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Global Financial crises and its effect on Islamic Finance

July 23, 2012 in Uncategorized


The Islamic finance industry today offers a broad variety of products and services as well as corporate finance, project finance, equity funds, personal and wealth management, venture capital investment, real estate investment and private equity, mainly providing Islamic trade financing solutions. Structured in accordance with Shariah principles are all these products and services, as interpreted in their respective jurisdictions. The Shariah compliant capital markets products have gathered acceptance in the global market and are now shaping up into an attractive investment in market place. The demand for Shariah compliant securities has been high and is growing the supply side is also witnessing increasing activity.
The development of Shariah compliant securities “Sukuk” is one of the capital market products that have been developed to avoid the Islamic prohibition of Riba (interest). Sukuk (plural of Sak) mean certificates and papers with the features of liquidity, tradability and cash equivalence, while a conventional bond is a promise to repay a loan, Sukuk present partial ownership. They’re several types of Sukuk, Ijarah Sukuk, Mudarabah Sukuk, Istisna Sukuk, and Musharakah Sukuk

Islamic Perception of Money
Money is a social convention and was invented based on the need to facilitate socio-economic activities. Progress in business has transformed money, and it has evolved from its original basic functions to sophisticated modern applications. Money is an integral part of the financial system and has a fundamental effect on the whole system.

From the Islamic point of view, money should be observed as a medium of exchange and a standard of measurement. Money is consideration, not an object that can be traded or something that is expected to generate returns without economic activities. Money is neither a productive good nor consumption good. Therefore, if money needs to be exchanged with money, the Islamic injunction on trading ribawi material is applied. Such a transaction must take place with the condition that it is on spot basis and for an equal amount. Similar to conventional finance, in Islamic finance money exchanged with money on a deferred basis has become a norm, and the repayment of loaned money with additional

Islamic Debt Securities (Sukuk)
As far as the Islamic finance industry is concerned, Sukuk are not new. Since the early days of Islamic civilization the concept of Sukuk has been in use – in the first century Hijri (corresponding to the seventh century AD) the Umayyad government would pay soldiers and public servants both in cash and in kind. The payment in kind was in the form of Sukuk, which is commodity coupons or gain permits.

Sukuk re-emerged in Bahrain in 2001, almost fourteen centuries after they were first recorded, as an Islamic alternative to conventional debt securities. In the domestic market, the State of Bahrain offered Sukuk with an al-ijarah issue. The issue amount was US$250 million and had a tenor of five years. The Sukuk al-Ijara concept was derived from prevailing practices of “lease ending with purchase” (Ijara muntahiyah bi-tamlik) known in conventional finance as “financial lease”. The Sukuk carried six monthly lease rentals that were fixed at the lease inception and paid in arrears during the lease term. The Sukuk offering was highly successful. The Bahrain Sukuk issue was a major milestone in Islamic finance as it marked the birth of an Islamic capital market where Islamic equity and debt-based instruments are issued and traded.
Another landmark was initiated by Malaysia in 2002 when it issued the first Islamic securities that complied with US Regulation S and Rule 144A formats that are used for conventional global bonds. Prior to that in December 2001 Kumpulan Guthrie Berhad, a Malaysian public listed company involved in the plantation and construction sectors has offered a Sukuk al-Ijara. A number of successful Sukuk issues have followed, including the Islamic Development Bank’s offering of US$400 million Sukuk in 2003, the State of Qatar’s US$700 million Sukuk al-Ijara issue in 2003 and the Kingdom of Bahrain’s US$250 million Sukuk al-Ijara issue in 2004. In the Islamic finance markets these successful issues have created much excitement and more issuers looking for a viable and attractive alternative source of funds are considering the Sukuk option.

Features of Sukuk
A fundamental requirement of Shari’ah is that the security must reflect or evidence the security holder’s share in an underlying asset or enterprise, which must of course be Shari’ah compatible. On the basis that the security reflects the holder’s ownership of the underlying assets of the company, contemporary Shari’ah scholars have allowed investment in equity or share in a company. Through the ownership of the company, the shareholders are deemed to indirectly own the company’s assets.
A conventional bond typically confers on the bondholder a contractual right to receive from the issuer of the bond certain interest payments during the life of the bond and the principal amount at the maturity of the bond. Creditors to the issuer of the bond are the bondholders themselves and are ranked as senior unsecured and unsubordinated creditors of the issuer in priority to the shareholders.
Bonds vs. Sukuk
A bond is evidence of debt issued by the issuer or borrower to an investor or lender, an IOU with a promise to pay the debt or the financial obligation at the end of a specified period. It is also a debt instrument with fixed return (loan + interest), the obligation to pay the debt being evidenced by papers certificate called bonds or securities issued by the borrower or issuer; these certificates are tradable on the secondary market. Bonds are evidence of indebtedness only.
Sukuk provide evidence of financial obligation from the issuer to the Sukuk certificate owner of the underlying asset. It is an asset instrument whereby the issuer pays the value being evidenced by a paper certificate called a Suk, or securities issued by the issuer. This paper certificate is tradable on the secondary market. Sukuk are evidence of assets, not debit; therefore, Sukuk are wider and have higher value than bonds.

Global Financial Crises
The global financial crisis shook the international financial system around the globe, and its repercussions are still being felt globally. Owing to its severity it has been labeled as the worst crisis since the Great Depression. It is now, more than ever before, clear that the current financial system is not stable and that the invisible hand is not doing what its proponents claimed.

The prolonged period of “the great moderation”, together with runaway credit growth, paved the way for the current crisis. Easy money, uncontrolled growth of credit and debt, lax regulation and supervision, innovation of complex and opaque financial products, mismanagement of risks involved, lack of disclosure and transparency, predatory lending and high leverage – among other factors – are thought to be the main culprits behind the crisis The current global financial crisis brought Islamic financial industry (IFI) into the limelight as a possible alternative. However, IFI has not been totally immune to the crisis; it has been hit as well, although to a much more moderate extent. This may indicate a possible correlation between IFI and its conventional counterpart, as it lives under the same umbrella and is governed by the same rules of the game.

Being a niche industry, Islamic finance faces considerable challenges. The way the industry responds to these challenges will determine whether it will become “a significant alternative to the conventional system in global financial markets” (Karuvelil, 2000). Moreover, lack of an efficient legal framework and of standards and procedures, qualified manpower and effective government support exacerbate the risk exposures of IFI (Khorshid, 2009).
The limited impact of the global financial crisis on IFI, there are many lessons that should be learned from it, and commensurate steps must be taken within IFI in order to make it more resilient to similar shocks. One of the steps necessary for strengthening the resilience of Islamic finance, according to Bank Negara Malaysia is the assimilation of Shari’ah values in the realization of benefits to the relevant stakeholders.

Islamically for justice, fairness, cooperation and shared responsibility. Its goals go far beyond monetary indicators and growth as it promotes ethics, responsibility and market discipline (Aziz, 2008; Chapra, 2008). This is an opportune time for IFI to reduce reliance on debt-like products and move closer to equity-based, risk-sharing instruments. However, whatever choice is made by the industry, there is a need for an efficient regulatory and supervisory framework that will stay ahead of the market so as to prevent regulatory arbitrage from making significant inroads in the market (Aziz, 2008; Mirakhor and Krichene, 2009). An effective system of checks and balances has to be constructed that will help avoid making mistakes similar to those which led to the current crisis.

Social interest. Among the Islamic countries, Malaysia has had by far the greatest success in creating a flexible, innovative environment with the potential to provide both the incentive structure as well as the administrative apparatus to allow steps towards developing new risk-sharing instruments under an effective regulatory structure. The country’s courageous step of unifying the Shari’ah-ruling framework, as well as its long standing commitment to provision of human capital to IFI and its encouragement of innovation, gives it a leadership position that can serve to strengthen the progress of Islamic finance.

Islamic finance is a limited niche activity; while international financial markets are dominated by Riba based activity. There are significant pressures from international organisations such as the IMF and the WTO for Muslim countries to open up their financial markets to multinational banks. International rating agencies such as Moody’s and Standard and Poor classify Muslim government debt and rate commercial banks, and even some Islamic banks, which affects the terms on which they can conduct their business. The Basle based Bank for International Settlements has capital adequacy guidelines that pose significant challenges for Islamic banks and Islamic finance more generally.
Islamic finance has become a worldwide industry, with assets under management in accordance with the Shariah law valued at over $1.4 Trillion US Dollars. Within individual countries, especially in the Muslim world, Islamic finance plays a significant role, with the financial systems of countries such as Malaysia, Pakistan, Iran and the Sudan operating under the Shariah law. Other countries such as the Gulf States Islamic banking are playing an increasingly significant role, accounting for over 40 percent of deposits in Kuwait and Qatar. Bahrain has become a major regional center for Islamic finance. At the same time many major multinational banks including Citibank, HSBC, ABN-AMRO and Deutsche Bank are offering Islamic financial products, while in Malaysia a sophisticated market in Islamic securities has developed, and Bahrain is providing money management instruments that comply with the Shariah law.
The Muslim world was exploited in the 19th century and for much of the 20th century with the penetration of western capital, but in its early years, Islam itself promoted globalization through the transmission of its value system, a process that has been reinvigorated in recent decades. Contemporary globalization involves not merely freer trade and capital movements, but also the communication of ideas by new methods including the Internet. Indeed it is the advance in information and computer technologies that is one of the major forces driving globalization, which makes it possible for market participants and regulatory bodies to collect and process the information they need to measure, monitor and manage financial risk and to price and trade complex new financial instruments. Islam, and Islamic finance in particular, has a message to spread, and global networks are arising for this purpose. It is the spread of ideas rather than mere money that is the greatest challenge, but one that presents hope for Muslims.

To some extent these views of globalization may reflect disciplinary biases rather than different strands of Muslim thought, this in itself demonstrating the dynamic interaction of western ideas with modern Islamic scholarship. These ideas can be applied to Islamic finance, which facilitates the creation of Muslim wealth that can be used for social purposes.
The role of Islamic banks and financial institutions can be to enable this process. In contrast the hoarding of personal riches, even in Muslim countries, makes those that hoard subservient to and dependent on global secular capitalism with its corrupting influences. Capitalism without faith is corrupt but cannot generalize
Within international financial organisations there is considerable interest in Islamic banking, and it would be wrong to see those organisations associated with the “Washington consensus”, notably the IMF and World Bank, as being antagonistic to Islamic economic ideas. Indeed the IMF sponsored a study back in the 1980s on Islamic banking that was seen by many as an important contribution to the growing literature at that time, and a work that helped bring Islamic finance to the attention of a wider non-Muslim readership. At the macroeconomic level there has also been a willingness by the IMF to encourage investigation of how monetary policy can operate and debt management handled in compliance with Islamic principles.
The World Bank has long had close relations with the Islamic Development Bank and both organisations have co-funded projects in a number of Muslim countries. There are also a number of Muslims working for the World Bank who are enthusiastic about Islamic finance, and keen to point out the merits of such a system.
General Agreement on Trade in Services (GATS) and the opening up of domestic retail and investment banking markets from an Arab banking perspective, within the Islamic financial community only limited attention has been paid to the issues of international banking competition. The majority of middle and high-income Muslim states are World Trade Organisation (WTO) members, including Malaysia, Turkey, Egypt, Jordan, Tunisia, Morocco and five of the six GCC states. This membership not only has implications for trade, but for financial services through the GATS provisions for the opening up of markets for banking and insurance. In some Muslim states such as Egypt and Syria the banking system is largely state owned, while in other states, notably Kuwait and Saudi Arabia, there are limitations on the share that foreign institutions can hold in the ownership of local banks. Privatization of the state owned banks, and the removal of ownership restrictions is likely to result in the take-over of local banks by multinationals.
Muslim countries can open up their conventional banking sector under GATS while still protecting their Islamic finance sector using infant industry arguments. In the January 2002 Trade Policy Review of Pakistan, the review team noted Pakistan’s commitment to liberalisation under GATS in forty seven activities including banking, insurance, business and communications. Pakistan requested and received GATS exemptions under the most flavored nation clause (MFN) in financial services where there were reciprocity agreements and in Islamic financing transactions. This ruling by the WTO should help the position of Islamic banks in Pakistan, demonstrating that a sympathetic treatment of globalization issues can prove beneficial to those seeking to ensure Shariah compliant financing facilities are offered to potential Muslim clients.
As financial systems become more open, national discretion in the determination of interest rates is reduced, as if money flows freely, differentials in inter-bank rates between currencies will largely reflect exchange rate expectations in relation to a dominant currency, usually the United States dollar.
Most Muslim countries apart from the GCC member states maintain controls over capital movements and some payments restrictions for import transactions. IMF structural adjustment policy encourages member states to eliminate multiple exchange rates and float currencies so that an equilibrium currency rate can be determined in the foreign exchange market, potentially facilitating the reduction of external deficits. In practice the results of such policies have been mixed in the Muslim world, but in the longer term the dismantling of foreign exchange controls seems likely for most countries. This will create additional opportunities for Islamic banks to offer Murabaha trade financing facilities as well as leasing, Ijara, and project financing, Istisna. With foreign exchange liberalisation the pricing of Islamic financing products has to be internationally rather than simply nationally competitive.
The Basel Accords, the rating of Islamic banks and FSAP financial monitoring
Like conventional banks Islamic banks are not only regulated by the central banks of the countries in which they are based, but they are also potentially subject to the scrutiny of international monitoring agencies, notably the Bank of International Settlements (BIS) in Basel. National regulation by central banks is also subject to international inputs, an example of this being the IMF and World Bank intervention through the Financial Sector Assessment Program (FSAP), which was started as a response to some of the issues raised by the Asia financial crisis of 1997. The annual reports of Central Bank Governors of Asian countries such as Malaysia and Indonesia are monitored and disseminated by the BIS, including their reviews of Islamic banking developments. In addition there is also continuing assessment of both Islamic and conventional banks by other commercial financial institutions, a process facilitated by the work of the ratings agencies.
Although there is no obligation to adhere to the BIS minimum requirement of 8 percent of capital to risk weighted assets, Islamic banks that are seen as being adequately capitalized are more likely to have their trading instruments recognised, and can negotiate better terms for their assets which are managed by other banks. Capital therefore can be a constraint on Islamic bank growth, especially when the bank has been successful in rapidly building up its deposit base. Often it has taken longer for Islamic banks to identify profitable lending opportunities than build up their deposit base, which implies lower initial profitability. This may delay stock market quotation to increase the capital base, or where the bank is already a quoted company, it may preclude rights issues to raise additional capital.
The IFSB is to serve as an association of institutions that have responsibility for the regulation and supervision of the Islamic financial services industry. The aim is to set and disseminate standards and core principles as well as adapt existing, mainly AAOIFI, standards. Adoption of the standards will be voluntary, but banks and countries that adhere to the standards are likely to be more favorably rated. The IFSB is also responsible for liaison and cooperation with other standard setters, including central banks and security market regulators, in the area of monetary policy and financial stability, opening up the possibility of the adoption of Shariah law in this area for the first time. In addition the IFSB is responsible for the promotion of good practice in the area of risk management through research, training and technical assistance.
Standardisation of Islamic financial products can come about by adhering to international regulations, whether from secularist institutions such as the IMF or BIS or from designated Islamic international institutions such as the IDB, AAOIFI or the IFSB. It can also result from the interchange of ideas by national Islamic banks at international conferences, which encourages the spread of “best” practice. Even more influential in standardisation has been the emergence of major multinational banks and fund management groups as providers of Islamic financial products either directly to their own clients, or indirectly to those of the national Islamic banks. As HSBC Amanah Finance typifies this type of initiative by a major multinational bank, it is perhaps instructive to examine its experience.
Despite its size as the largest United Kingdom based bank, with a significant presence in many Muslim countries from the Middle East and the Gulf to Malaysia, HSBC was a relatively late entrant to Islamic finance. Banks such as Citicorp, ABN AMRO, Deutsche Bank and some of the British merchant banks were involved from the 1980s, but HSBC only established its Amanah Finance division in 1998. In its mission statement HSBC Amanah Finance stresses its respect for the sanctity of the Shariah, its professionalism, uncompromising integrity and strong customer focus. The aim is to build Amana’s reputation amongst Muslim clients of HSBC who already use its financial products and potential internal and external clients. Initially the emphasis has been on cross selling Amanah products to existing HSBC Muslim customers who use its conventional financing facilities, the internal clients, rather than reaching external clients of other banks through marketing and advertising the Islamic products. Direct cross selling is cheaper, and usually more effective given the captive nature of the market.
Credibility with Muslim communities internationally rather than within single countries is important for multinational banks such as HSBC. Reputations can be enhanced internationally by having Shariah committee members accountable who combine academic scholarship with practical work on the Shariah committee and understand Western economics system and Islamic economics.
Towards a pluralist international financial system
Far from being a threat to Islamic finance, globalization provides an opportunity. Islamic finance extends choice, and enables Muslims internationally to conduct their financial affairs in a manner that is consistent with their beliefs and values. Many non-Muslims are concerned with the ethics of how their money is utilized and their financing derived, hence the rise of the ethical finance industry encompassing some western banks and many mutual funds. Western and Eastern non-Muslim clients have shown their willingness to use Islamic financing when it is attractive. HSBC Amanah financing, for example, have found that 20 percent of their Malaysian clients are non-Muslim Chinese. Islamic finance adds value to the international financial system and encourages non-Muslims to think more seriously about debt issues, from the injury caused by lending sharks in the consumer loan market to the issue of developing country debt.
The challenge of globalization is both to regulation and to markets, with a widening in the remit of the former and in the breadth and depth of the latter. Islamic finance should not only be judged by its quantitative impact on global markets, which though increasing, remains small, but more importantly by the quality of the service and its effect on the perceptions and thinking of global financial players. Ultimately finance is more about values than the mere accumulation of money. Finance is also concerned with social responsibilities, including that of the wealthy towards the less fortunate in an often too selfish global economic order based on greed rather than economic justice.

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February 28, 2012 in Uncategorized

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