The post-crisis period has seen huge scrutiny of bank solvency, the sale of toxic debt, corporate governance and risk management inadequacies as well as the lack of accountability and ethics that triggered it. Regulators could have prevented the crisis, but didn’t properly supervise the market. They failed to forestall excessive borrowing, ensure a high level of transparency or stop credit agencies from incorrectly pricing risk.
Ethical Attraction and Financial Performance
For these reasons both Muslims and non-Muslims began seeking more ethical ways of banking, buying and selling loans, and for investing. “After the financial crisis they started to look at Islamic finance because of its ethical nature, whereby you can only do business according to the worth of the underlying security – such as an asset – and you cannot exceed its value”, says Mirza Baig, chief executive (CEO) and chief investment officer (CIO) of Unites Arab Emirates (UAE)-based investment holding company MKB Global Holdings. Conventional non-Islamic financial models allow for a loan to be made to a person, company or an institution in multiples of the actual value of an asset, but this is prevented by sharia law.
Investors also found financial incentives in Islamic finance. Dr. Hatim El Tahir, director of Deloitte’s Bahrain-based Islamic Knowledge Center (IFKC), says there was a general shift in attitude away from traditional asset classes, such as equities and real estate funds that were badly affected by the post-2008 downturn. This led to the development of several new asset classes in Islamic finance – including sharia-compliant exchange traded funds (ETFs), structure funds and hedge funds. These often outperformed their conventional counterparts while offering reasonable liquidity and investment security buffers to investors as well as sukuk issues (Islamic bonds) – worth a record US$140bn in 2013.
Sharing and Mitigating Risks
Treasury and investment banking expert Yousef ‘Joe’ M. Alsufiani outlines how Islamic finance works in practice within treasury operations: “For a product to be sold to you that is sharia compliant, you would have to take a certain amount of the risk as a customer. So you have to be exposed to risk, and demonstrate that you are making an effort to generate revenue.”
The financial institution (FI) shoulders some of this risk, which is often mitigated through a process of profit-sharing. So if a customer ‘loses’, the FI can’t make money. Conversely if he ‘wins’, the bank can share the profits with its customer. However, sharia forbids the charging of interest.
Daud Vicary Abdullah, president and chief executive (CEO) of the Kuala Lumpur, Malaysia-based International Centre for Education in Islamic Finance (INCEIF), adds that Islamic liquidity management (ILM) is no different from conventional liquidity management in terms of purpose and reasoning – except as regards the instruments used within treasury operations.
Malaysia has been foremost in creating an enabling environment for Islamic financial Institutions (IFIs) to manage their liquidity. In 1994 the Islamic Interbank Money Market (IIMM) was created to help IFIs with this task. The three components to the IIMM are: a mudarabah-based interbank market for deposits, a platform for issuing and trading short-term Islamic financial instruments, and an Islamic cheque clearing system.
Bank Negara Malaysia’s Islamic Interbank Money Market within the Dual-Banking System:
Interbank deposits are a key component of IIMM. By using the Mudarabah Interbank Investment Scheme (MIIS), Islamic banks and FIs can lend and borrow between themselves. A mudarabah contract involves negotiating a profit-sharing ratio rather than the charging of interest. “To avoid any moral hazards within the IIMM, Bank Negara Malaysia the central bank has a minimum benchmark rate for Mudarabah Interbank Investment (MII), equal to the prevailing rate of the Malaysian government investment certificate (GIC) plus a spread.
Another key component has been the creation of a separate cheque clearing system from the conventional one – as Bank Negara Malaysia has done. It requires Islamic banks to have an Al Wadiah current account with the bank. Al Wadiah is defined by Bank Muamalat as: “a concluded contract between the owner (the depositor) of the goods or money and the custodian (the banks) for safekeeping (under which) the depositor grants the bank their permission to utilise the money for whatever is permitted by [sharia]”. To avoid any questions over liquidity, it requires Islamic banks to “automatically offset the funding position based on the Wakala concept”, says Abdullah.
Wakala is an agency contract for brokerage services when a client seeks finance for an asset or activity deemed as ethical under the principles of sharia. It requires the client to act as the agent of the bank to acquire the asset before it is sold to him by the bank in interest-free credit instalments. Agents can be compensated with a fixed, variable or performance-based payment model, which is utilised to establish the cash flows and payouts as part of the financial engineering process.
Ijara is an alternative transaction model, requiring an exchange based on a specified asset in return for a payment, but in this case ownership is not transferred – much like an instalment leasing agreement in conventional finance.
“Under an Ijara structure, an FI acquires a specific asset based on mudarabah or istisna’a – the latter of which funds the construction of a particular asset, which it immediately leases to a customer for an agreed period of time as a lease or rental payments by either using a predetermined rate or by referencing it to an underlying rate (such as the London Interbank Offered Rate [LIBOR]) plus an agreed profit margin”, explains Mirza Baig.
Enforced Transparency and Regulation
As mentioned, inadequate transparency was cited as a key failure of conventional banks and FIs. Sharia compliant contracts require transparency from the outset of any negotiation – including in a sharia-compliant treasury. “It is part of the contract with regards to charges, fair terms of agreements, clarity, avoidance of uncertainty and ambiguity and it must detail the type of investment”, says Samir Alamad, head of sharia compliance and product development at Al Rayan Bank.
“The Islamic finance principle and the risks involved should be made clear to the other party, and the agreement should show that is has been approved from a sharia compliance perspective.” Compliance approval usually comes from a Sharia compliance board, although this is complicated by opinions often diverging on whether an investment is or isn’t sharia compliant.
Since 2008, conventional banks and other traditional FIs have faced increasing levels of regulation, designed to prevent a reoccurrence. By comparison Sameh Fouad, Middle East and North Africa Director at SunGard, suggests there is a need for “properly defined regulations in Islamic banking as some countries have no mechanism in place for regulating the Islamic finance market – so Islamic finance should not be viewed as an escape from regulation for conventional banks, but as a rather exciting and new opportunity for them.” Yet they will still be affected by market trends – not even Islamic FIs can totally avoid them although they were less impacted by the crisis.
Baig also underlines the fact that sharia is not a codified law, but a set of provisions derived from different sources, and as such subject to different interpretations. “Islamic products and structures must be therefore be developed in co-operation with Islamic scholars – the sharia compliance boards”, he says. Even so some standards of practice are being developed. For example, the Bahrain-based Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) has launched a programme to harmonise practice of Islamic finance and aims to offer independent assessment of sharia compliance.
There is also the International Islamic Financial Market (IIFM), which has drafted master agreements intended to provide a basis on which transactions may be negotiated. Furthermore Islamic treasuries are often set up – even in conventional FIs – to ensure that sharia compliance is upheld. At the same time Islamic finance already complies with international regulations, such as the Markets in financial Instruments Directive (MiFID). The religious element of Islamic finance, absent from conventional finance, nevertheless makes compliance with Basel III a challenge.
The key Islamic finance markets are the Middle East, North Africa and Asia. Yet investors and financial intermediaries in North America and Europe – particularly the UK – would like to understand, use and benefit from Islamic finance’s structures and products. The liquidity of Islamic finance is among the attractions and interested parties include Goldman Sachs and Société Générale. Baig mentions that in 2008 the market wanted to gain a share of the Islamic funds liquidity pool of US$2 trillion, which will grow to US$2.6 trillion by 2017. The UK’s issue of a
£200m sukuk bond
last July attracted £2.3bn in investments.
Abdullah predicts further strong growth over the next decade: “The Islamic finance industry will continue to grow at an outstanding pace – in 2015 by nearly 19% (US$2.5trn) according to the AlHuda Centre of Islamic Banking and Economics (CIBE), based on the same CAGR of 16.4% of 2009 to 2013, and its total assets are expected to expand further to above US$4trn by 2020.” However, the industry must innovate to grow by developing new products and instruments that offer an alternative to, for example, derivatives and futures options.
Bryan Foss, an independent director and visiting professor at Bristol Business School, agrees that the growth prospects for Islamic finance are good – from a small base at least. Conventional banks are nevertheless “upgrading their systems and capabilities to meet its challenges and opportunities, but they will still need to have a mixture of sharia and non-sharia compliant products because Islamic finance doesn’t as yet offer a full range of the required services.” He supports the widening product choice that the ongoing growth of Islamic finance offers, and agrees that a positive future lies ahead.
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