ISLAMIC FINANCE
Faysal Itani of political risk experts Exclusive Analysis outlines the
competing interpretations of this major growth industry
Islamic finance is a major growth industry – particularly in the Gulf countries, as well as Europe and Malaysia – with assets increasing at the rate of around 10-15 per cent each year. There are now approximately 300 Islamic financial institutions spanning over 75 countries. Given the present financial climate, Western banks are desperate to attract new sources of capital, just as investment managers are eager to find new funds to manage; however, religious incompatibilities may limit their ability to access the Islamic market. What, then, is Islamic finance, and how does it differ from ‘mainstream’ financial practices? Will more Western institutions look to become compliant with Sharia (the body of Islamic religious law), and what will this process entail? Who determines what is ‘Sharia-compliant’ and what is not, and on what basis? Are these standards consistent, and, if not, what risks might this present to business? These are some of the key questions addressed in this piece.
THE PRINCIPLES OF ISLAMIC FINANCE
Sharia is derived from the Qur’an (Islam’s sacred text), the Sunnah and Hadith (the practices and sayings of the Prophet Muhammad) and other sources such as fatwas (rulings made by Islamic scholars). It broadly prioritises equality, justice and partnership over uncertainty (gharar) and individual profit. Applied to finance, these principles prohibit the sale and purchase of money or debt – interest, or riba, being considered the ‘price’ of money – and require that investment income derive only from tangible assets. Thus a number of transactions familiar to conventional finance – such as insurance, forward foreign exchange trading and share options – are denied under Sharia, since they hedge outcomes against what is considered to be God’s will. Still, most conventional finance mechanisms do find their counterparts in Islamic finance; for example, Islamic financiers can generate profits by entering into partnerships with borrowers or by charging transaction fees that usually correlate closely to conventional interest rates. The following glossary of key Islamic finance mechanisms further illustrates these occasionally subtle differences and similarities.
WHO DETERMINES COMPLIANCE?
WAside from Sharia principles, there is no agreed-upon body of law governing Islamic finance, which therefore remains a work-in-progress characterised by the simultaneous proliferation of different types of financial products (see above) and of differing compliance interpretations across the Muslim world. The key challenge for the sector is to ensure that these products offer similar financial returns to conventional products without compromising religious standards; so long as there is no ultimate human or institutional authority to determine Sharia compliance, this will remain an area that permits considerable latitude for interpretation.
In practice, the determination of Sharia compliance falls to boards of scholars who liaise with lawyers and bankers to create instruments that meet consumer needs. At this point in time, however, there are reportedly just 60 scholars globally with the requisite skills in both Islamic law and finance – far less than the number required to create consistency across major international institutions. One such institution, the Bahrain-based Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI), has, since 1991, issued up to 70 standards on accounting, auditing and governance. A similar body is the Islamic Financial Services Board (IFSB) located in Malaysia, which hosts the world’s largest sukuk market. But thus far no institution has successfully established itself on a global scale to deliver and ensure technical and contractual standardisation. Regional variation is significant and unlikely to be overcome, given the enormous diversity in how Islam is practised across the Muslim world, from relatively liberal Malaysia to conservative Saudi Arabia and among a broad array of Muslim communities in the West. Ultimately, standards articulated by these institutions are not enforceable, allowing different scholars – even within the same jurisdiction – to maintain divergent interpretations.
THE COMPLIANCE CONUNDRUM:
JUST HOW ‘ISLAMIC’ IS ISLAMIC FINANCE?
The majority of Islamic finance products, including most takaful and retakaful transactions and profit-bearing deposits, are uncontroversial. However, with more diverse products coming onto the market in recent years, some Islamic scholars have complained of a loss of control and integrity – of banks that appear to place market demands ahead of the need to facilitate ethical investment. Bankers have sought more flexible forms of finance that do not depend on the collateral of an asset or property but nonetheless provide investors with capital protection, thus taking on the appearance of debt financing.
The trade-off between market demands and the principles of Islamic finance was illustrated in early 2008, when Sheikh Muhammad Taqi Usmani of the AAOIFI ruled that 85 per cent of sukuk contravened risk- and reward-sharing principles. Sukuk issuance subsequently fell by 50 per cent in the first half of 2008 (though this was likely significantly due to global financial conditions). The AAOIFI also saw the particular musharaka and mudaraba mechanisms used in such sukuk as illegitimate, since they offer investors an undertaking that the issuer will pay back the face value of the sukuk when they mature or in the event of default – in other words a guaranteed return, which undermines the prohibition of interest and the prescription that borrowers and lenders share risk and profit. Elsewhere, the use of commodity murabaha by some Islamic banks (whereby surplus cash is used to purchase a basket of commodities – such as metals – held by another bank for a specific amount of time and for a pre-determined return) has been criticised because many of these transactions do not actually result in assets changing hands or even involve commodities at all.
As Islamic finance continues to innovate, there are ongoing debates about the status of new instruments. Rather than lead to the dilution of Sharia-compliant values, such debates are just as likely to lead to a more explicit assertion of them. For example, since the AAOIFI judgement, over 50 per cent of issued sukuk have been in the form of ijara sukuk (lease financing), widely regarded as permissible. However, this sort of standardisation is only likely to occur at a regional level, as Islamic finance products generally cater to domestic or regional markets. Complications remain likely with regard to more complex financial instruments and organisations such as derivatives, hedge funds and those that involve cross-border markets.
ISLAMIC BANKING IN THE GULF COOPERATION COUNCIL STATES
Among the Gulf Cooperation Council (GCC) states – Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates – in particular, complying with the requirement that a tangible asset represents the underlying source of investment income has led to a concentration of risk in real estate. Islamic investment banks in Bahrain, and even more so in Kuwait, are highly exposed to large scale real estate projects for which there is falling demand. Retail banks in the UAE are particularly exposed to the housing market, as they provided ‘mortgages’ at a loan-to-value ratio of up to 95 per cent against apartments in residential areas that were rapidly appreciating at the time but have seen prices fall significantly in 2009 – by as much as 55 per cent in Dubai, for example. (Saudi banks are much safer, due in large part to the absence of a mortgage law.)
Deterioration in real estate asset values throughout the GCC states is likely to continue until 2011, with those projects that have not been cancelled coming to the market with reduced specifications, scope and prices. Also at risk are Islamic bonds, where the requirement of a beneficial interest in a real asset links bondholder payments to the receipt of timely payments on sales of real estate assets – for example, the huge sukuk issues undertaken by the Nakheel Group, Dubai’s largest property developer.
ISLAMIC BANKS VERSUS ISLAMIC ‘WINDOWS’
Islamic windows – such as HSBC Amanah, Bank of Ireland’s Amaar and Lloyd TSB’s Islamic Account – are Sharia-compliant divisions within conventional global banks. For some Muslims, the integrity of the products offered by these windows is compromised because the banks cannot guarantee that the overall capital base that underpins them is Sharia-compliant. Islamic banks, on the other hand, sidestep this issue because their deposit base is independent from the inter-bank market. Preference for either form is likely to vary with geography: Muslims in the West are more likely to be familiar with the conventional banking system. For example, the UK now boasts 23 conventional banks providing Islamic products – more than the rest of Western Europe combined – alongside several exclusively Islamic institutions, such as Islamic Bank of Britain, the European Islamic Investment Bank and the Bank of London and the Middle East; making it the biggest Islamic finance hub in the West.
www.exclusive-analysis.com
Ijara is a leasing arrangement whereby a bank, instead of lending money and charging interest, profits by purchasing an asset and leasing it to the customer for a pre-agreed rental over a specific period. Various forms of ijara financing are seen as equating to conventional mortgage mechanisms.
Murabaha is a purchase and resale arrangement. Capital providers purchase an asset on behalf of a customer and, after adding a predetermined profit margin, re-sell it to them on a deferred basis. As with a rent payment arrangement, the provider owns the asset until the agreed amount is paid in full.
Mudaraba is an investment contract under which one party provides the capital and another – for example, a bank – provides investment expertise in order to advance a business activity. Profits are shared between the parties according to a predetermined ratio. In the event of a loss, only the capital provider/customer is liable, while the ‘expert’ takes no fee.
Musharaka is a profit and loss sharing partnership whereby two or more parties combine their capital, ideas and labour to create a business. While profits may be distributed according to any pre-agreed ratio, losses must be borne in proportion to the partners’ original investments.
Sukuk are popularly known as ‘Islamic bonds’, but whereas bonds represent contractual debt obligations, sukuk confer whole or part ownership of underlying assets and may be issued through any of the above mechanisms.
Takaful and Retakaful are alternatives to conventional insurance and reinsurance, respectively, under which participants contribute money to a collective pool in order to guarantee each other against loss or damage.
Islamic finance is a major growth industry – particularly in the Gulf countries, as well as Europe and Malaysia – with assets increasing at the rate of around 10-15 per cent each year. There are now approximately 300 Islamic financial institutions spanning over 75 countries. Given the present financial climate, Western banks are desperate to attract new sources of capital, just as investment managers are eager to find new funds to manage; however, religious incompatibilities may limit their ability to access the Islamic market. What, then, is Islamic finance, and how does it differ from ‘mainstream’ financial practices? Will more Western institutions look to become compliant with Sharia (the body of Islamic religious law), and what will this process entail? Who determines what is ‘Sharia-compliant’ and what is not, and on what basis? Are these standards consistent, and, if not, what risks might this present to business? These are some of the key questions addressed in this piece.