasing, the output expansion paths, OA’ and OB’, fan out to OA’ and OB’, respectively. The results of this are the larger trade triangles, PA’ CA’ OA, and PB’ CB’ DB, respectively. Along with these increased production and consumption effects of real mark-up comes the more pronounced complementary effect between the economies of A and B. This is shown by the outward tilt of the output expansion path, but since an increased production of the non-tradable goods can only mean home consumption, therefore, either of the two effects must accompany the increased production and consumption effects. Either population must increase or the new category of goods being produced must be of improved quality. This is of course the effect of the progressively changing basic needs regimes of production and consumption, with good complementarity between the primary and secondary goods sectors.
The backward linkage of the mark-up-induced productive and consumption change, while maintaining economic complementarity between A and B, is seen also in a greater utilisation of the abundant factors of production. Such factors would be of comparative cost advantage to A and B. We have therefore, denoted QI to be the value of either good, A or B.
In Figure 3, CAPA denotes the volume of import of A = volume of export of B. DAPA denotes the volume of import of B = volume of export of A. CBPB denotes the volume of export of B = volume of import of A.
The connection between the productive and consumptive changes in the economy and foreign trade financing shows that there must be direct link between this development financing instrument and the products/services market. Through such a channel, foreign trade financing also gets tied up with the overall profitability of the economy. It thereby plays an important contributory role in the formation of the overall profit rate as a policy variable for the fiscal, monetary and capital market matters of national economies in the regional integration set-up.
It has been shown in this article that a general theory of Islamic development financing can be based on the extension of the principles and instruments/institutions of Islamic political economy to the study of the international economy. Here, the very cooperative nature of the Islamic socio-economic order necessitates that the various development financing instruments revolve around the concept of profitability and product, economic and risk diversification. The principal examples of the development financing instruments, namely, equity participation, co-financing, capital market instruments and foreign trade financing, are shown to be generated through proper linkages between a selection of projects promoting equally labour-capital-augmented technical change, an evolutionary basic needs regime of development and mobilisation of resources at the grassroots levels with mudarabah-type ventures. The total rate of profit that so emanates is shown to play the central role as a policy variable in the market adjustment of fiscal, monetary and development matters.
Since the total rate of profit is shown to arise in a regional economic integration context, the model of Islamic economic integration is shown to be a regionally-interlinked system. In this, complementarity, not individuated competition between tradables and production menus, must be observed by the member countries and promoted by Islamic development finance organisations.
Underlying the modus operandi of the Islamic system of development cooperation is the indispensability of embryonic shuras at various levels, supported by their ijtehadi departments and policy-enforcing bodies. The crux of the shura is the interpretation and exercise of Shari’ah to various politico-economic issues facing the ummah. The methodology of these interpretations and ijtehad underlies the social choice formulation of an Islamic polity and thereby clearly defines the social welfare function whose simulation the polity-market interactions, the shuratic process seeks through the process of knowledge evolution.
Dr. Masudul Alam Choudhury is Professor of Economics in the Department of Economics and Finance, College of Commerce and Economics, Sultan Qaboos University, Muscat, Sultanate of Oman. He is also the International Chair and a founder member of the Postgraduate Programme in Islamic Economics and Finance, Trisakti University, Indonesia. Professor Choudhury taught economics for twenty-two years in Cape Breton University, Sydney, Nova Scotia, Canada before his retirement. He continues to conduct advanced research and to teach
NEWHORIZON January to June 2014
Ethical Behaviour in Business
In late 2013 Eversheds’ Multi-Faith Network* group hosted an event asking whether there is a place for faith in the context of business. Attended by 40 city professionals and with speakers including Paul Diamond, barrister specialising in the law of religious liberty; Fazl Syed, lawyer and member of the Institute of Islamic Banking and Insurance and Andrew Copson, CEO of the British Humanist Association, the debate was a lively one.
The ethical behaviour of business is rarely out of the headlines these days the financial crisis, the Occupy London protest at St Paul’s, phone hacking and scrutiny surrounding corporate tax regimes are just a few examples. The common themes to emerge when reading the miles of column inches which have been generated by such events are:
• do the current regulatory frameworks for business work effectively to encourage ethical behaviour?
• has big business really lost its sense of ethical behaviour and if it has, what are the options out there to get it back on track?
• or is it unavoidably inherent in the capitalist system we operate that profits sometimes do come at the expense of ethics, people and/or the planet?
Albeit not speaking at all from a religious perspective, a recent article published in the Huffington Post from Unilever CEO Paul Polman was striking. He talks about the ‘collective loss of our moral compass’ in the context of the recent financial crisis. It caused the conference attendees to think. If there is a collective lack of moral compass, for whatever reason, could that be a cue for religion to step in?
The guest speakers were asked to give their perspective on whether faith has a place in the workplace or any relevance in the debate as to the way business should operate and behave. The general consensus was that ‘honesty’, ‘justice’, ‘fairness’, ‘compassion’ and ‘caring about others and/or the environment’ were all accepted examples of ethical behaviour. As one can imagine, however, the conference attendees had strong views from both sides of the argument as to whether religion/faith is how you get there.
Unsurprisingly, those on the panel and in the audience from a religious background held strong views that faith was very relevant, if not essential, to their ethical behaviour. As one participant said in an offline discussion after the event, when he put on his work suit in the morning, he did not first take off his religion until he returned home. He was of course speaking metaphorically and yet there are people who do (or are required to) hide the symbols of their religious beliefs in the workplace maybe that’s a topic for the next debate!
Of course, there are very many people in business who do not have a faith and there is no serious debate that people who do not follow a particular faith or religion do not act ethically.As the speaker from the British Humanist Association argued, morality and ethics are developed through a combination of factors, such as family values and upbringing, schooling, the communities we live in and role models and being religious is not at all a prerequisite to being ethical. He too received a warm round of applause from the audience!
Everyone appears to agree that business needs to behave more ethically. As some commentators have said, it is not the system or
capitalism that is the problem; it is the people who operate it! Most businesses these days have adopted statements of core corporate values and principles. The overlap between corporate values statements, ethical behaviour and religious principles is for some very clear and comforting. For others religion is irrelevant to corporate values and ethical behaviour and any overlap is coincidental.
In every organisation’s workforce some people will be more religious than others and some will not follow any religion at all. Speaking for Eversheds, we want to encourage an inclusive and diverse environment within our firm and respecting religious beliefs is a part of that, but it is also just as important to understand and respect the many people who do not subscribe to a religion or do not wish it to be a factor in the workplace.
One of the conclusions from the debate was that disagreement as to the relevance of faith in
business/workplace ethics is inevitable, but having the debate promotes a better understanding of each other. Eversheds plan to have more debate of this type in the future.
In the meantime, the debate around the ethical behaviour of business will continue to feature prominently. The recent launch of the ‘B Team’** is one example of how business is meeting this challenge. Interesting times ahead!
* The Eversheds Multi Faith Network group is one of a number of diversity network groups at the law firm, including Perspective, Eversheds’ Lesbian, Gay, Bisexual and Transgender group; the Disability Employee Network; and Carrie, the firm’s network for female in-house counsel.
** The B Team is a not-for-profit initiative formed by a global group of leaders to create a future where the purpose of business is to be a driving force for social, environmental and economic benefit. The B Team includes Shari Arison, Sir Richard Branson, Kathy Calvin, Arianna Huffington, Mo Ibrahim, Guilherme Leal, Strive Masiyiwa, Blake Mycoskie, Dr. Ngozi Okonjo-Iweala, François-Henri Pinault, Paul Polman, Ratan Tata, Zhang Yue, Professor Muhammad Yunus and Jochen Zeitz. Mary Robinson and Dr. Gro Harlem Brundtland are honorary members of the team, representing People and Planet.
NEWHORIZON Rabi Al-Awwal – Sha’ban 1435POINT OF VIE
Nonperforming Islamic Loans
Loan repayment is always an issue. Non-performing loans, defaults, delayed receipt of loan instalments are a significant problem for financial institutions. Researchers are always in search of new and efficient ways to promote repayments, but repayment is more than an act of fulfilling promises. It is about behaviour.
Understanding human behaviour means collecting information about diversified human natures and how they respond to different conditions. Behaviour is not an independent factor. Unintentional and sometimes intentional behaviours are the outcome of culture, inheritance, situations, mood, time and space, perceptions, etc. Human behaviours are diverse in nature and keep on changing and adjusting according to conditions. Individual behavioural science is different from that for groups.
Stimuli are not always constant; they keep on changing in one way or another. Even if they are unchanged, their nature and intensity keep on varying and resultant behaviours also mutate. Behaviours are uncontrollable, but underlying elements and stimuli help in modifying outcomes. Changing the elements and stimuli is a planned activity in order to arrive at an expected future, but sometimes the results can be unexpected. Human behaviour is not a controllable science, but may be altered up to a level. Behaviour is developed over time and for that reason a substantial period of time is also needed to achieve change. Moreover, before attempting to change a stimulus, a change agent needs to understand the philosophy behind a specific stimulus. Changing stimuli creates a need for an in-depth study of how a stimulus was created, the philosophy behind it and the overall life of a stimulus. Even when the information is collected, understanding individuals or group of individuals, in order to achieve desired behaviour, is quite different.
The Muslim View of Repayment Default
How does a Muslim society view default? The Prophet Muhammad (pbuh) refused to offer funeral prayers for a Muslim when he came to know that the deceased had debts, unless surety of payment was provided (narrated in Sahih Bukhari).
The hadith not only provides laws in relation to debts, it also provides enlightenment about the importance paying debts. There is another hadith according to which if a person has the power to repay debts but delays, that person is a sinner (Sahih Bukhari).
These two hadiths give a clear picture of the Islamic verdict on timely repayments. More interestingly, the binding nature of these laws is without any discrimination; they apply to both Muslims and non-Muslims. Islam emphasises the importance of giving loans to those in need and on the other hand ensures timely returns. In a Muslim society repayment should conceptually not be an issue. We have very detailed and applied laws to protect repayments. These apply not only to repayment, but also to timely repayment provided the rules are strictly observed by borrowers.
Islam provides laws for every aspect of life and tells us what to do in any possible situation, which a person can experience in life. Muslims have been provided with comprehensive directives leading to a balanced economic system. All we need is to understand the fundamentals behind the laws and to follow Husn-e-Muamlaat (Beauty of Transaction), which is one of the philosophies behind the science that underlies a practical society guaranteeing the rights and obligations of both parties.
Let’s look at the issue in another way. While designing a product, prices are fixed keeping in mind the inherent risks of delays and defaults. If the risk can be mitigated, financial institutions can easily keep the price low and provide loans on easy conditions. If we analyse the situation in detail we can easily understand that the offerings are solutions for our needs. The cost of the facilities is an important factor especially in business transactions, because it is directly linked with costs and the resultant pricing. Likewise, we all know that price is an important factor in competition particularly in cost-leadership strategies.
Muslims are bound to fulfil their obligations and ensure justice in society. Islam focuses on promoting ethical behaviour and creating an environment in which repayment is not an issue. Financial institutions, while conducting business in Muslim societies, should be free of the fear of default and delays. It is a bilateral relationship; successful and low-priced offerings will not be a fairytale any more if both parties understand their obligations and fulfil their part. Islam allows taking a loan when it is needed, but, the loan must be used for the intended purpose only and repaid as agreed.
In the financial industry, we can see that a microfinance institution religiously emphasises the identification of a valid reason for taking a loan and ensures that the loan is utilised as intended. They know that this is the only way they can secure their lending and ensure repayments. Loan products, whether Islamic or conventional, must bear zero risk of delays or defaults. Institutions should be free of the fear of default and instead of employing R&D to search for new ways to prevent loans from becoming bad, should focus on designing more sophisticated products.
Debtors are also provided with rights in religion. Allah has announced rewards for those who waive or pay the loans of needy persons, but the main point here is ‘needy person’. If a loan is really utilised for the purpose for which it was taken there is no reason for loan to go bad.
Every delayed repayment has multiple effects; ranging from higher pricing to bankruptcy and finally no offering for financial need.
Syed Mehboob is an MBA graduate and holder of a PGD in Business Administration from IBA-Lahore and PGD in Islamic Banking & Issuance from IIBI-London. He has more than 10 years’ professional experience in the fields of audit, credit and business management, including a period with a leading micro finance bank. Currently he is working with Education Services Pvt Ltd (an international educational institution).
NEWHORIZON January to June 2014
January: How Should Indirect Taxes Deal
With Islamic Finance?
By: Mohammed Amin
Mohammed Amin began by addressing the issue of tax in general. He said that the phase two work being undertaken in a study of tax and Islamic finance was very different from phase one. In phase one, a 20 page questionnaire was produced describing four Islamic finance transactions – commodity murabaha, salam, istisna and sukuk in great detail. There were 68 tax-related questions on how these transactions would be treated in various countries.
Phase two will be basically desk research, although there will be a bit of a look at the outside world, for example how the UAE (United Arab Emirates) is planning to treat Islamic finance and VAT (Value Added Tax), because they are bringing in a VAT law and Singapore and the way they treat conventional financial services and VAT. Ultimately the report will consist of proposals about good practice in the view of its authors.
Mr Amin began by considering what makes a good tax; what kinds of taxes are there and it will then home in on consumption taxes, particularly VAT. Mr Amin stressed that the contents of his lecture were theoretical; at the practical level where the issue is changing the law, there are all kinds of implementation issues. The biggest of these as far as the UK is concerned is that there is no independent ability to change VAT law; that is a harmonised European tax. The only way to change the VAT system is for the countries of Europe to agree to change it; no country can change unilaterally.
What is a good tax?
Adam Smith said it all in The Wealth of Nations a couple of hundred years ago. He laid down four criteria – equity, neutrality, certainty and administrative efficiency. Mr Amin said that he would not talk about the first three of these criteria, but efficiency would come up every so often, when considering different kinds of tax and how they might work.
What can you tax? Everyone is used to income tax and capital gains tax. Consumption taxes are an interesting issue. Mr Amin said he was not aware of any tax anywhere in the world that is a genuine tax on consumption; instead consumption taxes work by taxing people when they spend money to buy something they might consume later.
There are also wealth taxes. There used to be wealth tax in the UK called Schedule A, which was abolished in 1961. This was a tax on imputed income from an owner-occupied house. Finally there are transaction taxes such as transfer taxes.
Transfer taxes are the point at which it starts to matter for Islamic finance. The very first tax change made by the UK in relation to Islamic finance was to real estate transfer tax or stamp duty as it was then; now it is stamp duty land tax.
The diagram shows a simple sukuk structure. A company owns some real estate and wants to raise finance. With the help of its investment bank it sets up a Special Purpose Vehicle (SPV), which in turn is owned by a charity, so the SPV is not part of the owner’s group. It sells the building to the SPV, which pays for the building by issuing pieces of paper, sukuk, to investors and gets in the subscription price, which it pays to the owner to buy the building. As soon as the SPV owns the building, it rents it back to the owner for a period of, say, five years.
The sukuk that have been issued to the investors are technically ownership rights over the assets of the SPV, effectively ownership rights over the building. The SPV is receiving the rent on behalf of the sukuk investors and it passes that rent to the investors. At the end of the period of the sukuk, five years in this case, the original owner will buy the building from the SPV and the SPV will pass the purchase price to the investors, because it is their building.
The UK has changed its tax law to eliminate all three instances of stamp duty land tax for the transactions shown in the diagram. It did that in 2009. Similarly, around the world many jurisdictions have changed laws related to real estate transfers in Islamic transactions. For example, in the state of Victoria in Australia, if you sell a house to a bank or a bank buys a house from a third party and supplies it to someone on an Islamic mortgage, which means that the house effectively changes ownership twice, only one stamp duty charge is applicable. There is a need to look at every jurisdiction to see how real estate transfers are treated in relation to Islamic finance.
Mr Amin said that Malaysia is a country he had looked at in quite a lot of detail. The Malaysians have done more thinking about Islamic finance than any other country with the possible exception now of the UK, which has thought very deeply about Islamic finance. One of the things that came out of the phase one study is the way that both Malaysia and the UK have been able to make their tax law fit Islamic finance, while taking very different philosophical approaches.
Mohammed Amin is an Islamic finance consultant. Previously he was a partner in PricewaterhouseCoopers LLP and led their Islamic finance practice in the UK.
He is a chartered accountant, a chartered tax adviser, a qualified corporate treasurer and a Council member of the Chartered Institute of Taxation. He is also a member of the IIBI Editorial Board.
There are three land transactions involved in the sukuk. There is the sale by the owner to the SPV; there is the renting of the building and in many jurisdictions, including the UK, renting a building is a transaction in land and finally there is the sale by the SPV back to the original owner. If all three transactions are subject to stamp duty land tax, that is a crippling penalty, which will make the transaction completely unfeasible. Bear in mind that a conventional loan secured on that building there would have been no land transactions and therefore no stamp duty land tax.
Malaysia has a central Shari’ah authority for Islamic finance transactions, the Shari’ah board of the central bank. They are able to specify what counts as Islamic finance and in particular Islamic finance structures and if a bank uses one of those transaction structures, favourable tax rules apply.
The UK, being a country that wants to keep religion out of its tax law, takes a completely different approach. It describes different types of transaction including investment bonds, which equate to sukuk, but they describe them in completely religious-neutral language. Both countries, however, get to the right answer, which is to avoid treating Islamic finance worse than conventional finance for tax purposes.
Consumption taxes fall into two categories – sales tax and value added tax. There are fundamentally different issues in these two taxes, although they sound almost the same. These are often obscured by people getting too immersed in the detail. It is necessary to look at the bigger picture.
NEWHORIZON Rabi Al-Awwal – Sha’ban 1435IIBI LECTURES
Sales tax is normally charged when something is sold. Imagine a company that makes tins of beans in vast quantities. It does not normally send direct to end users; it will normally sell to another business and sales tax is charged. The second business then sells to a smaller business and again sales tax is charged. That smaller business, say a corner shop, sells to the end user, so again sales tax is
charged. Effectively tax is charged at each stage in the chain and it is compounding, so if the item was first sold for £1, with a sales tax of 5%, the second business has paid £1.05. When it sells to the next business, allowing for some profit margin, it will charge the 5% tax on the price it paid, which already included tax, plus a profit margin. The more stages there are in the chain the more the tax element grows and this can feel unfair. If the tax is at a relatively small rate, no one may mind too much, but if the tax is at a substantial rate such as 5%, there is a lot of cascading.
It is possible to charge the tax only on the last sale to the final consumer. That might feel fairer and in some ways it would be. There is, however, one practical problem, which is compliance risk, because the three businesses outlined in the example are in reducing order of size with a very big business at the start of the chain and a very small business at the end.If sales tax were
charged only on the sale to the final consumer, all of the compliance responsibility of collecting sales tax would then be on the smallest business, which is the business most likely to falsify its results and indeed has the most opportunity to do so, because it is selling to the end consumer for cash. The earlier sales in the chain, which are bulk sales, will be sales for cheques or electronic bank payments, which are much harder to falsify and hide. There is no easy solution to that problem with the design of sales taxes. This is one, but not the only, reason why countries get rid of sales taxes in favour of value added taxes.
Value Added Tax
Value added tax is also a consumption tax, but it is designed to be borne only by the end user. It is also not charged to foreign consumers, so it becomes a kind of export rebate; it is a way of incentivising people overseas to buy goods by not charging tax. (With sales tax, if the goods are exported part of the way down the chain, there is often no easy way of getting back the sales tax that was built into the price of the goods.)
Crucially value added tax is charged at each stage of the value chain, which minimises the compliance risk and does that in a way that avoids compounding, which happens with traditional sales taxes.
The diagram shows a transaction with two stages in the chain plus the sale to the final consumer. There is a mining business digging things out of its own mine; it owns the ground where things are being mined. In theory, therefore, the materials being dug out of the ground are free. Yes, they bought the land at some stage, but how you attribute that to what is being dug out you have to leave to the accountants.
Digging out the materials incurs costs in the form of wages and, of course, the company want to make a profit. The diagram does not differentiate between wages and profits, because in economic terms both of those are the same thing – added value.
This mining firm sells things for 100, so an economist would say, ‘You have sold things for 100; it costs you nothing, because you found it free in the ground, so you have added value of 100.’ That 100 is made up partly of wages paid to human beings and partly of profits and both of those are components of value added.
The sale is to a manufacturing business, which will spend some more money on wages and make some more profits. The manufacturing business will sell it to the end user for 150. It does not really matter how much is wages and how much is profits, because both of those components are part of value added; the tax system does not care.
How do the transactions work for value added tax? The mining company has dug materials out of the ground for nothing and sells them for 100. Value added tax will have to be paid on that sale. Assuming a rate of 20%, there will be a tax of 20, which the mining company has to pay to the government. It gets that 20 from its customer, the manufacturer, so the customer pays 120.
The true cost of the purchase for the manufacturer is 100; 20 is tax. The manufacturer sells what it makes with the materials for 150; it is adding value of 50. It charges 20% VAT, 30 of tax, on the sale, so the end user pays 180. It does not, however, pay 30 to the government, because it has already paid 20 in tax to the mining business, so it pays 10 to the government.
In total the tax authority has now received 30 – 20 from the mining company and 10 from the manufacturer, which equals the VAT paid by the end user, which is the only sale that gives rise to real tax. There is no real cost/tax on the transaction between the mining company and the manufacturer; it is just accounting.
The VAT system also helps to reduce the compliance risk, because tax is being paid to the government at each stage of the transaction rather than leaving all the tax collection to the last stage of the chain, which is where the greatest compliance risk would be. This is why value added taxes are becoming so popular around the world with more and more countries changing from traditional sales tax to VAT.
NEWHORIZON January to June 2014
The examples have talked about goods, manufactured items, but the principle applies in exactly the same way to services; ultimately it is only the final customer that pays tax, although the tax is collected at each stage and paid to the government to reduce compliance risk.
There are two conceptual approaches to financial services and VAT. One approach is to say all services are just services; there is no need to differentiate between types of service. This would mean VAT is charged on financial services in exactly the same way it would be charged on any other service.
An alternative approach is to say that financial services are special and different and therefore need special and different VAT rules. It is quite common to do this, although it makes life more complicated.
The diagram illustrates the first approach. Here a depositor putting money into a bank, which then lends to another bank, which in turn lends to a borrower. This is a very common transaction. Each of these transactions/loans is a service. It is the supply of money in return for a payment, because each of these loans is interest bearing.
Loan two and three will attract VAT. Oddly enough loan one will not attract VAT, assuming that the depositor is not in business. If the depositor was a business registered for VAT it too would attract VAT.
In the alternative approach where financial services are deemed to be different from other services, the financial service might be ‘exempt’, which means no VAT is charged on that service, but the bank providing that service cannot recover VAT on its own costs incurred in delivering that service, e.g. building, computer systems, etc. That situation applies now in the UK with financial services delivered to people in the UK or anywhere in the European Union.
Another option within the alternative approach is to allocate financial services a ‘zero rated’ status. This means that no VAT is charged, but the bank can recover VAT on its own costs. There are also other possibilities involving a mix of these two alternative approaches.
VAT and Islamic Finance~
Islamic finance makes things much more complicated, because the legal form of a transaction can differ substantially from the economic substance of the transaction. The diagram shows an example using commodity murabaha.
In the diagram a customer is receiving £100 from the bank, but the transaction is not done in the form of an interest-bearing loan. Instead the bank buys £100 worth of a commodity and sells it to the customer for £105 payable in 12 months. The customer then sells that commodity to a third party for £100, which is its value and gets £100 in cash.
How does this transaction work for VAT purposes? How should the tax authority deal with the first transaction between the commodity seller and the bank? The safe approach is to charge VAT. If it is treated as an exempt transaction on the grounds that it is part of an Islamic finance transaction equivalent to a loan, there are all kinds of risks for the tax authority. In the first place it does not know that this is going to be an Islamic finance transaction.
Similarly in the sale by the bank to the customer, on what do you charge VAT? If you do not charge VAT, are you creating some kind of compliance risk? Is the customer the end user or is he going to sell the commodity on to someone else? There are the same kinds of issues when the customer sells the commodity to the commodity buyer.
If we assume the customer is not in business, in that case there is no mechanism for charging VAT, but VAT has probably been paid on the sale from the bank, so suddenly you have a massive, sticking cost of VAT. That problem does not go away in the UK. The UK cannot solve this problem unilaterally. There is a working practice in the UK where the mark-up is not subject to VAT, but that leaves the original 100 which is subject to VAT and the customer cannot get it back. If the customer is not in business, there is, therefore, a massive VAT cost in Islamic finance compared with conventional finance.
Is There a Solution?
Mr Amin said that his ideas on the subject were at the moment ‘off the wall’, but hopefully by the time of the final report these ideas will have been field tested with colleagues and tax administrators to see what they think of them. The first idea builds on UK practice. There are rules already in the UK for things that are in bonded warehouses. Things in bonded warehouses can be bought and sold without incurring any VAT, but this rule does not apply to private individuals, who are treated as if they are final consumers rather than businesses. If the rule applied to non-business persons as well, then essentially there is a solution. In a commodity murabaha transaction, provided the commodity remains in a bonded warehouse, all three of those sales are not subject to VAT.
Another idea invented by Mr Amin, which might be feasible in the electronic age, is that at each stage of the transaction, the bank, assuming it can be trusted by the government, issues certificates to the commodity seller and the customer stating that these sales are part of an Islamic finance transaction. Each person in the chain is then authorised to carry out the sale without any VAT being charged. All the electronic certificates are delivered to the tax authority, which is able to match them and see that there is a full, three-part, stepped sale. As a consequence the commodity is able to go all the way around the chain without incurring any VAT, but without the opportunity to disappear or for someone to do a runner without paying VAT. All the parties are named on the certificate, with identification, addresses, etc.
The final idea would be to allow the end consumer to charge VAT as a special one-off, if they are involved in an Islamic finance transaction. Even that, however, raises challenges in terms of process; how do you register that consumer for VAT purposes and are you creating as compliance risk, because that consumer would always be in a repayment position. They would be buying something for 105 on which they would be paying VAT and selling it for 100 also incurring VAT, so net there would be a VAT repayment due. That person, the consumer, however, is the least reliable part of the chain; it is a human being who might disappear. For example, “carousel fraud” chains have demonstrated that governments can lose billions in tax.
There are no easy solutions, but these are the kinds of solutions with which the study is
NEWHORIZON Rabi Al-Awwal – Sha’ban 1435
Thoughts on Structuring an Islamic Home Finance
Product in the UK
By: Iqbal Asaria
Iqbal Asaria began by saying that the content of the lecture was based on 30 years of reflection on the issue of what type of Islamic home finance is possible in the UK that is true to the Maqasid not just the form of the Shari’ah. He said that he saw developments in both banking provision and technology that can make it possible. Previously there were a lot of banking regulation restrictions, especially in relation to products that were sharing risks. Today he said there were many banks prepared to do things that had been thought impossible, as well as public, equity-sharing schemes, which had effectively changed the home finance landscape.
Home Ownership in the UK
There is a great demand for home ownership in the UK and particularly for affordable homes. Looking at 60 70 years of statistics on home ownership in the UK, it is evident that there has been a real, underlying 2 3% per annum rate of increase in house values, despite ups and downs. We, therefore, need to find solutions that capture that capital gain and offer it as a discount or a service to the buyer.
The most prevalent product in the UK market is a conventional repayment mortgage. Endowment mortgages have fallen by the wayside in recent years, given returns on investments. Typically mortgages are for a period of 25 years with a 95% loan to value. Lending is based on income multiples of a single person or a couple who are working. It is essentially a loan contract with the home as collateral. If there is a capital gain, the borrower keeps that, but, if there is negative equity, the borrower is still liable for the full amount of the loan and the lender can call on any other assets the borrower may have to recoup the loan.
Some of the subprime problems arose through unreasonably high income multiples and also on the practice of self certifying, where the lender simply takes the word of the borrower on his or her income. These are elements of the business that the regulator needs to address.
Islamic Home Finance
When the Islamic finance industry began to think about home finance 25 years or so ago, the challenging issue was how to replicate this loan contract as buy and sell contract. Most of the problems in Islamic home finance have resulted from trying to reverse engineer conventional repayment mortgage contracts.
The first attempt at Islamic home finance came from Al Ahli Bank. This was essentially a murabaha contract – fixed rate, full term, 25 years, but because it is a sale contract, if a borrower defaults in the middle of the term, he or she becomes liable to repay the full amount. Mr Asaria said that in his view murabaha was not suitable for a long-term contract and the industry discovered that it did not really work. It was also too expensive. Only about 50 people, in fact, took out that Al Ahli contract.
The second attempt was an ijara-based mortgage. The bank would buy the home and rent it to the would-be home owner, with the option to buy at the end of the rental period, but this contract says nothing about capital gain or loss. That contract too proved difficult.
The next instrument was diminishing musharakah, which is a diminishing ownership contract, where the would-be home owner buys jointly with the bank and the rental paid reduces the bank’s share in the property. Effectively it works exactly like a repayment mortgage. The problem arose when the home was increasing in value and accruing a capital gain. If the home buyer decided to sell after five years and the home had increased in value, but the home owner still only owned 40% of the property, technically the capital gain had to be shared with 60% going to the bank and 40% to the home buyer. What the banks did in practice was to forgo their share of the gain. If, however, the home buyer was in a negative equity situation, the bank could not force the buyer to fund 60% of the loss, because they were part owners.
As a result the banks did some engineering with the Shari’ah scholars and mixed musharakah and ijara to ensure that neither the gain nor the loss were shared, so that it became exactly like a repayment mortgage. One of the challenges that the Islamic finance industry has is that this product has nothing new other than substituting a rental for an interest payment. Ownership does not bring any advantages or disadvantages to the borrower or the lender.
In addition there are a number of other problems. Firstly, how do you determine the rental? Technically the rental should match market rental levels, but rental rates differ for very similar properties depending where it is in the UK. Clearly there is a lot of room for arbitrage there and no bank is willing to do that. Their solution was to fix the rental according to LIBOR (London Interbank Offered Rate), which is unrelated to the value of the house, its location or rental value. In terms of Maqasid, this does not take the industry very far; it is compliant in form, but that is the end of the story.
Fixing that product was quite a challenge, because when a loan contract is converted into a buy and sell contract, there was the issue of double stamp duty. The Islamic finance industry worked with the then Governor of the Bank of England, the late Eddy George, to resolve this issue, which resulted in a change to the Finance Act in 2005 allowing the two contracts to be considered as one. This was followed by other legislative adjustments to create a level playing field.
Other issues have been fixed informally. For example, council house tenants were given the right to buy their homes at a discount. If that discount was not passed on by the bank to the home buyer, there was a problem.
Another issue arises if a home buyer becomes unemployed and is unable to pay their mortgage. In this situation state benefits will cover the interest payments.
If however, the home buyer is a Muslim, paying rent, they are not covered, because the law stipulates interest payments. That too has been fixed informally with arrangements with local authorities.
That mixed musharakah/ijara contract is offered in the UK by Al Ahli, HSBC Amanah, Lloyds TSB, United Bank of Pakistan, Islamic Bank of Britain and Ansar Housing.
Alternative UK Schemes
Following the failure of endowment mortgages, the last Labour government introduced a number of equity sharing schemes. These meant that key workers, for example, were able to get up to 50% of their homes as shared equity with the government. The more recent Help-to-Buy scheme works in a very similar way. These schemes are technically very compliant with Shari’ah and share both losses and gains.
M Iqbal Asaria, a qualified economist and accountant, is an associate of Afkar Consulting Ltd. He is also head of European operations for Yasaar Ltd and non-executive director at Amiri Capital Services. He has worked as an investment analyst in the City of London for several years. More recently he has been involved in consultancy on financial product structuring and niche marketing services to faith and ethnic communities in the UK and was a member of the Governor of the Bank of England’s working party set up to facilitate the introduction of Shari’ah-compliant financial products in the UK market. He teaches graduate level courses in Islamic finance, banking and insurance at a variety of UK universities and business schools. He was awarded a CBE in 2005 for services to international development.
Mr Asaria said that he had been using home finance as one of the options for student projects for the last eight years. The projects asks – if you set out to design a product that shares both the loss and the gain from day one and then factor in a 2.5% gain, what kind of product will emerge? Will a bank be able to reduce the home buyer’s initial charge by 2.5%, which is the real gain they are expecting? If you assume that, then any product will be far superior to any repayment product that exists. Both the lender and the buyer will benefit and it is much closer to what a Shari’ah product would be expected to do, although it still does not solve the rental calculation problem.
There are also other products. One recent introduction has been from Castle Trust. They offer up to 20% of the equity as risk-sharing equity and take 40% of the capital gain in return. Borrowers pay nothing on the 20% of equity put in by Castle Trust. This is much closer to the spirit and not just the form of Shari’ah-compliant finance. The product is affordable and the repayment flow in the early years is more bearable.
Do Alternative Schemes Provide a Template for Islamic Finance?
Mr Asaria said that he believed the Islamic finance industry in the UK could arrive at much better products by using the model of sharing capital gain. These would have the added benefit of being within UK banking regulations. This model, however, does not solve the rental problem, the LIBOR link and inflexibility being particular issues. Above all it does not make mortgages more affordable; it is only compliant in form.
Is There a Solution?
Mr Asaria began by looking at the Muslim community profile in the UK. There are quite significant links within families, where wealthier members are often willing to help if they can do so without taking on credit risk and also ensuring that they have access to the money should they need it in the future.
A solution may be found in offset plans. Effectively credit balances are offset against loans and no interest is charged on the loan amount when it is balanced by a credit amount. If the credit amount is equal to the loan amount, the result is that capital is paid off more quickly and the overall period of the loan can be reduced, so a 25-year loan may be paid off in 10 11 years. Few people, however, are in that fortunate position.
The Cheltenham and Gloucester Building Society launched a product to address this issue and it was called the Friends and Family Offset Plan, where up to 8 10 friends or family members can link their accounts to the borrowers account to provide the offset. The borrower pays no interest and the friends and family providing the offset receive no interest on their deposits. The offset providers can withdraw at any time if they need to access their deposits.
Effectively this is a product that really reflects the profile of the Muslim community without compromising the Shari’ah. Unfortunately the Cheltenham and Gloucester Building Society no longer offer this product, but there are other organisations such as the Yorkshire Building Society and the National Westminster Bank that do offer it. It would, however, be quite possible for an organisation such as the Islamic Bank of Britain to launch such a product. The lender gets 10 customers for each product sale, with the potential for cross selling other products. Furthermore, any organisation offering such a product would be identified as a genuine provider of something that fulfils the Maqasid, something really different from conventional repayment mortgages.
The World Bank has said that its overarching objective is poverty reduction, a somewhat non-specific target. Mr Asaria said that he and others working with the World Bank have now managed to get Millennium Development Goals (MDGs) introduced, which set real
targets such as the number of children in schools and every World Bank project now has to say just how it will contribute to those MDGs.
He said that what Islamic finance has to do is something similar, demonstrating how every activity contributes to the Maqasid, not how it will duplicate something in the market. Islamic finance needs to do something more than simply emulate conventional finance. The technology is there to allow such products to be developed and there is no regulatory bar. The Islamic finance industry will not have a leg to stand on if it fail to take advantage of these opportunities.
NEWHORIZON Rabi Al-Awwal – Sha’ban 1435
IIBI Awards Islamic Finance Qualifications
In order to offer wider choice to potential applicants, IIBI launched its Diploma in Islamic Banking (DIB) by distance learning in January, 2010. The course builds candidates’ knowledge of Islamic banking concepts as well as their practical applications. It supports candidates seeking a career in Islamic banking and also their career progression in the Islamic finance industry.
Candidates having a graduate degree may take up the IIBI Post Graduate Diploma in Islamic Banking and Insurance (PGD), however those who wish to build a good foundation of Islamic banking concepts and operations, may opt to take the DIB course and later on progress to the PGD. DIB holders wishing to take up the PGD course will get an exemption from some of the Post Graduate Diploma modules.
Post Graduate Diploma in Islamic Banking and Insurance (PGD) Awards
To date students from more than 80 countries have enrolled in the PGD course. In the period April to June 2013, the following students successfully completed their studies:
► Oualid Benallou, Director of Stategy and Programmes, Caisse de Depot et de Gestion, Morocco
► Tayyba Manzoor, France
► Abdul Muumin Saeed, Business Devcelopment Manager, Sayga Investment, Ghana
► Abdulrahman Alfa Usman, Pension Administrator /Client Relationship, Legacy Pension Managers Ltd., Nigeria
► Agnelio Martio Pinto de Chicava Pita, Studies and Regulation Officer, Banco de Mozambique, Mozambique
► Hafis Bello, Business Development Consultant, SystemSpace Ltd., Nigeria
► Minerva Khidr, UAE
► Muhammad Mahdi, Sri Lanka
► Pinto Fulane, Assistant Director, Central Bank of Mozambique, Mozambique
► Victor Sabino Belane, Inspector, Banco de Mozambique, Mozambique
Ali Korrow Issack, Accountant, Kingdom Management Consultants, Kenya
The knowledge I have gained through the PGD is way more important and beneficial than any other ordinary course I could have ever taken. The course has given me a detailed understanding of the concept of Islamic banking, finance and insurance. My tutor has gone the extra mile in coaching me through the course by giving me the best remarks and guidance throughout my studies.
Fouad Marhoum, Operations Specialist, RBC, Canada
The course content was informative, pointing to the important issues still facing Islamic banking and insurance and giving a detailed biased yet balanced view.
Hamid Rustamov, Saving Advisor, GLZ, Tajikistan
After completion of this course my understanding of Islamic banking and insurance improved significantly. This course showed me that the Islamic banking and economic system is much more humanistic and directed towards the protection and support of people. As a former DIB and CIT student this course contributed toward deepening of my knowledge of Islamic banking and finance. After completion of this course I plan to continue my carrier in the Islamic banking and finance sector and contribute toward the establishment and development of this sector in my country. I also plan to continue my education further and seek the opportunity to apply for Masters in Islamic banking and finance courses.
Shayar Irfan, Assistant Manager, K&S Stores Ltd., UK
The Post Graduate diploma in Islamic banking and insurance course has allowed me to get an in depth knowledge about Islamic banking and insurance. Overall the whole course was so comprehensive that it touches every aspect of Islamic banking. The way the course tries to explain how Islamic Banking is different from conventional banking is very comprehensive. Before taking this course, I personally did not have a great understanding of Islamic banking and insurance and whether Islamic banking could be an alternative to conventional banking and insurance. This course has given me an understanding that Islamic banking and insurance is the best alternative to conventional banking and insurance.
NEWHORIZON Jamatul Thani - Sha’ban 1434GLOSSARY
An Islamic version of option, a deposit for the delivery of a specified quantity of a commodity on a predetermined date.
This refers to the selling of an asset by the bank to the customer on a deferred payments basis, then buying back the asset at a lower price, and paying the customer in cash terms.
A murabaha contract using certain specified commodities, through a metal exchange.
A ruling made by a competent Shari’ah scholar on a particular issue, where fiqh (Islamic jurisprudence) is unclear. It is an opinion, and is not legally binding.
Lit: uncertainty, hazard, chance or risk. Technically, sale of a thing which is not present at hand; or the sale of a thing whose consequence or outcome is not known; or a sale involving risk or hazard in which one does not know whether it will come to be or not.
A record of the sayings, deeds or tacit approval of the Prophet Muhammad (PBUH) halal Activities which are permissible according to Shari’ah.
Activities which are prohibited according to Shari’ah.
A leasing contract under which a bank purchases and
leases out a building or equipment or any other facility required by its client for a rental fee. The duration of the lease and rental fees are agreed in advance. Ownership of the equipment remains in the hands of the bank.
A sukuk having ijara as an underlying structure.
ijara wa iqtina
The same as ijara except the business owner is committed to buying the building or equipment or facility at the end of the lease period. Fees previously paid constitute part of the purchase price. It is commonly used for home and commercial equipment financing.
A contract of acquisition of goods by specification or order, where the price is fixed in advance, but the goods are manufactured and delivered at a later date. Normally, the price is paid progressively in accordance with the progress of the job.
Gambling – a prohibited activity, as it is a zero-sum game just transferring the wealth not creating new wealth.
A form of business contract in which one party brings capital and the other personal effort. The proportionate share in profit is determined by mutual agreement at the start. But the loss, if any, is borne only by the owner of the capital, in which case the entrepreneur gets nothing for his labour.
In a mudarabah contract, the person or party who acts as entrepreneur.
A contract of sale between the bank and its client for the sale of goods at a price plus an agreed profit margin for the bank. The contract involves the purchase of goods by the bank which then sells them to the client at an agreed mark-up. Repayment is usually in instalments.
An agreement under which the Islamic bank provides funds which are mingled with the funds of the business enterprise and others. All providers of capital are entitled to participate in the management but not necessarily required to do so. The profit is distributed among the partners in predetermined ratios, while the loss is borne by each partner in proportion to his contribution
An agreement which allows equity participation and provides a method through which the bank keeps on reducing its equity in the project and ultimately transfers the ownership of the asset to the participants.
An interest-free loan given for either welfare purposes or for fulfilling short-term funding requirements. The borrower is only obligated to pay back the principal amount of the loan.
In a mudarabah contract the person who invests the capital. retakaful Reinsurance based on Islamic principles. It is a mechanism used by direct insurance companies to protect their retained business by achieving geographic spread and obtaining protection, above certain threshold values, from larger, specialist reinsurance companies and pools.
Lit: increase or addition. Technically it denotes any increase or addition to capital obtained by the lender as a condition of the loan. Any risk-free or ‘guaranteed’ rate of return on a loan or investment is riba. Riba, in all forms, is prohibited in Islam. Usually, riba and interest are used interchangeably.
Salam means a contract in which advance payment is made for goods to be delivered later on. Shari’ah Refers to the laws contained in or derived from the Quran and the Sunnah (practice and traditions of the Prophet Muhammad (PBUH)
An authority appointed by an Islamic financial institution, which supervises and ensures the Shari’ah compliance of new product development as well as existing operations.
A contract between two or more persons who launch a business or financial enterprise to make profit. sukuk
Similar characteristics to that of a conventional bond with the key difference being that they are asset backed; a sukuk represents proportionate beneficial ownership in the underlying asset. The asset will be leased to the client to yield the return on the sukuk.
A principle of mutual assistance. tabarru A donation covenant in which the participants agree to mutually help each other by contributing financially.
A form of Islamic insurance based on the Quranic principle of mutual assistance (ta’awuni). It provides mutual protection of assets and property and offers joint risk sharing in the event of a loss by one of its members.
A sale of a commodity to the customer by a bank on deferred payment at cost plus profit. The customer then a third party on a spot basis and gets instant cash.
The diaspora or ‘Community of the Believers’ (ummat al-mu’minin), the world-wide community of Muslims.
A promise to buy or sell certain goods in a certain quantity at a certain time in future at a certain price. It is not a legally binding agreement.
A contract of agency in which one person appoints
someone else to perform a certain task on his behalf, usually against a certain fee.
An appropriation or tying-up of a property in perpetuity so that no propriety rights can be exercised over the usufruct. The waqf property can neither be sold nor inherited nor donated to anyone.
An obligation on Muslims to pay a prescribed percentage of their wealth to specified categories in their society, when their wealth exceeds a certain limit. Zakat purifies wealth. The objective is to take away a part of the wealth of the well-to-do and to distribute it among the poor and the needy.