Thursday, May 28, 2009

Commodity Trading?

I’m not a Shariah scholar but I think I know a “hilah” or legal trick when I see one.

Selling and buying back a commodity (Bai Inah) between two parties is obviously a legal trick undertaken to circumvent the laws of Shariah. But what about artificially trading and exchanging commodities between 3-4 parties? By artificially I mean the trading of the commodities does not bring any economic benefit apart from facilitating the movements of cash and enabling a sum of money today to be returned at a later date inclusive of the “profit”. Hey, I just described Commodity Murabahah.

I have been made to understand and have always believed that Shariah based trade and finance must involve productive economic activity. Transferring commodities within seconds does not create any productive economic activity. Transferring commodities for this purpose tantamount to a legal trick, hilah. Correct me if I’m wrong.

Commodity Murabahah exist for liquidity purposes. Without it, how will Shariah based financial institutions manage their liquidity? Maybe the answer lies in how Shariah based financial institutions look at liquidity management. Do they need it in the first place? Deposits undertaken under the contract of Mudharabah are not demand deposits, they are investments, and liquidating investments has its steps and conditions. Savings deposit under the contract of Wadi’ah is for safekeeping and is not supposed to be utilised. If they are, then the onus is on the FI to meet the withdrawal demands of the customers.

Conventional banks use customer deposits to fund loans. They face the problem of matching short term liabilities with long term assets. Shariah based FI do not face the same dilemma because they are NOT supposed to fund financing with customer’s (Wadi’ah) deposits. Financing are done on a profit sharing basis, it is done in a partnership. Therefore, any financing arrangement is between the customers, and the FI merely acts a facilitator, arranger, manager or if they commit their own capital, as a partner and hence liquidity issues might not occur.

What I’m trying to say is, if Shariah based financial institutions undertake Shariah based financing exactly how it is supposed to be done, they won’t need legal tricks. There is no need to complicate things just to conform to the conventional norms.

Tuesday, May 26, 2009

Islamic Bank – Modus Operandi

Shariah based financial system needs to be clearly distinguished from its conventional counterparts. Shariah based financial solutions can effectively promote itself only when it is seen as an alternative rather than a complement to the conventional banking system. To use transport as an analogy, Islamic and conventional banking should be seen as trains and cars and not as different brands of cars. The objectives are the same, i.e. to get from point A to point B but the mechanics, platform, driving methods, fuel system are different despite having some similarities.

So how does an Islamic bank differ from their conventional counterparts?

First and foremost is the basic principle. Shariah based banking is a built on trade and partnership whereas conventional banking is purely a lender-borrower arrangement. Therefore, the personnel in an Islamic bank must be trained towards managing a trade and/or business partnership relationship rather than that of a lender-borrower.

How different are the two relationships? When a lender lends, his objective to recoup the money lent plus a compensation for the opportunity cost, i.e. principal plus interest. Information on the utilisation of the funds is only for the purposes of obtaining credit approval and once the loan is approved, the lender plays no part in assuring the proper utilisation of the funds. The lender is only interested in getting back the loaned funds plus interest. Inability of the borrower to repay the loan will result in him losing his collateral and could even be slapped with late payment penalties.

On the other hand, when an Islamic bank enters into a trade or business partnership, the objective is to make a gain from the relationship but the gain is dependant upon the business and economic conditions. Unlike the lender-borrower relationship where the lender expects the funds to be returned regardless of the economic condition, an Islamic bank cannot demand the same. The bank has to work with the partner throughout the tenure of the relationship and any realised gains or losses are to be shared as agreed. If unfavourable economic conditions caused the venture to register lower returns or even losses; the Islamic bank cannot demand anything from the partner (unless it can be proven that the loss is caused by negligence of the partner). If the venture turns a loss, the partner should not be compelled to bear the loss alone but instead the bank should work together to recover or at least minimise the losses. The role of a Relationship Manager in an Islamic bank is wider; it also covers the role of active business partner.

Secondly, the credit evaluation process in an Islamic financial institution should not be identical to that of a conventional bank. The reason is simple; a conventional bank looks at credit from the perspective of the customer’s ability to pay whereas an Islamic bank looks at credit based on the viability of the business venture.

As with my other postings, the point I’m trying to drive through is that conventional banking and Islamic banking, despite its similar objectives, cannot be run on similar platforms. Islamic banking has to operate from its own platform, on its own terms. Unless it does, there is no point in its existence.

A short take on Takaful

Takaful is an Arabic word that means “guaranteeing each other”. Takaful can be divided into two types, social and commercial. In this context, we are looking at the commercial model because as the name suggests, a social takaful is purely charitable without the commercial elements.

Takaful, which is often referred to as Islamic insurance, provide mutual financial aid and assistance to the participants in times of need and participants mutually agree to contribute for that purpose. The participants undertake to guarantee against any loss or damage incurred by any of them by providing material assistance in time of a misfortune. Takaful is based on the principle of mutual assistance (Ta’awun) and donation (Tabarru’) therefore; the risk is shared collectively and voluntarily by all participants.

Takaful

  • Risks are shared by takaful fund participants
  • Takaful funds are owned by participants and operator’s funds are owned by Takaful Institution
  • Surplus (or deficit) belongs to (borne by) the participants
  • Investments must comply with Shariah criteria
  • Two accounts – tabarru’ fund and investment fund
  • Investments and policies subject to Shariah Committee’s endorsement

Conventional Insurance

  • Risks are assumed by the insurer
  • Insurance funds are owned by the insurer
  • Surplus funds belongs to the insurer
  • Investments can be made in non-Shariah compliant sectors


Differences in Terminology:

Takaful

  • Contributions
  • Participants
  • Sum covered

Conventional Insurance

  • Premiums
  • The insured
  • Sum insured

Friday, May 22, 2009

Shariah “camouflage”

The Middle East market apparently has the perception that Islamic financial products developed in Asia are not truly Shariah in nature but instead only have a Shariah “camouflage”.

After going through the Monetary Authority of Singapore’s (MAS) Guidelines on the Application of Banking Regulations to Islamic Banking, I am inclined to agree with the above statement.

In Section 2, it was stated that both Islamic and conventional banks face similar risks and therefore MAS has adopted the same regulatory approach. Yes, most of the risks are similar if not identical but when it comes to credit risk and Shariah compliance risk, the picture changes altogether. The difference in Shariah interpretation and opinions poses a major risk especially when a dispute arises, although the governing law is defined in the terms, it would be unfair and somewhat illogical if Islamic law is not taken into consideration when resolving disputes.

Credit risk faced by institutions offering Islamic financial products cannot be similar to those of conventional banks. Most Islamic financial transactions are supposed to be partnership based whereby the returns are not predetermined, unlike a typical loan or bond. The terms which underlies an Ijarah transaction is not (should not) be identical to that of a conventional finance lease contract. Even a Murabahah transaction which in effect is a debt transaction has different risk considerations due to the Shariah call for justice, equity and transparency.

Given that, I do not totally agree with the risk management approach pursued by MAS.

In section 4.17 (Ijarah wa Iqtina), the bank has ownership of the asset but despite being the owner it is not to assume any ownership risks. Well, this is fine, if a willing agent can be found to assume the risk, why not? But what is not fine is when MAS expects the banks to ensure that they are protected against any losses from movements in the market value of the asset. This goes against the spirit of Ijarah, labelling such products as Ijarah would tantamount to mockery. IMHO.

Section 4.21 (Diminishing Musharakah) says that the bank should not be exposed to fluctuations in the market value of the asset, except in the event of a default. It goes on to say that the bank may structure the loan (yes, the term loan was used for a partnership based arrangement).

To ensure the success of Shariah based financial instruments, the regulators must be the main driver and should provide guidelines that truly conforms the uniqueness of Islamic banking. Drawing up a guideline that resembles (copies) the conventional infrastructure would not help in the growth of Islamic banking and finance but instead will cause Islamic finance to be seen as no different from their conventional counterparts.

Friday, May 15, 2009

A Review of the recently concluded IFSB Summit in Singapore

The summit concluded that there is an opportunity to nurture greater prominence and acceptance for Islamic finance during this period of uncertainty in the conventional financial market. To achieve this, three areas needs to be focused on; ensuring that the Islamic finance industry remains robust, continuous product innovation and development of the regulatory aspects.

The participants agreed that working to achieve these objectives is not without challenges. There is still a lack of standardisation in how the major organisations such as IFSB and IDB interpret the mechanics of Islamic finance. Adoption of the standards issued by IFSB and AAOIFI are purely voluntary and are not legally enforceable. It was highlighted that at the summit, participants were discussing issues which have not even been implemented in their own jurisdictions. The development of a uniform set of regulations could very well lead to a struggle for domination by a particular school of thought. Averting this will be the greatest challenge.

Also highlighted in the summit was the absence of a global Shariah compliant liquidity mechanism or inter-bank system for short term liquidity as well as for central banks to invest their reserves.

According to IFSB chairman Muhammad Sulaiman Al-Jasser, the global financial crisis has exposed the failure of self-regulation. IFSB secretary-general Rifaat Ahmed Abdel Karim said that as the global financial architecture undergoes structural reforms as a result of the financial crisis, the Islamic financial services industry would have to follow suit. The IDB and IFSB have formed a high-level task force on Islamic finance and global financial stability that will also study how the sector can dovetail with the revamp exercise for the international financial architecture, especially with regard to regulations and crisis management.

[IFN, Volume 6 Issue 19]

Wednesday, May 13, 2009

Pain in the Neck

Speculators are a pain in the neck; even a slipped disc between C5 and C6 cannot inflict as much pain as these pests. I was at a birthday party sometime ago and there was this guy blaming the Arabs for the high oil prices. I’m not trying to defend the Arabs or OPEC but the fact is they are powerless to contain the sharp rise in oil prices (as if they want to contain the price increase!). They are powerless because the oil price is not determined by the economic factors of demand and supply but instead by the power of the speculators' market manipulation by creating artificial demand.

We all know that an increase in quantity demanded will push the price upwards so the speculators capitalised on this economic fact to make money for themselves at the expense of the genuine participants of the economy. Basically what they do is bid for the oil without having any intention to take physical delivery of the commodity. Their excessive bidding will push the price up resulting in the genuine buyers having to pay more for their oil. The fallout in the global financial market put a stop to these speculative activities and the speculators abandoned the market, liquidating their positions and causing the oil price to drastically drop, the opposite effect now comes into play whereby artificial supply is created. This sharp drop in oil prices again affects the genuine buyers especially those who believed that oil prices will continue to rise, hedge their oil price obligations at high levels (Malaysia Airlines is apparently looking at almost RM3billion in paper loss after hedging their fuel costs at USD95-100 per barrel).

Now, do we see why Shariah forbids any form of speculation in trade and financial transactions? Speculating is akin to cheating the market, dishonest in the sense that it does not entail any genuine economic activity. Shariah based trade and finance is all about undertaking productive economic activity to increase wealth and not merely making money out of thin air.

So, don’t blame the oil producing countries for our oil woes, just ban speculation and our problems may just disappear.

Risk sharing? What risk sharing?

An Ijarah wa Iqtina transaction typically involves the bank purchasing an asset at the request of the customer and leasing the asset to the same customer for a specified period. The lease is terminated at the end of the period whereby the bank transfers the ownership of the asset to the customer, or by the customer terminating the lease prematurely by paying a pre-agreed price to the bank. Although the bank has ownership of the asset during the tenure of the lease, they are not expected to assume any risks associated with ownership and are protected against any negative movements in the market value of the asset. Instead it is the customer (lessee) who has to bear the risks of ownership and the risks of fluctuation in asset value. The profits banks make equals the returns for providing financing and independent of the market value of the asset. Sounds very much like the conventional finance lease doesn’t it? My question is, where is the justice and equity in such a transaction? Why can’t banks treat ijarah transactions as operating leases? Unless negligence or breach on the part of the lessee is proven, why can’t the risks be borne by the rightful party, in this case the owners of the assets? The reason why Islamic financing uses finance lease model is because it has / wants to conform to the conventional banking norms, to adapt to the conventional accounting treatment for banks and financial institutions.

Like I said before, IBF is a young, developing science but the development must be done in the right way lest it grows into a farce.

Beware of Singapore and Hong Kong

I received sad news today. A very close associate in the office is leaving for Singapore. He has been my point of reference for Shariah compliance issues for the past 2 years and his loss will be deeply felt. Another thing is – he’s leaving not only for a competitor bank but also a competitor country.

Singapore (and Hong Kong) have been trying to join the Islamic banking bandwagon for quite sometime now and doing everything possible to gain a foothold. The Monetary Authority of Singapore (MAS) has drawn up a guideline on the application of banking regulations to Islamic banking and Hong Kong Monetary Authority (HKMA) has agreed to review tax laws to accommodate IBF transactions.

Malaysia has responded quite positively to the threats posed by these other jurisdictions by announcing that more Islamic banking licence will be given out to foreign Islamic banks including the setting up of a mega Islamic bank out of KL. This is a good step to strengthen KL’s foothold of the industry but Singapore and Hong Kong are traditionally centres of finance and they have the global presence and appeal that KL lacks. Hong Kong has the additional advantage of being one of the entry points to the still expanding Chinese market.

There is also this on-going debate about the Malaysian Shariah standards being less stringent as compared to that of the Gulf. The global market tends to look at the Gulf as the standard for Shariah compliance and as long as Malaysia is adamant on promoting its brand of Shariah standards, it may lose out especially when Singapore and Hong Kong are adopting the Gulf (read global) standards.

So, how does KL counter all these threats? For a start maybe it should start adopting the Gulf standard of Shariah compliance (in all fairness, Malaysia has done quite a bit to standardise the standards). Producing capable Islamic banking professionals, especially true Islamic bankers who were never conventional bankers is crucial to ensure quality IBF solutions are structured. Instead of setting up Islamic subsidiaries, why not convert existing conventional banks into Islamic banks and thus having the size right from the start. And of course, continuous public education on the merits of IBF should be pursued rigorously.

Despite its 1400 year track record, IBF is still a relative young and developing science. There is still a lot of room to improve and a lot of untapped markets to explore. It is still anyone’s game.

It’s all About Branding

Quote from Dr Abdul Raman Saad, partner & founder of ARSA Lawyers.
“I would like to draw attention to the use of terminology in our industry. In Europe, especially in Germany, they do not use the term ‘Islamic finance’ or ‘Islamic banking’. Instead, they use ‘Shariah finance’ and ‘Shariah banking’. Following the 11th September tragedy, the term ‘Islam’ sometimes gives people the wrong impression. The term ‘Shariah’, however, is more neutral and could appeal to a wider consumer base. I recommend that we ponder on this and apply the term ‘Shariah finance’ instead of ‘Islamic finance’. Shariah has a more universal meaning and thus could embrace both Muslims and non-Muslims.”

Some people would disagree and ask why are we so afraid of the name Islam? I personally prefer the name Shariah Finance/Banking not because I’m afraid of the name Islam but like Dr Abdul Raman, I’m for a brand name which is acceptable to all. After all, IBF is for all regardless of religious or political belief. However, at the moment, Shariah based finance and banking is globally known as IBF, so in the name of uniformity, I shall refer to it as Islamic Banking and Finance, for now.

Stepping out from the Conventional Bond’s Shadows

Sohail Zubairi of Dubai Islamic Bank’s unit Dar al-Sharia, likens Sukuks as the step-sister of Conventional Bonds. According to him, Sukuk is heading in the wrong direction because it is replicates the Conventional Bond. New issuance of Sukuk completely dried up because Islamic banks were structuring them incorrectly from the start, According to him, authentic Sukuk issues should involve the company targeting investors first with a business proposal and inviting them to invest in the company or project. The company would also say how much it expected to generate from the project and the size of a potential return, payable regularly. The practice is however the opposite where companies looking to issue Sukuk had been approaching banks with a proposed sum of money they wanted to raise and soliciting bids — much like they would do if they were seeking to issue Conventional Bonds. “Sukuk collapsed because the starting point was conventional. If the starting point would have been correct, I’m sure we would still have been up and running but the Sukuk market is unlikely to rebound until bonds do as it is so intertwined,” Zubairi said.

Again, this highlights the fact that Sukuks are not debt instruments and should not be treated as such. Bankers and Shariah advisers/consultants must take the bold step of issuing Sukuks in the right and proper way instead of mimicking the mechanics of the Conventional Bond. Almost all Islamic banks in Malaysia offer corporate financing products identical to those offered by their conventional counterparts. They may be called by different names such as Murabahah Term Financing or Istisna’ Project Financing but the modus operandi save for some buying and selling activities are practically identical to that of the conventional alternative. I am of the opinion that these products are quite redundant as a Sukuk serves the same purpose but since the market equates Sukuks with Bonds, it often used to fund large ticket items and not to fund smaller scare projects which are traditionally funded through bank loans.

Sukuks need to step out from the shadows of the Conventional Bonds and stop behaving like a debt instrument.

Islamic Finance refresher

Definition:
Financial activities undertaken according to Shariah rules sourced from the Quran and traditions (hadith) of the Prophet s.a.w.

Objectives:

  • Equitable creation of wealth
  • Fair and Transparent transactions
  • Principles of Islamic Finance:
  • Finance is tied to actual economic activity
  • Returns from financing activities must be based on actual performance of economic activity
  • Money is an intermediary and not a commodity
  • Lending is a benevolent act without the profit motive
  • Equitable sharing of responsibilities, risk and rewards

Scope of Islamic Financial activities:
Economic transactions are generally accepted unless they are prohibited by Shariah

Prohibited transactions: Activities involving/related to;
1. Riba/usury based transactions (conventional, compounded bank interest)
2. Any form gambling or game of chance (casino, number forecasting, sports/horse/dog betting, bingo, lucky draws and the like)
3. Uncertainty, ambiguous contract terms (conventional insurance, derivatives and the like)
4. Alcohol production and distribution
5. Entertainment that does not adhere to the Islamic code (karaoke, cinema/theatre, bars, discotheques and the like)
6. Pork and swine related industries
7. Selling something the seller does not own (short selling)
8. Selling in pursue of a loan denotes intetion to circumvent rules prohibiting riba (hilah)

Islamic Finance is not a zero sum game where there has to be one party worse off for the other to be better off. Islamic Finance is a positive sum game where gains and losses are borne equitably together.

Will There be a New World Financial Order? by Pankaj Kumar (The Star, Business section, 21 January 2009)

Copy of the email I sent to the Editor of The Star, commenting on the need for an alternative financial model.

Dear Editor,

Quoted from Pankaj Kumar's article in The Star 21 January 2009:

"The simple argument is that asset managers or hedge fund managers do not need crude oil or other commodities for that matter or even currencies in their books.They have no business to be in these markets if they are purely speculating on price movements.They should stick to basic investment in asset classes, that is, genuine companies that use these commodities for real markets, real products and real profits. And yes, we do need a new world financial order to get rid of speculative activities which have time and again created asset bubbles and financial manias."

I cannot agree more with Pankaj's observation and would like to point out that an alternative financial order is already in place – Shariah (Islamic) based Finance.

The principles of Shariah disapprove of uncertain contract terms, prohibit gambling and abhor speculative practices. Unfortunately, these elements are prevalent in most financial instruments of late which ultimately caused the fallout in the financial markets that we are experiencing now. If undertaken in its true form, Shariah based financing can eliminate most of the problems associated with conventional financing as laid out by Pankaj in his article.

The key is however, to practice Shariah based financing as it should be, according to the principles of Shariah and not as a conventional product with an Arabic name. Shariah based finance is totally different in all respects from the conventional finance and banking the world has seen and grown to love for the past 100 years. It would be disastrous and detrimental to the development and growth of Shariah based finance if practitioners (and regulators) continue to develop so-called Shariah products based on the conventional platforms and norms.

What is needed is a paradigm shift in the way we approach and view Shariah based finance. We need to accept that although the objectives of Shariah based financing are similar to that of conventional finance, the means of achieving it is drastically different. Different here does not mean changing the product name or adding a few clauses in the transaction documents. The difference is in the mechanics, determination of profits (pricing), contractual obligations and relationship of all parties, the risk analysis and management, recovery methods, source of funds, utilisation of proceeds and remedies in the event of default.

In order for Shariah based finance to prosper, practitioners must not only be well versed in the laws of Shariah but more importantly understand the objectives of Shariah. The market also needs to be made aware of the uniqueness of Shariah based finance. Only then can we see the emergence of the true form of Shariah (Islamic) finance.

Regards,

Anyone Got Guts?

What does it take to succeed? What does it take to make a breakthrough? Guts, perseverance and belief. IMHO, none of that is presently present in the Islamic banking and finance industry. No, I’m not putting those hardworking Islamic finance professionals down. All I’m saying is the guts to develop a product which is not based on the conventional platform is absent. All the products from the BBA mortgages to the Inah based personal financing and even the Sukuk Musharakah is tailored to run on the conventional platform especially from the pricing aspect. Granted that different prices for identical products cannot happen in efficient markets but one must remember that a Shariah based mortgage and a conventional based one albeit having the same objective (i.e. home ownership) is drawn upon different principles and hence cannot be priced identically.

What we need is the courage to come up with a product or solution that is not only Shariah compliant in form but also in substance. Can we have an Ijarah based mortgage whose pricing is directly tied to the prevailing rental rates regardless of the base financing (lending) rates? It is after all a lease based mortgage. A Sukuk Musharakah in my opinion should not be priced and traded like a debt based bond; it should be priced and traded like an equity based instrument.Shariah based financial solutions are tied to real assets and actual economic activity and hence should be priced and traded accordingly. We have to breakaway from doing things based on the conventional norms and platforms if we are serious about promoting Islamic banking and finance.

Fractional Reserve Banking causing Complete Banking Disaster

Fractional Reserve Banking is a system where banks are required to keep a certain percentage (determined by the Central Bank) in cash as reserves. They will then loan out the balance and the process is repeated. In a system based on fractional reserve banking, the banks have the power to create money. The amount a bank is allowed to give out as loans is determined multiple of the bank's reserves. For example if the reserve requirement is 10% then for every RM100 of deposits a bank can give out RM1000 worth of loans. This newly created money is termed as “fiat” money. Fiat money has NO intrinsic value and NOT backed by any physical (valuable) asset such as gold and hence cannot be redeemed for any commodity or asset. It is made legal tender through government decree hence the value of fiat money depends on the strength of the issuing country's economy and therefore, issuing more fiat money by reducing the reserve requirement could lead to inflation.

How did this fiat money come about? Back in the old days when gold was still the medium of exchange, rich people (those with lots of gold) deposited their excess gold with the goldsmiths for safekeeping. Whenever they need to purchase anything, they will go to the goldsmith and withdraw some gold to pay for their purchases. This is how the banking industry was at that time, a custodian for excess gold. As trade increased, and to overcome the need for frequent withdrawals (there were no ATMs back then) the rich started issuing IOUs to their suppliers when making purchases whereby the supplier will take the IOU and redeem the gold from the goldsmith. Some of the traders use the IOU for their own purchases instead of redeeming it with the goldsmith, causing the IOUs to circulate as a payment mode. Subsequently, the goldsmiths (who happen to be Jews by the way) realised that not everyone redeems their gold; some kept them in the vaults for years. This made the goldsmith realise that they themselves could issue IOUs and lend them out and earn interest in the process. They were effectively making money out of thin air using other people’s money! That was how fiat money evolved and the system has been made legal and still practiced today. The only difference is the banks are playing the role of the goldsmith.

Fiat money contradicts with the economic theory of scarce resources; fiat money makes capital unlimited.

The fiat money created by the banks are given out as loans and used to purchase assets. This effectively means that assets are bought on debt using debt. Another way of saying it is, we are borrowing borrowed money. These borrowed money we are borrowing is actually created out of nothing, i.e. not backed by real assets.

So, there are effectively two levels of borrowers, the consumer (or corporation), who is the end borrower and the banks, the initial borrower. So, when the end borrower defaults, it will cause the initial borrower to default too as the initial borrower would not have funds to repay their lender i.e. depositors.

Money creation is the major cause of inflation. Increases in asset value may not have any correlation with actual asset value; it merely reflects the amount of money in circulation. My untested theory is that money creation creates economic bubbles and business cycles. It causes the economy to grow beyond it capabilities.

Shariah based financing on the other hand forbids money creation; every financial transaction must be based on actual economic activity. Money is defined by Shariah as a medium of exchange, a tool to facilitate trade, it is NOT a commodity on its own hence money cannot have a price and cannot be traded. Money should not grow through artificial creation but via productive activities.

Fiat money, excessive speculation and over leveraging are the root of the sub-prime triggered economic crisis. There is a reason after all for the Shariah prohibition of those unfair activities. So, the money we use as a medium of exchange and as a measure of wealth has no intrinsic value. Is all the paper money in our pockets worthless then? But isn’t cash supposed to be king?

NPL and Islamic Banks

Technically NPLs should not exist in the Islamic banking system. NPLs are loans which are not repaid. There are two reasons for non repayment of loans; the first is the borrower’s inability to pay due to economic circumstances and the other is a blatant refusal to pay by the borrower despite having the ability to pay.

In the first instance, the banks should play the role of a caring organisation and restructure the repayment schedule to ensure repayment can be resumed and the borrower is not made worse off. The debt won’t turn bad because it has been restructured.

In the second case, the borrower should have his hands chopped off for stealing. Borrowing money and refusing to repay when the borrower has the means to repay tantamount to stealing. The penalty for theft under Shariah is cutting off the hands. So, instead of charging the defaulter (or robber) penalties (ta'widh) and compounded interest, the Islamic Bank should just charge in him court for theft.

Now, if that kind of ruling is put in place, would there be any NPLs in Islamic banks?

Banks from the Shariah Perspective

A bank is essentially an intermediary between those with excess funds (depositors) and those in needing funds (borrowers). Banks take in deposits from those with surplus funds and lends them to those in need of financing. The difference between the interest charged to depositors and the interest charged to borrowers represent the bank’s income. A very simple model indeed!

Everyone wants to own a bank because banks print money (refer to Fractional Reserve Banking Causing Complete Banking Disaster). Fiat money allows banks to make so much money out of thin air.

Let me illustrate, a 1% reserve requirement (imposed by BNM recently) allows banks to lend out RM100,000 from a deposit base of only RM1000. Let’s assume the deposit rate is 2% per annum and the base lending rate (BLR) is 5.5% per annum – banks will make RM5,500 (5.5% x 100,000) but only pays out RM20 (2% x 1,000) to the depositors. Now you see how the banks make money and why so many want to own banks. Even when banks are losing money the government will bail them out (using taxpayers’ money despite most of the taxpayers not benefiting from the banks’ existence!). Granted, the banks face lots of risks, especially risk of non payment but given the cushion, the banks can afford to have an NPL (non performing loan) ratio of 50% and still make money!

I hate to be a party pooper but I don’t think Shariah will agree with the model.

Firstly, money must be backed by real assets; creating money out of thin air is a no no.
Second, money is not a commodity hence cannot be traded.
Thirdly, interest bearing loans are not allowed under Shariah laws, it has to be given out under a partnership or trading arrangement.
Fourthly, money (deposits) cannot grow unless it is put into productive purpose.
Fifth, risk sharing is absent in the conventional banking model whereby the risk is borne wholly by the borrower, they have to repay regardless of their financial state.

Banks, from the Shariah perspective are in actual fact trading houses/venture capitalist/trading partners. They still play the role of intermediary between the two groups, but the modus operandi is different. For starters, fractional reserve banking should not practised. Money is not to be traded but instead be put into real economic activity, profits and risks are shared. The basic principle of Shariah based financing is doing business in a transparent, just and equitable manner. But if one party (the one without the capital) makes 5,500 while the capital owner makes only 20, where is the equity in that?

Someone’s Afraid of Shariah Based Finance

I stumbled upon this very spiteful, malicious, bitter, and dangerous website – http://www.shariahfinancewatch.org/blog/
The objective of the website is to inform the public about the possible civil and criminal liabilities and risks of Shariah Compliant Finance, and the threats to human rights of Shariah Law. Going through the articles in the website, it is obvious that the promoters are trying to discredit Shariah based finance (SBF) to the extent of linking it with terrorism and human rights abuses. I have to disagree with the website as I don’t see any civil nor criminal liability arising from SBF not because I am a practitioner but because the system is based on the principles of just and equity. I also will add that in no way is Shariah Law a threat to human rights.

According to the promoters of this website, Centre for Security Policy (CSP) (the blog is headed by one Allyson Taylor) we face challenging times, as many European and U.S. government agencies are planning to establish Shariah Compliant Finance in 2009 as a standard in the newly nationalized financial institutions resulting from the financial crises of 2008. Do they really understand what Shariah based finance is? These insecure Zionists, in their attempt to consolidate their control of the world, will go to great lengths to discredit and destroy those standing in their way.

Islam should not be equated with terrorism even if some of the terrorists claim to be Muslims and fighting for the Islamic cause. I wonder why Christianity was never associated with the Christian terrorists of the IRA and the ETA (Basque separatists). I wonder who the financiers of these terrorist groups are. What about government sponsored terrorism like bombing of schools and hospitals by the IDF (Israel Defence Forces)? CSP claims that SBF is not transparent especially when it comes to Zakat and investment purification. The Zionists fear that the Zakat funds are being used to support terrorist activities. Do they have proof for this? Instead of just listing down and manipulating articles to justify their claims, why can’t they (CSP) provide evidence of the money trail from the Islamic banks to the terrorists’ bank accounts. This shows that their concern about SBF is brought about their insecurities. I’ll bet you if the Zakat funds are used to finance IDF nuclear weaponry or the mass murders of Muslim Bosnians, the CSP will be a staunch supporter of SBF.

The core principle of SBF is just and equity. That is why usury, speculation, uncertain contract terms are abhorred and the sharing of risk and rewards, transparency is promoted. True Shariah based financing does not condone injustice. SBF is just a way of doing business and it so happens that it follows the principles laid down by the Quran and Hadith. The shariahfinancewatch website has got nothing to do with SBF or business – it is all about destroying everything connected to Islam in order to further the Zionist cause and their supremacy ambitions.

  • Abu Hamzah Anas bin Malik, radiyallahu 'anhu, who was the servant of the Messenger of Allah, sallallahu 'alayhi wasallam, reported that the Prophet, sallallahu 'alayhi wasallam, said: "None of you truly believes (in Allah and in His religion) until he loves for his brother what he loves for himself" (Al-Bukhari & Muslim)
  • “Violence begets violence”
  • "Do not do to others what would anger you if done to you by others." (Isocrates)
  • "Do not do to others what you do not want them to do to you" (Analects 15:23)
  • "And what you hate, do not do to any one." (Tobit 4:15)
  • "...thou shalt love thy neighbor as thyself."(Leviticus 19:18)

The Future of Islamic Finance

What drives the growth of Islamic finance? Is there a correlation between the spike in oil prices (and hence wealth) with the tremendous interest in Islamic finance? I’m not being a sceptic or a party pooper but would Islamic finance thrive if the oil price is low and the Muslim Arabs are poor? Anouar Hassoune, a banking analyst at Moody’s seem to think so. According to him, “As long as oil remains expensive, which is our base-case scenario, Islamic banking will keep on growing successfully.” Few would deny the obvious correlation between oil price growth and Islamic banking growth. Given the recent slump in oil prices, will we be seeing a decline in the interest for Islamic financial products?

Concepts Used in Islamic Trade (and Banking)

Some of the common contracts and concepts used to facilitate trade the Islamic way. These contracts are also used in Islamic banking and finance to facilitate financing transactions.
  • "Bai-al-Dayn" - Debt-trading.
  • "Bai-Bithaman Ajil (BBA)" - Deferred payment sales. Where goods are sold on a deferred payment basis at a price which includes a profit agreed by both the buyer and seller.
  • "Bai Inah" - A buy and sell contract between two parties where one party sells his asset to the other (price is marked up, payment is deferred) and subsequently buys it back at the cost price paid on the spot. This is often considered a hilah to facilitate the transfer of money under the pretext of trading.
  • "Bai Salam" - A contract where payment is made spot while the goods are delivered at an agreed later date. A form of advance payment trade but the goods may not necessarily be in existence.
  • "Hibah"Voluntary, unilateral gift.
  • "Hiwalah" - Transfer of debt.
  • "Ijarah" - Lease contract. A lessor (owner) leases out an asset or equipment to its client at an agreed rental fee and pre-determined lease period. The ownership of the leased asset remains in the hands of the lessor for the duration of the lease.
  • "Ijarah Muntahiah Bittamlik" - Lease and subsequent purchase. Muntahiah Bittamlik describes the transfer of the title of the leased asset to the lessee at the end of the lease tenure.
  • "Istisna" - A contract to manufacture according to given specifications. The payment terms can either be spot, deferred or in instalments.
  • "Kafalah" - Guarantee or surety given by one party who agrees to discharge the liability of another party, as stipulated in the terms of the guarantee.
  • "Mudharabah" - Profit sharing and loss absorbing agreement between two parties, one the capital provider (Rab-al-mal) and the other, the entrepreneur (mudahrib). The profit-sharing ratio is agreed upon upfront while losses are borne solely by the financier.
  • "Murabahah" - Cost plus sale where goods are sold at a profit and the profit margin is known to the buyer.
  • "Musawamah" - Bargaining sale where the seller need not disclose the cost"Musyarakah"Limited liability partnership. All partners share profits on a pre-agreed ratio but losses are shared on the basis of equity participation.
  • "Qardhul Hassan" - Interest-free loan or benevolent loan without a specified repayment terms or tenure.
  • "Rahn" - Collateral. Where a valuable asset is placed as collateral for a debt, he collateral may be disposed in the event of default.
  • "Sarf" - Currency exchange, i.e. buying and selling of foreign currencies.
  • Tawarruq” - Used in “Commodity Murabahah” transactions where an agent is appointed by the bank to purchase certain goods (usually metals other than gold and silver) which are sold to the customer at cost price with payment made spot. The customer then appoints the bank to sell the goods to another agent at a marked up price but payment is deferred.
  • "Ujr" - Commission or fee charged for services rendered.
  • "Urbun" (Arboon) - Earnest money which forms part payment of the price of goods or services paid in advance.
  • "Wadiah Yad Dhamanah" - Savings with guarantee. It refers to a contract between the owner of the funds (depositor) and the Bank for safe-keeping purposes and the bank, as trustee, guarantees the repayment of the whole amount of deposits, or any part thereof, upon request.
  • "Wakalah" - Agency contract. It refers to the appointment of an agent who is authorised to act according to the term of the agency.

Tuesday, May 12, 2009

Sukuk

The Islamic Securities Guidelines (issued by the Securities Commission) defines Sukuk as: A document or certificate that represents the value of an asset; The Shariah Standard 17 under the Auditing and Accounting Organisation for Islamic Financial Institutions (AAOIFI) applies Sukuk to Investment Products: Certificates of equal value representing, after closing of subscription, receipt of the value of the certificates and putting to use as planned, common title to shares and rights in tangible assets, usufructs and services, or equity of a given project or equity of a special investment activity.

Sukuk
  • Undivided beneficial ownership in the underlying assets, entitled to share in the revenues generated by the Sukuk assets as well as being entitled to share in the proceeds of the realization of the Sukuk assets.
  • Sukuk represent ownership in existing and/or well defined assets.
  • Sale of a Sukuk represents a sale of a share of assets, business activity or project.
  • The subject of the contract in Sukuk is a contract based on lease or a defined business undertaking between the Sukukholders and the originator.
  • The underlying Sukuk assets, business or project must be Shariah compliant in nature.

Bond
  • A contractual debt obligation, the issuer is required to pay interest and principal to bondholders on certain specified dates.
  • Bonds represent pure debt on the issuer.
  • Sale of a bond basically represents sale of a debt.
  • Bonds basically create a Lender/Borrower relationship i.e. a contract whose subject is purely earning money on money.

Sukuks and Bonds are totally different instruments, serving different purpose, with different mechanics and goals. It would be erroneous to structure a Sukuk based on the conventional platform and norms. One must always look at structuring a Sukuk purely from the Islamic perspective and this includes contracts, legal documentations, pricing and the operational mechanics/modus operandi.

What are the factors that will make issuers and investors choose Sukuk over Bonds? From my observation, the decision is made mostly based on cost and price considerations. The attractiveness of Sukuk as compared to bonds in the Malaysian market is mainly due to the various incentives given by the authorities, especially tax exemptions/allowances. However, Sukuks are often structured to fit the conventional Bond model in the pursuit of mandates from clients.

Valuation:
Sukuk valuation at any point should be done based on market value; therefore both at issuance and dissolution, the Sukuk must reflect the market value of the underlying assets (except for Musharakah or Mudharabah where the value at issuance reflects the amount of equity injected into the venture). The same is true during an event of default and investors should expect to receive trhe market value of the asset and not a predetermined amount (principal) when a default occurs.

Role of the authorities:
The authorities that govern the financial markets play a very important and crucial role in developing the Sukuk market. Incentives should not stop at tax breaks but must also include providing the right platform for the Sukuk. Platform means the infrastructure, guidelines, rules and regulation, pricing and trading mechanism. Investor as well practitioners’ continuous education is of utmost importance, being a developing science,

Islamic banking faces new challenges and new developments all the time. Above all, the market, both the sell and buy sides must be fully aware of and understand what Sukuk and Islamic finance is all about. It is not about taking a conventional debt instrument; execute a few more legal documents and giving it an Arabic name.

Better Knowledge of Islamic Finance Needed

The Star, Thursday January 8, 2009
Don: Better knowledge of Islamic financing needed
KUALA LUMPUR: The lack of understanding of Islamic financing needs to be addressed so that people are not confused and misguided, says International Centre for Education in Islamic Finance (Inceif) chief academic officer/dean Prof Datuk Dr Syed Othman Alhabshi.He said even some employees who worked at Islamic banks couldn’t fully understand the concept of syariah-compliance.“We need to address this matter so that everyone will fully understand and have a clear picture of Islamic finance,” he told a press conference yesterday.

I couldn't agree more. The thing about Islamic banking is that since it started to make big waves in the last ten years or so, everyone thinks they can become an Islamic banker without formal and proper education in the field. Anyone with a certain number of years in a conventional bank, or insurance company or rating agency or research house or a business publication suddenly assume they are fit to structure and develop Islamic banking products and this is despite not being able to pronounce Mudharabah properly! This is why many of the Islamic financial products in the market today are only differentiated from their conventional counterpart by their Arabic sounding names. The mechanics and modus operandi of the product is almost identical.

Islamic banking and finance is totally different in all respects from the conventional finance and banking the world has seen and grown to love for the past 300 years. It would be disastrous and detrimental to the development and growth of Islamic finance if practitioners continue to develop so-called Islamic products based on the conventional platforms and norms.

What is needed is a paradigm shift in the way we approach and view Islamic finance. We need to accept that although the objectives of Islamic financing are similar to that of conventional finance, the means of achieving it is drastically different. Different here does not mean changing the product name or adding a few clauses in the transaction documents. The difference is in the mechanics, determination of profits (pricing), contractual obligations and relationship of all parties, the risk analysis and management, recovery methods, source of funds, utilisation of proceeds and remedies in the event of default.

In order for Islamic finance to prosper, practitioners must not only be well versed in the laws of Shariah but more importantly understand the objectives of Shariah. The market also needs to be made aware of the uniqueness of Islamic finance. Only then can we see the emergence of the true form of Islamic financing.

Note: Anomaly? According to the laws of Shariah, money is not a commodity and hence not tradable. What is traded at the Islamic Money Market (
http://iimm.bnm.gov.my/) then?

Riba

The prohibition of riba is the foremost issue in Islamic banking and finance. The literal definition for riba is “excess”, “increase”, or “growth”.

In Islamic banking and finance context, riba is often equated with interest. It is not inaccurate to equate riba with the interest rate as the term riba has a broader definition.

The following are the definitions of riba given by some scholars;

Abu al Ala al Maududi – a predetermined excess or surplus over and above the loan received by the creditor conditionally in relation to a specific period. Riba contain the following elements:
i) Excess over and above loan capital
ii) Determination of the excess in relation to time
iii) Stipulation of the excess in the loan document

Abu Bakar ibn al Arabi – riba is excess in return of which no reward is paid.

Engku Rabiah Adawiah – an increase or excess which accrues to the owner in exchange or sale of a commodity or by virtue of a loan arrangement, without giving in return equivalent counter value to the other party.

http://hazariba.com/DefinitionRiba.shtml - a forced increase of value in the medium of exchange (money/commodity) that is loaned or swapped.

Socio-economic justice is one of the main objectives of the Islamic faith. The definitions above show that riba guarantees that only one or some of the contracting parties benefits from the transaction at the expense of the other parties. Therefore, Islam prohibits riba to ensure that the principles of just and equity is preserved, enabling all contracting parties to share the benefits equitably.

Types of riba:
Riba al fadl – excess accruing in sale or barter transaction
Riba al nasiah – excess accruing from a loan transaction (similar ribawi items) in relation to time

Prohibition of Riba in Quran:
1st stage – Surah al Rum verse 39 (Makkah) – call to abolish interest bearing loans and give alms instead.
2nd stage – Surah al Nisaa verses 160-1 (Madinah) – riba was also prohibited to the Jews (reminder)
3rd stage – Surah Ali Imran verse 130 (Makkah) – stronger prohibition
4th stage – Surah al Baqarah verses 275-281 (Makkah) – Strict law prohibiting riba, establishes clear distinction between trade and riba and defines riba as any increment (however small, whatever the reason) added to the principal. Instructing to only receive principal and waive repayment if borrower is in hardship. Cites the consequences for indulging in usury.

Hadith on the prohibition of Riba
Sahih Muslim, Book 010, Number 3854:Abu Sa'id al-Khudri (r) reported Allah's Messenger (p) as saying: Gold is to be paid for by gold, silver by silver, wheat by wheat, barley by barley, dates by dates, salt by salt, like by like, payment being made hand to hand. He who made an addition to it, or asked for an addition, in fact dealt in riba. The receiver and the giver are equally guilty.

Islamic Finance - a Primer

Islamic finance, as the name implies, is finance based on Islamic laws and norms and is a subset of Islamic economics. The principles of Islamic economics are sourced from the two main sources of Shariah, the Quran and Hadith (sayings of the Prophet pbuh). Contrary to Adam Smith’s theory of self interest, Islamic economics subscribes to the policy of ‘prosper thy neighbour’.

The Western model of finance is based solely on monetary transaction where the bank acts as the middleman between those with excess funds (depositors) and those in need of funds (borrowers). The structure of Western banking is that of a lender-borrower, exchanging money for money. The price of money is interest rates and the determinant of the price is the risk associated with ability of the borrower to repay. The utilisation of the proceeds is of no concern of the bank, only the timely repayments of the loan. Hence, the success of the business does not matter to the bank for as long as loan repayments are met by the borrower. The bank does not assume any risks associated with the utilisation of the funds, even if the economy turns into a recession, the borrowers are still contracted to repay the principal and interest back to the bank within the stipulated period. Failing this will result in further monetary penalty, compounded over time.

Islamic and Western (conventional) finance is akin to Petrol and Diesel engines; they run on totally different platforms. Using the wrong fuel would be very detrimental to the engines. Therefore, how it is conducted; the mechanics and modus operandi, pricing, risk management, repayment, recourse, transaction documentation and marketing and sales must conform to the basic Islamic principle of just and equity.

The most significant difference is the basic concept of Islamic finance – risk sharing partnership instead of a borrower-lender relationship. What this means is that all transacting parties must enjoy equal benefits from the transaction and in a case of a loss, all must share the loss equally. The transactions must be conducted in such a way that none of the parties have an unfair advantage over the others.

Being just and equitable does not mean at the expense of profits. Islamic law requires debts to be paid, contracts to be honoured and promises to be kept. However, there is also a need to be compassionate, when the debtor is facing financial distress, it would be the duty of the creditor to understand and not make matters worse. An alternative arrangement must be made to ensure the debt is repaid. Loans per se are not an Islamic financial instrument. Borrowing and lending money is not encouraged unless in times of distress. Debts or obligations to pay only arise in trade transactions where the payment terms are deferred. The only type of loan recognised under Islamic law is the “benevolent loan” or qardhul hasan. This loan does not carry any interest rate nor does it carry a fixed repayment period. The debtor is expected to repay as soon as he is able and the creditor is not encouraged to demand repayment. The elements of trust and responsibility play a fundamental role in this transaction.

Money according to Islamic law is not a commodity. They are merely the intermediary to facilitate a transaction and therefore on its own cannot be traded.

The main characteristics of Islamic finance include;

  • Prohibition of interest (riba / usury).
  • Prohibition of elements of gambling and uncertainty.
  • Partnership instead of lender-borrower relationship.
  • Full transparency and disclosure
  • Transaction must not involve prohibited goods and services such as pork, alcohol, gaming, armaments.
  • Profit and loss sharing instead of fixed returns on the part of financiers.
  • Shariah compliant asset backed financing.
  • No short selling, i.e. full ownership must be obtained prior to selling.


Islamic finance can be used to facilitate any kind of financial transactions such as;

  • Project financing
  • Working capital financing
  • Leasing
  • Trade financing
  • Liquidity management
  • Sukuk (investment certificates)
  • Takaful (insurance)
  • Mortgages
  • Asset management
  • Hire purchase

Common contracts / concepts used in Islamic finance include:

  • Murabahah (cost plus sales)
  • Ijarah (leasing)
  • Musharakah (joint venture)
  • Mudharabah (trustee profit sharing)
  • Istisna (project financing)
  • Salam (forward sales)
  • Wadiah (trustee safekeeping)
  • Wakalah (agency)
  • Kafalah (guarantee)
  • Hibah (gift)
  • Ibra (rebate)
  • Qardul Hassan (benevolent loan)
  • Tawidh (penalty)
  • Ujr (fee)
  • Wad (promise)
  • Rahnu (collateral)