Islamic Banking

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.