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 Euromoney Encyclopedia Of Islamic Finance
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Aly Khorshid
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Producing a subject encyclopedia is always an ambitious task. A decade ago there was, arguably, insufficient breadth to Islamic finance to justify a specialist encyclopedia; as such a work might have been a rather slim volume. This work is therefore timely as there have been so many developments in Islamic finance that virtually all areas of banking, insurance, asset management and capital markets fall within the remit of the subject.

Work in this area is interdisciplinary, as it requires finance specialists, economists, commercial lawyers and Islamic scholars. Islamic finance brings together those with theological and historical interests and others focused on more worldly and immediate concerns involving money, profits and enterprise. The results have been remarkable, as it has not only resulted in the provision of Shari’a-compliant and Shari’a-based solutions for those wanting to manage their finance in accordance with their religious beliefs, but it has also contributed to the wider debate on the morality of much current financial practice.

Shari’a-compliant or Shari’a-based?

In an encyclopedia, it is usual to define basic concepts first; in this case the difference between financial transactions which are Shari’a-compliant and those which are shari’a- based. Shari’a itself refers to Islamic law which is derived from the teaching in the Holy Qur’an and the Hadith; the words and deeds of the Prophet, as recorded in the Sunnah.

This has been constantly re-interpreted over the ages with respect to each field of human activity, including banking and finance. This process of re-interpretation or application is known as ijtihad; the effort of an Islamic scholar qualified in fiqh, Islamic jurisprudence, to give an opinion on what is permissible, halal, and what is not, haram, in the light of religious teaching. To provide such an opinion or fatwa on the legitimacy of financial trans- actions, requires some understanding of contemporary financial practices as well as knowledge of fiqh.

Shari’a is universal and applies at all times in all states, both to those that are pre- dominately Muslim and to those where Muslims are in a minority. States are also governed by national laws which are jurisdiction-specific.

 Islamic financial contracts must comply with Sharia’h, but must also be enforceable under national laws. Therefore, Islamic finance contracts are usually drafted by the commercial law firms which serve the financial institutions, the role of the Shari’a scholars being to read the draft contracts and to suggest

what revisions are needed to ensure the contracts comply with Shari’a.

Financial contracts are usually drafted under common law rather than civil law, as under the former, the signatories to the contract are bound by the terms and conditions specified. Under civil law, the validity of a contract can be more easily challenged by one of the signatories in a secular court, but this implies the judgement of the Shari’a scholars is being questioned.

This is less likely under common law, where secular courts can withhold Shari’a principles, as long as these are reflected in the contract. Malaysia and the Indian subcon- tinent are governed under English common law, but in most Arab states and Indonesia civil law applies, apart from those designated financial centres such as the Dubai International Financial Centre or the Qatar Financial Centre, who have their own governing laws and regulations and are exempt from the national civil laws of the countries in which they are located. Both use common law and have become significant centres for Islamic financial activity.

If a contract is Shari’a-compliant or Shari’a-based, this implies different starting points from a legal perspective. Shari’a compliance is the most straightforward from a contem- porary common law perspective, as it involves taking a conventional financial contract such as a mortgage, and changing the terms and conditions so that there is no reference to riba or interest and that there is no element of ambiguity or contractual uncertainty (gharar) that one of the parties could potentially exploit. Often the changes are relatively minor and the contract continues to serve the same function as it did before the revisions and amend- ments were undertaken.

In support of this approach, it is argued that the financial needs of Muslims are no different from those of non-Muslims, the challenge for the scholars being to provide input into the contract specification that ensures they are halal. The legitimacy and validity of such contracts ultimately depends on the reputation and credibility of the scholars themselves, which is why they should be named in brochures and web-based material issued by the financial institutions, with details given of their qualifications and experience.

The alternative Shari’a-based approach implies starting from contracts developed by fiqh scholars over many centuries such as mudarabah or musharakah partnership contracts involving profit and loss sharing. There is no conventional financial equivalent of these contracts, although they may be drafted to comply with common law and be enforceable by national courts.

All scholars agree that it is preferable to have Shari’a-compliant contracts to those that are non-compliant, but most would prefer to see Shari’a-based contracts, not least as they accord most closely to Islamic financial principles, which stress justice in commercial transactions and the rightful earning of rewards. Wages and salaries, for example, are seen as a legitimate return for work but rewards for inactivity are unjustified, apart from for those that cannot work and are in need.

Economic justice in Islamic finance

Islamic finance should not simply be viewed as being concerned with prohibitions but rather as a positive approach to ensure the parties to financial transactions are involved in a morally worthwhile endeavour. Financial systems should be designed to serve a wider social good, and not simply individual greed, all too often pursued at the expense of others.

All rewards have to be justified in Islamic finance, with wages and salaries related to work and effort, as already indicated, and rental income to landlords justified through their responsibilities for the properties leased. Financing leases are prohibited in Shari’a as the owner tries to pass on all responsibilities to the tenant, whereas to justify a rental income from a building, the owner must assume responsibilities for the external maintenance of the building as with an ijara operating lease.

Profit is also seen as a justifiable reward in Islamic finance, which rather than being related to work or ownership, is compensation for risk sharing. In business and finance there are always risks including credit, market and operational risk, but if risks are shared between the parties, this is more just than simply assigning all the risk to a single party. With conventional lending the borrower assumes all the risk, and is penalized further for payment delays or defaults. In contrast, in Islamic finance, the risks are shared between the bank and the client. Of course Islamic banks have to manage credit risk, and unscrupulous defaulters should not be treated leniently, otherwise moral hazard problems might arise.

Misselling of financing products is clearly immoral, as with the sub-prime mortgages in America and to a lesser extent in Britain, where borrowers were encouraged to take on debts they could not afford by mortgage brokers and bank sales teams, who earned up-front fees for each mortgage sold.

When the inevitable defaults occurred this was of no concern to the mortgage brokers and sales teams who had moved on to other activities. Islamic banks have to adopt fair and transparent charging structures which do not exploit the ignorance of the client. Their staff must ensure, as far as possible, that clients can meet their financial obligations. So far, the record of Islamic home financing has been favourable, with none of the defaults that have characterized the sub-prime crisis.

Islamic finance is inherently participatory, with the financier getting involved with the client and taking an interest in how the funding is utilized. This is not only to ensure the financing is serving a moral purpose, although that is important, but also to help the client manage the funds received effectively.

The financier can act as an agent for the client, as with murabahah where the financier purchases a good on behalf of the client and re-sells it to the client for a mark-up which makes the transaction profitable. What justifies the mark-up is the ownership responsibilities exercised by the bank, which serves as a trader rather than simply a financier. If the good is defective, the bank has a responsibility to remedy this, which is why it needs to check on the validity and transferability of warranties, thus taking a burden from the client.

Islamic and conventional banking: similar services but different financing methods

Critics of Islamic banks suggest that their remit should be different to conventional banks, with a focus on serving the poor and needy, rather than promoting the development of capitalism. The early experiments with Islamic finance in the 1960s in Pakistan and Egypt involved the establishment of credit unions in poor rural areas, enabling members to obtain interest free finance from the contributors’ funds. The clients were similar to those of the Grameen Bank in Bangladesh, a microfinance institution which serves a poor rural constituency, but is not Shari’a-compliant as its lending involves interest.

The take-off for Islamic banking coincided with the oil boom of the 1970s in the Gulf, with institutions such as the Dubai Islamic Bank being established in 1975 and the Kuwait Finance House opening for business in 1977.

These were oil-rich states, not poor developing countries, the initial clients of the new Islamic banks being wealthy merchant families wanting to finance their growing import and distribution businesses. Murabahah was the ideal tool for this, as not only was it Shari’a-compliant but also, as the bank acted as initial purchaser, no letter of credit was required to guarantee payment by the client.

This resulted in significant cost savings for the client. Furthermore as the bank could bulk purchase on behalf of several clients it could often obtain discounts which could be shared with the client.

By the late 1980s, Islamic banks were seeking to diversify their asset portfolios and identify more profitable financing methods, as there was increasing competition in murabahah and mark-ups were being squeezed. Ijara leasing contracts were promoted, as these lengthened the period to asset maturity, reducing asset turnover and the resultant arrangement  costs. Whereas  murabahah  financing  was  typically  for  periods  of  three  to eighteen months, ijara contracts were for three to five years. Of course with ijara financing, liquidity was reduced and risks increased with the longer period to maturity, but this could be built into the rental, to provide an attractive risk and return profile for this category of asset.

Financial engineering involving Shari’a-based products

The 1990s witnessed further product development involving both short-term receivables financing using salaam and longer-term project finance with istisna. Salaam involves making a pre-payment for a good to be delivered in the future, usually after ninety days. As an up- front payment is made, the price paid will usually be at a discount to the anticipated spot price on delivery.

 The effect is similar to a forward transaction where the price is guaran- teed. Salaam contracts cannot be traded, as such activity would be speculative; rather it can be regarded as a hedging instrument. To increase liquidity, however, a bank can enter a parallel or reverse salaam contract, under which the commodity or good will be delivered to a third party after, for example, sixty days. As the period is shorter to delivery, the third party will pay a higher price for the contract, the difference between this and the initial purchase price representing the bank’s margin or profit.

Istisna finance can be for periods of five years or more with this traditional method of financing manufacturing being adapted to cover projects. Often an investment bank is involved as it covers payments by the project management company for supplies and wage costs. Once the project is completed, it is handed over to the operating company which pays the project management company. This revenue can then be used to repay the investment bank.

Rather than having an illiquid asset for a five-year period or longer, the investment bank may enter a parallel istisna agreement to sell the right to the repayment to one or more Islamic banks or investment companies. This creates smaller tranches suitable for investors who want to place millions of dollars rather than billions. Rather than having a single large investment in a potentially high risk project, where there could be cost over-runs or delays in construction, the Islamic banks and investment companies may prefer to have a diversified portfolio of istisna assets to spread risk.

The preponderance of Islamic retail banking

Most Islamic banking is retail rather than involving investment banking, with employees having their salaries paid into current accounts where the funds are restricted to financing Shari’a-compliant activities conducted without riba.

Those with savings are encouraged by Islamic banks to open unrestricted investment mudarabah accounts which enables them to share in the bank’s profits or restricted mudarabah accounts where the deposits are used for a specific project and the depositor shares in the profits from the project. The latter usually produces a higher return, but the risks from concentration are greater. Many Islamic banks have been promoting these accounts, which have proved popular with clients worldwide.

Retail banking products include car and housing finance, with the former usually involving murabahah or ijara and the latter ijara wa iqtina, a hire purchase contract, or diminishing musharakah. With diminishing musharakah, the client and an Islamic bank form a partnership, with the client providing ten per cent or more of the capital and the Islamic bank ninety per cent or less. This initial funding is used to purchase a property.

Each year the client buys out part of the bank’s share in the partnership, creating a repay- ments stream, with the client’s share in the partnership gradually increasing. The client also pays rent for the share the bank owns. If each repayment instalment was equal, this would front-load the payments obligations of the client, as they have to make larger rental payments at the start to reflect the bank’s higher ownership share. In order to avoid this scenario, the repayments are usually structured exponentially with lower repayments initially but higher repayments later. This may suit younger home buyers whose income will increase with career progression.

It is worth noting that the property is not re-valued during the life of the financing. The client enjoys all the capital gain on the property if the market is rising. The bank only has its initial funding repaid, its gain accruing from the rent. Arrangement and management costs are covered by set up charges and the administrative fees. In other forms of musharakah, all parties share in any capital gains or losses, but this is not accept- able to most property buyers who anticipate long-term asset appreciation.

Shari’a-compliant capital market products

The major development in Islamic finance in the last decade has involved the issuance of sukuk Islamic securities and a methodology for ensuring that equity investment can be Shari’a-compliant.

Sukuk are based on Islamic financing structures such as salaam, murabahah, ijara, mudarabah and musharakah which are securitized so that apart from salaam sukuk, they can be traded in a market. All sukuk must be asset backed to be Shari’a-compliant and hence buyers and sellers are not merely trading financial instruments, but a title to a real asset such as piece of real estate, buildings or equipment. Salaam sukuk are similar to treasury bills but provide a mark-up for the investor rather than interest. Unlike treasury bills, they cannot be traded as indicated above, as the asset is only delivered in ninety days when the sukuk matures and is not in possession of the investors.

Murabahah sukuk have a fixed return and correspond to bonds, while with ijara sukuk returns vary which means they have the financial characteristics of floating rate notes. These have proved the most popular type of sukuk, not least because returns usually vary in line with changing market funding costs.

The main concerns of Shari’a scholars with sukuk is that the investors have a clear title to the underlying asset, and that in the case of mudarabah and musharakah, the assets themselves are re-valued so that the investors do not merely get the nominal value of their investment refunded as with a debt instrument. This creates a dilemma for the investors, as those wanting Shari’a-compliant debt instruments, do not wish to invest in assets subject to market risk, their preferred exposure being to default risk only. Takaful Islamic insur- ance operators, for example, cannot take too much exposure to market risk, as although a proportion of their holdings are in equities, most are in sukuk for the same reasons as insur- ance companies hold bonds and floating rate notes. If there were excessive holdings of equity instruments and the market value of these investments fell, takaful operators would no longer be able to fulfil their obligations to those policyholders making claims.

 This would mean a breach of contract and would be unfair to those in need of accident or other compensation. Those who argue for all sukuk being equity-based need to be aware of the wider social and legal consequences. Land or buildings may be used as the underlying assets for sukuk, but investors wanting exposure to real estate may prefer to invest directly in this rather than in sukuk. From a portfolio perspective, sukuk have to be viewed as one component of a multi-asset allocation strategy.

Implications of financial market volatility for Islamic investment

Sukuk issuance has increased enormously since 2000, with over 200 issues in 2007 alone worth $45 billion. Much of the activity was in the first seven months of the year however, as sukuk issuance after August was adversely affected by the crisis in securitized debt obli- gations resulting from the sub-prime defaults.

The pricing of sukuk has been linked to that of conventional debt securities, as sukuk represents only a small proportion of the overall market, and therefore sukuk issuers and investors are price takers rather than price makers. The higher price which needs to be offered for sukuk financing has deterred many issuers, with funding plans either abandoned as projects are rethought, or postponed until market conditions become more certain.

The slow-down applied more especially to US dollar-denominated sukuk, the currency for most sub-prime debt, but issuance in other currencies has been less affected.

Malaysian sukuk are mostly local currency denominated, and appear to be unaffected and in the Gulf, there has also been a trend in favour of local currencies. Only the Kuwaiti dinar has been allowed to appreciate against the US dollar so far, but investors in riyal- or dirham- denominated sukuk are expecting that these currencies are likely to be decoupled from the US dollar, possibly in 2010, when a new joint float might occur as part of a move towards monetary  union  in  the  Gulf  Co-operation  Council  states.

 It  is  likely  that  there  will  be increasing currency diversification in sukuk issuance. The British government is planning a

series of sterling denominated sovereign sukuk issues, the pricing for which will provide a benchmark for subsequent sterling corporate sukuk issuance from London. There have already been several euro-denominated sukuk, including on behalf of the German state government, and many more are likely in the years ahead.

The volatility in equity markets worldwide does not seem to have constrained investor interest in Shari’a-compliant managed funds. By 2008, there were over 400 of these funds, most of which were equity based, although there were also 50 specialized real estate funds. Investment in equity is permissible, as long as the companies are involved in acceptable business activities and have limited debt-based leverage.

A methodology has been developed to ascertain what is permissible by institutions such as the Dow Jones Islamic Indexes. Ideally, any company involved in interest-based transactions, especially conventional banks, should be excluded but the guidelines recognize that most companies may have some interest- based income and obligations. Borrowing up to one third of capital is permissible in line with the discretionary limits in Islamic inheritance law, but beyond that the financing is regarded as highly speculative and therefore not allowed.

The future for Islamic finance

A browse through this encyclopedia demonstrates how wide ranging the areas covered by Islamic finance have become. The scope extends to banking regulation and risk manage- ment as well as corporate and Shari’a governance. The coverage also includes takaful and wealth management, as well as retail open and closed funds. Product innovation is also discussed, as are tax issues and the role of Islamic finance in offshore centres. Aly Khorshid has succeeded in attracting an excellent group of contributors who are the leading academics and  professionals  in  the field  of  Islamic  finance  and  the  reader  can  benefit  from  their knowledge.

The future will of course be determined partly by the choices made today, and in this, Islamic finance is no exception. Being Shari’a-compliant is not simply a substitute for being Shari’a-based; rather they represent different directions for Islamic product development. The industry is also changing as the economies of the Muslim world evolve.

Some remain poor and underdeveloped, but many are highly developed and play an increasing role in the global economy, enhancing the prospects for Islamic finance. Some observers see a type of Islamic capitalism developing based on riba-free finance which challenges the assump- tions underlying Western capitalism. There is an ideology implicit in Islamic finance that may ultimately shape the development of global finance, not least because there is increasing worldwide concern with moral and ethical issues and not simply with making money and material advance.

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