Islamic Finance - An Alternative Alternative
by
Jeremy Hetherington-Gore, February 2006
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to investors, but do not constitute investment advice
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information given in order to choose types or routes
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A concept virtually unheard of outside banking circles
a decade ago, the Islamic banking and finance industry
has undergone something of an explosion in recent years
as demand for an alternative to western banking products
structured along ethically-aware Islamic principles
has grown.
Broadly
speaking, under the guiding principle of Shariah law,
the goal of trade and enterprise within an Islamic-based
society is the sharing of wealth and prosperity within
the community through morally acceptable business activities.
Likewise, Shariah law dictates that risk in trade and
business should also be shared. This means that the
accumulation of wealth through the receipt of interest,
or riba, is prohibited, as interest income is deemed
effortless profit. It also means that investment in
certain business activities is forbidden on ethical
and moral grounds, such as those involving alcohol,
tobacco, pornography, armaments and gambling.
Whilst
trade along Islamic lines is as old as the religion
itself, modern Shariah banking didn’t really take
off until the 1960s with the launch of the Social Bank
in Egypt, a project later replicated in other areas.
In the intervening years, some countries, such as Pakistan
and Sudan, have made attempts to completely ‘Islamicise’
their financial systems, although the Islamic banking
and investment industry has been, until recently, confined
largely to the Middle East.
The
concept of a bank making a profit without charging interest
can be a difficult one to grasp for those of us brought
up in a western-style capitalistic environment. However,
numerous financial products and contracts have been
developed and are appearing on the market place all
the time, based on a number of structures which seek
to eliminate the need for interest, and share both profit
and risk.
Possibly
the most popular of these is the contract known as Murabaha.
Described as a cost-plus-financing contract, a Murabaha
contract can be used to finance a variety of purchases.
For example, in order to buy a house using this contract,
the prospective buyer agrees a sale price with the seller
and approaches a bank, which will buy the property and
sell it back to the customer at a higher price. The
house will be registered in the buyer’s name and
he will agree to pay back the amount in instalments.
This technique is also applied to the financing of other
purchases, such as cars or household appliances. Murabaha
contracts are also used to issue letters of credit and
to provide financing for trade.
A
similar method, known as Ijara, works in much the same
way, except that the bank will buy an asset and then
effectively lease it to the customer for an agreed period.
During the term of the lease, the buyer is required
to pay a form of rent, which is deemed by the bank to
be reflective of the risk that it is taking as part
of the transaction. This rent can be either fixed or
variable, depending on the specific contract terms offered
by the institution.
Another
popular method of financing under Islamic law is Musharaka,
which can be loosely translated to mean a partnership.
This is widely recognised as perhaps the purest form
of Islamic contract available within the modern banking
framework, because it has more of a basis in the profit
and risk sharing principle. Within a personal banking
context, a Musharaka arrangement may see the bank providing
the funds to enable the customer to buy an asset, with
the bank and customer agreeing a profit or equity sharing
ratio for that asset. Losses are shared on a similar
basis.
There
are also variations on the above themes, such as Ijara-wa-iktana.
This is similar to Ijara, the difference being that
included in the contract is a promise from the customer
to buy the asset or goods at the end of the lease period
at a pre-determined price. Rentals paid during the period
of the lease constitute part of the purchase price,
and often under these arrangements the final sale will
be for a token sum.
Ljara
with diminishing Musharaka means that an institution’s
equity in an asset may be reduced as the buyer makes
capital payments over and above the agreed rental payments
or lease payments. This means that the bank’s
ownership decreases and the customer’s equity
increases over time, until ownership is eventually transferred
entirely to the buyer.
Another
important tool within the Islamic finance framework
is the Mudharabah contract, which is used in the financing
of new business ventures. In short, under this arrangement,
one party known as the rabal-maal provides the funding,
while the other party - the entrepreneur or mudarib
- provides the effort and labour. Profit is shared at
an agreed ratio at the start of the contract; however,
in the event that the venture fails, any losses are
borne completely by the owner of the capital, whilst
the entrepreneur derives nothing for their efforts.
Instruments
have also been developed to serve part of the investment
industry that were previously off limits to the Islamic
investor, such as the international bond markets, in
which sukuks are fast becoming a visible feature. These
certificates bear a resemblance to conventional bonds,
but unlike their western counterparts, they are backed
by an asset, such as pools of ijara contracts. The asset
will be leased to the client to yield the return on
the sukuk, and backing by real assets ensures that a
sukuk is also tradable in a Shariah-compliant secondary
market.
Location
And Size Of The Islamic Finance Sector In 2006
According
to some estimates, the global Islamic banking industry
is now worth more than $500 billion in terms of assets,
having doubled in the last two to three years. Although
this figure remains just a fraction of global assets,
given a world Muslim population of around 1.5 billion
people, the industry has enormous potential, and this
is a fact that is starting to be recognised in boardrooms
of some of the world’s largest western-based banking
groups, some of which have recently launched banking
facilities compliant with Shariah law.
The
UK's RICS (the Royal Institution of Chartered Surveyors)
published a report in July 2005, saying that London
has become a major centre for Islamic banking and investment.
Based
on research commissioned by international property consultants,
King Sturge, the report stated that London is securing
its position as a major centre for Islamic banking and
investment due to the availability of relevant expertise
and a flexible, well developed regulatory environment.
The
report revealed that 90% of investors cited the UK as
their favoured location for Shari'ah funds because of
its political environment, legal and institutional frameworks,
human capital and expertise. London’s wide range of
skills in particular puts its commercial property industry
in the strongest position to take advantage of the growth
in Shari'ah compliant real estate investment.
Like
“ethical funds”, Islamic investment funds require careful
portfolio and stock selection to ensure compliance with
Shariah law. Shariah property investment funds also
prohibit renting properties to organisations engaging
in business relating to pornography, gambling, arms,
pork, tobacco, cinema and alcohol consumption, as previously
mentioned.
The
commercial and industrial property sectors are reported
as the most popular investment by Shariah funds, with
three quarters of respondents already investing in industrial
property. A growing trend is the market’s move into
property investments in leisure and care for the elderly,
which are compatible with Shariah principles and somewhat
reflective of developments in other ethical funds.
According
to Angus McIntosh, Partner & Head of Research at King
Sturge:
"UK
business is now familiar with ethical funds but there
is a real need to find out more about the growing opportunities
for Shari'ah compliant real estate investment and the
nature of the market as this area represents a crucial
opportunity for many UK businesses."
The
most important factor considered by Shari'ah compliant
funds when buying and selling property was tax status
(cited by 65% of respondents in the King Sturge research),
followed by the availability of specialist expertise
(61%), the regulation of investment and risk assessment
regulation (both 47%) and the transparency of transactions
(41%).
According
to Ali Parsa, author of the report, and director of
research at London South Bank University’s Property
Surveying and Construction department:
"The
research indicates the likelihood of a substantial increase
in the funds available for Shari'ah investment as a
result of growing wealth in Muslim countries and communities,
and that most of the new investments will be through
some form of Shari'ah compliant funds."
UK-based
HSBC has launched a number of Shariah-compliant products
through its Amanah Finance division. The bank is also
seeking to establish a firm foothold in the US market,
offering Islamic banking services in the New York area.
Other institutions, such as the UK’s Lloyds TSB
and the US-based bank Citigroup, have also stepped into
the market.
However,
new ground was broken in 2004 with the launch of the
Islamic Bank of Britain, the first in the UK to concentrate
solely on offering Shariah-compliant banking services
to the country’s 1.7 million Muslims (although
it must be pointed out that one doesn’t necessarily
have to be of the Muslim faith to take up Islamic banking
services). Its product offerings include mortgages,
current accounts, savings accounts and personal finance.
The bank is also planning to launch its own credit card.
Offshore
jurisdictions have played a major role in the development
of Islamic finance markets, particularly Labuan and
Dubai.
Kuwait
Finance House, a leading Islamic banking group in 2005
announced its intention to break into the South East
Asian market the following year through a new base in
Labuan, .
Jamelah
Jamaluddin, deputy chief executive of Kuwait Finance
House in Malaysia, said that the group saw potentially
lucrative investment opportunities in real estate, infrastructure
assets and power plants within the region.
"We
want to position Malaysia as a regional hub for KFH
in this part of the world which includes Thailand, Singapore,
the Philippines, to a certain extent China and India,
and maybe Australia and New Zealand," Jamelah stated,
adding that KFH is also attempting to make inroads into
the Indonesian market.
Kuwait
Finance House was incorporated in the State of Kuwait
in 1977, and is listed on the Kuwait Stock Exchange.
The Government of Kuwait owns 49% of the equity, and
the general public holds the remaining shares.
AMBB
Capital (L) Ltd, a wholly owned subsidiary of AmBank
(M) Berhad, Malaysia's sixth largest bank with total
assets of $13.7 billion, said in July, 2005, that it
would list $200 million in Hybrid Securities on the
Labaun International Financial Exchange (LFX).
The
bank announced that it had completed the book building
process in relation to the issue of the 'Fixed-to-floating
Rate Step-up Non-cumulative Non-voting Guaranteed Preference
Shares,' or Hybrid Shares, with AmMerchant Bank Berhad,
BNP Paribas and Credit Suisse having been appointed
by AmBank as the joint lead managers and joint bookrunners.
The Hybrid
Securities are guaranteed on a subordinated basis by
AmBank and will be listed on the LFX and the Singapore
Exchange. They are open to international institutional
investors.
The
initial book size was set at $150.0 million, but was
twice oversubscribed, leading to its increase to $200
million.
"The
Hybrid Securities issued by AMBB Capital has garnered
strong demand from international investors and the attractive
pricing for the Hybrid Securities demonstrates international
investors' confidence in AmBank's Business model," commented
Mr Cheah Tek Kuang, Chief Executive Officer of AmBank.
The LFX is
an offshore exchange wholly owned by the Kuala Lumpur
Stock Exchange (KLSE). It was officially launched in
November 2000 and it is seen as one of the key components
in promoting Labuan as an offshore financial centre.
In
August 2005, the total market capitalisation of Labuan
International Financial Exchange (LFX) had reached $12.09
billion, and the exchange accepted its 34th listing
with the debut of Eucalyptus Investment Holdings Limited's
$30 million variable rate guaranteed secured bonds.
AmBank,
with total assets of RM51.6 billion ($13.7 billion)
as at 30 September 2005, is the sixth-largest Malaysian
bank by assets with over 170 branches nationwide.
Emirates
Islamic Bank said in July, 2005, that it had launched
a new real estate investment fund which will investment
in property along the principles of Shariah law.
The
fund, which is registered in Jersey and managed by Belgravia
Asset Management, invests mainly in property based in
the United Arab Emirates.
The fund
is open to both institutional and individual investors
with a minimum investment of US$100,000. Minimum top-up
investments are set at US$25,000. In addition to capital
growth, the fund will target an income distribution
of 7% per year, which will be paid on a bi-annual basis.
“The UEA
has been one of the market leaders for property development
and innovation in the region," commented Mr Ebrahim
Fayez Al Shamasi, CEO of Emirites Islamic Bank.
"The success
of residential and commercial developments over the
last three years has proved the increasing popularity
of this asset class amongst investors in the Middle
East," he added.
A
substantial market is developing in both sovereign and
corporate sukuks and some US$30 billion worth of certificates
have been issued to date. Although the market is still
in its infancy, on the sovereign front, sukuks are beginning
to attract the attention of non-Muslim issuers and investors.
International
law firm, Walkers announced in January, 2006, that it
had opened the first fully transactional office for
an offshore law firm in the Dubai International Finance
Centre (DIFC).
The office is staffed jointly with a combination of
regional lawyers and leading attorneys from London who
specialize in Islamic finance and Middle Eastern issues.
"Walkers
recognizes that having counsel in Dubai doing the transactional
work in the same time zone and same culture is vitally
important to getting the job done. Walkers’ expertise
in investment funds, structured finance, and international
insolvency matters coupled with a presence in the Cayman
Islands, London, the British Virgin Islands, Hong Kong
and now Dubai, means that the firm can offer worldwide
clients an even broader range of products and services,"
the firm stated.
According
to a recent survey by McKinsey & Company, more than
75% of the top 30 global asset managers are now active
in Dubai. The MAN Group plc, a leading hedge fund group
that has operated in the Gulf Cooperation Council region
(GCC) for more than 20 years and was part of the McKinsey
survey, reported an upswing of institutional investments
in hedge funds.
The Dubai
International Finance Centre (DIFC), a financial free
zone that promotes economic development in the United
Arab Emirates (UAE), has a strong regulatory framework
based on best practices of the world’s leading financial
centres.
Companies
in Dubai recognize multiple benefits from the jurisdiction,
including zero tax on income and profits, 100%foreign
ownership, no restrictions on foreign exchange or capital/profit
repatriation, operational support, and business continuity
facilities.
Islamic
Insurance
The
world of insurance, which by its very nature runs counter
to Shari'ah principles because its profits are derived
through effectively gambling on uncertain outcomes,
was an area that until recently Islamic investors either
had to tolerate or abstain from altogether. However,
this problem has been overcome with the development
of the takaful insurance industry. Using the Islamic
principle of Ta'awun, or mutual responsibility, the
takaful industry rests on the same foundations of profit
and risk sharing as other areas of Islamic finance.
On a basic level, it provides mutual protection of assets
and property in the event of loss or damage based upon
joint risk sharing.
Takaful
Re Limited, an Islamic insurance company, was licensed
by Dubai Financial Services Authority (DFSA) in January,
2006, to operate from the Dubai International Financial
Centre (DIFC).
Takaful
Re is dedicated to offer Shari’ah compliant reinsurance
and related services to the growing Takaful & Islamic
insurance markets. Takaful Re offers reinsurance capacity
in all major lines of property, marine and family Retakaful
business.
With an authorised
capital of US$500 million and paid-up capital of US$125
million, Takaful Re has plans to focus on retakaful
business in the Middle East, North Africa and other
Islamic countries.
“This is
a significant announcement for DIFC, especially when
we already have some major international insurance companies
located here," commented Dr. Omar Bin Sulaiman, Director
General of the DIFC Authority.
”The DIFC
is committed to actively promoting the growth and development
of the Islamic insurance industry in accordance with
Shari'ah principles. The Takaful market is one of the
fastest growing in the world. It is expected to grow
at nearly 20 per cent per annum to reach US$7.4 billion
in global annual premiums in 15 years. Firms domiciled
in the DIFC will complement the regional market and
help it grow. By providing the ideal environment, both
in terms of regulations and infrastructure, the DIFC
aims to maximise this potential," Dr. Omar Bin Sulaiman
added.
Meanwhile,
Mr. Khalid Ali Al Bustani, Takaful Re Chairman, commented
that: “We are pleased to associate ourselves with the
DIFC which is renowned internationally. For Takaful
Re, to be in the DIFC is a commitment for integrity,
transparency and efficiency."
Islamic
Hedge Funds
2004
saw Islamic finance take its first foray into the hedge
fund arena after regulators, lawyers and Islamic scholars
gave the go ahead to the first ever Shari'ah-compliant
hedge fund.
However,
this is still new territory for Islamic finance, and
significant barriers and obstacles remain for Shari'ah
hedge funds, in terms of compliance, liquidity and regulation,
as evidenced by the two years and several million dollars
that it took to get the first Islamic hedge fund off
the ground.
Regulation
Of Islamic Finance
Regulation
and interpretation of Shari'ah law are two key issues
in the Islamic finance industry. Before an institution
can offer such products to the public, they must first
be scrutinised and approved by a panel of Islamic scholars.
However, this is by no means a clear cut issue, and
the opinions of individual scholars can vary. Indeed,
there are many academics in the Muslim world who have
been quite critical of contemporary Islamic finance
culture, and who have taken issue with certain forms
of financing, notably Murabha and Ijara contracts which,
it has been argued, are too similar to conventional
forms of financing, and which do nothing to share risk
and profit, the central tenet of Islamic capitalism.
To
ensure a degree of quality control over the Islamic
finance industry, regulating institutions, such as the
Malaysian-based Islamic Financial Services Board (IFSB),
have been set up to police the emerging industry. The
IFSB serves as an international standard setting body
of regulatory and supervisory agencies and its core
mission is to guard the integrity and stability of the
Islamic financial services industry across the spectrum
of banking, capital markets and insurance. The board
also provides guidance for institutions offering Islamic
investment products and liaises with other rule-making
bodies in the industry.
Whilst
modern Islamic finance may not be as pure as some scholars
and academics would like, the development of financial
products to cover the whole gamut of the finance and
investment industry, and the creation of the regulating
institutions to oversee them, is evidence that the industry
in its current form is likely to be here to stay.
And
the fact that the new industry has really only scratched
the surface of potential demand for Shariah compliant
and more ethically aware capitalism means that the Islamic
banking and finance is likely to continue growing apace
for some years to come.
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