Islamic Banking

Interest and Islamic Banking - Contemporary Issues - Bilal Philips

By: Jean-Pierre Fenech

Switzerland’s UBS has become the latest of just a handful of Western banks to open up to Islamic banking, aiming to capture a $180 billion market that seems to be underserved and certainly expanding1. In June 2003, HSBC in Malaysia completed the world’s first Islamic Global Bond Issue valued at $600 million2. In September 2003, Citibank in Bahrain was the sole lead manager to underwrite another $250 million International Islamic compliant funds, bringing the total to $1 billion over three years 3. This list of new ventures keeps going on, an indication that Islamic banking is on an aggressive expansion phase.

But what is really Islamic banking and how does it differ from conventional banking?

The Islamic holy book, the Qu’ran regulates the way Muslims are to carry out their day- to- day banking transactions. In fact it includes a prohibition against charging interest. That is the charging or receiving of interest on bank accounts being either deposit accounts or loan accounts is forbidden. This paper will investigate the different ways Muslims carry out their banking transactions. Readers need to be aware that Islamic scholars are continuously studying new ways to develop banking products that are in line with Islamic thinking.

Muslims like everybody throughout the world would like to save money, keep up with inflation, invest in ways that will offer a steady return and meet other financial needs. In addition Muslims would like the companies they own to expand, build new plants and finance their working capital needs. These contradictory demands of religious belief and economic necessity have provided the impetus to the origin and growth of Islamic Banking. More so when the petro-dollars started pouring during the 1970’s and local companies/governments planned major capital spending projects. A school of economic thought began developing new ways of meeting the saving, investing and financial needs of Muslims in a religiously acceptable way. In 1975 the Islamic Development Bank was formed to promote Islamic financial markets that was acceptable to Islam. Banks (both private and also government owned) were also being established all over the Middle-East, offering banking services. Some followed a strict Muslim regime, others offered conventional banking services and others offered both.

Permissible Financial instruments, allowing Muslims to acquire finance for capital expenditure purposes:

Islamic banks offer current and savings accounts. Although the deposit is guaranteed (a fundamental concept in Islam is that capital entrusted to the bank by a depositor must be returned to him/her in full) the depositor does not receive interest. To induce clients to open accounts, some banks may allocate part of the year’s profit to the accounts at the end of the financial year. This may usually be equivalent to the savings rate a conventional bank pays on its current/savings accounts. This profit allocation is not seen as interest but regarded more of a profit sharing exercise.

Other banking services such as money transfers, bill collections and trade in foreign currencies at the spot rate (forwards are not allowed as discussed below) are provided on a commission or charges basis. These services are granted as long as the bank’s own money is not involved.

Mortgage facility, a cost-plus asset exercise:
Since Islamic Banks are not allowed to charge interest on loans they approve, another way to finance the real estate needs of Muslims is to go for the cost-plus asset method. This is a system where a customer will approach an Islamic Bank and ask the Bank to purchase the house on the customer’s behalf at a particular price with x% profit margin for the bank. This ‘round-about-way’ of financing is completely permissible and in line with Islamic philosophy. So once the debt covenant between the customer and the bank has been agreed upon, a repayment program will be established. This way of financing property is not subject to interest rate risk, since the bank’s profit will already have been established at the outset of the agreement. The bank will continue to own the property until the customer makes his final payment and that is when ownership is transferred. The cost-plus method is proving to be quite popular in countries where interest rates are quite volatile. In fact it has been reported that there are non-Muslim customers that have taken up this option to finance their homes or other investments.

Financial Instruments used to hedge any form of risk:

In any transaction between two or more parties, the object of sale must be well defined and specific. Forwards, futures, options and other derivative instruments are not allowed since the underlying asset may not exist at the time of when the trade is to be executed. All such cases involve the sale of an item, which may or may not exist. This way of thinking goes back a very long time when contracts where drawn on the purchase of the unborn animal in its mother’s womb, the sale of the milk in the udder without measurement and the purchase of the catch of a diver. These examples are analogues with today’s derivative trading, where the underlying asset might not even be purchased by one of the contracting parties such as for example the sale of a commodity option by a bank on a recognised exchange. The commodity, like for example wheat or coffee, will not have been purchased as yet but the bank is still prepared to sell an option contract. So Islamic Jurists strongly recommend that the object of sale and price is well defined and all ambiguities are eliminated.

Likewise in a contract, where premia are paid regularly, the insured receives compensation for any insured losses in the event of a loss. This uncertainty does not constitute a sale and therefore is also not allowed.

Trade Finance, overdraft facilities and lines of credit:

Islamic Banks are allowed to finance a purchase on behalf of their customers so long as the consideration is agreed upon at the outset of the agreement. The payment to the seller may be deferred and paid in instalments. The deferment ensures that the seller’s profit is collected over a period of time. If the buyer misses out on a payment, the seller cannot claim interest for further deferment of the payment of such debts as a function of time. This will constitute the worst form of ‘Riba’ which is condemned in the Qur’an. The opposite rule in which the amount of the debt is reduced due to prepayment is also prohibited. The rule ‘prepay and reduce’ breaches another fundamental rule that the debt must be settled ‘at face value’ only, nothing more and nothing less. Therefore credit sale facilities may be used as a form of finance – as long as interest-bearing loans are avoided.

Leasing:
Legally, the lease contract is not a sale of the object, but rather a sale of the usufruct (the right to use the object) for a specified period of time. The sale of usufruct is permissible in Islam. The leasing agency must own the leased object for the duration of the lease, sub-leasing requires the permission of the lessor and late payment penalties must be handed very carefully to avoid the forbidden interest.

Leases will have an additional promise by the lessor that he will agree to sell the leased object at the end of the lease at a pre-determined residual value. This promise is binding on the lessor only, and the lessee has the option of purchasing the item at the end of the lease, or returning it to the owner-lessor.

Partnerships and Joint Ventures:
Various forms of partnership can be direct financing methods. Here the financing house and the customer share the ownership of real estate. In contrast to the leasing model, where ownership of the financed item remains with the lessor for the entire period, ownership in a diminishing partnership is explicitly shared between the customer and the Islamic financial institution. The periodic payments of the customer in this model contain two parts:

• A rental payment for the part of the property owned by the Islamic financial institution; and
• A buy-out of part of that ownership.

Over time, the portion of the asset which is owned by the customer increases, until he owns the entire asset and needs to pay no more rent. At that time the contract is terminated. This method may look like a conventional mortgage schedule, where a large portion is ‘rent’ (corresponding to ‘interest payment’ in conventional mortgage) and a small part is ‘buy out’ (corresponding to the ‘principal payment’ in a conventional mortgage). Although there are many similarities, the main difference remains that the mortgage company does not hold a lien on the property.

Permissible Investment vehicles and instruments available to Muslims:

Shares in companies may be bought and sold only if the potential Muslim owner sees fit. In fact there are ‘filters’ in place to assist the Muslim investor.

The first set of filters exclude all companies whose primary business involves forbidden products. These products consist of items like alcohol (supermarkets and hotels that sell alcohol are also forbidden), pork, tobacco, financial services like banks and companies (since they charge and receive interest), weapon production and entertainment centres that include gambling/casinos, pornography etc.

The second set of filters is based on financial ratios. Islamic investors exclude companies:

• with a debt to total asset ratio of 33% or more;
• companies with ‘impure plus non-operating interest income’ to revenue ratio of 5% or more is also excluded; and
• companies with accounts receivable to total assets ratio of 45% or more are also excluded.

Equities:

Therefore removing the above mentioned ‘impurities’ one wonders what Muslims can invest in. Al-Ahli Europe Trading Equity is one of the best performing funds on the Islamic markets. It is based in Saudi Arabia and has $92.2 million worth of assets under its control. It has a minimum investment of $2,000. The following are the top 10 holding equities within this fund:

The world markets were affected by the events of September 11, but managed to recover most of the losses in the following months. The Technology market was the worst performing sector and most Islamic funds had a considerable exposure in such a sector. Subsequently the defensive strategies of such investors were to reduce the exposure to the hi-tech sector and invest more in the petrochemical industry, pharmaceutical, healthcare and food industry.

Equity investment is a multi billion- dollar business. The latest figures supplied by Failaka International Inc4 (the official equity body in the Middle-East) states there are $3.3 billion worth of assets held under Investors control invested according to Islamic principles. This area suffered a set-back with the September 11th event and also with the uncertainty in the financial markets. The losses are being recovered and more money is being channelled in this sector, because of the wish Muslims have to invest according to the Qu’ran teachings. (For an industry report look up the Failaka Islamic Fund Review at www.failaka.com)

‘Fixed Income’ funds:

Many retirees and others need to invest in income generating vehicles with minimal risk. The vast majority of conventional fixed income investments include the forbidden interest. Retirees and those nearing retirement are limited in their choice but investments in real estate, eg an apartment building or warehouse can generate income in the form of rent. Rent will go up with inflation, as will the value of the real estate, thus providing a reasonable inflation hedge and helping the investor keep the real value of his or her wealth, while generating an income on which to live. Not all individuals may afford to purchase real estate so investors may team-up and own collectively one building or a collection of buildings in different areas. This simple diversification method can allow investors to maximise their income with a group of well hedged assets.

Permissible Alternatives:

When thinking about reducing risks, one often thinks of taking out a policy. The majority of the Islamic jurists have concluded that conventional contracts are invalid mainly due to the fact that companies invest in interest-bearing bonds that obviously include interest. The Islamic response to conventional is Cooperative5. This is a system where subscribers contribute to a pool of funds and whenever one of the members makes a legitimate claim they draw money out of the pool. In the meantime, the funds in the pool are invested in an Islamic manner, without exposing the policy holders to any extra significant risk. The profit is subsequently distributed among the policy holders.

Population Statistics:

Islam is the fastest growing religion and the second largest religion in the world. According to the CIA World’s Facts Book (which can be found at: http://www.odci.gov/cia/publications/factbook) the Muslim population is expanding at a high rate. These results were reproduced on an Islamic website and may be downloaded from http://www.islamicweb.com/begin/population.htm. According to these sources among every four humans in the world, one of them is Muslim. Muslims have increased by over 235 percent in the last fifty years, up to nearly 1.6 billion. By comparison:

• Christians have increased by 47 %
• Hinduism, 117 %, and
• Buddhism by 63 %.

Islam is also the second largest religious group in France, Great Britain and USA These statistics strongly indicate that the Muslim population will eventually have a say in the day to day running in the countries where they have a significant number of people. Malta does not seem to be immune to this new wave of Muslim population.

Effects on the Maltese banking System/Society:

Banks in Malta are not offering any Islamic banking instruments as yet. The above- mentioned web-sites are stating that in Malta from a population of 375,576 there are 52,581 that declared that they follow the Muslim religion. ie 14% of the Maltese population is Muslim. If this statistic is correct, then one may put forward many questions, like for example, What will the Muslim population in Malta be in 10 years time? This is a question that people involved in marketing will definitely analyse. If there is a niche market that is underserved then it is up to these people to develop products that can service these needs. In the introduction of this paper there is mention of International banks that are already active in this area. Even HSBC which is a main player in the Maltese Banking sector is heavily involved in Islamic Banking in the Middle East. They already have the expertise, all they need to do (when the need arises) is to apply it in the local context.

Islamic Banking is certainly not a fad. The market size in dollar value terms is increasing and is definitely not letting down. Many traditional Muslims have decided to follow banking practises that are in line with Islamic philosophy. There is evidence that interest from non-Muslims is also starting to grow, the reason being that in Islamic banking there is no talk about collateral since the viability and profitability of the project is given more importance. There is also the issue of no interest rate volatility – since interest is prohibited.

The future of Islamic Banking depends to a large extent on product development6. Bank officials together with Islamic jurists need to work together to continuously provide their customers with financial instruments. This is certainly not an easy task but certainly it will not discourage policy makers to pull the plug on this industry. On the contrary there is a great deal of optimism and Islamic Banking will continue to be the main driving force in the Middle East and in North Africa for many years to come.

References:
1 Iley k, and Megalli M, (2003), Western banks eye billion dollar Islamic market, Banker Middle East, Vol 2, No 2
2Home J, (2003), Malaysia’s Islamic global first. – www.financeasia.com.
3 Akbar S, (2003), Billion Dollar Sukuk, Islamic Banking Hub Bahrain, Vol 1, No 3. Failaka International Inc., Company profile.www.failaka.com.
4 Failaka International Inc, Failaka Islamic Fund Review Year End 2002/3, pg 2.
5 Mills P.S. and Presley J.R., (1999), Islamic Finance: Theory and Practice, PALGRAVE.
6 Gainor Thomas, (2000), Product Development, Fourth Harvard University Forum on Islamic Finance.

JEDDAH, 4 April 2008 — A three-day international conference on Islamic economics ended yesterday urging Islamic banks to address problems such as poverty and unemployment in Muslim countries.

The conference, hosted by King Abdulaziz University (KAU), adopted a number of important recommendations to promote Islamic economics in the world. Nearly 1,000 delegates from across the globe, including several pioneers in Islamic economics, attended the forum.

The organizers presented 19 recommendations and proposals at the concluding session based on papers presented at the event. The proposals emphasized the need to focus more on training professionals to run Islamic banks and financial institutions.

While talking about the new strategic vision for research in Islamic economics, Dr. Najatullah Siddiqui, winner of the King Faisal International Prize for Islamic Studies and author of 30 books, urged researchers to be more creative and explore new horizons rather than wasting their efforts on conventional topics.

Siddiqui, who has worked for 22 years as a professor at KAU’s Islamic Economics Research Center (IERC), called for rebuilding Islamic economics on the basis of moral values rooted in spirituality. “This is essential for making sacrifices for noble goals, disregarding vested interests,” he said.

He added that the KAU conference came at a time when capitalism had failed to address major international economic issues including poverty, inflation and unemployment. “We should present Islamic economics to the world as the best solution to its problems in a convincing manner,” he said.

The conference urged universities and research centers in Muslim countries to prioritize Islamic economics and encourage research in the field. It also called on Islamic banks and financial institutions to fund such research projects, especially on topics relating to boosting economic development and fighting poverty and unemployment.

“Studies on waqf (endowment), Zakah and public finance during the time of the Caliphs must be given importance,” it added.

Dr. Abdullah Omar Bafel, undersecretary for higher studies and scientific research at the university, presided over the concluding session. He commended speakers and other delegates for their active participation to set out a new strategy for Islamic economics that would involve the whole Ummah.

The conference called for more efforts for the development of Islamic financial engineering — based on the objectives (maqasid) of Shariah — to present new products that would meet current and future needs, said Dr. Abdullah Turkistani, director of IERC.

“We believe that Islamic teachings, if applied properly, can fight poverty and thus we can contribute to fighting world poverty,” said Dr. Abdul Raheem Saati of KAU.

Dr. Usamah Uthman, associate professor at King Fahd University of Petroleum and Minerals in Dhahran, described Islamic economics as a relatively new discipline that required more study.

“Knowledge of fiqh (jurisprudence) is essential for researchers in the field.”

He added that although Islamic banks have made remarkable progress, “many of us are not happy with its direction. Some of them have deviated from the set principles.”

Uthman was apparently referring to the present focus of Islamic banks on corporate financing to maximize profits, neglecting its original goal of social development.

Professor M.A. Mannan, founder chairman of Social Investment Bank (SIB) in Bangladesh, also emphasized that Islamic banks should give priority to fighting poverty. “They are now focusing on corporate financing, hunting for profit,” he told Arab News.

He also believed that ideal Islamic banking products could not be marketed in a corrupt society and called for the training of professionals to manage the wealth of Muslim countries. “Many Muslim businessmen invest their money in Western countries because we don’t have skilled professionals to manage them,” he said.

Attendees also stressed the importance of training a new generation of distinguished researchers in Islamic economics. “Students of Islamic economics should be given due support including scholarships and grants,” the recommendations said, adding for the need to inject new blood into research projects and that research should be translated into Arabic, English, France, Turkish, Persian and other languages.

The concluding session was lively as delegates competed with one another to make vital proposals. Women delegates were equally enthusiastic as one of them said the recommendations were more generalized without addressing specific issues.

Dr. Afaf, another woman delegate, said Islamic economics should focus on problems in the Muslim world and finance small-scale projects.

“We have hundreds of satellite channels for sports and entertainment and why don’t we launch a channel for Islamic economics,” was a question raised by one delegate. Such a channel will also help provide distance education on the subject.

Abdul Wadood Khan from Pakistan called for a concrete plan to replace interest-based banks with Islamic banks. Another delegate suggested the Saudi government allocate a small portion of its budget to promote the research of Islamic economics in the world.

“How can we achieve development and justice together,” was the topic given by a delegate to potential researchers. “This is an area where others have failed,” he added.

Many delegates called for the teaching of Islamic economics from the high school level and creating public awareness programs on the subject. They urged organizers that the recommendations should not remain in paper and called for an executive committee to translate them into action plans.

Source: Arab News

Boustead Holdings Bhd plans to establish an Islamic banking operations in China via a joint venture with its foreign partner the Bank of East Asia (BEA).

It was now “exploring that opportunity with BEA,” group managing director Tan Sri Lodin Wok Kamaruddin said, adding that the proposal was subject to approvals from the authorities concerned.

He said the potential for Islamic banking operations in China was “quite great” as there were some 100 million Muslims in the north-western region of the republic alone.

Source: the star online

Professor M.A. Mannan, founder chairman of Social Investment Bank (SIB) in Bangladesh, yesterday urged Muslim countries and organizations to promote "cash waqf" (endowment in cash) as a new product to collect funds required for their educational, social and charitable projects.

"The main attraction of this product is that it enables every Muslim to participate in it by contributing any amount he or she can afford," Mannan told Arab News while attending the 7th International Conference on Islamic Economics at the King Abdul Aziz University.

Mannan, former chief economist at the Islamic Development Bank in Jeddah, said contributions to cash waqf could be collected through banks. "We have introduced cash waqf at SIB and have received encouraging response from the public," he said. Bank Muamalat and other Islamic banks in Indonesia have also adopted the system. "We don’t use cash waqf funds directly to finance projects. The fund will be invested in viable ventures and the returns from projects will be used to finance projects. This will help organizations to maintain funds for their projects without resorting to contributions," he explained.

Mannan said SIB had made 300 percent growth during the past 10 years. "I hope SIB would pave the way for the establishment of a world social bank in order to finance social infrastructure projects for the Ummah."

The conference was officially opened on Tuesday by acting Higher Education Minister Dr. Matlab Al-Nafeesa. He said the economic problems facing the humanity today were the results of its distancing itself from Islamic teachings and values. He hoped that the conference would open a new chapter in Islamic economics research. The minister honored eminent economists who had contributed to the development of Islamic Economics Research Center at the university.

Dr. Osama Tayyeb, president of KAU, stressed the conference’s significance in exchanging expertise and making use of research works.

Speaking to Arab News, Dr. Najatullah Siddiqui, winner of King Faisal International Prize for Islamic Studies, called for more efforts to promote Islamic endowment and Zakah systems and fight poverty in Muslim countries. Siddiqui emphasized the need for narrowing the gap between the rich and poor and reminded the wealthy of their duty toward the less fortunate. He presented a paper on "Obstacles to Research in Islamic Economics."

Dr. Mehmet Asutay, lecturer in political economy at School of Government and International Affairs, Durham University, was one of the nearly 1,000 delegates attending the conference. His school, which offers training in Islamic finance, has a pavilion at the conference along with other major players in the industry including Harvard Law School and the Islamic Development Bank.

"There is a lot of demand for our Ph.D and master degree programs in Islamic finance," Asutay told Arab News. He also disclosed the university’s plan to open a center for Islamic finance studies. "We provide short-term courses for employees of Islamic banks and other financial institutions. Last year we provided training to more than 40 people from different countries including Australia, Germany, Italy and Switzerland. Half of them were non-Muslims." Asutay said Islamic economics was making "impressive" progress over the past years. However, he emphasized the importance of developing authentic Islamic finance products to meet the needs of different societies.

"Islamic banking has to move from commercial banking to social and retail banking. It should also get involved in social issues such as environment protection." He called for concrete efforts to establish transparency.

Professor Mohamed Aslam Haneef of International Islamic University in Malaysia was one of the speakers yesterday. He called for the establishment of an international fund for research in Islamic economics. "Students of Islamic universities should become agents of change, not changed agents," Haneef said. "We should also chart a clear agenda for the future," he told the delegates who came from all over the world including the US, UK, Egypt, Pakistan, India, Indonesia, Malaysia, Australia and New Zealand.

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