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.

we have moved

to http://relook-islamicbankingfinance.blogspot.com/

Islamic Banking in Singapore

Reuters reported that DBS, Singapore and south East Asia’s largest bank is scaling down on its Islamic banking operations, signalling the city-state’s efforts to promote Shariah banking are not bearing fruit.

DBS’ Islamic Bank of Asia (IBA), Singapore’s only wholly-owned full licensed Islamic bank, suffered a loss of US$77.1 million (RM256 million) in 2009 after making specific allowances on debt owned by customers in the Gulf region. The bank had US$725 million in assets as at end-2009, including US$453 million in payments due from non-bank customers. A source had earlier told Reuters the Islamic unit of DBS planned to get out of the lending business entirely. (Reuters; May 24, 2010)

What struck me was the statement on “lending business”. I have argued in past and still maintain my stand – Islamic banking is not about lending. Islamic banking is all about putting resources together and sharing risks and rewards in an economically beneficial business venture. Any lending should be kept at a minimum and should only be for exceptional cases and given interest free.

So, given my stand, I’m not surprised that Islamic banking is not making much headway in the non-traditional markets. While the traditional markets (read Muslim countries) have the added advantage of having religious obligation as a marketing tool, the non traditional markets needs more than that to push Islamic banking. Focus has to be on the uniqueness of system, the part that differentiates it from conventional banking. One of it is that it promotes risk and reward sharing instead of just plain borrowing and lending.

It is often lamented that Islamic finance lack knowledgeable practitioners. I want to add that the industry also lacks knowledgeable investors. By knowledgeable investors I mean investors who appreciate what Islamic finance stands for. For as long as investors demand a solution that mimics conventional products, Islamic finance will not take off, even in traditional markets. 

Islamic Finance Resists Equity Shift, May Stunt Growth

Shariah finance has been labelled “copycat” for its reliance on debt funding

Reuters – KUALA LUMPUR, April 27 — When Kuwait Finance House Malaysia helped develop a US$1.3 billion (RM4.1 billion) real estate project in the country in 2005 as a partner in the deal, Islamic equity property ventures were a rarity.

Five years on, the bank is embarking on its fourth building project using a similar equity concept but few others in the industry want to follow the same path, reflecting Islamic finance’s slow and difficult shift away from debt instruments.

Debt funding’s dominance of Shariah finance has earned the US$1 trillion industry the tag of “copycat” and limited its growth as critics question its ability to offer a fairer way of sharing risks and rewards that truly distinguishes it from conventional banking.

“Profit-sharing or equity structures are the true way of doing Islamic financing,” said Siti Mariam Mohd Desa, Kuwait Finance Malaysia’s real estate advisory director.

“It is a different concept because if you were to give out straight loans, you may as well go to a conventional bank.”

As the global financial system emerges from the debt crisis and banks shy away from assuming added risks, practitioners want Islamic finance to rely more on partnership structures and less on straight financing which they say has created a brand of finance which is Shariah compliant in form, but not in spirit.

They say equity financing such as musharaka and mudaraba are closer to the Shariah’s aim of ensuring gains and losses are shared equitably and a shift back to it would help banks win new business beyond its traditional markets.

While Islamic finance has flourished in Muslim markets such as the Middle East and Malaysia, many non-Muslims are unconvinced, saying the industry differs from conventional banking only in name.

“We cannot add value in markets which are mimics of conventional markets. At the moment, it’s difficult to see the value-added,” said Safdar Alam, head of Islamic structuring at JP Morgan in Bahrain.

“It’s a real opportunity, with the increased awareness globally of Islamic finance, to demonstrate this value and the difference and benefits. This is a chance that we might miss if we don’t do this well quite quickly.”

But banks’ reluctance to bear the risk of projects funded, companies’ unwillingness to share profits and scarcity of banking capital make equity financing an unappealing proposition.

The recent property slump in the Gulf, where equity financing is more common, badly hit Islamic firms such as Bahrain’s Gulf Finance House and could compound banks’ fears of becoming project partners.

Kuwait Finance Malaysia, which uses the musharaka equity structure to develop real estate, had a non-performing financing level of 6.73 per cent in September, more than thrice the industry average.

Its parent Kuwait Finance House, the Gulf state’s top Islamic bank, posted a 24 per cent drop in net profit in 2009 to 118.74 million dinars.

Equity financing models were born out of a belief in Islam that the financier must share the risks if he wants the rewards and that profits should be earned through enterprise.

While equity funding is commonly associated with higher returns, bankers say it may not necessarily be more profitable than debt as the latter allows for higher leverage.

Traditionally, popular Islamic debt-based instruments such as istisna and murabaha have been likened to interest-based loans where banks take limited risks and are guaranteed a return.

But as Islamic finance grew beyond traditional roles such as agriculture financing to funding government budgets and billion dollar real estate projects, some banks began leaning more towards debt instruments to limit their risks.

As banks’ capital grows scarce, they will be wary of parting with large sums to back equity ventures, said Mohammad Faiz Azmi, PriceWaterhouseCoopers’s global Islamic finance leader.

“On the demand side, the issue are is there enough corporates who are essentially willing to give up the upside?” Faiz said, referring to profit-sharing structures.

“The reality is that the people that would want to have equity forms of financing are usually the ones that you want to avoid lending money to anyway.”

Some practitioners say the push for more Islamic equity financing is ill-conceived.

“From the shariah’s perspective, there is no such evidence to support (the view) that Islamic banks or whoever wants to do business should do profit-sharing more than debt-based,” said Shariah scholar Aznan Hasan, who advises Barclays Capital London and Malaysia’s stock exchange operator Bursa Malaysia.

“Whether it is debt or equity that suits you better, it depends on commercial and business decisions, not Shariah matters.” — Reuters

Did She Say That?

http://www.financeasia.com/article.aspx?CIaNID=118130
Dubai World creditors await court definition of Sukuk
At issue with Nakheel's sukuk is how a court will handle the restructuring, note observers familiar with Islamic finance. Much depends on the structure of the instrument. A court could declare the instrument the equivalent of a conventional bond with repayment terms comparable to international norms, or it could find the sukuk to be structured as either a mudharabah (profit-sharing) product or a musyarakah (a partnership involving profit- and loss-sharing) product, both of which would likely involve the creditors sharing some of the issuer's losses.

Creditors stand to benefit if a sukuk is declared essentially the same as a conventional bond, whereas the issuer stands to benefit if it is defined first and foremost as an instrument that is compliant with Shar'iah (Islamic law) -- and thus subject to the idea of profit-sharing.

"The whole presentation of the structure is one where investors are meant to receive a share of the profits and not interest on debts - two very different obligations," said Khalid Howladar, a senior credit officer at Moody's. "It could be argued that, because an issuer is not generating profits, it should not have to pay sukuk investors."

Not everyone agrees: "This is a credit issue, not an Islamic issue," said Raja Teh Maimunah, global head of Islamic markets at Bursa Malaysia. "A sukuk is a bond and issuers need to pay back the money they borrowed."

The quandary faced by the holders of Nakheel’s Sukuk has been well documented and discussed in recent weeks. At this juncture, how they will move forward with the restructuring depends on how the courts define this instrument called Sukuk.

In the above article, the global head of Islamic markets at Bursa Malaysia claims that a Sukuk is a bond. I find it appalling that a person of such stature as Raja Teh with all her experience can come up with such a statement which IMHO seriously undermines the principles of Islamic finance.

In case she forgot, a Sukuk is defined as follows:

“Certificates of equal value representing after closing subscription, receipt of the value of the certificates and putting it 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” by Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI, Standard 17).

“A document or certificate that represents the value of an asset” by The Securities Commission (SC).

A bond is defined as a fixed interest financial asset. Bonds pay the bearer a fixed amount a specified end date. A discount bond pays the bearer only at the ending date, while a coupon bond pays the bearer a fixed amount over a specified interval (month, year, etc.) as well as paying a fixed amount at the end date.

Click here for a comparison between Sukuks and Bonds.

If Sukuk is a bond, why bother with the Shariah structures & approvals, legal documentations etc.? Why bother calling it a Sukuk?

Let’s put it this way, Sukuks and bonds are like fish and chicken, they are both sources of food and can be cooked the same way but they will NEVER look the same, taste the same, they will never be the same.

It is a credit issue, so going forward, let’s use Nakheel/Dubai World as an example and learn from it. The first and most important lesson to remember is to structure a Sukuk as a Sukuk and not as a bond. And that includes evaluating the credit from the Sukuk perspective and not the bond perspective.

For as long as the Islamic finance industry is lead by people with a conventional worldview on Islamic finance, it will never break away from being a conventional product with an Arabic name.

Saxony-Anhalt Sukuk Ijarah

In 2004, a €100 million Sukuk, structured as a Sukuk Ijarah, was issued in the federal state of Saxony-Anhalt in Germany with The Federal Republic of Germany guaranteeing the debts of Saxony-Anhalt. The underlying transactions are a number of buildings owned by the Ministry of Finance. The master lease was sold for 100 years to a special purpose vehicle, incorporated in the Netherlands for tax reasons. The SPV in turn rented the properties back to the Ministry of Finance for five years. The certificate holders receive a variable rent benchmarked to the EURIBOR over the leased period and the Sukuk is listed on the Luxembourg Stock Exchange. Incidentally, as of July 2007, the Saxony-Anhalt Sukuk remains the only sovereign Sukuk from a non-Islamic country to have tapped the market.

I am of the opinion that the Saxony-Anhalt is one of the best examples of how a Sukuk Ijarah should be structured, apart from one element – determination of the rental rates. Why can’t the issuer set the returns based on the actual, prevailing, market determined rental rates? Wouldn’t that have made it more authentic?

Wa'd

Wa’d is a unilateral promise and is considered as a voluntary contract. Al-Zarqa’ opines that it does not convey any binding effect on the promisor hence they are not obliged to fulfil the promise and will not be liable in a case where they fail to fulfil the promise made to the promisee.

The BNM Shariah Council in its 49th meeting held on 28th April 2005 / 19th Rabiul Awal 1426 resolved that an Islamic banking institution is allowed to enter into forward foreign currency transaction based on unileteral binding promise (binding only on the promisor) and the compensation for breaching of promise could be implemented. This permissibility is only applicable for currency hedging purposes. Such a transaction may be arranged between the Islamic banking institution and its customers, or between the Islamic banking institutions, or between the Islamic banking institutions and conventional banking institutions.

The fatwa of Islamic Bank of Jordan (Jordan Islamic Bank, al-Fatawa al-Syar’iyyah, 2001, v2, p.29) states that the bilateral promise made in currency exchange where it bonds both parties to the contract, is generally prohibited (umum al-nahyi) as it amounts to bai` al-kali’ bi al-kali’ (sale of debt with debt). However, if the promise is made unilaterally i.e. binding only on one party who made the promise, then the transaction is allowed.

Ibn Hazm (Ibn Hazm, al-Muhalla, Dar al-Turath, Cairo, V.9, p.583) has also allowed the promise made to sell and purchase of currency with an agreed price on the same day followed by actual conclusion of the contract afterward. The parties is also given the choice to proceed or not to proceed with the agreement made and thus do not conclude the actual contract. This is permissible according to Ibn Hazm as the promise is not binding on the parties.

Having said all that, it is clear that Wa'd is a non-binding unilateral promise meaning that in the event the promisor decides to rescind the promise, the promisee is in no position to demand compensation. In reality however, most banks demand compensation for breach of promise. How is it non-binding then?

Moving Away from Tawarruq?

Twenty-six Islamic banks signed off on a standardised Wakalah deposit agreement, which some bankers said could help the industry reduce its reliance on the controversial Commodity Murabahah structure, Reuters reports. “Besides cost and resource savings, the adoption of the standardised Wakalah placement agreement would promote transparency, consistency, operational efficiencies and robustness in Islamic deposit placement transactions,” said the Association of Islamic Banking Institutions Malaysia, which launched the template agreement. “In six months’ time, all the banks will be using the Wakalah,” said one Malaysian Islamic banker. “It has fewer issues than the Commodity Murabahah.”

Wakalah is an agency structure where a depositor or investor authorises an agent (the bank) to invest his funds in Shariah compliant assets or businesses.

Finding alternatives to replace controversial instruments is a step in the right direction and it augurs well for the industry.

Organised Tawarruq not a perfect structure

In its basic form, Tawarruq is an asset sale to a purchaser with deferred payment terms. The purchaser then sells the asset to a third party to get funds. Organised Tawarruq is similar although the transactions are executed through banks.

Reuters reports Shariah adviser Rusni Hassan saying that Organised Tawarruq as it is currently practised is not ideal from the Shariah's viewpoint.

According to the report (Nov 4, 2009), Rusni opines that organised Tawarruq should avoid specifying beforehand the parties' obligations under the contract although this protects their legal rights, backing a divisive Fiqh Academy ruling that had thrown the industry into turmoil. She objects to organised Tawarruq because the two contracts are in one when they should be independent of each other.

I agree with her views but I foresee it will further divide the industry especially when respected scholars like Nizam Yaqubi and Akram Laldin see no harm in organised Tawarruq.

Other scholars who disapprove of Tawarruq include Muhammad Nejatullah Siddiqi and Monzer Kahf.

Siddiqi views Tawarruq to be identical to interest based loans both from the functional and macroeconomic perspective. His justification for categorising Tawarruq as non-compliant is due to its harms (mafasid) being greater that its benefits (masalih). He lists;
1) creation of excessive debt;
2) exchange of money with more money in future, which is unfair in view of the risk and uncertainty involved;
3) debt proliferation, which is liken to gambling and speculation;
4) inflationary expansion;
5) inequity in the distribution of income and wealth;
6) greater instability in the economy; and
7) inefficient allocation of resources.
as the many harms of Tawarruq.

Kahf opines that Tawarruq is worse than the practice of interest-based loan legally and economically.

I have to disagree (with apologies) with Sheikhs Yaqubi and Akram on the permissibility of Tawarruq. Being of limited knowledge, I depend on the views and opinions of the scholars and in this case the arguments presented by Siddiqi make more sense to me.

Cost of Funds

When determining the interest rate to charge borrowers, one of the factors to consider is the cost of funds, i.e. the price the bank has to pay to the owners of the funds, who are either depositors or lenders for using the funds.

On the other hand, a partnership or trade based (Islamic) financial transaction should not have a cost of funds simply because the owners of the funds are not lending or selling the funds and therefore should not expect any consideration for the transaction. Funds are monetary capital and Shariah stipulates that money cannot be traded because it is not a commodity, it is merely a medium of exchange.

So, technically, under Shariah terms, capital has no cost. Surely this is a concept which traditional conventional bankers may find difficult to grasp.

Why is money devoid of any cost?
This is because the owners of money cannot expect to earn more money without undertaking some form of economic activity. Shariah stioulates that owners of money cannot trade the money for profit. Any exchange of money which is not equal in amount constitutes riba.

When determining the profits to be charged to customers (‘profits charged’, oxymoron?) for a Murabahah or Istisna transaction, banks cannot base it on the cost of funds simply because there is no cost to start of with. The cost of funds arises when Shariah based banks operate in an identical manner to a conventional banks, i.e. as an intermediary between lenders and borrowers.

Mudharabah and Musharakah are NOT Debt Contracts. Get it?

A Shariah expert claims that Asset-based Sukuk Mudarabah and Musharakah will fall out of favour as it is hard to accommodate a ruling on repurchase pledges, indicating the market would be permanently affected by the decree.

According to Moody’s, the issuance of Musharakah and Mudarabah based Sukuk fell 83 percent and 68 percent respectively last year.

Bankers and lawyers have been seeking ways to structure Sukuks that comply with a 2008 ruling by AAOIFI which forbids “borrowers” in Sukuk Mudarabah and Musharakah from promising upfront to pay back their face value at maturity. This follows a rule that parties must share risks under these structures but the industry had been concerned it would make Islamic bonds less palatable to investors. But the market is trying to find ways to accommodate the prohibition. However, Shariah adviser Dr Mohd Daud Bakar said it would be tough to do so, "It's very difficult because it goes against the very essence of Mudarabah and Musharakah because you cannot guarantee the capital (or profits) in equity-based contracts." (Reuters)

Which is exactly my point. Mudarabah and Musharakah are equity-based contracts and therefore should not be treated as debt-based contracts. Why the industry continues to structure debt papers based on an equity structure baffles me.

A Sukuk is not a bond and a Sukuk is defined by the underlying contract that governs it.

After so many years of being exposed to Shariah based finance, I’m stumped that the so called Islamic bond fund managers (and the rest of the market really) still view Mudarabah and Musharakah Sukuks as debt instruments. Well, I’m telling them again – it’s NOT. Sukuk Mudarabah and Musharakah investors are not borrowers, they are partners who are supposed to understand and willing to assume risks associated with such investments.

The market should take the lead by re-identifying their investment needs and demand the appropriate structure. If they want to invest in fixed income instruments, look for Ijarah, Murabahah or Istisna based structures.

If they want to invest in Mudarabah and Musharakah Sukuks, they better make sure they are looking at them from the equity perspective.

The reason why we are facing this problem is because we (the market/industry) continue to apply Shariah based finance on the conventional platform. If a Mudarabah and/or Musharakah based Sukuk has identical features with a conventional bond, why bother having an Islamic finance industry? Since the underlying structure is identical, we might as well merge the two since there is no difference apart from the name and legal documentation.

The growth of the Sukuk market can only be achieved if the industry accepts Sukuk as a unique instrument instead of equating it to and treating it like a conventional bond.

Islamic Derivative Contracts Soon?

Reuters reports that the first template for over-the-counter Islamic derivative contract will be launched this year or by early 2010. The contract is expected to pave the way for quicker and cheaper Islamic risk management and more frequent cross-currency transactions.

According to Ijlal Ahmed Alvi, chief executive officer of the International Islamic Financial Market (IIFM), "It's a completely new instrument. We have done the consultative work. Now what we are waiting for is the Sharia meeting... some time in December". The IIFM, an industry body backed by the central banks of several Muslim countries, has been working with the International Swaps and Derivatives Association (ISDA) on the contract. Once in place, the new Islamic derivatives contract is expected to initially attract at least 150 players.

Scholars are however split on the legitimacy of derivatives; some see them as permissible instruments to hedge risks but others dismiss them as speculative transactions, which Islam forbids.

My contention is that derivative instruments is not the only solution to hedge of risks. There is no need for Shariah based finance to mimic each and every conventional instrument. Isn’t there any indigenous Shariah based risk management tool?

3Ps – Products, Placement, Promotion

Experts (in Islamic banking & finance) are saying that in order to effectively challenge and compete with conventional finance, Islamic finance needs more products and a wider distribution channel. It would be difficult to attract liquidity into the industry without adequate products and distribution network. This growing industry also needs to develop more unique financial solutions and not resort to merely replicating conventional finance’s product line.

The wealthy GCC sovereign funds are believed to resort to investing in conventional products due to the lack of Shariah approved investment options.

Shariah based finance and investment is mainly based on partnerships and joint-ventures making it suitable for private equity ventures, venture capital as well as asset management. These sectors will allow the Islamic finance industry to create products according to Shariah values, especially on the prohibition of riba via pre-determined return rates.

According to a report published by Ernst & Young this year, as of 1Q 2009, there are only 14 Shariah compliant funds larger than USD500 million out of the 750 Islamic mutual funds under management. Total assets under management is less than USD50 million.

John Sandwick, an Islamic asset management consultant claims that the supply of Islamic funds is not enough to satisfy the demand. The market needs more products. The advent of the pension fund in the Middle East as well as the growing takaful industry will definitely increase the need for more products.

Experts also pointed out most Islamic funds tend to focus on equities and real estate and not much asset diversification especially into fixed income investments.

Sukuk is a ready made instrument to facilitate the Islamic asset management industry. Ijarah, Murabahah and Istisna based Sukuk will provide asset managers with more fixed income investment options.

Silke Bernard, a lawyer specialising in funds said, Islamic funds lacked access to the large distribution platforms used by asset managers and that Islamic funds often lacked the required minimum size of typically USD100 million and a track record of several years required by large asset managers.

It is often pointed out that there is a sizeable amount of Islamic (GCC) wealth looking for Shariah compliant investments. There have also been claims that Shariah compliant investment is already attracting a global fan base from Europe to Australia and Japan and this augurs well for the industry’s long term growth.

Controversies / Issues in IBF

Bay Inah / Tawaruq
Is viewed by some observers and practitioners as a hilah (legal trick), as the objective of the transaction is to exchange of money in different quantities at different times.
The argument for legalising or forbidding Inah and Tawarruq is based on the intention (niyyah) of the parties, i.e. real vs. declared intention.

Bay Inah is a legal sale in the Shafie School, where the intention is not a significant element in determining the validity of the contract. This is the basis for the endorsement of Bay Inah by BNM’s and SC’s SAC.
Rayner (The Theory of Contract in Islamic Law, 1991) concludes that the Malikis and Hanafis give due effect to the real intention or niyyah of the parties, but that as regards illicit motives both schools are reluctant to make such an uncertain element as motive a dependent factor of a legal act. The Hanbali School however, always gives precedence to real intention over declared intention. According to him, the general tendency of Islamic law seems to be to give priority to the declared intention. However, in the Shafie School, this is not just a tendency but a doctrinal stance.

Debt - property or money?
The Malaysian (presumably based on the Shafie’s opinions) view is that debt is a property and hence can be traded freely. For example, a RM100 million debt can be exchanged for RM90 million in cash without any implications.

The middle eastern views debt as money and therefore can only be changed with money of equivalent value. The RM10 million difference in the above example is therefore riba.

Purchase undertaking in an Ijarah transaction - valuation issues?
A purchase undertaking is part of an Ijarah transaction for the sole purpose of returning the leased asset(s) back to the originator. The Purchase undertaking (PU) is present because it was never the intention of the originator to sell the assets in the first place. Another reason is to facilitate the redemption of the principal, similar to the mechanics of a conventional bond/loan which explains why the PU is undertaken at nominal value and not marked to the prevailing market values.

The issue with PU is not whether it is allowed by Shariah or not but it has more to do with the price transacted under the undertaking. If the price is based on the prevailing price at the time of executing the undertaking, I see no issues. It is about justice and fairness to the contracting parties. If the market price is below the PU exercise price, it would mean injustice to the purchaser and conversely, it would be unfair to the seller if the market price is more than the price transacted under the PU.

Purchase undertaking in a Musharakah/Mudharabah transaction – capital protection?
Like the PU in an Ijarah transaction, its presence in a Mudharabah/Musharakah transaction is to facilitate the principal redemption to mirror the mechanics of a conventional bond. A PU under this circumstance tantamount to guaranteeing capital. It is permissible for a third party to guarantee capital but it should be done on the basis of hibah (gift).

BBA, Justice Abdul Wahab and the Court of Appeal

In July 2008, High Court judge Datuk Abdul Wahab Patail had ruled that the application of the BBA contracts in Arab Malaysian Finance Berhad v Taman Ihsan Jaya & Others (2008) was contrary to the Islamic Banking Act 1983 (IBA).

On March 31, the Court of Appeal unanimously overturned Abdul Wahab's much-debated judgment in the Bank Islam Malaysia Bhd v Ghazali Shamsuddin & Two Others, and nine other cases.

Abdul Wahab Patail ruled that BBA is a loan transaction and not a trade based financing. This is because there is no transfer of title from the customer to the bank during the PPA and hence the bank has no legal or beneficial capacity/right to make a valid sale under the subsequent PSA. This was why there was a fear of default under BBA contracts because the contract itself is deemed not enforceable.

Therefore, the BBA is deemed a conventional loan with an Arabic name, the form changes but in substance it is still a plain conventional loan and the profits charged under a BBA transaction are therefore deemed to be interest.

On 31st March (the report in the Malaysian Reserve is 6 months late), the 3 member CoA ruled that Abdul Wahab had erred in making his judgement and reversed the ruling, re-establishing BBA as a bona fide sale transaction and upholding to sanctity of the BBA contracts. The 3 member bench rules that “civil courts should not decide whether a matter is in accordance with the religion of Islam”. Such issues need to be solved in consultation with Islamic scholars. And since BNM’s SAC has endorsed BBA as an approved product, civil court judges should not dispute it.

My opinion – the BBA was created in 1983 based on the conventional loan platform to enable Islamic finance to break into the market while operating on the existing platforms. It was true 26 years ago when awareness on Islamic finance was low and such products were necessary to avoid “cultural shocks”. But as knowledge on Islamic finance grew, such Inah based products are not necessary anymore; the market has more understanding of the Islamic financial system and is ready to accept the structural differences.

Abdul Wahab was arguing on valid grounds, he is merely exposing the “loan behind the façade of a trade” element of the BBA.

It is about time the market, the regulators and the judiciary accept the fact that BBA is a product designed to ease the entry of Islamic finance into the market. It has outlived its purpose and should be phased out completely.

Tendering for Short Term Papers

In the Malaysian debt market, a short term bond is called a Commercial Paper (CP). A CP is either issued via a tender or private placement. In a tender, the CPs will be issued to the highest bidder(s) making the tender process a platform for investors to demand a rate of return that matches their risk appetite and/or investment objective. The basis for the bids is on the credit worthiness of the issuer. Once the CPs is issued to the winning bidders, the issuer is compelled to pay the promised returns to the investors.

Surprisingly, the same tender process applies to the Islamic CPs (ICP). I can understand if the ICPs are issued based on the Ijarah or Murabahah contract, there should not any problem with individually setting the rental or mark-up. The problem is when Musharakah and Mudharabah based CPs are subjected to the same procedure. I just cannot comprehend how an investor can demand, upfront, a fixed profit from a Musharakah/Mudharabah venture. It is totally against Shariah principles and contravenes the “profit and loss sharing” (PLS) model. Although the transaction documents clearly states that the returns are merely “expected” profits but in all likelihood, the projection will be met, 100% of the time.

What’s worse, the ICP is (usually) issued at a discount to nominal value and the issue price is calculated in accordance with the formula specified in Part III, Section 5 of the FAST Rules, the same formula used to calculate the discount for the conventional CPs.

Shariah based instruments and transactions may not be compatible with conventional platform all the time, it must un on its own unique platform.

So much for being in the forefront of Islamic finance.

Liquidity Management

Conventional wisdom states that money must generate returns all the time, even when it is idle. Hence the creation of the money market, a place for trading idle money. When there is a trade, there will be a price; and the price of money is the interest rate. What determines the interest rate? Other than the forces of demand and supply; monetary policy, expectation of changes in the base rate, inflation also influences the price of money.

The money market is also a place where mismatches in assets and liabilities are rectified. Banks with excess funds (liabilities > assets) will sell (lend) the idle cash in the money market and banks facing a shortage of funds (assets > liability) will buy (borrow) money from the market.

The money market is therefore crucial to ensure the banking system and the economy works smoothly.

Why then do I say that the money market is an anomaly in Shariah based finance?

Firstly (I’m already sounding like a broken record), my understanding is, Shariah prohibits the trading of money because money is not a commodity; it is merely a tool to facilitate trade. Money is potential capital, useful only when put into productive economic use.

Secondly, money is a ribawi item, one which cannot be exchanged unless it is equal in value and transacted spot. The following hadith is the basis of this ruling.

The Prophet s.a.w. said “gold for gold, silver for silver, wheat for wheat, barley for barley, dates for dates and salt for salt should be exchanged like for like, equal for equal and hand to hand [on the spot]. If the types of the exchanged commodities are different, then sell them as you wish, if they are exchanged on the basis of a hand-to-hand transaction. (Sahih Muslim)

Therefore, the act of lending overnight money at 3.2%, contravenes the above hadith because (1) the exchanged value differs and (2) it is not exchanged on spot basis.

Then Tawarruq came along. Liquidity management in a Shariah compliant manner is now possible via the buying and selling of commodities (which does not leave the warehouse and is reused again and again for subsequent transactions). The route is longer but the objective is met nonetheless, money is exchanged in different amounts at different times, made “permissible” due to the presence of the trade. It sounds like a hilah to me because the whole transaction is undertaken merely to circumvent Shariah ruling on riba. It also does not entail any direct economic activity. The biggest beneficiary is the commodity brokers, getting paid for facilitating a seemingly pointless transaction.

No doubt, there will be times of excess liquidity and it does not make economic sense to keep the potential capital idle without generating any income.

This excess liquidity can be channelled towards financing short term projects or providing short term funding. Trade financing would be a good place to start. Retailers/traders usually buy from suppliers or wholesalers or manufacturers on credit terms. Banks could offer a short term murabahah facility to finance this type of transactions in the form of a 3 day, 1 week, 2 week or 30 day murabahah financing. This would channel the excess liquidity towards funding real economic activity.

Another way to absorb the excess liquidity is by way of a short term lease. A clearing house needs to be set up. The clearing house shall own a pool of tenanted properties. When a bank (or anyone for that matter) has excess liquidity, they will purchase property from the clearing house and the rental will be paid to them. When they need the cash, the property will be sold back to the clearing house at market value. In most cases, the purchase and sale price would be the same as it is quite unlikely for real estate values to fluctuate very much in the span of a few weeks.

Both methods entails actual economic activity and the returns from the investment are generated from actual economic activity.

There is always a Shariah based solution to every financial need. If there isn’t, the financial transaction is probably not in tandem with Shariah in the first place.

Islamic Structured Investment

An Islamic Structured Investment (or deposit) is an investment product which is linked to or benchmarked against a Shariah compliant underlying range of performance indicators such as equities, real estate or commodities. There are some Shariah compliant structured products in the market which is benchmarked against (Shariah compliant) indices, foreign exchange and even inter-bank offered rates. The returns from the structured investment are therefore dependant upon the performance of the underlying range of performance indicators.

A structured investment can either be principal protected or non-principal protected.

A Shariah compliant structured investment works the same way as their conventional counterpart, the only difference is in the nature of the underlying asset, it must not contravene Shariah principles.

The mechanics are as follows:
The promoter pool funds via the sales of the structured investment. The contract between the promoter and investor is usually that of a wakalah fi istithmar (investment agent).

For a principal protected structured investment, the promoter will split the funds into two, one portion will be invested in the Islamic money market or a fixed income instrument (zero coupon / discounted Sukuk) and a smaller portion will be utilised to purchase an option, applying the Urbun contract and referenced against the underlying.

The investment in the (Shariah compliant) fixed income instrument is for the purpose of reserving the principal investment and the option will provide the upside, if any.

The capital protection will only be enjoyed if the investment is held to maturity. Any premature withdrawal will result in the investment being valued at market and the investor will incur mark-to-market losses.

The maths is basically, allocate a portion based on the prevailing (profit?) rates that will ensure the capital is 100% preserved at the end of the investment tenure. The balance will be used to purchase an option. The participation rate (in the upside) of the option may not be 100% as it will depend on whether the balance after setting aside for the money market/fixed income Sukuk is sufficient. In some cases, the participation rate is less than 100% meaning the option holder is not entitled to all of the gains made from exercising the option.

Let’s dissect the structure.
Pooling of funds for investment purposes are perfectly fine and Shariah compliant.
Investing a portion to preserve capital – this would be done via the money market using Tawarruq. My stand on Tawarruq can be found here

Capital preservation is often a sticky issue with Shariah, if economic conditions go against the investment, what right does the investors have to demand full capital preservation? It becomes a zero sum game and there will be one party in the transaction who will lose out at the expense of the other. Shariah based finance is about justice and equity, sharing of profits and losses.

Buying an option using Urbun*, putting a deposit/downpayment to earn rights to purchase an asset – sounds compliant but are indices, foreign exchange and even inter-bank offered rates Shariah compliant assets? Does buying an intangible asset serve any economic purpose? I have no issues on Urbun for tangible assets like property or commodities.

My take on structured investment is it sort of looks and sounds like a mutual fund with a derivative (the option) and capital preservation elements. My views on derivatives can be found here and I’m of the opinion that capital should be positively correlated to the economy, preserving it would entail going against economic trends and causing some party somewhere to suffer more losses than necessary.


*Urbun is sometimes spelled Arboon

Islamic Profit Rate Swap (IPRS)

IPRS is the Shariah compliant version of the conventional Interest Rate Swap (IRS). The IPRS/IRS is a risk management tool whereby an institution which is contracted to pay fixed profit rates may hedge its risks by swapping the fixed rate payment obligation for another party’s floating rate obligations. IRS refers to a generic rate swap in which one party pays a fixed rate while receiving a floating rate. As in the IRS, the notional principal in an IPRS transaction is never exchanged, only the difference is settled.

The IRS is a derivative product and the widely accepted market standard is the International Swap & Derivatives Association, (ISDA).

As usual, I want to be the party pooper. My question is; is IPRS a Shariah based solution or a conventional product made Shariah compliant?

Azrulnizam Abdul Aziz of Standard Chartered Bank Malaysia (now Saadiq) describes the Islamic Profit Rate Swap as follows (Islamic Finance news (IFN) Guide 2007):
The Islamic Profit Rate Swap (IPRS) was introduced to assist in the management of profit rate risks, thus enhancing cash flows. Profit rate swap is a mechanism structured to allow bilateral exchange of profit streams using two parallel and back-to-back Islamic marked-up sale transactions (Murabahah).
It comprises of three possible structures, namely the IPRS, Islamic Cross-Currency Swap (ICCS) and Islamic Forward Rate Agreement (IFRA). In IPRS, a series of Murabahah sale and purchases are conducted, allowing parties to swap or exchange profit rates from fixed to floating rate or vice versa.

Therefore, in theory, an Islamic Profit Rate Swap would operate in the following manner:

Party A purchases assets on Murabahah (fixed mark-up/profit) terms. They know the exact amount of profit due throughout the repayment tenure.
Party B enters into a Musharakah venture. They can estimate the returns but would not know exactly how much profit is made until the accounts are finalised.
An IPRS would entail Party A paying Party B a fixed, known amount of profit while Party B pays A an amount which is only known at the end of the financial year. The two profit amounts will not be identical; being identical defeats the whole purpose of the transaction!

A Murabahah or Istisna transaction has a fixed profit rate. Ijarah transaction can have a fixed lease rate while Musharakah and Mudharabah have variable profit rates, even loss rate!

If profits are made by the Musharakah (or Mudharabah) venture, the swap works fine(-ish). What if the venture suffers a loss? What is swapped?

An IPRS utilises the controversial Tawarruq structure. If the two parties are merely paying each other the (cash) amount of profits, utilising Tawarruq clearly shows an attempt to circumvent Shariah prohibition of exchanging unequal amount of money (which results in riba).

I would conclude that the IPRS is not a solution based on Shariah principles. An IRS is created with the primary objective of capitalising on the movements of interest rates. It is a tool to make (or save) money from the movements in the price of money (interest). It does not entail any productive economic activity. It is merely a transfer of money from one party to another.

How then does an Islamic financier hedge against movements in profit rates? Profit rates, unlike conventional interest rates are dependent on the underlying transaction. There is no one universal profit rate across the board. A Murabahah profit rate for a risky aerospace venture for example, would not be equal to the profit rate of an identical Murabahah transaction involving the government’s (less risky) purchase of educational equipment. Similarly, the Ijarah rate for a residential property is not the same as that of a CBD commercial property. For equity based contract like Mudharabah and Musharakah, profits cannot be guaranteed; returns depend on actual performance of the venture.

My stand remains – continuing to develop solutions that mimic the conventional system will not develop Shariah based finance.

The “will” to regulate

Islamic finance could also face a systemic failure and reputation risk unless there is a unified and dynamic regulatory framework applied not only domestically but also globally, warned an economist and former International Monetary Fund (IMF) executive director Dr Abbas Mirakhor.
He added that the industry may have more regulatory standards but there is no implementation of the standards in a unified manner and there is no organisation that supervises the instruments. Therefore, Mirakhor said that to ensure a decent chance of growth and development, one has to make sure the regulations are unified and accepted by all jurisdictions.
“We need to create a uniformed standardisation for Shariah products and at the same time you need a uniformed, comprehensive and universal regulatory system in place, which can have the authority of early warning when it comes to weak instruments," he said.
However, the question is whether it should be done via an association of Islamic banks or central banks that have Islamic Finance operating in its jurisdiction. Such arrangements are not difficult but it depends very much on the "will" of the participants, said Mirakhor. (Bernama)

In my previous posting, I made a feeble attempt at article review in which one of the points raised was the difficulty in finding a unified opinion due to the differing mazhabs followed by the different scholars. It was also raised that perhaps a product should be approved with a “warning” label as to which mazhab the approval was arrived at.

Speaking about “will”, a lot of jurisdictions leave the Shariah compliance and monitoring role to the individual banks, the question is, are the banks willing to let go of this “power” to approve products?

Given this major obstacle in reaching a unified stand, how then do we proceed with a global, central authority to supervise and regulate the industry? I feel the IFSB, AAOIFI, Fiqh Academy are global institutions which can (and should) play the regulators role, if allowed.

I agree with Mirakhor when he said a regulatory authority “needs to have enough mandate to supervise/regulate the policy”. Getting the mandate however, might not be so easy.