Current Issues in Islamic Banking and Finance

CURRENT ISSUES IN ISLAMIC BANKING AND FINANCE – Book Sample

FOREWORD – CURRENT ISSUES IN ISLAMIC BANKING AND FINANCE

Southeast Asia is the powerhouse of skills and innovation in Islamic finance as the GCC is the pool of liquidity. Recently, there have been many issues of concern in the sector, with some recalled certifications and Shariah incompatibility concerns. The sector is young and growing rapidly, thereby demanding close monitoring to enable the establishment of a robust and sustainable alternative to conventional finance.

This is a timely book as it addresses the issues facing the momentum that Islamic finance has taken in the world. The sub-prime crisis and the credit crunch have focused considerable attention on the sector: its viability and sustainability. The challenges are many and not insurmountable. The market place is constantly evolving and expanding beyond the Muslim clientele and regions. The expected growth of the Islamic finance sector worldwide is estimated at about 15% by the year 2020, but if it exceeds that it should come as no surprise.

Standardization and harmonization are issues raised consistently at many fora and being addressed and dealt with by many of the active members and institutions involved in the Islamic finance sector. It takes time but the start has been made and many intelligent minds have committed to establishing this means of finance.

Dr. Angelo Venardos has provided a valuable service in the publication of this book with contributions from some of the legends in the Islamic finance industry who have considerable knowledge of their subject and are active practitioners. The leading lawyers, bankers, regulators, and accountants in the sector are among the contributors and some of them are personal friends.

They are talking the talk and walking the walk on a daily basis and are at the cutting edge of development in the industry. There is not much available in the form of literature on the current issues in the sector and this is a fine addition that will prove useful to academics, practitioners, students, and others who would be interested in this sector — where it has been, where it is, and where it is going. All extremely relevant.

RESILIENCE AND STABILITY: SOCIOECONOMIC RESPONSE IN SOUTHEAST ASIA

Islamic Banking and Finance (IB&F) is recognised by both Muslims and non-Muslims as an ethical alternative, protecting against the worst excesses of leverage whilst reinstating values, such as trust, which have been lost in conventional finance. Figures cited show that Islamic finance is growing in popularity as a result of the current crisis and there is scope for it to move into the financial mainstream with the sector estimated to reach US$4,000 billion in the next 5 years.

However, the first defaults of Sukuk are set to expose the vulnerabilities of Islamic finance, with most investors expected to have no better legal redress than conventional bondholders as underly- ing assets have not been truly transferred to them.

Dr. Zeti Akhtar Aziz, the Governor of Bank Negara Malaysia, has drawn attention to the issue of the resilience of IB&F in confronting the financial crisis. The resilience of IB&F can be tested only if it is exposed to the current turmoil in the financial markets. Dr. Zeti has stated that IB&F had proven to be resilient during the Asian finan- cial crisis.

These statements drew attention to the issue that whilst IB&F was able to withstand the Asian crisis, the Asian crisis was only confined to a certain region and, hence, the resilience of IB&F remained to be tested in the light of the present crisis, which is of a greater magnitude and wider geographical scope.¹ Undoubtedly, compared to the Asian crisis, the magnitude and scope of the cur- rent financial crisis is substantially greater owing to the processes of financial globalisation and liberalisation which have reinforced the global inter-linkages across the financial markets. Given that the Islamic financial system has evolved to become part of the global financial system, it is therefore timely and appropriate to deliberate the issues relating to the question: Is the Islamic financial system truly strong enough to weather the current economic and financial crisis?

The current financial crisis essentially emanated from the oper-

ations of the originate-to-distribute business model, in which large international banks originated loans (or underwrote loans originated by brokers) in the US sub-prime mortgage market, and then securitised the loans thus taking the credit exposure off their balance sheets. In contrast to conventional finance, in Islamic finance, lending on the basis of interest is prohibited by the Shariah.

The Islamic financial system is driven by trade and production and is intimately linked to the real sector (‘Main Street’ and not ‘Wall Street’). Islamic banks do not act as pure lenders; they have to be directly involved in trade and investment operations and assume direct ownership of real assets. This activity pre-empts un- backed expansion of credit and restricts speculation.

Although Islamic banks have debt receivables on their balance sheets arising from credit sale transactions, they cannot securitise and offload these debt receivables, as the majority of Shariah scholars prohibit the trading of debt except at par value. Even in the Malaysian case, where debt receivables are currently allowed to be securitised and traded, the securitisation process is limited to only a single-tier trans- action. Shariah also prevents Islamic banks from purchasing instruments that carry debt-based credit risks.²

In addition, Shariah prohibits selling or leasing something which one does not own, and hence excludes the practice of speculative short selling from the Islamic financial system. In essence, the IB&F system derives its fundamental strength from the Shariah principles, which assure discipline and responsibility in financial activities that are necessary requirements for financial stability.

However, even with the strong fundamental Shariah under- pinnings, the Islamic financial system is not immune to risks and can be susceptible to financial crises due to a number of reasons. First, as Islamic finance is closely linked to the real sector, unexpected adverse developments in the real sector may adversely affect the business activities and performance of Islamic banks in the absence of robust and effective risk management practices.

Risks in the real sector have been declining consistently in the past decades, as shown by recent studies, while risks in the financial sector have been consistently increasing.³ This suggests that financial institutions face less risks and instability than those that are not. Nevertheless, real economic shocks of large magnitude may create systemic risks in the Islamic financial sector.

Second, Islamic banks may be influenced to pursue aggressive speculative investment strategies with higher risk and higher expected returns, particularly during economic upturns, without a concomitant adherence to fundamental and sound risk management standards. A key cause of the current crisis was the fundamental combination of aggressive lending and inadequate risk management leading to a breakdown in confidence between counterparties.

These basic considerations confirmed the need for rigorous and consistently applied global standards of prudent risk management and other supporting infrastructure for safeguarding financial stability in the Islamic financial system. To date, the Islamic Financial Services Board (IFSB) has issued a whole spectrum of prudential and supervisory standards — covering risk management, capital adequacy, corporate governance, and transparency and market discipline — which together constitute the equivalent of Basel II in IB&F. These standards take into account international prudential standards across the banking, investment and securities market sectors and simultaneously cater effectively for the specificities of Islamic financial business, its risks and Shariah compliance.

Examples of these safeguards of the Islamic financial business model include the following: (a) the universal banking model that integrates commercial banking, investment banking and asset management activities that are carried out without clear and established legal, financial or administrative separation; (b) the transformation of risks in Islamic financial instruments; (c) direct investment in real estate activities for the objective of financing real economic activities, rather than speculative trading; and (d) the management of investment accounts which contractually share in the overall risks of assets funded by these accounts and managed by the bank.

The management of investment account holders’ funds also raises specific governance, transparency, depositor protection and investor protection issues, which have been addressed in the standards. The IFSB standards also deal with the unique operational risk aspects of Islamic banks arising from Shariah non-compliance risk and fiduciary risk towards current account and investment account holders, which may expose Islamic banks to reputation risk and thus adversely affect their market position, profitability, solvency and liquidity.⁴

Socioeconomic Response in Southeast Asia 5

In October 2008, the IFSB Council approved the issuance of two additional standards, one on the governance of Islamic investment funds and the other on capital adequacy standards for Sukuk securiti- sations and real estate investments. In Sukuk structures, the discipline that Islam introduces theoretically prevents events such as the current credit crunch. For example, some of the Shariah rules and principles to be observed include: (a) the asset which is being sold or leased must be real, and not notional; (b) the seller must own and possess the goods being sold or leased; and (c) the transaction must be a gen- uine trade transaction with full intention of giving and taking delivery. The current credit crunch revealed that significant failures in risk management have been inherent in the way the originate-to-distribute business model has been implemented.

The capital adequacy standard issued by the IFSB for Sukuk securitisations sets out different minimum capital adequacy requirements to address the specificities of risks underlying the different Sukuk structures. The standard also deals with issues surrounding the securitisation process, in particular as regards compliance with Shariah rules and principles.

For example, Islamic asset-backed securities (ABS) must involve effective legal or beneficial transfer of ownership rights to the underlying assets, in virtue of which the Sukuk holders have an effective right of recourse to the assets in case of default. This is in contrast to conventional finance, where bond holders have the right to collateral over such assets, but no ownership rights.⁵

Another criterion which led to the current turmoil, according to

Professor Karim, the Secretary-General of the IFSB was the surge in the global demand for US sub-prime mortgage debt, fed by unrealistically positive rating designations by the credit agencies. In the context of IB&F, the IFSB has issued a Guidance Note in Connection with the Capital Adequacy Standard.⁶

Angelo M. Venardos

Recognition of Ratings by External Credit Assessment Institutions (ECAI) on Shariah-compliant financial instruments, which is intended to assist supervisory authorities in recognising external rating agencies as being competent for the purpose of allo- cating risk weighting to the assets held by the institutions offering Islamic financial services (IIFS). The Guidance Note emphasised the need to acknowledge Shariah–compliant financing assets as a distinct set of asset classes, for which ECAIs should develop a dedicated rating methodology. This should contribute to ensuring that the rating of Islamic financial instruments would realistically reflect the specific features and risks of such instruments in a manner that would assist investors more appropriately to apply necessary market discipline.

Apart from the standards that have been mentioned above, work was also in progress for the preparation of 4 new standards, namely, on Corporate Governance for Takaful (Islamic insurance) Undertakings, the Solvency of Takaful Operations, Conduct of Business and Shariah Governance. The standard currently being developed by the IFSB on the conduct of business of institutions in IB&F addresses issues with respect to their treatment of clients, namely, customers, policyholders and investors. For these institutions, the code of ethical business conduct is derived from the principles of the Shariah. The observance of principles of good business conduct by Islamic institutions is both a religious obligation and in some cases, for example Islamic securitisation, a requirement in order for the transaction to be valid or for a contract to be enforceable. Indeed, the ethical crisis, which lies at the heart of the present crisis in the conventional financial system, involves issues of bad faith, corruption, concerns of fairness and lack of confidence.⁷

The IFSB was also developing a standard on the Guiding Principles on Shariah Governance, which complements the other IFSB

⁷ Akerlof, G. A. and Shriller, R. J., Animal Spirits — How Human Psychology Drives the Economy and Why It Matters for Global Capitalism, Princeton University Press, NJ, 2009.

 prudential standards. The IFSB standard on Shariah Governance outlines the necessary structures and procedures that should be put in place for effective Shariah–compliance on both an ex ante and an ex post basis. This standard is crucial, as non-compliance with Shariah principles would erode confidence in IB&F and undermine the stability of IB&F. In addition, in order for the Shariah injunctions to function effectively as an in-built mechanism that promotes financial stability in the Islamic financial system, the Shariah princi- ples must be upheld in their true essence.

Given that IB&F currently operates in a global environment that in most cases caters for conventional financial practices, financial innovation in Islamic finance at times involves emulating conven- tional financing techniques and products, for example multiple SPVs. This may expose IB&F to similar destabilising forces inherent in the conventional financial system. In this regard, the work of the IFSB is intended to create an enabling environment for Islamic financial practices to comply with Shariah principles in economic substance and not just in a legal form.

Further, the current financial turmoil has highlighted the signif- icant and unexpected tensions in the major (uncollateralised) interbank money markets. Situations of massive illiquidity occurred in certain financial market segments such as those for complex structured products. The turmoil also underlined the importance of effective liquidity risk management for cross-border and foreign currency operations, owing to the increasing integration of financial markets and cross-border flows.⁸ The development of a robust systemic liquidity management infrastructure for the IFSI is indeed an area that needs to be accorded priority. The IFSB has issued a Technical Note on Issues in Strengthening Liquidity Management of Institutions Offering Islamic Financial Services, which outlines a