Rating of Islamic Financial Institutions

The Islamic financial institutions have seen mushroom growth during the last decade owing to fact that there is a large demographic of untapped consumers around the globe have waited for a long time to have such products. Such an immeasurable success has compelled conventional financial institutions to launch products for this segment of consumers so that they are not left behind in the race. However, this has created serious doubts in the minds of the consumers about the products which are offered by Islamic Financial Institutions [hereinafter referred to as “IFI”] and Conventional Financial Institutions [hereinafter referred to as “CFI”] alike. Hence, this is high time that a rating agency of IFI needs to be launched which would set a benchmark for IFI and would also serve the purpose of removing the doubts in the mindset of consumers whose major motive is to seek Allah’s pleasure. For this very purpose we need to look at the brief history of IFI’s.

HISTORICAL BACKGROUND

It was portrayed that such a system was inherently prone to instability because there would always be maturity mismatch between liabilities being short-term deposits and assets being long term investment. Owing to the fact that the nominal values of liabilities were guaranteed, but not the nominal value of assets, when the maturity mismatch became a problem, the banks would go into a liability management mode by offering higher interest rates to attract more deposits. There was always the possibility that this process could not be sustained resulting in erosion in confidence and bank runs. Such a system, therefore, needed a lender of last resort and bankruptcy procedures, restructuring processes, and debt workout procedures to mitigate contagion.

As we know that, in the absence of an analytic framework recognizable by modern economic and financial theory, most western observers and commentators termed to Islamic banking and financial system as a “zero-interest” system, by which they meant “no return to capital”. The challenge faced by Iran, Pakistan. and Sudan in mid 80’s when they started a joint effort to adopt a system-wide Islamic banking and finance to show that such a system was first theoretically and analytically a viable financial system; second, it had to be shown that such a system was empirically workable as a whole and financially viable for each of its parts, meaning Islamic banks and financial institutions although the Dubai Islamic Bank has already come into existence by that time but it was in its infancy. However, the folly of adopting such a system can be summarized in six propositions:

Zero interest would mean infinite demand for funds but with zero supply
System’s capability of equilibrating demand for and supply of funds?
Zero interest rate may lead to no savings at all
No saving would lead to no investment and no growth
in this system, there could be no monetary policy since no instruments of liquidity management could exist without a fixed predetermined rate of interest; and, finally,
This all meant that in countries adopting such a system there would be one way capital flight.
However, in the late 80’s, challenge been met when research, using modern analytic financial and economic theory, showed that:

A modern financial system can be designed without the need for an ex ante determined positive nominal fixed interest rate and this study has also proved by western researchers that there was no satisfactory theory that could explain the existence of a positive nominal ex ante interest rate
In furtherance, it was shown that by not assuming a nominal fixed ex ante positive interest rate, i.e., no debt contract, did not necessarily mean that there would have to be zero return to capital
The basic proposition of Islamic finance : return to capital would be determined ex post and that the magnitude of return to capital was determined on the basis of the return to the economic activity in which the funds were employed
Expected return determines investment
Expected rate of return and income determines savings
Positive growth
Monetary policy of this system would function as in the conventional system, however, its efficiency depends upon the availability of instruments which could be designed to manage liquidity
Finally, it was shown that, in an open-economy macroeconomic model without an ex ante fixed interest, but with returns to investment determined ex post, there was no justification to assume that there would be a one-way capital flight.
Hence, it was effectively concluded that the system which prohibited a fixed ex ante interest rate and allowed the rate of return to capital to be determined ex post, based on the returns to the economic activity in which the funds were employed, was theoretically viable as was initiated by three countries.
The western researchers has also shown the fact that in the conventional system, based on debt contracts, risks and rewards were shared asymmetrically with the debtor carrying the greatest part of the risk, and with governments enforcing the contract. Such a system had a built-in incentive structure that promoted moral hazard and asymmetric information requiring close monitoring whose costs could be managed if monitoring could be delegated to an institution which could act on behalf of the collectivity of depositor/investor: hence the reason for existence of banking institutions. By early 1990s, it was clear that an Islamic financial system was not only theoretically viable, but had desirable characteristics that rendered it superior to a debt-based conventional system.
The phenomenal growth of Islamic finance during the decade of 1990s, demonstrated the viability of the system owing to the gap created by the crises witnessed in the international financial system since 1997 which had set the stage for Islamic finance to demonstrate its viability as potentially a genuine alternative global financial system.

At times, there are no guarantees that the international financial system which has witnessed its last crises leaving huge domestic costs and have threatened the very foundation and fabric of societies. The most obvious example is of Indonesia, it took this country 25 years to reduce poverty by 50 percent, but it took a year of severe financial crisis to wipe out most of this gain. Countries with an otherwise viable economic system have paid dearly for crises generated by a debt structure whose nominal values and maturities were out of line, with the ability of the economic structure to service them. It is now a serious advice of the IMF to developing countries that they should:

Avoid debt-creating flows
Rely mostly on FDI
If they have to borrow, they should ensure that their debt obligations are not bunched toward the short end of maturities
If they have to borrow, they should ensure that their economy is producing enough primary surplus to meet their debt obligations
Ensure that their sovereign bonds incorporate clauses (majority action clause, engagement clause, initiation clause) that make debt workout and restructuring easier. That is, to make sure that there exists better risk sharing mechanisms to avoid moral hazard: and finally
They should put in place an efficient debt management structure.
There are many analyses of financial crises and a long list of their causes, but surprisingly little is said about the one underlying common denominator to all of them: debt contracts that are by nature out of sync, and unrelated to, the income flows that the underlying productive and capital assets of these countries can generate to serve them. The jury is still out as to the reasons why Malaysia did not suffer from contagion as much as other crises countries. While capital controls may have played a role, some analysts believe its liability structure and its general reliance on non-debt-creating flows made Malaysia less vulnerable to crisis. An Islamic financial system has the potential to redress this serious threat to global financial stability because of its fundamental operating principle of a close link between financial and productive flows and because of its requirement of risk sharing.

In these circumstances, Islamic finance can provide a viable financial system on a global scale to cope with accounting, auditing and financial services board to cope with a liquidity management centre with the backing of an International Islamic Rating Agency. Hence, Islamic finance has to adopt the best standards of accountability, transparency and efficiency.

IFI’s INFRASTRUCTURE

In the light of the above referred discussion and which are primarily the experiences, healthy IFI’s came into existence which has solid conceptual infrastructure of Islamic investments and the backing of shariah boards.

Islamic Investment can be defined as investment in financial services and investment products that adhere to principles established by the Shariah (Islamic law as revealed in the Quran and Sunnah). These principles require that investments must be in ethical sectors. In other words, profits cannot be made from prohibited activities such as alcohol production, gambling, pornography, etc. Also investing in interest (riba) based financial institutions is not allowed. All wealth creation should result from a partnership between the investor and the user of capital in which rewards and risks are shared. Returns on invested capital should be earned (i.e. tied to the profits generated by the capital) rather than be pre-determined (as in interest based returns provided by bank deposits).
One of the implications of Islamic investment principles is in the selection of the type of financial instrument among those available in global financial markets today. Interest based securities (e.g. bonds, bank deposits etc.) are not acceptable as Shariah compliant investments, since these securities provide returns that are predetermined, and unrelated to the underlying performance of the asset that is generating the returns. By the same logic, equity securities (shares) are considered permissible by a consensus of contemporary scholars (e.g. the Islamic Fiqah Academy), because the profits an investor makes on equity securities are tied to returns of the underlying company and hence are risk related.

The shariah board lies at the heart of Islamic Financial Institutions and Conventional Financial Institutions. The primary onus lies on such shariah board regarding the fact that the product of financial institutions passes the conceptual model of Islam. However, with the passage of time, such shariah boards are now termed as fatawa boards to authenticate the decisions already taken.

A Shariah Board is a committee of ‘ulama’, established to ensure that the financial institution’s practices and products it offers are in compliance with the Shariah.
The religious scholars, or ‘ulama’, of Islam have played an indispensable role in the contemporary movement of Islamic finance and investment. For one, they interpret and analyze the sources of Islamic law and constitute a link with the vast body of work on commerce in the Islamic legal tradition. This is crucial in deriving the principles of Islamic finance and investment. As a group, they also arrive at collective positions on contemporary financial issues in representative bodies such as the OIC Islamic Fiqah Academy.

Perhaps most importantly for Islamic financial institutions, selected Shariah advisors or Shariah boards are in continuous dialogue with economists and bankers to develop new financial products in compliance with Shariah principles. This is necessary to ensure that Islamic finance stays abreast of the latest developments in financial markets and those Muslim investors have access to proper Shariah advice on how to approach these markets. Recognizing this necessity, all credible Islamic financial institutions today have a Shariah advisor or Shariah board.

Islamic scholars have reached a general consensus on many issues related to Islamic investment by considering the established sources of Islamic law in the following order:

Quran
Hadith texts (the recorded statements and practices of Prophet Muhammad (PBUH))
Ijma (consensus of the ‘ulama’) and
Qiyas (drawing analogies from the Quran and Hadith texts)
Ijtihad (the scholar’s own reasoning).
Readers must note that a scholar’s Ijtihad only comes after the analysis of the other sources, and remains within the parameters established by them.

NEED FOR EFFECTIVE INTERNATIONAL ISLAMIC RATING AGENCY

However, Islamic finance possesses the basic instruments that can be spanned into a wide, varied, and variegated menu of financial instruments. There is a theory developed in the 1980s referred to as the spanning theory which asserts that if there is one basic financial instrument it can be spanned into an infinite number of instruments. Islamic finance has at least 14 basic instruments and financial experts can span these into a much larger menu to provide greater security, liquidity, and diversity to meet the demand of investors on a global scale.

Such a variation is a blessing from Allah but on the other hand an examination from Allah too. The reason is that it would be easy to manoeuvre and for this very basic reason the income element of products offered by IFI’s normally equate to the IRR prevailing in the market as offered by CFI’s.

It is very simple to create a logic related thereto even for the wrong. For example, an ijara scheme for cars may have inbuilt IRR offered by the IFI’s as prevailing in the market and one can say that the rental amount varies according to the nature of the car. The technique is to use the term amount while for internal purposes percentages are used. Similarly, housing loans are also based on such concept. However, the rental figure needs to be varied according to the type, size and model of the car prevailing in the market. Similarly the rental amount for a house needs to be varied according to the locality and rent prevailing in such locality.

It seems that the IFI’s are competing CFI’s without recognizing the basic fact that the funds available to them are not based on a fixed interest amount which was the root of deviation and discriminatory factor for the establishment of this practical concept. The root also lies in the fact that conventional accountants and financial analysts are unable to come out the mental syndrome of their qualification’s teaching which in no way compete with the divine one.

This situation requires an effective international Islamic rating agency which should set the benchmarking. Although, there is a long list which is available if one tries to use the experience of existing rating agencies, however, the conventional rating model encompassing the environmental rating, labour and human right rating, employment equality rating, corporate social responsibility rating and industry practices rating needs to be secondary rating criterion which needs to be used after passing the primary rating criterion.

The primary criterion for assessing the products offered by an IFI must revolve around the following Hadith while working over the spanning theory. Last Prophet [PBUH] said, “There are certain things, which are allowed [halal], while there are certain things which are forbidden [haram], among them there are things which are neither allowed nor forbidden, don’t seek them. You could understand it in such a manner that cattle farmer makes its sheep grazing in an area which is near the grazing area of the king’s cattle. He does not know when the sheep enter into the grazing area of the King” [Crux Hadith]. Similarly, the legal documents forming the structure of balance sheet would be used to judge the adequacy of the financial arrangement.

It is not the size; capital base etc which needs to be used in primary criterion but the spirit of Islamic concepts needs to be used in primary criterion. The shariah board must understand the fact their intentional wrong decisions would make them gods in the light of following Hadith.

Hazrat Adi bin Hatim [RA] came to Last Prophet [PBUH] and asked, “In various places of Holy Quran, it was written that ahl-e-kitab do rukoo and sujjood before their Ulama, however, I did not found anyone even when I was among them.” Last Prophet [PBUH] replied, “would you accept whatever they say halal, as halal and what they say haram, as haram.” He replied, “yes”. Last Prophet [PBUH] said this meant that you were praying before them [Crux Hadees].
by Mohammad Ashraf
source : accountancy.pk

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