Governor’s Speech at the Official Launch of Affin Islamic Bank Berhad

Islamic finance has become one of the most dynamic growth areas in international finance. While Islamic finance has become an increasingly important form of financial intermediation in several countries, more recently, we have seen the international dimension gain significance. The Malaysian Islamic financial system is now well positioned to become internationally integrated with the international Islamic financial system. The progress and development of the Islamic financial services sector in Malaysia is evidenced by:

 

  • the rapid expansion in new and innovative Islamic financial products and services;
  • the enhanced competitive environment in which Islamic finance has developed;
  • the progressive development of the prudential, regulatory and supervisory framework for Islamic financial institutions;
  • the active issuance of both corporate and sovereign Islamic financial instruments;
  • the progressive liberalisation for foreign participation; and
  • the strengthened financial and non-financial institutional infrastructure, including the development of the domestic money and capital markets, and the establishment of institutions to promote human resource development in Islamic finance to ensure the pool of talent that is necessary to sustain the long term growth of the industry.

 

Our domestic Islamic financial system is one of the most developed, with its diversity of players and financial products and services in Islamic banking, takaful and the Islamic capital market.

 

Today, we are witnessing the establishment of another dedicated Islamic banking subsidiary that will contribute towards further strengthening the Islamic financial institutional infrastructure in Malaysia – the launch of Affin Islamic Bank Berhad as an Islamic banking subsidiary of Affin Bank Berhad.

 

With the domestic Islamic financial infrastructure in place, the emphasis is now to become more internationally integrated with the international Islamic financial system, thus increasing our economic and financial linkages with other parts of the world. Our efforts are to position Malaysia as an international Islamic financial centre and thus facilitate this international integration process. In this regard, the establishment of an Islamic subsidiary also increases the opportunity for entering into strategic partnerships with foreign interests, thereby increasing the potential for greater interface with more extensive markets beyond our domestic borders.

 

On the domestic front, while tremendous progress has been achieved, much more needs to be done. The Islamic financial industry needs to allocate more resources toward investment in research and development to create more innovative products. Consumer awareness and consumer education also needs to be enhanced to support the growth of the Islamic financial industry. In a financial environment that is transitioning towards greater deregulation and towards more market-based rules, it is important that the Islamic financial institutions inculcate a high level of confidence among consumers not only on the Shariah-compliance aspects of the Islamic financial products offered, but also on their business operations.

 

Concerted efforts by the industry to develop standardized documentation and features of Islamic financial contracts would enhance the level of public understanding of the different types and concepts of Islamic financial products. Islamic financial institutions also need to provide consumers with the information that accurately represents the unique features, risks and returns associated with the Islamic products and services. Enhanced financial literacy on Islamic financial products will facilitate the process for consumers to make well-informed and effective decisions on their financial transactions, with a clear understanding and appreciation of the unique characteristics and features of Islamic finance and its real economic value.

 

Indeed, the strengthening of the range of Islamic products and services needs to be accompanied by an improved market understanding of the Islamic financial products. This requires well trained staff who are equipped with the required skills and knowledge in Islamic finance that are able to provide quality advice to the customers. Correct terminologies need to be used with an ability to highlight the distinguishing features of the products and services. This is particularly important in a dual financial environment where both conventional and Islamic financial system are operating in parallel.

 

The regulatory framework governing market practices by the Islamic financial institutions can also be strengthened further to ensure its continued soundness. This will involve the implementation of the prudential standards that have been issued by the Islamic Financial Services Board, the IFSB. Greater transparency through the observance of minimum disclosure requirements needs to be adopted by the industry. Good business practices need to be embedded in all aspects of Islamic financial operations, not only as part of good governance and corporate social responsibility, but also as part of brand building. Market efficiency in conducting Islamic business activities can also be enhanced further to ensure its sustained competitiveness as an intermediation process.

 

As we are advancing into the third phase of the Financial Sector Master Plan, where the environment will become increasingly more liberalised and dynamic, we now have to look beyond the 2010 strategies. A key feature of the new environment is increased competition. The benefit of this trend will be to the consumers and businesses in terms of better prices, better range of products and services that are of a higher quality. This in turn would contribute to the overall performance of the economy. To be at the leading edge of competition, continuous efforts have to be intensified to enhance business efficiency and innovation. In this regard, the Islamic subsidiaries, with their increased autonomy in business operations, would be better positioned to determine their own business strategies and to realise the vast growth potential in the Islamic financial industry. On this note, it is my pleasure to congratulate the Affin Group on the occasion of the official launch of Affin Islamic Bank Berhad. I wish Affin Islamic Bank Berhad every success in maximising the potential opportunities and contributing to achieving its objectives.

source : bnm gov

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The Muslim banking world faces the challenge of expanding internationally while remaining true to Islamic principles

By Nasser M. Suleiman

Introduction

Corporate governance in banking has been analysed almost exclusively in the context of conventional banking markets. For example, there has recently been some discussion of the role ‘market discipline’ exerted by bank shareholders and depositors in constraining the risk taking behaviour of bank management. At the same time, there is growing interest in, and analysis of, banks as stockholders in companies themselves playing a central role in corporate governance, especially in Germany and other countries with universal banking structures of the traditional type.

By contrast, little is written on governance structures in Islamic banking, despite the rapid growth of Islamic banks since the mid 1970s and their increasing presence on world financial markets. There are now over 180 financial institutions world-wide which adhere to Islamic banking and financing principles. These banks operate in 45 countries encompassing most of the Muslim world, along with Europe, North America and various offshore locations. Islamic financing increasingly is a market segment of interest of Western banks, and the latest addition to the list of Islamic banks in October 1996 in the Citi Islamic Investment Bank, Bahrain a wholly owned subsidiary of Citicorp.

Islamic banking represents a radical departure from conventional banking, and from the viewpoint of corporate governance, it embodies a number of interesting features since equity participation, risk and profit-and-loss sharing arrangements from the basis of Islamic financing. Because of the bank on interest (riba), an Islamic bank cannot charge any fixed return in advance, but rather participates in the yield resulting from the use of funds. The depositors also share in the profits according to predetermined ratio, and are rewarded with profit returns for assuming risk. Unlike a conventional bank which is basically a borrower and lender of funds, an Islamic bank is essentially a partner with its depositors, on the one side, and also a partner with entrepreneurs, on the other side, when employing depositors’ funds in productive direct investment.

These financial arrangements imply quite different stockholder relationships, and by corollary governance structures, from the conventional model since depositors have a direct financial stake in the bank’s investment and equity participations. In addition, the Islamic bank is subject to an additional layer of governance since the suitability of its investment and financing must be in strict conformity with Islamic law and the expectations of the Muslim community. For this purpose, Islamic banks employ an individual sharia Advisor and/or Board.

My examination of corporate governance in Islamic banking begins with the comparing governance structures in the Islamic bank and will continues with the principles of Islamic banking. This study compares the Islamic banking, financial model and its implications for governance structures. The study intends to give a small picture on the principles of Islamic banking.

The Islamic bank

Governance structures are quite different from these under Islamic banking because the institution must obey a different set of rules – those of the Holy Qur’an – and meet the expectations of Muslim community by providing Islamically-acceptable financing modes. These profit-and-loss sharing methods, in turn, imply different relationships than under interest-based borrowing and lending.

Figure 1 sets out the key stockholders in an Islamic bank. There are two major difference from the conventional framework. First, and foremost, an Islamic organisation must serve God. It must develop a distinctive corporate culture, the main purpose of which is to create a collective morality and spirituality which, when combined with the production of goods and services, sustains the growth and advancement of the Islamic way of life. To quote janachi (1995):

‘Islamic banks have a major responsibility to shoulder ….all the staff of such banks and customers dealing with them must be reformed Islamically and act within the framework of an Islamic formula, so that any person approaching an Islamic bank should be given the impression that he is entering a sacred place to perform a religious ritual, that is the use and employment of capital for what is acceptable and satisfactory to God.’ (p.42).

There are equivalent obligations upon employees:

‘The staff in an Islamic bank should, throughout their lives, be conducting in the Islamic way, whether at work or at leisure.’ (p.28).

Further, obligations also extend to the Islamic community:

‘Muslims who truly believe in their religion have a duty to prove, through their efforts in backing and supporting Islamic banks and financial institutions, that the Islamic economic system is an integral part of Islam and is indeed for all times … through making legitimate and Halal profits.’ (p.29).

Second, interest-free banking is based on the Islamic legal concepts of shirkah (partnership) and mudaraba (profit-sharing). An Islamic bank is conceived as financial intermediary mobilising savings from the public on a mudaraba basis and advancing capital to entrepreneurs on the same basis. A two-tiered profit-and-loss sharing arrangement operates under the following rules:

The bank receives funds from the public on the basis of unrestricted mudaraba. There are no restrictions imposed on the bank concerning the kind of activity, duration, and location of the enterprise, but the funds cannot be applied to activities which are forbidden by Islam

The bank has the right to aggregate and pool the profit from different investments, and share the net profit (after deducting administrative costs, capital depreciation and Islamic tax) with depositors according to a specified formula. In the event of losses, the depositors lose a proportional share or the entire amount of their funds. The return to the financier has to be strictly maintained as a share of profits.

The bank applies the restricted from of mudaraba when funds are provided to entrepreneurs. The bank has the right to determine the kind of activities, the duration, and location of the projects and monitor the investments. However, these restrictions may not be formulated in a way which harms the performance of the entrepreneur, and the bank cannot interfere with the management of the investment. Loan covenants and other such constraints usual in conventional commercial bank lending are allowed.

The bank cannot require any guarantee such as security and collateral from the entrepreneur in order to insure its capital against the possibility of an eventual loss.

The liability of the financier is limited to the capital provided. On the other hand, the liability of the entrepreneur is also restricted, but in this case solely to labour and effort employed. Nevertheless, if negligence or mismanagement can be proven, the entrepreneur may be liable for the financial loss and be obliged to remunerate financier accordingly.

The entrepreneur shares the profit with bank according to previously agreed division. Until the investment yields a profit, the bank is able to pay a salary to the entrepreneur based on the ruling market salary.

Many of the same restrictions apply to musharaka financing, except that in this instance the losses are borne proportionately to the capital amounts contributed. Thus under these two Islamic modes of financing, the project is managed by the client and not by the bank, even though the bank shares the risk. Certain major decisions such as changes in the existing lines of business and the disposition of profits may be subject to the bank’s consent. The bank, as a partner, has the right to full access to the books and records, and can exercise monitoring and follow-up supervision. Nevertheless, the directors and management of the company retain independence in conducing the affairs of the company.

These conditions give the finance many of the characteristics of non-voting equity capital. From the viewpoint of the entrepreneur, there are no fixed annual payments needed to service the debt as under interest financing, while the financing does not increase the firm’s risk in the way that other borrowings do through increased leverage. Conversely, from the bank’s viewpoint, the returns come from profits – much like dividends – and the bank cannot take action to foreclose on the debt should profits no eventuate.

Governance structures

These structures are depicted in Figure 2 which sketches the conceptual framework of corporate governance for Islamic bank. Central to such a framework is the Sharia Supervisory Board (SSB) and the internal controls which support it. The SSB is vital for two reasons. First, those who deal with an Islamic bank require assurance that it is transacting with Islamic law. Should the SSB report that the management of the bank has violated the sharia, it would quickly lose the confidence of the majority of its investors and clients. Second, some Islamic scholars argue that strict adherence to Islamic religious principles will act as a counter to the incentive problems outlined above. The argument is that the Islamic moral code will prevent Muslims from behaving in ways which are ethically unsound, so minimising the transaction costs arising from incentive issues. In effect, Islamic religious ideology acts as its own incentive mechanism to reduce the inefficiency that arises from asymmetric information and moral hazard.

Such matters are obviously basic to the successful operation of Islamic modes of finance, and they are assessed in the next section when I examine Principles of Islamic Banking.

Principles of Islamic banking

An Islamic bank is based on the Islamic faith and must stay within the limits of Islamic Law or the sharia in all of its actions and deeds. The original meaning of the Arabic word sharia was ‘the way to the source of life’ and it is now used to refer to legal system in keeping with the code of behaviour called for by the Holly Qur’an (Koran). Four rules govern investment behaviour:

the absence of interest-based (riba) transactions;

the avoidance of economic activities involving speculation (ghirar);

the introduction of an Islamic tax, zakat;

the discouragement of the production of goods and services which contradict the value pattern of Islamic (haram)

In the following part I explain these four elements give Islamic banking its distinctive religious identity.

Riba

Perhaps the most far reaching of these is the prohibition of interest (riba). The payment of riba and the taking as occurs in a conventional banking system is explicitly prohibited by the Holy Qur’an, and thus investors must be compensated by other means. Technically, riba refers to the addition in the amount of the principal of a loan according to the time for which it is loaned and the amount of the loan. While earlier there was a debate as to whether riba relates to interest or usury, there now appears to be consensus of opinion among Islamic scholars that the term extends to all forms of interest.

In banning riba, Islamic seeks to establish a society based upon fairness and justice (Qur’an 2.239). A loan provides the lender with a fixed return irrespective of the outcome of the borrower’s venture. It is much fairer to have a sharing of the profits and losses. Fairness in this context has two dimensions: the supplier of capital possesses a right to reward, but this reward should be commensurate with the risk and effort involved and thus be governed by the return on the individual project for which funds are supplied.

Hence, what is forbidden in Islamic is a predetermined return. The sharing of profit is legitimate and that practice has provided the foundation for Islamic banking.

Ghirar

Another feature condemned by Islamic is economic transactions involving elements of speculation, ghirar. Buying goods or shares at low and selling them for higher price in the future is considered to be illicit. Similarly an immediate sale in order to a void a loss in the future is condemned. The reason is that speculators generate their private gains at the expense of society at large.

Zakat

A mechanism for the redistribution of income and wealth is inherent is Islam, so that every Muslim is guaranteed a fair standard of living, nisab. An Islamic tax, Zakat (a term derived from the Arabic zaka, meaning “pure”) is the most important instrument for the redistribution of wealth. This tax is a compulsory levy, one of the five basic tenets of Islam and the generally accepted amount of the zakat is one fortieth (2.5 per cent) of Muslim’s annual income in cash or kind from all forms of assessed wealth exceeding nisab.

Every Islamic bank has to establish a zakat fund for collecting the tax and distributing it exclusively to the poor directly or through other religious institutions. This tax is imposed on the initial capital of the bank, on the reserves, and on the profits as described in the Handbook of Islamic Banking.

Haram

A strict code of ‘ethical investment’ operates. Hence it is forbidden for Islamic banks to finance activities or items forbidden in Islam, haram, such as trade of alcoholic beverage and pork meat.

Furthermore, as the fulfilment or materials needs assures a religious freedom for Muslims, Islamic banks are required to give priority to the production of essential goods which satisfy the needs of the majority of the Muslim community, while the production and marketing of luxury activities, israf wa traf is considered as unacceptable from a religious viewpoint.

In order to ensure that the practices and activities of Islamic banks do not contradict the Islamic ethical standards, Islamic banks are expected to establish a Sharia Supervisory Board, consisting of Muslim jurisprudence, who act as advisers to the banks.

Profit-sharing agreements

Although the restriction against the use of interest might seem to be a binding constraint upon expansion, Islamic banks and financial institutions have in fact grown rapidly. Table 1 sets out the number of banks, paid up capital, total deposits and total assets of these Islamic banks, classified by region. It shows that the total assets of these reporting banks amounted to US $155 billion in 1994, with employment in excess of 220,000 (data supplied by the International Association of Islamic Banks).

If the paying and receiving of interest is prohibited, how do Islamic banks operater It is necessary to distinguish between the expressions ‘rate of interest’ and ‘rate of return’. Whereas Islam clearly forbids the former, it not only permits, but rather encourages, trade. In the interest-free system sought by adherents to Muslim principles, people are able to earn a return on their money only by subjecting themselves to the risk involved in profit sharing. As the use of interest rates in financial transactions is prevented, Islamic banks are expected to undertake operations only on the basis of Profit and Loss Sharing (PLS) arrangements or other acceptable modes of financing. Mudaraba and musharaka are the two profit-sharing arrangements preferred under Islamic law.

Mudaraba

A mudaraba can be defined as contract between at least two parties whereby one party, the financier (sahib al-mal), entrusts funds to another party, the entrepreneur (mudarib), to undertake an activity or venture. This type of contract is in contrast with musharaka. In arrangements based on musharaks there is also profit-sharing, but all parties have the right to participate in managerial decisions. In mudaraba, the financier is not allowed a role in management of the enterprise. Consequently, mudaraba represents a PLS contract where the return to lenders is a specified share in the profit/loss outcome of the project in which they have a stake, but no voice.

In interest lending, the loan is not contingent on the profit or loss outcome, and is usually secured, so that the debtor has to repay the borrowed capital plus the fixed interest amount regardless of the resulting yield of the capital.

Under mudaraba, the yield is not guaranteed in profit-sharing and financial losses are borne completely by the lender. The entrepreneur as such losses only the time and effort invested in the enterprise. This distribution effectively treats human capital with equally financial capital.

Musharaka

Under musharaka, the entrepreneur adds some of his own to that supplied by the investors, so exposing himself to the risk of capital loss. Profits and losses are shared according to pre-fixed proportions, but these proportions need not coincide with the ratio of financing input. The bank sometimes participates in the execution of the projects in which it has subscribed, perhaps by providing managerial expertise. Figure 3 illustrates the elements.

Mudaraba and musharaka constitute, at least in principle if not always in practice, the twin pillars of Islamic banking.

The two methods conform fully with Islamic principles, in that under both arrangements lenders share in the profits and losses of the enterprises for which funds are provided and shirkah (partnership) is involved. The musharaka principle in invoked in the equity structure of Islamic banks and is similar to the modern concepts of partnership and joint stock ownership.

Two-tiered mudabara

For banking operations, the mudaraba concept has been extended to include three parties: the depositors as financiers, the bank as an intermediary, and the entrepreneur who requires funds. The bank acts as an entrepreneur when it receives funds from depositors, and as financier when it provides the funds to entrepreneurs. In other words, the bank operates a two-tier mudaraba system in which it acts both as the mudarib on the saving side of the equation and as the rubbul-mal (owner of capital) on the investment portfolio side. Insofar as the depositors are concerned, an Islamic bank acts as a mudarib which manages the funds of the depositors to generate profits subject to the rules of mudaraba. The bank may in turn use the depositors’ funds on a mudaraba basis in addition to other lawful (but less preferable) modes of financing, including mark up or deferred sales, lease purchase and beneficence loans. The funding and investment avenues are now listed.

Sources of funds

Besides their own capital and equity, Islamic banks rely on two main sources of funds, a) transaction deposits, which are risk free but yield no return and, b) investment deposits, which carry the risks of capital loss for the promise of variable. In all, there are four main types of accounts:

Current accounts

Current accounts are based on the principle of al-wadiah, whereby the depositors are guaranteed repayment of their funds. At the same time, the depositor does not receive remuneration for depositing funds in a current account, because the guaranteed funds will not be used for PLS ventures. Rather, the funds accumulating in these accounts can only be used to balance the liquidity needs of the bank and for short-term transactions on the bank’s responsibility.

Savings accounts

Savings accounts also operate under the al-wadiah principle. Savings accounts differ from current deposits in that they earn the depositors income: depending upon financial results, the Islamic bank may decide to pay a premium, hiba, at its discretion, to the holders of savings accounts.

Investment accounts

An investment account operates under the mudaraba al-mutlaqa principle, in which the mudarib (active partner) must have absolute freedom in the management of the investment of the subscribed capital. The conditions of this account differ from those of the savings accounts by virtue of: a) a higher fixed minimum amount, b) a longer duration of deposits, and c) most importantly, the depositor may lose some of or all his funds in the event of the bank making losses.

Special investment accounts

Special investment accounts also operate under the mudaraba principle, and usually are directed towards larger investors and institutions. The difference between these accounts and the investment account is that the special investment account is related to a specified project, and the investor has the choice to invest directly in a preferred project carried out by the bank.

Uses of funds

The mudaraba and musharaka modes, referred to earlier, are supposedly the main conduits for the outflow of funds from banks. In practice, however, other important methods applied by Islamic banks include:

Murabaha (mark up). The most commonly used mode of financing seems to be the ‘mark-up’ device. in a murabaha transactions, the bank finances the purchase of a good or assets by buying it on behalf of its client and adding a mark-up before reselling it to the client on a ‘cost-plus’ basis profit contract. Figure 4 illustrates the sequence.

Bai’ muajjal (deferred payment). Islamic banks have also been resorting to purchase and resale of properties on a deferred payment basis. It is considered lawful in fiqh (jurisprudence) to charge a higher price for a good if payments are to be made at a later date. According to fiqh this does not amount to charging interest, since it is not a lending transaction but a trading one.

Bai’salam ( prepaid purchase). This method is really the opposite of the murabaha. There the bank gives the commodity first, and receives the money later. Here the bank pays the money first and receives the commodity later, and is normally used to finance agricultural products.

Istissanaa (manufacturing). This is a contract to acquire goods on behalf of a third party where the price is paid to the manufacturer in advance and the goods produced and delivered at a later date.

Ijara and ijara wa iqtina (leasing). Under this mode, the banks buy the equipment or machinery and lease it out to their clients who may opt to buy the items eventually, in which case the monthly payments will consist of two components, i.e. rental for the use of the equipment and instalment towards the purchases price.

Qard hasan (beneficence loans). This is the zero return type of loan that the Holly Qura’n urges Muslims to make available to those who need them. The borrower is obliged to repay only the principal amount of the loan, but is permitted to add a margin at his own discretion.

Islamic securities. Islamic financial institutions often maintain an international Islamic equity portfolio where the underlying assets comprise ordinary shares in well run businesses, the productive activities of which exclude those on the prohibited list (alcohol, pork, armaments) and financial service based on interest income.

 

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References

1. Abdul Gafoor, A.L.M., 1995. Interest-free Commercial Banking. Groninigen, The Netherlands: Apptec Publications.2. Ahmed, Z., lqbal, M., and Khan, M. f., 1983. Money and Banking in Islam. Jaddah: international Centre for Research in Islamic Economics, King Abdual Aziz University.

3. Algaoud, L. M. and Lewis, M. k., 1997. Bahrain as an International Centre for Islamic Baking, Proceedings of international Conference on Accounting, Commerce & Finance. The Islamic Perspective, University of West Sydney, Macarthur.

4. Arrif M. (ed), 1982. monetary policy in an interest free Islamic economy: nature and scope in Ariff, M. (ed), Monetary and Fiscal Economic of Islam, Jaddah: International Centre for Research in Islamic Economics.

5. Handbook of Islamic Banking, 1977-86. Published in Arabic by the International Association of Islamic Banks, 6 Vols., Cairo.

6. Islamic finance : Turning the Prophet’s profits. Economist, 8/24/96, Vol. 340 Issue 7980, p58, 2p.

7. Janahi, A. L., 1995. Islamic Banking, Concept, Practice and Future, 2 nd edition. Manama: Bahrain Islamic Bank.

8. Khalaf, Roula: Banking the Islamic way. World Press Review, Jan. 95, Vol. 42 Issue 1, p35, 5/6p.

9. Khan, M S., 1986. Islamic interest-free banking: A Theoretical Analysis, IMF Staff Papers, Vol. 33, No. 1, pp. 1-25.

10. Kuran, T., 1986. The Economic System in Contemporary Islamic Thought: Interpretation and Assessment, International Journal. Middle East Study, No. 18, pp. 135 – 154.

11. Kuran, T., 1995. Islamic Economic and the Islamic Sub economy journal of Economic Perspectives, Vol. 9 No. 4, pp. 155-173.

12. Lewis, M. k., 196. Universal banking in Europe: The Old the new, International Symposium on Universal banking, Korean institute of Finance, Seoul, January.

13. Mannan, M. A., 1986. Islamic Economics: Theory Practice, Cambridge: Hodder and Stoughton.

14. Siddiqi, M. N., 1988. Banking without Interest, Leicester: The Islamic Foundation.

15. Ul-Haque, N. U. and Nirakhor, A., 1986. Optimal Profit-sharing Contracts and Investment in an interest-free Islamic Economy, IMF Working Paper, No. 12, Washington: international Monetary Fund.

 

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Footnotes

This treatise, first published in 1990, is distributed by the Baharain Islamic Bank.

The concepts are examined in Siddiqi (1983) and Abdul Gafoor (1995).

The incentive problems are examined in Ul-Haque and Mirakhor, (1986).

The higher price shows in (HIB, 1982, vol., p.427).

The five basic tenets ( or pillars) are: (1) acceptance of shahada, (2) prayer or namaz, (3) zakat or alms, (4) fasting, and (5) hajj or pilgrimage to Mecca.

The Islam clearly forbids are examined in Khan, 1986, pp. 4-6.

source : al-bab

 

 

 

Islamic finance

by Ibrahim Warde

Islamic banking and financial institutions grew along with political Islam: it declined, they did not. In fact, Islamic finance is now a confident part of the new global world of venture capital, ethical investment and profit-and-loss sharing.

by Ibrahim Warde

The assets of Islamic financial institutions now top the $230bn mark. That is more than a 40-fold increase since 1982 (1). Most of the large Western financial institutions, following the example of Citibank, have their own Islamic subsidiaries or, at the very least, Islamic “windows” or products aimed at their Islamic clientele. As proof of how many companies are compatible with Islamic law – and not just from within the Muslim world – there is now even a Dow Jones Islamic market index.

This may seem strange. We often hear it said that Islam is incompatible with the new world order that emerged with the end of the cold war (2). How can practices rooted in the Middle Ages thrive in the age of technology-driven global finance? Or institutions that are suspicious of interest operate within a global, interest-based financial system? And how can Islamic finance, often considered a facet of political Islam, experience its most rapid growth just as that same political Islam is on the wane (3) ?

Modern Islamic finance began in the early 1970s at the intersection of two important developments in the Muslim world: the rise of pan-Islamism and the oil boom. The 1967 Six Day war marked the end of the secular pan-Arab Nasserite movement and the start of the regional dominance of Saudi Arabia under a pan-Islamic banner (4). With the start of the Organisation of the Islamic Countries movement (OIC) in 1970, the idea of updating traditional Islamic banking soon became part of the agenda. It was something that had preoccupied Islamic scholars, particularly in Pakistan, for a number of years.

Research institutes focusing on Islamic economics and finance began to spread throughout the Muslim world. In 1974 the OIC summit in Lahore voted, after oil prices quadrupled, to create the inter-governmental Islamic Development Bank (IDB). Based in Jedda, this became the cornerstone of a new banking system inspired by religious principles. In 1975 the Dubai Islamic Bank – the first modern, non-governmental Islamic bank – was opened. In 1979 Pakistan became the first country to embark on a full Islamisation of its banking sector; and Sudan and Iran followed suit in 1983.

The first paradigm of modern Islamic banking was established in those years. Islamic jurisprudents reinterpreted a rich legal but pre-capitalist tradition to suit the requirements of the modern era. There was a central problem: although commerce had always been central to the Islamic tradition (the Prophet Mohammad was himself a merchant), profits from pure finance were viewed with suspicion. The Koran says, for example, that despite their superficial resemblance, profits from commerce are fundamentally different from those generated by money-lending (sura 2, verse 275). More specifically, Islam prohibits riba. Though the term literally means “increase”, it has been variously interpreted: sometimes as usury (or excessive interest), more often as any kind of interest. The majority of Islamic scholars still equate riba with interest, even though major scholars – including the current head of Egypt’s Al-Azhar, one of Islam’s oldest and most prestigious centres of learning – have condoned the use of certain forms of interest.

Pricing time

Islamic scholars accepted that time must be priced, but objected to the fixed, pre-determined aspects of interest-based lending with its inherent risk of lender exploiting borrower (5). In the early days of Islam, the dominant form of finance consisted in a partnership between lender and borrower, based on the fair sharing of both profits and losses – a logic similar to today’s venture capital where financiers link their fate to the firms in which they invest. For instance, in medieval Arabia, wealthy merchants financing the caravan trade would share in the profits of a successful operation, but could also lose all or part of their investment if the merchandise was stolen, lost or sold for less than its cost.

A distinctive feature of Islamic banking was to be its focus on developmental and social goals. Profit-and-loss-sharing (PLS), or partnership finance, with its focus on cash-poor but promising entrepreneurs, held more economic potential than conventional, collateral-based lending, which favours established businesses. Islamic finance also promised to benefit local communities and draw into the banking system people who had shunned riba-based finance. In addition, banks were to contribute to, as well as manage, zakat funds (6) earmarked for a variety of charitable and social purposes.

The first Islamic banks were committed to partnership finance – mudaraba(commenda partnership) and musharaka (joint venture) – though most of their operations consisted of cost-plus operations such as murabaha, where the bank would purchase the goods needed by the borrower, then resell them to the borrower at a profit. Remuneration of deposits (current, saving or investment accounts) was based on a profit-and-loss sharing logic: investment accounts were remunerated based on the performance of specific investments by the bank; and holders of savings accounts shared in the bank’s overall profits.

After a few years Islamic finance began to look like no more than an exercise in semantics: Islamic banks were really no different from conventional banks, except in the euphemisms they used to disguise interest. Forays into profit-and-loss sharing were disappointing, and often abandoned. The image of Islamic banks was also tainted by the failure of Islamic Money Management Companies (IMMCs) in Egypt in 1988 and by scandals such as the BCCI (Bank of Credit and Commerce International) collapse in 1991. People dismissed Islamic finance as a passing fad associated with the oil boom.

In reality, it was on the cusp of a major boom. Deregulation and technological change had produced a major readjustment in international finance. And the Islamic world had been transformed by new political, economic and demographic circumstances (the impact of the Iranian revolution, the Gulf war, the collapse of the Soviet Union, the emergence of new Islamic states, a changing oil market, the rise of Asian tigers, a growing Islamic presence in the West, the emergence of new Islamic middle classes).

The traditional world of finance, dominated by commercial, interest-based banking, could raise potentially troublesome theological issues. But Islamic finance thrived in the new world, with its downgrading of interest income, financial innovation and blurring of distinctions between commercial banking and other areas of finance. The downgrading of interest (and the concomitant rise of fees as a major source of revenue for financial institutions) allowed Islamic bankers to sidestep the controversial riba issue. Deregulation fostered the creation of tailor-made Islamic products. Until the 1970s financial institutions could sell only a narrow range of financial products. With the lifting of constraints on products that could be devised to suit every need, religious or not, Islamic products could be created. For example, the process of slicing and splicing makes it possible to split the interest and principal components of a bond, and sell them separately.

Moralising finance

At the ideological level, the Islamist critique of statism converged with the emerging “Washington consensus”. The Islamic commitment to private property, free enterprise and the sanctity of contracts meshed with the emphasis on privatisation, deregulation and the rule of law. The reliance on zakat and other religiously-based redistribution schemes matched increased preference, since the Thatcher-Reagan years, for the downsizing of the welfare state. In many countries, Islam became a tool for entrepreneurs seeking to get around restrictive regulation, and the best excuse to disengage the state from the economy. Malaysia and Bahrain used Islam as a tool of financial modernisation – essentially as a way of countering the rentier inclinations of the private sector and the anti-competitive leanings of entrenched elites who benefited from the status quo. The Financial Times noted that Islamic institutions are now often at the forefront of innovation and dynamism.

Perhaps the main impetus behind the current boom in Islamic finance lies in the excesses of global finance (7). Just as current business excesses have spawned a preoccupation with ethics, the amorality of contemporary finance has generated an interest in “moralising” finance. And whereas Western or Judeo-Christian finance has become thoroughly secularised (the religious origin of many financial institutions has long receded from people’s minds), the idea of Islamic finance was bound, at a time of rising pietism (8), to strike a chord. Islam has a positive view of economic activities, while providing for a strict ethical framework; and Islamic finance offers a fruitful compromise between finance and ethics.

This explains the current tendency to focus on the spirit, or “moral economy”, of Islam. In contrast to the 1970s, when literal, legalistic and scholastic interpretations dominated, the ijtihad (interpretation) now underway focuses on making modern financial instruments compatible with Islamic principles. The modernist slant disavows the view that whatever did not exist in the early days of Islam is necessarily un-Islamic. Challenging common perceptions that Islam is rigid and fossilised, it emphasises those adaptive mechanisms – such as departures from tradition for reasons of local custom (’urf), public interest (maslaha) or necessity (darura) – that have allowed the religion to thrive on every continent for 14 centuries.

Whereas the early years of Islamic finance were dominated by oil-producing Arab states (primarily Saudi Arabia ), and to a lesser extent Egypt and Pakistan, the new paradigm reflects the diversity of the Islamic world. A wide range of Islamic products is now available in at least 75 countries. Even countries that have Islamised their entire financial systems have done so under different circumstances and in vastly different ways. In addition, much innovation and scholarship now originates within Muslim minorities outside the Islamic world.

Today the fastest growing segments of the industry are outside traditional banking products and in areas of finance that were either initially dismissed as unacceptable to Islam (such as insurance or takaful) or that barely existed in the 1970s (such as micro-lending and Islamic mutual funds). Funds invested in stocks acceptable to Islam (shunning unethical or highly-indebted firms, or engaged in gambling, alcohol sales and other prohibited activities) are increasingly popular, just like their “socially-responsible” secular counterparts. Islamic finance still faces a host of challenges (strategic, economic, regulatory, political, religious), but the current boom does not seem likely to abate.

 

(1) http://www.islamicbanking-finance.com

(2) Samuel Huntington, The Clash of Civilizations and the Remaking of World Order, Simon and Schuster Touchstone, New York, 1997, p 211.

(3) See for example Olivier Roy, L’Echec de l’Islam politique, Seuil, Paris, 1992.

(4) Edward Mortimer, Faith and Power: The Politics of Islam, Faber & Faber, London, 1982, pp 177-220.

(5) Until recently, the Christian and Judaic traditions had comparable misgivings about interest. See Rodney Wilson, Economics, Ethics and Religion: Jewish, Christian and Muslim Economic Thought, New York University Press, 1997.

(6) Zakat, or almsgiving, is of the five pillars of Islam. The others are the profession of faith, daily prayers, fasting during Ramadan, and for those who can afford it, a pilgrimage to Mecca.

(7) Roula Khalaf, “Dynamism is held back by state control: As family dynasties stifle creativity in most of the industry, the Islamic sector is showing signs of the greatest vibrancy”, Financial Times, 11 April 2000.

(8) Yahya Sadowski “’Just’ a Religion: For the Tablighi Jama’at, Islam is not totalitarian,” The Brookings Review, summer 1996, vol 14 no.3, pp 34-35.

Amana Takaful Insurance profits grow by 396%

As more and more Sri Lankans look to the Takaful way of insurance, known as the most rewarding in the industry, its Sri Lankan flag-bearer Amana Takaful Insurance (ATI) revealed remarkable growth, for its financial year of 2006.

The net profit after tax shows an extensive rise of 396%, from Rs.2mn to Rs.11.5mn, while the total Gross Written Premium (GWP) has increased by a significant 57%. Total assets increased by 38%, and are at Rs.597mn, as at the end of the financial year. According to the financial statements Earnings per Share is recorded at Rs.0.92. ATI’s prolific year showed General Takaful achieving a growth of 53% and Family Takaful boasting a growth of 85%.

Recently completing 8 years of operation in Sri Lanka, Amana Takaful Insurance has made tremendous headway in the insurance industry, showing potential to lead the Takaful industry in the South Asian region. ATI’s growth in 2006 confirms and reflects the Global Takaful industry growth of 15-20%.

“The Company’s business operations are based on fairness and a commitment to sincerely serve all participants on a mutually beneficial platform,” said Mr. Ehsan Zaheed, CEO/ Director – ATI, when asked to comment on the Company’s performance during 2006. “We have, throughout the past year, strengthened and reinforced key activities such as, risk management, corporate governance and the overall organisational structure – geared to provide a total Takaful solution and a company wide focus to provide a service that exceeds the expectations of customers.” One of the key strategic priorities was the investment in enhancing people and their skills. The development of our people has helped motivate employees reach their individual goals by complimenting the overall corporate objectives, he added.

Marketing and branding has also played a key role in ATI’s recent achievement. The nature of Takaful commands the creation of an innovative model to take it to the market. According to ATI’s Asst. Marketing Manager Aashiq Aminuddin, ATI has been able to enlighten the market about the benefits of Takaful through proper education. This has reflected in the market acceptance and growth of sales.

“The concept of Takaful can be termed as the next phase or generation of insurance. Its evolution has brought about a product that is a truly win-win proposition for everyone involved. Not only does it take care of participants, the system of operation also gives back a return to them. This is something new and interesting for the market”, Aminuddin added.

ATI has led the way in many instances in the industry. It was the first to open out mobile phone insurance and also medical insurance for individuals, fulfilling a dire need of the masses. ATI is also has a strong hold in Aviation and Hull Insurance, which is mainly in the Maldives.

The Takaful concept of insurance has become widely popular locally as well as globally due to its practice of giving back a ‘surplus refund.’ When you take a life or general cover, your premiums are pooled into a fund which yields returns from prudent investments while every member’s needs are taken care of. In General Takaful once all claims are paid the remaining (underwriting profit) is proportionately paid back to members who have not claimed during the policy year as surplus refunds.

Amana Takaful Limited, in collaboration with Takaful Malaysia, one of the largest Takaful operators in the world, has from inception catered for both Family and General Takaful Insurance. Its success is mirrored in its phenomenal growth and the extent of customer loyalty it commands today.

The Company’s operations have expanded to include 15 locations island-wide including in the South and East of Sri Lanka, also extending overseas with the setting up of a fully fledged branch in the Maldives. Amana Takaful Insurance is currently backed by some of the best re-insurers in the Takaful Industry, including Takaful Re, Best Re, Malaysian Re, Asian Re and Lauban Re.

source : prleap

Turkey: Islamic Finance Transactions in Turkey

The term “Islamic finance” refers to a system of financing or financial activity that is consistent with Islamic rules and principles. The model outlined under the Islamic finance is generally based on two main pillars, namely the sharing of profit and loss; and the prohibition of charging interest. There are several modes of financing currently being used in Islamic finance practice, certain of which can be considered as similar to conventional banking products. However, the main rule dominating the financial instruments in Islamic finance is the prohibition of recovering interest, which gives rise to the essential mode of financing based on the deferred sale of a commodity, namely “Murabaha”.

Murabaha, which was originally a contract of sale in which a commodity is sold on profit, has been modified for application in the financial sector and has thereby become the single most popular technique of financing amongst Islamic banks all over the world. A Murabaha transaction is completed in two stages. In the first stage, the client requests the financial institution to undertake a Murabaha transaction and promises to buy the commodity specified by him if the bank acquires the same commodity. In the second stage, the client purchases the good acquired by the bank on a deferred payment basis and agrees to a payment schedule. In sum, the Murabaha transaction consists of two sales contracts, one through which the bank acquires the commodity, and the other through which it sells it to the client.

The Murabaha form of financing is widely used by Islamic banks to satisfy various kinds of financing requirements. It is used to provide financing in a variety of diverse sectors (e.g. in consumer finance, for the purchase of consumer durables such as cars and household appliances; in real estate, to provide housing finance; and in the production sector, to finance the purchase of machinery, equipment and raw material).

Islamic Financing and its Aspects in the Turkish Market

 

Turkey has been institutionally utilizing Islamic finance techniques since the late 1980s through financial institutions known as “Special Finance Houses” (Özel Finans Kurumu), which became the “Participation Banks” (Katılım Bankası) with the enactment of the Banking Act No. 5411 (“Banking Act”) on 1 November 2005. There are currently four participation banks operating in Turkey, whose activities are under the supervision of the Banking Regulation and Supervision Agency. Participation banks are authorized by the Banking Act to collect deposit funds from the public under the “profit-and-loss participation accounts” and the “special current accounts”. The profit-and-loss accounts can be considered as a version of the Islamic finance instrument known as the “Mudaraba”, where the bank utilizes the funds deposited by account holders and that are accumulated in a pool for specific business activities. Any profits earned are shared between the account holder and the bank, in proportion to an agreed ratio.

Participation banks mainly offer two types of financing. The first is Murabaha, under which the funds are made available to companies in need of capital. The other is financial leasing, with terms similar to those offered by other leasing companies.

Apart from the institutionalized Islamic finance activities described above, a large number of syndicated loans in the form of Murabaha were made available to major Turkish companies such as Turkcell, Petrol Ofisi and Vestel in recent years. Under these transactions, the companies mentioned were provided with syndicated loans in the Murabaha form made available by credit consortiums consisting of financial institutions from the Persian Gulf region, led by the major actors of the global financial market. Considering that rising oil prices cause considerable capital accumulation in the Gulf Region, the Murabaha syndications can be considered as serious financing alternatives for Turkish companies.

Experts discuss Islamic banking challenges

LOCAL and foreign participants from Islamic financial institutions and regulatory bodies are gathering in the sultanate to tackle new challenges in implementing safety standards for Islamic banking in the region.

Increasing collaboration and interaction among financial institutions and other relevant agencies is needed to further expand the rapid growth of Islamic banking, said Dr A G Karunasena, executive director of South East Asian Central Banks (SEACEN) Research and Training Centre yesterday.

Speaking at the opening ceremony of a course on regulation and supervision of Islamic banks, he said that the sharing of knowledge and experiences among practitioners is essential to meet the diverse needs of consumers and businesses.

“Innovations of various Islamic financial products and services are not only expanding but also becoming more complex and sophisticated, resulting in new challenges to those who are responsible for overseeing and supervising financial institutions,” he said.

He hoped that the 46 participants from 24 institutions would be able learn the main elements of Islamic banking supervision and address differences between Islamic banking and conventional banking regulatory arrangements throughout the five-day course at Rizqun International Hotel.

Participants will also explore techniques and applications on Islamic banking regulation through case studies on the experiences of specific countries.

Dato Paduka Hj Ali Apong, Permanent Secretary at the Ministry of Finance, said that regulators and supervisors of Islamic banks need to keep abreast with the latest developments in Islamic financial services because “Islamic banks have now become a world force”.

He said that the launch of the first 91-day Sukuk Al-Ijarah, or Islamic bond in 2006, has “paved the way for Brunei to become the first sovereign to bypass conventional capital markets towards developing an Islamic capital market instrument”.

“The Ministry of Finance has issued the sukuk six times, which totalled $730 million to date, as one of the efforts to promote and develop Brunei as the hub for Islamic banking and finance,” he said.

Brunei has two Islamic banks, the Bank Islam Brunei Darussalam and Tabung Amanah Islam Brunei, or Brunei Islamic Trust Fund (Taib).

Islamic financial services comprise an estimated US$1 trillion market worldwide, according to credit rating agency Standard & Poor’s.

SEACEN Research and Training Centre, which has 16 member countries, including Brunei, was established in 1982 to review and analyse financial, monetary, and economic developments in the region.

The Islamic Research and Training Centre, on the other hand, provides training and information services in developing financial and banking activities that conform to Syariah or Islamic law principles.

The course is the third of its kind to be organised by SEACEN centre and the Islamic Research and Training Institute of the Islamic Development Bank. Malaysia and Indonesia previously hosted the course in 2005 and last year, respectively.

Shareen Han
BANDAR SERI BEGAWAN
The Brunei Times