This article aims to continue to develop the understanding of Islamic finance and follows the first article on this subject, 'Islamic finance – theory and practical use of sukuk bonds', published in February 2013 (see 'Related links'). The first article focused on Sukuk finance and case studies where Sukuk finance was utilised. This article is more general and considers different aspects, issues and developments of Islamic finance. It also extends the explanations provided in the appendix to the first article.
Islamic finance has been a recent addition to the Paper P4 syllabus. It is expected that future questions in this area will focus on developments and understanding of Islamic finance. However, questions could also focus on the application of Islamic finance as an additional source of finance, and assessing its benefits and drawbacks, in different business scenarios and situations.
Islamic virtues and tenets specify the need for ethical behaviour and fair treatment. Within a business context, this means that organisations should maintain high ethical standards in all business dealings. Specifically, business and enterprise should be conducted with honesty and integrity, maintaining truthfulness and morality in all dealings. In particular, such business and enterprise should not capitalise on the misfortune of others or take unfair advantage. For example, higher prices should not be charged to an individual because they lack knowledge and information about the fair price of a product that they are purchasing. Profit creation should be the result of business activity that benefits society at large.
Within this context, the Islamic finance framework is based on certain prohibitions. In particular, money (and money substitute products such as gold and silver) should not be viewed as commodities, but rather as means of exchange. Therefore, interest (or riba) cannot be paid or received on loans. Furthermore, although it is fully acceptable to engage in profitable business activities, such business should be ethical. In particular dealing in alcohol, pork-related products, armaments, gambling and other socially detrimental activities is not acceptable. Engaging in activities involving speculation is also not allowed, limiting the use of derivative instruments and money markets, which are based on interest.
OPERATIONALISING ISLAMIC FINANCE
Organisations need access to short-term and long-term sources of finance. The basic, fundamental function of banks is to provide a channel that enables the flow of financial resources from investors to borrowers, and thereby provides a source of finance for organisations. Investors invest their excess funds to earn interest, and borrowers use the funds in business activity to generate profits, some of which are then used to pay interest on the borrowings. Among other sources of finance that involve the payment and receipt of interest are corporate and government bonds.
The question that could be asked is how could finance flow between investors and borrowers without involving interest. The answer provided by Islamic finance, in its basic form, is through profit-sharing arrangements or partnerships. The article on Islamic finance published in February 2013 explained it as follows:
In an Islamic bank, the money provided in the form of deposits is not loaned, but is instead channelled into an underlying investment activity, which will earn profit. The depositor is rewarded by a share in that profit, after a management fee is deducted by the bank.
Islamic finance institutions (IFIs), including banks, could raise finance via Mudaraba and Musharaka equity-type contracts through multi-partnership contracts (see below). Here, investors (known as rub-ul-mal) would invest funds with the IFI (known as the mudareb or investment manager). The funds are then pooled and used in profit-making projects while also keeping within Sharia rules. Therefore, the IFI would effectively become the rub-ul-mal and the corporation that uses the funds for investment purposes becomes the mudareb. In each case, the emphasis is on partnerships, and the profits earned are shared between the corporation, the bank and the investors. It is possible that all three parties share the losses as well, if the business venture is not successful.
However, with corporations requiring different modes of finance and IFIs keen on providing these, different types of Islamic financial products have been developed. The challenge for IFIs is to ensure that the products comply with Sharia rulings, as well as normal financial regulations and law.
COMMON ISLAMIC FINANCIAL PRODUCTS
IFIs offer two broad categories of financial products: equity-based and fixed income-based. The appendix to the February 2013 article on Islamic finance explained many of these financial products and it is recommended that this article is read in conjunction with the first article for further detail.
Equity-based financial products
Equity-based financial products consist of Mudaraba and Musharaka contracts. With these contracts, the investor or IFI (rub-ul-mal) and the investment manager or corporation (mudareb) share the profits from the business venture, in which the funds are invested, in a pre-arranged agreement. The key differences between the two contracts are two-fold.
With a Mudaraba contract:
- all losses are borne solely by the investor (IFI), although provisions can be set up to carry forward these losses against future profits, and
- the mudareb, as the expert in the business venture takes the sole responsibility for running the business.
With a Musharaka contract:
- losses are shared between the two parties in proportion to their monetary investment or investment-in-kind, and
- both parties would participate in managing and running the venture jointly.
Diminishing Musharaka contracts are a recent innovation where not only are the profits shared between rub-ul-mal and the mudareb, but the mudareb would pay greater amounts to the rub-ul-mal. In this way the mudareb owns greater and greater proportion of the asset, until eventually the ownership of the asset is passed to the mudareb entirely.
Fixed-income based financial products
With Murabaha contracts, the IFI purchases the asset and then sells it to the business or individual at cost plus a fair profit. The business or individual pays for the asset in pre-agreed instalments and over a pre-agreed time period.
Ijara contracts are similar to short-term leases where the IFI purchases an asset for the business or individual to use. The lease payments, the lease period and payment terms are agreed at the start of the contract. The lessor is responsible for the maintenance and insurance of the asset. Provisions can be made to allow the lessee to purchase the asset for a nominal fee at the end of the contract.
Sukuk bonds were covered in some detail in the February 2013 article on Islamic finance and it is recommended that you study that article in detail. Sukuk bonds have been based on underlying securitised Islamic contracts such as Ijara and Mudaraba, as well on individual or groups of physical assets. Some Sukuk bonds have been based on securitised Murabaha contracts, but there is some debate on whether these comply with Sharia rulings, as they may be viewed as debt on debt and therefore attracting riba. Some Sharia rulings have allowed minor proportions of Murabaha and Istisna contracts within the securitised asset portfolio, used as the underlying asset portfolio.
Salam contracts are similar to forward contracts, where a commodity (or service) is sold today for future delivery. Cash is received immediately from the IFI and the quantity, quality, and the future date and time of delivery are determined immediately. The sale will probably be at a discount so that the IFI can make a profit. In turn, the IFI would probably sell the contract to another buyer for immediate cash and profit, in a parallel Salam arrangement. Salam contracts are prohibited for commodities such as gold, silver and other money-type assets.
Istisna contracts are often used for long-term, large construction projects of property and machinery. Here, the IFI funds the construction project for a client that is delivered on completion to the IFI’s client. The client pays an initial deposit, followed by instalments, to the IFI, the amount and frequency of which are determined at the start of the contract.
Sharia Boards (SBs) ensure that all products and services offered by IFIs are compliant with the principles of Sharia rules. They review and oversee all new product offerings made by the IFI and make judgments on an individual case-by-case basis, regarding their acceptability with Sharia rulings. Additionally, SBs often oversee Sharia compliant training programmes for an IFI’s employees and participate in the preparation and approval of the IFI’s annual reports.
SBs are normally made up of a mixture of Islamic scholars and finance experts to ensure that fair and reasonable judgments are made. Where necessary, the finance experts can explain the products to the Islamic scholars. The Islamic scholars often sit on several SBs of a number of different IFIs. SBs are in-turn supervised by the International Association of Islamic Bankers (IAIB).
SBs face several challenges when making judgments. Sharia law can be open to different interpretations, leading to different outcomes on the acceptability of the same products by different SBs and Islamic scholars. Furthermore, precedents set by SBs are not binding, and changes in SB’s personnel over time may shift the balance of the SB’s collective opinions and judgments on the acceptability of existing and new products.
SBs need considerable resources to operate effectively, especially where Sukuk finance is concerned. IFIs need to ensure that their SB members are well informed about the developments and trends in global financial markets.
BENEFITS, DRAWBACKS AND CHALLENGES
Corporations, individuals and IFIs engaged in raising and issuing funding based on Islamic finance virtues may be viewed as belonging in stakeholder-type partnerships that are engaged in deriving benefits from ethical, fair business activity. The result of these partnerships is one of mutual interest, trust and co-operation. The ethical stance and fair dealing of Islamic finance virtues means that partnerships, business activity and profit creation comes from benefiting the community as a whole.
Since the virtues of Islamic finance and enterprise prohibit speculation and short-term opportunism, it encourages all parties to take a longer term view of success from the partnership. It focuses all the parties’ attention on creating a successful outcome to the venture. This should result in a more stable financial environment. Indeed, literature in this area suggests that had banks and other financial institutions conducted their business activity based on Islamic finance principles, the negative impact of the banking and sovereign debt financial crises would have been much reduced.
IFIs or conventional financial institutions with products based on Islamic finance principles gain access to Muslim funds across the world and provide finance for organisations and individuals who need them. As the February 2013 article stated, it is estimated that Islamic financial assets have exceeded $1,600bn worldwide. As the world emerges from the global financial crisis and business activity increases, this should increase. Furthermore, access to Islamic finance is not restricted to Muslim communities only. The wider business community could have access to new sources of finance. This may be particularly attractive to corporations focused on ethical investments that Islamic finance virtues stipulate.
Drawbacks and challenges
Because of the prohibitions of riba and on speculation, IFIs may be slower to react to market demand and changes. They may lack sufficient flexibility in their product offering when compared to conventional financial institutions and may be less able to take advantage of short-term opportunities.
Moral hazard and principal-agent issues may be more pronounced between IFIs and organisations and individuals to whom they lend funds. This is because Islamic finance virtues stipulate close relationships from partnership-like arrangements. However, information asymmetry between the IFI and the borrower of funds will always exist. Therefore, costs related to increased level of due diligence and negotiating are probably higher for IFIs.
Costs related to developing new financial products may also be higher for IFIs because not only will the products have to comply with normal financial laws and regulations but also with Sharia rules. As stated above, the resources required by SBs can be considerable.
Added to this, because these financial products need to go through stages of compliance and layers of complications before they are approved, the approval process can take time. The pace of innovation of new Islamic financial products may be considerably slower than that of conventional products. This may make the IFI less able to compete with conventional financial institutions and may make it restrict its activities to smaller, niche markets.
Some Islamic financial products may not be compatible with international financial regulation – for example, a diminishing Musharaka contract may not be an acceptable mortgage instrument in law, although it could be constructed as such. The need to ensure that such products comply with regulations may increase legal and insurance costs.
The interpretation of Sharia rulings may allow certain Islamic finance products to be acceptable in some markets, but not in others. This has led to some Islamic scholars, who are experts in Sharia and finance, to criticise a number of product offerings. For example, some Murabaha contracts have been criticised because their repayments have been based on prevailing interest rates rather than on economic or profit conditions within which the asset will be used. Some Sukuk bonds have faced similar criticisms in that their repayments have been based on prevailing interest rates, they have been credit-rated and their redemption value is based on a nominal value rather than on a market value, and thereby, perhaps, making them too close to conventional bonds and their repayments too similar to riba. On the other hand, the opposite argument could be that in order to make Islamic financial products competitive in all markets, their valuations need to be comparable. Therefore, benchmarking them using conventional means is necessary.
So far the discussion on drawbacks and challenges has focused on IFIs, as providers of Islamic finance. It is also important to consider the drawbacks and challenges that corporations may face when using Islamic finance.
From the above discussion, the costs related to developing and gaining approval for Islamic financial products is likely to be passed down to customers and possibly make these products more expensive. In addition to this, access to new products and flexibility within existing products may be limited, due to the more complicated approval process that is necessary. These more expensive and less flexible sources of finance may make the corporation using them less competitive when compared to rivals who have access to cheaper, more flexible sources of finance.
The partnership nature of Islamic finance contracts may also cause agency type issues within corporations. These may be more prevalent in joint venture type situations or where the diverse range of stakeholders may make it more difficult for corporations to determine and act upon the importance of various stakeholder groups. For example, in the case of a Musharaka contract, where the IFI and the organisation are both involved in the management of a project, dealing with other stakeholder groups may be more challenging.
Before the financial crisis, trading in asset backed and securitised Sukuk products, issued by corporations, has been limited (a notable exception was Sukuk products denominated in Malaysian ringgits). Furthermore, since the financial crisis, issuance in new Sukuk products has reduced somewhat.
Using Islamic finance may also increase the cost of capital for a corporation. For example, it may be more difficult to demonstrate that repayments for Mudaraba, Musharaka and Sukuk contracts are like debt, and therefore they may not attract a tax-shield. However, an equivalent organisation which raises the same finance using conventional debt finance may be able to lower its cost of capital due to tax-shields and therefore increase the value of its investment.
The increasing global interest in and use of Islamic finance means that this is an important source of finance which organisations need to consider. Its many attributes that are common to ethical investment and finance would make it an attractive source of finance particularly to organisations that place importance on ethical issues. The innovations in Islamic financial products by IFIs, such as Sukuk and diminishing Musharaka, have meant new and innovative Islamic finance products are being developed and are coming into the market. This is likely to continue as the impact of the financial crisis recedes.
However, IFIs face a number of challenges such as agency-related issues, increased costs, lack of flexibility, difficulties with complying with Sharia rulings, and also normal regulations and law. The IFIs (and the wider Islamic finance regulatory bodies) need to put into place mechanisms and strategies that will help to overcome these challenges, and thereby ensure that Islamic finance-based products compete and compare with conventional riba-based financial products.
Written by a member of the P4 examining team