Islamic Finance Paper

8/7/2019 Islamic Finance Paper

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dIscussIon paper


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Islamic nance is one o the astest-growing segments otodays banking industry. Formerly deemed a marginalindustry by some, Islamic nance is now recognised as avital and thriving market. While the size o Islamic nanceand banking activities, estimated to range rom $500bn to$1,000bn, is still a raction o conventional banking, theimpressive growth rates o 1015% seen in recent yearsemphasise the potential market or such activities.

It is the act that this growth is increasingly being seenoutside the traditional markets o the Gul CooperationCouncil (GCC) countries and Malaysia which has meantthat global market participants and policy makers areincreasingly paying attention to its potential. Both NewYork and London have launched indices aliated to theirmain Dow Jones and FTSE indices, to provide abenchmark or equity prices or investments in Islamicnancial institutions. The UK Government has also playeda major role in trying to make the City o London theglobal centre o Islamic nance by extending supportwherever possible, including the abolition o double stamp

duty on Islamic mortgages, and the recently announcedplans to test the easibility o issuing Shariah-compliantsukukbonds. The 2007 Budget introduced new measuresor sukukbonds to be issued, held and traded on the UKnancial market.

Indeed, the emergence and growth o sukuk instruments(commonly reerred to as Islamic bonds) haverevolutionised the Shariah-compliant debt securitiessector. They have not only given momentum to the Islamicnancial industry on a global scale, but have also providedopportunities or the development o secondary debtmarkets. Ater the German state o Saxony-Anhalt becamethe rst non-Muslim issuer to enter the Islamic debtmarket in 2004, US and Japanese rms have also issuedsukukbonds. In the UK, the leveraged buy-out o AstonMartin rom Ford (2006) was carried out using a sukukinstrument.

IslamIc FInance: an

ethIcal alternatIve toconventIonal FInance?

Aziz Tayyebi is nancialreporting ocer at ACCA and

is a leading contributor toACCAs responses to globaldevelopments in this area.


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What Is IslamIc FInance?

Islamic nance is any nance that is compliant with theprinciples o Islamic law (Shariah). In terms o nance,

Shariah explains in detail the ethical concepts o moneyand capital, the relationship between risk and prot andthe social responsibilities o nancial institutions.

I (riba)The most well-known aspect o an Islamic nancial systemis the prohibition o paying or receiving interest on capital.Essentially, any positive, xed, predetermined rate tied tothe maturity and the amount o principal, which isguaranteed irrespective o the perormance o theinvestment, is considered riba and is so prohibited.

This prohibition is not to be conused with a rate o returnor prot on capital, as the earnings and sharing o prot isvery much encouraged within Islam. Moreover, prot,determined ex post, symbolises the creation o additionalwealth through successul entrepreneurship, whereasinterest, determined ex ante, is a cost that is accruedirrespective o the outcome o business operations, andmay create wealth, even i there are business losses.

rik i (gharar)Contractual risk is also orbidden. In general, this prohibitsthe selling o goods or services that the seller is not in aposition to deliver or the making o a contract which isconditional on an unknown event. You cannot sellsomething you do not own. Also, the price and nature o

the goods being transacted are dened in detail andagreed upon by both parties, thereby avoiding a sale thatmay represent a gamble (or example, conventional shortsales or sales on margin are prohibited).

Although the prohibition o interest can indeed be viewedas the nucleus o Islamic doctrine relating to nance, thereare a number o other supporting principles which provideguidance or an Islamic nancial system:

advocating risk sharing

promotion o entrepreneurship

discouraging speculative behaviour

preservation o property rights.

These are evident through consideration o the Islamicnancial system and conventional banking.

What dIFFerentIates IslamIc FInance andconventIonal FInance?

The evolution o Islamic banking and nance has come

about rom two main objectives, namely the elimination ointerest-based (riba) nance and the development olow-risk products which would give condence toregulators, shareholders and depositors alike. This latteraim was all the more necessary given the ailure o someo the earlier Islamic banking models in Egypt, Pakistanand Malaysia in the 1950s.

One o the most notable eatures o the current Islamicnance market is the development o a comprehensiverange o product oerings, with the industry now havingalmost like-or-like parity with conventional banking,whether it be investment banking, commercial banking orpersonal nancial services.

Many o the primary products developed in Islamicbanking were debt based in order to be more akin to theanatomy o conventional banking products. The use othese products, clearly similar to conventional instrumentscertainly appeased many o the stakeholders, including thenancial services industry itsel. However, those sameresemblances did and continue to receive criticism romthose wishing to see Islamic nance based on the coreprinciples o Shariah.

Nonetheless there are quite distinct aspects o Islamicnance which dierentiate it rom conventional modes o

nance. Describing the Islamic nancial system simply asinterest-ree does not do justice to the system. Itsessence stretches to the promotion o entrepreneurship,preservation o property rights and the transparency ocontractual obligations. These and the other pivotal andunderlying principles are ormed through a thoroughconsideration o Shariah.

The nature o capital as solely being a medium oexchange (ie no intrinsic value) is central to the prohibitiono interest, and orms the central tenet o Islamic bankingand nance. However other important principles include:

the prohibition o contractual risk

advocating sharing o risk and return

asset-banked nance (as banks cannot rely on issuingagainst collateral alone).

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What are the most commonly used InstrumentsoF IslamIc FInance?

Given the restrictions outlined above, modern-day scholars

have developed principle modes o nancing which can beapplied to contemporary nancial scenarios while adheringto Islamic principles. Some common nancial instrumentscurrently being utilised in Islamic nance in various ormsare as ollows.

F fi wki i iqii Murabaha: this is eectively cost-plus nancing, as used ortrade and asset nance, allowing deerred payment bycustomers. Rather than lending money as in conventionalloan, the bank purchases the requested commodity(thereby taking in on risk) and sells it to the customer atthe agreed mark-up price. In recent times murabahacontracts have been the instrument o choice or manynancial products, be it trade and asset nance or theprovision o working capital acilities.

Istisnaa: aimed at long-term construction projects, thisalong with murabaha products, is one o two types onance which allows the sale o a commodity prior to itcoming into existence. Istisnaa contracts are clearly aimedat long-term projects, and are requently used to nancethe construction o real estate developments and largeassets such as ships.

F fIjara: this is a quasi-debt instrument, essentially equivalent

to leasing. Oten used in the context o home purchasing,most aspects o an ijara are the same as those oconventional leasing, whereby the investor (lessor)purchases and leases the underlying asset to theprospective borrower (lessee) or a specied rent andterm. Ijara are requently used to nance the acquisition oreal estate and equipment, although they have also beenutilised to eect leveraged buy-outs in private equitytransactions.

Diminishing musharakah: recent times have witnessed ashit in emphasis away rom ijara towards diminishingmusharakah (DM) as a mode o nancing Islamicmortgages. Many o the major Islamic mortgage providershave either already switched to DM (HSBC Amanah usesDM) or are planning to do so imminently. DM is a hybridnancing technique involving both ijara and musharakah. Itappeals to Islamic investors because it is based on theundamental principle o sharing risk. The attraction ornanciers is twoold, in that it can incorporate a variablerate o return and has a credit prole that would beacceptable to most conventional institutions.

eqi-ik iMusharakah: this is akin to a joint venture arrangement,through an equity participation contract. Ownership isdistributed according to each partners share in the

nancing, and prot and loss is shared by the partners.Such contracts are oten used in connection with large-project nance and private equity unds. Despite it being apreerred option by many Islamic scholars, musharakah still

captures only a tiny portion o all Islamic nance, as therecan be questions over the control o the assets.

Mudarabah: this is essentially an investment und where

one party provides the entire capital, and the other partyprovides the management (usually the bank, but can bethe reverse). Prot sharing is agreed up-ront, although theloss is borne by the provider o the unds alone.

Fix i iSukuk: this is an investment certicate (bond) thatrepresents a proportionate interest in a well-dened poolo assets that yield income and capital returns. Usually setup through the conventional securitisation process, with aspecial purpose vehicle acquiring the assets, the returnsrom the assets are passed to sukukholders (investors). Todate popular asset classes have included real estate. Thismethod has been a popular way or many governments toraise unds or inrastructure, and accounts or the largestportion o Islamic nance.

Who regulates IslamIc FInance?

At the micro level, institutions that wish to oer Shariahcompliant products have to have a Shariah SupervisoryBoard (SSB) (or at least a Shariah scholar). It is theirresponsibility to review and approve nancial practicesand products or compliance with Islamic principles.

However, just as Shariah itsel is open to interpretation, soShariah scholars oten disagree as to what is Shariah

compliant or not. Thus the laws that govern Islamic nanceand the regulation o Islamic nance institutions continueto vary (mainly across jurisdictions).

At the macro level, given the markets where Islamicinstitutions initially developed, and the act that the largestproportion o the market still remains in thosejurisdictions, it is unsurprising that the major regulatoryinstitutions are located in countries like Bahrain andMalaysia. The ollowing are the most infuential standard-setters regarding accounting or Islamic nancialinstitutions.

ai aii oii Ii Fi(aaoIFI)AAOIFI was ounded in Bahrain in 1990. Its standards(about 70 to date) are ollowed by a number o countriesand institutions in the Gul region, in particular.

mi ai s B (masB)MASB is the national standard setter or Malaysia and alsoproduces Islamic accounting standards or Islamicinstitutions (since about 2001).

Ii Fii s B (IFsB)IFSB, based in Malaysia, is more akin to the BaselCommittee, and aims to promote the development o a

prudent and transparent Islamic nancial servicesindustry. It also has a member on the InternationalAccounting Standards Boards Standards Advisory Council.


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hoW Is the uK leadIng the development oFIslamIc FInance?

Having initially relied on products created in traditional

markets, the UK has in recent years used its long-standingreputation or innovation to develop products which arenow being marketed in other countries such as the MiddleEast. The reasons or this are numerous but are headed bythe UK nancial services proven skills base, with the largepool o legal, accounting and banking proessionals leadingthe way in developing Islamic nance in the UK as well asaround the world. The preerence or English law in manyIslamic nance transactions outside the UK is testament tothat skills base.

We have earlier mentioned the various public policy andtax initiatives the UK Government has taken since the early2000s. The relaxation o double stamp duty was aconsiderable relie, as property or instance purchasedusing Islamic nance would be bought and sold (legal titletranserred) more than once. Thus stamp duty wouldotherwise be payable initially when the bank purchasedthe property and again when the legal title is transerredto the borrower upon repayment o the loan to the bank.Subsequent Finance Acts have contained urther measuresat equalising the tax position o other Islamic productswith those o their conventional counterparts.

In the UK, the regulation o Islamic nancial institutionsalls within the remit o the Financial Services Authority(FSA). However, in contrast to other centres o Islamic

banking such as Bahrain and Malaysia, which haveseparate authorisation and regulation or Islamic banks,the FSA regulates all nancial institutions to the samestandards. Thus while aiming to promote the UK as aglobal hub or Islamic nance, the FSAs approach wasclearly articulated by its then Chairman, Sir Howard Daviesin 2003, as being one o no obstacles, but no specialavours.

This unique position that the FSA has to maintain meansthat when authorising an Islamic bank in the UK, careulconsideration is required. While Islamic nancialinstitutions all within the same regulatory regime asconventional banks, some specic issues which the FSA

have previously raised have included the regulatorydenition o products and the role o the SSB. Thesignicance o Shariah denitions in Islamic contracts isparamount, and it is thereore vital that institutions assesswhether those products are within the bounds o regulatedactivities. With regards the role o SSBs there is particularconcern around whether members should require FSAapproval and, where members are on more than oneboard, how potential condentiality issues are dealt with.

ensurIng FInancIal promotIons oF sharIahcomplIant products are clear, FaIr and notmIsleadIng.

In practice both the FSA and Islamic institutionsthemselves have been pragmatic, and issues over thedenition o deposits, separating the responsibilities oSSBs and management have been resolved. This approachhas already seen the establishment o six solely Islamicbanks in the UK. These now operate alongside theincreasing number o Islamic business lines (Islamicwindows) being operated by major international nancialinstitutions such as HSBC, Deutsche Bank and Citibank.

While growth rates or Islamic nance are relatively high itstill only constitutes a small proportion o the globalnancial services sector. For it to take a greater share andto expand in other jurisdictions, Islamic nance needs toocus on a number o key issues.

p As some risk management tools are not available toIslamic rms, such as certain derivatives, other riskmanagement methods need to be developed.

siiDierences o opinion rom Shariah scholars on whethercertain practices or products are Shariah compliantcontinue. A common set o standards and closer linksbetween regulators and standard setters such as AAOIFI,the IFSB and the FSA are crucial.

h iThe nuances o Islamic jurisprudence and its assimilationwith conventional banking requires a great deal oexpertise. Investment in training and ormal qualicationswill be vital to attract and maintain the right level oproessionals to allow the industry to develop.

As would be expected with a relatively recentphenomenon, there remain legitimate concerns over themechanics and regulation o Islamic nance. However, as aCongressional Research Service report on Islamic nancein July 2008 notes: Some also view the integration oethics and values into nance as a positive development,with many investors reportedly considering SCF (Shariah-compliant nance) to be more reliable than conventionalnancing, given the recent global credit crisis and ears oeconomic recession.

No responsibility or loss occasioned to any person acting or reraining rom acting as a result o any material in this publication can be

accepted by the author or publisher. Published by Certied Accountants Educational Trust or the Association o Chartered Certied

Accountants, 29 Lincolns Inn Fields, London WC2A 3EE

The Association o Chartered Certied Accountants, August 2008


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