NEWHORIZON September to December 2013News
Pent Up Demand for Islamic Pension Funds
According to estimates by Ernst & Young’s (EY) Global Islamic Banking Centre, the pent up global demand for Islamic pension funds is currently between $160 billion and $190 billion. At present, most of these funds are parked under conventional sovereign pension funds due to lack of investing options.
Ashar Nazim, Partner, Global Islamic Banking at EY said, ‘Several fast-growth emerging markets including Malaysia, Saudi Arabia and the UAE are
seeing strong demand for retirement plans that are Shari’ah compliant.
With the maturity of the sukuk market and Shari’ah-compliant equity indices, as well as technology available to screen conventional indices to carve-out Islamic sub-indices, there appears to be sufficient assets available for many of the pension funds to take the first step towards Shari’ah compliant propositions.’
EY go on to say that green-field operations would take too long to satisfy market demand and suggest the more practical approach would be the partial transformation of existing pension funds to carve out Shari’ah compliant subsidiaries. They caution, however, that this carving out would involve the valuation of pension funds’ assets at the date of transformation, which in turn may have legal, financial and tax implications.
Nazim added, ‘There is a clear preference by individuals in these markets to manage their financial affairs in a Shari’ah compliant manner. This segment represents anywhere between 10% and 70% of the overall market, which is sizeable. Traditionally, the focus had been on switching their banking relationship from conventional to Islamic. Only now are we beginning to see a greater awareness regarding wealth management and retirement planning, which in turn is encouraging public pension funds to consider offering Shari’ah compliant alternatives.’
A key decision is whether to allow members of the fund to transfer their existing account balance to the Shari’ah compliant fund or if only the future contributions should be segregated as conventional or Islamic. Additionally, the timing of such transfers is important.
Nazim continued, ‘We believe that the emerging demand for Shari’ah compliant retirement plans offers significant opportunities for financial institutions to diversify their products and strengthen fee income. This in turn will help improve profitability, which is clearly under stress for many Islamic banks.’
The report went on to say that Indonesia and Turkey are two other rapid growth markets with strong prospects for Shari’ah compliant pension programs. The development, however, is likely to be a gradual evolution due to the relatively smaller size of the Shari’ah-compliant asset management industry.
Nazim concluded, ‘Regulatory impetus will be critical for successful roll-out. Countries that are able to move swiftly are likely to strengthen their global leadership in Islamic finance.’
UK Leads the Islamic Finance Education Sector
Earlier in 2013, Thomson Reuters and the Islamic Corporation for the Development of the Private Sector (ICD) announced the creation of the ICD-Thomson Reuters Islamic Finance Development Indicator (IFDI), a numerical measure representing the overall health and growth of the Islamic finance industry worldwide.
The indicator measures five key components - quantitative development, governance, social responsibility, knowledge and awareness. Its first report covers the issue of education and based on its analysis, the IFDI has found that the UK is the global leader in Islamic finance education with over 60 institutions offering Islamic finance courses and 22 universities offering degree programmes specialising in Islamic finance.
Malaysia and the UAE, both established global Islamic finance hubs, followed the UK in terms of a comprehensive Islamic finance education infrastructure. Malaysia has 50 course providers and 18 universities offering degree programmes, whilst the UAE has 31 course providers and nine universities offering degree programmes. Pakistan was placed fourth, with 22 course providers and nine universities offering degree programmes. Overall the IFDI recorded 420 institutions offering courses in Islamic finance and over 113 universities offering Islamic finance degrees.
Malaysia also led in terms of research published on Islamic finance in the last three years, with 169 research papers, of which 101 were peer reviewed. The UK and USA followed with 111 research papers (56 peer reviewed) and 73 research papers (39 peer reviewed) respectively. A total of 655 research papers were issued globally on Islamic finance in the last three years, of which 354 were peer reviewed.
Khaled Al-Aboodi, Chief Executive Officer, Islamic Corporation for the Development of the Private Sector, said, ‘Our research shows that countries that build their educational infrastructure can benefit most from the growth of their Islamic finance industries. Through their research and thought leadership countries, like the UK, Malaysia and the UAE have the potential to significantly influence the direction of the regional Islamic finance sector.’
(Interestingly, in an article in this issue David Evans asks questions about the whole Islamic finance education industry – is it producing too many ‘graduates’, who have little hope of employment and should it have a stronger practical element. See ‘Where are all the promised Jobs in Islamic Finance?)
Closer Financial Ties Between Malaysia and the UAE
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.’
NEWHORIZON Zil Haja 1434 – Safar 1435 News
Professional Association for Shari’ah
In recent years Shari’ah scholars, their qualifications and fitness to serve on the Shari’ah boards of Islamic financial institutions have been constantly in the spotlight. Questions have been asked particularly about their understanding and knowledge of finance and economics and also their independence. A group of well-known Islamic scholars have responded to these questions by launching a self-regulating professional association, which aims to develop training and professional conduct standards for scholars. The organisation is called the Association of Shari’ah Scholars in Islamic Finance(ASSIF), a British-registered charity and it will address this longstanding problem with a clear, commonly recognised set of qualifications for scholars.
The new association aims to work with the industry’s existing bodies around the globe rather than replace them. Mufti Abdul Kadir Barkatulla, ASSIF’s deputy president said, ‘ASSIF will help to organise advisory providers with a verifiable unified standard of Shari’ah guidance. We expect a professional code of conduct and continuous professional development (standards) to be issued by mid- February 2014.’
Currently, standards set by industry bodies such as the Bahrain-based Accounting and Auditing Organisation for Financial Institutions (AAOIFI) are enforced in full or in part by some countries but not all of them. These standards focus on the intricacies of Islamic financial instruments and their accounting treatment, rather than scholars’ qualifications or their professional conduct.
ASSIF will have a governing council of between 10 and 30 scholars. Co-founders and trustees already include Bahrain’s Sheikh Nizam Yaquby, Syria’s Abdul Sattar Abu Ghuddah, Saudi Arabia’s Mohamed Ali Elgari and Malaysia’s Mohamad Akram Laldin, who share around 270 Shari’ah board seats around the world.
Significant Opportunities for Turkish Participation Banks
Thomson Reuters’ new Islamic Finance Country Report on Turkey forecasts that there is a significant opportunity for participation banks (the name used for Islamic banks in Turkey) to more than double their share of the total banking sector to as much as 13.5% by 2017 from the current 5.1%. Participation banks’ assets are growing 25% annually, twice as much as non-participation banks.
It also found that 38% of non-participation bank consumers would consider using a participation bank, although there is still significant need to educate Turkish consumers – more than 80% of non-participation finance customers and 40% of participation finance customers said they had little to no understanding of Islamic finance concepts.
Turkish participation banks have also had greater success than non-participation banks in finding profitable places to deploy new capital while remaining well capitalised. Participation banks’ average capital ratio is 13.7% compared with non-participation banks’ 17.4%.
The report is based on a national retail financial services perception survey and interviews with key influencers in the financial industry.
Ernst & Young Identify Problems for the Takaful Industry
During the period 2007 to 2011 the takaful industry enjoyed an annual compound growth rate of 22%, but according to the latest report from Ernst & Young this fell to 16% in 2012. They describe this as ‘an alarming deceleration’. In 2012 Saudi Arabia dominated the takaful market with a 51% measured by gross takaful contributions (GWC), with South East Asia, mainly Malaysia, having 25% and the GCC 16%.
This is, however, a story of two halves. Saudi Arabia and Malaysia are, by and large, doing well. They have larger populations than the Gulf States, for example and their gross written contributions per operator are also higher. The picture in other markets is far less rosy. Small operators are being dragged down by heavy start-up costs and companies are pursuing a limited market, which is already saturated, e.g. car insurance. The result is that they grow market share at the expense of profitability.
One possible way forward is for companies to develop their cross-border business, but they are hampered in this by different regulatory requirements and the lack of a standard approach to Shari’ah compliance. Even assuming progress towards a more level playing field in terms of regulation and Shari’ah compliance, the industry still needs large, regional champions to exploit the opportunities this would present and there is little evidence currently of any sort of consolidation that would allow such champions to emerge. On a more positive note the report suggests that the regulatory enhancements in rapidly growing markets such as Turkey and Indonesia will create new opportunities, providing operators can finds ways to meet this demand cost effectively and efficiently.
Interestingly the operators themselves identify the top two risks in the market as rising competition and evolving regulation. In the case of evolving regulation the report identified the new Malaysian Financial Services Act 2013, requiring operators to separate their general and family takaful businesses and Qatar’s decision to disallow takaful window operations as actions that are having a significant impact on the development of the industry.
NEWHORIZON September to December 2013News
Islamic Trade Finance Fund Launched
EIIB-Rasmala, a joint venture between the European Islamic Investment Bank and the Dubai-based Rasmala Leasing Fund has launched the Rasmala Trade Finance Fund. The company say the fund aims to offer a diversified portfolio of trade finance transactions exposed to different geographies, industry groups and individual companies in order to lower exposure to rising interest rates. It is designed to obtain enhanced investment returns from assets that can often be undervalued due to lack of recognition of their intrinsic payment capabilities. The overall strategy of the fund is expected to provide it with a means to achieve global diversification in both the primary and secondary trade finance markets.
Commenting on the new fund, Eric Swats, Head of Asset Management, said, ‘We are delighted to announce the launch of our latest fund, which will cater to the increasing demand for low risk, income-orientated Shari’ah-compliant investment products. The Rasmala Trade Finance Fund will provide investors with a low-risk alternative investment opportunity to obtain attractive and stable returns.’
Interestingly Ernst & Young suggested earlier this year that trade flows with the East and emerging markets are likely to grow and Islamic trade finance is likely to be one of the beneficiaries of this growth, providing Islamic banks can put together the sort of trade finance operations that will persuade businesses to switch to them. The EIIB-Rasmala Trade Finance Fund would therefore seem to be the right offering at the right time.
Emirates Islamic Bank has rebranded as Emirates Islamic. The new branding was the result of more than 12 months of market research. Jamal Bin Ghalaita, Chief Executive Officer, Emirates Islamic said, ‘The Emirates Islamic brand is a reflection of the transformational journey that we have undertaken over the past two years. It is a reflection of how we see ourselves today and into the future.’
First Gulf Bank has announced the completion of its acquisition of Dubai First. This is in line with FGB’s expansion strategy of developing existing businesses and offering more value to an expanding UAE customer base. Ms. Hana Al Rostamani will lead the newly constituted Board of Directors as Chairman of the Company.
It is reported that the Libyan Central Bank proposes to issue licenses for three fully-fledged Islamic banks in 2014. Apparently five local investors have lodged applications for these licenses. Evaluation of these applications is expected to be complete in the first half of 2014.
The Global Centre for Islamic Finance has opened in Istanbul. It aims to become a knowledge hub for developing Islamic finance globally, conducting research and training and providing technical assistance and advisory services to World Bank Group client countries interested in developing Islamic financial institutions and markets.
Maybank Eyes US Expansion
Malayan Banking Bhd, (Maybank) has identified at least four new areas to expand into, as part of its strategy to boost its operations in the United States. These include transaction banking, asset management, fixed income distribution and Islamic banking. The intention to expand in the US has been driven by the expected pick-up in the US economy and the future growth opportunities that this represents. The Maybank Group currently has a wholesale banking presence in New York, as well as a broking presence through Maybank Kim Eng.
Speaking at the opening of a new office in Park Avenue, New York Datuk Abdul Farid Alias, Maybank’s President and CEO said, ‘We are proud to say that Maybank remains the sole Malaysian bank in New York and one of the only three ASEAN banks to have a branch licence here.’ He added that as the US economy gained traction, the Group expected an increase in US-ASEAN trade flows. Two-way trade which stood close to $20 0 billion in 2012 is expected to grow further if the Trans Pacific Partnership is finalised. He believed that this would create opportunities for Maybank to explore new drivers of growth and revenue, especially in transaction banking, asset management, Islamic banking and fixed income distribution including sukuk. He added, ‘By capitalising on our network and core strengths in Islamic banking, we will harness opportunities through better synergy between our broking and banking arms in the US.’
This announcement came just two weeks after the Group had
launched an Islamic asset management company in London. They positioned the new company as a gateway to the Asian Islamic finance industry for global investors. .
Maybank Eyes US Expansion
The governor of the UAE central bank, Sultan Nasser al-Suweidi has announced that the bank plans to develop an independent authority which will supervise the country’s Islamic finance industry, backed by legislation. It is believed that the legislation, which is being developed by the UAE government, will enhance the authority’s ability to influence industry practices.
NEWHORIZON Zil Haja 1434 – Safar 1435SUKUK UPDATE
Market Slowdown in 2013
Thomson Reuters Annual Sukuk Perceptions and Forecast Study suggests that the gap between the supply and demand for sukuk will reach its peak in mid 2014 and will then steadily narrow. The amount of outstanding sukuk currently stands at $237 billion and is expected to reach $749 billion by 2018. Issuance in 2013 stood at around $100 billion and is forecast to almost double by 2018 to reach $187 billion, with 2014 expected to show healthy growth of just less than 30% to reach $130 billion.
To say that Malaysia dominate the market is something of an understatement. In 2013 Malaya issued $53.3 billion of sukuk, with Saudi Arabia in second place with $8.7 billion, the UAE third with $5.2 billion and Indonesia fourth with $5.0 billion.
Dr. Sayd Farook, Global Head of Islamic Capital Markets for Thomson Reuters, said, ‘Although the sukuk global market in 2013 has slowed down in terms of new issuance, we see positive signs in 2014. We expect the appetite for sukuk to increase in 2014 as cross-border sukuk issuances continue to gain momentum. Critically, we are seeing increased support from governments with a number of countries finalising regulations to allow the issuance of sukuk in their local markets. Countries such as Morocco, Nigeria, Oman, South Africa and Tunisia have also shown great interest in issuing sovereign sukuk in 2014 to finance infrastructure projects.
‘Despite the healthy outlook for 2014, several sukuk market challenges remain unresolved. Deficiencies still persist in the areas of transparency, standardisation and liquidity in the secondary market due to limited trading mechanisms and the different treatment of certain sukuk structures in different jurisdictions.’
Interestingly the study sees some signs of change, which may encourage growth in the secondary market. In the 2013 survey only 14.2% of investors expected to hold sukuk until maturity, down from 25% last year.
The study is based on a survey of sukuk lead arrangers and investors, predominantly based in Islamic markets in MENA and South East Asia, conducted in August and September 2013.
Senegal Signs Sukuk Agreement with ICD
The Islamic Corporation for the Development of the Private Sector (ICD), an entity of the Islamic Development Bank Group (IDB) and the government of Senegal have signed a sukuk agreement, which is the first of its kind in the West African Economic and Monetary Union. The signing of the agreement took place in Washington DC during the World Bank/IMF Annual Meeting.
Mr. Khalid Al-Aboodi, the CEO of ICD, represented the Corporation, while Mr. Amadou Ba, the Finance Minister of Senegal represented the government of Senegal. The Sukuk agreement worth US $200 million is expected to be implemented from as of 2014. ‘We hope this sukuk will serve the purpose of the government and the people of Senegal. We are grateful for the trust bestowed by the government of Senegal on ICD’, said Mr. Al-Aboodi. ‘We will do our best to see that it is successful, and we hope this will open the door for other African countries to sign more sukuk agreement’, Mr Al-Aboodi told the delegation from the Islamic Development Bank Group and the Government of Senegal.
In his response, the Senegalese Finance Minister, Mr. Amadou Ba, expressed his appreciation to the ICD, and suggested that the President of Senegal, Mr. Macky Sall strongly supports this initiative. In fact, he has initiated legislative reforms to accommodate the products of Islamic finance. Mr. Amadou Ba stated that the government of Senegal is grateful for the cooperation with IDB and reiterated the interest of President Macky Sall for a stronger relationship with the Islamic World.
Tilal Development Sell Oman’s
Tilal Development Co has sold Oman’s first sukuk. The five-year, $130 million sukuk offers a rate of 5% and is based on an ijara structure.
It is believed that this is a move that will be emulated by other companies in Oman. The sukuk was privately placed with investors, the overwhelming majority of whom are believed to be local pension funds and banks.
Tilal, which is 40%-owned by the Qatar Investment Authority, plans to use the proceeds to expand the Tilal Complex in Muscat. The Complex incorporates the Muscat Grand Mall as well as residential and office space.
Cagamas Conclude Malysia’s Largest Commodity Murabahah Sukuk
Cagamas Berhad (Cagamas), Malaysia’s national mortgage company, has successfully concluded the country’s largest sukuk commodity murabahah issuance amounting to RM4.2 billion (Malaysian ringgits). The first issuance, which was upsized to RM3.8 billion from the initial issue size of RM2.5 billion due to overwhelming
demand, which attracted a book size of about RM8.0 billion from a diverse group of domestic and offshore investors resulting in a subscription rate of more than 3.2 times. Tenures range from 1-20 years.
The proceeds of this issuance, along with a second issuance of RM400 million in tenures of 1-3 years, will be used to fund the purchase of Islamic financing from the financial system.
Senegal Set to Issue Sukuk in 2014
The government of Senegal have been looking at the possibility of issuing a sovereign sukuk, but it has now announced that it is planning to issue its first sukuk in 2014. The sukuk programme is expected to be worth $200 million. This would be a cooperative venture between the the Senegalese government and the Jeddah-based Islamic Corporation for the Development of the Private Sector (ICD), an affiliate of the Islamic Development Bank. The Central Bank of West African States has indicated that it would be willing to accept the Senegalese sukuk in its repurchase operations.
Saudi Arabia’s Riyad Bank to Issue Sukuk
Riyad Bank is planning to issue a medium-term Sukuk in Saudi Riyal. It will be private placement offer to institutional investors in the local market. The sukuk will be for seven years maturity callable after five years with a variable return, which will be determined according to subscriptions.
Riyad Capital has been appointed as a financial advisor and lead manager to this issue.
Talal Ibrahim Al-Qudaibi, Riyad Bank’s CEO explained that Riyad Bank aims to diversify its sources of funding and reduce the asset/liability maturity mismatch by securing long-term funding and provide good investment opportunities for the bank’s clients and investors in the local market. The issue is expected to earn a high rate of investor interest given the bank’s strong financial position. This is supported by the bank receiving grade (AA-) from Capital Intelligence and (A+) from Standard and Poor’s and Fitch Agency, which are the largest global financial credit rating agencies. These ratings are considered the highest among all banks in the kingdom. They also confirm the stable outlook of the bank, which reflects the financial position of the bank.
Turkiye Finans Plan More Sukuk Issues in 2014
Turkish participation bank, Turkiye Finans, has announced that they plan to issue further sukuk in 2014. (The bank issued a $500 million sukuk earlier in 2013.) ‘We think that the experience we have gained from previous sukuk issues will reflect on future sukuk issues. We plan both domestic currency and forex-denominated sukuk issues in 2014,’ said Chief Executive Derya Gurerk.
IDB Chooses Dubai for its Third Sukuk Programme
The Islamic Development Bank (IDB) is planning to set up a $10 billion sukuk programme on the Dubai NASDAQ. IDB has already launched such programmes in London and Kuala Lumpur; this is the first in the Middle East. This announcement will boost Dubai’s attempts to establish itself as a centre for Islamic finance. IDB has so far given no timeframe for the launch of the programme. IDB is also planning to extend its London programme, from $6.5 million to $10 million.
NEWHORIZON September to December 2013NEWS SPECIAL
David Cameron Announces Plans
for a UK Sovereign Sukuk
It might seem strange to devote two pages to the announcement of a relatively small sukuk, just £200 million. The announcement is, however, seen as significant by commentators both in the UK and in the wider world. It is, therefore, worth examining what the announcement said and the reactions to it.
n October 2013 David Cameron, the British Prime Minister, announced the UK’s intention to issue a £200 million, five-year sovereign sukuk. In his speech at the World Islamic Economic Forum held in London in October 2013, he said, ‘First, for years people have been talking about creating an Islamic bond – or sukuk – outside the Islamic world. But it’s just never quite happened. Changing that is a question of pragmatism and political will. And here in Britain we’ve got both.
‘This government wants Britain to become the first sovereign outside the Islamic world to issue an Islamic bond. So the Treasury is working on the practicalities of issuing a bond-like sukuk worth around £200 million and we very much welcome the involvement of industry in developing this initiative which we hope to launch as early as next year.’
The key phrase is ‘the Treasury is working on the practicalities of issuing a bond-like sukuk.’ That is a statement that falls short of saying ‘we will do this’; it still leaves room for the Treasury to come back and say they have looked at the practicalities and they have decided against such a move. The Treasury has apparently been down this road before, although, it has to be said, before such a public commitment by a serving Prime Minister. On previous occasion they reportedly rejected the idea on the grounds of value for money. So, what is different this time?
Richard de Belder, a partner with international law firm, Dentons, believes there is a difference. He commented, ‘I view the announcement of the sukuk against a broader backdrop. In March the Government announced the formation of the Islamic Finance Task Force of which I was a member. Its role was, in part, to re-open a dialogue with the various players in the Islamic finance sector in the UK to re-invigorate the Islamic finance sector. Various areas were looked at including a UK sovereign sukuk, so I would say the announcement of the UK sovereign sukuk should be seen as part of the overall wish of the Government to promote and expand Islamic finance in the UK. I have had no indication that the Government has changed its mind either in terms of this bigger picture or in relation to the UK sovereign sukuk and this is further borne out by the Chancellor in his Autumn Statement referring to the various benefits that would flow from a sovereign sukuk issue. My understanding is that we have moved on from a ‘value for money’ analysis to looking at the practical steps that need to be taken to structure and document a sovereign sukuk issue.’ In his speech Prime Minister Cameron also said, ‘Foreign investment creates wealth, jobs and growth. And far from weakening our industrial base, that investment actually strengthens it. Islamic investment is already fundamental to our success.’ He went on to list some of the Islamic investments from which the UK has benefited including the London Gateway development, the Shard, the development of the Chelsea Barracks site and Battersea Power Station among others. It is also worth mentioning that the UK government is keen to consolidate the City of London’s position as a leading centre of Islamic finance. If the price of helping to achieve these twin objectives is a sukuk with somewhat higher costs than a conventional bond issue, the Government currently seem to think it is a price worth paying.
What has the industry had to say about David Cameron’s announcement? Bank of London
and the Middle East’s Finance Director and Chairman of the UK Islamic Finance Secretariat, Richard Williams, commented, ‘We are gratified, after years of championing a UK Sukuk issuance, that the Government has now taken this step. A sukuk will consolidate the UK’s position as a global leader in finance, deepen relationships with the Middle East and Malaysia and above all demonstrates pro-active support for the country’s Islamic finance industry. The ambition shown by the Government to cement the UK as a western hub for Islamic finance highlights just how much the sector has done to support the British economy.
‘There are six Islamic banks in the UK of which BLME is the largest that until now have been without a UK AAA-rated liquidity instrument. This challenge will now be resolved and is one of the final measures in creating a truly level playing field for the UK Islamic banks. In the future we hope that Islamic institutions will also be able to access schemes such as Funding for Lending in a Shari’ah-compliant manner.
‘At present the UK is the 9th largest provider of Islamic finance in the world, but a sukuk can only strengthen this position and provide further opportunities for growth for an industry that is predicted to be worth more than $15 trillion by 2015.’
The British Banking Association’s Executive Director, Simon Hills said, ‘This will offer greater choice for the Islamic banking community in the UK and will allow them to meet their regulatory liquidity requirements by investing in sukuk-style bonds for the first time. To fill the gap between now and the issuance of the Government’s British Islamic bond next year it would be helpful if the Bank of England was prepared to accept non-interest bearing deposits for liquidity management purposes from Islamic banks.’
The size of the proposed sukuk, £200 million is modest, but Mohammed Amin, Deputy Chairman of the Conservative Muslim Forum and former UK Head of Islamic Finance at PricewaterhouseCoopers, comments, ‘Despite its small size, I do expect this announcement, if followed through by an issue, to have a major positive impact on the perception of the UK as the leading country in Islamic finance outside the OIC (Organisation of Islamic Cooperation). Accordingly it will be good for London’s competitive position. He added, ‘The size of the issue has clearly been set at a value, £200 million, where the Government can feel confident that UK Islamic banks can take up the entire issue.’
Richard de Belder, Partner and Global Head of Islamic Finance at law firm Dentons is also bullish about the proposed issue. He told NewHorizon, ‘As for the amount, it is small but people I speak to believe the most important thing is that there is a sukuk issue, regardless of the size. The view of most people I know in the Islamic finance space is that they fully expect the issue will be successful and there would then be the expectation there would be subsequent issues. The sukuk issue will make a big difference. The announcement itself has generated a lot more interest and confidence in the future prospects for Islamic finance in the UK. It should also help globally in that, once a leading Western government has issued a sovereign sukuk, it should help persuade other governments to consider this form of finance. Within the UK it is important for there to be a sovereign sukuk benchmark before corporate sukuk can be issued for infrastructure projects and so this is another positive development.
‘It is also a critical requirement for the UK Islamic banks in terms of their liquidity management and regulatory compliance. Their ability to buy a Sterling-denominated sovereign sukuk will assist them in the expansion of their activities.’
Samer Hijazi, a director in KPMG’s financial services practice said, ‘I am very optimistic about the announcement and believe it will lead to increased Islamic financial investment in the UK across the financial services and infrastructure sectors. I believe that many outside the UK will see it as a confirmation of the UK’s desire to engage and do business with the Islamic world. It will consolidate the UK’s position as the leading hub of Islamic finance in the Western world. David Cameron’s statement that he wants London to stand side by side with cities in the Gulf states and Kuala Lumpur as an accepted and recognised centre of excellence in Islamic finance can only give further confidence that the UK is open to Islamic finance.’
The Government must, however, be careful about how they structure the sukuk. Two years ago Goldman Sachs notoriously fell flat on its face, when it proposed to issue a sukuk through the Irish Stock Exchange. There were a number of problems with the proposed issue, including the fact that it was based on the controversial reverse tawarruq structure. Although details are sparse at the moment, it is believed the UK Government will avoid this pitfall by electing to use an ijara structure backed by government property.
The response to the announcement has been positive, with publications around the world apparently viewing it as more than just a publicity stunt designed to coincide with the World Islamic Economic Forum in London. Some of the comments on the announcement are as follows:
Arab News commented, ‘London’s decision to issue sukuk opens the way for the Islamic finance industry to contribute something and add value to the ongoing search for solutions to current economic problems facing the world.’
The Kuala Lumpur-based Business Times described it as ‘a positive step towards the internationalisation of the Islamic finance industry.’
The UAE’s TheNational said, ‘In tangible financial terms, the UK sukuk offers Islamic investors a benchmark for sovereign debt in the western world. It will set up a yield curve for such financial instruments and the London Stock Exchange listing should ensure transparency and probity.’
KPMG’s Samer Hijazi agrees that the announcement could well have an impact beyond the UK. He said, ‘I believe other Western governments will follow this situation very closely. These remain very challenging economic times, but I expect that once the issuance goes ahead and is well received (over-subscribed in my view) by the market then other Western governments will take concrete steps to attract Islamic financial investment to their own shores. As I said, I am of the belief that this issuance, when it goes ahead, will be successful and, as such, should lead to further issuances.’ He warns, ‘The industry has waited a long time for this and it is critical that the issuance goes ahead in accordance with the timings announced by David Cameron otherwise confidence will be lost. This is a great moment for Islamic finance, an industry which is barely 40 years old and yet has so much promise that Her Majesty’s Government is prepared to publicly announce its commitment to the industry.’
There are, however some mean-spirited and sceptical voices determined to downplay the significance of the announcement – unsurprisingly the main culprits are the ‘usual suspects’ in the British press. Their voices are, however, drowned out by the welcome for this announcement from a wide range of commentators inside and outside the UK. A UK sukuk has been a long time in gestation and it is a fairly small ‘baby’, but the more optimistic commentators see it as a harbinger of more to come. It is now down to the Government. David Cameron himself has said the Government has the political will to make it happen and the positive response to the announcement suggests the goodwill is out there; now they need to get the technical details right. Given the experience and advice they have available to them, it would indeed be a miracle of mismanagement if they failed.
NEWHORIZON Zil Haja 1434 – Safar 1435FOOD FOR THOUGHT
Rational for the Prohibition of Interest in Islamic Economics
Interest on money is not equivalent to rent on goods; money is a medium of exchange and a unit of value not a commodity
Without reference to any particular time, place or condition, God Almighty prohibited usury in the Qur’an. Though the prohibition is gradual, its implementation is unconditional till the Last Day. There is no verse in the Qur’an and hadith where Allah (swt) declares war against any individual except the verse which discusses the prohibition of interest in chapter 2, verses 278-279.
“O ye who believe! Fear Allah, and give up what remains of your demand for usury, if ye are indeed believers. If ye do it not, Take notice of war from Allah and His Messenger: But if ye turn back, ye shall have your capital sums: Deal not unjustly, and ye shall not be dealt with unjustly.” (The Qur’an, 2: 278-279).
Wherever the Qur’an talks about disobedient servants, Allah refers to them as fools, who will be put into the hellfire, but in case of extravagance and interest, Allah (swt) admonishes them by a severe warning.
Logically anyone reading the Qur’anic verse on the war against interest givers and receivers will conclude that the war is not in opposition to poor people. It is clearly understood that the dealers of interest are the strong people in a society who are proud of their power and money. It is an unchallenged fact that contemporary financial institutions are very strong. They are backed up by central banks and governments. These commercial financial institutions circulate money in a particular class of society and deprive most of the people who live below the poverty line. Hardly any commercial bank works for the betterment of the underprivileged people of the society.
Many people argue that modern day interest is not similar to the usury of olden day. Earlier interest was based on exploitation and prevalent interest is based on just principles. Some people refer to the statements of several economists of the 19th and 20th centuries especially John Maynard Keynes, that interest is similar to renting land and property.
The permissibility of renting is based on the quality and nature of goods in Islam. The principle of Islamic jurisprudence does not permit the renting of perishable goods (talful ain goods) like rice and barley. Renting property, land and machinery are allowed in Islam; it comes into the category of non-perishable goods and there are minimum possibilities of Talfulaian in this particular group of goods. Rent is a reward for the depreciation of value and use of benefit in the case of non-perishable goods. Some financial experts believe that renting property and money is similar. In fact it is not so; the nature and quality of the goods is different. Islam does not consider money as goods. Even for the sake of argument if we consider money as goods then we cannot give money in rent due to its perishable nature. The borrower cannot return the exact notes (currency) received from lender. He may return another note of the same denomination, which is not allowed under the principle of Islamic jurisprudence.
Secondly money is a medium of exchange, a store of value and a unit of measure. Contemporary writings on the function of money do not accept money as goods. If money were to be considered as goods, it should have been mentioned in the function of money. Renting money is a phenomenon of banking and finance.
A classical scholar of the first Islamic century, Imam Hassan Al-Basri (May Allah have mercy on him), has described the nature of money in Islam. He says ‘Money is such a companion of yours that it does not benefit you, unless it leaves you.’ Moreover Imam Ghazali has said in Ihya-ul Uloom that money is an instrument which facilitates exchange of goods. Islam does not perceive money as the ultimate goal, but an instrument which leads to a goal. The one who uses money in a manner contrary to its basic purpose is, in fact, disregarding the blessings of Allah. Consequently, whoever hoards money is doing an injustice by defeating its actual purpose. He is like the one who imprisons a ruler or postman. For instance, if a ruler is imprisoned, he could not fulfil his duty towards his subjects and similarly if a postman is imprisoned thus he cannot distribute letters. The important news enveloped in the letter cannot reach the concerned person. Due to the delay in receiving the news the concerned person may suffer a loss or cause loss to an entire community. Hoarding or renting money is an attempt to poison money and preventing money rendering its duty.
There are more than seven places in the Qur’an where interest is condemned. There are two kinds of riba discussed in most of the book of hadiths. A careful study of riba-al-fadal and riba -ansia will remove confusion about interest. Riba bilfadl discusses usury in relation to goods and exchange. Taking a superior kind of goods and returning more of the same kind of goods of inferior quality is an example of riba-al-fadl. Riba-ansia discusses usury on lent money. (For an in-depth study kindly refer to Riba and Bank Interest by Najatullah Siddiqui and Sood by Maulana Maudoodi.)
Islam encourages ihsan and trade. Ihsan promotes compassion, generosity, sympathy, tolerance, kindness and humility, while usury develops greed, selfishness, cruelty and cold-heartedness in people. It oppresses the poor man.
Interest fosters a society of debtors and sleeping business partners and promotes the circulation of money only amongst the rich. Small entrepreneurs cannot have access to credit or loans due to high interest rates and poor credit in the market. Recent studies conducted by various research institutes show the unavailability of microfinance to farmers and small businessmen. Microcredit was found to be too costly in south India where many farmers committed suicide due to their inability to repay debts. Even after a lot of efforts by NGOs (non-government organisations) no commercial bank is prepared to offer micro loans on minimum interest rates or zero interest. Why would a commercial bank give loans to small businessmen or to farmers on a minimum interest rate when interest is considered profit and rent of money? Rather the bank will prefer lending to tycoons and creditworthy corporates that can shell out huge sums in interest.
According to the survey by the United Nation 20% of the richest people of the world consume 82% of the GDP (Gross Domestic Product) of the world. The remaining 80% of the world’s population is surviving on just 18 % of the world’s GDP. It shows a huge difference in the consumption patterns of people.
Our current economic and financial system is responsible for this disparity. Dr Yusuf Qardavi has quoted an incidence of the wellbeing of economy in his book Alfaqr walejoha fil Islam (Islam and Poverty) where a person roams with his money in the era of Umer bin Abdulaziz, but he does not find any needy person to accept it. That is the golden period of Islam which provides complete social, moral and economic security to its subjects. Some Ulama (Religious Clerics) and monarchs have imprisoned Islam in the mosque and the madersa (religious seminary). When the principles of Islam are implemented in the markets, courts and parliaments of any society, then all the said problems will be systematically solved.
Interest cannot bring an economy into a position of stability and equilibrium. Our economy is based on interest. Systematic economic research and development has been going on for more than 100 years, during which time there have been several financial crises, millions became unemployed, thousands of companies have been liquidated and a number of people passed away, yet economists and bankers could not solve the problem backed up by interest.
The practice of benevolence will be encouraged in society when the sacrifice of opportunity cost is promoted. Interest does not let people make that sacrifice. It corrupts the whole society, demeans human personality and induces negative growth in the economy.
Some scholars translate the Arabic Word ‘riba’ as zulm (oppression) and fasaad (corruption), which is an apt term given its ill effects on society.
Some businessmen argue that interest is the cost of inflation and it is quite similar to profit, but a careful study shows that it is not so. Inflation occurs due to the mismanagement of the supply of and demand for goods and services in the economy where profit is the outcome of business derived by deducting production costs from sales prices.
Islam promotes business through fair partnership using the mudarabah, musharkah, ijarah and wakala models mentioned in various hadiths and books of Islamic jurisprudence. Modern Islamic banking and finance uses these models to develop financial products such as mortgages, sukuk and takaful.
Irfan Shahid is an Islamic finance and economics professional and a Shari’ah scholar. He has taught economics and Islamic finance at various business schools in India, Europe and the Gulf. He has worked closely with eminent Islamic scholars and economists to nurture Islamic finance in India and abroad. He is currently teaching economics and Islamic finance to postgraduate students at the Rizvi College, Mumbai.
NEWHORIZON September to December 2013ACADEMIC ARTICLE
Revisiting the Principle of Tabarru’ in Takaful Structures
It has been widely accepted today that Islamic insurance or takaful, unlike its conventional counterpart, is based on the fundamental principles of mutual cooperation (ta’awun) and donation (tabarru`). Under the Islamic laws of transactions (fiqh muamalah), the existence of gharar (ambiguity) and maysir (gambling), which normally nullify an exchange contract (muawadah), are tolerated in a contract of donation (tabarru`). This corresponds to the Islamic legal maxim:
‘uncertainties are tolerable in a gratuitous contract’.
This is mainly due to the fact that parties who enter into a tabarru` contract do not aim to make profit out of the contributed sum and hence the potential dispute, which normally arises in a profit-making transaction, is deemed to be negligible in a gratuitous-based transaction. Furthermore, the issue of uncertainty is irrelevant since the contributor voluntarily gives away his property or right to the recipient without any consideration.
In contrast, conventional insurance, which is based on the principle of muawadah (exchange) and aims at making profit out of the insurance operations, is prohibited from the Shari’ah viewpoint since it contains gharar (ambiguity). This is particularly true since a person who pays the premium (insurance price) for the insurance policy has actually paid for ‘peace of mind’, which will indemnify him should any mishap occur in the future. Being free from uncertainties is never possible in the insurance industry, because uncertainties are peculiar and integral to both premium/contribution and claim/compensation.
On the other hand, the Islamic alternative to conventional insurance, also known as takaful, reflects a reciprocal relationship and agreement of mutual help between participating members who undertake to mutually guarantee and indemnify each other in a particular defined event. The act of guaranteeing each other implies mutual help and mutual indemnity on the basis of brotherhood deeply rooted in the tabarru` principle, which tolerates the presence of gharar.
Notwithstanding the above, many contemporary scholars have started to raise concerns about the current practice of takaful. This concern stems from the fact that many takaful products and operations have begun to converge closely to the practice of conventional insurance. In particular, the fundamental structure of takaful, which is premised on the basic concept of tabarru’, has started to be questioned, because many benefits are offered to the participants at the beginning of the takaful contract in return for the contributions paid to the tabarru’ pool managed by takaful operators. This article, therefore, aims to highlight some of the issues with regards to this fundamental issue of tabarru’, which has been used to underpin the concept of takaful, as an alternative to conventional insurance. To begin with, let us first understand the concept and principle of tabarru’.
The Concept of Tabarru’
Tabarru’ is derived from the word tabarra’a, which carries the meaning of contribution, gift, donation or charity. Tabarru’ technically is a unilateral declaration of intent, which is a contract with a particular nature in Islamic commercial law. The purpose of this type of contract is to give a favour to the recipient without any specific consideration in return. Unlike the exchange contract, this type of contract is valid and enforceable in Islamic commercial law even for no consideration.
The basis for tabarru’ is stated in the Qur’an:
‘It is not righteousness that ye turn your faces to the East and the West; but righteous is he who believeth in Allah and the Last Day and the angels and the Scripture and the prophets; and giveth wealth, for love of Him, to kinsfolk and to orphans and the needy and the wayfarer and to those who ask, and to set slaves free; and observe proper worship and pays the poor-due; and those who keep their treaty when they make one, and the patient in tribulation and adversity and time of stress. Such are they who are sincere. Such are the God-fearing.’ (2: 177)
It is also supported by many hadiths; for instance, in a hadith Asma’ narrated that the Prophet (p.b.u.h) said:
‘Give (in charity) and do not give reluctantly lest Allah should give you in a limited amount; and do not withhold your money lest Allah should withhold it from you.’ (Sahih Bukhari)
Essentially, tabarru’ is a contribution or donation that entails no return but rather a reward from Allah alone. There are two important pillars of tabarru’, namely the absence of counter-value and the intention to perform tabarru’. In the absence of any of the two, it is no longer considered tabarru’. For instance, if a donor contributes with an expectation of a counter-value from the donation given, then the whole transaction will be perceived as an exchange (muawadah) rather than a tabarru` contract.
The Issue of Ownership and Possession in Takaful
This basic structure of takaful premised on the tabarru` principle gives rise to one of the fundamental Shari’ah concerns, which is regarding the absolute ownership transfer. When a participant pays a premium to the takaful operator, he has effectively donated his contribution as tabarru`, hence, relinquishing his ownership over the object donated as prescribed by the rules of tabarru`. Ibn Qudamah in his famous book Al-Mughni asserts that hibah (which is a form of tabarru` contract) requires the gift giver to enable the beneficiary to own the object of hibah. It is further reiterated by Ibn Nujaym in Al-Bahr al-Ra`iq Sharh Kanz al-Daqa`iq that the most important implication of hibah will be the transfer of the subject matter to the beneficiary/donee, which entitles him to hold the title of ownership over the object of hibah (thubut al-milk li`l mawhib lahu).
Unlike the majority of scholars who deem possession as one of the pillars of hibah, Hanafi schools on the other hand regard it to be an important condition for the validity of hibah. According to Al-Utsaimin in Al-Sharh al-Mumti’ Kitab al-Waqf wa al-Hibah wa al-Wasiyyah, hibah will only take effect upon the recipient of the donation taking possession of it. This corresponds to the Islamic legal maxim ‘La yatimmu al-tabarru’ illa bil qabdi’, which means ‘tabarru’, will not take effect unless there is a possession’.
This hadith is based on the saying of the Prophet Muhammad (peace be upon him):
‘Hibah is not permissible unless it (the subject matter of hibah) is possessed’ (Al-Zailaie al-Hanafi, Fakhruddin Uthman Ibn Ali.Tibyan al-Haqaiq Syarh Kanz al-Daqaiq. Kitab: al-Hibah. Dar al-Kitab al-Islami). Hibah, therefore, is voidable without complete possession. This is further reiterated by a Maliki’s scholar, Al-Qarafi in his book, Anwar al-Baru’ fi Anua’ al-Furuq, who mentioned the following:
‘If possession does not take effect in hibah, it is void’.
Shafie scholars also shared the same view with regards to taking possession as an important pillar for hibah to be valid. They based their opinion on the famous saying of Imam al-Shafie in his book al-Umm:
‘Hibah and sadaqah are all permissible contracts which exclude compensation and should be completed by possession’.
Nevertheless, it is observed that a takaful contract cannot be considered a pure tabarru’ contract but rather a qualified or conditional tabarru’ contract due to the following reasons:
1. The contribution made by a participant in takaful is with consideration to a right to claim for compensation in the event of loss or damage of subject matter. Thus, the tabarru’ is not merely for charity but conditional upon certain consideration, namely the right to claim takaful benefits in the event of loss. Without such a right, he will neither participate nor perform the tabarru’. This is deemed to be a violation of the fundamental objective of tabarru’.
2. Takaful participants are normally obliged to pay different amounts of contributions depending on the different degree of risk exposure. This inevitably implies that their participation in the fund is conditional upon a certain amount of contribution to deserve a certain amount of compensation. Should the participant disagree with the amount, he will not be allowed to participate or benefit from the takaful protection scheme. Again this would be perceived as contradictory to the nature of tabarru` since the real intention of the contracting parties is not for donation, but rather to make them eligible for certain benefits under takaful.
3. There are some controversial practices in takaful operations which contravene the pure tabarru’ concept. For example, the surrendering of benefit, survival benefit or even the sharing of underwriting surplus among participants of takaful although they have surrendered all their rights over their moneys to the fund. It should not, therefore, return to the participants upon maturity of the policy or liquidation of the fund.
As an alternative to the pure tabarru` concept, the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) suggested the principle of iltizam bil tabarru’ or a commitment to donate to underscore the relationship between the participant and the fund. According to this concept, a contributor may donate a sum of money for mutual assistance purposes on condition that the balance, if any, should be returned to him. This will allow him to retain his ownership right over the initial contribution he made, with a provision allowing him to waive his right of ownership over the portion used to indemnify other participants.
This principle was expounded by Maliki jurists, whereby if a person commits himself to do a good deed without subjecting it to other conditions, he is obliged to fulfil it as long as he did not die or become bankrupt (See Al Hattab, Tahrir Al Kalam fi Masa’il Al Iltizam, Beirut: Dar Al Gharb Al Islami, 1984 at p 71). In takaful, the participants commit themselves to perform tabarru’ to other participants who sustain losses. This principle is important as the majority of scholars are of the opinion that tabarru’ is not complete unless the subject matter is transferred to the donee, although a commitment to donate has been given. This is observed in the question of hibah, whereby possession (qabd) of the subject matter is a condition for a binding hibah; this is the opinion of many jurists but not Maliki jurists.
The Maliki jurists, however, are of the opinion that a commitment to donate or give is sufficient to create a binding donation, based on the saying of Saidina Ali and Ibn Mas’ud that:
‘A gift, if specifically defined, is binding, whether received or not’ and to prevent the
materialisation of the saying of the Prophet:
‘a person who withdraws his gift or donation is like a dog that withholds its vomit.’ (Sahih Bukhari).
This principle is important in the case of takaful whereby, upon participating in a takaful contract, the participants are said to have given full commitment to pay contributions to the takaful fund; the fund is also committed to compensate them against any losses experienced by them, within the period of the policy. Thus, in case a participant delays payment of his contributions, the company can claim the contributions from him and it may be considered as his debt to the fund until he officially withdraws from the policy. The fact that he has not delivered his donation does not make him not liable to pay it as he has committed himself to pay it and it is already a binding contract. So, iltizam bil tabarru’ here is deemed to be binding and enforceable as iltizam or a pledge alone can create a binding tabarru’ contract. Asserting that takaful is a binding contract is important as it is the basis for the computation of the periodical contributions and the amount of compensation payable to the participant.
On the other hand, the relationship between the fund and the recipient of the compensation is said to be iltizam bil ta’wid or a commitment to compensate, which is a form of iltizam bil tabarru’. It is said to be a form of conditional commitment whereby the performance of the commitment is subject to the certain need, namely a claim by a takaful participant due to some loss sustained. Thus, in takaful, the contributions of the participant may be utilised fully or partially, thus allowing him to claim any underwriting surplus. This is based on the opinion of Sheikh Abdul Sattar Abu Ghuddah in Buhuth fil Mu’amalat wal Asalib Al Masrifiyyah Al Islamiyyah, vol. 6, Jeddah, Majmu’ah Dallah Al Baraka, 2005 at p. 300.
Hibah Bil Thawab
Notwithstanding the above, the question remains whether the counter-value in such takaful practice is tantamount to an exchange contract? This is so according to Al Hattab in his book Tahrir Al Kalam fi Masa’il Al Iltizam; if a commitment is given subject to a condition that when a donor contributes something, he is expecting a counter value then it falls under the category of hibah al thawab, a gift given to the beneficiary on condition that a reward is given to the donor in exchange. For example, I give this pen as a gift on condition that you give your book in return.
As indicated earlier, hibah is a form of tabarru’ or charitable gift in which the donor has unilaterally relinquished his right of ownership over the object of gift to the recipient or donee. The matter is known in classical jurisprudence as hibah bi al-thawab (gift with expected compensation) or hibah bi shart al-’iwad (gift with stipulated counter value). Shafie and Hambali’s scholars disallow such a transaction based on the following hadith:
‘A person who withdraws his gift or donation is like a vomiting person who withholds his vomits’.
This is also supported by another hadith narrated by Al-Tarmizi:
‘A person who withdraws his gift or donation is like a dog that withholds its vomit.’
On the other hand Maliki schools allow the transaction. They perceive, however, that hibah bi shart al-iwad is no longer deemed as a charitable (tabarru’) contract but rather a muawadah or exchange contract. In the takaful context, the gift is the contribution and the thawab is the indemnification by the risk fund. It is opined that the ruling of hibah bi al-thawab will take the ruling of an exchange contract. The main issue now, should takaful be considered as an exchange contract, is that the whole issue of riba, gharar and jahalah will emerge and resemble conventional insurance. The practice of surplus sharing and other benefits derived in takaful, therefore, is in violation of Shari’ah principles, which prohibit riba and gharar.
Assoc. Prof. Dr Asyraf Wajdi Dusuki is currently Head of Research Affairs, International Shari`ah Research Academy for Islamic Finance (ISRA). He also serves as a Chairman of Shari’ah Committee for AIA AFG Takaful and AIA Takaful International.
NEWHORIZON Zil Haja 1434 – Safar 1435REGULATORY MATTERS
Malaysia Tightens Regulations for Conventional
and Islamic Banks
Since the 2008 world banking crisis there have been many voices calling for bankers to be sent to prison for the actions, which brought the world to the brink of economic collapse. The US authorities have defended their decision not to prosecute any individuals for fraud on a variety of grounds including already overstretched judicial resources and the role the US government played by encouraging more people to buy homes, keeping interest rates low and deregulating the financial sector. In the UK a few bankers have been made to grovel in front of parliamentary commissions, but again no prosecutions. Five years on it seems like business as usual for the bankers.
One country that has taken the issue very seriously is Malaysia. In their 2013 Financial Services Act they have laid out very clearly what they expect from the banking sector and set fines and terms of imprisonment for anyone who contravenes their rules.
The Act tightens consumer protection; requires financial institutions to adhere to comprehensive standards of business conduct; strengthens rules on corporate governance; introduces stricter rules on shareholding; brings financial intermediaries such as cooperatives and leasing companies under the control of the Bank Negara, Malaysia’s central bank and empowers the central bank with greater powers of intervention. The central bank must approve the appointments of directors and senior officers of financial institutions. They want to ensure that these individuals are properly qualified and have no criminal record. (Such powers may be eyed enviously by other central banks around the world, not least the Bank of England in view of the recent case of Cooperative Bank Chairman, Paul Flowers.)
Importantly, the Act allows the central bank to take action against individuals rather than just companies. In Malaysia at least the days when senior officers of financial institutions can hide behind the corporate facade look as though they are numbered. If such individuals are found to be in breach of the Bank’s regulations, either through omission or commission, they will be held liable.
Most telling is Bank Negara’s intention to identify and act on unsound practices before these practices cause the failure of an individual institution or affect the stability of the broader financial system. In the announcement of the Act, they say, ‘This includes an increased focus on pre-emptive measures to address issues of concern within financial institutions that may affect the interests of depositors and policyholders, and the effective and efficient functioning of financial intermediation.’
Regulations Applying to All Banks
• Anyone carrying out a financial business not authorised by the Malaysian government and the bank will be liable to a prison term of up to 10 years and/or a fine of up to RM 50 million (Malaysian ringgits).
• Anyone conducting an approved financial business needs a professional indemnity insurance or takaful policy in an amount specified by the central bank. A failure to comply could result in a prison term of up to five years and/or a fine of RM 10 million.
• The authorised personnel of company that do not meet and maintain the capital requirements set out by the central bank will be liable to a term of imprisonment of up to eight years and/or a fine of RM 25 million.
• The authorised personnel of a company that fails to comply with any license conditions imposed by the central bank will be liable to up to five years imprisonment and/or RM 10 million.
• Authorised personnel may not carry on any business inside or outside Malaysia that is outside the remit of its license unless they have the written permission of the central bank. Anyone contravening this regulation will be liable to up to eight years imprisonment and/or a fine of RM 5 million.
• Licensed insurers, except for reinsurers, may not carry on both life and general insurance business. Anyone contravening this regulation will be liable to up to eight years imprisonment and/or a fine of RM 25 million.
• Directors of financial business may only exercise those powers conferred on them for the purposes for which those powers were conferred. Anyone contravening this regulation will be liable to up to eight years and/or a fine of RM 25 million.
Regulations Applying to Islamic Banks
• Licensed financial organisations including banks, insurance companies, financial advisors and clearers that have applied to and been approved to carry on an Islamic finance operation must keep its Islamic capital funds and assets and liabilities separate from its other funds at all times.
• Islamic funds may not be used to fund the other licensed operations of the financial organisation.
• Payment system organisations must ensure that their operational arrangements are Shari’ah compliant.
• The boards of directors of Islamic financial institutions are enjoined to have due regard for the advice of their Shari’ah advisors in respect of the conduct of their business.
The Act also lays out the procedures to be followed if Bank Negara Malaysia (BNM) believe that any of their regulations have been contravened. BNM have the right to launch and conduct investigations themselves. The investigating officers appointed by the Bank can apply to magistrates with written information about the offence in order to get a warrant to enter the premises of the institution/person under investigation, if necessary by force and to examine and/or seize anything that they believe is material to the investigation. They also have the right to search individuals. Anyone who hinders the investigating officers in any way, whether by physically denying them access or by destroying relevant materials will be liable to up to eight years in prison and/or a fine of up to RM 25 million.
This Act is a bold move on Malaysia’s part to try to consolidate their position as a leading financial centre in South East Asia. They want their financial sector to be seen as well regulated, transparent and tough on those who would put their customers, shareholders and indeed the whole financial sector at risk. It will be interesting to watch their progress as the Act is implemented.
NEWHORIZON September to December 2013IIBI SEPTEMBER WORKSHOP
Structuring Innovative Islamic Financial Products
IIBI London 7th Annual Three-day Workshop 2013
The 7th annual ‘Structuring Innovative Islamic Financial Products’ workshop took place in London from Friday, 13th to Sunday, 15th September 2013. The event regularly attracts delegates from around the world and this year the countries represented included Nigeria, Pakistan, Kenya, Malaysia, the United Arab Emirates (UAE) and the United States (US). The workshop, as always, focused on the practical application of Islamic finance, looking at what is actually happening rather than the theory.
Commenting on the event, Euroweek’s Hassan Jivrak said, ‘The event highlighted the complexity of product structures, which some investors find less attractive than interest-based products (particularly mortgages). It also pinpointed the need for better infrastructure, support systems, marketing, accounting standards, international Shari’ah harmonisation, as well as the governance of banks and Shari’ah scholars.
‘The workshop also revealed that standards are not fully developed in practice. Although Islamic banks structure their services in accordance with Shari’ah, in practice they operate closer to their conventional rivals.’
The following report contains a fuller flavour of the workshop with two separate articles on takaful progress and the issue of money creation and debt-based finance based on presentations given by Iqbal Asaria, Afkar Consulting who also teaches Islamic finance and Yusf Jha who currently works as Shari’ah Manager at a major GCC based Islamic bank.
One country that has taken the issue very seriously is Malaysia. In their 2013 Financial Services Act they have laid out very clearly what they expect from the banking sector and set fines and terms of imprisonment for anyone who contravenes their rules.
Welcome and Introduction
Richard de Belder, a partner and head of Islamic finance with international law firm, Dentons, opened the workshop. He said that the financial crisis of 2008 meant that now was a very interesting time for Islamic finance. He said that the challenge was whether the Islamic finance industry could innovate and come up with new products and ideas, particularly bearing in mind the dichotomy between trying to get closer to Shari’ah goals and what is currently on offer.
In the UK Mr de Belder said the government had set up an Islamic finance taskforce, of which he is a member. The objective is to build on what has happened in the UK so far in terms of Islamic finance. He believed that this was a positive message for the Islamic finance industry.
The workshop began with a brief overview of accounting standards for Islamic finance as set by AAOIFI (Accounting and Auditing Organisation for Islamic Financial Institutions) was given by Zahir Rashid of Ernst & Young. In most jurisdictions regulators require financial institutions to provide financial statements. These are prepared according to three global standards, US GAAP (Generally Accepted Accounting Principles), IFRS (International Financial Reporting Standards) and J GAAP (Japanese GAAP), but the problems is that none of these standards really accommodate Shari’ah-compliant institutions. As a result AAOIFI was established in 1991 in Bahrain to develop and promulgate standards more relevant to Islamic financial institutions.
AAOIFI covers four key areas – accounting, auditing, ethics and governance. To date they have issued 88 standards and are currently undertaking a review to bring them more into line with IFRS without contravening any Shari’ah requirements. The key difference between IFRS and AAOIFI is that IFRS looks at substance over form, while AAOIFI looks at both substance and form.
AAOIFI standards are, however, advisory everywhere except in Bahrain. There is no requirement outside Bahrain to comply with AAOIFI standards.
Islamic Banking – The Context
Dr Salman Khan, who is head of the Shari’ah office for a prominent GCC-based Islamic bank and also a well known trainer in the field of Islamic finance, began by stressing the importance of developing a truly Shari’ah-based financial industry with the right support systems and infrastructure in place. He also stressed that Islamic banks should be genuine traders, investors and entrepreneurs; they should not simply be lenders or financial intermediaries. The only justification for making a profit is sharing risk; being an integral part of, for example, setting up a new business or taking part some sort of trading activity.
The basic premise on which Islamic banks were founded is that they have a system of ethics that is superior to the conventional banking industry. That system of ethics is primarily based on muamalat or ethical principles in mutual transactions, e.g. fair and honest dealings, acting for the common good and the avoidance of exploitation. These principles should be evident in Islamic financial contracts, so, for example, avoiding exploitation translates into the ban on riba or interest.
In summary, there should be no unfair benefit involved in Islamic financial contracts and actions should reflect intentions. If these principles are observed, the contracts should reflect both the form and substance of Shari’ah; the theory will equal the practice.
The problem for the Islamic finance industry in applying these ethical principles is that it was not created in a holistic way – it developed in different geographies at different times; development has been haphazard. As a consequence the nascent Islamic finance industry started to use the conventional banking systems and infrastructure and this has created some problems. Conventional banking systems are based on four principles:
• Money is a commodity.
• Money has a time value; it cannot be allowed to lie idle.
• The bank’s priority is to look after its own interests.
• Any profit accrues to the bank first of all.
All of these principles are disallowed in Shari’ah. By using the systems and infrastructure designed for the conventional industry, Islamic banking is trying to fit a square peg into a round hole. Islamic finance has had to adapt to these systems and as a result Islamic financial products have begun to follow the rules of the existing system; Shari’ah products have no space in that system.
Islamic Financial Product Analysis
Dr Khan continued with an analysis of the existing products in the Islamic finance sector, focusing on the innovations in the different product areas.
Murabaha is basically a cost plus sale involving tangible goods, where the bank buys the goods and then sells on to the customer at an agreed price, which is something above the amount they paid. The price fixed at the outset does not change. In its original, antique form, there was no provision for deferred payment; it was a straight spot sale, but in the 1970s and 1980s deferred payment became an accepted element of murabaha, despite the doubts expressed by many scholars.
Dr Khan highlighted some of the controversial aspects of murabaha, such as the advanced promise, which effectively makes the transaction risk free for the bank and is therefore not Shari’ah compliant. The innovation that has largely solved this issue now is a returns policy, which allows banks to return goods to the supplier within a specified time at no cost to themselves, should the buyer renege on the contract. Other issues discussed and the innovations to address them included title, the use of agents, cost of funds, IBOR (InterBank Offered Rate), exchange rate risks, performance risk and letters of credit.
Dr Khan made the point that many problems arise because Islamic banks are trying to play by a set of rules that were not designed for them – like trying to play football according to the rules of squash. Furthermore, he said that in 30 years Islamic banks have lobbied more effectively to have these rules amended to allow them to be truly Shari’ah compliant in all aspects of their operations.
Dr Khan explained that commodity murabaha or organised tawarruq, which is very similar to a cash overdraft, is particularly controversial, because the goods involved in the financing transaction, usually metal, never actually move, although AOIIFI regulations say that the goods should move. In effect this is not a real transaction and the source of the profit in such a transaction is entirely based on the fact that the metal does not move. In practice, therefore, tawarruq transactions breach AOIIFI’s rules. The Jeddah-based Islamic Fiqh Academy has a much more straightforward approach; it has ruled that tawarruq is not permissible in any circumstances. The simple fact is that the market is choosing to ignore these rules with Shari’ah dispensations based on market
NEWHORIZON Zil Haja 1434 – Safar 1435IIBI SEPTEMBER WORKSHOP
A variety of other types of murabaha transactions such as rollover murabaha and murabaha with shares and the problems associated with them were also discussed. In all cases the essentially non-Shari’ah-compliant transactions are justified on the basis of market need.
Ijara means rental or lease or a durable, tangible asset. It requires a lessor and a lessee, each having different rights and responsibilities. For example the lessor is responsible for any damage to the leased asset, unless the damage is caused by the lessee, insurance, taxes, etc. The lessor may set the rental at a level that reflects these additional expenses. The lessee is obliged to take proper care of the asset and make regular, agreed rental payments as soon as the lessee takes possession of the asset. If the asset is totally lost no rentals may be charged and the agreement may be terminated at any time with mutual agreement. Dr Khan also described the range of ijara agreements including sale and leaseback, service ijara, diminishing musharakah and syndicated lease, which is a sukuk version of ijara.
Dr Khan highlighted some of the Shari’ah-related problems and the solutions that have been developed to get around issues such as combinations of contracts, the risk that assets may fall in value, the cost of funds and the restructuring of ijara agreements. Perhaps the most controversial of these solutions has been the permission by scholars for banks to link the variable rental part of contracts to IBOR, provided that there is a ceiling beyond which rentals may not rise. They justify this on the grounds that this is a minor uncertainty and not an excessive one.
Other issues covered included forward leases and mortgages. There was a lively discussion about the issues raised by ijara, particularly the separation of contracts, genuine sale (for example, the intention in sale and leaseback is never anything other than to sell back to the leaseholder) and the use of sale and leaseback to settle debt (debt to settle debt). Dr Khan suggested that there was a desperate need for standards to bring clarity to all of these issues.
Service ijara is a relatively small volume business, but it is growing. It raises yet another set of issues, such as who is responsible when the service provider fails to deliver the service or delivers it in such a way that the outcome results in damage. Banks, with Shari’ah approval, typically frontload the repayments to minimise their risk. The payments are deferred, but the client remains responsible for them regardless of whether a service provider goes out of business or fails to provide the service for some other reason.
Ijara sukuk are similar to sales and leaseback except that the investors’ funds are secured against an asset. One of the key concerns with this instrument is that the investors get a guaranteed return; they take no risk. A second is that investors are not free to sell the asset in the case of a default. Thirdly most ijara sukuk are used to restructure debt.
Another variation of ijara sukuk is based on a syndicated lease, where the asset is leased rather than owned. A major concern here is that the rent may be frontloaded to ensure that the investor is guaranteed a return.
The session on sukuk was presented by Fazl Syed, an Ivy League educated lawyer who has advised Islamic financial Institutions and other Shari’ah-compliant businesses and also acts as a global consultant to law firms and Shari’ah consultancies.
He examined the structure of sukuk, murabaha, musharakah and ijara and the controversies surrounding their Shari’ah compliance. For example, if the investors are given a guaranteed payback at the end of the period of the sukuk, are they taking any risk and if not, does this contravene Shari’ah. In effect sukuk appear to be mimicking conventional bonds. He also discussed other issues including the ownership of the asset being used to back the sukuk and whether the sale of the asset to the SPV (Special Purpose Vehicle) that acts as the trustee and issues the bonds to investors is a true sale, particularly important in situations where the beneficial owner of the asset goes bankrupt.
Mr Syed stressed that it was particularly important for investors to understand what they are investing in and what recourse they have in the case of default. For example, in Dubai foreigners cannot own assets in the country and so foreign investors have no right to claim the asset backing a sukuk in order to recoup their investment.
He also highlighted the differences between the treatment of murabaha sukuk in the Middle East and Malaysia. Murabaha is effectively debt and in the Middle East debt cannot be traded, but it can be in Malaysia. The variation in attitude is attributable to the different schools of thought prevailing among Shari’ah scholars in these two geographies.
Sukuk and Syndication Innovations
Dr Khan addressed the issue of innovation in sukuk and syndications. He suggested that most of these innovations have been designed to help sukuk fit more comfortably into the delivery structure of conventional banks. He reminded delegates that sukuk can be based on equity or debt, the latter being in the majority. The main purposes of sukuk and syndications are for refinancing and rescheduling debt. These structures closely resemble collateralised loans.
Dr Khan outlined a series of innovations that have been developed to overcome Shari’ah objections. For example, he said that with conventional bonds, borrowers are liable to pay a range of fees to the investors, most of which are not permissible under Shari’ah, e.g. commitment fees. To get around the problem with sukuk these charges are loaded into the arrangement fee, which is permissible as a payment for services provided by the arranger. Other innovations have also been developed to address the issue of charging the borrower for any major, unforeseen maintenance that has to take place – unforeseen and uncertain at the time the original contract is signed and therefore technically not Shari’ah compliant.
In summary, contracts are arranged so that the investors/owners incur few additional costs, whether that is maintenance, insurance or anything else and almost no risk, because in the event of total loss the onus is always on the borrower or lessee, either to have insured the asset or if that has not been done, to bear the cost of the loss. Yet, under Shari’ah law, the owner (investor), should bear those costs.
Dr Khan covered the issues of substitution, early settlement, purchase undertakings and the interdependence of documents. He also highlighted various practices, which are proscribed by organisations such as AOIIFI, e.g. organised tawarruq, but which are being used. The justification is market need. Other topics covered included floating rates and default conditions. He stressed that innovations in sukuk contracts have been organised to protect the interests of banks/investors, rather than borrowers, even when on the face of it this would seem to contravene Shari’ah laws.
Shari’ah-compliant investments may not be in certain sectors of the economy such as alcohol production or the arms industry. There are also a series of financial prohibitions, such as trading debt or money and receiving money from interest-bearing sources. For example, if a company is carrying a large amount of debt on its balance sheet, trading in the shares of that company would equate to trading in debt. The problem is that it is very difficult to find equities that do not have some prohibited elements in their overall makeup, so the Shari’ah scholars have allowed a certain degree of flexibility; this flexibility has tended to increase over time.
Hedge funds are all about avoiding/managing risk to produce a return for investors. There are two common hedging strategies. This first is to buy with a view to holding on to the investment and to sell in the future for a profit; buying long and there are no issues with that. The second is shorting, where a fund borrowed shares, rather than buys, because they think the price will fall; they then sell when the price has fallen and actually buy the shares at the lower price in order to complete their contractual obligation. This strategy does have Shari’ah problems; you cannot sell what you do not own. Typically Islamic hedge funds get round the problem by using a third party, a conventional broker to acquire the shares on the basis of a salam contract, an advance payment from the broker with delivery to be made at a later date. The Islamic hedge fund earns money from the advance payment, which will be invested elsewhere and through the lower cost of the shares that have to be delivered to the broker at a later date. The broker is rewarded through the payment of commission on the transaction.
NEWHORIZON September to December 2013IIBI SEPTEMBER WORKSHOP
There are, however, still problems. For example, salam assumes homogenous goods, such as oil, coffee, etc., that always have a value, but that may not be true of shares, e.g. if the company goes into liquidation the shares no longer have any value. How then can the hedge fund deliver the shares at the appointed time?
Dr Khan also covered structures based on arboun, which involves a down payment, but is in other respects similar to salam.
Swaps and Derivatives
Islamic swaps and derivatives are based on wa’ad or mutual promises and are based on a concept called Shari’ah conversion technology. The advertised aim is to wrap a non-Shari’ah-compliant structure into one that is Shari’ah compliant. The concept was pioneered by Deutsche Bank and then adopted by other banks. The result of this conversion technology is that if Islamic investors choose to exercise the swap option, taking their returns from the parallel conventional investment and not from the salam contract, they are effectively investing in conventional funds, with all the problems that these may pose to Shari’ah compliance. This structure has been extremely controversial, although some scholars have been prepared to approve it.
Dr Khan posed the question, is current best practice in Islamic finance based on Shari’ah principles. In essence these principles can be summed up as unfair benefit being prohibited and actions equalling intent.
Every product in the Islamic financial industry is based on an underlying, permissible commercial or economic activity. In order to be genuinely in line with Shari’ah principles, the commercial arrangement of a product should be in line with the characteristics of the underlying economic activity as it is known in the world. It is very important to follow this rule, because the Islamic finance industry was set up to challenge what were perceived as the unfair practices of the conventional industry. Shari’ah-based products cannot be replicas of conventional products, which emanate from an industry that not only does not embody Islamic principles, but is also based on principles, which are actually inimical to Islam. Similarly the support or delivery system needs to be designed for Shari’ah-based products and that support system needs to come before the products.
There is a gulf between the characteristics of current Shari’ah-based products and the characteristics they ought to have. There has been little effort to work towards bringing the products and the underlying system into line with the Shari’ah, nor has there been real thought leadership in the matter.
Why has no-one challenged this state of affairs, which has been ongoing for the last 30 years? Firstly, there is no desire to stir up controversy. Second, anyone who does question the state of affairs tends to be accused of damaging the Muslim ummah (community). Dr Khan stressed that he was not promoting revolution, merely asked for some open recognition and discussion of the issues, in the hope that this will lead to some modest moves in the right direction.
Some people justify what is happening on the basis that the industry needs to achieve a certain critical market share, before they can begin to diverge from the conventional banking norm. It is questionable whether this is likely to be a successful strategy – would customers who have signed up for one service be happy if they suddenly found the ground rules had changed and they were being offered something very different. The fact is that you cannot challenge a flawed system with something that is in effect a complementary system.
Infrastructure is key to the whole argument. The Islamic finance industry has to have a vehicle to deliver truly Shari’ah-compliant products, which have different characteristics and demands. Such an infrastructure cannot be put in place overnight, but the industry should be continuously working towards a bespoke system.
Shari’ah governance is one of the most important elements in this infrastructure. Malaysia has done some meaningful work towards effecting change in Shari’ah governance. Dr Khan described the IFSB (Islamic Financial Services Board) standard on Shari’ah governance as a crown jewel, but many scholars around the world are not comfortable with applying it strictly, because it would change the way they are used to working, for example their ability to serve on multiple Shari’ah boards.
One of the key differences is that outside Malaysia standards are advisory; in Malaysia any infringement attracts punitive action. Dr Khan also touched on other issues relating to Shari’ah governance such as the dire shortage of young Shari’ah scholars, scholars’ qualifications and conflicts of interest.
Dr Khan summarised by saying the industry needed Shari’ah-based products founded on genuine business templates and a code of business ethics; products should be based on real contracts relating to, for example, lease and trade; there should be profit sharing; the focus should be on real deals, substance rather than form and there should be no combining of contracts.
Working Towards Greater Shari’ah Compliance
Achieving greater and genuine Shari’ah compliance will not happen overnight; there are no quick fixes. Dr Khan examined the common financial instruments, highlighting the problems with them as they exist today and the aspects of these instruments that should be avoided. For example, murabaha contracts should not involve advanced promises; there should be genuine trade involved; banks should be operating like a trader, a paradigm shift in a world where banks typically own nothing other than office space; profit should not be benchmarked against IBOR; there should be no agencies involved; the transaction should involve normal trading risks in order to warrant earning a return on the transaction and there should be no repricing. Other types of instrument such as salam, ijara and sukuk were also discussed. Dr Khan said that many instruments that are widely used today were based on exceptions made at a point in time for a particular reason, which have now become accepted as normal practice.
The Product Lifecycle in Islamic Finance
This session was presented by Mufti Barkatullah, a prominent UK based Shari’ah advisor and member of the Shari’ah Supervisory Committee of several Islamic financial institutions. He described the product development process and particularly how the Shari’ah process begins even before a financial organisation is up and running, at the business planning stage. The Shari’ah advisors then continue to be involved through product development, launch and delivery, along with other departments such as marketing, finance, etc. Their continuous involvement ensures that products are and continue to be Shari’ah compliant throughout their life.
He suggested that to some extent the scholars’ role was to achieve a balance of fairness between buyer and seller, between the bank and its customers taking into account financial, legal, regulatory and social issues. He also reminded delegates that scholars do not have overarching authority; they often have to compromise, for example with regulators.
Mufti Barkatullah said that Shari’ah at the moment is being practised pragmatically in a given set of circumstances. It is unrealistic to think that Islamic finance can exist in a vacuum, untainted by prevailing circumstances. Muslims and non-Muslims cannot cease to influence each other, because they must trade with each other. Islamic finance will always have to deal with the fact that it is doing business with the interest-driven conventional industry. Shari’ah is basically pragmatic and accepts that the world is imperfect. There should always, however, be a quest for perfection.
The Malaysian Story
This brief presentation was made by Professor Laldin, who is a highly respected scholar and member of a number of Shari’ah advisory committees in Malaysia and internationally. He talked about the history of Islamic banking in Malaysia. He pointed out that in 2005 Malaysia set up a Central Shari’ah Advisory Council, which is part of the central bank, Bank Negara and mandated that scholars can only sit on one bank Shari’ah board and one takaful Shari’ah board. In 2009 an amendment to the law made it mandatory for courts to follow the written decisions of the Central Shari’ah Advisory Council.
In 2013 an Islamic Financial Services Act was introduced. Under that act every Islamic financial institution has to share the risk with customers; the risk cannot be passed in its entirety to the customer. In order to
facilitate this change, ISRA (International Shari’ah Research Academy) has developed in conjunction with the central bank a set of standards for contracts. Second, under the new act, Shari’ah scholars will be held accountable for what they do; they can sued, taken to court, heavily fined and even go to jail.
The workshop concluded with a panel discussion and the presentation of certificates to delegates.
NEWHORIZON Zil Haja 1434 – Safar 1435IIBI SEPTEMBER WORKSHOP
Money Creation and Debt-Based Finance: A Fundamental Challenge to the Islamic Finance Industry
Mr Jha opened his session with a quote from the Koran, ‘Where then are you headed?’ He stressed that this question is important to everyone, Muslims and non-Muslims. Whenever anyone decides to pursue an activity, it is important to understand what we hope to achieve and where it is taking us.
He said that his understanding is that the financial system of the world today in its whole global architecture and how it operates arose out of a simple act; that act was the legalisation of interest. Once interest was legalised it brought about the creation of money as being interest based.
Money is what connects goods and services; it is something that connects institutions and the way society interacts. When countries such as Pakistan and Sudan declared themselves to be Islamic, they had to ask themselves the question – what does Islam say about banking and finance? Their conclusion was that banking is interest based and Islamic finance has to be different.
How does Islamic finance provide something different and was that articulated before people jumped into the Islamic finance project? The fact that money itself is interest based has ramifications for Islamic finance. Much of the way that the monetary economy works is diametrically opposed to the Islamic mindset.
The History of Money and Interest
History is important specifically with regard to interest and how it has affected the banking system. Prior to the 17th century interest was almost universally felt to be wrong. Christians, Jews, Hindus, Buddhists and the ancient Greeks all felt that interest was wrong; it was among the major sins. The reformation with its emphasis on realism and industry, led by men such as Martin Luther and John Calvin, was a turning point. This period saw the introduction of terms such as usurious rates of interest, whereby interest above a certain level was a sin, but below that it was acceptable. It saw society develop a tolerance for ‘acceptable’ levels of interest.
Before banks emerged, the goldsmiths performed the function of safeguarding money, which at the time was gold. They took in the gold and gave the depositor a receipt, which was not name specific; it simply said ‘the bearer’. The bearer, anybody holding the receipt, could go to the goldsmiths at any time and ask for the gold. People soon realised that they could trade in the receipts, thus the goldsmiths effectively created money.
The next step was when goldsmiths started to lend the receipts into the economy, loans. When the receipts came back to settle the loans, the goldsmiths simply cancelled the receipts and no-one ever discovered that they were not actually based on gold held by the goldsmiths. They were so successful that the practice became institutionalised and the first banks came into being.
The first central bank, the Bank of England, grew out of King William III’s need to raise money to fund a war with France. Unwilling to raise the money through taxes and become unpopular with the people, he borrowed from the goldsmiths, who, in return, asked for the right to create the first central bank. This effectively legalised the goldsmiths’ practice of creating money out of nothing and money itself became interest bearing. This is relevant, because this is how money comes into existence today.
The Creation of Money
nly 3% of the ‘money’ in circulation is in the form of coins and banknotes; 97% is electronic. For example if you go the bank and ask for a mortgage, you sign a contract, which says you owe the bank £x and that contract is then part of the bank’s assets. The bank
enters the amount, principle plus interest, into your account as a liability; this entry is money in terms of how it functions. Bank credit makes up the majority of money. Money only comes into existence when someone agrees to pay back more.
• Commercial banks create more than 97% of the money in the economy.
• Modern day money is simply created as an accounting
• Banks can create as much money as they want based on their reserves.
This is how banks make money. They are incentivised to keep people in debt, because the system needs us to be in debt for it to survive and banks need us to pay the interest. The question is, if money only comes into existence when someone agrees to pay back more, where does the more come from? Every country in the world from the developed economies through to the third world needs to grow in order to perpetuate this system. If there is no growth, there is not enough money to pay back debts and the result is a recession.
The Money Multiplier
The money multiplier is not a way of creating money; it is a concept normally taught in economics courses. Economists try, increasingly unsuccessfully, to suggest that this process has some kind of control on it, some type of regulatory control, i.e. the central banks can require banks to limit the creation of money to a certain percentage of their reserves. The reality is that is not the case. In the UK, for example, the Bank of England has not imposed any reserve requirement since 1981. Since that date UK banks have applied loose capital adequacy ratios.
The Basel Committee, which has been responsible for setting capital adequacy standards, is a loose conglomeration of banks, who sit with regulatory authorities to propose ratios that they consider banks should have for their own stability. It is also something of a public relations exercise to promote public confidence in the banks, because the system is reliant on the public accepting that what banks are creating is, in fact, money.
Late 20th Century Changes in Currency Regulation
The proportion of money created by central banks has been gradually decreasing since the early 1900s, but the pace of that decrease accelerated dramatically from the 1970s onwards. In the 1970s money was still somehow pegged to a commodity. All the currencies in the world were pegged to the US dollar and the dollar was pegged to gold. President Nixon decided to remove this peg.
In the 2009 Banking Bill debate in the UK’s House of Lords, the Earl of Caithness said, ‘Our UK money supply has grown from £31 billion in 1971, when President Nixon closed the gold window, to in excess of £1,700 billion today. Let us consider the implications of those last two figures. They mean that every year since 1971 the banking system has created on average for its own use £44 billion. That is more per year than the entire money supply, which until 1971 had sustained our economy since our recorded history began.’
The 2008 financial crisis completely shook this paradigm. Banks simply stopped lending. The policy of quantitative easing deployed by central banks, who bought debt from the banks to create a reserve for them, should have helped to restart lending, but it did not. If nothing else this is a proof that the reserve theory has nothing to do with banks lending. Banks only lend when they know the money will be paid back; the only thing banks worry about is a default and having to take a loss somewhere else on their balance sheets.
Does it Matter?
Charles Eisenstein, the American degrowth activist, said, ‘The logic of interest is the logic of an addict.’ The more an addict goes on, the more he runs out of resources to support his addiction. This is exactly what our money system has become. It thrives on debt; it needs us to go into debt for it to survive and there is only so much debt we can take. The more money is created, the more of it has to go towards goods and services; money does not exist in and of itself; something has to be bought and sold. Our planet itself is being bought and sold. The forests have to be deforested; fish have to be fished and depleted across the rivers and oceans. A tree standing as a tree is not worth any money, but when you convert it into lumber and deforest Indonesia to produce palm oil that can go into toothpaste in Tesco and Asda, then it is worth money. The system has to destroy the environment.
No matter how much money comes into existence, there is never going to be enough to pay it back, so the system is geared to conflict; who are going to be the winners and losers. When anyone talks about money today, it is rarely talk about collaboration. A business has to succeed; if it is static the business model is flawed. A business needs to be constantly ahead of its rivals in competing for scarce resources.
Key economic axioms suggest there are limited resources for unlimited wants and each person wants to maximise his utility. This is not a given; it is an assumption. Perhaps human beings can have limited wants. How many assets can you own and does that fulfil any deeply felt desire? It is a numbers game. Human nature does not accord with this system. This may be a theoretical argument, but there are more practical examples.
When you understand that most of the money in the world is created as debt, inevitably the people with the debt are the ones that benefit the most. As a result there is concentration in every field of trade. Every area of trade is controlled by a handful of companies, big business and there is a tie-in between big business and the banks. If you look at the US company, Walmart, their trade with China exceeds the combined trade of the UK and Germany with China. One in five items in any US household comes from Walmart. Companies such as Shell and Exxon have more money than Bangladesh and Pakistan combined. In the US four or five companies control all the agriculture business; another four or five control the pharmaceutical business and so on. The same is true in the UK. Every single industry has become an oligopoly and trade has become distorted.
Allah in one of his sayings made trade halal and riba haram. One of the connotations of this is that once you adopt a paradigm of riba, you distort the paradigm of free trade and grant the freedom to oppress.
Systemic Booms and Busts
One of the results of the banks creating more and more money is inflation, because there is more money than there are goods and services and prices rise. If there is less money there is a recession. This is systemic, built into the system.
Monetisation of the Commons
As more and more money comes into the system, it needs to go into goods and services, which, in turn, means we have to sell more and more things. Things that were previously common have to be bought and sold. For example, no-one would ever have thought we would be buying and selling water, but today it is one of the biggest commodities being bought and sold. In Bolivia, Bechtel, managed to get a law passed to say that any rain water that falls is the property of Bechtel, which led to the water wars.
The concept of the commons is a deeply Islamic concept. Some things have no right to be bought and sold.
Money comes into being through debt and those who already have money have the ability with interest to make money. This is creating a polarisation. If you take the top three wealthiest individuals in the world today, they have a combined wealth that is greater than the combined GDPs of the 48 poorest countries. The richest 2% of people in the world today own 52% of the world’s assets.
Even if you take a developed country such as the USA, fewer than 7,500 individuals collectively control 75% of the nation’s industrial financial assets, 66% of the banking assets and more than 75% of its insurance assets.
The average European cow in terms of the value of what it eats per day is wealthier than 75% of Africans. This is nothing to do with wealth; it is about how the system has been set up. Africa is rich in minerals, soil and many other things, but the globalised system operating on the premise of debt then says to relieve poverty, you need to receive credit. The credit comes through the banks operating through the World Bank and the IMF (International Monetary Fund). They make loans with interest and many countries have actually paid back their loans many times over, but the compound interest means that they can never ever pay back the principle. The result is that an increasing proportion of that nation’s economy, which could otherwise be spent on healthcare and social care, is going to pay back interest. Africa has been systematically robbed of its wealth.
The World Bank and the IMF are heavily influenced by the G7, the seven richest countries in the world, as to where loans go. The G7 countries, however, are under pressure from big business in their home markets, to lend in such a way that it supports their own growth. Usually that pressure is in the form of privatisation of the economy within the recipient countries.
Today, for example, it is cheaper to go to the supermarket and buy strawberries shipped half way around the world than to go to the small greengrocer across the road and buy the locally-grown equivalent, because trade has been globalised and trade itself is controlled by this conjunction of big business and money.
How Do Islamic Banks Tackle the Problem?
In Mecca and Medina, there are Islamic Macdonalds restaurants, selling Islamic Big Macs. If you have an Islamic high cholesterol diet, you will get Islamic diabetes and Islamic heart attacks. To append the adjective Islamic to something does not make it Islamic.
An Islamic analysis has to be holistic taking into account means and ends. That has not happened in the Islamic finance industry. One of the founders of Islamic banking when he accepted a prize from the Islamic Development Bank said, ‘The reality is we failed to give our financial institutions any characteristics beyond simple financial intermediation.’
Mufti Taqi Usmani, one of the most influential scholars in Islamic finance said, ‘It was expected that we would progress in time to genuine operations step by step, but what we have found now is, if anything, the same characteristics as conventional, interest-based marketplace products and we are going backwards instead of going forwards.’
Islamic banks operate today within a conventional marketplace that survives on debt. Money comes into existence only when you pay back more of it. In the history of Islam you will never find a contract that says, ‘I will give you money, if you give me more of it.’ That contract does not exist for the very simple reason is that is based on riba, but that is the very system on which banks operate.
Some scholars, however, said that when money was created out of nothing, it was created relevant to a sale or an asset and, therefore, it was not like conventional banks. The reality is, however, that Islamic banks use sales to simulate the way conventional banks work, i.e. interest-based loans. The remit for Islamic banks is always to fit in with conventional banking modes. This is not the mode that the industry should maintain. There are opportunities to change, but the industry needs to think about how money comes into existence and the effect it has, alternative economies, alternative currencies and areas of trade. The industry needs to change its own mindset.
Yusuf Jha is an AAOIFI certified Chartered Shari’ah Auditor and Advisor. He is Shari’ah Manager at a major GCC-based bank, and is involved with auditing, contract review, structuring and product development for a variety of products with the primary focus being on the Treasury, Corporate and Investment Banking divisions. He has worked on a variety of Treasury Products and has been involved in various Investment Banking Transactions, playing a key role in both the structuring and documentation of major deals.
NEWHORIZON September to December 2013IIBI SEPTEMBER WORKSHOP
Innovations and Developments in
Takaful and Re-takaful
Dr Asaria began by posing the question – is it acceptable from an Islamic point of view to have insurance? He went on to say that risk is in the hands of Allah, but only after humans have done everything they can. Secondly he said that it had always been acceptable (and indeed sanctioned in the Sunnah) to pool funds to compensate someone for a loss, e.g. the payment of ‘blood money’ in cases of manslaughter. Insurance operates on the principle that there is a need in society to do something about risks that are beyond anyone’s normal day-to-day control or bigger than any individual can handle.
How do insurers calculate risk and therefore how much to charge? First of all they rely on data such as the incidence of car accidents. The probability of having an accident is then tweaked according to other data such as the age and sex of the driver. From this data they build models to calculate insurance premiums. This approach applies to the category of insurance called general lines – cars, houses, etc.
The other category of insurance is life, where premiums are based on mortality statistics. For Muslims, life presents a slightly more complicated problem, because of the element of betting against Allah. As a result, in places such as Malaysia, they do not call it life insurance; they call it family takaful, e.g. you are insuring the future of your family home bought with a loan or mortgage, which is paid off by the policy in the event of death. In many countries regulators require separate licenses for general lines and life.
Takaful, Re-takaful and Retro-takaful
There are about 143 takaful companies worldwide, plus about 35 window operations attached to conventional insurance companies. In 2012 the estimate of total contributions/premiums was $12.4 billion annually. The split between general lines and life is moving towards life.
In addition there is re-takaful, which is the Islamic equivalent of reinsurance. This allows insurers/takaful companies to pass on some of their risk and ensures that claims are paid.
There is also retro-takaful. In the case of exceptional risks, such as an air crash, premiums are pooled, but the problem is that contributors to the pool will not all be takaful companies. Ways have to be found to allow takaful and non-takaful companies to work together. This can be done with enough imagination and expertise.
The need for insurance increases as GDP (Gross Domestic Product) rises. In many Muslim countries GDP is rising. In Malaysia for example GDP per person has increased from $300 400 in 1970 to $8,000 9,000 today. Consequently the potential market for takaful is also increasing.
The growth in Muslim countries is also changing the way people live. When there is little social and geographic mobility, people tend to stay in the same place in extended family groups and the family in effect provides the insurance. As people move into cities away from their families the need for insurance also increases. Again using the Malaysian example, in 1970 30% of the population lived in cities; today 70% live in cities.
In conventional insurance the model that has become most common is the shareholder-driven model, where the shareholders invest their money to offer insurance and in return individuals or companies transfer their risk to them for a premium. This is called risk transfer. If there is a profit, it goes to the shareholders. It is not a mutual scheme; it is a one-to-one contract for risk transfer. Scholars do not like this model.
An alternative model is a mutual or cooperative model, where people come together and pool their contributions; this is risk sharing. There are issues with this model. One of the main problems is if the calculated risk proves to be underestimated and the claims cannot be paid, the only recourse is to ask the participants in the pool for additional premiums. That is only practical with a small community of contributors; it is impractical with national or global operations. If, however, the operation has been going for five or six years without any claims being made, a reserve will have been created and that can be used to pay the claims. Most of the mutuals and cooperatives that have survived have done so because they have been able to build up reserves.
Shari’ah Objections to Shareholder Models
The primary Shari’ah objections to shareholder models are based on the prohibition of gharar (uncertainty), maysir (gambling/speculation) and riba. Insurance is inherently about uncertainty, whether it is conventional insurance or takaful. It is impossible to take uncertainty out of it, but maysir should not feature in a well-defined insurance contract. It can be removed without problems. Riba becomes an issue when the premiums are invested in non-Shari’ah-compliant funds. (Premiums are invested to deliver a return thus allowing the operator to offer more competitive premiums.) Riba can be removed easily by having a policy of only investing in Shari’ah-compliant funds.
If there is uncertainty in a contract it is intrinsically non Shari’ah compliant and therefore not valid. To overcome that problem contributions are pooled under a tabarru contract. Tabarru is normally translated as a donation, but this is an unsatisfactory translation. A donation is usually given with no expectation of any return, but that is not the case with takaful; a contributor will expect any claim to be paid. A better translation is that it is a pooling for the common good and minor gharar does not interfere with that arrangement.
Takaful Operator Models
An operator is needed to manage the pool of contributions, assuming the number of contributors is significant. The operator is paid through a contract that may be mudarabah, wakala or waqf. This is allowed because they are operators and not insurers.
A basic mudarabah model is a risk-sharing arrangement, where the operator is paid a percentage of the investment profits. Any surplus after claims and the operator has been paid is returned to the participants. If the fund is a large one, the percentage the operator receives will be an adequate reward, but if the fund is small it is unlikely to be attractive to an operator. Furthermore, if there is a loss, the operator does not get paid.
In a modified mudarabah model the operator shares in the whole surplus, not just the returns on investments. This is slightly better, but still very risky for the operator and definitely not attractive for small funds. The scholars are also not keen on this arrangement, because the sharing of the surplus implies the transfer of risk.
In a basic wakala or agency models the operator receives a management fee, a percentage of the contribution upfront. This is slightly better, but if there is a loss the operator has to pay qard hassan, effectively a short-term loan to cover the shortfall. The temptation for the operator is to sell as much as possible and this may lead to under pricing, which in the longer term is looking for trouble.
In modified wakala the operator is given a share in the management of the investment and a performance fee in addition to the upfront fee. In the event of a deficit, he is still liable for qard hassan.
How do deficits occur? One way in which deficits occur is that in a bad year there are more claims than were predicted. That may equal out over time and losses can be recouped. Second, if the risk has been underestimated and the cost of insurance underpriced, the only solution is to increase premiums and risk losing business, which is something of a vicious circle and recovery can be difficult. Third, management may be weak leading to costs running out of control. Qard hassan is a strong incentive for operators to behave themselves. If you know the loss is going to come out of your own pocket, you will not under price.
Re-takaful is about spreading risks, but it carries a cost; it will impact profits. Re-takaful can be approached in a number of ways. The takaful company can say, for example, that they will give 40% of the premiums to the re-takaful company in return for 50% of the risk. In this case the re-takaful company has no choice in which bits of the risk they take; it is across the board. This is a proportional model.
An alternative is a facultative model, where, for example the takaful operator will agree that the re-takaful company takes on any claim over $1 million. The cost to the takaful operator will in this case be less than in the proportional model. Managing re-takaful is a key factor in profitability.
In the Islamic investment market certain types of instrument are not available. One of the biggest of these is debt securities, e.g. bonds, treasury bills, etc. There are sukuk, but there are not enough of them. As a result takaful companies have to keep more funds in cash form and there is no return on cash, so to make the same return as conventional companies, takaful companies put more of their funds in risky investments.
The situation is improving as more Shari’ah-compliant asset classes become available. Takaful is, however, still at a disadvantage at the present time and will probably remain so for some time.
In 2006 GGC takaful companies were earning 97% of their returns from investment, mainly property investment and just 3% from management, e.g. efficient claims handling, hiring the right staff, etc. As a result management was largely ignored and consequently management effectiveness deteriorated; companies were bloated and inefficient. By 2008 with the slump in the property market, 84% of returns were coming from management. The only way companies could make more money was to improve management, which is the bread and butter of insurance companies.
Malaysian companies were in a better position. They had a lower proportion of their return coming from property investment and concentrated more on management efficiency. They also had access to a broader range of sukuk, bringing their percentage of investment in this type of instrument close to the percentage invested in debt securities by conventional companies.
Return on Investments
Investors want to maximise their returns. Takaful always gives lower returns than conventional insurance. Part of the problem is that conventional insurance companies are bigger and therefore benefit from economies of scale. To continue to attract investors takaful has to provide some confidence that it can catch up with the performance of conventional companies.
One of the problems for takaful is that it is not well understood or indeed explained by the industry itself. Takaful needs to attract the man on the street and make clear what takaful offers. For example, fair trade products are well understood. The buyer pays a fair price to the producer, even if they pay slightly more than they would for alternative products; it a value-driven price; the consumer likes the idea of paying the producer a fair price.
Takaful needs to project a similar message to persuade customers to switch from conventional insurance. The customer needs to be persuaded they are doing something good by sharing risks and managing investments in a more ethical manner.
When insurance companies began to use the web to promote their products it was one-way traffic. The site told customers what was on offer and invited them to buy. There were about 25 million such sites. Today sites have two-way traffic, where customers can communicate back to the company in a variety of ways; there are 80 million such sites and growing. The caveat is that if you make a mistake the whole world knows about it straightaway. Companies have to be very sure what they are doing to use new media.
Microtakaful is a very useful concept. Microfinance is designed to provide funds for very poor people, for example, to create a business. If that person becomes ill, they default on the loan because they have no collateral. Microtakaful can help to address this issue and the default rate of microfinance providers will go down and it will be possible to make more loans. Microtakaful must accompany microfinance to make it more successful.
Many people, including scholars, have argued that the best use of zakat (the percentage of income of wealthy Muslims given for charitable purposes) is to use it for microtakaful contributions, because it leverages the whole poverty chain. It is much more effective than giving direct handouts.
Malaysia has already set up regional zakat boards to do this. They have been assisted by the fact that Shafi’i jurists have already broadened the ways in which zakat can be used. The Hanafi jurists are still very literal.
Iqbal Asaria has advised many banks and insurance companies in the UK on their launch of Islamic financial services. He is also consultant to a number of institutions on structuring and marketing Islamic financial products in the UK He is now a Special Adviser on Business and Economic Affairs to the Secretary General of the Muslim Council of Britain. In this capacity, he 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 was awarded the CBE in the 2005 Queen’s Honours List for services to international development. He also teaches various BA, BSc, MSc and MA courses in Islamic Finance, Banking and Insurance at various UK University affiliated Business Schools. He also teaches the Islamic Economics module for the CASS Business School EMBA in Dubai.
NEWHORIZON Zil Haja 1434 – Safar 1435LETTER FROM AMERICA
Sacred Economics vs. Financial Tyranny
This article contains is reproduced with permission of the author from his HuffPost blog in which he expressed the urgency to share something about the financial tyranny that is governing life on this planet. There are many problems in today’s world, but practically all of them can be traced back to out-of-control finance capitalism and the tyranny of debt. It is an issue of profound moral consequence and therefore should be addressed as a religious issue.
What if our religions and many great philosophers were right about usury? What if there is something inherent in the creation of interest-bearing debt that leads to profound economic injustice?
I will admit that there was a time when I saw the prohibition against usury (creating debt with interest) as a quaint relic of the past. I reasoned like this: the prohibition against usury arose from situations where lenders charged outrageous rates of interest, but surely there’s nothing wrong with lending at a reasonable rate of interest. How else would we have access to capital when we need to buy a house or start a business? How else would we keep up with inflation?
Well, what if it could be shown that inflation itself is the net result of the system of debt based on the charging of interest, a vicious cycle. What if the charging of interest inevitably leads to an increasing proliferation of debt and an increasing inequality between rich and poor?
It is becoming more and more obvious to many people that there is something terribly wrong with the economic system under which we live. Vast amounts of wealth continue to be more and more concentrated in less than one percent of the population. And within our political system we do not find leaders who are willing and able to clearly identify the problems of our monetary system, nor offer coherent solutions. Systemic greed favours a tiny class of people who concentrate more and more capital, as well as more and more control over our lives.
As Henry Ford said, ‘It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.’ But all the lawlessness, fraud and criminality is so well-dressed in respectability, and even admiration, that most people are blind to what’s happening right before their eyes. If we could truly see the naked reality of this situation, we would be witnessing these bankers for what they are: at best, conscienceless champions of greed who add nothing to the productive economy, pursuing their own short-term advantage; and in many cases, soulless con men plundering nature, profiting from endless war, privatising profit, foisting liabilities for all their damages on the public at large, and charging us interest on all the debt!
The conflict between sovereign citizens and an oppressive central banking system predates the founding of our country (the USA). The currency act of 1764, passed by the British Parliament under the influence of the Bank of England, was the cause of economic hardship and unemployment in the colonies and, according to Benjamin Franklin, was the primary cause of our revolution.
The super rich have relentlessly striven to dominate and control all resources, economic activity and political power. The central banks of the world, governed by a few unelected individuals, have claimed for themselves the unrestricted power to set interest rates and control the money supply. President James Garfield, an implacable foe of the banking cartels, expressed his opposition by saying, ‘Whosoever controls the volume of money in any country is absolute master of all industry and commerce. And when you realise that the entire system is very easily controlled, one way or another, by a few powerful men at the top, you will not have to be told how inflation and depression originate.’ Garfield was assassinated in 1881.
The bank panics of 1873, 1893, in 1907 were crises engineered by international bankers through the manipulation of credit, which further set the stage for the public to believe that a central banking system was needed to protect them. Senate Republican leader Nelson Aldrich spent two years in Europe consulting with the central bankers of Germany, France, and England and upon his return he lobbied for the creation of a central bank for America. His wish would soon be realised.
In November 1910 a secret meeting on Jekyll Island attended by Aldrich and representatives of major, interconnected banking families the Morgans, the Rockefellers, the Schiffs, the Vanderbilts, the Warburgs formulated plans for what would become the Federal Reserve (the Fed). The Federal Reserve Act passed Congress on December 23, 1913, at a time when few members of Congress were present because of the Christmas holidays. Congressman Charles Lindbergh, Sr. said upon its passage, ‘From now on, depressions will be scientifically created. Invisible government by the monetary power will be legalised. People may not know it immediately, but the day of reckoning is only a few years removed. The worst legislative crime of the ages is perpetuated by this bill.’
From this point on, money creation was in the hands of these private bankers who have been able to manipulate the economy through a series of financial bubbles and busts. Also known as ‘pump and dump’, these intentionally created cycles have allowed the central bankers to further consolidate their wealth by buying assets on the cheap during the busts by having privileged access to vast amounts of capital, while continuously creating more and more debt through the fractional reserve system.
If you could join this club with all its privileges, you would be able to borrow as much money as you like at nearly zero percent interest; you would be able to extend mortgages to others just by making an entry on your account ledger; you would be able to buy up the mortgages and debts of others and purchase any equities, commodities, or real property. And, oh yes, you would also be able to gamble with these great sums of money! Except that your bets would be insured by the rest of the population. The justification for all these privileges is that by increasing your wealth in this way, some of this wealth would gradually trickle down to the rest of the population if and when you decided to let it.
How did we get from merely charging interest to the universal system that is now enslaving most of humanity? Well, in America it went something like this: our Constitution mandates that money creation is the right of the Treasury Department. Some of our founding fathers understood that a central banking system, like the Bank of England in their time, is designed to profit from lending to governments, especially by financing wars and eventually leads to the control of government itself. Presidents Thomas Jefferson and Andrew Jackson were two courageous opponents of the idea of a central bank. A ‘maxim’ attributed to the House of Rothschild says, ‘Let us control the money of a nation and we care not who makes its laws.’
In other words, these banks acquire capital that can be used as reserves for lending at a ratio of 10 to 1, though in some recent situations today the leverage is much higher 50 to 1, for instance. The money that is lent as debt multiplies through the whole banking system through further leveraging, bringing not only individuals but whole countries into unsustainable debt. In other words, the debt created is much more than the real world assets needed to eventually pay off the debt. This inevitably leads to extreme levels of indebtedness in which not only individuals but whole countries owe more than can ever be repaid and the banking cartel confiscates what real assets exist.
It’s a very clever system, designed to appropriate all of our common wealth and transfer it to the banking class. The financial sector produces nothing; it exists as an intermediary between producer and consumer. In 1870 it was only 2 percent of the economy; it reached 5 percent in 1980 and in 2010 it was 9 percent of GDP. It not only puts our whole financial system at risk through its derivatives, it skims trillions of dollars from the real economy without producing anything.
The Fed has institutionalised inflation, causing the dollar to decline to less than 5 percent of its 1913 value. But, one might argue, our wages have increased too. What is obscured here is that inflation disproportionately harms the average person, depleting their savings, pensions and retirement resources, while giving a major advantage to those with greater capital who gain through speculation and other investments.
The Fed’s recent spell of ‘quantitative easing’ (QE) has boosted the value of stocks by more than 25 percent this year alone, but the vast majority of that wealth has gone to a tiny percentage of the population who own stocks. QE has been described by billionaire hedge fund manager Stanley Druckenmiller as ‘the biggest redistribution of wealth from the middle class and the poor to the rich ever.’
In the current system capital automatically flows to whatever makes the most money, no matter how destructive it is to life. We don’t spend dollars, the dollars spend us! From the apparently insignificant beginnings in the mere charging of interest, a whole system of out-of-control capital has developed.
Almost every religion has warned against usury (interest-bearing debt) and many great thinkers as well (Solon, Plato, Aristotle, Cato, Cicero, Seneca, Jesus, Muhammad, Aquinas, Jefferson, and Goethe). What we are witnessing today is just the most sophisticated and comprehensive rip-off in the history of the world.
What if we found out that most of the wars of history were caused not by religions and clerics but by banks and financiers? Politicians and governments are bought and paid for. Wars are financed with credit extended to both sides of the conflict by bankers who stand above the fray but profit handsomely. The public would never be willing to pay for such wars if they immediately had to pay out of their own pockets. But the system doesn’t work that way. It would be too obvious. Instead, irrational fears are promoted; enemies and scapegoats are proffered; we stumble blindly into war and the costs are temporarily deferred, while the majority of us and future generations are stuck with the costs. It is time for communities of faith to confront this unjust system that pillages our whole economy and enables the war-making machine.
Sacred economics is an economics that serves the cause of human dignity and well-being. The Financial Tyranny we have today is a consciously designed system of debt enslavement that perpetually harvests the energy and substance of the people.
In this system all money is created as debt, first of all to the Fed and other central banks, then to all banks and credit card companies that extend debt to borrowers, businesses and government. More and more money is ‘being made’ through financial instruments, through the Fed’s pumping up the economy with empty dollars; less and less through actually making things. And all of this ‘money’ comes into being as debt owed to the Fed.
Is there a solution, an alternative to this interest-based system? As a minimal first step, reinstitute Glass-Steagall, to separate normal banking from investment, i.e. take the heroin away from the addict; do not let these too-big-to-fail banks gamble with money that is not theirs. Next, revisit the Chicago Plan, devised during the Great Depression by some of the world’s best economists, though vehemently opposed by the banking cartel at the time. Eventually, end the Fed; restore money creation to the Treasury so that money will not be created as debt, but money will be created as a reflection of the actual resources of the country.
Yes, it is difficult to grasp how fundamentally our monetary system needs to change in order to avert economic and environmental catastrophe. There are two interconnected problems here: one is the intrinsic nature of debt-with-interest that empowers capital to prevail over human needs. The second is the extent of the privileges given under the current financial architecture to the worldwide financial elite, namely the Fed and other central banks.
Jesus threw the money lenders out of the temple and proposed the forgiving of debts. People of good faith must try to understand this system of debt-enslavement and organise to end it. Our economy requires the suicidal increase of consumption to meet the requirements of increasing debt. It is a profoundly unrealistic and unsustainable trajectory that makes an idol of profits no matter what the cost to human life and dignity. We need a new vision of economic justice, a sustainable economic system that respects the sacredness of life.
Kabir Helminski is an author as well as the translator of numerous books of Sufi literature and especially Rumi. He is the co-director, with his wife, Camille Helminski, of the Threshold Society, a nonprofit organistion dedicated to sharing the knowledge and practice of Sufism. As the publisher of Threshold Books for some twenty years, he was largely responsible for making Rumi the most widely read poet of our time. He leads workshops and retreats for Sufis and the broader multifaith community.
NEWHORIZON September to December 2013ANALYSIS
Examining the Determinants of
Operational Risks in Islamic Banking
A complete version of this study was presented at Global Development Finance Conference, 5- 7 November 2013 in Cape Town, South Africa; organised by Africa Growth Institute in collaboration with Chartered Institute of Development Finance.
It is very well understood that the complexity of operational risk measurement has been exacerbated by two major spectrums of operational risk data, namely high frequency-low severity (HF-LS) and low frequency-high severity (LF-HS) and the integration of scaling external and internal data. Consequently, each type requires a different approach to cater for operational risk. The current literature on operational risk mainly focuses on two issues firstly, the estimation of operational risk loss processes using extreme value theory or Cox processes1 , and secondly, the application of these estimates to the determination of economic capital 2. Despite that, an essential issue remains to be resolved, i.e. to determine the main factors of operational risks to help bank management make a better decision in carrying out a desirable scale of operational risk management.
In an attempt to estimate the level of operational risk exposures, Allen and Bali (2004) deploy the residual of their econometric models to approximate operational risk exposures. In order to deal with the data problem, they estimate an operational risk measure for individual financial institutions using a monthly time series of stock returns over the period 1973-2003. The model is represented by ordinary least squares (OLS) regression of the monthly rate of return on a large number of explanatory variables, which include the first difference of 22 variables representing credit risk, interest rate risk, exchange rate risk and market risk. The three Fama-French (1993) factors are also used as explanatory variables. An important finding resulting from Allen and Bali’s research is that operational risk exposures often exceed market risk resulting in higher capital charges for operational risk.
Another approach in analysing operational risk exposures is by deploying financial ratios. This can be found in the study by Tripe (2000); who investigates some benefit in using ratios derived from financial statements to determine capital requirements for a number of New Zealand banks based on the volatility of non-interest expenses. He also considers two ratios the ratio of operating expenses to total assets and the ratio of operating expenses to income. The figures suggest that bank capital levels should embody a significant element of operational risk. Ford and Sundmacher (2007) also advocate the use of financial ratios such as cost to income ratio as a leading indicator of operational risk. The underlying argument is that a reduction of this ratio, which is essentially a measure of efficiency, is favourable since it implies lower cost per dollar of income. The volatility of this ratio is also a leading indicator as it results from factors associated with operational risk such as asset write-downs, unstable or unpredictable cost structures and volatile income sources. They also suggest a ratio of training expenditure to total expenses and the proportion of incentive-based remuneration.
In another study, Chernobai et al. (2007) examine the microeconomic and macroeconomic determinants of potential losses in financial institutions. On the basis of 24 years of US public operational loss data covering the period 1980-2003, they demonstrate that the firm-specific characteristics (such as size, leverage, volatility, profitability and the number of employees) turned out to be highly significant in their models. They also found that the overall macroeconomic environment is less important, although operational losses tend to be more frequent and more severe during economic downturns. The evidence they obtained indicates that contrary to the traditional view that operational risk is unsystematic, operational loss events cluster at the industry level in excess of what is predicted by the stochastic frequency estimates.
In the context of Islamic banking, there has not been any single study on both methodological and empirical studies in operational risk. Nonetheless, some empirical studies on the aspect of operational soundness in Islamic banks can be found in Ismail and Suleiman (2005), Hassan and Dicle (2005) and Muljawan (2005). This study therefore attempts to fill the gap in the empirical sphere of operational risk by investigating the determinants of operational risks. The empirical part of this study has benefited from utilising the data of the Islamic banking industry in Indonesia which spans the period from January 2001 up to June 2010 (monthly time series data), extracted from published monthly financial reports (balance sheet and income statement) comprising 10 fully-fledge Islamic commercial banks and 23 Islamic business units.
The estimation approach in this study commences by partitioning the business units in Islamic banks into three different income generating channels (IGC), which would then function as the unit of analysis for measuring operational risk3 . Each IGCI, is partitioned into three different units, (a) investment channel- IGCI, (b) financing channel- IGCF, and (c) service channel- IGCS. 4 The level of operational risk exposures is measured as the uncertainty of earnings in each IGC in terms of a series of risk factors. This study, hence, defines uncertainty as volatility.5
An investment channel consists of any investment in the form of a partnership, while a financing channel contains any financing instruments that are used primarily to finance obligations arising from the trade and sale of commodities or property. Service channel, however, consists of any financial transactions that create earnings by charging fees.
In IGCI, earnings are represented by the rate of return on financial securities (RoS), which is based on profit sharing. The financial securities represent ownership of profit-sharing-based investments carried out by Islamic banks.
A proposed set of operational risk categories that can be mentioned here are Shari’ah non-compliance risk, fiduciary risk, people risk, legal risk and technology risk. Due to the quantitative nature of the data, Shari’ah non-compliance risk, legal risk and technology risk, which are qualitative in nature, will not be included in the model as they cannot be captured by the data. As a result, that leaves the model with fiduciary risk and people risk.
Fiduciary risk can be characterised as a condition whereby Islamic banks are liable for losses arising from their negligence, misconduct or breach of their investment mandate. In other words, fiduciary risk is an indication of failure to ‘perform in accordance with explicit and implicit standards applicable to their fiduciary responsibilities’ (IFSB, 2005:26).
In the model, a set of proxies for fiduciary risks is decomposed into a series of risk factors, namely volatilities of (i) volume of investment in financial securities (FS), (ii) return on saving deposits (RoSD), (iii) return on 1-month time deposits (RoTD) and (iv) the ratio of operating expenses over operating income (BOPOI).
The choice of a proposed set of fiduciary risks mentioned in the previous paragraph results from an inference drawn from the definition of fiduciary risk set out by IFSB. It can also be read as follows an unstable volume of investment in securities, return on saving deposits, return on one-month time deposits and operating expenses; reflected by their respective high (low) volatility would demonstrate an inability (ability) of Islamic banks to sustain their fiduciary responsibilities. In other words, a highly steady performance of investment, return on saving deposits and time deposits demonstrates the ability of an Islamic bank to safeguard the interests of their fund providers. Moreover, a high volatility of operating expenses might attribute to the operational errors that a business may incur during its operations (Makridakis, 1998).
People risk, nonetheless, is another type of operational risk arising from incompetence or fraud, which exposes Islamic banks to potential losses. This includes human errors, lack of expertise, compliance and fraud (Akkizidis and Kumar: 2008). A proxy for people risk, on the other hand, is represented by the volatility of training expenses (TrI). It is argued that training expenditure has a reverse effect on the number of employee errors and customer complaints (Taylor and Hoffman, 1999 and Shih, Samad-Khan and Medapa, 2000). The more skilled the bankers, a result of intensive training, the less people risk the bank would incur (Jackson-Moore, 2007). Hence, the higher the volatility of training expenditure the more it would affect the volatility of the operational risk indicator. Therefore, it is expected that the two variables have a positive relationship.
In IGCF, on the other hand, rate of return on financing (RoF) signifies earnings. RoF contains a bulk of returns on financing, which unsurprisingly, is still dominated by the murabaha mode of finance.6 Fiduciary risk in IGCF is symbolised by the volatilities of two elements, namely volume of financing (F) and the ratio of operating expenses over operating income (BOPOF). As for people risk, IGCF employs a similar variable to IGCI, that is the volatility of training expenses (TrF).
IGCS has deliberately been taken out of the analysis since the volume of service fee does not contribute significantly to the value adding process.7
Hence, IGCI has the following the earnings function:
Volatility of return on securities is a function of a series of risk factors, i.e. volatilities of investment in securities (FS), return on saving deposits (RoSD), return on one-month time deposits (RoTD), ratio of operating expenses over operating income in investment channel (BOPOI) and training expenses in investment channel (TrI ).
In the equation above, proxies for fiduciary risk, namely FS, RoSD, RoTD and BOPO are also expected to have a positive relationship with the target variable, RoS. The argument is that the more unsteady or volatile the explanatory variables the more volatile RoS can be. To put it differently, a higher fiduciary risk will be likely to positively impact a greater exposure of operational risk, represented by the volatility of RoS.
IGCF has the following earnings function:
Volatility of return on financing is a function of a set of risk factors, i.e. volatilities of volumes of financing (F), ratio of operating expenses over operating income in financing channel (BOPOF) and training expenses in financing channel (TrF ).
In IGCF, rate of return on financing (RoF) signifies earnings. RoF contains a bulk of returns on financing, which unsurprisingly, is still predominated by the murabahah mode of finance. Fiduciary risk in IGCF is symbolised by the volatilities of two elements volume of financing (F) and the ratio of operating expenses over operating income (BOPOF). As for people risk, IGCF employs a similar variable as IGCI, that is the volatility of training expenses (TrF).
Discussing the Empirical Results
A set of econometric misspecification tests conducted on the models show that both IGCI and IGCF earnings functions have violated the basic assumption of the classical linear regression model in three respects - normality, presence of serial correlation and heteroskedasticity. Thus, the regression results cannot be used as the basis for drawing the conclusion in the analysis. Therefore, modification of the regression models is required.
A technique adopted in this study is weighted least squares (WLS) which, according to Asteriou and Hall (2007), is one of the effective ways of overcoming heteroskedasticity. In addition, this study also utilises the White heteroskedasticity test developed by White (1980).
Due to the presence of autocorrelation problem in IGCI, the model is transformed into an autoregressive model through the Cochrane-Orcutt iterative procedure, which proves to make a positive difference in its DW value from 0.42 to 1.75. More importantly, the model transformation is also very significant at the 1% confidence level.
The empirical results of this study show that there are two main determinants of operational risk exposures in IGCI the volatility of training expenses and the volatility of return on saving deposits. Volatility of training expenses is significant at the 1% confidence level, whereas the volatility of return on saving deposits are positively related to the target variable and significant at the 5% level of confidence. The dominance of training in investment activities gives an indication of the role of an intensive training, which will produce highly specialised human resources, well versed in both Shari’ah and financial economics. In other words, the result shows that the performance of investment activities in Islamic banking is significantly affected by the highly-skilled personnel who run the banking activities, which are unfortunately quite scarce at the present stage. The finding also confirms the concerns raised by Archer and Haroon (2007) and Jackson-Moore (2007).
It is also apparent that volatility of return on saving deposits, which represents a fiduciary role in an Islamic bank, is also essential as demonstrated by the significance of its t-statistics. However, it can be argued that investment activities in Indonesian Islamic banks are highly affected by people risk as compared to other type of operational risks.
The rectified model, nonetheless, is also proved to be the best model, since the variability of explanatory variables can be explained by the model at around 95% as shown by the value of R-squared.
As for the financing function model (IGCF), it is re-estimated by using WLS to address the issue of non-normality and the presence of heteroskedasticity. The empirical results of IGCF show that all variables produce a positive coefficient as expected. Meanwhile, the values of R-squared, F-stat and DW, which are 73%, 96.58 and 2.2 respectively, show that the model now fits in explaining the variation of the explanatory variables with respect to the target variable, namely volatility of return on financing.
It is worth stating that although people risk (represented by TR and is significant at 5% level of confidence) still plays an important role in affecting the magnitude of operational risk exposures; it is no longer dominant in financing activities as compared to its impact in investment activities. Ratio of operating expenses to operating income (BOPO), on the other hand, plays a major role in this regard.
The findings indicate that for financing activities, the role of maintaining operational efficiency as part of an Islamic bank’s fiduciary responsibilities is extremely high in the case of Indonesian Islamic banks. In the model, BOPO is significant at 1% level of confidence.
Following some corrections on the initial models, the empirical finding in this study shows that fiduciary risk and people risk are significant in both channels, IGCI and IGCF. However, people risk is immense and plays a major role in affecting the magnitude of operational risk exposures in Islamic banks, particularly in investment activities. The finding is in line with the concern raised by Archer and Haroon (2007), Jackson-Moore (2007) and Nienhaus (2007) over the high degree of people risk in Islamic banking activities. This finding also validates the priority of Bank Indonesia, being the regulator of the Indonesian Islamic banking industry, to enhance the capacity of the human resource that runs the Islamic banking business, particularly in investment activities, which show an inexorable growth trend over the last three years.
As for financing activities, although people risk is also significant, its impact on the exposure of operational risk is outweighed by the role of the operational efficiency ratio, represented by BOPO. The results suggest that an expansion of financing activities should retain the prudential principle combined with a principle of costs minimisation, as it would otherwise increase the level of un-repayment. Such a finding is in line with the projection of central bank of Indonesia as reported in Indonesian Islamic Banking Outlook (2011).
In a nutshell, the empirical findings of the study suggest that enhancing human capacity and increasing the know-how in investment activities should be the priority of the Islamic bank’s policy, whereas a cost-reduction strategy should be emphasised more strongly in an Islamic bank’s financing activities.
1See Chavez-Demoulin et al., 2006; Coleman, 2003; de Fontnouvelle et al., 2004; de Fontnouvelle et al., 2005; Ebnother et al., 2001; Jang, 2004; Moscadelli, 2004; Lindskog and MecNeil, 2003 ; K. Dutta, J. Perry, 2007.
2See de Fontnouvelle et al., 2004; de Fontnouvelle et al., 2005, Moscadelli, 2004, and Basel Committe on Banking Supervision, 2009.
3Income generating channel is defined as the production unit by which an Islamic bank creates a product to its customers.
4Hence, the bank has three IGCs, namely IGCI (income generating channel for investment channel), IGCF (income generating channel for financing channel), and IGCS (income generating channel for service channel)
5From this point onward, the term volatility is used to explain uncertainty
6As of June 2010, murabaha makes up over 60 percent of the total financing.
7As of June 2010, service fee only contributes less than 2% to the value adding process
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.
NEWHORIZON Zil Haja 1434 – Safar 1435POINT OF VIEW
Where are all the Promised Jobs in Islamic Finance?
The Islamic finance media is at times overwhelmingly of the opinion that there is a significant demand for qualified personnel in Islamic finance in today’s market. In July 2013, Amilin published an article quoting Prof. Dr Baharuddin Aziz, the director of communications for the International Islamic University Malaysia commenting that by 2020 the industry would need 65,000 trained Islamic finance personnel. This message was reiterated in a November of 2012 article by Paul Clark in the financial services recruitment website, efinancialcareers.com, which identified the need for 57,000 trained personnel.
At first glance the enthusiastic student of Islam or financial services would, upon taking stock of these figures, probably decide that an investment in training for Islamic finance would reap sound benefits as the industry is bereft of qualified job candidates. CIMA’s own website currently highlights the need for 50,000 professionals over the next seven years, interesting and worthy of further investigation, isn’t it?
Well, actually the figures can be misleading. The first challenge to the proposed shortfall lies in the definition of ‘qualified personnel’, qualified in what exactly? Is there a need for 50,000 new personnel trained in Islamic finance or is it simply financially services trained in activities such as operations and payments?
Undoubtedly there are regional demands within the Islamic financial services industry such as those seen in Malaysia where Islamic finance has seen phenomenal growth over the past 10 years. Whilst the UK Islamic finance sector has increased its dominance in Europe, the industry at best hires 1,000 personnel (based on insight of the size of BLME, Gatehouse, IBB and others) in non-consulting, delivery roles ranging from teller/customer support through to treasury, front office sales and senior management positions, hardly a dominant force in the recruitment market and not even a consideration for new graduates.
Dedicated Roles in Islamic Finance
Within Islamic financial services there are very few roles that are purely dedicated to the needs of Islamic financial services knowledge. For example, in processing a payment for an ijarah the majority of the necessary product knowledge is based upon activities that are aligned with its conventional cousin, the lease arrangement. Clients need to be brought on board, screened for credit worthiness, accounts will be set up, contracts will be drawn up and signed, payments will be established and funds will be transferred.
When considering the need for a strong knowledge of Islamic financial products we can see that those who have knowledge of the product structures will design the product, the Shari’ah supervisory boards will approve those designs and the legal team will establish the contractual terms and conditions. This is true for most products highlighting that most skills are generic to conventional finance with only a few needing a true grounding in Islamic finance.
Automation and Information Technology
The activities mentioned above are also seeing increasing levels of automation through the utilisation of information technology (IT) with product structures standardised within the software systems. The back office support staff is typically focusing on data validation and entry with very little movement outside of the processes and rules established earlier. Increasing levels of automation within financial services driven by the desire for greater profitability and time to market is recognised as a key influencer in the reduced resource demands across financial services today. It is, therefore, a safe assumption that IT systems in Islamic finance follow the same patterns and as such the need for headcount faces the prospect of further reduction and not growth. The use of IT in turn also brings with it the laws of economy of scale in that the cost to process 100 transactions is not ten times the cost of processing 10 transactions. So, whilst growth will see a demand in the volume of personnel needed it will not be a 1:1 in personnel growth to volumes.
The Mathematical Perspective – Validating the Numbers
We can take an educated guess using a simple mathematical approach to analysing the figures, where we see a very interesting picture of the possible demand/ growth. The illustration below shows a conservative estimate of the number of open positions per year that must be occupied by individuals ‘qualified’ in Islamic finance.
Note The average number of staff per institution total is based on my own estimate, as no official/quantifiable figures are available. As such I have used my experience of institutions within Islamic finance as a benchmark.
We need to reflect, however, that there is growth within the industry when considering the above figures. In 2010, the Islamic Financial Services Board quoted a growth rate of 20% year on year. Table 1 below shows a year on year growth pattern assuming that 20%.
Taking a cumulative picture of those 2,079 candidates growing at 20%, in year five we are hiring 4,311 new personnel per year and in year ten we are hiring 10,727 new staff per year. The total number of new hires over a ten-year period equals 53,968.
Table 1. Staff Growth at 20%
(please see below)
Whilst we can see some validation in the top-line figures mentioned at the start of this article, we must consider that we have assumed that, first of all, job leavers do not simply move to another Islamic financial services organisation and we gain no further operational efficiencies over the 10 years for the figures to hold true. Finally, when considering the mathematics, at year six (assuming 2020), we have only engaged 20,644 new personnel and not the 50,000 – 65,000 we see mentioned at the start of this by media sources. We can therefore see a discrepancy in the expected demand for new personnel within the industry with the media figures not holding mathematical probability.
Social Media Commentary
If one was to visit the various social media websites such as the professional career/networking site, LinkedIn and toured the Islamic finance forums we can see further evidence that challenges the volume of required qualified personnel. There are numerous conversation threads at play from those with all levels of qualifications from industry certifications from organisations such as CIMA and AIMS through to those with Masters and PhDs all looking desperately for their first role in the industry. Whilst the use of social media presents anecdotal evidence at best, it does highlight that there may be contradictory perspectives a shortage of qualified candidates yet with an apparent abundance of qualified personnel desperate to find their desired roles.
The Industries Challenge – Under Qualified Graduates
The challenge for a number of the freshly qualified is that there are no graduate training schemes focused on those with Islamic finance qualifications, but no operational experience. Secondly, the majority of the courses in Islamic finance focus on the academic and theoretical and not the practical. When hiring for an open position in finance, payments, operations and trade-finance, most financial services organisations will not be able to afford the luxury of employing those with no experience as they inevitably need hands-on training, extra supervision and development when there are experienced candidates in the marketplace that can be productive at a much quicker rate than those with no experience and who can study for their IFQ/CIMA at a later date if required.
Logic may say therefore that what Islamic financial services organisations need is a training programme for new entrants. This however takes time and money with no short-term return, a concept that is alien to shareholders who wish to see profit and a return on their investment. Remember, Islam prohibits interest but approves of a fair profit and therefore the desire for a return via profit is halal (not forbidden) and as such the move towards profit is core to the teachings of Islam.
In reality we see the media messages proclaiming a shortfall coming from those with a vested interest in selling the value of education. Education in itself is a good thing, something we all should actively promote. To quote figures that may be construed as misleading to prospective candidates in the hope that they sign-up for expensive courses is not, however, the image that the industry should be portraying and ultimately will leave the industry with an abundance of very highly qualified candidates and little prospect of working in Islamic finance.
To ensure that we manage the long-term picture supporting the potential for Islamic finance we need to ensure that we do not frustrate those who support our industry through false promises and instead turn our focus and paint a more reflective picture of the potential opportunities. That picture will reflect the true growth, the regional variations in demand and turn our education system around so that we deliver graduates with a combination of both the theoretical and practical.
Today’s course offerings would undoubtedly benefit from a combination of practical education in the day-to-day operations of a financial institution examining payment processing, KYC/AML and other such activities with a period of job placement/internship in order that the industry delivers candidates with more than the theoretical perspective. Today’s financial services industry desires and needs those that can be productive on day one and not those that have the theory and no experience as this cost is prohibitive in todays marketplace.
Clearly the message of an abundance of jobs and unqualified candidates is a mixed message. Yes, the industry is growing; yes, the industry needs qualified candidates, but, the industry also needs experienced candidates and this is part of the problem, theoretical training is good but only when supplemented with experience. Can we substantiate the numbers presented by some in the training industry? I don’t believe so; the numbers and the facts just do not tally up.
Prior to undertaking his MA, David was The Interim Head of Projects at the Bank of London and the Middle East and previously the Senior Vice President of Business Change and Process Re-Engineering at the Bank of America where he researched in Islamic financial services. Currently David is a member of two professional bodies: The Chartered Management Institute (FCMI - Fellow) and the Institute of Engineering and Technology (MIET – Member). David’s academic qualifications include an MA Islamic Banking Finance and Management from the University of Gloucestershire/Markfield’s Institute, Postgraduate qualifications in Senior Management and Strategy from the Open University MBA programme and certifications in Islamic Banking, Insurance and Commercial Law from the Charted Institute of Management and Accounting (CIMA).
NEWHORIZON September to December 2013IIBI LECTURES
IIBI Monthly Lecture Series – September to November 2013
Mr Muhammad Khan, a partner at PricerwaterhouseCoopers, began by saying that takaful companies are Islamic insurance companies and like any company they are there to do one thing, which is to make a profit. He added that there is nothing wrong with making a profit. The reason he made that point is that people often say to him that there needs to be a social good in Islamic finance. While that is right, they also need to make money albeit in an Islamic/Shari’ah-compliant way. If you do not make money, you do not really have an enterprise anymore.
If you look at the history of insurance, it is all about pooling risk and if you are talking about more than a handful of people, you need a company to run that pooling activity. The basic tenet of takaful is that you share in the risk and you pay someone to run a company on your behalf and allow them to make a profit. That is non controversial.
The Difference between Convention Insurance and Takaful
In insurance in the UK generally, when you buy an insurance policy from someone such as Royal Sun Alliance or Churchill, what you are doing is outsourcing your risk; paying the insurance company to take the risk off you. That is not true of takaful, where you are still sharing in the risk, i.e. if the takaful company runs out of money because they have had a lot of claims, they can call on their policyholders for more money. This is not true in conventional insurance. The problem is that most people today do not think of insurance as sharing risk. They believe that if they do not make a claim, the premiums they pay should reduce; they forget about risk sharing.
The company taking the contributions/premiums makes money in two ways. It can charge an expense fee or make money by reinvesting the premium fund. In the past there has been a slight misunderstanding about how much you can charge in terms of those fees. Traditionally, when takaful companies have first set up in business, the fees have been quite high. They can be 30-40% of the premium. This is not necessarily unfair as the companies need to build up funds to pay out on claims, but most policy holders do not realise that and yet the whole point of Shari’ah insurance is to make things easier for people to understand.
In addition most customers probably do not understand that if a company makes a profit, the policy holders’ fund makes a profit and they are entitled to a share of that profit. If you look at takaful companies around the world, how many of them have issued a profit to the policyholders? The answer is hardly any, although, because the industry is so young, many takaful companies may have decided to retain profits for prudential reasons.
The rationale for highlighting these points is that takaful companies were originally established, just like insurance companies, in most countries, by the people, for the people. Most people, however, do not understand the contracts to which they are signing up and secondly what they are entitled to under the contract. This is quite fundamental, because, if the one of the main purposes of Shari’ah finance was to make it easy for consumers to understand, it is failing. Part of the reason for this misunderstanding is traditional. Most people, when they think about insurance or takaful, think about what they already know.
There are also very few people who will look at the accounts of the insurance company from which they buy insurance. In the UK they probably do not need to, because, for example in the case of motor insurance, if a company fails, there is a body who will step in. In most countries that sell takaful, there is no such body. When consumers take out an insurance policy, they should think about whether the company is going to survive or not.
How Insurance Works
Insurance companies use their premium income to pay out claims; they set some aside to create a reserve against future claims; they need a proportion to cover expenses and what is left is the profit. The difficult part of this sum is deciding how much to set aside for future claims. Takaful companies are more complicated. They need to deduct the amount of money needed to run the company plus the profit for the takaful operator. As mentioned earlier, they can charge an upfront premium to cover that (wakala) or they can share in the profit the insurance company makes (mudarabah).
If a mudarabah model is being used, the operator wants to maximise the profit of the insurance company, which might mean they take more risks with the company; invest in riskier assets. Under the wakala model the operator wants to maximise contributions; bluntly it wants more customers or to charge higher premiums.
What Policyholders Want
What do policyholders wants from the insurers? First, they want the company to last a long time; they want to maximise profitability, but at the same time they want the company to be prudent in the way it runs itself. Some companies have taken a hybrid approach using what they see as the best elements of both models. Typically the way that has worked in the Middle East is that companies have taken a percentage of the insurance premiums (it used to be 40%, now it is about 10%) and they also try to take a percentage of the investment income.
If you look at takaful companies around the world, one of the big problems they face is one of scale. Muhammad Khan said that in his view there were too many takaful companies in the Middle East. For example, in Qatar there are more than 40 such companies, predominantly writing motor insurance for a population of slightly less than 2.1 million people; that is probably too many companies. That pattern is replicated in the rest of the Middle East. That leads to problems, because there are not enough customers to enable the companies to drive premium revenue. Similarly, if they are trying to maximise profit, they are faced with a large expense base and the efficiency measures that can be taken are finite.
In Malaysia there is competition between conventional insurers and takaful companies. When premiums are low in takaful companies, you will find 30-40% of policy holders are non Muslim and vice versa.
Mohammad Khan is a partner in PricewaterhouseCoopers LLP. He leads the personal and commercial lines actuarial practice and is also the firm’s UK Islamic Finance Leader. He is an expert in insurance and reinsurance in the Middle East and has significant experience of working in the region.
As PwC UK’s Islamic Finance Leader he has advised clients on converting their banking and insurance operations to be Shari’ah compliant and helped to establish and grow takaful and retakaful businesses.
Today, most takaful companies just sell policies to the general public – personal lines. They do not provide business insurance, where operators require substantial funds (capacity) to enter this sector of the market. For example, if one of the jackets of a North Sea oil platform collapses, how much would an insurer have to pay to rectify the problem? You are probably looking at £150 million. The problem is takaful does not have much capacity, even in Malaysia.
Another problem is whether people understand the pricing in these markets, whether that is takaful or conventional insurance. In the Middle East in particular there is so much competition that premiums are insufficient to cover claims. The operators’ duty in this situation is to raise premiums, but if they do they will lose all their business. If they do not do that and say maybe premiums will rise in the future, implicitly what you are doing is sacrificing your current policy holders for future policy holders. How can that be equitable or Shari’ah compliant? What would a scholar say about that? It is an interesting question with which people have not really grappled.
Separation of Funds
In takaful there is a requirement to have a separation of funds – the participant or policyholders’ funds and the shareholders’ funds. Participants put money in; the operator takes some of that money to run the company and all the rest of that money has to be kept completely separate from how the operator spends its money. In a conventional insurance company that is all one single fund. Most important, in a takaful company is the separation of the money set aside for claims, because that is by far the biggest number on any insurance company’s balance sheet, whether that is conventional insurance or takaful.
If a takaful company runs out of money, they will pay out on claims by giving the policyholder an interest-free loan and any future profits will be used to pay off those loans. To some extent this explains why takaful companies in the early years of operation may charge as much as 40% in expenses; they know there is a strong probability that they will have to make these interest-free loans, but at the same time they need to make a return. High fees at the start are not necessarily non-Shari’ah compliant or unfair.
If the takaful entity makes a profit, the profit can be distributed
back to the policyholders. That could be in the form of a cheque in the post, a reduction in premiums or a guarantee of lower premiums for the next three years, for example. These are all ways of distributing the profit. Muhammad Khan said that he felt that there was currently insufficient transparency around that issue. He added that did not mean the companies were not trying, but that policyholders did not understand what was going to happen. Any distribution, of course, assumes the company will make a profit and it might not.
Mr Khan went on to say that one of the advantages of pooling risk rather than outsourcing it was that participants/policyholders might be more likely to think twice about making exaggerated/fraudulent claims, because they could see the direct effect that would have on them and the profit made, although he warned that not all policyholders might understand that. He said that if the takaful industry was going to expand, it was key for policyholders to have a much clearer understanding of what takaful is all about and the risks they are taking on when they buy a policy.
An Operator’s Duty
An operator’s duty in takaful is very much a balancing act. The operator has to maximise profit in order to remain in business; they have to have fair contributions or premiums, although these may in the early years be relatively high; they have to meet participants’ reasonable expectations, which again raises the issue of whether they fully understand the policy they are taking out and the operator has to protect the takaful funds.
In response to a question about tax on profit distributions Mr Khan said that in a UK context he believed that any such distribution would be treated as income and would therefore be taxable. He said he did not know what the situation would be in the Middle East. He added that all the profit distribution examples of which he was aware had been in the form of reduced premiums in future and this would not be treated as income.
A second question related to cash calls on policyholders. Mr Khan said that he was not aware that any such calls had ever been made. He suspected that if anyone made a call no one would pay.
NEWHORIZON September to December 2013IIBI LECTURES
Mr Faisal Khan, Director, Banking and Insurance, 3i Infotech, Western Europe began by saying that his presentation would look at both takaful and Islamic banking and compare these two manifestations of Islamic finance to conventional insurance and banking from a competitiveness point of view. At the end of the day we live in a plural world and Islamic finance has to coexist with competitive forces, i.e. conventional forms of insurance and banking.
He said he would then turn to technology and share some thoughts on where technology is today and what are the conventional worlds of banking and insurance thinking about. In other words how will they exploit technology to make themselves more competitive and be as strong as possible. He said he would then look at how Islamic finance can exploit the same technology and why it is not doing it at the moment. He said he believed if Islamic finance were to do so it would compete and progress would be much faster than it is.
The good news is that year on year global premiums for takaful have been increasing at around 20% per annum. The premiums, which are now touching $19 billion per annum, are, however, miniscule compared to conventional insurance; it is probably less than a half of 1% of global insurance premiums. We can on the one hand be justly proud of the growth of something that started in 2004; it has grown by about six times in the space of nine years, but it was a small start and the industry has a huge amount of work to do to make this a stable offering in the Islamic world.
What are the business challenges faced by takaful operators? The challenges vary somewhat from year to year as the market changes. Looking at Ernst & Young’s 2012 takaful report the least difficult challenge was tapping pent-up demand. That is to be expected, because the market for takaful is vast and today the industry is just skimming the top of that demand. The issue is and never has been, therefore, about demand.
The number one issue in 2012 was competition. (It has always been a top three concern.) That tells us that it is tough to compete against other takaful operators and most importantly it is extremely tough to compete against conventional insurers. It is critical for takaful operators to ask themselves how they make themselves more competitive and secure a bigger share of the market.
In 2012 the second most significant challenge was regulatory compliance. In particular Solvency II is lurking just around the corner. This is an extremely strict set of solvency requirements that every company, certainly in Europe, has to face. It will demand a lot of changes among insurance operators, particularly around the data that is captured and the data they have to provide to the regulator for transparency purposes. It has, therefore, become a significant cost. For the relatively young takaful industry with immature systems, this is a significant challenge.
In third place in 2012 was a shortage of expertise. Again, this has been a top three challenge since 2009. This is to be expected, because takaful is a new industry. Experience of underwriting and risk assessment is limited.
For the first time we are beginning to see takaful operators talking about costs, misaligned costs relative to conventional insurers. Mr Khan said that is why he believes the industry has to grasp the technology challenge and begin to address some of these issues.
Insurance Company Statistics
It may be argued that the aims of a takaful operator are not the same as for conventional insurance. Takaful is, however, competing in the marketplace with conventional insurance and therefore it is necessary to have some KPIs (Key Performance Indicators) to measure their success. The measures in the diagram have been chosen, because, even in takaful, there are three sets of stakeholders – the investors, the takaful operator and the people requiring insurance.
The comparisons are based on takaful and conventional operators in the GCC states. Firstly, return on equity is what the investors will be looking for. Takaful operators in general are less than half as successful as conventional operator on return on equity.
Second is investment returns, the money insurance operators earn by investing surplus funds. Takaful earns 6% compared to 11% in conventional insurance.
The expense ratio is essentially the ratio of all administration costs relative to the premiums being collected. It is an important measure of efficiency. Conventional insurance sits at 23% and takaful at 33%; takaful is almost 50% less efficient.
The combined operating ratio represents claims plus administration relative to premiums. If the claims plus administration is more than the premiums, the company is making an operating loss. The ratio for takaful is 102%, which means they are making a loss. This is counterbalanced by the 6% they earn from investments. Conventional insurers have an operating ratio of 77%. There are two factors that contribute to the higher administration costs in takaful. Firstly, they are inefficient and secondly the claims are higher, suggesting their risk management is also less good. This comes back to expertise, having systems and data to analyse, which conventional insurers do very well.
Looking at the other big centre for takaful, Malaysia, again the return on equity is very small and the investment return is half that of conventional insurers. Takaful operators have, however, started to address the issue of efficiency and are as efficient as their conventional counterparts. Malaysia seems to have more mature operators, who have understood how to compete against the conventional operators.
This situation in relation to takaful operators cannot be sustained, if the market is going to continue to grow at 20% or higher. It has to address those issues. If they do not, in 10 or 15 years, even though there is market demand, it will not have the sustainable profitability to continue to operate.
The Takaful Operator’s Viewpoint
The people inside the takaful operation have a lot of pulls and pushes acting on them. Firstly, they have to follow the principles of Shari’ah, which is not easy, because there is no uniform regulatory environment across the different countries. Being compliant is a significant cost.
Second, as well as being Shari’ah compliant, they have to be compliant with Solvency II, another set of regulations. Mr Khan said that he believed the first quarter of 2014 is the date when insurance companies have to be compliant with Solvency II. That is a massive overhead. Conventional insurers, however, only have to comply with Solvency II. Takaful operators have a double headache, because they have to be Shari’ah compliant as well.
Third, how do companies safeguard everyone’s interests? Some of the edicts coming from those bodies that set Shari’ah rules are contradictory.
Faisal Khan’s career in the IT industry spans 34 years, 19 years spent with IBM. He currently runs the banking and insurance business for 3i Infotech (Western Europe) Ltd as well as sitting on the Partner Advisory Board for Oracle. He is an engineering graduate from Cambridge University and has a Masters in Computer Science from London University.
As PwC UK’s Islamic Finance Leader he has advised clients on converting their banking and insurance operations to be Shari’ah compliant and helped to establish and grow takaful and retakaful businesses.
For example, how can takaful operators use surpluses? There has been a recent edict, which said that any surplus can be shared between not only the contributors, but also with the takaful operator. What about the shareholders? Why should they not be able to share in any surplus? There are all sorts of interesting issues that have to be addressed by the takaful operators concerned.
Profitability is also a challenge, as is consumer confidence. A case in point is the former UK Principal Insurance, using the brand name, Salam Halal Insurance. This was £60 million of private investment into the first takaful operator in the UK. It failed after 18 months to the chagrin and anxiety of the Muslim community, because many Muslims had supported it by insuring with it. It was sold in 2012 to a run-off operator in the UK for £4.5 million. The industry can continue to grow, but if the bottom line does not work, there is going to be a lot of disappointment and dissatisfaction among the Muslim community.
Key Strategic Issues for Takaful
The efficiency of the operation is fundamental, so too is the quality of the underwritten business. Unless companies have the ability to analyse their risk and understand what it is they are underwriting, then claims will be much higher than expected. Capital requirements, solvency and regulation are the other issues.
The Potential for Takaful
There is, however, huge untapped potential for takaful. If the industry can get the fundamentals right, there is a very bright future for takful in both Islamic and non-Islamic countries, because takaful has an appeal to everyone. It is about ethics and how you provide trust in a world that does not have trust. In a recent survey conventional insurers do not come out very well on trust, so this is an opportunity for takaful.
There is a very small Muslim population in the West, but the GDP created by Muslims in the West is significant and so their potential for premium is massive. Some 50% of the potential premium for takaful could come from Western Europe and the USA and the industry needs to be conscious of that. It needs to develop takaful so that it is efficient and provides a service that is as good as that provided by conventional insurance.
The good news is that Islamic banking is growing at 20%. In 2012 the sector had assets worth $1.4 trillion, but that is still only 1% of the world’s total assets and there are some underlying concerns.
Key Performance Indicators
Islamic banking produces a return on equity of 12% whereas conventional banking produces 15%. Return on assets is 1.3% in Islamic banking compared to 1.7% for conventional banking. There is better news on cost of funds with Islamic banks being able to obtain their funds at the same sort of costs as conventional banks.
Comparing operating costs with operating income, the cost for Islamic banks is 47%, whereas for the conventional sector it is 40%. That is significant; to operate at 7% higher costs than your competitors is a tough call. Finally, provisions compared to operating income are 19% for Islamic banks compared to 12% in the conventional sector.
On almost every count Islamic banking has a challenge. Analysts and commentators recognise that Islamic banking has a challenge in relation to regulatory issues, risk transformation and how they operate in the retail environment.
Technology is what will make the difference in banking. It is required to help compliance with regulation; to understand customers and the environment and delivery.
Banks, Insurers and Technology
The technological concepts being debated by conventional banks and insurers are also key to the future of the Islamic sector; this is the path Islamic banks and insurers have to follow. If they do not bite this bullet, then the conventional sector will move ahead.
Relationships at Scale
To deliver service to a customer today banks and insurers have to take advantage of all the digital information that is around their relationships with customers.
NEWHORIZON Zil Haja 1434 – Safar 1435IIBI LECTURES
Whereas 15 years ago IT used to spend all of its time worrying about the transactions, the issue today is how do banks and insurers use technology for interactions; how do they manage their relationships with customers through the digital information they get. That is the challenge with which conventional banks and insurers are grappling. The Islamic sector has to start to think about that. It is all around the fact that today there is so much digital information available and how institutions use that data to ensure its relationship with each customer is individual; it is about mass personalisation.
Typically large institutions have been heavily departmentalised. These departments have been silos. Technology at first mimicked that style and accentuated those silos with the results that today one department simply does not know what another is doing.
The issue today is how to use technology to create seamless collaboration. This really does address the fundamental issue of efficiency, because when an institution has to go from department to department to get something done that creates cost. Relatively new social technologies such as Facebook have really revolutionised the way information can be opened up across silos, so the challenge is embedding social technology into enterprise technology.
Today the world is creating huge quantities of data. The diagram illustrates this very clearly.
Another term for this phenomenon is ‘big data’. Some 90% of the world’s data has been created in the last two years, so before that we had conventional systems and all they did was generate transaction data, but suddenly the world has opened up to data, which is being generated all the time. We are all part of that; we use Facebook, Sykpe and similar technologies, which adds to the data in the world. On a daily basis we are generating 2.5 quintillion bytes of data or the equivalent of one billion Wikipedias.
The real issue about design for analytics is that there is a sea of data and in it there are nuggets of gold. From a corporate point of view we have to find ways of navigating that data to create a better understanding of organisations and their customers. If that can be done, then we start to leapfrog where conventional banks and insurers are today.
Everything today is real time, but enterprise systems were designed to be batch, so there is a real need for banking and insurance systems to move onto a world where data is generated and analysed in real time in order to take decisions in real time. This topic is at the top of the agenda for the finance industry today.
Processing virtualisation has happened already. Once upon a time we used to run one process on one operating system on one processor. Virtualisation has allowed us to run as many programs as we want on as many processors as we want and it is transparent. This means that processing is now a commodity.
We have done the same with storage. Through storage networks we do not care where data sits; we can always find it and we can manage huge amounts of it.
The same is happening now with networks. We are going to be able to manage networks through software and that will bring another level of flexibility and agility in markets.
Everybody has heard of the Cloud. The Cloud means the movement from fixed cost. In the old days organisations had to build £2 million of hardware, £1 million of software and a lot of networks, before you could even start business. Today in a Cloud environment they are basically buying a bit of an infrastructure that already exists. They are, therefore moving from fixed costs to variable costs. That is a fundamental shift. When we look at things like return on assets and return on equity, this is a shift that the world of Islamic finance has to absorb.
Organisations can have a private Cloud, a managed Cloud or a public Cloud, so this is offering all sorts of new flexibility and choices for people who are savvy enough to understand what they are doing. Many banks today will not consider the Cloud. They say it is insecure, but they have not understood what the Cloud means.
It is critical that Islamic finance institutions put in the work to assess the likely impact of the various technologies on different aspects of the business. This is not a trivial exercise, but it is worth doing, with a view to making the investments that will produce a quantum leap in performance. The diagram shows the likely impact of different technologies in takaful and banking.
Institutions need to address the underlying performance of Islamic financial services. They also need to understand that technology can be a weapon. Mr Khan said that virtually every takaful and Islamic banking operation he had come across viewed technology as a necessary evil that they have to have because the conventional sector has it. That is a defensive reason for investing in technology. Mr Khan said that he believed Islamic finance has to turn that around and begin to think of technology as a weapon.
The people who will drive a change in thinking are the boards and CEOs. The key issue is, do they even understand what this debate is about, so there is a huge education task that needs to take place. Sound external advice is also going to be critical.
Principal Insurance, the failed UK takaful operation, chose Capita to provide their IT services. Mr Khan said that Capita is the most expensive outsourced IT operator in the UK. This decision was taken, because nobody on the board of Principal understood anything about IT. It is critical to get across to people in leadership positions the real benefits of technology; how it should be used and what should it cost.
The UK has many young, outstanding technology experts. Their knowledge has to be harnessed and brought into Islamic finance debates.
Everybody will be familiar with recent initiatives in London to try to establish the UK as a centre for Islamic finance. Everyone also knows that Kuala Lumpur and Dubai are also vying for supremacy in this field. Islamic finance in the UK does not have a very good track record in the retail elements of finance. For example, if you look at the six Islamic banks in the UK, none of them is profitable. That is not a very strong story to tell. On the wholesale side, however, there is a huge amount of activity and there is a need to use our expertise to ensure London is pre-eminent. London has lots of legal and accounting expertise, but not technology expertise; that situation needs to be remedied.
It should be remembered, however, that conventional banks also have their problems, particularly the reliance on legacy systems. Islamic banks do not have that legacy, so they are at something of an advantage there, if they understand the power of technology and start to adopt it now.