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by the InvestorsOffshore Editorial Team, August 2012
31 August, 2012
Although the Islamic finance sector suffered along with other investment sectors during the credit crunch, its long-term future seems assured.
Islamic finance has shown resilience during the past two years at a time when global recovery has slowed and conventional banking in Western countries has remained under pressure, although it is not unaffected by broader global macroeconomic problems, with some Islamic banks exposed to the volatile real estate markets. In the Middle East, especially the Gulf, Islamic finance has benefitted from economic and financial stability in most countries, despite political unrest in a few.
A new report from TheCityUK’s UK Islamic Finance Secretariat (UKIFS) indicates that Islamic finance assets worldwide continued a long run of growth to reach an estimated USD1.3 trillion in 2011, 150% up over the previous five years.
Despite political unrest in some countries the industry has continued to expand, not only in its core markets of the Middle East but also in South East Asia and offshore jurisdictions such as Bermuda.
Islamic funds, for example, reached a new high of USD58bn in 2010, with the available pool about ten times larger at over USD500bn. Even so, competition is fierce, with average management fees worldwide down from 1.5% in 2006 to 1.0% in 2011.
UKIFS, like many economic commentators and analysts, says that considerable potential exists for expansion of the industry worldwide, although appropriate legal and regulatory structures are crucial for its development in individual countries. The Banker estimates that only 12% of Muslims worldwide use Islamic financial products. The extent of the industry’s penetration also varies substantially. In Bangladesh, for example, Islamic banking accounts for 65% of total banking assets but only 4% to 5% in Turkey, Egypt and Indonesia.
More countries are looking to expand the availability of Islamic financial services, with The Banker reporting new Islamic financial institutions in Australia, Azerbaijan, Nigeria, Oman, Pakistan, Qatar and Russia. However, UKIFS notes that while leading countries for Islamic finance should provide fertile ground for future growth, the long-term impact of political unrest on the development of Islamic finance in some Middle Eastern countries, such as Egypt, remains to be seen.
However, Zainal Izlan Zainal Abidin, Executive Director, Islamic capital market, of the Securities Commission Malaysia (SC), believes that the Islamic finance industry is at a crucial stage where it needs to redefine and establish the enabling environment that will spur its next phase of growth.
"The next phase of growth of the Islamic capital market will be characterised by greater internationalisation which entails, among others, a growing number of product issuers and service providers expanding beyond their home market, more investors seeking products or instruments with international exposure, as well as greater diversity in terms of currencies used in issuing Shariah-compliant instruments," Izlan said in June 2012 in his welcome remarks at the four-day Islamic Markets Programme, a flagship programme by the training and education arm of the SC, the Securities Industries Development Corporation.
What Is Islamic Finance?
It's almost no longer necessary to ask that question, but for the record, 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.
Ijara 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 Of The Islamic Finance Sector
The largest centres for Islamic Finance remain concentrated in Malaysia and the Middle East, including Iran, Saudi Arabia, the UAE, Kuwait, Bahrain and Qatar. Other key locations for this rapidly developing sector are Dubai and Labuan, because they are sophisticated low-tax centres in Islamic regions with concentrations of wealthy investors, while London and the Cayman Islands, as existing banking and investment fund centres, are home to the highly skilled legal and financial professional communities needed to bring Islamic products to market.
Assets that can be allocated to individual countries from The Banker’s survey of 500 organisations reveal that the leading countries for Sharia compliant assets are Iran with USD388bn, Saudi Arabia USD151bn and Malaysia USD133bn. These are followed by other Gulf states including UAE, Kuwait, Bahrain and Qatar, and then Turkey.
Countries with most of the 345 firms reporting to The Banker’s survey include Kuwait and Malaysia, each with 39 firms, and Bahrain with 33 firms. A group of countries including Indonesia, Iran, Saudi Arabia, Pakistan, UAE and the UK each have between 20 and 27 firms supplying Islamic finance.
The industry is growing in a number of other Asian countries such as Indonesia, which has the largest indigenous Muslim population in the world, as well as Hong Kong, Singapore, Bangladesh, Pakistan, China and India.
London's Growing Role
With assets under management of USD19bn, it is worth noting that the UK continues to maintain its position as the leading Western provider of Islamic finance and is in ninth place overall in The Banker's survey - well ahead of predominately Muslim countries like Bangladesh, Indonesia, Pakistan, Egypt and Brunei.
In the UK, banks, sukuk issuance and exchange traded products are buttressed by the strong infrastructure of professional support for Islamic finance deals and transactions. This includes over 25 major law firms and the largest four professional services’ firms, and this has yet to be seriously rivalled by any other European financial centre.
The UK is also making an increasing contribution to the development of Islamic finance education and skills with four professional institutions and 10 universities and business schools offering qualifications. These include the Chartered Institute of Management Accountants, Cass Business School, the University of East London and Durham University. With sharia compliant finance utilised for the redevelopment of Chelsea Barracks and the construction of the Shard of Glass in London, Islamic finance also has a crucial role to play in infrastructure development in the UK.
Keith Phillips, Executive Director, UKIFS observes: “The UK also benefited from a globally buoyant sukuk market in 2011, with issuance up 60% to USD84bn. This was reflected in ten new sukuk listings on the London Stock Exchange’s markets in 2011 and two in early 2012. There are now 37 sukuk with a combined value of USD20bn listed on the London Stock Exchange’s markets. Additionally, seven exchange traded funds and two exchange traded products are also listed on these markets.”
The growth of the Islamic finance industry in the UK was given a helping hand back in 2007 by then Chancellor Gordon Brown, who introduced a new regime for sukuk (Islamic securitisations) giving comparable tax treatment to conventional securitisations, and guidance clarifying the treatment of diminishing musharaka (partnership share) and takaful (insurance) products.
Commenting on the move, Darshan Bijur, Director, KPMG Islamic Finance Advisory, observes that this new legislation created the framework for London to emerge as undisputed global leader in the Islamic finance industry.
“Sukuk will be the equivalent of Eurobonds, and the likely exponential growth in UK Sukuk issuance will ensure that Islamic finance moves from niche to the mainstream," he said. “It will cost the UK next to nothing, and opens up the way for UK companies to access Islamic finance, and the Middle East wealth that has been generated by oil."
Then in January, 2010, the UK Treasury introduced measures in Parliament to support Islamic finance and the issuance of corporate sukuk. The new measure provides clarity on the regulatory treatment of corporate sukuk, reducing the legal costs for these types of investments and removing unnecessary obstacles to their issuance. Then Exchequer Secretary to the Treasury Sarah McCarthy-Fry said: “The government’s objectives on Islamic finance are to enhance the UK’s competitiveness in financial services by maintaining the UK’s position as a Western leader for international Islamic finance; and to ensure that everybody, irrespective of their religious beliefs, has access to competitively priced financial products. This measure is another important step in the development of the Islamic finance sector in the UK and will help to provide a level playing field for Islamic financial products in this country. It is good news for the UK economy and for our Islamic finance industry.”
HSBC is the leading UK-based bank offering Shariah-compliant services, through its Amanah Finance division, launched in 1998. The bank is also seeking to establish a firm foothold in the US market, offering Islamic banking services through 300 branches in the New York area.
In February 2012, HSBC Amanah was named Best International Islamic Bank by Euromoney in its Islamic Finance Awards 2012 for the third consecutive year. The annual awards are widely considered to be the most high profile accolades in the Islamic finance industry and recognise outstanding performance, quality, service, and innovation in the sector.
HSBC Amanah also recently launched HSBC Amanah Premier - the world's first Islamic banking service aimed at internationally mobile, affluent consumers. HSBC Amanah Premier is available in UAE, Saudi Arabia (through SABB Amanah as SABB Amanah Premier), Qatar, Bahrain, Malaysia and Indonesia.
HSBC Amanah Premier customers and their families in these countries receive international recognition and emergency support across 40 markets where HSBC operates, taking their credit history and banking relationships with them. They have access to banking and wealth management products, complying with the strictest standards of Shariah compliance, in their home market.
The launch of HSBC Amanah Premier is a direct response to the growing number of affluent consumers who have a preference for Shariah-compliant banking - currently estimated to be three million people globally.
HSBC Amanah Premier enables a customer from UAE or Malaysia who is visiting Hong Kong, to be recognised as an Amanah Premier customer and given priority assistance. This includes a connection to the customers' home country Relationship Manager or phone banking service and world wide emergency assistance for customers and their families, including emergency cash, next day credit card replacement and expert local advice.
Mukhtar Hussain, Global CEO, HSBC Amanah, said: "HSBC Premier has struck a chord with customers around the world - over three million have discovered the benefits in just three years. Amanah Premier is the next logical step for HSBC: it brings a Shariah-compliant service to a proven demand from affluent customers."
"Though many consumers with a preference for Islamic banking live in Muslim markets like UAE, Malaysia or Saudi Arabia, where HSBC Amanah has significant operations, these individuals are increasingly internationally mobile and demand a banking service that can support this lifestyle. We believe HSBC Amanah Premier is that service."
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.
According to the 2012 edition of the Ernst & Young World Takaful Report, the Takaful industry continued to show double digit growth in 2011 albeit at a relatively slower rate of 19% as compared with previous years. According to the report, Malaysia and the UAE again achieved growth rates of over 24%, whilst Saudi Arabia saw its gross contributions increase by USD0.5bn. The report also noted that the Takaful industry has now obtained significant market share versus conventional insurance in most GCC countries as well as South East Asian markets. Though there are a number of drivers behind this growth, the one that is becoming increasingly important is regulatory support through appropriate amendments in legislature to provide a level playing field with conventional insurance companies.
Addressing the 7th Annual World Takaful Conference in Dubai on April 7, 2012, Hussein Al Meeza, Managing Director and Chief Executive Officer, Dubai Islamic Insurance and Reinsurance Company (AMAN) said that “with the Takaful segment expected to continue growing by leaps and bounds, the future of the industry looks very bright and promising. In order to ensure that the industry maintains its growth levels, it is essential to raise the level of awareness on the significant benefits of using Takaful products and services. It is also vital that collective efforts should be made to strengthen underwriting capabilities. In addition to this the industry players should also tap into newer markets and industry verticals and should also act upon the downward price pressure that is brought about by increased market competition.”
He also said that “in order to drive Takaful towards achieving its full potential, industry players should also make considerable investment into research and development as the strength of the industry lies in its ability to identify and capitalize on what makes this market segment grow. Having a better grasp of their demands and requirements will lead us in developing solutions that can be very advantageous for them.”
Speaking to the media present at the event, David McLean, Chief Executive of the World Takaful Conference said that: “Takaful operators are yet to fully achieve critical business volumes despite having incurred substantial establishment costs. Increasing competition from not only new Takaful players but also well established global conventional insurers entering the Takaful market space, is putting immense pressure on the profitability of many existing players. However, with the Takaful industry being currently concentrated only in limited markets, segments and business lines, there is huge potential that is yet to be realized.”
Islamic Investment Funds
According to the 5th annual Ernst and Young Islamic Funds and Investments Report (IFIR) released at the World Islamic Funds and Capital Markets Conference in September 2011, global Islamic fund assets under management (AuM) grew by 7.6% to USD58bn in 2010, up from USD53.9bn in 2009.
The growth was largely due to market performance and partially on account of new money inflows, says E&Y. Concentration in equities remains, as it accounts for 39% of the USD58b assets under management, but bringing new money into equities is challenging, the report noted.
However, fixed income, commodities and alternatives did well in 2010, which was a record year for Sukuk with issuance of USD50bn.
As the industry continues to realign itself, 23 new Islamic funds were launched in 2010 while 46 were liquidated. The Islamic funds universe comprises of some 100 fund managers and 800 Islamic funds but represents only 5.6% of the USD1 trillion Islamic financial services industry. In the Gulf Cooperation Council area, liquid wealth of Shariah sensitive investors is expected to add more than USD70bn to Islamic funds by 2013.
According to Ashar Nazim, MENA Head of Ernst & Young’s Islamic Finance Services: “Growth in 2010 is welcome given the industry’s flat performance since 2007. Looking ahead, the challenging times are by no means over. There are serious concerns about the increasing likelihood of sovereign debt crisis in Europe and a double dip recession in the US. Both these factors will continue to influence conventional and Islamic asset managers through 2012.”
As part of its trend-spotting in cooperation with leading Islamic fund managers, the IFIR 2011 predicted three top priorities for the industry. The first lies in origination and structuring. Fund managers are faced with limited availability of quality Shariah compliant assets and fewer products to invest in. Improving levels of investor and industry trust in their brand and track record will favor established and larger players in origination.
The second priority is to continue to attract institutional and affluent client fund flows. Over dependence on a few institutional funds that made up two-thirds of the total new funds launched in 2010 is a key structural weakness in Islamic markets in all regions except Malaysia. Institutional funds make up 67% of global Islamic funds’ AuM while retail funds make up 33%. Access to affluent investors and institutional clients is central to future growth. Fund distribution models will place more emphasis on alliances to attract institutional and affluent funds over the next few years, the report observes.
The third priority for the industry is to increase operational efficiency. The 30% fee compression over recent years will force a re-look at the revenue and cost strategy, operating model and most importantly, the risk infrastructure for sustainable growth.
“Achieving scale is even more critical to ensure long term sustainability. Over 70% of funds fall below estimated break-even AuM level of USD100 million, while the top 10 have 80% market share. The big will get bigger as the going gets tougher to win investors’ trust. The growth performance will be difficult to repeat this year as the Islamic funds industry had benefited from performing markets in 2010, which may be hindered going forward by global economic uncertainty risks,” adds Ashar.
“Even though stock prices in the MENA region are near 2004 levels today, investors are not confident about their rise even in 2012. They remember that equity markets were flat for years before the spike began in 2005. The global economic scenario, investors’ risk aversion and the aftermath of the Arab Spring are the top three risks for Islamic fund managers. The economic situation in Europe and the US is the single biggest concern for future market performance as no region or market will be immune to a double dip recession,” concludes Ashar.
Islamic Hedge Funds And Derivatives
The first Islamic hedge fund was given the green light by regulators, lawyers and Islamic Scholars back in September 2004 and many observers expected this to be the first of many shariah hedge funds. The much anticipated growth has, however, failed to materialise, largely because Islamic investors consider that hedging does not comply with Shariah principles.
Islamic law forbids many transactions utilized by hedge funds such as short selling, and the use of options and futures and forward contracts. This is because the strict code does not allow the selling of goods that one does not own, or the making of ‘selling promises’ and rights without obligation which create uncertainty. This has made 'alternative investment' pretty much off limits to those seeking to invest in accordance with Shariah law.
As Sarasin Alpen, the Dubai subsidiary of the Swiss private bank Sarasin & Co, observed in its 2012 Islamic Wealth Management Report: "Islamic hedge funds which follow a long-short strategy are often discussed but not widespread among Muslim investors. Over many years speeches have been made and articles published but the Muslim investor continues to disdain hedge funds, whether structured in an Islamic way or not, despite approval by many scholars. Alternative investments as an Islamic asset class, with liquidity, remain a rare offering."
Nevertheless, there have been some breakthroughs in the world of Shariah hedge funds. In June, 2008, for example, Barclays Capital, the investment banking division of Barclays Bank plc, and the Dubai Multi Commodities Centre Authority (DMCC), an agency of the Dubai government, announced the first Shariah compliant hedge funds to be launched on the Al Safi Trust alternative investment platform.
DMCC committed to seed five commodity hedge fund managers on Al Safi with USD50 million each, a total of USD250 million, for a Shariah compliant fund of funds product to be offered under the Dubai Shariah Asset Management (DSAM) brand.
The commodity strategies and hedge fund managers approved by DMCC are Tocqueville Asset Management Gold, Lucas Capital Management LLC Energy/Oil & Gas, Zweig-DiMenna Intl. Managers Natural Resources, Ospraie Management Agriculture and BlackRock, Inc. Global Resources and Mining.
Al Safi is a comprehensive Shariah compliant platform comprised initially of single strategy alternative investment managers with Shariah Capital as the Shariah advisor and Barclays Capital as the prime broker and structured product distributor.
Al Safi is described as a “plug and play” solution offering an established process of due diligence which accepts only those hedge fund strategies and managers that meet the exacting criteria of its Shariah Supervisory Board. It claims to offer Islamic investors the same high-quality managers and strategies available to conventional investors including comparable returns, competitive fee levels, diversification across asset classes and access to customised structured products which can provide full capital protection, all within a pre-established Cayman trust framework.
Al Safi has been created in response to market demand for Shariah compliant alternative investments and the considerable impediments fund managers have faced meeting that demand.
Eric Meyer, Chairman and CEO of Shariah Capital said: “With the capital support of a sovereign government and the prime broker and structuring expertise of Barclays Capital, the Al Safi Trust platform is a historic development that unites modern investment strategies with Shariah. The initial commodity hedge fund managers who will be available through Dubai Shariah Asset Management are truly world-class. They represent the best and most successful commodity strategists in the world, and they have agreed to accommodate Shariah within the strict guidelines established by our Shariah Supervisory Board."
January, 2010, witnessed another first in Islamic finance with the launch of the 'Tahawwut' (Hedging) Master Agreement, following an agreement between the Bahrain-based International Islamic Financial Market (IIFM) and the International Swaps and Derivatives Association, Inc. (ISDA). This marked the introduction of the first globally standardized documentation for privately negotiated Islamic hedging products.
“Given the growing nature of the Islamic finance industry, the institutions operating on Shari’ah principles can no longer afford to leave their positions un-hedged,” said Khalid Hamad, Chairman of IIFM and Executive Director of Banking Supervision at Central Bank of Bahrain. “Hence, some key hedging products are now becoming common across jurisdictions to mitigate risk. The ISDA/IIFM Tahawwut Master Agreement gives the industry access to a truly global framework document which is neutral in terms of treatment to both the transacting parties and at the same time strictly conforms to Shari’ah principles."
The Agreement provides a framework and mechanism on hedging or risk management transactions that can be undertaken by the Islamic finance industry. It has been developed by the IIFM jointly with the International Swaps and Derivatives Association (ISDA).
Farhan Al Bastaki, Executive Director of Islamic Finance at the DIFC Authority, stated that: "While the world has been searching for an alternative to the conventional banking system deeply impacted by the global financial crisis, few have realised that a more stable, asset-backed and efficient system already exists. Islamic Finance has withstood the negative impact of the global financial crisis, proving its resilience, effectiveness and relevance to the global financial industry.”
He continued: "The system is there, but its wider acceptability has to be created by spreading awareness as well as by providing depth to the market. The IIFM has been making significant efforts to provide depth to the Islamic finance industry such as through its latest framework for risk management."
Although the structure of the master agreement is similar to the conventional ISDA master agreement, the key mechanisms and provisioning such as early termination events, closeout and netting are developed based on the Islamic shari’ah principles.
“Given the growing nature of the Islamic finance industry, the institutions operating on shari’ah principles can no longer afford to leave their positions un-hedged,” said Khalid Hamad, Chairman of IIFM and Executive Director of Banking Supervision at Central Bank of Bahrain. “Hence, some key hedging products are now becoming common across jurisdictions to mitigate risk. The ISDA/IIFM tahawwut master agreement gives the industry access to a truly global framework document which is neutral in terms of treatment to both the transacting parties and at the same time strictly conforms to shari’ah principles.”
“Standardization is a key element in the progress of Islamic finance though it is not a simple process as evident from the efforts put in to the development of this master agreement,” continued Ijlal Ahmed Alvi, Chief Executive Officer, IIFM. “A record number of drafts - 24 drafts – were developed during the industry consultation and shari’ah guidance process before ultimately reaching the final version, which is comprehensive as well as practical in terms of usage with no compromise to shari’ah principles."
“Demand for customized, privately negotiated hedging tools that conform to the principles of Islamic finance has increased in momentum,” added Eraj Shirvani, Chairman of ISDA and Managing Director, Head of Fixed Income for the EMEA Region, Credit Suisse. “The tahawwut master agreement provides the critical framework for the growth and evolution of shari’ah-compliant hedging instruments.” In addition to developing documentation for Islamic transactions, ISDA in coordination with IIFM is in contact with various regulators in a number of Islamic jurisdictions, such as the Gulf Cooperation Council region, namely UAE, Bahrain and Qatar, plus Pakistan to improve the local legal framework for hedging products and close-out netting provisioning.
While many Islamic hedge funds do exist, they are still small in numbers compared with conventional hedge funds and are still widely perceived as being against the spirit of Sharia law. As a result, demand for hedge funds is "negligible", according to Sarasin Alpen.
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.
Bankers and other finance professionals are concerned that the validity of many Islamic finance transactions is open to interpretation, and financial institutions look to guidelines set by Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) for guidance. Nonetheless, there is no definitive and binding set of rules saying that banks must stick to these rulings.
One Middle Eastern banker told Reuters recently that there was "real concern" among the conventional banks over the absence of an authoritative centralized body to frame rules. "Islamic finance was originally about establishing an Islamic economy but we don't even have synergy between banks in Malaysia and the GCC (Gulf Cooperation Council)," he told the news agency.
There are however, tentative plans by a recently-founded body of Islamic scholars to develop a global code of ethics for the Islamic finance industry. The Association of Shariah Adivsers in Islamic Finance was established in Malaysia in April 2011, and its president told Reuters in August 2012 that it was planning to launch an financial literacy test for Islamic scholars, and ask members to sign up to a code of ethics. While the test and code will initially apply only in Malaysia, the ASAS believes that these standards could be applied worldwide.
Taxation Of Islamic Finance
In addition to regulation, taxation is seen as a barrier to growth in Islamic investment, largely because many of the concepts involved are not recognised under the tax codes of many countries. Things are changing on this front however, and a number of countries have proposed or enacted amendments to their tax laws designed to facilitate Islamic investment, such as the aforementioned changes in the UK.
In June 2012 for example, in his opening address to the Second World Islamic Banking Conference Asia Summit, the Deputy Chairman of the Monetary Authority of Singapore (MAS), and Minister for Trade and Industry, Lim Hng Kiang, said that Singapore’s Ministry of Finance would issue new income tax regulations for Islamic finance.
Lim disclosed that “to provide greater tax clarity and certainty to the industry”, he was able to announce that Singapore will provide additional clarification and detailed explanation of the income tax treatment of further defined Islamic financing arrangements, including financing through a partnership arrangement, project finance and the interbank placement of funds.
“This is in keeping,” he added, “with our long-standing principle that Shariah-compliant products should not be disadvantaged in terms of regulatory and tax treatment where the economic substance and risks are similar to conventional products. We hope that this will expedite the development of more such financial products in Singapore.”
In 2010, the South Korean government announced that a tax exemption would be offered for revenues from Islamic bonds. As interest is not allowed by Shariah law, earnings on Islamic bonds are taken as profit, which is subject to being taxed in South Korea. The tax so paid is said to be the equivalent of interest of between 1.3% and 3.4%. The government has therefore introduced a bill to offer the same tax incentives as are given to normal bonds - income and corporate tax exemptions for interest received on bonds denominated in foreign currencies.
The South African government’s 2011 Budget provisions proposed the enactment of a tax framework to allow the government to issue Islamic bonds. Amendments to the country’s tax code will essentially allow for asset-based financing with the yield giving rise to tax that is equivalent to interest. Such bonds will serve as the standard for risk-free Islamic financing within South Africa.
Hong Kong is also keen to tap into the Islamic finance industry, and in March 2012, the Financial Services and the Treasury Bureau launched a two-month consultation on proposed amendments to the Inland Revenue Ordinance and Stamp Duty Ordinance to promote the development of an Islamic bond, or sukuk, market in Hong Kong.
The Secretary for Financial Services & the Treasury, Prof KC Chan, said the amendments seek to level the playing field for common types of sukuk compared with their conventional counterparts in terms of profits tax, property tax and stamp duty liabilities.
"The legislative amendments would also help to attract sukuk issuers using our Islamic finance platform,” he explained. “The structuring of sukuk often involves transfer of underlying assets and setting up of special-purpose vehicles, which may give rise to additional tax and stamp duty implications and uncertainty under the existing laws, putting sukuk at a disadvantage when compared with conventional counterparts. Amendments are therefore necessary.”
Under the legislative proposals, the government proposes “to adopt a prescriptive and religion-neutral approach, in line with that adopted by other major financial markets such as the United Kingdom, as prescriptive legislative provisions without specific reference to Shariah principles would provide more certainty in implementation to market players in Hong Kong”.
It is proposed to cover the most common types of sukuk in the global market - Ijarah, Musharakah, Mudarabah and Murabahah – and to adopt a tripartite structure, comprising an originator, a bond-issuer and bond-holders, as the basis for the framework of the proposed legislative amendments.
Specifically, a new term would be introduced known as an alternative bond scheme containing two arrangements - a bond arrangement and an investment arrangement. The former refers to the arrangement between the bond-issuer and the bond-holders, while the latter refers to the arrangement between the bond-issuer and the originator.
Under each of the aforesaid arrangements, a set of essential features and qualifying conditions would need to be satisfied in order for the parties involved to enjoy the special tax treatment and stamp duty treatment/relief applicable to that arrangement.
Chan added that "the consultation exercise seeks to gauge market views on the proposed legislative amendments with a view to ensuring they are practicable and able to meet the latest market development needs".
In the government’s opinion, the legislative exercise would be conducive to the development of a sukuk market in Hong Kong. "This will in turn help diversify (Hong Kong’s) financial platform and consolidate (its) role as an international financial centre."
It is planned that a bill will be tabled in the Legislative Council in the next legislative session.
However, in her keynote address to the recent IFN 2011 Issuers & Investors Asia Forum in Kuala Lumpur, Nik Ramlah Mahmood, the Managing Director of the Securities Commission Malaysia, said that, for the Islamic capital market to make further progress, more jurisdictions would need to put uniform tax frameworks into place.
In addition to a further development of standards and guidelines by international organizations, such as the Islamic Financial Services Board and the Accounting and Auditing Organization for Islamic Financial Institutions, and a greater harmonization of Shariah rulings and interpretations, Mahmood believes that a uniform tax framework will also be necessary to provide a more common platform for industry players to operate across jurisdictions.
“There is also a need to address the elements of uncertainty and disparity in the legal, regulatory and tax frameworks for Islamic capital market transactions, particularly in cross-border situations,” she confirmed. “Malaysia has established relevant frameworks that put Islamic financial products effectively on the same playing field as their conventional counterparts. However, for Islamic capital market to progress further internationally, more jurisdictions would need to move in a similar direction.”
In 2012 however, such developments still appear to be a long way off.
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