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.

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
  

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.

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]

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.